SEVN - Cell Tower REITs: 5G's Killer App

2023-03-29 10:00:00 ET

Summary

• Cell Tower REITs have been one of the weakest-performing property sectors since early 2022, an uncharacteristic stretch of poor performance following a half-decade of industry-leading returns.
• Concern over the long-term competitive positioning of land-based cellular networks in the ever-evolving telecommunications industry has been amplified by the accelerated rollout of satellite-based networks offering some mobile connectivity.
• Low-Earth-Orbit ("LEO") satellite-based networks are an improvement over older geostationary technology, but there remain unavoidable physical and technical limitations that will limit its use-case to niche applications that lack better options.
• 5G has found its "killer app." Fixed Wireless Access ("FWA") - home broadband provided by carriers through cellular networks - is for real. Roughly 90% of net broadband subscribers added in 2022 are using FWA, taking share from traditional wireline and satellite services.
• Legacy cable providers have responded by expanding their own cell service offerings - in some cases becoming tenants themselves on macro towers and small-cells, a dynamic that we believe further solidifies the competitive positioning of cell tower REITs for at least the next decade.

REIT Rankings: Cell Towers

This is an abridged version of the full report and rankings published on Hoya Capital Income Builder Marketplace on March 26th.

Historically one of the primary growth engines of the real estate industry, Cell Tower REITs have been one of the weakest-performing property sectors since early 2022, an uncharacteristic stretch of poor performance driven by concern over the long-term competitive positioning of land-based cellular networks in the ever-evolving telecommunications industry - concerns that we believe is significantly "over-discounted" in current valuations. Within the Hoya Capital Cell Tower REIT Index, we track the three Cell Tower REITs which account for roughly $175 billion in market value: American Tower (AMT), Crown Castle ( CCI ), SBA Communications ( SBAC ). The three cell tower REITs employ slightly different strategies: AMT and SBAC focus primarily on macro towers, but each has a significant international presence. CCI focuses exclusively on the United States, but has a significant small-cell business to complement its macro tower portfolio. We also track Uniti Group ( UNIT ), which owns a fiber-optic cable network that connects digital communications infrastructure.

Cell tower REITs comprise 15% of the market capitalization of the REIT sector - the single-largest real estate property sector weight. Cell Tower REITs' relative dominance over the real estate sector is dwarfed by its even more impressive dominance over the telecommunications sector, as these REITs control nearly 75% of wireless communication infrastructure in the U.S. and more than 50% in several major international markets. These REITs are the landlords to the four nationwide cellular network operators in the U.S.: AT&T ( T ), Verizon ( VZ ), T-Mobile ( TMUS ), and DISH Network ( DISH ), and own 50-80% of the roughly 140k macro cell towers in the United States and a significant share of multi-tenant "small cell" infrastructure. Six additional companies own portfolios of at least 2,000 towers, including DigitalBridge ( DBRG ), U.S. Cellular ( USM ), and private equity firms Peppertree Capital, Diamond Communications, Palistar Capital, and Tillman Infrastructure.

The major carriers sold most of their tower assets to these REITs over the past two decades to de-lever their balance sheets and simplify their business strategies, including AT&T's sale of nearly 10k towers to Crown Castle in 2013 and Verizon sale of 11k towers to American Tower in 2015. Supply growth is almost non-existent in the US, as there are significant barriers to entry through the local permitting process and due to the economics of colocation versus building single-tenant towers. The relative scarcity of cell towers, combined with the absolute necessity of these towers for cell networks, has given these REITs substantial pricing power even as the number of potential tenants has dwindled down from over a dozen regional carriers to just four national carriers over the last two decades. Competitive advantages are rarely "permanent" in the ever-evolving telecommunications industry, but recent dynamics have further solidified the favorable positioning of cell tower REITs.

This commanding competitive positioning has given these REITs substantial pricing power amid the roll-out of 3G, 4G, and 5G wireless networks, which has translated into enviable shareholder returns. While 4G networks gave us the "streaming" and "e-commerce" age, pioneered by Amazon ( AMZN ) and apps like Uber ( UBER ) and Spotify ( SPOT ), 5G networks are expected to spur a new wave of technological innovation fueled by "fiber-like" speeds and ultra-low latency over wireless nodes. 5G adoption in mobile devices has been propelled by the success of Apple's ( AAPL ) lineup of 5G iPhones. Nearly 60% of smartphones in the U.S. now have 5G capability, and as we'll discuss throughout this report, we continue to believe that home wireless broadband - called "Fixed Wireless Access" or "FWA" in the industry - is the true "killer app" of 5G and will significantly disrupt the traditional wireline broadband industry.

Competition From Above? Satellite Concern

The recent sell-off has come amid concerns over emerging - and potentially competing - satellite technologies, which came to a head when Apple launched its new iPhone lineup that is capable of sending "emergency" text messages over satellite networks - the first satellite-based connectivity offered in a mainstream consumer cell phone. Several carriers have subsequently announced partnerships with Low Earth Orbit satellite services, including a deal between T-Mobile and SpaceX's Starlink to develop sat-to-cell service utilizing its next-generation satellites, which could theoretically provide 2G/3G-like broadband speeds. AT&T, meanwhile, has partnered with AST SpaceMobile ( ASTS ) to provide emergency satellite-based connectivity for FirstNet, the company's public safety network, and plans to launch a consumer application that would incorporate satellite connectivity. Verizon has recently teamed-up with Amazon's yet-to-be-launched Project Kuiper program with an initial focus on providing backhaul to connect rural cell tower equipment.

Satellite internet has been around for decades through providers including EchoStar's ( SATS ) HughesNet and Viasat ( VSAT ) that use geostationary satellites that are roughly 20k miles from earth, but LEO systems can theoretically provide broadband-like speeds through "constellations" of satellites that are several hundred miles above Earth. Starlink - which has already deployed roughly 3,000 LEO satellites and recently surpassed 1M subscribers - is one of a handful of companies working on LEO broadband and related technologies. LEO networks are an improvement over older geostationary technology, but there remain unavoidable physical and technical limitations - including its high power consumption, higher latency, and line-of-sight requirements that will limit its use-case to niche applications that lack better options. We see a higher likelihood that LEO networks will be customers or perhaps partners rather than competitors to tower REITs with satellite networks providing backhaul connectivity between towers while ground-based 5G networks facilitate the "last-mile" connectivity.

Fixed-Wireless Access Is 5G's 'Killer App'

Awed by impressive rocket launches, we believe the market has overlooked a more meaningful industry dynamic that has played out over the last several quarters - the accelerated rollout of fixed wireless access ("FWA") - which has further solidified the competitive positioning of land-based wireless networks - a market that is effectively "cornered" by the three cell tower REITs. We've long-viewed FWA - home broadband provided by cell carriers through mobile networks - as the true "killer app" of 5G wireless networks. Using a mix of traditional 4G LTE served from macro towers - and increasingly by small-cell 5G notes - wireless carriers are now competing directly with "wired" home internet providers with comparable speed and service offering - without the service appointments for "last mile" wiring into the home.

Verizon and T-Mobile reported an impressive haul of 3.5 million new FWA subscribers in 2022, representing 90% of total broadband additions for the year - growth that is coming largely at the expense of traditional cable operators and in areas where these "wireline" operators were previously the "only game in town" for high-speed internet. Interestingly, the "counterpunch" strategy used by Comcast ( CMCSA ), Charter ( CHTR ), and Altice ( ATUS ) is to get into the wireless carrier business themselves, offering bundled wireless services options at steep discounts to existing subscribers. While these "mobile virtual network operators" ( MVNO ) networks have traditionally "rented" capacity from existing cell carriers, these carriers are incentivized to offload capacity from high-cost third-party networks onto first-party networks. Comcast recently begun deploying their own 5G radios on cell towers while Charter is currently running tests on 5G networks in one market, opening the door to the dynamic that these wireline cable operators will increasingly become more active "customers" of cell tower REITs.

Speaking of potential new customers, the past year also saw the launch of DISH Network's 5G service. DISH - which acquired Boost Mobile as part of the T-Mobile/Sprint merger - plans to compete as a low-cost provider by leveraging its existing satellite subscriber base and its network sharing agreement with T-Mobile and AT&T to provide immediate nationwide services as it deploys its 5G network. As of December 31, 2022, DISH reported that it has started construction on over 15,000 5G sites that, if completed, will be capable of providing broadband coverage to over 60% of the US population. Given the industry skepticism over DISH's viability, any level of success is incremental for tower REITs and not "baked in" to the numbers or guidance. The 5G "arms race" between these traditional cell carriers - and the new entrants - has driven record levels of leasing activity over the past 24 months, an "arms race" that is expected to continue over the next several years regardless of the macroeconomic environment.

Cell Tower REIT Earnings Analysis

As discussed in our REIT Earnings Recap , investors were expecting more from the perennially-outperforming cell tower REIT sector, where lukewarm guidance calling for muted FFO growth in 2023 has done little to reverse the recent downward pressure. Variable rate debt headwinds and international exposure has been the primary focus as FX impacts from U.S. dollar strength have hit the sector particularly hard despite reporting full-year 2022 results that exceeded their prior guidance. The more domestic-focused Crown Castle has been the better-performer this year after beating its prior 2022 guidance and maintaining its outlook for full-year 2023 which calls for revenue and FFO growth of roughly 3.0%. CCI noted that near-term headwinds from higher interest rates and the effects of the Sprint churn would partially offset projected organic revenue growth of 6.8%.

Meanwhile, American Tower has lagged after beating its prior revenue and FFO guidance for 2022, but providing soft initial guidance calling for a 1.6% decline in FFO at the midpoint of its 2023 range as higher interest expense is expected to offset an otherwise strong year of domestic property-level growth. AMT commented that its "absorbing about 8% headwind from financing costs in our guide for 2023, probably 6% of that is from floating rate debt." SBA Communications has been the weakest performer of the three cell tower REITs this year despite posting significant beats on its 2022 full-year revenue and FFO results, but provided similarly mixed guidance pointing to soft leasing activity in its international markets. SBAC has also been pressured by news that its president and CEO, Jeff Stoops, will retire at the end of 2023 and will be succeeded by CFO Brendan Cavanagh.

Small-cap Uniti Group, meanwhile, has been a notable victim of higher interest rates despite its relatively steady property-level performance, projecting an earnings hit to its full-year FFO of over 20% from incremental interest expense and from dilution from share offerings that were needed to hedge some of its variable rate exposure. UNIT has been slammed over the past year due to this debt-heavy balance sheet, dipping more than 70% since mid-2022. With the exception of UNIT, the other three cell tower REITs operate with fairly conservative balance sheets with overall leverage-levels that roughly match the REIT average with average Debt Ratios in the low-30% range. AMT and CCI do, however, utilize a slightly higher degree of variable rate debt than their peers with average variable rate ratios (Variable Debt/Enterprise Value) at 6% and 4%, respectively. AMT has been active in the capital markets this year to fix some of this variable rate debt with about $3B in fixed rate debt offerings - a $1.5B unsecured bond offering in February and through a new $1.3B unsecured mortgage loan in March.

The rate-driven moderation in FFO growth hides the underlying reacceleration in property-level "organic" growth seen across the sector. Due to the effects of churn related to the T-Mobile/Sprint merger, this "same-store" growth slowed from 2020-2022 to an average of 3.7% - the weakest since 2014 - but these REITs forecast an acceleration in 2023 back to an average of 5.0%. AMT expects 5% organic "same-store" tenant billings growth in the U.S. - an acceleration from the 1% growth in 2022 as the headwinds from the Sprint merger subside. CCI expects organic growth of 6.8% consisting of 5% from towers, approximately 25% from small cells, and approximately 5% from fiber solutions. SBAC expects organic growth of 3.2% in the U.S., which reflects the delay of some of the Sprint-related churn from 2022 into 2023.

Cell Tower REIT External Growth

After a busy few years of M&A activity from mid-2021 through mid-2022, Cell Tower REITs have been quieter on the acquisitions-front over the past several quarters. Major deals during that period included American Tower's $3.5B deal to acquire InSite Wireless which owns 3,000 communications sites in the U.S. and Canada and an $9.4B deal to acquire Telxius Towers, which owns 31,000 sites across Europe and South America. The major deal during this period was AMT's acquisition of data center REIT CoreSite for $10B - a portfolio that consists of 27 data centers in 10 U.S. markets. Strategically-located network-dense data centers have been a recent focus for cell tower REITs amid a push to build out "Edge" network capabilities - the concept that many cell tower sites will soon be hosting "mini data centers" on the "edge" of communications networks in order to reduce latency for ultra-time-sensitive applications like self-driving vehicles. Crown Castle , meanwhile, has been quiet on the M&A front since its deal in 2017 to acquire Lightower for $7.1B while SBA Communications has also been fairly quiet apart from several smaller portfolio deals in Latin America.

While acquisitions have historically been the external growth engines of the sector, both firms have focused recent efforts on internal ground-up site development. AMT provided insightful commentary on this focus: "We're having a tough time making the math work on M&A. We are focused on deleveraging. But being able to continue to deploy [into development] at a time where we might not find M&A to make financial sense, the ability to build scale through an accretive internal organic CapEx pipeline, building, call it, 4,000 sites a year... these are all really attractive opportunities." CCI provided updates to its plans for small-cell deployment, noting that it expects to double the rate of new small cells in its portfolio in 2023, noting that small-cell co-location is expected to be the driving force behind the faster roll-outs.

Cell Tower REIT Stock Performance

As noted above, Cell Tower REITs have been one of the weakest-performing property sectors since early 2022, an uncharacteristic stretch of poor performance following a half-decade of industry-leading returns. The Hoya Capital Cell Tower REIT Index dipped 29% in 2022, underperforming the broad-based Vanguard Real Estate ETF ( VNQ ), which declined by 25%. Through the first quarter of 2023, Cell Tower REITs are lower by another 9%, lagging the 5% decline from the broader REIT Index.

The two-year stretch of underperformance follows a streak of six-straight years of outperformance from 2015 through 2020, which was the second-longest streak in REIT sector history behind the nine-straight years of outperformance from the Manufactured Housing REIT sector from 2013-2021. Despite this weak recent performance, Cell Tower REITs have still delivered total returns of 8.1%, which are double that of the broader REIT Index (4.2%) over the past five years. Over the past five years, SBAC has delivered the highest average annual total return at 9.4%, followed by AMT at 8.9% and CCI at 7.5%. UNIT has been a laggard over the past half-decade.

Cell Tower REIT Dividend Yields

Cell Tower REITs pay an average dividend yield of 3.7%, below the market-cap-weighted REIT sector average of roughly 4.1%, but have been among the leaders in dividend growth throughout their history. Cell towers were one of the few property sectors that were untouched by the wave of dividend cuts and suspensions that hit the REIT sector in 2020 and have delivered robust annual dividend growth averaging over 7% over the past five years. Cell Tower REITs retain roughly half of their free cash flow, leaving ample free cash flow for external growth and additional dividend growth.

Among the three larger cell tower REITs, we note that only Crown Castle acts like a "typical REIT" when it comes to distributions, paying a relatively healthy 4.9% dividend yield, which is roughly 80% of its available cash flow. American Tower , meanwhile, pays a relatively lower 3.2% yield, while SBA Communications pays a yield of roughly 1.3%. Uniti Group pays a yield of 17.1%, but has lagged behind its peers when it comes to dividend growth and its debt-heavy balance sheet has prompted calls from analysts in recent quarters to focus on debt reduction through a dividend reduction.

Takeaways: Tech Wreck Opportunity

Concern over the long-term competitive positioning of land-based cellular networks in the ever-evolving telecommunications industry has been amplified by the accelerated rollout of satellite-based networks offering some mobile connectivity. Low-Earth-Orbit ("LEO") satellite-based networks are an improvement over older geostationary technology, but there remain unavoidable physical and technical limitations that will limit its use-case to niche applications that lack better options. 5G has found its "killer app." Fixed Wireless Access ("FWA") - home broadband provided by carriers through cellular networks - is for real. Roughly 90% of net broadband subscribers added in 2022 are using FWA, taking share from traditional wireline and satellite services. Legacy cable providers have responded by expanding their own cell service offerings - in some cases becoming tenants themselves on macro towers and small-cells, a dynamic that we believe further solidifies the competitive positioning of cell tower REITs for at least the next decade.

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