By Nick Del Deo, Tower Market Analyst, MoffettNathanson
‘
“We thought it would be prudent to briefly revisit a topic that is (once again) at the forefront of tower investors’ minds: the risk of rising inflation and interest rates. These worries had cropped up in the wake of the 2016 election, but had subsided over the course of 2017 when those outcomes did not play out. The 10 Year has recently moved through 2.5% and tower stocks have been reacting more closely to its changes, however, so we’ve been receiving a numbers of questions on this front. Rising inflation and interest rates would not be good for tower operators, but there are important mitigating factors to consider that would mute any bottom-line impact.”
“The bear case holds that the tower companies are ill-equipped to handle an environment where inflation rates move up. The key issue in the U.S. is that tower leases are overwhelmingly struck with fixed escalators (~3-3.5%) rather than CPI-linked ones, and the contracts are very long-term in nature, which limits the towercos’ ability to reset rates in response to macroeconomic changes. If inflation were to spike, real tower revenue growth would fall. While this is absolutely correct, there are two important offsets to consider. First, the Towers’ 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 co-location pricing is not set in stone but is negotiable. If things started to get hairy, the Towers 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 ~7% gross growth the industry has been posting, 3-3.5% has stemmed from escalators and the balance from amendments and new co-locations; to the extent that steps up in the coming year or two, it will skew more towards amendments and co-locations. A majority of revenue growth is thus coming from sources that aren’t entirely “locked in.” We would note that the difference between Treasury and TIPS yields, a quick proxy for anticipated inflation, currently stands at about 2%, in-line with realized CPI growth ex-food/energy over the past 15 years.
Rising interest rates, which are obviously correlated to inflation, wouldn’t be good for the Towers, either. They’ve managed in the past, however, maintaining multiples like what they sport today when the 10 Year rate was much higher (granted, the companies were probably growing faster back then, but generate more cash flow today with a business model that has been proven out). Their debt maturity profiles are much more staggered, so it would take time to show up in AFFO (though the market could simply apply a lower multiple in the interim). Assuming the equity risk premium doesn’t shift, WACC would rise and high multiple stocks would mechanically get dinged more than low multiple stocks, especially those with meaningful leverage like towers. 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.
January 19, 2018
Reader Interactions