VZ - Crown Castle: An Activist Steps In To Reveal Significant Value

2023-11-28 18:49:22 ET

Summary

• Elliott Investment Management has acquired a 10% stake in Crown Castle Inc. and is pushing for significant changes in the company.
• Crown Castle has underperformed its peers in the telecommunications industry, according to Elliott Investment Management.
• The firm suggests that Crown Castle should sell or spin off its fiber and small cell operations, which are undervalued by the market.
• Doing so or making some other change could open the door to significant value for shareholders from here.

Many investors benefit from looking at the ideas of others. While I have done that from time to time, it is usually only done if I am having difficulty digesting a complicated scenario. Every so often, however, I find myself agreeing with a particular investor on a particular theme. But rarely has that occurred twice within the same year.

Earlier this year, I ended up writing some bullish articles regarding Goodyear Tire & Rubber ( GT ) after an activist firm, Elliott Investment Management , acquired a 10% stake in the company and came out with a stellar presentation detailing significant changes that management could make that would add value to shareholders moving forward. I found their analysis to be highly insightful and ended up acquiring some units myself.

Fast forward to today, and instead of finding myself drawn to a bullish prospect that they discovered, I am now seeing that they have been drawn to a company that I recently rated favorably . The firm in question is none other than telecommunications giant Crown Castle Inc. ( CCI ), a business that owns and operates telecommunications towers and other related assets. To be clear, this is not the first time that Elliott Investment Management has owned shares of the company. They initially bought around $1 billion worth of the stock back in 2020 and urged management to make some changes. But today, they are taking a much more active approach toward influencing the enterprise.

For years now, according to Elliott Investment Management, Crown Castle has underperformed its peers. And that is because of suboptimal investments that the company has made in small cells and fiber. During this time, rivals like American Tower ( AMT ) and SBA Communications ( SBAC ) have made investments in telecommunications towers in other countries and, in the case of American Tower, in data centers. And in its presentation , Elliott Investment Management sets forth a rather compelling argument as to why something needs to change. To be honest, I don't entirely agree with their assessment, even though their math is currently accurate. At a minimum, however, their argument does make clear that my decision earlier this year to rate the company a "strong buy" does make sense.

Big changes are demanded

As of this writing, Elliott Investment Management is a rather large player in the asset management space. The company has $59.2 billion in assets under management or AUM. But out of all of the different investment prospects that exist in the market, one of the firms that the company believes makes the most sense to bet on is Crown Castle. I say this because the firm has allocated over $2 billion, or 3.4%, of its assets under management toward buying up shares of Crown Castle.

Companies like Elliott Investment Management don’t make investments in other firms when things at those firms are going perfectly. As an activist investor, its goal is to step in when things are not going as well as they could. And, in doing so, they provide their own plan for how to create shareholder value. The idea is that if the leadership of those firms that they approach do listen to their guidance, the end result could be additional shareholder value for all parties involved.

When it comes to Crown Castle, Elliott Investment Management maintains that, since 2016, the company has failed to create meaningful value for its investors. In fact, they claim that Crown Castle has underperformed its direct peers by an average of 85% when it comes to total return. That translates to $26 billion in missed shareholder value. But the company doesn't stop there. Included with the letter was a 50-page presentation detailing what had gone wrong and what needed to be done to fix it.

My goal in writing this article is to not litigate every single point made by Elliott Investment Management. For that, I would recommend that you just read the presentation. But there are some important points in it that are definitely worth focusing on. The problems for Crown Castle began over the past several years as the tower industry in the U.S. market hit maturity. If you look at the three big players in the space, which would be the three I have already cited for this article, the number of towers spiked from about 53,000 in 2011 to 96,000 by 2015. From there, the number gradually increased until, in 2021, the number of towers plateaued at around 100,000. All of the players have experienced stagnation in this respect. But given that these are all REITs with assets that generate significant cash flows, the demand for growth from shareholders caused the companies to get innovative.

Each player has addressed these challenges in a slightly different way. For instance, SBA Communications decided to invest heavily into the international towers business. Today, about 27% of its revenue comes from overseas. American Tower, meanwhile, also focused a lot on international expansion, with 45% of its revenue now coming from towers that are overseas. However, the company also invested a tremendous amount of cash into data centers. The biggest investment it made in this regard involved its purchase of CoreSite, an owner and operator of 25 data centers and related assets, in a deal valued at $10.1 billion when we include net debt.

While all of this was going on, Crown Castle decided to allocate its capital toward fiber and small cell operations. This is a topic that I have written about previously and I would encourage you to read about it here . Personally, I view the small cell business as being particularly attractive in the long run. As data usage skyrockets, there's a real chance of existing telecommunications infrastructure in densely populated areas becoming overburdened. Small cells essentially add capacity without adding large and expensive towers. But this is an initiative all on its own. Elliot Investment Management has estimated that, over the years, Crown Castle has invested about $19.1 billion into fiber assets. Unfortunately, the market has not been terribly enthusiastic about these initiatives.

Using data from 2022, the fiber assets owned by Crown Castle generate around $1.2 billion worth of EBITDA. This represents an increase of only about $200 million compared to what was seen in 2020. And yet, from 2020 through 2022, Crown Castle invested around $3 billion into capital expenditures related to its fiber initiatives. Using data for the most recent 12-month window, Elliott Investment Management estimates that the effective ROIC (return on invested capital) for fiber assets has only been around 5.8%. They assert that this is only slightly above the risk-free rate. That is true. But they also made the claim that this is substantially lower than the 7.3% cost of capital for Crown Castle as a whole. While I accept that the low return figures are accurate, there truly is no such a thing as a measurable cost of capital. But that is a minor quibble that I have with an analysis that is otherwise well thought out.

On the small cell side of the equation, management pointed out that growth in this industry has fallen far short of what analysts anticipated. Back in June of 2023, Verizon Communications ( VZ ) made the claim that there are around 40,000 small cell nodes currently launched in the U.S. market. And growth from this point on should only be between 3 thousand and 5 thousand each year. If this is true, it would fall far short of the 800,000 nodes that the management team at Crown Castle estimated would be deployed by the end of 2026.

The end result has been significant amounts of capital that the company has underutilized. For instance, cumulative dividends paid out by Crown Castle since its inception currently stand at $40.76 per share. That number would be about 20% higher, or $48.77 per share, had these fiber investments not been made. For 2024, Crown Castle anticipates generating free cash flow of $1.5 billion. Assuming that management still intends to pay out $2.7 billion of dividends, this will result in a $1.4 billion shortfall that has been driven by an identical amount of capital expenditures dedicated to the company's fiber operations.

The market has not been silent on this matter. Elliott Investment Management has even gotten so far as to calculate that during the 1,884 days that Jay Brown has been Crown Castle’s CEO, during only 7 of those days did shares of Crown Castle outperform rival SBA Communications. That number drops to 3 if we compare the company's performance to the performance achieved by American Tower.

To be perfectly clear with you, I recognize that Elliott Investment Management has been correct when it comes to the total return that shareholders of Crown Castle have received and how that return has fallen short compared to what shareholders and the other two competitors have seen. But this does not necessarily mean that Crown Castle is a bad company in and of itself. In a previous article , I compared the firm to American Tower. My objective here is not to rehash all of the details from that article. What I did recognize, however, were two things.

First, American Tower was successful in achieving more rapid growth in revenue, profits, and cash flows. This makes sense when you consider the divergent paths it and Crown Castle have taken. Second, even though the company was growing at a more rapid pace, its profit margins were, with only one exception, lower than what Crown Castle had demonstrated. For the purpose of this article, I recreated that chart to reflect margins for SBA Communications as well. It has outperformed both American Tower and Crown Castle, the latter of which it has beaten using four of the six margins I used.

There is a bit of a trade-off here. In that article, I calculated that Crown Castle and American Tower had similar amounts of net leverage, while Crown Castle was trading at a substantial discount to its peers. SBA Communications and American Tower, however, are substantially more expensive than Crown Castle. As for leverage, SBA Communications is the riskier of the firms at this time. We also should not forget that while it is true that Crown Castle has underperformed both of its rivals, this year has not been particularly pleasant for any of them. Shares of American Tower are currently down 6.3% year to date. This is far better than the 22.5% decline seen by Crown Castle. However, SBA Communications is not far off from our main prospect with a decline of 15.7%.

The fact of the matter is that a high cost of borrowing, spurred by tighter credit markets and higher interest rates, has made growth more challenging. Add on top of this the fact that high interest rates also make investments that pay out distributions less appealing, and it's not a surprise to see some weakness in this market this year.

As for what the future holds, the management team at Elliott Investment Management believes that significant changes can lead to significant upside. One such change might involve the sale or spinning off of Crown Castle’s fiber and small cell operations. Other sorts of transactions might make sense, as might the decision to bring on strategic investors. As for what kind of upside, that is really anybody's guess. I do know, however, that the management team at Elliott Investment Management performed the analysis below. In it, you can see that the implied enterprise value associated with the company’s fiber operations is only $941 million despite generating $1.01 billion in EBITDA over the last 12 months.

To me, this is a sign of just how undervalued the company as a whole is. In essence, there is no true value assigned to the fiber operations when you factor in all of that EBITDA.

Takeaway

Even though the fiber assets owned by Crown Castle are only being valued by the market at $941 million, that is an absurd valuation for an asset that's generating $1.01 billion worth of EBITDA. At the same time, it's probably impossible to guess exactly what those assets might be worth to some other player or as a standalone enterprise. This is because of how tied up they are with Crown Castle’s core assets. And naturally, the nature of the relationship between Crown Castle and the buyer would also play a role in determining the value of the assets.

But I have to imagine that they would be worth at least 7 to 10 times EBITDA. At the low end, that would imply upside for shareholders of Crown Castle of 15.7%, while at the high end, we would be looking at upside of 22.5%. Just prior to the publication of this article, a third-party report came out indicating that the fiber operations of Crown Castle might be worth as much as $15 billion. If so, that would translate to a gain of 33.4% for shareholders.

Add on top of this the enthusiasm that investors would likely get from a major change that would result in different investments moving forward and/or a commitment to pay out even more in cash to shareholders, and it's not difficult to imagine a scenario where any sort of action by the Board of Directors would yield significant upside for current Crown Castle Inc. investors.

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