Crown Castle has a different strategy than its two biggest competitors, which focus almost exclusively on towers and have a multinational footprint. Crown operates exclusively in the United States and has aggressively invested in fiber to pursue small cell communications sites. We like the prospects for towers more than small cells and therefore prefer the businesses of Crown’s competitors.

Crown’s legacy tower business (72% of total revenue in 2022) is fantastic. For at least the past decade, Crown has held steady with about 40,000 towers in its portfolio, meaning its tower business has required very little incremental capital investment, and absolute tower operating costs have risen only modestly. Cash sales, on the other hand, have grown at a mid-single-digit rate annually. The tower business model entails wireless carriers leasing space on towers to install antennas and other equipment that power their networks. The carriers enter long-term leases that include roughly 3% annual rent escalators for equipment they add, and they add new equipment—on the same or additional towers—as needed to further improve network quality or deploy new spectrum holdings. Costs to operate a tower are largely fixed, so as more tenants and equipment get added to towers, Crown benefits from significant operating leverage. Towers have benefited from the explosion in mobile data use, and we think towers will continue to be an integral part of the long-term mobile network solution.

Since 2017, Crown has focused its investment—about 75% of total capital spending—on fiber and the small cells it powers. Despite the spending and relatively small revenue base, fiber segment sales growth hasn’t outpaced that of towers. Management maintains that the up-front spending will be very lucrative once it can colocate additional tenants on the fiber, but we are skeptical how big that opportunity is. Unlike with towers, where all U.S. carriers use third parties to meet nearly all their infrastructure needs, AT&T and Verizon each own a lot of fiber and will serve a significant portion of their small cell needs internally.

We have a narrow moat rating on Crown Castle. We don’t see competitive advantages in its fiber business, but towers, which accounted for 72% of companywide revenue in 2022, are protected by switching costs and an efficient scale dynamic and are unlikely to be uprooted by competition. Additionally, 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.

Crown Castle’s fiber segment generated less than $2 billion in revenue in 2022 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 about $1 billion in 2022. 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 great 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%.

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 raising our fair value estimate for Crown Castle to $140 from $135, implying a P/AFFO multiple of 19 and an EV/adjusted EBITDA multiple of 18 based on our 2023 estimates.

We project Crown to average 5% revenue growth annually throughout our 10-year forecast, with both the towers and fiber segment growing at roughly that rate. Our fiber revenue growth assumes 10,000 small cell nodes added in 2023 and 10,000-15,000 annually throughout the rest of our 10-year forecast, 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 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 faster small cell revenue growth, which we project to average about 10% annually over the next decade, slower-growing enterprise fiber sales will hold back the overall fiber segment's revenue growth.

We expect margins to continue expanding over the next decade, though we expect the pace to slow after 2022. We project both gross margin and EBITDA margin to rise by about 200 basis points between 2022 and 2031. We think operating leverage in the tower business and a higher proportion of co-located small cells will be responsible for the continued expansion. 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 as a percentage of sales to continue declining as small-cell deployments rely less on initial fiber build-outs and can more frequently co-locate on existing fiber. After averaging 30% from 2017 through 2020, capital intensity dropped below 20% in 2021 and 2022. We project it to trend down to the low double digits by the end of the decade.

Our Morningstar Uncertainty Rating for Crown Castle is Medium. The firm is allocating most of its recent spending to fiber and small cells, but towers continue to dominate Crown's business, and they are very stable.

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 $12 billion acquiring and constructing fiber assets over the past 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 72% of revenue in 2022, could suffer, and Crown does not have nearly enough small cells to mitigate a large decline in its tower business.

We do not think Crown Castle faces abnormally high ESG 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 is worthy of a moat and mints cash. Rather than invest in the towers or return huge levels of cash to shareholders, the firm has consistently plowed half to three quarters of its free cash each year into 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 70% of Crown Castle’s revenue but only about 20% of capital spending ($1.3 billion firmwide in 2022), and the segment generates 70% 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 57%. 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 ($5.98 in 2022, for a yield in the 3%-4% range 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 maintainable 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.