Crown Castle operates 40.1k towers, 80k route miles of fiber supporting more than 70k small cell networks, entirely based in the United States. Elliott Management is an activist hedge fund investor with $41bn of assets under management and 161 investment professionals, throughout New York, London, Hong Kong, and Tokyo.
Elliott Management took a $1bn economic interest in Crown Castle and released a presentation and letter at reclaimingthecrown.com. Elliott is targeting Crown Castle’s capital allocation strategy, after first approaching the company privately with its plan in May 2020.
Specifically, the report recommends that Crown Castle management reduce its aggressive investments in fiber and small cells going forward. Instead, a new focus on Return on Invested Capital (ROIC), a significant increase to its dividend, and refresh of its board of directors is recommended by Elliott. These measures are intended to reduce a large valuation discount that Crown Castle trades at relative to its publicly-traded peers. Specifically, American Tower (NYSE: AMT) and SBA Communications (NASDAQ: SBAC).
Crown Castle Overview
Crown Castle’s business comprises three of the four main verticals of digital infrastructure including towers, fiber, and small cells. Each of these categories of digital infrastructure is helping to facilitate the roll-out of 5G technology. Consumer wireless devices, including smartphones, laptops, tablets, and wearables are becoming more bandwidth-intensive. At the same time, carriers in the United States, including AT&T, Verizon, and T-Mobile, are among the first in the world to offer commercial 5G mobile cellular communications services to support this growth.
Crown Castle provides the digital infrastructure for these carriers to continue to focus on improving network quality and expand capacity. The company is doing this through 5G initiatives, by utilizing a combination of towers, fiber, and small cells. To meet the higher capacity and lower latency demands of a 5G network, the investment and density of digital infrastructure assets will need to increase.
Crown Castle’s revenue is divided into four main segments. Towers contribute 60% of revenue, fiber comprises 22%, small cells make-up 9.5% and “site development services” add the remaining 8.5%.
Comparison of Business Models
Fiber, which has a higher capital intensity and customer churn rate, has a lower return profile relative to Towers. However, the Small Cell business, which is core to Crown Castle’s underwriting of Fiber investments, is still minor in terms of revenue contribution at only 9.5% of total revenue.
Fiber and Small Cells have upside optionality over the long-term, especially as this asset will become more integral in a 5G world, as demand for 5G increases. At the same time, Fiber and Small Cells offer less stability given their lack of rental escalators. Specifically, fiber lease contracts typically have no rental escalators and small cells have only 1.5% rental escalators per year. This compares to the towers business model which has rental escalators of 3% per year.
In terms of churn, enterprise fiber experiences heightened levels of 6% to 9% per year. This compares to towers churn at only 2% to 3% per year. Regarding tenancy, small cells currently average only 1 to 2 tenants per node, which is lower than towers at an average of 2+ tenants in the United States. Further, towers have the capacity to grow to their tenant base to 4 to 6 tenants.
Finally, Crown Castle’s small cell investment thesis remains unproven. Particularly, given how relatively subscale the business is, and the limited visibility there is on a path to longer-term returns.
Four Key Points Addressed in Elliott Management’s Plan
(1) Fiber is the Reason for Crown Castle’s Stock Market Underperformance, Compared to Peers. Fiber and Small Cells Capital Expenditure Reduction is Recommended to Increase Unlevered Free Cash Flow by 35%
- Elliott believes Crown Castle’s consistent underperformance is directly attributed to the company’s fiber strategy. The fiber business has yielded disappointing returns, despite $16bn of investment. Note that the $16bn of investment includes organic investments and acquiring other FiberCos
- Elliott believes, Crown Castle should re-focus fiber spend on its highest return opportunities. Further the company should target fiber capital expenditures as a % of revenue of at least a 40% return on investment (ROI). This equates to a 2-year payback
- Further, the company should limit discretionary fiber capital expenditures to $600m annually, in the future. As compared to $1.4bn in 2019 and a ~$1.2bn run-rate for 2020
- In summary, Elliott is not against fiber’s merits as an asset class. Rather, their issue is more focused on Crown Castle investing too much in fiber. Especially considering the company does not have proven returns historically to justify further future investment
(2) Crown Castle Should Incorporate Return on Invested Capital (ROIC) into its Management Incentive Plan
- Elliott wants to appropriately align capital allocation decisions with compensation
- Crown Castle executives are currently measured on Adjusted EBITDA and Adjusted Funds From Operations (AFFO) per share. Neither of these metrics includes discretionary capital expenditures
- Elliott thinks aligning management compensation with improving Return on Invested Capital (ROIC), will result in better shareholder outcomes
(3) Dividend Increase to Enhance Returns
- Re-allocating savings towards an enhanced dividend of $7.00 per share in 2021, growing to $8.00+ dividend per share by 2023
- Compares to a dividend per share of $4.89 in 2020E
- Implied dividend growth rate of 7-8% per year from Elliott’s plan
(4) Improved Oversight at the Board of Directors
- Elliott’s letter argues that Crown Castle should address its long-tenured Board to improve oversight of capital allocation
- Elliott notes that ~50% of Crown Castle’s board have a tenure of more than 15 years. Additionally, eight of the 11 non-executive directors of the twelve-member board have a tenure of at least 13 years
- Ensure Crown Castle’s fiber business has the “appropriate management skill set to deliver improved results”
How This Debate Could Unfold
Crown Castle has made a significant, $16bn of cumulative investment in amassing a scaled portfolio of high-quality fiber. Additionally, Crown Castle management has conviction for small cell returns. Specifically, the company believes small cell returns are at an inflection point of materializing in a 5G world. Because of these factors, Crown Castle is not likely to meaningfully alter its fiber and small cell capital allocation strategy.
Crown Castle’s main customer for small cells to-date has been Verizon. Undoubtedly, this is a result of Verizon having deployed significantly more high-band, millimeter wave spectrum for 5G than the other U.S. carriers. In the future, T-Mobile and AT&T will offer greater lease-up potential for small cell assets. This is because these carriers too will deploy millimeter wave spectrum for 5G. With this backdrop, Crown Castle believes it is well-equipped to leverage towers, fiber, and small cells as important components of digital infrastructure in the 5G ecosystem.
Crown Castle currently has a framework to payout ~75% of annual Adjusted Funds From Operations (AFFO) per share as dividends. Further, Crown Castle already has a higher dividend yield of 3%, compared to it peers. Specifically, American Tower has a 2% dividend yield and SBA Communications has a 1% dividend yield.
Fiber Segment Sale or Spin-Off
A sale or spin-off of the fiber segment (detailed below) could be possible, however, this could prove disruptive and more costly than any value created. It is unrealistic for Crown Castle to attain a valuation greater than a ~16x EBITDA multiple in a sale or spin-off scenario. At the same time, even a 16x EBITDA multiple represents only the average of what Crown Castle paid over its 5 fiber acquisitions. This implies that Crown Castle may have overpaid for its prior fiber bolt-on transactions.
Certain fiber M&A deals have traded at 16x+, including assets such as SummitIG at 22x EBITDA and Everstream at 17.5x EBITDA. However, these premiums have been paid for smaller regional fiber networks growing significantly faster than Crown Castle’s fiber portfolio.
It is more appropriate to compare fiber M&A deals of greater than $500m in transaction value, where Crown Castle was not the buyer. However, the majority of these deals traded well below 16x EBITDA, including:
- May 2019: Digital Colony and EQT acquired Zayo Group for $14.3bn, equating to a 11x EBITDA multiple
- February 2018: GTT Communications acquired Interoute for $2.3bn, equating to a 11x EBITDA multiple
- November 2016: Zayo Group acquired Electric Lightwave (formerly Integra) from Searchlight Capital Partners for $1.4bn. The valuation for this transaction equated to a 7.9x EBITDA multiple
For our full list of precedent data center transactions, visit our Shop, at dgtlinfra.com/shop. Here, you can get full access to our list of fiber transactions dating back to 2015.
Disappointed by Crown Castle’s progress, Elliott issued a follow-up letter on July 20th requesting the following framework of additional disclosures by the company:
(1) Fiber Segment 5-year Plan (Crown Castle to Provide)
- Fiber segment financial metrics including revenue, gross margin, segment profit, discretionary capital expenditures, enterprise fiber & small cell revenue and capital expenditure mix, and bifurcation of small cell anchor build and colocation capital expenditures
- Elliott highlighted that Crown Castle has repeatedly missed fiber revenue targets. Further, it has repeatedly missed small cell node goals. Finally, the company has had a consistently declining Return on Invested Capital (ROIC)
(2) Quarterly Key Performance Indicators (KPIs) for the Fiber segment
- Metrics cited include new bookings & associated capital expenditures, installations, churn, upfront cash payments, capital expenditures segmented by payback period, reported separately for small cells and enterprise fiber
(3) Small Cell Cohort Analysis
- Small cell investments by year of deployment, including capital invested, fiber route miles, number of nodes, small cell revenue, and enterprise fiber revenue
Actions Crown Castle Has Taken Since Engagement With Elliott
Crown Castle made a number of additions to disclosures including:
- Explicit revenue breakouts of its fiber segment including “Fiber Solutions” and “Small Cells”
- Breakout of Fiber Solutions revenue mix by customer type. The revenue mix for Fiber Solutions is 40% from Carriers, 13% from Education, 10% from Healthcare, 10% from Financial Services and 27% from Other
- Return on Invested Capital (ROIC) by segment. In Q2 2020, ROIC was 10.4% for its Tower segment and 7.6% for its fiber segment
Crown Castle provided additional visibility into how its investments into fiber and small cells are progressing in five markets:
The company identified 5 case studies of distinct markets for fiber and small cells. The intention was to provide a representation of how its overall fiber and small cell strategy is performing over time. Each market is different when it comes to the scale of the investment, the revenue mix between small cells and fiber solutions, the node density, and the contribution from acquisitions.
Provides evidence of Crown Castle’s acquisition strategy. In this market, more than 70% of the invested capital is associated with several acquisitions, including NextG, Sunesys, and Wilcon. Initially, these acquisitions generated a return of less than 6%. Since the time of acquisition, Crown Castle has added 2.3% of further yield to the overall invested capital base. The company was able to grow its yield by adding customers and cash flow to its 6,700 route miles of fiber in the market. Specifically, most of this growth came from adding small cell customers.
Also encouraging is Philadelphia, with a current yield of ~10%. As a result of combining Fiber Solutions and Small Cells on the same assets, Crown Castle was able to meaningfully increase its returns in this market. In turn, yields will continue to increase as the company adds small cells to the fiber, over time.
Represents the market where Crown Castle’s nodes-per-mile is the highest. However, the majority of the investment activity to-date has been focused on anchor builds for small cell customers. Notably, Denver’s 5.5% yield is lower than Crown Castle would typically expect from small cell anchor builds. This is due to some higher costs that were incurred during construction, which were beyond what the company had initially estimated.
Generates 11.7% returns, which is higher than what Crown Castle would expect with a node density of just 2 nodes per mile. Phoenix’s returns are primarily driven by colocation that has occurred in the market.
Represents a market where Crown Castle made its first investment in its small cell strategy, more than 10 years ago. Crown Castle built this initial system for one carrier, and was able to subsequently lease it up to other carriers. The initial system has also benefited from both amendments and increased density for evolving technologies.
Orlando provides a clear example of what a fully leased-up or stabilized market can produce in terms of financial results. Capital which Crown Castle invested in Orlando now yields 19.4%. This is the stabilized level that the company believes all markets can reach once the level of lease-up accelerates in the future.
After reviewing Crown Castle’s five case studies, it is worth critiquing Crown Castle’s disclosure from a third-party perspective:
- Elliott noted that Orlando is a market where less than 1% of fiber capital, or only $100m, has been spent. Thus, is not a credible demonstration that Crown Castle’s fiber and small cell strategy as a whole is on track
- Elliott posits that the company’s reliance on such snapshots is further evidence that Crown Castle either does not have comprehensive data or does not like its conclusion
- It is also worth noting that cities with a significant enterprise fiber mix of revenue (Los Angeles and Philadelphia) were acquired markets. Indeed, this means that enterprise revenue was already part of the mix in these markets
- Conversely, Denver, Phoenix and Orlando were built organically and have effectively no enterprise revenue. This demonstrates where and in which segment of fiber Crown Castle is focusing its efforts
Crown Castle Q2 2020 Commentary on July 30th Earnings Call
Small Cell On-Air Nodes Estimate (see left below)
Crown Castle referenced market research (above) that noted an outlook for >1 million small cells by 2024. This would suggest significant upside (from 200k small cells today) for Crown Castle’s fiber and small cell business. Even if 1 million smalls cells are not deployed by 2024, there will nonetheless be a significant growth opportunity for Crown Castle. As an example, T-Mobile will likely need 40-50k outdoor small cells, double the 20-25k it has today, once it fully builds out its 5G network.
Potential Long-Term Small Cell Densities (see right above)
Crown Castle assumes that 2 to 3 small cell nodes per mile is adequate in a 4G/LTE environment for one anchor tenant. Further, 1 additional tenant is assumed to be added over a 10-year period, meaning another 2 to 3 small cell nodes per mile is added to the network – assuming only 4G/LTE needs. However, 5G has the potential to drive network densities well beyond Crown Castle’s underwriting assumptions. Specifically, 5G network requirements and higher spectrum bands available to meet future mobile demand, will require further small cells. Therefore, Crown Castle believes node densities approaching 20 small cell nodes per mile could represent an achievable upside scenario long-term.
Small Cell Risk-Reward Opportunity
Crown Castle presented an illustrative upside and downside scenario for small cell node densities (see above). The takeaway is that small cells could result in 7x potential upside relative to potential downside, a compelling risk-reward. The purple line on the graph (above) is an illustrative representation of possible total shareholder value in 10 years. Crown Castle assumed that small cell node densities increase from <2 nodes per mile to 7 nodes per mile as you move from left to right on the chart. The light green shaded area on the chart illustrates where Crown Castle could be on that curve if the company sustains the current growth profile of the business. Notably, this growth can be achieved even based on 4G/LTE network densities for small cell nodes.
Small Cell Densities Increase
Small cell densities can increase further, which is depicted on the graph by moving left to right. In this case, Crown Castle’s small cell strategy could result in value for shareholders being 4x higher in 10 years. This scenario assumes densities of 7 small cell nodes per mile on average. Ultimately, 5G densities could present requirements for significantly more than 7 small cell nodes per mile on average. As mentioned previously, there is potential for small cell node densities to reach 20 nodes per mile over the long-term.
Small Cell Densities Decrease
Going from right to left on the graph, provides visibility if the current volume and mix of small cell colocation activity does not increase from current levels. Therefore, the Fiber Solutions segment as a whole would experience growth deceleration. Even in this scenario, Crown Castle believes the potential downside is fairly muted, demonstrated by the light red shaded area.
Crown Castle has tremendous growth runway in small cells should forecasts for 1 million small cells by 2024 and higher small cell node densities come to fruition. As of Q2 2020, Crown Castle had 45k small cells “on-air”, with the company’s goal to deploy 10k small cells during 2020. Furthermore, the company has 25k small cells in backlog, which should support similar small cell growth of 10k or greater in 2021.
Additional Actions Crown Castle Has Taken in Response to its Engagement with Elliott
- Crown Castle has amended its Corporate Governance Guidelines to institute a mandatory Board retirement policy. Whereby non-employee directors over the age of 72 will not be nominated. This implies 5 of 12 Board members will be leaving through 2022
- The company’s Board has approved a plan for five current directors to transition by May 2022. Three current directors will not be nominated for re-election at the 2021 annual shareholders meeting, and two current directors will not be nominated for re-election at the 2022 annual shareholders’ meeting. At this time, a new independent board chair will be selected
- Crown Castle announced an executive compensation program review. The review will consider additional performance metrics to evaluate management by
- Crown Castle announced in August 2020 that its Chief Operating Officer of Fiber, Jim Young, would be retiring. The company plans to search both internally and externally for his replacement
Crown Castle is not presently pursuing Elliott’s return recommendations to i) substantially reduce fiber capital expenditures to focus on 40%+ ROI projects and ii) re-allocate cash flow toward a dividend of $7.00 per share
Crown Castle believes a 40% return threshold on fiber capital expenditures would limit the company’s strategy to solely enterprise fiber solutions, within its existing footprint. This pivot would eliminate the primary driver of future value in the fiber strategy being colocation builds on small cells. Crown Castle believes its small cell strategy represents the best opportunity to drive the strongest returns for shareholders.
Crown Castle will spend capital on an enterprise fiber deal if that fiber can eventually benefit small cells as well. The company is not yet at the point of focusing solely on colocation builds. If the company were to focus solely on colocation, capital expenditures would begin to decline relative to growth. Yields would in turn increase from 6%-7% to 20%+.
Reports of Potential Strategic Investor
On August 26, 2020, Reuters reported that Colony Capital (through its Digital Colony Partners I fund) had contacted Crown Castle to indicate its interest in purchasing a minority stake in its fiber business. Colony proposed that Crown Castle keep its investment in fiber but bring in an additional partner in a joint-venture structure.
Following these reports Crown Castle indicated that it sees no rationale to raising equity in its fiber or small cell businesses. Particularly given that the company does not need additional equity capital. Furthermore, private equity capital is expensive, targeting returns of 20%+ per annum. At the same time, given Crown Castle’s low borrowing rates (<3.5% for 30-years), the company is likely to continue to self-fund its capital expenditure needs.
A short-term valuation mark on the fiber and small cells business from an equity investor could provide Crown Castle some respite. However, having minority shareholders in the capital structure could place further operating restrictions on the business going forward.