Crown Castle's second-quarter numbers looked great, with higher-than-expected revenue and profits serving as a prelude to the firm raising 2019 guidance. However, 100% of the outperformance relative to our forecast was due to nonrecurring network services and other revenue rather than site-rental revenue (leasing revenue on towers, small cells, and fiber). More importantly, we are yet to see impressive fiber revenue results. Our inability to find a competitive advantage in fiber led us to our no-moat rating, and until the firm can parlay its high capital spending into outsize revenue growth, we expect to maintain our preference for pure-play tower businesses. After incorporating the current results, we are raising our fair value estimate to $86 from $84, but we still see shares as overvalued.
Total revenue grew 11% year over year, though site-rental revenue grew at a more typical 6% rate. The consolidated gross margin--which we expect to trend upward due to tower and small-cell operating leverage--was up 100 basis points from last year's second quarter, and the adjusted EBITDA margin was effectively unchanged at 58%.
Fiber revenue grew 6% year over year, and we estimate small-cell revenue growth within the segment was in the low teens. We project small-cell revenue to grow double digits throughout our 10-year forecast, but we don't believe it adds value until Crown colocates multiple tenants on each fiber run, thereby leveraging the investment. According to management, anchor tenants will continue to dominate for the foreseeable future, so we expect fiber capital intensity—greater than 80% over the last 12 months—to remain high. Fiber gross margin was up 50 basis points year over year, which we attribute mostly to the lagging, lower-margin fiber solutions sales rather than operating leverage. We still anticipate margins will continue trending up as small cells make up a continually greater portion of segment revenue and more colocation occurs.
Crown Castle's strategy has deviated from its two biggest competitors, which focus almost exclusively on towers and have a multinational footprint. Crown now operates exclusively in the U.S. and is aggressively investing in fiber to pursue small-cell communications sites. In our view, Crown Castle has adopted a high-risk strategy. While we acknowledge the potential upside of its fiber investments, they require heavy initial investment and lack the competitive advantage that Crown has with its towers.
We like Crown's legacy tower business (70% of total revenue in 2018), where it leases space on its towers to wireless carriers, who install antennas and other equipment. The carriers enter long-term leases with Crown that include rent escalators (annual increases of about 3%), giving the business a highly visible and stable revenue stream. Towers are also the beneficiaries of the explosion in mobile data use, which has been growing 30%-40% per year in the U.S. To meet the demand, carriers either locate equipment on additional towers or add or modify equipment on existing towers. Significant operating leverage makes both alternatives highly profitable for Crown—additional tenants and equipment upgrades can both be added to towers for very little incremental cost. We think towers will continue to be an integral part of the long-term mobile network solution.
Crown is transitioning to become less reliant on its tower business by acquiring fiber (it now owns 65,000 route miles) and setting up small cells on it. We see this as a response to the growth in consumers' data use and a pending evolution in network infrastructure, which may be necessary as the U.S. moves to 5G networks. However, we think Crown faces challenges with its fiber that will keep returns on invested capital depressed for several years. Crown is limited in how quickly it can set up small cells, leaving an extended period before we think it can fully monetize its fiber. We estimate Crown can only build about 15,000 cells per year. We are also concerned with the very high capital expenditures associated with the small cell buildout and think competition will constrain pricing power.
We rate Crown Castle as having no moat. We think Crown Castle's tower business, which accounted for 70% of companywide revenue in 2018, continues to have very moatworthy qualities. However, the company has spent more than $10 billion over the last several years acquiring fiber assets and fiber companies. Fiber competition from wireless carriers and cable companies makes generating excess returns on fiber uncertain. We think Crown will ultimately monetize those assets to a greater degree than it is currently and generate excess returns on them, but we don't see it happening yet, and we expect it to take time. Consequently, the company has not outearned the 8.1% cost of capital that we estimate for it since 2013, and in our view, the firm will be challenged to generate excess returns in the near term.
Crown Castle's inability to generate excess returns is a direct result, in our opinion, of all the capital it has spent on fiber assets. Crown's vision is to primarily use the fiber to set up small cells, which are effectively mini-towers that wireless service providers use to support their networks. The massive growth in consumers' wireless data usage over the last several years strains providers' networks. If carriers don't have additional spectrum to deploy, their best alternative to improve their networks is densifying them, meaning locating towers closer together. In cities, this often means using small cells, where antennas are located on fixtures such as light poles rather than higher tower structures. Furthermore, as 5G becomes the standard wireless technology over the next decade, and 5G will be defined by both faster speeds and lower latency, or lag times, small cells are likely to become vital in cities.
With its significant acquisitions, Crown Castle now holds more than 65,000 route miles of fiber. However, we think the company can set up a maximum of only about 15,000 small cells per year. We estimate that it will take several years for Crown to get its small cell network fully (and profitably) deployed on the fiber it already owns. Given that small cells are in the early stages, it is possible that Crown Castle will be unable to develop switching costs or other competitive advantages on small cells that we think would be necessary to earn adequate returns on capital. Adding to the challenge, many telecom companies own substantially greater amounts of fiber than Crown Castle. Globally, AT&T owns over a million route miles, and Verizon owns about 900,000. With so much fiber already in the ground, it's possible that wireless carriers like AT&T or Verizon, or even cable companies like Charter or Comcast, will use their networks to rival Crown's.
Crown's tower business does have a moat in our opinion, but it hasn't shown it can generate returns strong enough to overcome the recent building of the fiber business and keep the firm economically profitable. 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 multi-year leases. The tower business is very capital intensive, and returns are typically not stellar 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 four wireless carriers. Given this industry dynamic, where yields on towers are typically in the mid-single 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 five to 10 years, and, especially given a likely need to offer lower average prices to carriers to entice them to switch, would likely 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 years-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 between 1% and 2%.
Even if a competitor wanted to take on a tower incumbent, it could struggle to obtain the permits necessary to build a tower. Towers are subject to zoning restrictions, and zoning authorities and community residents often oppose tower construction in their communities. The opposition has obviously not been such an impediment that it precludes towers from ever gaining approval, but we think additional towers in areas that already have sufficient network coverage would face significantly greater difficulty obtaining approval than those that are built to improve a network, thus making tower construction for the sole purpose of providing competition a much more difficult regulatory endeavor.
Although we believe the biggest part of Crown's business has a moat, we cannot say the company has one while it consistently fails to earn returns in excess of its cost of capital. The investments may one day prove to be lucrative, but for the time being we can't say with confidence that the firm is more likely than not to earn excess returns for most of the next decade.
We are raising our fair value estimate for Crown Castle to $86 from $84. Based on our 2019 projections, our valuation implies a P/AFFO multiple of 15 and an EV/adjusted EBITDA multiple of 15, both well below where the stock has traded in recent years.
We project Crown to average 6% revenue growth annually throughout our 10-year forecast, driven by 6% average annual growth in towers and 8% average annual growth in fiber, resulting in towers falling from 70% of total sales in 2018 to 65% by 2028. Our fiber revenue growth assumes 15,000 small-cell nodes added each year, 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 colocated on fiber the company has already deployed for small cells, leading to substantially lower capital spending to activate those nodes. We project that by 2023, nearly half of the nodes deployed each year will be colocated nodes rather than nodes built for anchor tenants (compared with 30% colocated nodes in 2018). In conjunction with our expectation for few tower-builds each year, we expect capital expenditures as a percentage of sales to drop substantially over the next decade. However, despite rapid small-cell revenue growth, which we project to be 15%-20% annually for each of the next five years, slower-growing enterprise fiber sales will hold back the overall fiber segment's revenue growth.
We expect margins to improve significantly over the next decade, with both gross margin and EBITDA margin rising between 500 and 700 basis points by 2028. We think operating leverage in the tower business will be largely responsible. With less investment in new towers, which typically have significantly fewer tenants per tower, revenue growth will be primarily from colocations, amendments, and escalators, which will mostly drop straight to the bottom line. We expect the lower-margin fiber business to constitute a bigger portion of companywide revenue (from less than 30% in 2017 to over 35% by 2028), but we expect significant margin improvement in that segment as well. We believe small cells generate higher margins than fiber solutions sales to enterprises, so a higher mix of small-cell revenue will improve the segment's margins. Additionally, as more new small-cell nodes are colocated on existing fiber, small-cell margins themselves should improve.
We view Crown Castle as a high uncertainty name, as it has recently transformed its business model from one that focuses exclusively on macro towers to one betting on the success of the small cell business. 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 upwards of $10 billion acquiring fiber assets over the last 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 70% of revenue in 2018, could suffer, and Crown does not have nearly enough small cells to mitigate a large decline in its tower business.
We think Crown is also the most exposed tower company to U.S. carrier consolidation. It is the only one of the three major U.S. tower firms operating solely in the U.S., leaving its entire tower business exposed. Furthermore, we think T-Mobile and Sprint are likely much more dependent on Crown's fiber for small cell purposes than AT&T and Verizon, which both own significant amounts of fiber themselves. Whereas each of the U.S. carriers are dependent on third parties for all their tower needs, we think some areas count only Sprint and T-Mobile as small-cell prospects, leaving a combination of the two more painful for Crown Castle's fiber segment.
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 view Crown Castle as having Standard stewardship. We think it has many shareholder-friendly policies, including the splitting of the chairman and CEO roles and annual elections for all directors. The 12-person board has been led by J. Landis Martin since 2002, and 10 directors are independent. Jay Brown moved into the CEO role in mid-2016. He has been with Crown Castle since 1999 and spent eight years as executive vice president and CFO immediately before becoming CEO. Board member W. Benjamin Moreland preceded Brown as CEO; he too served as executive vice president and CFO before becoming CEO in 2008. Daniel Schlanger became senior vice president and CFO upon Brown's promotion. However, he did not join Crown Castle until 2016, and he came with little telecommunications experience, having spent most of his career working in the oil and gas industry. At 44 years old, he may be groomed to be a successor down the road. If a successor was needed nearer-term, we think it would more likely be senior vice president and COO James Young, who is 56 years old, joined the company in 2000, and previously worked for Nextel.
We applaud the board and management for not being complacent and being on the forefront of potential industry shifts. Most recently, that has taken the form of several large acquisitions of fiber companies. Our concern is that in the near-term they have bought more fiber than they can sufficiently monetize. We expect it will be several years before they can earn economic profits on their fiber, but we expect them to get to that point eventually. Crown has chosen to enter the fiber business rather than diversify its tower portfolio internationally, as its competitors have done. It also has chosen a portfolio concentrated in urban areas, again opposite of its peers. We think its strategy is riskier, but small cells could be integral pieces of future networks, so if management can execute on its purchases, we think they will prove to be smart.
We also favorably view management's decision to become a REIT in recent years. We think the tax advantages benefit shareholders, and we don't expect Crown to have any difficulty meeting its dividend obligations. We expect the dividend to grow 9%-10% annually throughout our forecast, and we expect it to be the primary method of shareholder return, as we don't project significant share repurchases.
We think management is sufficiently invested in the stock's performance, but we think that cuts both ways if it encourages riskier acquisitions with bigger upsides. Seventy to 80% of targeted compensation for top executives is in the form of long-term RSU bonuses; 8%-13% is base salary. That said, because we think annual salaries are extremely fair—the CEO's base salary was $725,000 in 2017—we don't think equity bonuses are viewed like lottery tickets. We think management has sufficient personal financial reasons to avoid too much risk to the equity.
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