How to achieve scale in the Chinese independent towerco market: Build or buy?

What is the size and structure of the independent towerco market in China? How investible are those towercos? What will be the role of independent towercos as China continues its evolution toward a philosophy of shared infrastructure, injecting 1mn+ legacy towers into China Tower Company (CTC); can independent towercos compete with CTC? TowerXchange recently visited the leaders of several independent Chinese towercos in Beijing and Shanghai: here’s what we learned.

It’s 4pm in Beijing but 9am back home – I’ve just effectively worked through the night again and the jet lag has kicked back in. I haven’t slept much on my week-long tour of the Chinese tower industry, but I’ve learned a lot from 14 face to face meetings and meals in which I’ve drunk a lot of tea, drunk rather too much wine, and decided TowerXchange needs to expand our research practice to cover the highly investible, exciting, massive new Chinese tower market.

Independent towercos own just 1.7% of China’s ~1.18mn towers. TowerXchange forecast independent towerco penetration in China to rise to 6.5% by the end of FY17.

If that sounds small, consider this: by the end of 2017 we forecast that independent towercos will own 100,000 towers in China, and the largest independent towerco in China will probably be one of the top ten largest towercos in the world by tower count.

In 2014, as few as 5,000 towers were owned by independent towercos in China, with the balance, and most the new build, remaining on the books of the country’s three State-owned MNOs. With the advent of CTC came a moratorium on MNOs building their own towers, but whilst CTC gets up to capacity, there is a window for local tower builders and real estate entrepreneurs to build towers for the MNOs. Of the ~150,000 new towers built in 2015, around 10% were built by independent towercos. Some of the more bullish estimates I heard in China were for that proportion to rise as high as 30% within a year. And with China Telecom and China Unicom racing to catchup China Mobile’s 4G rollout, China is building a lot more towers!

Hundreds of new independent towercos have been created to exploit this new and potentially expanding window of opportunity, creating a highly fragmented market of ~200 independent tower companies. A handful of 1,000+ towercos (exemplified by Guodong, Miteno and Sinonetstone) represent ~40% of the independent tower market in China, a further ~35 regional towercos with tower counts between 100 and 999 (for example China Victory, Q Towers and Senno Telecom) represent the next 40%, with the final 20% represented by ~25 towercos with double digit counts (for example Sanyuan Tec) and the usual assortment of “onesies and twosies”.

While the original vision might have been for China’s MNOs to discontinue building their own towers and for all new build to go through CTC (the MNOs do seem to have stopped building, and the majority of new builds are going through CTC), the reality is that new towers are commissioned through a variety of different formal and informal processes as you move across China’s vast territory, and there are ample opportunities for third parties to secure business.

Before TowerXchange came to China, we had heard reports of a formal ‘Clearing House’ type system through which MNOs commissioned new towers. While that may be the case in some regions, it’s not something we encountered. Where the local network planner has a good relationship with CTC, and where CTC has the capacity, CTC will generally build and own the tower. Where CTC lacks the capacity, their preference is to contract a third party purely as a tower builder – the third party makes a modest margin, but the tower ends up on CTC’s balance sheet. But we heard of plenty of instances where independent tower companies were able to step in and build their own tower in the absence of CTC capacity. And we heard of instances where independent tower companies were able to undercut CTC – sometimes by as little as 3%, sometimes by a double digit percentage.

Open processes are used to attract bidders for tower build projects in several parts of China – we heard reports that competing with eight different bidders was normal, one interviewee said they participated in a process with 34 bidders!

So don’t assume CTC will build all the new towers under the new co-construction regime in China: there are opportunities for independent tower companies to cultivate local relationships, to be lean and agile, to build towers faster or cheaper than CTC can. While CTC will still build the majority of new towers, how large a majority may depend on how long it takes CTC to get up to capacity.

Whilst this window exists for China’s independent tower companies to get to scale, what does success look like?

I’d like to propose three different definitions of scale when discussing the Chinese tower market. One, at what scale can a tower company be a meaningful stakeholder within a regional market, for example within one of China’s 31 Provinces? Two, at what scale do an independent Chinese tower company’s options increase in terms of access to capital? And three, at what scale could a Chinese tower company consider an IPO or trade sale at a scale necessary to meet private-equity-type return expectations?

A tower company doesn’t have to have a double digit market share in a million tower market to still be an interesting and investible business. Don’t think about China as one country of a million towers, but as a collection of 31 Provinces, each with differing network investment needs, and each with it’s own set of local stakeholders. There are over 180 cities in China with over one million inhabitants in their urban area – and 32 cities with over 3mn inhabitants. TowerXchange heard report of one of those top 32 cities where two independent tower companies share over 80% of the towers between them. If an independent towerco has great local site hunters, can cultivate relationships with local network planners, can cultivate relationships with local city planners, and can build a significant footprint in a dense urban area, that’s one definition of scale, whether it takes a few hundred towers or a few thousand!

Our second definition of scale concerns access to capital. Access to capital is the principle growing pain for Chinese independent tower companies seeking to reach scale. Chinese banks do not yet recognise towers as securable assets and, even where a dialogue can be established with a financial institution, accessing debt is time consuming and expensive. While internationally telecom tower companies are accepted as operating a business model which naturally lends itself to a degree of leverage, the investment culture in China strongly favors investment in profitable companies. While tower entrepreneurs worldwide are used to the challenge raising capital for a portfolio of less than 1,000 towers, the definition of scale insofar as it concerns access to capital is determined less by site count and more by bottom line profitability in China.

Our third definition of scale naturally follows the last: if they can raise capital, how big does a Chinese independent tower company have to become in order to realise the kind of exit which would satisfy a private equity investor looking to deploy RMB 300mn+ / US$50mn+?

A Chinese independent towerco of scale has a range of options, from single or dual IPOs on the Shanghai, Shenzen or Hong Kong stock exchanges, to realising an exit through a trade sale. There is one listed tower company in China, Beijing Miteno Communication Technology Co. Ltd (Miteno), but Miteno is an imperfect benchmark for scale because the company has a substantial tower design, manufacture and installation business in addition to their 1,000 tower portfolio. A pureplay tower company might need to be approaching Tower Cash Flow (TCF) of RMB 500mn (US$175mn), and might need to be profitable, before an IPO became a realistic option. And there is a long queue to list on China’s domestic stock exchanges.

International tower companies have visited to China to meet with the country’s local tower companies, indeed more than one international tower company already has capital at work in Chinese towers. But to provide a meaningful exit, an international strategic investor is going to need more scale than there is currently to be found among China’s independent tower companies. Appetite and interest might increase for a portfolio of 25,000+ Chinese towers, a scale which TowerXchange forecast China’s largest independent tower company could reach by the end of FY2017.

In summary; if you define scale as a function of the importance a towerco has attained in a regional market, the road to scale for China’s independent tower companies may be shorter than you think. If you define scale as a function of access to capital, it’s a long and painful march to scale. And if you define scale as having the option to exit via IPO or trade sale, you may need 5,000+ towers and RMB 500mn+ TCF to realise the former option, 25,000 towers and RMB 2.5bn+ TCF to realise the latter.

A fourth question about scale: at what scale might an independent tower company be seen as a challenge to the realisation of the vision and valuation of China Tower Company, such that this State owned entity might be prompted to take action?

We can identify the risks of ‘Nationalisation’ of independent tower company’s assets, but TowerXchange are not qualified to quantify those risks. What we can say is that CTC is currently preoccupied with auditing and ingesting over a million cell sites, and has an order book in excess of 100,000 towers per year. CTC is also following a roadmap to an IPO within around 18 months. So CTC are very busy. Aggressively competing with, or acquiring, independent tower companies does not appear to be a near term priority for CTC.

Any sound approach to risk management will tell you that even if the risk has low probability, if its prospective impact is great it must be taken seriously, and this certainly applies to the risk of ‘Nationalisation’ of independent towers in China. When TowerXchange speaks to international investors about China, this is one of the first questions they ask.

So if they wanted to, how could CTC apply pressure to the independent sector in the Chinese tower market? One, the State could increase the pressure on China’s three MNOs to order all new towers through CTC. China’s infrastructure sharing guidelines already prohibit signing exclusive agreements with third parties for the construction or leasing of communications infrastructure, but to date hasn’t precluded individual build projects being assigned to independent towercos. Even if the MIIT, or more likely SASAC, tightened up restrictions on use of third parties, there would likely be a time lapse between policy change and enforcement. That said, I would characterise the attitude of the MIIT toward independent towercos as progressive, so this paragraph represents exploration of one scenario, and is a scenario I currently feel is unlikely to be played out.

The second way CTC could apply pressure to independent towercos is a more commercial strategy; simply build parallel infrastructure alongside independent towerco sites, or aggressively undercut independent towerco prices. Neither seems a likely course of action for a company that is both struggling to build up build capacity, and at the same time seeking to build an attractive valuation for IPO. China’s aforementioned infrastructure sharing guidelines explicitly prohibit the building of parallel infrastructure (on pain of dismissal!), so this scenario is even less likely.

A third course of action might be some sort of compulsory purchase order of independent infrastructure, presumably at a price favoring the State owned entity. This kind of open ‘Nationalisation’ of assets would seem to fly in the face of “The China Dream” proposed by President Xi Jinping, built on an open market system driven by competition.

While Nationalisation undoubtably scores high impact risk, whilst the independent towerco sector in China represents <10% of the total market, my feeling is that Nationalisation risk scores low on probability.

Let’s establish a few baseline numbers before considering the relative merits of building versus buying towers in China. The economics of an individual Chinese tower are more comparable to Indian than to the U.S. tower market, with capital outlay per Chinese tower of 250,000-350,000 RMB (US$37,500-52,500) and lease rates in a RMB 4,500-6,000 pcm range (US$650-900). It should be noted that a significant proportion of Chinese ground based towers are monopoles, which reduces both steel and land costs.

There hasn’t been enough transaction volume to set a reliable benchmark for the acquisition of an existing tower, but TowerXchange has heard reports of valuations from RMB 350-600,000 per tower (US$52,500-90,000). We were told that at one point CTC had a standing offer to buy existing independent towers for around US$80,000 each, but that intel was not repeated during our visit so it either had little effect, or the offer is no longer on the table.

I spoke to some very smart tower entrepreneurs in China who favor organic growth; they’re building fast, and think they can achieve scale without paying a premium for inorganic growth whilst the market is under-supplied. I also spoke to some equally smart and respected tower entrepreneurs who enthusiastically evangelised the rollup of small to mid-sized independent Chinese tower portfolios to accelerate the path to scale.

From Brazil to Myanmar, from Nigeria to Indonesia, most tower entrepreneurs will tell you the return on capital invested (ROCI) to build a new tower will generally comfortably exceed ROCI in an acquisition. Many of those entrepreneurs also bemoan the escalating premium to be to acquire a tower once valuation benchmarks are known, and once aggressive competition drives those valuations up.

So it seems with China, one thing will be the same as in any other tower market; if you build smartly, you create value; and if you acquire towers with discipline, you can also create value. But you need to have the discipline to walk away from bad deals. Perhaps some of the excitement about Chinese stems from the fact that valuation benchmarks haven’t yet been established; and perhaps valuations haven’t been inflated yet.

We currently believe that Guodong is the largest independent tower company in China. TowerXchange met with Guodong’s management team at their Shanghai head office, and were impressed with the clarity of their vision. One of China’s first independent tower companies, Guodong was established in 2008, claims to have been profitable since 2013, and at time of writing had a portfolio of ~6,000 towers spread across 25 of China’s 31 provinces, with a particular concentration in densely populated coastal cities.

As China’s only listed tower company (300038), Miteno raised RMB 598mn when they listed on the Shenzhen Stock Exchange’s Growth Enterprises Market. Founded in 2004 as a tower designer and manufacturer, supply of steelwork remains a key part of the business, and CTC is a key client of Miteno. Meanwhile, Miteno has built up a portfolio of their own 1,000+ towers, the majority of which are in Jilin Province in the North of China, and is working on a rollup strategy which is both ambitious and which has international precedent. While Miteno represents a potential platform for international investors to participate in the Chinese tower market, Miteno also has their own international ambitions, with appetite for opportunities across the ‘One Belt, One Road’ footprint.

Q Towers was one of the first bona fide independent tower companies in China and, while they don’t boast a tower count as substantial as Guodong or Miteno’s, their vision is equally big, and equally credible – and there is plenty of room in China for all three and more!

A dark horse, international tower company, who shall for now remain nameless, already has secured a substantial stake in at least one, perhaps as many as half a dozen Chinese tower companies. This international investor has a track record of rolling up tower companies, and has the capital and credibility to drive to scale rapidly.