SBA Communications – Too much Debt, not enough Growth

October 3, 2010

I have been interested in short ideas lately, and the last two I identified, Red Hat Inc. and Concur Technologies, were demonstrably overpriced and already showing signs of running out of growth. However, there was no catalyst lurking in the wings that had the potential to throw a wrench into the market’s optimism. However, with SBA Communications (SBAC) I think I’ve found a company which, in addition to slowing growth, is also staggering under a large and growing burden of debt. If their debt covenants are breached–and they are already under pressure–it could definitely serve as the desired catalyst.

SBA Communications owns or leases a number of wireless communications towers, and leases space on them to wireless service providers. Their revenues have been increasing, but they have been continually expanding their portfolio of towers through the issuance of debt. Because of the large amounts of depreciation that their business generates, they have no actual earnings. Their free cash flow, although positive, is showing slowing growth. Wireless traffic in the United States is also on the rise, which would explain the optimism surrounding this company, but the debt of this company appears to me to be approaching a dangerous level.

The company’s earnings figures are complicated first because depreciation is much greater than capital expenditures, which is a common enough occurrence. But the true earnings power of the company is also occluded by noncash interest expense and gains and losses from bond redemptions. Not only has the company had to resort to increasing debt levels in the first place, but it has also had to get creative in the form of its debts; they have three outstanding convertible issues as well as a securitization-type structure whereby they have transferred some of their tower holdings into a special purpose vehicle and securitized the income from them.

I have spoken before of how certain convertible bonds produce non-cash interest expenses; accounting rule ASC 470-20 now requires them to be divided into a debt component, as determined by the estimated value of a non-convertible bond paying the same coupon, and an equity component consisting of the value of the conversion privilege. The equity component is considered paid-in capital and is amortized over the lifetime of the convertible instruments. I have said previously that, instead of increasing the clarity and information content to the user of financial statements, this rule decreases it. The borrower is not on the hook for only the debt value of the instrument when it is issued; it is on the hook for the full amount, and the company is forced to recognize interest payments that do not exist to amortize paid in capital that never existed. The phantom interest distorts the earnings calculation, and a user who is unfamiliar with the application would easily be induced to undervalue a target company. Furthermore, the amounts are not updated alongside stock price and volatility, and linear amortization also does not correctly model the behavior of options. In SBA’s case, the application of this accounting method actually reduces the stated amount of their liabilities from $2.549 billion to $2.386 billion.

Fortunately, I am somewhat conversant with ASC 470-20 (and SBA lists the nonexisting interest separately on their income statement anyway). So, we can calculate their free cash flows once we adjust for this noncash interest and depreciation and capital expenditures. We should also adjust for the nonrecurring profits and losses from their continuous extinguishment and reissuance of debt. In SBA’s case this is often a significant amount: in the last three full fiscal years they have issued $2.57 billion in debt (not counting $182 million in warrants and $375 million in options to reduce the effect of the conversion features, which it seems to me would defeat the purpose of issuing convertible debt) and paid back $1.42 billion in several transactions.

In fiscal year 2007, free cash flow after all the above adjustments was $87.540 million; in fiscal year 2008, $122.078 million; in fiscal year 2009, $140.573 million, and year to date 2010, $70.911 million as compared to $77.402 million for the first half of 2009. The serial growth, then, is 39.5% for 2008, 15.2% for 2009, and -8.4% year to date. If we annualize the year to date cash flows, we get a price/free cash flow ratio of 32.6, which seems high for a company with a slowing growth trajectory. Revenues increased 16.4% between 2008 and 2007, 17.0% between 2009 and 2008, and 11.5% for the first half of 2010 as compared to 2009, so there is an apparent slowdown there too.

Now, the price/free cash flow ratios for our other shorts were somewhat higher; Concur Technologies was 102, and Red Hat’s was 67. However, neither of those companies are hampered by a large and increasing burden of debt. SBA, on the other hand, has a very weak interest coverage ratio: 1.94x times in 2007, 2.16x in 2008, 2.07x in 2009, and 1.95x year to date, which is typically consistent with a credit rating in the B- area. The company’s current credit rating is apparently BB-, but according to Etrade that hasn’t been updated since July 2009. The face amount of their long-term debts is $3.06 billion, but they are carried on the balance sheet at $2.81 billion (owing mainly to the convertible discount above), plus other miscellaneous debts, produces a total liability of over $3.14 billion, set against $3.43 billion in book assets. Of course, the high levels of depreciation has made the stated asset values unreliable, but it is still not an attractive picture.

But what leapt out at me was SBA’s credit facility, which requires that they have on an annualized basis, a debt/EBITDA of less than 5x, an EBITDA/cash interest of greater than 2x, and a debt/adjusted EBITDA of less than 8.9x. The company claims to be in full compliance with these provisions, but it occurs to me that they may be cutting it close. I have already calculated an interest coverage ratio of less than 2, and their actual debt/EBITDA on a year to date annualized basis is 10.77. Presumably, this apparent breach is cured by the securitization arrangement; the revenues and income from the securitized towers are consolidated for reporting purposes but not for the purposes of the credit facility, as they are in a special purpose vehicle and are nonrecourse anyway.

Unfortunately, we do not know what amount of revenues and cash flow are offsetting the interest requirements of these towers, but the firm claims that they meet the required 1.3x coverage of the securitization agreement. The debts issued by the securitization entity have a weighted average coupon of 4.6%, which, out of $1.23 billion in face value, is $56.58 million, or $14.1 million per quarter. Multiply by $1.3, and we get $18.4 million per quarter that is the minimum “reserve” from cash flows to comply with the terms.

So, carve out $1.23 billion in debts, $14.1 million in interest payments, and $18.4 million in securitization entity cash flows, and we are left with parent-level quarterly cash flows of roughly $58.8 million, interest payments of roughly $23.3 million, and total debt of $1.91 billion. This represents interest coverage of 2.5x and debt/EBITDA ratio of 8.1x. So it is pretty clear that the SBA is bumping up on the edge of their covenants. I should point out that the company has no borrowings on its credit facilities at this time. (I am also aware that the way I’ve written this test, the greater the share of securitization income, the lower the cash flows of the parent company are, but since the majority of the securitization’s cash flows are pledged to the debtors anyway, not very much of the income can be counted in favor of the parent company, at least until the notes are paid down somewhat).

So, although it seems that the market is willing to accept SBA Communications with an overall interest coverage ratio of 2, it would also appear that the company’s growth is decelerating and any actual diminution in the company’s current earnings would put them in a difficult situation covenant-wise. Furthermore, even if wireless traffic does expand, SBA may not be in a position to take advantage of the expansion without the ability to acquire more capital freely as necessary. This, coupled with decelerating growth, suggests to me that SBA is an attractive short candidate.

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