Description

For those that want the document with formated tables, I posted the write up here too. (Often my tables do not see to format well on the VIC.)

cablebeach did a great write up on ADT last November. Still I believe he did not address what I think is the most relevant part of the short thesis. He is right about the high valuation, but did not address the serious risk of the cable providers ramping up in order to compete in the property security space. ADT will see pressure on its margins and its market share, which will worsen its ROIC and drive multiple contraction.

Most of us know what ADT does. It is the main provider of residential security systems in theUSwith about 25% market share in a very scattered field of competitors, overwhelmingly small players. The next largest competitor has less than 5% of the market. 90% of revenues are classified as recurring and 10% comes from installation. 55% of sales are in house while the other 45% is generated through a network of dealers. Once in a while ADT also purchases a number of alarm customers from other outside sources too.

The industry grows unit volume at about 1% to 2% a year. Penetration is about 20% of all housing units in theUS. Although, before stating that the runway is the other 80%, the addressable market is a lot smaller. For one, about 25% of all household units are rental units that do not have alarm service and will likely never install the service. Also in the condo market alarms have less penetration. In addition alarms are not very prevalent in poorer areas. In general thieves go where the money is.

The long thesis is that ADT is a great business as represented by its high EBITDA margins in a slowly growing market on a unit basis. There is nothing that should stop ADT from garnering more market share in its fragmented market. The feeling is also that ADT has significant pricing power in excess of inflation with a long runway. ADT is also looked at favorably because it seems to pay little in taxes. Lastly long investors believe a secular change is taking place in the industry towards more complex monitoring services that will drive up ARPU and profits.

On first sight this is an attractive story but it is my belief that it is way too optimistic. This is a story where investors are looking in the rear view mirror rather than through the windshield. New, large and well capitalized competitors that have a strategic advantage are aggressively entering the market at prices significantly below those of ADT. This will drive lower margins for ADT and impact its pricing power significantly. Actually, ADT is at a cost disadvantage compared to these competitors. In short, my thesis is that ADT is trading at multiples that are at the higher end of the range at exactly the time it is about to face a significant new and powerful competition.

So what about the competition …

Well the current new competition I am talking about is mainly Comcast, Time Warner Cable and AT&T. These are the front runners, but I believe more players will enter the market, as they did in the past.

The large cable players have been ramping up operationally in the security business in a big way. From their perspective it makes sense to enter this market:

1. The cable companies are already in the home. ADT has a 25% market share with 20% penetration. In short, ADT is in 5% of all the household units. Contrary to that the cable industry (including the Direct TV's and Dish's of this world) are already in 90% plus of all household units. Cable is in about 60% while the other 30% is satellite and the rest does not pay for service. The cable companies also have a more active relationship with their consumers in general than ADT does. They already have the phone numbers and personal information of all these consumers. It will cost the cable companies a lot less to reach the consumer than it costs ADT.
2. The cable sales cycle also has a higher dollar value and is already in place as the cable company is setting up more services at the same time. How much will it cost Comcast when Mr. Johnson calls to setup his new service cable service? “Mr. Johnson would you need a security service added to your triple play? We are running a great special.” In Q2 2013 ADT paid $583 per unit in marketing and sales expenses and $292 in commission expenses per new unit in direct channel subscriber acquisition costs. That is a total of $875 per unit installed just in sales and commission expenses. Somehow I find it hard to believe it is going to cost the cable companies $875 per unit to ask a new subscriber if he’d like a security service added to his order. Nor does it cost as much for the cable companies to reach out to current consumers in order to offer them alarm service. Also regarding the general advertising budget, the cable providers won’t even need to spend much additional money on advertising for the new security service as they have already enough other advertising driving the consumer to call the cable companies. Or they can just change the current advertising for the triple play into advertising for a quadruple play.
3. In addition, the cable companies also have installation cost advantages over ADT. After all the installer will already be in the house in order to install the cable package. It won’t cost much more to install the alarm system at the same time.
4. The cable companies also have different EBITDA margins. Where ADT runs around 50%, the cable companies currently in the mid 30%. Just that allows the cable companies to offer significantly lower pricing.
5. Bundling of services has been a great strategy for the cable companies as not only an offensive play, offering increased value, but also as a defensive play in order to drive down attrition as much as possible. After all, it is a lot cheaper to keep a customer than to have to replace one. The cable companies over the last few years have struggled to maintain TV subscribers and bundling TV with broadband and VOIP has been a very effective strategy. Actually nowadays the value creator is broadband. Bundling services has been the driver of growth in the last few years and adding security systems is a logical extension. Just as with VOIP, the cable companies had lower sales, marketing and installation expenses and were able to drive that business at the expense of the independent operators.

Actually, it seems bundling services is going to be even more important in the future than it is now. For example John Malone believes that the TV landscape and bundling of TV content is going to struggle long-term. He believes the TV content bundle will break apart and that different sales/media channels/business models will emerge. I would recommend that you check out the following interviews with John Malone at http://www.cnbc.com/id/100637283.

In addition, from talking to someone at Dish, they are seeing disturbing trends in viewership especially among young viewers. Their surveys see young viewers still watching as much content as the rest of us, but they watch it through different channels. The share of TV time amongst that group is in fast decline. And it gets worse the younger they get. Currently 30 year olds watch more TV than 25 year olds and 25 year olds more than 20 year olds, etc. The younger they are the less they rely on TV. Also 30 year olds currently still watch as much TV as they did 10 years ago and so on. So you get the fear they have in TV land. It also points out that TV is losing in value in the cable companies offering, but increases the value of broadband especially and the rest of the service bundle in general.

Now lets compare the different service offerings.

ADT

According to the ADT sales rep, soon ADT will change its offerings. Today, June 8, 2013, if you go on the site you will see three offerings, QuickConnectPlus, Pulse Choice and Pulse Premier Lite. Soon there will be five plans.

• Traditional which is the basic plan for $35.99 a month, which basically includes burglar alarm and smoke monitoring. If you do not have a landline you pay an additional $4 monthly for the cell phone connection. If you want temperature control, water detection and carbon monoxide the price goes up ex cell phone to $39.99. The installation fee is $299, but if you add cell phone it is another $100. If you want to add temperature, water and carbon monoxide it is another $100 per item for installation. Currently there is a $200 rebate with installation. This is the plan that is currently called ADT Quick Connect Plus and used to cost $42.99 without cell phone, carbon monoxide, water and temperature. So ADT is lowering the price from $42.99 to $35.99.
• Pulse Remote which is the entry Pulse system. It basically has the same functionality as Traditional, but it allows you to remotely arm your alarm and gives you text notifications in case of an incident. In addition it is already cell phone based. The installation fee is similar to that of Pulse Control at $349 with a $200 rebate and the monthly monitoring cost is $47.99. There is no extra monthly fee for carbon monoxide, water and temperature, but there is an extra $100 charge per item for installation of carbon monoxide, water and temperature. Pulse comes with a cell phone connection, so there is no additional monthly charge.
• Pulse Control, which is similar to the old Pulse Choice, is $49.99 a month and is similar to Pulse Remote, but it adds remote lock control and lighting and thermostat control. The installation fee is $349 with a current $200 rebate for a total cost of $149. Again additional charges for carbon monoxide, temperature and water installation.
• Pulse Video Lite is Pulse Control with video added to it, which is now going to be $55.99 a month rather than the $57.99 a month it is today. The installation cost is $499 with a $250 rebate. The video offering is in essence live video with a 30 second rewind function.
• Pulse Video which is going to cost $57.99 a month with pretty much the same video service as Pulse Video Lite, but with more equipment installed, like a touch screen which the other packages do not have and 1 more camera. The installation fee for that is going to be $999. And I assume the current $250 rebate will be valid here too.

I have no idea when the installation rebates are going to disappear, but they might not for some time. They have been available for some time now and it seems to be a strategy by ADT to bring their installation pricing down to the level of the cable providers, which offer in general equal or more generous installation packages at lower prices. Installation is the typical switch and bait game and a great way to confuse things for the consumer.

So here are the basic packages for ADT

Time Warner Cable – Intelligent Home

Time Warner Cable only services its own customers with Intelligent Home. Where the competitors offer different service levels Time Warner has one level of service. In short, if you install the equipment, you can have it all for one monthly price. Time Warner Cable offers $39.95 per month all included if you are signed up with Time Warner Cable for broadband. Then if you sign up for a second service you get the monthly service for $33.95. If you have a triple play, meaning TV, Broadband and VOIP, the price of the security service goes down to $28.95 per month.

Compare that with the monthly fees of ADT, going from $35.99 a month for basic all the way to $57.99.

Here is an overview of the monthly costs for ADT versus TWC.

Below are the current Time Warner Installation packages.

The Ultra installation package at $699 is significantly cheaper than the ADT Video installation package which even after rebate is $749, with a pre rebate price of $999. And still TWC’s package contains significantly more value.

The Premier package is better than ADT’s Video Lite, with a current post rebate cost for ADT of $249 and a pre rebate price of  $499 with the TWC full price being $399. Btw, when mentioning the ADT rebate, the TWC person said he would gladly match the offer.

The Select package is cheaper than ADT’s for similar items. ADT’s has a pre rebate cost listed of $349 for its Pulse Control package with a post rebate cost of $149, where TWC offer $99 for this installation package.

Also TWC requires only a 18 month contract where ADT wants 36 months.

In short, TWC has in general cheaper installation costs than ADT, but also has lower monthly service charges and a lower contract period.

Comcast – Xfinity Home

Comcast offers three levels of service. All require a three year commitment. One is required to have at least Xfinity Broadband service.

• Basic service is $29.95 per month. This is a similar product as the Traditional product offered by ADT for $35.99, although ADT’s works through a landline while Comcast’s service uses broadband and has a cell phone backup. Adding the cell phone brings the ADT price up to $39.99.
• Preferred is $39.95 per month. Preferred can be compared to ADT’s Pulse Video service which retails for $57.99 a month.
• Premier which is $49.95 per month and includes enhanced video service. It is somewhat of an upgraded version of ADT’s Pulse Video, but not by much. It just offers better quality video and you can save some video clips. You also get a better installation package, but the additional price does not seem to warrant it. I do not fully understand why paying the extra $10 a month makes sense. I guess its another marketing gimmick, which certainly is not a first for Comcast. Comcast could easily get rid of this package when competing with ADT.

Anyway when comparing plans, Preferred can best be compared to ADT’s Pulse Video and the cheaper ADT plans.

So Comcast is about 20% cheaper when it comes to the basic plan and about $16 to $18 per month cheaper than ADT’s similar plans. If one compares the Preferred service to ADT’s Remote and Control plans Preferred is still $8 to $10 a month cheaper.

Still as part of the plays, Comcast also discounts the home security service monthly fee further in case one purchases more than just Comcast Broadband. If one adds one more service it offers a monthly discount of $10 monthly for the first 6 months. In case one purchases TV, VOIP, Broadband, and Xfinity home security service, the monthly $10 discount is valid for $24 months. So in case of two services the average monthly price paid over 36 months then becomes $38.28. In case one purchase broadband, TV and VOIP, the average monthly cost becomes $33.28.

Here is an overview of the monthly costs for ADT versus Comcast.

Comcast’s installation packages are significantly more competitive than those of ADT. Let’s start with the Comcast Premier installation which is $399 and comparable in value offered to that of ADT Pulse Video at a post rebate price of $749. Comcast’s Preferred installation is $99 and comparable to that of Pulse Remote and Control at a post rebate cost of $149.

So across the board Comcast is a better value. On the installation package cost it does very well and on the monthly fee it is significantly cheaper than ADT.

AT&T.

AT&T does not offer a discount for signing up with Uverse, but offered $100 off the installation cost and the first month free.

Their basic package which they call Simple Security is $29.99 and can be compared to the other basic packages, like ADT’s Traditional Package. It is about $6 cheaper on a monthly basis than ADT in case one has a landline and in case of no landline, the cost of the basic package with AT&T is about $10 cheaper monthly.

Then there is the Smart Security package. So AT&T's Smart package is $39.99 to start. Then in case one wants water detection it is an additional $4.99 a month, in case one wants the energy solution that’s another $4.99 a month, the door solution is another $4.99 a month and video adds another $9.99 a month.

Here is the cost for similar services from AT&T

As you can see, AT&T is really competitive up to the point we get to ADT’s Pulse Control package at which point its price escalates above that of ADT. Now as you will see later, AT&T makes up for that with the Smart Installation package which is a lot more competitive than ADT’s.

Regarding equipment, AT&T the Simple Security installation package post the $100 rebate is more competitive than ADT’s after the $200 rebate. On the Smart Security Package then AT&T is certainly more competitive than ADT. The Smart package can be compared to the ADT Video package when one adds 2 cameras. If one adds 2 video cameras to the Smart package at $200 total, then the total cost is still only $349 while ADT Video is $749. All for a package that has way more value than ADT’s.

So overall, I would say that AT&T’s monthly fees on the low end as well as installation fees are a better deal than ADT. On the higher end the monthly fees are not as competitive, but the installation packages are way cheaper than ADT’s. At least $400 difference in value, which represents about $11 a month on a 36 month contract.

Apples to Apples comparison

So I decided to compare similar packages from all four providers. The installation package I requested was the following:

• 1 keypad
• 2 doors
• 3 motion detectors
• 6 windows
• 2 inside cameras

The system had to be able to provide me with video and basic protection.

Here is a comparison of the total cost:

*The base price for ADT was $1,419, but ADT offered me a $200 rebate offer.

** After $100 rebate from AT&T.

Lets now take a look at a basic package, similar to Traditional by ADT. I took the prior package, but removed the video cameras.

*The base price for ADT was $1,419, but they have a $200 rebate offer.

** After $100 rebate from AT&T.

Looking at the “Average Cost Per Month” rows one sees how out of touch ADT’s pricing is. Does anyone think that ADT will be able to maintain that pricing against an onslaught of the likes of TWC, Comcast and AT&T and still maintain or gain market share?

Coverage Cable Companies

Now one of the arguments made is that TWC and Comcast do not cover the whole country while ADT does. Well TWC and Comcast cover about 2/3^rd of the country. AT&T seems to be interested in covering the whole country independent of Uverse.

There are about 114 million households in theUS. Of that 60% or 68.4 million pay for cable. 30% or 34.2 pay for satellite. The other 10% does not pay. At the end of 2012 TWC had 14.7 million residential consumer relationships and about 0.6 million business relationships. At the end of 2012 Comcast passed 53.2 million homes in 40 states plus theDistrict of Columbiawith more than 22 million consumers. Together TWC and Comcast have 53% of the market in the cable market. In short all three have plenty of coverage to have a huge impact on ADT. And that assumes that the other cable or satellite companies won’t jump in too.

Cable companies want size.

ADT has about a $25% market share with $3 billion in recurring revenues. That would make for a market of $12 billion a year. Now for sure the security market size is smaller as ADT is in general at the high end for ARPU. TWC and Comcast, nor AT&T do not enter markets for small $. Just the VOIP revenue for Q1 2013 for TWC was $519 million or about $2 billion annualized. TWC is interested in this market as they believe they can gain market share and make this a business of size. If it was just to add another $100 million to the top line they wouldn’t have bothered. If they want to make the security business of the same sizes as VOIP it would have to capture 18.35% of the market.

More Competition

I believe that other providers will enter the market, although my thesis does not rely on it. In addition there is a push for self monitored systems. The idea is that you as the owner get warned yourself, not through a 24/7 monitoring station. When an incident happens, a number of people are contacted at the same time. So you might have your phone turned off, but your wife/friends/family are still getting the texts stating there is something going on. I haven’t figured out if this is a trend of the future. It has some weaknesses for sure. My main worry is one of liability? So a friend ignores an incident signal, a burglar kills the resident and his relatives sue the friend afterwards? I struggle with this whole concept of self monitoring, but who knows. It doesn’t matter though if I am wrong, because in case self-monitoring happens it is just as bad for the future of ADT as they are for Comcast or TWC. Verizon has a plan for about $9 a month and Lowe’s too is selling a similar product. Comcast offered me a self-monitored plan for $14 a month.

Competitive Advantage

In his December write-up sandman898 makes an argument that ADT has some kind of competitive advantage. I must respectfully disagree there. To me the moat seems to be about an inch wide. Especially against these new competitors they are at a disadvantage when it comes to scale, sales and marketing, and installation costs. ADT has about 6.4 million customers, Comcast has 22 million, TWC has 15 million. And Comcast and TWC both deliver multiple services from cable and broadband to VOIP. All services that are more technically difficult to operate than a security alarm service. Lastly Comcast, TWC, nor AT&T have a problem properly underwriting its customers, something that was mentioned to often be a problem for small operators.

In its basic form an alarm is a service that sends a signal to a remote center which then calls the police and the owner. If it was more complicated the field would not be full of small mom and pop operators.

Regarding the social proof of saving $10 by not using ADT, I can’t agree with that argument. If that argument was that powerful ADT would already have a lot more marketshare. Also since ADT has only a 25% marketshare in a market that has 20% penetration I find it hard to assume there are many streets and neighborhoods exclusively using ADT.

More than 50% of ADT customers are off contract

More than 50% of ADT customers are off contract. I assume that is the case for the whole industry at this time. All households the cable operators can reach out too cheaply.

The installation cost and its impact on ADT’s cash flow

The shift to lower installation pricing, what ADT calls retaining ownership, ends up in increase Subscriber System Assets, has a significant impact on the financial statements.

First regarding the term retaining ownership. Yes on paper ADT is the owner of the equipment, but the consumer maintains functional ownership of the equipment. What is ADT going to do? Call the consumer to see if they can setup an appointment where they can go and rip out depreciated equipment that has no value to ADT? I spoke to two ADT reps to clarify this issue and they both had never seen an instance where ADT retrieved equipment. As one rep said, “disassembling an alarm system is not like unplugging and sending back a cable box and we can’t force our way into the property”.

Now the impact is that there is a larger cash layout upfront, which leads to more depreciation and higher EBITDA. So be careful with using EBITDA as the valuation method over the next few years as the quality of the EBITDA is going to deteriorate.

Also lowering installation costs while increasing the monthly subscriber fee does help the first 36 months when you are under contract, but after the 36 months are over you have to lower your pricing in order to match the competition or you will drive your attrition numbers up. Any alarm company will give you a great deal if it does not have to subsidize installation. Btw. I do not believe ADT is going to be able to increase its monthly pricing as an offset for higher installation subsidies.

Also, the same argument can be made around the ARPU increase because of the change from landlines to cell phone connections. Switching from landline to cell phone added $4 a month to the ARPU, but that’s just a pass through from expenses with no additional margin.

Increased installation costs also increases the risk of the business. If I use $1,360 in SAC per new unit, that gets me $36.11 per month and the cost to serve per unit is about $13.28 per unit monthly. That gets me to a cost of $49.39 a month per unit. Some plans have a lower revenue per month, some higher, so it takes ADT about 36 months to get its money back. If in month 37 the consumer leaves, ADT’s ROIC will be close to 0%. Basically the more upfront subsidies you offer, the worse the risk profile becomes. And the business clearly is moving towards increased installation subsidies.

The evolution of the Subscriber Acquisition Costs is not good.

Especially the Direct SAC per unit is increasing consistently and seems to be accelerating over the last few quarters. Installation revenue is slightly decreasing while installation cost is increasing. Based on my apples to apples comparison, if ADT wants to bring its net installation cost to the consumer in line with that of TWC and Comcast it would have to take down per unit installation revenue by $200 to $300. The difference with AT&T’s $769 and $869.

ADT experience

So as part of my scuttle butt I did call ADT as well as the other providers a lot about pricing and making it sound as if I was installing a system. So Friday morning the ADT rep calls me and asks if I am ready to move forward. Upon which I make up an excuse saying that I went with another provider because of price. This was the instant reply of the rep, “Comcast … right?” At which point I say yes and give him a soft apology, saying “you did great work, but Comcast was just a lot cheaper.” Again rep “I know, I know. You aren’t the first one I lost to Comcast.”

Maybe I was the second one or the third, but given the rep’s frustrated reaction it seems he has lost a fair amount of business to Comcast. Why otherwise would his first reaction be “Comcast … right?”.

Attrition and Depreciation

Attrition is important and has been going up. For every customer that disconnects you have to find a new one, either a resale or new customer. Every 1% attrition represents about $30 million in recurring revenue that needs to be replaced. This also has an impact on depreciation. ADT depreciates 58% of the subscriber system assets in the first 5 years, 25% in the next 5 years and 17% over the last 5 years and the intangible assets, which basically is the business purchased from the dealers, are depreciated 67% in the first 5 years, 22% in the second five years and 11% in the last five years. For an easy calculation I assume that approximately 50% of ADT's business is direct and 50% is dealer. This gives me a weighted average depreciation period of 7.58 year which points to an attrition rate of 13.1%. Actual unit attrition currently runs at 17% indicating a 5.9 year average effective life. ADT points to recurring revenue attrition which is 13.9% in Q2 2013. They say that the customers cancelling are lower ARPU customers so one needs to us recurring revenue attrition. I disagree and believe that one should use the unit attrition numbers when thinking about depreciation. After all, the life of the equipment is not related to the ARPU a consumer pays. Independent of the ARPU, ADT has to depreciate the equipment. So based on the current unit attrition rate of 17% ADT seems to be under depreciating its subscriber assets and intangibles by about 28%.

So either the unit attrition rate comes down again to the 13% rate long term or at some point ADT will have to adjust its depreciation and accelerate its depreciation schedule. Naturally this does not have much of an impact on the FCF, but it does mean that the current income statement net income might be too high.

My believe is that this attrition rate will stay high or increase. Even if ADT takes its pricing down, it still is going to be fighting an uphill battle, Vonage style, against the cable companies. And high attrition means lower average effective life per unit, resulting in lower ROIC.

Market Cap and EV

Comments:

1. Cash: I took 50% of the Q2 2013 cash. After all, companies need cash to operate.
2. Deferred Taxes: I included deferred taxes. In case ADT’s growth goes flat these deferred taxes will have to be paid soon. And you need cash to pay taxes to the IRS.

Using the income statement for the valuation.

In the above table I valued the company just using the income statement. Some comments:

1. T6M: In order to give ADT the benefit of the doubt I decided to use ADT’s 6 month trailing as it had higher recurring revenues.
2. Revenue: I left Installation Revenue flat as we are still installing as many units. Installation revenue per unit will likely go down over time as the trend is to have higher installation subsidies for consumer.
3. Cost of revenue and SG&A: The ARPU is pretty much independent from Cost of Revenue and SG&A. While I kept units flat in this exercise I do not see why expenses would come down.
4. Interest expense: In the levered version I took the interest rate for Q2 2013 as it reflects the increase in debt taken on in Q2, 2013.
5. Taxes: Yes, I am aware that at this time ADT does not pay a lot of cash taxes at this time. But once growth slows down, the cash taxes will normalize. Lets say you spend $300 upfront and you depreciate it 1/6^th over the next 6 years or you depreciate $0 in years 1 to 3 and then 1/3^rd in years 4 to 6, the difference in NPV is pretty small. You can defer the taxes, but not avoid them.
6. Lastly, you' see that I excluded the separation costs and the other income in order to focus on the operating side of the business.

So I stuck to ARPU decline instead of taking a mix of ARPU declines and unit declines. Trying to get to a scenario that predicts unit and price declines and run that through a pro-forma income statement would have just been more confusing and had little benefit. Now if you assume that ARPU goes down by 3% and ADT losses a net 2% of subscribers, that number is pretty close to my minus 5% ARPU decline number. Or you can assume flat ARPU and 5% net loss in subscribers.

It all comes down to how well ADT will hold up to the new competition. I think we all agree that when Comcast, TWC and AT&T entered this business it had to be worth their while. In order for this business to make a dent all three need to capture real market share, which I am sure they are all planning on doing. And they have shown us they can do so with broadband and VOIP. For example TWC’s VOIP business has revenues of about $2 billion a year currently. In order for TWC to match that with Intelligent Home it has to end up with a market share of 18.35% or 4.7 million units. So does anyone believe that in a market in which units expand by 1% to 2% a year at best, with the new competitors aggressively courting market share, that ADT will be shielded to the point ADT might lose almost no customers nor see a decline in ARPU? Especially since its total average monthly cost is significantly higher than that of the competition?

Steady State Free Cash Flow

ADT makes a Steady State Free Cash Flow argument, meaning how much free cash flow would be generated in case ADT wanted to keep its recurring revenue flat. They assume they replace the attrition by replacing 100% of the direct sales and then buy as much from dealers as is needed to maintain recurring revenue. The numbers they show are huge, close to $950 million using ADT’s Q2 2013 number. Btw. ADT calculations can be found in their Q2 2013 slide presentation on page 8 and page 11 of the Q2 2013 earnings release.

Now the way I calculate the adjusted SSFCF I get to a much smaller number. I started with the 6 month trailing numbers, then annualize and deduct the necessary capex. My adjusted SSFCF number is $587 million. I have three scenarios below. One is based on the inputs ADT used. The next one is the same calculation but assuming that no increase in prices would have taken place over the last 12 months and the 3^rd one assumes what would have happened in case the recurring revenue declined by 5% over the last 12 months. The numbers do not look pretty. In case we had had a 5% decrease in recurring revenue the adjusted SSFCF would have been negative $266 million. In case of no price increase the adjusted SSFCF would have been $244 million. ADT throws a number of $953 million at us.

A large difference is made by the fact that I use a post tax number. In my world, taxes need to be paid. That’s why in ADT’s situation they end up as deferred. Anyway, in a steady state scenario, the gap between the GAAP Income Statement tax rate and the cash tax rate would disappear. After all, it is the combination of upfront cash outlays and growth that drives that gap. When we go steady state, that growth goes away. In short, one can’t go steady state and assume that ADT’s cash tax rate will stay low.

In addition, in a steady state, many of the other operating cash flow changes, like working capital would become neutral over time.

As you look at the multiple below, you can see that ADT isn’t cheap on a steady state basis. I for one would not be interested in paying 20 times plus for a steady state business. And you can see what happens to the multiple if prices start going down.

Comments:

1. T6M: Just giving ADT the benefit of the doubt I decided to use ADT’s 6 month trailing as it had higher recurring revenues.

Recurring Monthly Revenue valuation

I use an RMR of $250 million and an EV of $12.4 billion to get a current RMR valuation of 50.

What do I think ADT is worth?

I believe it’s worth a lot less than $40 per share. It all depends on what multiple we think its worth given the new scenario and that’s naturally a personal decision. Using my own expectations, being a mix of higher installation subsidies, lower ARPU and at best equal, but probably declining units, I assume a fair value at this time of $24 to $26 a share. Assuming my 5% decline in ARPU scenario, which I believe to be pretty benign, and putting a 15 multiple on that NI, I get to $20.

One last point

Even if you think I am wrong, you can’t be guaranteed to be right yourself … so should ADT be selling for its current multiple given the increased risk profile?

After all, ADT was just drafted into the major leagues and it is going to find out that the majors are a lot harder to compete in. Now I am not saying ADT does not belong in the majors, just that its old competition was from the minor leagues, while Comcast, TWC and AT&T are used to playing in the majors and no one is sure how well ADT will hold up.

Risk

The cable companies mess up the roll out and do not get traction. Since each run more than 15 million customers they should be able to get the operations right.

Catalyst