ADT CORP ADT S
January 05, 2015 - 8:05am EST by
cross310
2015 2016
Price: 36.13 EPS 2.00 1.85
Shares Out. (in M): 175 P/E 18.1 19.5
Market Cap (in $M): 6,306 P/FCF 18.8 22.2
Net Debt (in $M): 5,032 EBIT 772 800
TEV ($): 11,338 TEV/EBIT 14.7 14.2
Borrow Cost: General Collateral

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  • Management Change
  • Competitive Threats
  • Misaligned Incentives
  • Highly Leveraged
  • Consumer Electronics
  • Earnings Miss
 

Description

ADT has been written up several times previously, including a very detailed writeup by Den1200 on competitive pressures from cable/telcos in June 2013. Since that time, ADT has been targeted and exited by activist investor Corvex Management - leaving ADT signficantly levered and without many strategic options going forward (more Corvex details below). I won't rehash any of the past writeups, but as I sit here in Las Vegas on the eve of the Consumer Electronics Show (CES), I believe ADT makes a compelling short at current levels.

 

THESIS

ADT is the largest residential home security business but is facing aggressive competition, pricing pressures and existing homes sales impact.

1) Competition:Telcos/Cable entering market with lower SAC and willing to subsidize installation costs with cheaper/comparable security offering (home security over triple-play)

2) Unlikely M&A: Corvex left the Board in 2013, and sold its entire position back to ADT at ~$44/sharew while leaving ADT ~3x levered

3) CapEx Ramp: Substantial CapEx to maintain flattish revs/negative gross adds

4) Home Automation growth initiative is likely negative NPV

5) New market entrants add to competitive headwinds making growth strategy difficult to execute

6) Increased leverage limits flexibility, share repurchases and opportunistic M&A

 

ADT/CORVEX HISTORY

ADT was spun off from Tyco (TYC) in October 2012. Meanwhile, Keith Meister's Corvex Managemunent was accumulating ADT shares and filed a 5% stake later that month. At the 'Excellence In Investing' Conference held in San Francisco on 10/24/12, Meister presented how ADT can improves its business and create shareholder value. At the time, Meister believed ADT possessed 'a defensive and predictable business model with consistent cash flows as well as unappreciated secular growth tailwinds.'

Given the mispricing from the spin-off dynamics, ADT had a sub-optimal capital structure - 'an equity shrink story waiting to happen' - and should increase leverage and buy back 30% of its shares for a target price of $61/share.

Here's a copy of his presentation: http://www.sec.gov/Archives/edgar/data/1535472/000119312512433991/d429924dex996.htm

According ADT's 10-K:

"During fiscal year 2013, we made open market repurchases of 15.5 million shares of our common stock at an average price of $43.01 per share. The total cost of open market repurchases for fiscal year 2013 was approximately $668 million, of which $635 million was paid during the period. Additionally, between September 28, 2013 and November 13, 2013 we repurchased 7.3 million shares of our common stock for approximately $300 million.

On January 29, 2013, we entered into an accelerated share repurchase agreement under which we repurchased 12.6 million shares of our common stock for $600 million at an average price of $47.60 per share. This accelerated share repurchase program, which was funded with proceeds from the January 2013 Debt Offering, was completed on April 2, 2013."

ADT/Corvex Timeline

  • 11/27/12: ADT's board authorized a three-year, $2 Billion accelerated buyback and initiated a dividen
  • 12/19/12: Meister was appointed to ADT's Board
  • 03/14/13: ADT's stock hits an intra-day high of $50.35/share
  • 11/20/13: ADT completed its 3-year, $2 Billion buyback (in less than a year), while the Board announced an additional $1 Billion buyback
  • 11/25/13: "Corvex Buyback" - ADT announced it was buying 10.24mm (most of Corvex's 11.1mm stake) for $44.01/share. ADT also announced Meister was immediately resigning from the board
  • 01/30/14:  ADT missed Fiscal Q1 subscriber growth expectations and consensus estimates sending its shares down ~17% to close at $31.50/share
  • 2014: ADT purchased a total of 35mm shares at $38.49/share

ADT's largely followed Corvex's strategy of levering up to finance buybacks. At the time, Corvex was ADT's 3rd largest shareholder with 11.1mm shares (5.3% stake) and garnered ~20% return for a year's worth of trouble. All-in, ADT spent ~$2.4B to retire ~20% of its float.

Investors may never know if Meister/Corvex had learned something as Board participant that necessitated selling out of its ADT stake and resigning from its board. What we DO know is ADT invested in debt-fueled financial engineering at far higher prices (mid-$40s) vs. investing in growth or back into the business, just as growth stalled. Put another way, EPS would have fallen ~25% (vs. ~11%) had it not been for the accelerated buyback.

In subsequent meetings with ADT, management highlights that the 'Corvex Buyback' allowed them to buyback over 10mm shares of ADT stock: in one transaction, at a set price, without transaction costs in a 'cost-effective' manner, while the accretive EPS impact benefited ALL shareholders.

 

BEAR CASE

After reporting a disastrous FY Q1 (1/30/14), ADT traded down from the high $30s down to the high $20s - and established that competitive pressures from both Cable and Telcos were really impacting their business.

In summary, Cable/Telcos can easily enter the home security market with:

  • Better, technology infrastructure (copper/fiber)
  • Lower Subscriber Acquisitions Cost (SAC)
  • Subsidized installation for customers - offering installation $100-200 lower than ADT with monthly payments $10 less than ADT, on average

Bottom Line: Cable/Telcos have an inherent cost advantage as they can leverage their installed base to upsell a more affordable, more robust home security product over their 'triple-play' bundle. Adding home security reduces churn on existing customers - allowing Cable/Telcos to make attractive returns on far lower ARPU.

In fact, AT&T disclosed for the 1st time that their Digital Life home automation product exceeds 140k subscribers (vs. 82mm homes passed). While still small in comparison to ADT's 6mm subscribers, most of these adds came in H1 2014 as AT&T marketed the product.

As Den1200 pointed out in his ADT writeup, ADT is not competitive against TWC, Comcast, AT&T and others. Additionally, there are a number of high-quality, affordable DIY systems that work over WiFi, app-enabled and are integrated with your smartphone/tablet. To be sure, I am looking forward to seeing several of them at CES this week as the 'connected home' is a major theme this year. 

 

ADT TODAY 

ADT has since rallied to over $36/share on the back of expectations of improving metrics, the home automation opportunity and perhaps unfounded M&A chatter. In fact, ADT's CEO has been open about their conversations with about integrating and cross-selling Nest's products. It is all speculation at this point, but I expect to hear more at CES.

Here is a Forbes article on Nest/ADT: http://www.forbes.com/sites/aarontilley/2014/12/22/googles-nest-close-to-partnering-with-worlds-largest-home-security-company-adt/

 

Home Automation

The overall market is shifting - moving from a traditional security business to a 'connected home' - playing into what Cable/Telcos are offering. Essentially, they have a very fat pipe into the home, as well as WiFi - and want to get as many products/services delivered over this fat pipe. This is very efficient for them to do, but not so much for ADT as they own the pipe.

Currently, ~10% of ADT's existing subs have some home automation while about half of ADT's gross adds are signing up for home automation. In theory, there's a large part of the existing base who doesn't yet have (or doesn't know they need/want) home automation. Management states SAC or install costs on these customers are much higher TODAY, albeit on a small base - in other words, too early to tell. However, their BELIEF is churn is ultimately lower - again, this is too early to tell. What we do know today is this comes at a higher cost today (negative NPV) and it is unclear if these customers becomes profitable in the future. Regardless of the SAC, the business is becomes more capital-intensive (more equipment) and more expensive to serve as the complexity increases.

For instance, telecoms providers are completely moving away from 2G services. AT&T plans to phase out 2G networks by 2017, and ADT now will be spending $25mm to $32.5mm per year for the next 3 years to replace 2G with newer technologies.

 

M&A: Financial/Strategic Buyer?

Some of this rally off the lows has been due to M&A speculation. While Cable/Telco/Satellite M&A is expected to continue (which I count as even more powerful home security competitors), I don't see any of these acquiring ADT. Said another way, why would you look to take on a new separate subscriber base when it is far more efficient and profitable to sell into your own installed base. 

AT&T has mentioned to me, there is only a small portion of the country that cannot be served by Cable/Telcos and only be served by an ADT. However, the low hanging fruit is the ~1-2mm subs (in their estimate) that have signed up and pay for ADT, but get little utility from it (like my folks) but pay $40/month without thinking. Getting these subs to think about home security or the utility they get from their current provider is an opportunity for a high value ADT customer to churn. In fact, they need to be careful when trying to upsell customers to Pulse as they have seen some increased churn in their long-time customers. 

I also don't believe M&A makes any sense for a financial buyer, especially given the leverage profile of the ADT currently. If anything, I believe ADT is a buyer smaller competitors but is again hamstrung by the increased leverage.

ADT M&A Transactions:

  • May 2010: Brink's Home Security (Broadview) - $1.973B for 1.3mm accounts / 44.3x RMR multiple
  • Aug 2013: Devcon Security Services Corp - $149mm for 117k accounts / 41.3x RMR multiple

  •  Aug 2014: Reliance Protectron - $500mm for 400k accounts / 45.5x RMR multiple 

     

Potential Issues

  • Churn: ADT nets out resales and reconnects that have a SAC associated with it. While management claims to have a 14% yearly churn, it is likely closer to 18-20% per year in a run-off analysis. Typically, it is cheaper to retain a customer than to get a new one, but this doesn't seem to always be the case with ADT - the costs associated with upsell or operating the business more efficiently are higher
  • Capital Leases: ADT previously expensed SAC costs related equipment sold to customers, but now treats this as a capital lease. While this has little impact on FCF, it does drive accounting EBITDA - though with ~90% of gross adds now under capital lease, there is a little benefit going forward.
  • Housing starts: ADT states they are negatively levered to the housing market (An improving housing market means more relocations and higher attrition)

 

VALUATION

I arrrive at a 12-month Price Target of $25-28/share based on:

  • 15x 2016E EPS of $1.85/share
  • $1,500-1,600 per subscriber - what I believe a financial buyer may pay

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Given the short interest, any improvement in the business or a strategic announcement (Nest/ADT?) would result in a short squeeze. However I believe any such move will be short-lived.

  • Earnings Miss
  • Continued Cable/Telco home security incursions
  • CES 'connected home' product announcements
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    Description

    ADT has been written up several times previously, including a very detailed writeup by Den1200 on competitive pressures from cable/telcos in June 2013. Since that time, ADT has been targeted and exited by activist investor Corvex Management - leaving ADT signficantly levered and without many strategic options going forward (more Corvex details below). I won't rehash any of the past writeups, but as I sit here in Las Vegas on the eve of the Consumer Electronics Show (CES), I believe ADT makes a compelling short at current levels.

     

    THESIS

    ADT is the largest residential home security business but is facing aggressive competition, pricing pressures and existing homes sales impact.

    1) Competition:Telcos/Cable entering market with lower SAC and willing to subsidize installation costs with cheaper/comparable security offering (home security over triple-play)

    2) Unlikely M&A: Corvex left the Board in 2013, and sold its entire position back to ADT at ~$44/sharew while leaving ADT ~3x levered

    3) CapEx Ramp: Substantial CapEx to maintain flattish revs/negative gross adds

    4) Home Automation growth initiative is likely negative NPV

    5) New market entrants add to competitive headwinds making growth strategy difficult to execute

    6) Increased leverage limits flexibility, share repurchases and opportunistic M&A

     

    ADT/CORVEX HISTORY

    ADT was spun off from Tyco (TYC) in October 2012. Meanwhile, Keith Meister's Corvex Managemunent was accumulating ADT shares and filed a 5% stake later that month. At the 'Excellence In Investing' Conference held in San Francisco on 10/24/12, Meister presented how ADT can improves its business and create shareholder value. At the time, Meister believed ADT possessed 'a defensive and predictable business model with consistent cash flows as well as unappreciated secular growth tailwinds.'

    Given the mispricing from the spin-off dynamics, ADT had a sub-optimal capital structure - 'an equity shrink story waiting to happen' - and should increase leverage and buy back 30% of its shares for a target price of $61/share.

    Here's a copy of his presentation: http://www.sec.gov/Archives/edgar/data/1535472/000119312512433991/d429924dex996.htm

    According ADT's 10-K:

    "During fiscal year 2013, we made open market repurchases of 15.5 million shares of our common stock at an average price of $43.01 per share. The total cost of open market repurchases for fiscal year 2013 was approximately $668 million, of which $635 million was paid during the period. Additionally, between September 28, 2013 and November 13, 2013 we repurchased 7.3 million shares of our common stock for approximately $300 million.

    On January 29, 2013, we entered into an accelerated share repurchase agreement under which we repurchased 12.6 million shares of our common stock for $600 million at an average price of $47.60 per share. This accelerated share repurchase program, which was funded with proceeds from the January 2013 Debt Offering, was completed on April 2, 2013."

    ADT/Corvex Timeline

    ADT's largely followed Corvex's strategy of levering up to finance buybacks. At the time, Corvex was ADT's 3rd largest shareholder with 11.1mm shares (5.3% stake) and garnered ~20% return for a year's worth of trouble. All-in, ADT spent ~$2.4B to retire ~20% of its float.

    Investors may never know if Meister/Corvex had learned something as Board participant that necessitated selling out of its ADT stake and resigning from its board. What we DO know is ADT invested in debt-fueled financial engineering at far higher prices (mid-$40s) vs. investing in growth or back into the business, just as growth stalled. Put another way, EPS would have fallen ~25% (vs. ~11%) had it not been for the accelerated buyback.

    In subsequent meetings with ADT, management highlights that the 'Corvex Buyback' allowed them to buyback over 10mm shares of ADT stock: in one transaction, at a set price, without transaction costs in a 'cost-effective' manner, while the accretive EPS impact benefited ALL shareholders.

     

    BEAR CASE

    After reporting a disastrous FY Q1 (1/30/14), ADT traded down from the high $30s down to the high $20s - and established that competitive pressures from both Cable and Telcos were really impacting their business.

    In summary, Cable/Telcos can easily enter the home security market with:

    Bottom Line: Cable/Telcos have an inherent cost advantage as they can leverage their installed base to upsell a more affordable, more robust home security product over their 'triple-play' bundle. Adding home security reduces churn on existing customers - allowing Cable/Telcos to make attractive returns on far lower ARPU.

    In fact, AT&T disclosed for the 1st time that their Digital Life home automation product exceeds 140k subscribers (vs. 82mm homes passed). While still small in comparison to ADT's 6mm subscribers, most of these adds came in H1 2014 as AT&T marketed the product.

    As Den1200 pointed out in his ADT writeup, ADT is not competitive against TWC, Comcast, AT&T and others. Additionally, there are a number of high-quality, affordable DIY systems that work over WiFi, app-enabled and are integrated with your smartphone/tablet. To be sure, I am looking forward to seeing several of them at CES this week as the 'connected home' is a major theme this year. 

     

    ADT TODAY 

    ADT has since rallied to over $36/share on the back of expectations of improving metrics, the home automation opportunity and perhaps unfounded M&A chatter. In fact, ADT's CEO has been open about their conversations with about integrating and cross-selling Nest's products. It is all speculation at this point, but I expect to hear more at CES.

    Here is a Forbes article on Nest/ADT: http://www.forbes.com/sites/aarontilley/2014/12/22/googles-nest-close-to-partnering-with-worlds-largest-home-security-company-adt/

     

    Home Automation

    The overall market is shifting - moving from a traditional security business to a 'connected home' - playing into what Cable/Telcos are offering. Essentially, they have a very fat pipe into the home, as well as WiFi - and want to get as many products/services delivered over this fat pipe. This is very efficient for them to do, but not so much for ADT as they own the pipe.

    Currently, ~10% of ADT's existing subs have some home automation while about half of ADT's gross adds are signing up for home automation. In theory, there's a large part of the existing base who doesn't yet have (or doesn't know they need/want) home automation. Management states SAC or install costs on these customers are much higher TODAY, albeit on a small base - in other words, too early to tell. However, their BELIEF is churn is ultimately lower - again, this is too early to tell. What we do know today is this comes at a higher cost today (negative NPV) and it is unclear if these customers becomes profitable in the future. Regardless of the SAC, the business is becomes more capital-intensive (more equipment) and more expensive to serve as the complexity increases.

    For instance, telecoms providers are completely moving away from 2G services. AT&T plans to phase out 2G networks by 2017, and ADT now will be spending $25mm to $32.5mm per year for the next 3 years to replace 2G with newer technologies.

     

    M&A: Financial/Strategic Buyer?

    Some of this rally off the lows has been due to M&A speculation. While Cable/Telco/Satellite M&A is expected to continue (which I count as even more powerful home security competitors), I don't see any of these acquiring ADT. Said another way, why would you look to take on a new separate subscriber base when it is far more efficient and profitable to sell into your own installed base. 

    AT&T has mentioned to me, there is only a small portion of the country that cannot be served by Cable/Telcos and only be served by an ADT. However, the low hanging fruit is the ~1-2mm subs (in their estimate) that have signed up and pay for ADT, but get little utility from it (like my folks) but pay $40/month without thinking. Getting these subs to think about home security or the utility they get from their current provider is an opportunity for a high value ADT customer to churn. In fact, they need to be careful when trying to upsell customers to Pulse as they have seen some increased churn in their long-time customers. 

    I also don't believe M&A makes any sense for a financial buyer, especially given the leverage profile of the ADT currently. If anything, I believe ADT is a buyer smaller competitors but is again hamstrung by the increased leverage.

    ADT M&A Transactions:

    Potential Issues

     

    VALUATION

    I arrrive at a 12-month Price Target of $25-28/share based on:

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise do not hold a material investment in the issuer's securities.

    Catalyst

    Given the short interest, any improvement in the business or a strategic announcement (Nest/ADT?) would result in a short squeeze. However I believe any such move will be short-lived.

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