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3G Means High Times for Towers

In the race to provide third-generation wireless services, operators of the towers housing the equipment stand to gain, says S&P's Ken Leon

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While wireless services stocks have retreated this year, one niche within the industry has stayed strong: wireless tower companies. The four publicly traded companies in this area—American Tower (AMT), SBA Communications (SBAC), Global Signal (GSL), and Crown Castle International (CCI)—have jumped an average of 29.6% so far this year (through Oct. 4), and are trading close to their 52-week highs. The shares got another boost from the Oct. 6 news that Crown Castle will acquire Global Signal for $5.8 billion, including debt, or $55.95 per Global Signal share.

The proposed Crown Castle deal to buy Global Signal, which would create the No. 1 tower company with more than 23,500 towers, slightly above American Tower, could spark more consolidation in the group. Leon says he thinks SBA Communications is a potential takeover target.

However, Leon cut his recommendation on Global Signal to hold from buy on Oct. 6 after the shares jumped 10% on the acquisition news. He raised his target price to $56, from $53, based on a projected 22.2 ratio of 2007 enterprise value to EBITDA, a slight premium to its wireless tower peers and matching Crown Castle's offer. "We see merger synergies for increasing average lease revenue per tower and widening margins with centralized billing and support services," Leon says. "Based on valuation, we would hold Global Signal shares, but not add to positions."

Wireless tower companies are essentially owners of land and equipment used by wireless services providers. They enter into long-term leases with wireless carriers wherein they also provide the maintenance of the equipment on site, which includes antennas, amplifiers, and base station equipment.

"The strategy of wireless tower companies is to secure long-term leases on their site properties, and to maximize the use of their tower capacity so that their towers accommodate multiple tenants, or wireless carriers," says Ken Leon, who follows wireless telecommunications stocks for Standard & Poor's Equity Research.

Growth opportunities for these companies continue to be in traditional voice services, and also the emerging growth of third-generation (3G) and broadband services, Leon says. "This group has a successful business model and predictable revenue and cash flow," he says.

BusinessWeek.com's Karyn McCormack recently spoke with Leon about why he's bullish on the group and what his favorite stocks are. Edited excerpts from their conversation follow.

Note: Ken Leon is a Standard & Poor's Equity Research analyst. He has no ownership interest in, or affiliation with, any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this story.

Why do you like the wireless tower industry?
Part of our investment thesis, which is positive on the wireless tower industry, is that new broadband services from existing customers, new available spectrum for wireless carriers, and new disruptive technologies such as WiMAX will spur growth for the wireless tower companies.

First, the introduction of 3G wireless services means operators such as Verizon (VZ) have to upgrade their networks. This requires greater capacity of the network, which includes the equipment on the tower sites. Also, broadband services stimulate increased voice and data traffic. This is all good for wireless tower companies because the carriers have to either expand their networks or capacity or launch new cell sites in partnership with the wireless tower companies.

The second opportunity is the FCC recently auctioned billions of dollars of radio frequency spectrum for advanced broadband services. Most of the spectrum was successfully won by the established nationwide carriers such as T-Mobile USA, Sprint Nextel (S), as well as Cingular and Verizon. In the case of T-Mobile, the auction gives them an opportunity to build new cell sites around the country where they do not have a network, and this will benefit the wireless tower companies.

Finally, the third area of growth in the U.S. market comes from new entrants that have secured spectrum to get into wireless or WiMAX. A good example is Clearwire, a privately held company founded by Craig McCaw, one of the pioneers of the cellular industry, which has raised over $1 billion from private investors that include Intel (INTC) and Motorola (MOT).

We believe Clearwire will also work with the wireless tower companies so it can focus on the end market and not have to focus on building their network. Outside of the U.S., wireless tower companies have invested in select markets in Latin America and elsewhere.

Are these companies profitable?
Some of them got big very quickly by acquiring most or all of their towers that were previously owned by Sprint Nextel and Cingular Wireless. They paid for the towers by getting loans from banks and other investors and financing through the public debt market. Many of these companies have high debt on their balance sheet, but they have high recurring revenues from the lease rentals with the carriers.

It means that most of these companies are not profitable today. But we believe investors focus more on the operating and free cash flow of these companies with the intent that they reduce their debt over a period of years and offer the shareholders and management of tower companies an attractive return on investment.

What could go wrong?
The biggest risk that we see is tower lease cancellations by the largest carriers. With potential lease cancellations, the wireless tower companies' ability to service their substantial indebtedness may be at risk. However, so far, tower lease cancellations have been less than 5% of the total towers in operation.

Potentially, the upgrade to 3G networks may create more efficient networks that may require fewer tower sites. Also, there's tower site redundancy that may arise from the recent combinations of Cingular Wireless, which acquired AT&T Wireless in 2004, and Sprint PCS and Nextel, which merged in August, 2005.

The final risk is the high customer concentration for most of their revenues with a few U.S. wireless service providers. For tower companies, 20% to 30% of their revenue might be from one customer.

How have these stocks performed?
The wireless tower stocks have been strong performers in both 2005 and 2006. S&P does not have an index for the group, but they are up sizably.

Which stocks do you like?
We cover the four publicly traded companies. The largest one is American Tower, which is a buy. American Tower has an SEC review of stock option compensation. The company recently said it would restate historical results, and they were mostly non-cash adjustments.

We have a strong buy opinion on SBA Communications. Based mostly on valuation, we have a hold on Crown Castle International. And we downgraded Global Signal to hold from buy, based on valuation, after it agreed to be acquired by Crown Castle.

Each of them has the same rhythm of the fundamentals we talked about.

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report.
Standard & Poor's Regulatory Disclosure

Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.

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