|Shares Out. (in M):||12||P/E||17.7x||16.0x|
|Market Cap (in M):||67||P/FCF||5.8x||5.3x|
|Net Debt (in M):||-5||EBIT||16||18|
AlarmForce (AF CN) is a North American residential alarm monitoring company. Like ADT (owned by Tyco), Broadview Security (CFL, formerly Brinc's), Protection One (PONE), AlarmForce competes in a fairly fragmented industry where the top 10 market participants enjoy less than a 40% combined market share). AlarmForce is still run by Candian founder Joel Martin, who sold a commercial security business in the 80s, created AF in 1988 and grown it organically since from zero to over 100,000 subscribers paying a little over $25/month. AlarmForce is a widely recognized brand name in Canada, where the company was "incubated" until 4 years ago when it entered several attractive US markets.
In a nutshell, the thesis boils down to several major points:
a) Sustainable cost advantage: the company markets directly to its customers through TV and radio (with the CEO as its spokesman) instead of buying customers from dealers. As a result, AF can pass these savings on to customers and profitably charge $25/month when ADT charges $35-$40. Importantly, incumbents can't afford to lower prices to match AF at the expense of existing margins.
b) Tremendous incremental economics and a rare opportunity to invest capital at high returns: we estimate total subscriber acquisition costs at $662/customer (vs. over $1000 for competitors) at 90% incremental margins. With an average customer life of 7 years, the after-tax IRR is 26%. The alarm industry overall is very lucrative, with recurring revenues, 80% gross margins, and adjusted EBITDA margins in excess of 50%.
c) Overly conservative accounting and resulting valuation: unlike most competitors, AlarmForce expenses all of its SAC immediately and takes an upfront hit on earnings, so in periods of high growth earnings are depressed. Because of that, the company today trades at 6.2x EV/EBITDA after accounting for growth, and 3.2x if you back out marketing expense to get at steady-state EBITDA. 3.2x for a business with these economics and long-term prospects is as close to a no-brainer as you could hope to get in a non-distressed situation. Keep in mind that the EBIT and TV/EBIT metric above is adjusted for growth and approximates steady-state numbers. The CEO has indicated that if growth proved unprofitable, he would shut off the marketing dollars and pay "enormous dividends" from free cash flow.
d) Favorable market-related dynamics: Relative obscurity among investors due to small market cap, low float, and Canadian listing. Management doesn't market the company to institutional investors at all.
There are several ways to think about the business and long-term opportunity. A comparison with GEICO is not out of place. Although alarm monitoring is not a government-mandated service, it does have the key benefit that regular home insurance policies provide discounts for customers with installed alarms. Like GEICO, the company has very low market share, a very long runway for growth, hard to replicate cost advantages, and compelling incremental economics.
The cost advantages are probably the most important to understand, as the rest of the business is fairly intuitive. AF does not acquire any of its customers from third-party commissioned dealers, as do its competitors. Rather, CEO Joel Matlin has opted for a measured, profitable long-term growth model, where he markets to consumers directly through TV/radio ads and retains 100% of the relationship as a result. AF has just one call center in Toronto which handles all alarm monitoring for US/Canada. The company also has full vertical integration on equipment, which they develop in Canada and manufacture themselves in Asia. This also allows for rapid innovation and deployment of new technologies, the most notable of which is two-way voice (enables the AlarmForce employee to speak inside the house when a burglar enters as opposed to just sounding an alarm). The company has also been working on consumer video-surveillance technology which should be introduced soon. All of these things are made possible by in-house development and manufacturing. Importantly, the direct-to-distribution model is hard to difficult for incumbents to duplicate, as it would displace the very distributors who have the relationships with customers today and provide current growth.
As a result of the cost advantage inherent in AF's business model, the same product can be offered at substantially lower cost. AlarmForce's companywide gross margins for 2008 were 78%, a testament to the high quality of the business and low ongoing requirements. The alarm business has proven itself to be recession-resilient over the cycle, as is evidenced by growth in EBITDA from $7.4mil in 2008 to almost $10mil this year. All of the growth the company has experienced has been organic and self-funded, without having to tap debt and with past debt being retired very quickly through free cash flow generation.
The CEO is extremely conservative in terms of capital structure, with a net cash position of $5.5 million. Considering the recurring revenue nature of the business, the balance sheet is clearly underlevered, which artificially increases the cost of capital. Joel believes that "slow and steady wins the race" and would rather grow more slowly than expose the company to leverage risk that has caused problems for some competitors over time. Frankly, I disagree with him on this point, as the total lack of leverage unnecessarily inflates the cost of capital for the business. To Joel's credit, though, he did buy back stock when the stock dipped into "stupid cheap" category in the $3s. Nonetheless, a private equity buyer (Joel would sell the company at the right price) would absolutely see the capital structure as an asset, considering how easy (relatively) it would be to borrow against. A strategic acquirer or a financial sponsor with portfolio companies in the industry would also have the benefit of pricing power as the book of business was brought to "market" pricing.
As regards growth, the sky is the limit. When the company entered the US, it essentially doubled its potential market size just by entering markets like Atlanta and Columbus. Since then, the number of customers has grown from 49k at the beginning of 2005 to 100k today. Joel thinks he can grow the company from 100k to 250k within 3 to 5 years. Although an ambitious goal, he has proven his ability to deliver on aggressive targets in the past (5 years ago he told another investor that he will double the size of the company), but even if he falls short and does 200k within 5 years, this will prove to be a very attractive investment.
One of the catalysts I see is that as the company grows and gains visibility in the US, it should get a multiple more commensurate with its quality and its growth. One thing is clear - a maintenance free cash flow yield near 20% prices in a path for the business that is vastly different from the likely very positive path it will continue to take over time.
Rollout of video surveillance product
Continued growth in subscribers and recurring monthly revenues
Growing visibility and exposure to institutional investor base
|Entry||11/09/2009 10:25 AM|
Good write up... I own this but have a few issues I'd be interested in your take on.
1) In your maintenance fcf calc you ding them for marketing required to replace churn, right? REason I ask is that I get a higher multiple than you do.
2) In your conversations have you been able to get a satisfactory answer about how they evaluate the US growth investments they're making and at what point they would pull out of a market if things weren't going as planned? My conversations have been disappointing on this front.
3) I don't know if you've talked to them about this but I think it would be nice if they reported marketing in Canada vs. the US and if they reported churn on a quarterly basis. Each of those would make it much easier for investors to monitor the profitability of the base business and of the growth initiatives.
All of that said I like the company and I like Joel. These are just my list of issues after having had a decent amount of time to dream up complaints. Any thoughts would be appreciated.
|Subject||RE: RE: AF|
|Entry||11/17/2009 08:10 PM|
Cameron--there are 12,200 subs in the US. They entered in 2004/05 if I remember correctly. You can go back and calculate that the subscriber acquisition cost was under $300 of marketing prior to 2004. So if Canada SAC has remained constant over the years the SAC in the US is still quite high and the US is not economically profitable yet but it's close. These are just my guesses because the data isn't provided to really do the analysis. I'd be interested to hear if the author of the post has a similar view.
Cameron, what is the US company with direct model you're referring to?
|Subject||RE: RE: RE: RE: AF|
|Entry||11/18/2009 12:27 PM|
Thanks. I checked out the website and it appears they are a dealer that sells accounts to monitoring companies. If so the business model is not similar to AF's.
|Subject||RE: Product Quality|
|Entry||11/18/2009 08:47 PM|
I don't mean to speak out of turn but since the author of the post has been silent I figure I might as well throw in my 2 cents.
I think it's important to understand about AF that the product is different from that of Broadview and ADT and is, therefore, marketed differently and aimed at a different customer. AF targets less affluent people who live in smaller homes. If you live in a 4000 sq ft house in CT, you would never choose AF, and that is why AF is in Georgia, North Carolina, and Ohio. These are under-served locales where the penetration of home alarm monitoring can be in the single digit %s, versus the 20% national average. AF doesn't send a salesperson to do a consultation and it doesn't put wires in the walls. The complexity of the installations is lower also because fewer features are purchased (motion detectors, for instance), and fewer door and window contacts.
So, AF doesn't sell the same product at a lower price, like GEICO does. However, the question is does the product work well enough to be valuable. I think the evidence shows that the product does its job (not perfectly, as pointed out by a handful of negative reviews on the internet) and that AF is considered a very well run company within the industry. If the product didn't work, it would be difficult to explain AF's 20 year track record. 100,000 customers is a lot. AF's churn historically has run only slightly above Broadview's (about 10% versus about 8% if I remember correctly) and that could possibly be explained by the fact that AF's customers, unlike CFL's, put no money down for equipment--so you get more customers who are not sure if they want the product or who can't afford it.
|Subject||RE: RE: Product Quality|
|Entry||11/19/2009 03:54 AM|
Apologies for the delay, as I have been traveling.
As far as leverage goes, I think that this is something that Joel's personality is naturally not keen on, and he has shown this trait outside of AF (e.g. his real estate holdings are unencumbered by mortgages). I completely disagree with him on this because borrowing at 4% after-tax and investing at 20-25% after-tax is an incrementally better value proposition than borrowing from shareholders at whatever cost of equity you assume. Part of his reluctance to use debt comes from the fact that he has seen other companies in this industry expand too aggressively (often with borrowed $s) and get burned. My point of view is that there is a happy middle ground between 8 turns of leverage and net cash. For example, I think he could create a lot of value if he borrowed $6 mil to open two new US markets. In the long run, he would do better and become bigger if he used debt. I'm not happy about this aspect of his capital allocation philosophy but I would rather have him be too conservative than an empire builder. Talking to him you really get the feeling that this truly is his philosophy and as long as he is in charge, the company will live by it. I don't think he has aspirations to gain market share come hell or high water, and that is a good thing for shareholders. His whole mantra is "controlled, profitable growth." I can't say Joel is completely frugal, by the way, but he tries to squeeze costs where he can (shoots the ads himself instead of hiring ad agencies, has people who harass radio stations to get the lowest possible rates, etc). So while he may not be taking full advantage of today's cost of debt, he at least thinks like an owner (and is a big owner).
A fair point was raised with respect to product quality and positioning in the market. Joel himself thinks of AF as the Walmart of the alarm industry, so perhaps that would have been a better comparison than GEICO. The product feels "cheaper" because it IS cheaper, but it is just as functional and therefore performs the same service at a lower price. He can't be all things to all people, and if you own a $10mil property in Palm Beach you probably will call Brink's or ADT. However, I think that it is a fantastic value proposition for the bulk of the middle class, of which OH, GA, and NC are probably good representatives (which is why he's there and not in Palm Beach). I have not read a complaint that someone broke in and the alarm failed (although that has probably happened, as it has probably happened with other systems). From what I have seen, the product works well and out of 100,000 subs there are going to be some p*d off ones. The fact that their churn rates are only marginally higher than best-in-breed Brink's and significantly lower than ADT is a testament to the fact that there is something compelling about what they do. The fact that the product is made internally at lower cost and is cheaper to install (it is not hard-wired, so the installer can be in and out of the home quickly and make it to the next appointment = fewer installers) may not make it the sexiest alarm, but it does make this the sexiest balance sheet / P&L in this industry. Would it be better if the alarm looked nicer? Yes. Does the lower cost of components, installation enable AF to offer basically the same service at lower prices? Absolutely. And savings of $10/month is significant to a lot of people who want a secure home but don't need the bells and whistles. In this way AF expands the market for alarm monitoring, and in so doing creates a moat that is going to be tough to compete with long-term.
Greenshoes, I do think that it is very fcf positive and has a very long runway for growth. I can prove the fcf but can't give you evidence that the runway for growth is very long other than to point out their track record of profitably adding new markets/subs, and to look at other cities around the US with relatively high densities and low alarm penetration. To understand the gross margins, think about how the business actually works. You spend money in period 0, sign a customer in period 1, and keep him paying in periods 2 through x. What do gross margins look like? Period 0 is awful because you placed an ad on the radio and haven't seen a return. In period 1, you send your installer to come out to the home and install it. You get the first check. In periods 2 through x, it costs you almost nothing to "monitor" the home and you continue to receive checks in the mail, so incremental gross margins are effectively 100%, and if you amortize the cost of the monitoring center over the entire, growing base of customers, you get to 75%. If anything, this number should be increasing over time, although in reality more subs mean more people who need to be monitoring so there is a theoretical ceiling on margins. I agree - for people to send you a $25 check, they need to think that they are getting something in return. 100k customers continue to send checks, so my read of their history is that it is a business people trust. The ads on TV might be annoying but they are effective at driving people to the brand and keeping them there. The churn numbers are a testament to the stickiness of this brand. If a significant % of people thought the equipment was lousy, you can bet that they would flee en masse. There are also lots of intangibles, too many to go over here. For example, the brand actually enjoys strong recognition in AF's markets. Everyone knows the jingle that they use on TV, and I have asked friends who have moved from Toronto and they remember Joel by name and the jingle by heart ... years after leaving Canada.
We haven't discussed the prospects of their upcoming video offering, but Joel is very optimistic that this could be a game changer for them as a catalyst for bringing far more subscribers onto the alarm monitoring platform. Interestingly, Joel comes from a video surveillance background from his days with FriscoBay (which he started, grew in the 70s and sold in the late 80s), and despite that has always been very skeptical about the prospects for residential video monitoring on the basis that it is expensive, invasive and more generally not compelling enough. He thinks that what they have developed internally is very unique and compelling for consumers. He could be wrong, but I get the impression that he is not tilting at windmills and genuinely thinks he has a winning product. We will have to wait until next year to see what it is, but Joel is visibly very excited and thinks it is the most interesting thing they have done since inception. It is worth noting that they did not spend a large amount of money to develop this, so they are not betting the farm on the video project. Moreover, I simply don't think you are paying for this massive optionality and that even if it is bogus and consumers vote it down, you will still have the same attractive economics that you have today. Joel has mentioned that he thinks the company will have 250k subscribers within 3-5 years and that they hope they can get there in 3. This is very ambitious, but he thinks that the video offering will be a big catalyst in getting them there. If that's the case, the growth rate will have to increase substantially, which would be terrific.
It is interesting that rainman mentioned the overburdening of police departments. One of the unique things about AF is that they can speak inside the house and hear what is happening, so if there is an obvious false alarm they actually don't burden the police. This is a moot point, because I don't foresee legislation/taxation risk.
Otaa212, I ding them for the marketing required to replace churn, which I estimate at 20% of the marketing that they actually do, and at today's price I get to 3.8x EBITDA on next year's numbers. In my conversations I did get a sense for how they evaluate it and I came away disappointed in the sense that I didn't feel it was scientific enough. I think it is more a function of whether or not Joel thinks there is still a big market opportunity in whatever market they are struggling in, so he is willing to give it time to turn things around. He is very competitive and hates to lose, so this plays a part, but there is some prudence to it in the sense that as long as the "story hasn't changed" on a market, he is willing to tweak the offering to try to make it work because the sunk costs are already in. I don't think he is reckless in throwing good money after bad (one of the reasons he doesn't want to get into big markets like CA, NY, IL is that he knows they will be tough and that he might have to take pain for a while before the brand takes off). I agree in terms of reporting - I think their big concern is giving away too much secret sauce to competitors. I have polled some people who have looked at the stock and passed on it, and what I heard was that the lack of transparency has kept them away. This is great, considering that if we get comfortable with the economics ourselves, the lack of transparency is what creates the opportunity to get a bargain. If they did conference calls, jockeyed the stock and told you what their IRRs are, a) they wouldn't be focused on running the show, and b) competitors would know more than they do today (although I'm sure they know everything anyway).
cameron, I agree that this feels like it has all the ingredients that make a long-term play compelling. Small, Canadian, amazing business model, unlevered, not enough liquidity, insider ownership, opportunity to invest capital a) very profitably, b) for a very long time. I think that not only do you get it at a price that is lower than what it is worth today, but that that "fair value" will itself compound at a very attractive rate, and as it becomes more visible/liquid, you will have both numbers going higher and the multiple coming up to reflect all the good qualities of the business. As far as a financial sponsor taking it private, I agree that it is a no-brainer if I was in the LBO business I would feel very comfortable putting an entire fund into AF, considering how quickly it can pay down debt. One thing that hasn't been discussed that is worth noting, by the way, is that if Joel found that there is no more profitable growth, I think you would see a very high dividend yield very quickly, which would be a big catalyst for either very high yields or a much higher stock price. Joel doesn't have an appetite for debt, but he also doesn't want to stockpile cash.
Otaa/Cameron: I also don't have an exact breakdown of the costs, but I do know that Canada is in the $300 range (barring new markets within Canada) and that the US is high, although the more mature US markets have seen large drops in acquisition cost and increased returns, which you would expect. So the blended average is closer to $600, but over time I would expect acquisition cost to go down in the US as well after they learn exactly what works and what doesn't. That is also just a hunch.
|Subject||RE: RE: RE: Product Quality|
|Entry||11/19/2009 11:45 AM|
hb - Thanks you for your response. I agree that the company could be more data-driven (like CFL). And they said the same thing to me regarding sunk investments increasing their will to succeed. Clearly that's irrational. I guess I'm bringing it up in the hopes that if multiple investors point this out it might change the thinking.
I didn't mean to undermine the GEICO analogy because I think it's apt in many ways. I also like the WMT analogy because the strategy is to move into under-served areas and entrench as the low cost producer based on economies of scale.
Do you have an opinion about the PERS initiative? I'm actually more bullish on that than the video product.
|Subject||RE: RE: RE: RE: Product Quality|
|Entry||11/24/2009 11:14 AM|
otaa - I agree that PERS is lucrative, considering that it is a large and growing market, and the price point brings up ARPU. It is clear from communicating with management, though, that while they are not betting the farm on video in terms of capital invested, they think it is the platform that will take them to the next level. Fortunately you are not paying for that.
|Subject||RE: RE: RE: RE: RE: Product Quality|
|Entry||11/24/2009 02:24 PM|
Interesting thanks. I haven't spoken with them about video yet
|Subject||RE: Callisto Capital|
|Entry||12/23/2009 09:09 AM|
From what I learned, they normally try to get board representation and they try to "help" businesses grow and develop. As far as specific deals they did a deal with CBI Health Group in Toronto, where Callisto teamed up with the company's mgmt to take the CBI private.
I definitely view it as a positive as far as bringing more discipline to capital allocation (buybacks vs. organic investment), and a catalyst to a take-private transaction. Reading about Callisto, it would be unusual for them to take a passive stake in an unlevered equity and wait for business to grow. It is unclear where this leads us from here, but it seems to be positive relative to OTPP sitting on a 15% passive stake. If nothing else, Callisto's involvement gives me more confidence that the next time we see a 30% fcf yield, the company will be aggressive in buying back stock. As much as I would like to believe that they want to take this private ahead of the positive catalysts (I would), it's probably not a good idea to buy it on that thesis alone. I still own my stake in the co. and will continue to let the company build value.