|Shares Out. (in M):||236||P/E||25.0x||22.0x|
|Market Cap (in M):||10,600||P/FCF||0.0x||0.0x|
|Net Debt (in M):||2,300||EBIT||0||0|
ADT’s monitoring portfolio of 6.5MM residential and small commercial alarms is defensible and macro-resilient business that has above inflation pricing power, 90% recurring revenues, and 50% EBITDA margins. With more than 6x the market share of its nearest competitor, ADT is the dominant leader in an industry that happens to be at the inflection point of a secular trend that should enable the company to accelerate organic growth while putting pressure on smaller competitors who will be unable to adapt. Lastly, ADT’s operations should improve due to renewed focus as a stand-alone entity while management corrects the company’s materially undercapitalized balance sheet with a significant buyback which should result in the stock appreciating more than 20% to $55/share over the next year.
An alarm costs around $1,600 to install and lasts for about 15 years. The customer typically pays one-third of the installation cost as a down payment and then approximately $35/month. The total cost of ownership to the homeowner can be less than this amount given that homeowner insurance policies typically offer 15-20% discounts for monitored homes. Once a customer agrees to purchase a system, the dealer installs a few cameras, sensors, and a control panel in the home and then either flips the account to another company for a one-time fee or keeps the account in house by hooking it up to its own monitoring center. A portfolio of installed alarms has annual churn which runs around 10-15% a year and capital invested in a portfolio of new alarms generates an IRR of 15-20%.
Barriers to entry for the industry are low, as virtually anyone can start installing alarms and generating cash flow, but sustainability is much more challenging. Since a consumer never really knows for sure if their system will protect them and their families at the time that it is actually needed, most alarm companies really sell the reliability of their brand. As companies get larger over time, problems with maintenance and false alarms compound and any major issue can permanently damage a company’s reputation. ADT, for example, maintains 99.999% reliability at its six fully redundant monitoring centers. Over time, only operators with the ability to scale without execution issues have been able to grow to and maintain a respectable size.
In addition to the complexities that come from adding scale, a portfolio of home alarm contracts functions like an investment portfolio. Each alarm has an upfront subscriber acquisition and installation cost requiring two to three years to be paid back before any return is generated. Churn in the industry breaks down between a third moving, a third affordability, and a third a handful of other issues. The majority of churn occurs in the first four to five years after an alarm is installed, thus a portfolio of seasoned alarms, despite having a shorter shelf life before needing to be replaced, is arguably worth more due to a much lower rate of churn. Many overeager alarm startups are not disciplined investors and encounter problems with underwriting lower quality customers which ultimately comes back to haunt them in the form of higher churn rates. The lack of investment discipline throughout the cycles has caused a number of initially high-growth vendors to eventually fizzle out.
As a result of both the necessity of high-quality execution and financial discipline, the industry is highly fragmented with only a handful of larger competitors. Currently, ADT has a 25% market share followed by Protection 1 at 4%, Monitronics (ASCMA) at 3%, and Vivint at 2%. The remaining two-thirds consist largely of fragmented regional players.
Aside from the sale of their home or major political elections, home security is one of the few things that homeowners will actually put up a sign in order to advertise. ADT spends over $150MM a year marketing its brand, or nearly half of what its largest competitors generate in annual sales, and as a result ADT is effectively the only home security brand most consumers could identify. Every year ADT’s advertising reminds consumers that they can depend on ADT to protect their family. Since this advertising is nationwide, homeowners who move into a new geography know and trust ADT but not necessarily the local competitors. This is evidenced by the fact that ADT stickers go for a premium in the black market for consumers who don’t want to pay to actually protect themselves but at least want the illusion of protection. There is a huge amount of social proof at work here, in a street filled with ADT protected homes, very few homeowners want to be the one outlier who opted to protect their family with a lower-quality brand in order to save $10/month.
In addition to the brand, ADT’s relative scale creates a large competitive advantage. The company has 4,500 sales professionals and a network of 450 authorized dealers selling its products. As a result, ADT can acquire new accounts at a discount to its competitors. In addition, economies of scale enable service costs, overhead, and R&D to be spread over a larger base.
The growing emergence of smartphones, tablets, and integrated devices has created a wave of consumer interest in home automation. Rather than just monitor security, consumers now want to be able to operate and set schedules for lights, sprinklers, heating, air conditioning, and entertainment systems in their homes. This trend is creating a large secular shift in the home alarm industry. For the first time in history, alarm companies can market something that is exciting and new versus simply selling fear.
ADT is in an excellent position with a home automation product called Pulse. The product currently only represents just 13% of ADT’s business, but is now a material amount of all new installations and has just been rolled out to ADT’s dealer network. With a Pulse system, consumers can interact with their security systems in completely new ways. For example, a small restaurant owner can visually monitor his kitchen staff from his iPhone, or a homeowner can unlock the front door for the dog walker when out of town. With an ARPU 30% higher than the existing base, Pulse has the potential to drive organic growth for years. In addition, because of the increased stickiness with consumers, home automated accounts are tracking to lower levels of attrition which could drive up IRRs if this holds true as these accounts mature.
ADT is also investing in life safety equipment. ADT’s strong brand and nationwide presence should be a major competitive advantage in winning in these new markets. Applications here range from fairly simple personal emergency response systems (PERS) that can be worn around the neck and used to notify authorities in case of an emergency to more complicated vital monitoring or pill dispensing systems that let doctors know whether a patient’s pulse is irregular or if they have taken the appropriate medication on time. These products have huge IRRs given their limited installation costs, and building these products into home security should materially aid ADT by boosting ARPU while lowering attrition.
Spinoffs in the home alarm industry are not new to VIC. Since their financials don’t fit into the model most security analysts are accustom to looking at (more on this later), they tend to trade at a substantial discount to their private market value. Securitas Direct (SDIRB) was written up post its spinoff and was bought out a year later. A little while later, Brinks (CFL) was recommended after its spinoff and was bought out in slightly over a year. Both situations highlight the fact that home alarm companies, largely due to the fact that they expense the purchase of physical and tangible assets that typically last for multiple years, tend to have much higher private market values than usually awarded by the public market.
ADT has two sources of upside as a recently independent company. First, prior to the spinoff ADT cleaned house by taking a large price increase that drove attrition higher than it would have been otherwise. While churn in the industry has picked up due to more moving activity, ADT’s was artificially higher because of this one-time event. Second, ADT has a non-compete with Tyco (TYC) that restricts it from growing internationally and prevents them from servicing commercial accounts larger than 7,500 square feet. As a result, the company will spend the next two years focusing on improving and optimizing internal operations. Where in the past, the company may have been more inclined to allocate time and capital to global growth and branch offices prioritized serviced large commercial accounts, ADT can now focus solely residential accounts and small commercial accounts. Our conversations with industry participants suggest that there are still a fair number of costs that can be wrung out of its system and many processes that can be better standardized across regions in order to optimize operations.
Aligned with Shareholders
ADT initially began trading regular way at $38/share in September. While the company’s parent had a long history of providing conservative guidance and beating expectations, at ADT’s analyst day investors wondered if the public markets would ever appropriately value the company without management providing appropriate metrics, questioned management’s suboptimal utilization of its balance sheet, and also sought clarity on the sustainability of the company’s 7% cash tax rate.
In October, Corvex filed a 13D with a 5% position. Corvex recognized that the cash tax rate was likely to remain low for at least six years and thus calculated that ADT would be generating substantial FCF that it was able to reinvest back into its business at 15-20% IRRs. Due to the massive spread between this reinvestment opportunity and the company’s 3% post-tax cost of debt, Corvex concluded that with the appropriate capital structure ADT would be worth $55/share. Shares of ADT traded up to $42/share.
In November, ADT’s management responded favorably to Corvex. The company provided an intuitive calculation of its underlying FCF using Corvex’s framework. Management also agreed to lever up to 2x, noting that it wanted to maintain flexibility for acquisitions, and authorized a $2B buyback program as well as a quarterly dividend with a targeted 25-30% payout ratio. Finally, management provided clarity that cash taxes would be 3-4% in 2013 as well as confirmation that cash taxes would be 5-8% through 2019. As a result, ADT traded up to $45/share.
Recurring Monthly Revenue (RMR)
Valuation of alarm companies can be challenging for public markets for three reasons. First, most companies have some portion of non-recurring installation revenue that tends to be highly unpredictable and low-margin. Second, different companies capitalize different portions of the origination costs. This can cause large distortions in margins. For example, ASCMA’s 67% EBITDA margin is much higher than ADT’s 50% because ASCMA acquires all of its alarms from dealers and capitalizes the cost while ADT expenses a large portion of that cost that it sources with its internal sales force. For the companies that expense growth, faster growth somewhat counter intuitively results in lower earnings. Third, most growth is simply a function of the amount of capital reinvested. So while virtually any alarm company can grow faster by acquiring lower quality accounts, the rate of growth and quality of that growth are two very different things. Alarm companies with higher quality growth have the ability to add accounts at that have a combination of lower costs, higher ARPU, and/or lower churn, which results in superior long-term returns.
Due to these unusual valuation dynamics, there is some debate among public company investors as to how to value an alarm company. Bears argue that alarm companies generate minimal FCF, especially when they are growing quickly, while bulls argue that alarm companies throw of considerable FCF after adjusting for their growth and that by growing they can effectively defer paying cash taxes in perpetuity.
While the public markets have struggled given the infrequency of seeing public alarm companies, there is an entire private industry and multiple boutique investment banks that have been valuing hundreds of alarm transactions over the last 20 years. As a convention, the industry values alarm companies based off of a multiple of recurring monthly revenue (RMR). Many of the deals done historically are quite small but in general, the larger the deal, the higher the RMR multiple. Most alarm companies can buy single new accounts from their dealers for slightly over 30x RMR. Acquisitions of larger alarm portfolios with < $0.1MM in RMR tend to go for 35x, $0.1-0.5MM 37-40x, and > $0.5MM 45-50x.
The largest deals can receive substantially higher multiples. In September, Vivint was bought out by Blackstone for 57x RMR. And as recently as November, John Malone has been increasing his stake in ASCMA, which acquired Monitronics for 54x RMR. While there is a chance both overpaid, it’s more likely that these are sophisticated investors recognizing that alarm companies can borrow capital at very low rates and reinvest them at very high ones for a prolonged period of time while shielding most taxes in the process. In comparison, ADT has 6.5MM users paying $38/month resulting in total recurring monthly revenue (RMR) of $250MM. Management has guided for RMR to grow 5% in 2013 or to $260MM. Applying a 55-60x RMR multiple a year from now would yield an enterprise value of $14-16B or $52-58/share.
Steady State Free Cash Flow (SSFCF)
An alternative metric to RMR is SSFCF, defined as the FCF before interest and taxes that remains after adjusting for the capital expenditures necessary to keep RMR flat. For ADT specifically, SSFCF is unlevered pre-tax FCF assuming the company only acquired enough capital in new alarms through its dealer network to maintain RMR. This is a little bit lower than a true maintenance number given that the company is expensing higher R&D for new products and capitalizing the costs of back-office system integrations post the spinoff, but it gives investors a good sense of the company’s cash generating ability. SSFCF was just shy of $1B in 2011 and 2012 and should be slightly over $1B in 2013. Guidance calls for $150MM for interest and cash taxes resulting in ~ $900MM in SSFCF after interest and taxes which either is going to be returned to investors or allocated to growth at a high rate of return. Management has targeted $0.9-1.0B to return to investors next year in the form of dividends and buybacks or around $4/share. If the company maintains a 2x leverage ratio as EBITDA grows, forward looking SSFCF a year from now in 2014E should be well over $5/share. Applying an 8-9% yield would result in a stock price of $55/share.
Expensive on Traditional Metrics. Like a lot of great businesses during growth cycles that require large amounts of capital, ADT will continue to look expensive on traditional valuation metrics. At just over 7x forward EBITDA, it does not screen exceedingly cheap. The existing shareholder base arguably understands these nuances, but it may take time for the aggregate market to come around.
Cable Competition. The major threat to the industry is the emergency of cable competitors who have been trying with poor results to get a foothold for a long time. While current checks with most alarm companies yield almost no measurable impact, it’s clearly synergistic as a bundled solution and likely a market that they will continue to pursue as demand for home automation grows. That said, there is also a very reasonable chance that ADT would become an acquisition target as the sole way for a national cable company such as Comcast (CMSCA) to instantly and permanently take share in the home security industry.
Recap and Buyback
|Entry||12/24/2012 12:14 PM|
Thank you for the excellent write-up.
What do you think Corvex has planned for ADT now that they secured a seat on the board? Superficially, it appears that they got little of what they wanted from ADT - a small step-up in leverage targets and a measured buyback despite ADT's acknowlement that their tax assets were far superior to what they let on at the spin. I'd have expected Corvex to be a much more forceful advocate of accelerated buybacks, particularly given that a large percentage of their position is in call options that expire in Sep/Oct.
|Subject||why pay adt?|
|Entry||12/24/2012 02:22 PM|
When I was doing DD on Cablebeach's writeup I was impressed with ADT's pulse service/technology. I noticed the Apple store is selling those type of solutions, too, with no subscription... and a lot more options. "App-enabled" devices are popular and I'm enjoying quite a few myself (I have a drone, a cell tower, cloud cameras, wifi light bulbs but alas no ipad-segway, yet). You don't see that as potentially disruptive technology for ADT & security in general?