US Tower Stock: Expansion and Leverage in Brief (NYSE: AMT)

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Thesis

American Tower Society (NYSE: AMT), a real estate investment trust (“REIT”), continued its robust growth in the first quarter of 2022 (reported on April 27, 2022. It posted strong double-digit real estate revenues, with particularly rapid expansion in Europe due to the recent acquisitions. the number increased by approximately 3.7 times in Europe compared to last year and revenues increased by approximately 4 times.

Such growth, however, came at a price: leverage. Along with its robust growth, its long-term debt has ballooned in tandem, from less than $10 billion a decade ago to $43 billion now. The net leverage ratio sits at a relatively high 6.4x, and management stresses the need to deleverage in the 3x to 5x range over the next few years. Although I’m not too worried. I think it’s manageable when you look at it in terms of interest coverage ratio or leverage ratio. Its current interest coverage of 4.2x is actually close to the highest level in a decade. And its current leverage ratio of 0.37 is fully within the historical range.

The valuation is about fair, perhaps with a slight premium of around 5%. The EV/EBITDA ratio is currently 25.3x, around 5% above the historical average of 24.1x. You can expect a solid total return over the next few years (say three to five years) in the upper single-digit range (say 8.5% to 10%). These returns would come mainly from organic growth and not from the expansion of valuations.

Rapid expansion

With strong centuries-old support and efficient business operation, AMT has experienced robust growth over the past. As you can see from the following charts, net income and revenue grew at double digit rates. Dividends have grown at a spectacular rate of 20% over the past decade, funds from operations (“FFO”) by almost 15% and adjusted EBITDA by around 14.5%.

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Against such a broad backdrop, the company just announced another year of strong growth on its Q1 2022 earnings conference call (reported April 27, 2022). Adjusted EBITDA increased 12.8% year-on-year and 13.5% after adjusting for currency fluctuations. AFFO increased by 6.1%, or 6.7% when currency effects are adjusted. In terms of tower sites, the company’s wireless tower network has grown significantly. The number of its towers has increased to 220,000 from around 185,000 a year ago, representing an annual growth rate of 19%. Operations in Europe and Africa have experienced truly exponential growth. Thanks to the recent acquisition, its number of turns increased by approximately 3.7x in one year in Europe (from 5.3k to 19.8k) and by approximately 7.3x in Africa (from 30k to 22k). Such rapid expansion has led to a 4x increase in revenue in Europe.

Going forward, there is more growth to come given our ever-increasing appetite for more data. The rise of 5G will provide another wave of rapid expansion. And management is very confident to capitalize on such a centuries-old trend, as CEO Tom Bartlett commented (emphasis added by me):

We are off to a strong start in 2022 with organic tenant billing growth accelerating sequentially in each of our reported segments. 5G is gaining momentum in the United States and Europe today, as 4G coverage and densification initiatives continue to grow in early stage markets, and it is clear to us that macro towers will continue to be critical infrastructure for investments in carrier networks over the next decade and beyond. We believe our the global footprint of distributed communications real estate is well positioned to capture the benefits emerging technology trends, ultimately leading to what we hope will be an extended period of strong global growth and attractive returns for our shareholders.

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AMT First Quarter 2022 Earnings Report

Extended leverage

A price AMT paid for the rapid expansion above was increased leverage and a stretched balance sheet. As you can see in the following chart, long-term debt has grown from less than $10 billion at the start of the decade to over $43 billion today, an increase of more than 4.3 times . For the last quarter alone, long-term debt has increased by 21% year-on-year. Even though high leverage is common for tower companies. However, in the case of AMT, its leverage is at the larger end of the spectrum, management has been emphasizing a deleveraging plan in the near future. As CFO Rod Smith commented (emphasis added by me):

Finally, with respect to balance sheet management, following our recent issuance of senior unsecured notes, which I highlighted earlier, and pro forma for the execution of our equity financing, we will have issued a significant balance of our floating rate debt and we expect to bring our net leverage into the upper 5x range, with a clear path to return to our target range 3-5 times over the next two years.

To put that into context, currently its net leverage ratio (net debt divided by adjusted EBITDA) is around 6.4x. And the senior unsecured notes Smith mentioned were $1.3 billion issued by the company just after the end of the first quarter.

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Although I wouldn’t be too concerned about leverage myself. I think it’s manageable when put in the perspective of AMT’s strong profitability and strong business fundamentals. One way to appreciate this is illustrated in the top panel of the following table. This chart shows interest coverage calculated as EBIT revenue divided by interest expense. As you can see, its interest coverage has fluctuated between 2.3x and 4.4x over the past decade, averaging around 3.0x. And currently, 4.2x interest coverage is at the higher end of the spectrum, in fact near the maximum level in a decade.

Furthermore, its debt ratio, as shown in the bottom panel, is also within a very reasonable range. Its leverage ratio has fluctuated between 0.22x and around 0.46x over the past decade, with a long-term average of 0.33x. And its current level of 0.37x is only slightly above the historical average. The majority of its capital comes from equity (about 63%), and debt is only a minority. Given the strength of its business and the strength of stock prices, the cost of raising equity would be relatively low and able to offset the concern over rising borrowing rates.

Finally, AMT expects a significantly higher operating margin (around 370 basis points) in the near future to help it better manage its debt. As CFO Rod Smith commented (emphasis added by me):

As a result, we were able to continue to expand the significant operating leverage inherent in the tower’s business model. Halfway through our 2022 outlook, we expect an operating profit margin of 78.8%, representing an expansion of 370 basis points in the segment over the past five years, even absorbing the significant impacts of Sprint churn more recently.

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Valuation and expected return

The company is slightly overvalued compared to its historical standard as you can see on the following chart. Given the higher leverage mentioned above, I think a leverage-adjusted valuation metric like the EV/EBITDA ratio would be more meaningful. As you can see from the top panel of the chart, its EV/EBITDA ratio is currently 25.3x, about 5% above the historical average of 24.1x.

Given the slight overvaluation, projected returns would come primarily from organic growth and not from valuation expansion over the next few years (say three to five years). MY’s projected growth rate would be, conservatively, in the upper double-digit range (say 8.5% to 10%). And therefore, the expected annual return would also fall within this same range.

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Final thoughts and risks

Thanks to the combination of strong secular support, scale and an efficient business model, AMT has posted robust double-digit growth. Dividends have increased at a rate of 20% over the last ten years and FFOs at nearly 15%. Looking ahead, I anticipate this healthy growth to continue, and the rise of 5G provides an immediate catalyst. I see a conservative growth rate in the upper double digit range (say 8.5% to 10%) over the next 3-5 years, leading to a total annual return in that same range.

In terms of risk, its balance sheet is stretched. The price AMT paid for its rapid expansion was a 4.3x increase in debt over the past 10 years. Long-term debt stands at $43 billion today, compared to less than $10 billion a decade ago. The net leverage ratio stands at a relatively high level of 6.4x. Despite its strong fundamentals, such large debt securities could hamper its ability to invest and limit its flexibility in capital allocation.

Another risk is foreign exchange, which negatively impacted its earnings by around 0.6% in the last quarter due to the strengthening dollar. The Company’s outlook is based on average exchange rates in April 2022. The dollar may strengthen further in the near future. And exchange rates create headwinds when AMT reports earnings in dollars.

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