Look for the right short candidates (like Crown Castle)

October 26, 2010

I was involved in a conversation recently about short selling, where the old adage was trotted out that a stock can rise to infinity but only drop to zero, which is said to illustrate that short selling is more risky than investing on the long side. Although this is technically true, its impact on the risks of shorting has perhaps been overstated. Obviously, stocks can make large moves in short time periods where there is not enough liquidity to allow a graceful exit, but that applies to downside moves as well as upside. The real issue comes from the possible  asymmetry. As a result, a good short candidate should not have that asymmetry in place, and so a lot of short selling horror stories may come from stocks that were poor short selling candidates to begin with.

The example that was raised to me was a small biotech company that announced over the weekend that it had cured cancer. The announcement turned out to have been a gross exaggeration, but anyone short in that position would have had a very bad day. Likewise, shorting low-priced stocks (below $2, $3, or sometimes even $5 or higher) also run the risk of asymmetry. The reason for this effect is that startup companies or many low priced stocks tend to be have like call options, or bets on whether the company will achieve profitability before it runs out of financing. Of course, such bets are often losers, but shorting such a stock is putting oneself in the position of being short an option rather than a stock, and without even taking in an option premium. So, rather than shorting a low priced stock for pennies and hanging on for the bankruptcy, it would be preferable to short a high priced stock that the market has unjustifiably run away with.

In that vein, I am pleased to offer Crown Castle Industries (CCI). Like SBA Communications, it is a cell phone tower company, and again like SBA Communications it is under a heavy burden of debt and generating a free cash flow that is inadequate to justify its $12.36 billion market cap.

I will first deal with the free cash flow issue. As I have stated, a decent proxy for free cash flow is reported earnings plus depreciation minus capital expenditures. In Crown Castle’s case, reported earnings have been negative, although they have lately been approaching zero but for nonrecurring or arguably nonrecurring events. As they seem to be constantly refinancing their debts, they have reported refinancing losses which I am willing to treat as not related to their core operations. In the last few reporting periods, Crown Castle has also reported losses due to ineffective interest rate swaps. Although this is technically part of their financing strategy and should be treated as recurring, the firm has been reducing the size of their interest rate swap positions and so I could justify treating it as nonrecurring.

So, taking out noncore or noncash items, in 2007 they reported earnings of -$222 million, after $540 million in depreciation, $24 million in amortization of financing costs, $66 million in writedown charges, $75 million in impairments, $25 million in acquisition integration costs, and $300 million in capital expenditures (and $494 million paid for an acquisition, which I’m not counting), producing total estimated free cash flow of $208 million. However, $94 million off that $208 million consists of tax benefits, which, as they do not technically have any taxable income, becomes a net operating loss carryforward. Because they still have no reported profits, the company may not realize the value of their carryforwards for some time, and it actually does not represent immediate cash flow. In that same year, the company incurred interest expenses of $325 million, producing an interest coverage from free cash flow to the firm of 1.64x.

In 2008, the figures were -$49 in reported earnings plus $526 depreciation & amortization, $25 million in amortization, $17 million in writedowns, $56 million in impairments, $2 million in acquisition costs, minus $451 million in capital expenditures, producing $126 in estimated free cash flow, of which  $104 million is tax benefits. Interest paid that year was $330, producing interest coverage of 1.38x.

In 2009 the company was able to ratchet back its capital expenditures somewhat. The figures were -$114 reported earnings plus $530 million in depreciation, $91 million in losses from refinancing, $61 million in amortization, $19 million in writedowns, minus only $173 million in capital expenditures, producing free cash flow of $414 million, of which $76 million was tax benefits. Interest paid that year was $332 million, producing coverage of 2.25x.

Year to date 2010, they reported earnings of -$217 million (owing to a large loss on interest rate swaps), plus $267 million in depreciation, $66 million in losses on debt refinancing, $37 million in amortization, $4 million in writedowns, plus $187 million on the swaps themselves, minus $91 million in capital expenditures, producing estimated free cash flow of $253 million, of which $15 million is tax benefits. The same figures for the first two quarters of last year were $207 million in free cash flow of which $56 million was tax benefits. Most interesting to me, though, is the fact that in the same period, interest expense rose from $146 million last year to date to $208 million this year to date. Interest year to date is covered 2.22x, and the remaining cash flows produce a price/free cash flow of about 30. This strikes me as high for a company with such debts, particularly one with slowing growth.

Now, I did notice an interesting point in one of their filings, that their maintenance capital expenditures were only $10 million a year. I have noted before that, as stated in the useful Damodaran on Valuation only maintenance capital should count against free cash flow, because growth capital can be suspended at any time (presumably at the expense of the growth it would create). However, it is not clear that management is aware that they are in a financially precarious situation and so they may go on gleefully expanding their capital into oblivion. Furthermore, it strikes me that $10 million may be their current maintenance requirement, but that figure may go up dramatically. If many of their towers are of fairly recent vintage, it may be some time before wear and tear start to take its toll, but when it does capital requirements may increase in a hurry.

Sales have been increasing at a fairly steady 10% for the last few years. Operating income plus depreciation and nonrecurring events moved from $665 million in 2007 to $838 million in 2008 to $983 million in 2009 to $534 million for the first half of 2010, or $1068 million on an annual basis. This indicates to me a slowing rate of growth. Even assuming that interest takes precedence over capital expenditures, interest coverage has moved from 2.05x in 2007 to 2.54x in 2008 to 2.96x in 2009 but dropping back down to 2.62x for the first half of 2010 owing to higher interest requirements. It may be claimed that cell phone towers are in the nature of a utility company and can bear a lower interest coverage ratio, but the increased interest expense for 2010 suggests to me that some of their lenders are starting to become worried. The company announced that subsequent to their latest figures they issued $1.55 billion in debts to replace $1.33 billion in tower revenue notes (albeit at an interest rate 1.2% lower), which, like SBAC’s, are held in a securitization-type arrangement.

Crown Castle may be a bit further from breaching its covenants than SBA Communications, but it is not out of the question. The covenants in their credit agreement require that their adjusted EBITDA/total debt must be less than 7.5, and that their EBITDA/interest must be at least two. I don’t know what “adjustments” they are making, but they report that their adjusted EBITDA/total debt is 5.7 and their interest coverage is 2.7x, which is a little higher than I calculate it. Curiously, according to Etrade, its bonds trade at a premium despite yielding only 5% for the 2015 bonds and about 5.9% for the 2019 bonds, and a credit rating of B-. This is only anecdotal, but I’ve noticed that all the bonds I like are rated CCC+, suggesting that the credit agencies might consider them worth of a higher rating but aren’t willing to stick their neck out by pushing them up. I think the same reasoning could apply to a B- rating on the downside. At any rate, though, their calculation and mine is before Crown Castle’s capital expenditures, which take another bite out of actual cash flows.

So, it is my considered opinion that Crown Castle is in a bind. Its growth is slowing, requiring it to make high capital expenditures in order to grow into its current share price. However, it is bumping near the ceiling of its debt capacity, and funding capital expansion out of its own cash flows reduces free cash flow to shareholders. As a result it looks as though Crown Capital is too overextended one way or another to justify its valuation, making it a potentially attractive short.

Leave a Reply