Finding attractive businesses trading with an attractive valuation can be difficult. Case in point, Crown Castle International Corporation CCI has a very solid business that is poised to do well in the future due to consumer demand. On the other hand, the stock trades with a valuation that leaves a lot to be desired.
Company background and recent results
Crown Castle is structured as a real estate investment trust, or REIT, that specializes in data infrastructure. The trust is an owner and operator of cell towers in the U.S. Crown Castle owns, leases or operates more than 40,000 towers and 80,000 route miles of fiber in the U.S. Nearly three-quarters of annual revenues are generated from larger wireless carriers AT&T T, T-Mobile U.S., Inc TMUS and Verizon VZ that cover nearly every major market in the country. The trust also operates small towers in rural areas where large towers are not feasible. Crown Castle trades with a market capitalization of $71 billion as of the writing of this article.
Crown Castle reported first quarter earnings results on April 29. The trust’s revenue declined 0.4% to $1.4 billion year-over-year, which was $22 million below what Wall Street analysts had expected. Adjusted funds from operation of $1.42 per share was flat from the first quarter of 2019.
Site Rental revenues grew a solid 5% to $867 million with organic growth adding $71 million to results. This business benefited from new leasing activity and escalations in contracted tenant rent revenues. Combined, these two areas were up nearly 10% from the previous year. This was partially offset by a 4.1% headwind from tenant non-renewals. The trust’s Fiber business grew 7% to $443 million on strong demand for small cells and fiber solutions.
Crown Castle expects that new leasing activity will add $395 million to $425 million of revenue to 2020 results with an additional $90 million to $100 million of revenue coming from rent escalators. Non-renewals will offset these figures by $175 million to $195 million. Still, Site Rental revenues are expected to grow 5% from 2019 levels while adjusted FFO should be higher by 9%. Crown Castle reaffirmed its guidance of $6.12 per share in adjusted FFO for the year.
Crown Castle had a decent start to the year. The trust’s services should remain in demand for three reasons, the first being that parts of the U.S. remain under various desires to stay at home due to the Covid-19 pandemic. This has resulted in higher use of broadband and wireless services while consumers practice social distancing.
The second growth catalyst is that Crown Castle has been successful at building out networks in both densely populated areas as well as the more rural portions of the country. Consumers throughout the U.S. will continue to demand access to wireless and fiber networks for their connected devices.
The final catalyst that Crown Castle possess is the rollout of 5G networks. With 74% of revenues derived from the largest carriers in the country, Crown Castle is in a strong position to capitalize on the major players in the space expanding and improving their networks. While the pandemic may impact the suppliers and vendors used to create the trust’s network, this is likely to be a short-term issue.
Impressively, Crown Castle has grown its adjusted FFO by nearly 10% over the last decade even as the share count has increased by almost 4% annually during this time.
Dividend and valuation analysis
Crown Castle has raised its dividend for the past six years. The trust has increased its dividend by an average of 8.3% per year over the past three years and 19.6% per year over the past five years.
Crown Castle raised its dividend by 6.7% for the payment made Dec. 31, 2019. Dividend growth has slowed in recent years, but looking at the payout ratios gives us insight to why that might be.
Crown Castle is expected to distribute $4.80 of dividends per share in 2020. As stated above, the trust expects adjust FFO of $6.12 for the year. This gives Crown Castle an adjusted FFO payout ratio of 78%. This is just above the average payout ratio of 77% from 2014 to 2019.
The FFO payout ratio isn’t what worries me, as REITs have high FFO payout ratios due to industry regulations. Free cash flow is where I am troubled by Crown Castle’s dividend future. Crown Castle paid out $541 million in dividends during the most recent quarter while generating free cash flow of $206 million for a payout ratio of 263%. This is well beyond the payout ratio that most REITs tend to have. A payout ratio of this level means that a dividend cut could be forthcoming.
Going back further just reinforces this view. In 2019, Crown Castle paid out $2 billion in dividends while producing free cash flow of $641 million for a payout ratio of 343%. The trust distributed $4.7 billion of dividends in the prior three years while generating $2.5 billion of free cash flow for an average payout ratio of 188% over this period of time.
Crown Castle has spent capital to grow its business, but this has come at the expense of free cash flow. The trust has had to take on debt in recent years to help cover dividend payments. Long-term debt has increased 47% to $17.7 billion from 2016 through the end of the first quarter of 2020. As a result, interest expense has started to pile up from $494,000 in 2016 to $662,000 in 2019, an increase of 34% in just four years. This higher expense will reduce already limited free cash flows in the coming years.
Shares of Crown Castle yield 2.8% as of Thursday’s close. This is below the stock’s average yield of 3.6% since 2014. Using Thursday’s closing price of $170.45 and adjusted FFO of $5.69 for 2019, Crown Castle trades with a trailing price-to-adjusted-FFO ratio of 30. Using 2020 guidance, the forward price-to-adjusted-FFO ratio is 27.9. Both valuations are significantly higher than the stock’s five and 10-year price-to-FFO ratios of 22.1 and 22.2, respectively.
The trust’s five and 10-year average price-to-FFO ratios are so close together that an argument can be made that the stock deserves to trade in-line with that average. If the stock were to revert to a price-to-FFO of 22.1 on expected adjusted FFO for the current year, then the stock could fall more than 21%.
Given that that the trust has several catalysts for growth, I believe a price-to-adjusted-FFO range of 23 to 25 may be warranted. Still, this results in a price range of $141 to $153, which would be a 10 to 17% decline from the current price.
Final thoughts
Crown Castle is in an enviable position as a leader in its industry. The trust does business with the largest wireless communication companies in the U.S. and has operations in both major and rural markets. With a massive data infrastructure network already in place, Crown Castle has plenty of opportunity to grow its business.
That said, the trust’s free cash flow position looks extremely weak and its dividend is hardly recession tested. Crown Castle’s valuation has become stretched to the point where the stock could be priced for perfection. Any weakness in the trust’s business could cause a selloff.
Crown Castle is an attractive business that happens to be trading at an unattractive price. At a better valuation, I would consider purchasing the name. For now, I’ll pass.
Author discloser: the author is long AT&T and Verizon Communications
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