Why Fewer Hands Hold More Towers and Other Digital Assets
Episode ID S2E10
September 13, 2023
First it was towers, and now it’s fiber: The days of separately owned digital infrastructure assets are coming to an end. One driver is wireless operators, who want one-stop broadband partners who can handle complex needs. In this episode of All Day Digital, investment banker and former communications equity analyst Jennifer Fritzsche explains how rapidly changing customer needs are helping drive consolidation, and what that looks like for rural America.
Jennifer Fritzsche: Money is burning a hole in many of a pocket and needs to be put to work. I think we're going to see people get busy again, but certainly, when money was essentially free, it's a hard comp to compare it to.
Jeff Johnston: That was Jennifer Fritzsche, managing director at the global investment bank, Greenhill, regarding the current state of the digital infrastructure M&A market.
Hi, I’m Jeff Johnston and welcome to the All Day Digital podcast where we talk to industry executives and thought leaders to get their perspective on a wide range of factors shaping the communications industry. This podcast is brought to you by CoBank’s Knowledge Exchange group.
The digital infrastructure market is going through various waves of consolidation, given the adoption of AI, changing customer needs, and investors’ insatiable appetite to own these assets.
Jennifer’s extensive experience as a communications equity analyst and her current perspective as an investment banker makes her the perfect guest to talk about this dynamic and rapidly changing market.
So, without any further ado, pitter patter, let’s see what Jennifer has to say.
Jennifer, welcome to the podcast. It is an absolute pleasure to have you here with us today.
Fritzsche: Thank you for asking me, Jeff. I'm honored to be here. I'm a big fan of CoBank.
Johnston: Thank you. Well, I've been meaning to have you on for a while, actually. I've been tracking you down and, so we're super excited to have you here today and to talk about digital infrastructure and what's happening from a consolidation standpoint. Maybe just real high level, Jennifer, maybe you can just help us understand or provide an overview of, A, what is digital infrastructure and then, B, what's happening as it relates to M&A and consolidation in the space?
Fritzsche: Sure. Is it helpful to just give my background to talk about why I have this view, if that's helpful?
Johnston: Certainly, yes. Absolutely, would love to hear that.
Fritzsche: Perfect. Right now I'm a banker at Greenhill, but my view is different and experience is different from the typical banker because I was an equity research analyst for 25 years at Wells Fargo or different predecessors of Wells. During that time, I followed not only the carrier space, AT&T, Verizon, et cetera, but also what we called digital infrastructure. I followed the towers since the late '90s when they came public, fiber, data centers, and all that came with it.
Then about two-and-a-half years ago, I pivoted to the banker role, but I give that as the backdrop because the majority of my career, like the mother lode of my career was spent just going deep into these models, companies, management team, strategies, et cetera. To answer your first question, how would I define digital infrastructure? I would define it as the infrastructure needed to support all broadband needs, those both wireless, wireline, and different forms of that.
When I was an analyst, that used to be very neatly separated silos. I would call it towers, macro towers being one, small cells being another, fiber being another, and then data centers being another. You can add sub-bullets to all that, edge, in building, et cetera. What we've seen, and to answer your second question, in the space since my time as an analyst is a morphing of what used to be independent and separate silos. You have tower companies buying data centers. You have data centers playing the edge. You have tower companies buying fiber companies, and so you've seen this morphing of what used to be separate and distinct independent silos.
Johnston: Do you think that's because the industry is maturing and we're seeing this vertical integration theme play out, which we I think see in in certain mature industries? You think that's at play here, Jennifer, or is there other strategic things at play here that are resulting in all of this consolidation?
Fritzsche: I think the customer's needs are changing and the customers themselves are changing. I always quote this story to people, but when I did take that hiatus from going to be an analyst, took a year off to being a banker, one of my favorite former CEOs said to me, he is like, "Did you ever think you'd come back after a year and see Microsoft be the largest telecom company?" It was an interesting comment, but very telling, because when I was an analyst, the cloud providers weren't as aggressive as they are now.
You look at Microsoft as the example. They're very much in the wireless business although they don't own any exclusive license spectrum. They've made big bets through acquisitions on wireless, 5G, et cetera. The customers themselves are changing, and the customer needs also are changing. Verizon might have just dealt with American Tower or Crown Castle just for macro cell sites, but then they bought all the spectrum and said, "Okay, some of the spectrum if physics still works, is best supported for small cells. American Tower, can you help me with that? Crown Castle, can you help me with that?" I think what you've seen the digital infrastructure providers do is just put more tools in the toolkit to help this growing customer base.
Johnston: That makes sense. It's new spectrum was auctioned off, and it had different propagation characteristics. The architect of the network starts to change and takes on different types of configurations. I could see how that gets a heck of a lot more complicated. Having more of a one-stop solution from some of your infrastructure providers would help things a lot.
Fritzsche: That's right. Exactly. I don't want to say one throat to choke, but kind of. You want one point person to help you with those needs.
Johnston: Is there also a cost element here as well? The customer's needs are changing from an architecture standpoint, but look, we know margins are tight. The wireless industry, is obviously very competitive. Do you think there's a cost element here as well? If you aggregate more volume with certain vendors, you can get better pricing?
Fritzsche: That's true in some ways, but not always. For example, the towers is a great example of that. The tower margins are as good as any industry I've ever seen. I think the beauty of the tower model, not if you're a carrier, but is the NIMBY effect, the Not In My Back Yard is alive and well. It's hard for AT&T to say to American Tower, "I don't want to pay that price for the tower or lease on the tower because there's typically not another tower in site by a mile." Again, if physics still works, it's hard to support that signal. Then you go down the rabbit hole of the towers are protecting the integrity of the network, which is the number one focus of churn or keeping churn down.
I think, in some ways, it is. From a cost side of it, digital infrastructure, be it towers or small cells, just on the wireless sides are very small percentage of total costs for the carriers. I think it's less about costs, and they still have so much heavy lifting to do. Just sticking with the wireless side, Verizon paid north of $40 billion in the C-band spectrum auction. There's an extremely high carrying cost to just sitting with that spectrum and not building it out.
Johnston: That makes sense. What about data centers, whether it's co-location data centers, or edge data centers, or pick your pick your flavor, I guess? How do you think about consolidation in that industry?
Fritzsche: It's been massive, and I think we're still going to see major layers of it. Just to give you some perspective. Again, I was an analyst three years ago. Four of the names I used to follow, those being switched, CyrusOne, CoreSite, and QTS are now private companies in the hands of large infrastructure funds. It just shows you how much things have changed and how much consolidation has happened.
I think you will continue to see aggressive consolidation because one of the things that has been just the phenomenon has been AI. We all know and read the articles about what AI has done. The customers, I'm talking more on the hyper scaler, so the cloud service providers, are spending so aggressively ahead of that that the challenge is cost of capital and being able to fund ahead of those customers’ needs. That's the bag of tricks that all the data centers are really grappling with here.
Johnston: When you say the cost of capital, I hear of aggressive lending programs where you're securitizing assets and so forth. You're referring to that?
Fritzsche: Just everything's gotten harder in the data center world. It's gotten more expensive to build. Inflation is a real issue. Power is a real issue. Cooling is a real issue. Again, when I was an analyst, a big deal was 20 to 30 megawatts. I remember writing many a note saying, "Wow, big deal." Now that number is like 300 megawatts for a large deal. You're seeing this just massive demand. What I mean is spending ahead of that customer demand at a more expensive cost to do so, because those customers, the hyperscalers, will go to where there's room at the end. You need that room of that in. You got to be front-footed ahead of these customers.
Johnston: Got it. That makes sense. Do you see the hyper scalers primarily building versus buying, or are they looking at strategically around picking off data center locations that fit their network nicely and have the necessary capacity and access and all that kind of stuff? How do they think about that?
Fritzsche: They're doing both, but I think like towers and wireless, data centers is not the core business of cloud service providers. Their capital is better spent in other places. They've been leaning in and relying heavily in terms of using third party sources, and those third parties that have room, again, space, capacity, it's been key here.
Johnston: That would be, I guess, for an institutional investor, an infrastructure fund, that's got to be really attractive to fund those third-party companies that are signing these multi-year agreements with the likes of Facebook and others?
Fritzsche: Absolutely, yes. The definition of cloud service providers has also expanded. It used to be just mostly Microsoft, AWS, and Google. Now, you mention Apple, Facebook, the layer-- Oracle. There's layers of hyperscalers that are just aggressively growing as well.
Johnston: Yes. When you were talking about costs, you touched on the labor environment, I believe, and interest rates, and I certainly get how that can impact how quickly you can build a new network or build a new data center, and of course, the associated increased cost with that. What are you seeing or how are you thinking about the interest rate environment, the current economic environment as it relates to M&A?
Is there any sort of pullback at all just because some of these economic uncertainties and higher cost of capital from an M&A standpoint? Or is it still we've got so much to build, we need to build it quickly, but yes, things might be a little bit touch and go right now in the economy, but we can't wait? We got to continue just plowing full steam ahead. How do you think about that?
Fritzsche: I'm looking up notes because I wanted to call out this big point. You definitely have seen a slowdown for sure, and TMT Finance, which is kind of the go-to periodical in our world put out a first half of 2023 trend analysis. While the number of American U.S.-based telecom deals was relatively flat in the first half of '23 versus the first half of '22, the absolute dollar of those deals is down 64% year-over-year, first six months of '23 versus first six months of '22. I think that is very much a reflection of, "Oh my gosh, deer in headlights, interest rates, what's going on?"
I'm hopeful, and we'll see, we're recording this the first day when people are really back to work that I'm hopeful there will be an acceptance of, "It is what it is. This is the new reality, and now-- Money is burning a hole in many of a pocket and needs to be put to work. I think we're going to see people get busy again, but certainly, when money was essentially free, it's a hard comp to compare it to.
Johnston: Yes, for sure. Do you think there's also a valuation disconnect, too? Whereas you have might have investors who are looking at higher discount factors and reducing the value of assets in today's dollars because as we know, a higher discount factor reduces today's cash-flow. Looking at the value of businesses today where the seller might be saying, "Hey, look, there's all these tailwinds in my industry right now. Yes, I get that interest rates are higher than they were 12, 18 months ago, but things have only gotten-- demand is only growing and that's not going to slow down from my business, so I'm not going to sell at the number you want me to sell at, even though you're justifying it through higher interest rates." Is there any of those sort of staring contests going on, you think, out there?
Fritzsche: I do. I think you have a lot of that. I think though, like the classic example, again, back to towers is you've had the three public tower companies just take a whooping in terms of multiples. They've really probably decreased 6 to 8 turns, whereas the private multiples for tower industries was still north of 30 times in some cases. What our checks have shown is you've started to see that more, not get down to the high teens, but come downward from the private side. I think that is exact function of what you're saying, where maybe some sellers had too high of expectations, and now they're realizing the reality around them.
Johnston: Using a baseball analogy, if you will, around where we are in this consolidation trend, and I realize there's different industries with different characteristics, and they're all unique in of themselves, I think, whether it's towers or data centers or fiber, transport companies, et cetera. maybe with data centers, tower companies, where do you think we are right now in the consolidation phase, again, if we were to use a baseball analogy.
Fritzsche: The consolidation phase of the tower industry, I think we're in the eighth inning, because I don't think the big public ones would ever be allowed to merge. Many of the smaller deals have already been done. I think all eyes on U.S. Cellular. They are essentially the fourth-largest tower company. The company has announced intentions to pursue strategic alternatives, all eyes on U.S. Cellular. I think then if you break down the fiber industry, there's two sub-bullets to that. Fiber to the home. I would say people are walking in the ballpark, maybe getting their coats off to sit down. There's definitely going to be a major consolidation.
Fiber to the home has gotten so many little fiber to the home orphans, as you know, that are backed by many different funds both private equity and infrastructure funds. It reminds me of when I followed wireless and there were a lot of rural wireless companies, and they all got consolidated. That's where we are. We're going to be massive consolidation, I think. For data centers, it's an interesting thing because you've had, as I mentioned, a lot of the private capital come and take these public companies private. It wouldn't surprise me if we see eventually a reversal of that, that some of their exits might be back to the public markets.
I think that there will be continued consolidation there. You have, I think, ones to watch, TierPoint, DartPoints, Flexential, Cyxtera. There's a lot of ones that probably are going to be part of something interesting or get different financial backers to come in there and fund the next leg of growth. Then again, the sub-bullet under data centers is edge. I think they're, again, maybe first, second inning early. Still has to play out.
Then the one I wanted to mention also that seems to be the forgotten child left in the corner is enterprise fiber. No one wants to talk about it anymore. I actually think the perception of how bad it is is much worse than the reality. I think the growth in data centers is only enabled to happen with big fat fiber pipes leading to those. There is the infrastructure needed on the fiber side. Even if we do go into recession, which seems less likely now, should not be-- fiber, especially enterprise fiber is the nervous system of everything on the business side, and I think that that should not be overlooked.
Johnston: Yes, you're right. You don't hear a lot about that. What is the perception then?
Fritzsche: I think it's that the economy's going to hell in the handbag and that, therefore, no enterprise fiber will be needed. What I think the reality is this is very hard to replicate. It's a wide moat around the business. It's a hard business. As things like AI, data centers, 5G, the thing I try to remind people is wireless needs wires. All of this, the enterprise fiber side of it, again, it's critical-- Using the analogy I used to use as an analyst was the cardiovascular system, is these are the veins going through the body to allow the blood flow to happen.
Johnston: I would think, too, if we just think about the current labor market and how tight that is and how companies are having to rethink how they do things, how they can be more efficient, and so you look at AI as you mentioned. There's a lot of operational efficiencies that can be achieved with AI that can address some of these labor shortfalls. There's going to be a lot of data that's going to be created and have to be transported throughout different arteries using your analogy. That's an interesting perspective because I would think about it the complete opposite way given, even if we do go into recession, it's going to force companies I think to get even that much more creative and aggressive on reducing costs and improving efficiencies.
Fritzsche: That's right. I think the other thing I would add is there's a lot less competition in markets. There might be a lot of enterprise fiber in, I live in Chicago, downtown in the loop, but the ones that are crossing the country I think are very hard to replicate here. Again, I don't think that can be underestimated.
Johnston: No, I would completely agree. Well, Jennifer we have covered a lot here today, which is fantastic, so thank you so much for that. Before we wrap it up, I want to just give you an opportunity to talk about anything or share anything that we haven't yet talked about that you think is important to address.
Fritzsche: I do think just in general that we are still in the early innings. I think that we have yet to see what AI is not only going to do the data centers, but just to every layer of this business. I think it's critical that none of that computing power, 5G, all autonomous cars, none of that can happen without the infrastructure behind it. I think that people are realizing it, but I think there should be a lot of excitement around it going into 2024.
Johnston: That's great. I think a lot of the European infrastructure funds have realized that and are beating the bushes looking for opportunities here, so that makes a lot of sense.
Fritzsche: Definitely, definitely.
Johnston: Well, Jennifer, thank you so much for being on the podcast today. I sincerely appreciate it.
Fritzsche: Thank you so much, Jeff. Great to see you always.
Johnston: A special thanks goes out to Jennifer for joining us on the podcast today. The digital infrastructure market is a fascinating one with an unprecedented amount of capital being thrown at it by the largest companies in the world. One of the things that really jumped out at me in my conversation with Jennifer is how rapidly changing customer needs are one of the driving forces behind the consolidation trend. And I have to believe that is only going to accelerate as AI starts to fundamentally change how works get done and how we live our lives.
Hey thanks for joining me today and watch out for the next episode of the All Day Digital podcast.
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