Nick Del Deo 2018-03-05 07:05:41
Something at the forefront of tower investors’ minds is the effect the risk of rising inflation and interest rates may have on share prices. These same worries cropped up in the wake of the 2016 election, but they subsided over the course of 2017 when those outcomes did not play out. In January, the interest rate of the U.S. 10-year Treasury note moved through 2.5 percent, and tower stocks reacted closely to its changes. Rising inflation and interest rates would not be good for tower operators, but there are important mitigating factors to consider that would mute any effect on the bottom line. The bear case holds that the tower companies are ill-equipped to handle an environment in which inflation rates rise. The key issue in the United States is that tower leases are overwhelmingly struck with fixed escalators (about 3 to 3.5 percent) rather than escalators linked to the consumer price index (CPI). Also, the contracts are long-term, which limits the tower companies’ ability to reset rates in response to macroeconomic changes. If inflation were to spike, real tower revenue growth would fall. Although this is absolutely correct, there are two important offsets to consider. First, the tower owners’ largest single expense, payments for ground leases, also overwhelmingly have fixed escalators, on average a hair lower than the increases they collect on the top line. Revenue wouldn’t stagnate while expenses shoot up uncontrollably. Second, amendment and new colocation pricing is not set in stone, but instead is negotiable. If things started to get hairy, the tower owners would have the pricing power to shift the customary terms a bit to make up for the increases in inflation. The companies could increase the applicable escalator, set a higher baseline amendment rate or use more CPI-linked terms. Of the roughly 7 percent gross growth the industry has been posting, 3 to 3.5 percent has stemmed from escalators and the balance from amendments and new collocations to the extent that steps up in the coming year or two, it will skew more toward amendments and collocations. A majority of revenue growth is thus coming from sources that aren’t entirely locked in. The difference between Treasury notes and Treasury inflation-protected security (TIPS) yields, which is a quick proxy for anticipated inflation, stands at about 2 percent, in line with realized CPI growth, exclusive of food and energy prices, over the past 15 years. Additional Caution Rising interest rates, which correlate with inflation, wouldn’t be good for the tower companies, either. They’ve managed in the past, however, maintaining multiples like what they sport today when the 10-year Treasury note rate was much higher. Granted, the companies were probably growing faster back then, but they generate more cash flow today with a business model that has been proved to be successful. Their debt maturity profiles are much more staggered, so it would take time to show up in adjusted funds from operations (AFFO), although the market could simply apply a lower multiple in the interim. Assuming the equity risk premium doesn’t shift, the weighted average cost of capital (WACC) would rise, and high-multiple stocks would mechanically get dinged more than low-multiple stocks, especially those with meaningful leverage, such as tower stocks. If one believes a big move up in rates is happening or is an underappreciated risk — more than what’s anticipated by the yield curve — exercising additional caution when assessing the attractiveness of the stocks would be entirely appropriate. “If things started to get hairy, the tower owners would have the pricing power to shift the customary terms a bit to make up for the increases in inflation.” If you’re interested in reading more on this subject, we published a report, “U.S. Towers: Macroeconomic Melancholia,” in November of 2016 that addresses these issues in depth, and it remains relevant today. Tower Companies ᴑ American Tower ᴑ Crown Castle International ᴑ SBA Communications Nick Del Deo is an analyst with MoffettNathanson. He covers American Tower (stock symbol: AMT), Crown Castle International (CCI), SBA Communications (SBAC), CenturyLink (CTL), Level 3 Communications (LVLT), Zayo Group (ZAYO) and Cogent Communications (CCOI). Visit www.moffettnathanson.com`.
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