Crown Castle’s first-quarter revenue, operating profit, and adjusted funds from operations were all slightly better than our forecasts, and management said levels of new leasing activity on its towers are high, as carriers’ spectrum deployments for 5G are in full swing. Nonetheless, the firm’s full-year organic growth outlook for each of its businesses is unchanged. While Crown materially raised its full-year financial guidance, the boost was almost entirely due to higher than previously forecast straight-line revenue resulting from a long-term tower lease agreement recently commenced with Verizon. The boost to the anticipated 2021 top and bottom lines therefore won’t result in much higher cash inflows and isn’t a result of greater 2021 demand but rather a contract that extends for 10 years. We are maintaining our $110 fair value estimate. Strengthening small-cell performance would be the key to making us more optimistic, and we still haven’t seen that.

Total sales grew 5% year over year, with organic site rental revenue, which is adjusted for straight-line accounting, up 6%. The Verizon deal commenced April 1, and Crown expects $140 million in noncash straight-line revenue for the remainder of the year, so total year-over-year sales growth will be much higher over the next three quarters. We expect organic site rental revenue growth to be steady at about 6%, however.

First-quarter margins were strong, led by tower gross margins expanding a full percentage point year over year and exceeding 76% for the first time. The firmwide adjusted EBITDA margin exceeded 60% and was more than 3 percentage points higher than the same period last year. We don’t put too much importance on margin fluctuations quarter to quarter, but tower gross margins have trended up from about 70% during the middle of last decade, and we expect the trend will continue over the next several years as carriers continue adding spectrum to towers, where Crown’s costs are largely fixed.

Crown Castle's strategy has deviated from that of its two biggest competitors, which focus almost exclusively on towers and have a multinational footprint. Crown operates exclusively in the United States and is aggressively investing in fiber to pursue small-cell communications sites. In our view, Crown Castle has adopted a high-risk strategy. While we acknowledge the potential upside, small cells require heavy initial investment and lack the competitive advantage that Crown has with its towers.

We like Crown’s legacy tower business (68% of total revenue in 2020), where it leases space on its towers to wireless carriers, which install antennas and other equipment. The carriers enter long-term leases with Crown that include rent escalators (annual increases of about 3%), giving the business a highly visible and stable revenue stream. Towers are also the beneficiaries of the explosion in mobile data use, which has been growing 30%-40% per year in the U.S. To meet the demand, carriers either locate equipment on additional towers or add or modify equipment on existing towers. Significant operating leverage makes both alternatives highly profitable for Crown--additional tenants and equipment upgrades can be added to towers for very little incremental cost. We think towers will continue to be an integral part of the long-term mobile network solution.

Crown is transitioning to become less reliant on its tower business by acquiring fiber (it now owns 80,000 route miles) and setting up small cells on it. We see this as a response to the growth in consumers’ data use and a pending evolution in network infrastructure, which may be necessary as the U.S. moves to 5G networks. However, we think Crown faces challenges with its fiber that will keep returns on invested capital depressed for several years. Crown is limited in how quickly it can set up small cells, leaving an extended period before we think it can fully monetize its fiber. We are also concerned about the high spending required and think Crown faces more competitive alternatives for a smaller potential customer pool in small cells than it does with towers.

We recently upgraded our moat rating on Crown Castle to narrow from none. Our view on each of the two segments in isolation remains the same: We think towers, which accounted for 68% of companywide revenue in 2020, are protected by switching costs and an efficient scale dynamic and are unlikely to be uprooted by competition, while fiber does not benefit from similar barriers. However, Crown Castle has now brought fiber spending down significantly, so we no longer think returns on invested capital will fall below its weighted average cost of capital for the bulk of the next 10 years.

In early 2018, we downgraded Crown Castle’s moat from narrow to none, because we were concerned that excessive fiber spending would continue for many years and weigh on returns throughout that span. Although we didn’t believe that new fiber builds were competitively advantaged, we did realize that eventually, once up-front costs were sunk, the financial profile of fiber would look better and would no longer outweigh the excess-return-generating capabilities of the fantastic tower segment. We simply had no confidence the firm would refrain from huge fiber outlays for an extended period.

In retrospect, the firm’s fiber spending over the last few years, while enormous and wasteful in our opinion, has not been as large as we feared could be the case. More important, the level of capital spending on fiber has now moderated significantly, and after a splurge of more than $10 billion on expensive fiber acquisitions from 2015 through 2017, Crown has refrained from further fiber purchases. As a result, we don’t expect such a weight on returns over our forecast. Return on invested capital fell below the 8.1% weighted average cost of capital we estimate for Crown Castle every year from 2014 through 2019, but it reached 8.4% in 2020, and we expect it to average 9% over the next five years and 10% over the next decade.

Crown Castle’s fiber segment generated less than $2 billion in revenue in 2020 and has been growing in the midsingle digits annually the past few years, similar to the rate we project over the next decade. However, we now think fiber capital spending peaked at $1.5 billion in 2019. Fiber capital spending was $1.2 billion in 2020, and we project it to be just over $1 billion in 2021 before stabilizing between $800 million and $1 billion annually throughout our forecast, which will result in capital intensity for the segment falling to 50% in 2021 and 22% in 2030, after it was routinely in the 80%-90% range from 2014 through 2019. With less bloating of invested capital, we think the tower segment can drive companywide excess returns.

In our view, the moat in Crown’s tower business is underpinned by the efficient scale present in the tower industry and switching costs that make tenants reluctant to seek alternative providers once they have installed their equipment on towers.

The overriding feature of the tower business is the extreme operating leverage inherent in it. Costs to the tower provider are mostly fixed per tower, meaning costs to operate a tower are virtually the same whether a tower has one tenant or multiple tenants. Tower operating expenses typically consist primarily of the rent expense the companies pay to lease the land, which is subject to multiyear leases. Startup costs to put up new towers are significant, and returns are typically not stellar unless or until the tower provider can secure multiple tenants on the tower, a feat made more difficult for a competitor by the limited pool of potential customers--more than 70% of Crown Castle’s revenue comes from the big three wireless carriers. Given this industry dynamic, where yields on towers are typically in the midsingle digits with the first tenant, a competitor would need to average close to two tenants per tower before expecting to generate economic profits. However, Crown Castle states that it has historically taken about 10 years to add a tenant per tower. Consequently, even before considering other hurdles an upstart competitor would have to overcome to compete on Crown Castle’s turf, it would have to contemplate sinking tremendous amounts of capital into building towers, locking itself into $1,000 per month land lease payments over a term of 5-10 years, and, especially given a likely need to offer lower average prices to carriers to entice them to switch, would probably be looking at a 10-year time frame before becoming economically profitable.

We think the existing efficient scale alone is a deterrent to tower competitors, but they would have other obstacles to procuring carriers’ business. First, because carriers own and are responsible for the equipment they deploy at and on the towers, they bear the brunt of removing it when they leave a tower. Crown Castle has stated that it costs carriers about $40,000 to remove equipment from a tower in the U.S. With Crown Castle’s tenants paying under $35,000 per year in rent by our calculations, it means they would have to recoup over a year's worth of rent payments to break even. A rival would need to undercut Crown Castle’s prices by that much more to make up for the loss carriers would face in deciding to switch, further impeding a competitor’s prospects of generating excess returns. Yet direct costs are not the only switching costs carriers face. Carriers’ most valuable assets are their networks, and any disruption to the network, whether temporarily during a tower switch or more permanently as a result of a new setup and location, risks customer dissatisfaction. History suggests that carriers hesitate to leave towers that they are on, as non-consolidation-related churn for Crown Castle is historically 1%-2%.

Even if a competitor wanted to take on a tower incumbent, it could struggle to obtain the permits necessary to build a tower. Towers are subject to zoning restrictions, and zoning authorities and community residents often oppose tower construction in their communities. The opposition has obviously not been such an impediment that it precludes towers from ever gaining approval, but we think additional towers in areas that already have sufficient network coverage would face significantly greater difficulty obtaining approval than those that are built to improve a network, thus making tower construction for the sole purpose of providing competition a much more difficult regulatory endeavor.

Our skepticism of the fiber business stems from the small pool of potential customers and abundance of other fiber options, although we acknowledge that fiber is very location-specific, so even two providers in the same city can have significant areas where they don’t overlap and can’t serve as competition for each other. Crown’s vision is to primarily use its fiber to set up small cells, which are effectively minitowers that wireless service providers use to support their networks and are especially important for the fastest 5G networks. However, we don’t think Crown has the same advantages with small cells that it has with towers.

Unlike with towers, where all three major U.S. wireless carriers rely on third-party providers almost exclusively, two of the major carriers (AT&T and Verizon) own substantial amounts of fiber and will meet at least some of their small cell needs internally. As of early 2021, one third of Verizon’s small cells were on its own fiber, and the firm wants to get that proportion to over 50% within two to three years, leading us to believe it will not be aggressively adding small cells with outside vendors like Crown. AT&T said in early 2021 that it plans to increase its already vast fiber footprint by expanding to 3 million new customer locations in 90 metro areas, giving it even greater ability to self-serve its small-cell needs in many places. In addition, many other third parties own fiber, which is not the case with towers, providing further competition. Similar to towers, for the small-cell business to be attractive, it needs multiple tenants co-locating on fiber runs. Since the carriers have additional options with small cells (as opposed to with towers, where carriers must go to outside vendors to meet their critical needs), securing multiple carriers in many areas should be more difficult for Crown Castle.

In addition to the greater competition in fiber leasing, an efficient scale argument, which we think would be the most likely moat source for fiber, is deterred by the multiple uses that fiber has, which is another quality that distinguishes it from towers. Firms like AT&T and Verizon use fiber for their own fixed-line businesses, so they don’t need to justify spending with only the wireless business in mind. For them, small cells are another feature they can add to their fiber, but they use fiber to meet other core needs like enterprise transport, fiber-to-the-home and fixed wireless broadband service, and macro tower backhaul. Other network providers use fiber to transport all the data that we rely on in today’s digital world. As other firms have more reasons to own fiber, it makes it more difficult for Crown Castle to corner the market with existing infrastructure.

We are maintaining our $110 fair value estimate, implying a price/adjusted funds from operations multiple of 16 and an adjusted enterprise value/adjusted EBITDA multiple of 18, both still below where the stock has traded in recent years.

We project Crown to average 6% revenue growth annually throughout our 10-year forecast, with both the towers and fiber segments growing at roughly that rate. Our fiber revenue growth assumes 10,000-15,000 small-cell nodes added each year, which we think is the upper limit of the rate at which the company can deploy them. We assume that over time, a far greater portion of the nodes will be co-located on fiber that the company has already deployed for small cells, leading to substantially lower spending to activate those nodes. When combined with our expectation for few new towers built each year, we expect capital expenditures as a percentage of sales to drop substantially over the next decade. However, despite rapid small-cell revenue growth, which we project to average in the midteens over the next five years, slower-growing enterprise fiber sales will hold back the overall fiber segment's revenue growth.

We expect margins to improve significantly over the next decade, with both gross margin and EBITDA margin rising 400-600 basis points by 2030. We think operating leverage in the tower business and a higher proportion of co-located small cells will be responsible. With less investment in new towers, which typically have significantly fewer tenants per tower, revenue growth on towers will be primarily from co-locations, amendments, and escalators, which will mostly drop straight to the bottom line. Within fiber, a mix shift toward small cells from fiber solutions and to more co-located small cells from anchor nodes both contribute to margin improvement.

We also forecast capital spending to continue declining as small-cell deployments rely less on initial fiber build-outs and can more frequently co-locate on existing fiber. Capital spending as a percentage of sales was 35% in 2019 and 28% in 2020. We project it to gradually decline toward the midteens over the next decade.

We view Crown Castle as a high-uncertainty name, as it is allocating most of its recent spending to the nascent small-cell business. While getting ahead of the curve on an industry transition to small cells could be very rewarding, we think it is a less competitively advantaged business and could prove detrimental.

Crown Castle has spent more than $10 billion acquiring and constructing fiber assets over the last several years. If Crown proves to not have the same competitive advantages in fiber as it has in towers, the investments could end up being value-destructive. Even if small cells become the primary solution in metro areas and reduce the need for towers, Crown’s highly profitable tower business, which accounted for 68% of revenue in 2020, could suffer, and the company does not have nearly enough small cells to mitigate a large decline in its tower business.

We don’t think Crown Castle faces abnormally high environmental, social, and governance risks. The physical infrastructure it relies on makes its business prone to disruption from natural disasters, but we think the risk of widespread catastrophe is low right now. We assume individual sites of destruction as a normal course of business that is likely to happen on an annual basis, but entire regions would need to be put out of service to have a material financial impact. The firm’s ability to continue securing permits is also necessary, but due to the societal dependence on mobile communication, this is unlikely to be an issue.

Another risk is that Crown leases, rather than owns, two thirds of its land and more than half of its towers. We think taking control of land is competitors’ best path to overcoming Crown’s competitive advantages, but we think near-term risk is minimal. Crown has very long-term land leases and has the option to buy the towers it leases, leaving it empowered unless it has capital constraints.

We assign Crown Castle a Poor capital allocation rating. Our rating is driven by our view that the firm’s balance sheet is relatively weak and its investment strategy, namely its decision to aggressively buy and build fiber networks, is poor.

Crown’s investment strategy is the biggest factor in our rating. The firm has what we think is a phenomenal tower business that itself would be worthy of a moat, but rather than invest in it, the firm has allocated nearly all its capital spending toward fiber and small cells, which we don’t think are moatworthy and will face challenges generating returns as high as the firm’s cost of capital. Towers account for 68% of Crown Castle’s revenue but only about 20% of capital spending ($1.6 billion firmwide in 2020), and the segment generates 65% operating margins. The company’s remaining revenue comes from its fiber segment, which includes small cells. Fiber accounts for over 75% of capital spending and has operating margins around 55%. Crown has also spent over $10 billion in fiber acquisitions over the last several years. Aside from the current financial profile not looking favorable for fiber and small cells, we think it is a business unlikely to match the success of towers. Crown acknowledges that for small cells to be attractive, they need multiple tenants co-locating on fiber runs. However, unlike towers, where all major wireless carriers rely on third-party providers almost exclusively, two of the three major U.S. wireless carriers (AT&T and Verizon) own substantial amounts of fiber and will use it to meet at least some of their small-cell needs. With much more competition in fiber than small cells, we think the level of investment directed toward fiber is a mistake.

The significant spending has left Crown’s balance sheet stretched, although the steady tower business alleviates concerns that the firm is overleveraged. Net debt/EBITDA has consistently been between 5.0 and 6.0 for several years, which although high relative to the market is not unusual for a tower REIT. We expect the leverage ratio to stay above 5 but don’t foresee any difficulty with covenants, interest payments, or debt maturities. We expect capital spending to decline over our forecast as initial fiber build-outs are completed, so we don’t think the firm will have to raise as much new capital as it has needed over the past half decade.

Crown Castle pays a good dividend ($4.93 in 2020, for a yield around 3% for most of the year), and as a REIT, it must distribute 90% of its taxable income. Overall, we believe the distribution strategy is appropriate, even as the dividend payout has been well in excess of free cash flow the last several years. The heightened capital spending on fiber has contributed, and the ability of the firm to handle a higher debt load doesn’t make it worrisome for that period. While not sustainable indefinitely, we believe a shift in the fiber segment (either through profitability or divestiture) will keep the dividend policy intact long term. However, as noted by our view of the investment strategy, we think Crown would be better off distributing much of its operating cash to shareholders, or, if opportunities exist, deploying it toward towers, rather than putting it into fiber. Share repurchases have not been part of the strategy, as the firm instead has instead issued shares to partially fund (along with debt) fiber investment while maintaining the dividend.