American tower: the perfect exposure to lower interest rates

I consider American Tower (NYSE: AMT) a great way to potentially gain capital appreciation when the Federal Reserve starts lowering interest rates. The company has a solid business model that is resilient to harm macroeconomics, it has strong cash flows (or funds from operations, in this case) and interesting headwinds that could make its stock a great investment. My rating is a strong buy.

American Tower Stock Status

The stock has been in a correction since the start of the Fed raising the Fed funds rate in early 2022. Although the stock has recovered significantly from the 2023 lows, the current price-to-AFFO ratio of about 20 is still contracted compared to end of 2019 when it was closer to 25.

Meanwhile, in its latest earnings results, the company expects an AFFO per share of $10.7 for the year, up from $7.8 in 2019, or 37% higher, and with a CAGR of 6.5%. I think this is impressive given the pandemic period and subsequent era of high interest rates, as this directly affects AFFO and company growth, as low interest rates are vital to the real estate business.

The American Tower Business Model and Expected Resilience Through a Macroeconomic Recession

American Tower has a simple business model. Let’s take a look at the latest 10K record. As with many REITs, rents are the primary source of income, but in this case, the business is directed to telecommunications companies, offering them hundreds and in many cases thousands of spaces suitable for telecommunications equipment. The company is massive and has around 224,000 sites worldwide on every continent. AMT also has 25 data centers thanks to the acquisition of CoreSite.

This business model is quite resilient as it provides an extremely important infrastructure for the entire economy and culture of the places that AMT covers. For this, its clients enter into leases of about 10 years on average with American Tower. Typically, the company may charge an incremental fixed rate, which is about 3% on average in the case of the US, an inflationary or mixed index. Due to the nature and importance of the business in the telecommunications services space, the loss rate of AMT is extremely low, around 3% in 2023, mainly caused by an extraordinary event, which is the merger of T-Mobile and Sprint Corporation which reduced in finally the demand for space. since now they covered their needs under the same name.

This is quite important as it provides almost automatic revenue growth rates without increasing operating expenses. This generates operating leverage, providing accelerated earnings or funds from operations, in the case of REITs, to AMT shareholders.

Another advantage the company has is the ability to renegotiate leases once they expire. This gives them an important resistance to inflation if needed. On the other hand, if there is a tough macroeconomic environment, AMT can preserve its revenue streams as it is critical to the smooth running of the telco’s operations.

Although American Tower is a diversified company that generates revenues worldwide, most of them correspond to the North American segment, with 48% of revenues, followed by Latin America with 16%. The data center segment is a relatively new business segment that has existed since the aforementioned CoreSite acquisition.

Debt dependence and interest rate sensitivity

As a REIT, American Tower needs a low interest rate environment to thrive. This helps them acquire multiple sites without having to immediately deploy the relatively large amounts of capital it would cost to buy real estate without financing.

This business model works relatively well in economic environments with falling or constant interest rates, but not when the Federal Reserve raises interest rates. Looking at its income statements, AMT nearly doubled its revenue from 2016, but also weakened its balance sheet, doubling its long-term debt for the period. This means that the company reported in its most recent earnings presentation a net leverage of about 5. This is usually not a problem for REITs because of the strength of the collateral they hold, i.e. real estate itself, but when interest rates go this high so quickly, as recently as 2022, adjusted funds margins from operations begin to suffer somewhat from higher interest expense. For example, American Tower has seen a $500 million increase in interest expense since the end of 2020 alone, and now management expects it to reach about $1.5 billion this year, which equates to roughly 30% of estimated AFFO for the current fiscal year.

What does management do?

In AMT’s most recent earnings call, management acknowledged the goal of achieving net leverage below 5. For that, management is doing something right, in my opinion. It’s worth remembering that AMT has a relatively new CEO in Steven Vondran, who has been at the helm since the beginning of the year.

First, management is divesting some assets, such as fiber in Mexico and operations in Poland, sold in 2023, where the company could not achieve sufficient performance scale. In addition, AMT has reached an agreement with Brookfield to sell its ATC business in India for $2.5 billion. Management has expressed that these resources will be used in deleveraging and dividend payments. I agree, it’s a good opportunity to buy bonds at lower prices before they go up again when the Federal Reserve finally cuts rates again.

Management is also redirecting capital allocation, sending those cash flows to investments made in developed markets and CoreSite, rather than continuing to invest in developing markets.

I don’t have a strong opinion on this measure, but it is understandable given the experiences of global currency underperformance like Nigeria and Kenya, or being outright outperformed like India.

What should happen to AMT shares and business

I think due to the solidity of American Tower’s business model, some assumptions can be made. First, the company could continue to grow at a slow and steady pace for a long time. Indeed, the company could re-accelerate growth through Data Center initiatives, but I’m not convinced that these measures will be material enough to move the needle just yet. For example, the AMT is raising revenue by about 7% this year alone, based on these current high interest rates.

Second, the company should continue to see operational leverage, especially if it focuses on existing markets such as the US. This can help support decent stock valuation and consistent resilience to macroeconomic challenges.

Third, the company should holistically benefit from a drop in interest rates. First, lower interest rates should help the company acquire more land and real estate to build more sites and continue to grow, albeit at a slower pace because developed markets don’t need too much new coverage. Second, American Tower should see a significant drop in interest payments. In my view, the long-term interest rate should come down to be more in line with the inflation rate, which the Fed has targeted at around 2%. That means, in my view, American Tower could eventually see $0.8 billion to $1 billion in new cash for AFFO attributable to shareholders. In a third position, lower rates would make it harder to get high returns, raising stock valuations.

Usually, when the Federal Reserve lowers interest rates, it’s because the economy is in or close to a recession. For most stocks, this means bad news as revenues fall and margins tend to collapse, especially among cyclical companies. American Tower, however, is a company with highly resilient cash flows from the infrastructure needed for core resilient businesses such as telecommunications companies. This means that the stock should be able to have lower volatility compared to other stocks and even thrive in a recession, in my opinion.

ASSESSMENT

For this evaluation framework, we considered several assumptions. First, stocks will continue to grow earnings by at least 10% because of lower interest rates that facilitate earnings growth of at least 6%. Second, because of lower interest rates, the company would likely have lower interest expenses, reducing the burden and returning cash to shareholders.

I also assume an extended 25x price-to-AFFO ratio as it seems more appropriate than the current 21x when interest rates are falling.

This framework, though optimistic, predicts that AMT could ultimately deliver up to 19% CAGR by 2028, which is massive compared to the usual 8% brought by the market on average.

Risks to AMT Investment

The biggest risk, in my opinion, comes directly from the short tenure of the CEO. While Mr. Vondran has an impressive track record and I believe he is well suited for the job, things may get out of hand with the new management. This could ultimately cause misallocation of capital or failure to deliver on promises. I consider this a relatively low risk.

Another important risk to AMT is the resurgence of inflation or macroeconomic instability around the world. If inflation somehow manages to rise again, AMT could suffer from stagnation and falling multiples. Macroeconomic instability could cause major balance sheet impairments, such as those noted in the cases of Nigeria or Kenya.

Conclusion

American Tower is an extremely solid business with plenty of leverage and mostly good prospects for the future. The company has some balance sheet challenges, but ultimately, with lower interest rates, the company could unlock significant amounts of value for its shareholders. Therefore, I consider AMT a strong buy case.