Brink's Home Security CFL W
November 24, 2008 - 10:53am EST by
skimmer610
2008 2009
Price: 16.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 732 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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  • Spin-Off
  • Home security
  • Recurring Revenues
 

Description

Summary:

 

In the good ‘ole days, the VIC board might have loved the idea of anunlevered spin-off in a niche industry with complex financials trading at a gross discount to its fair value. We think that even in this market such an idea can work out extremely well and we believe Brink’s Home Security (CFL) is such an investment. With a net cash position and a current valuation of 17.0x recurring monthly revenue, 3.7x steady-state cash flow, and 3.1x EBITDA (that is after expensed investments in new subscribers – 2.1x before), we believe an investment in CFL offers tremendous upside potential and a firm margin of safety. [Note, share price used throughout this write-up is $16, closing price as of Friday.]

 

Thesis:

 

Brink’s Home Security (CFL) was recently spun-off from The Brink’s Company (BCO), and began trading as an independent equity security on 11/3/08. CFL is the premier company in the electronic security monitoring industry – a space we believe is relatively recession resistant and which possesses long-term growth prospects. At its current price, CFL is trading at what we believe represents roughly 1/3 its intrinsic value on both a Recurring Monthly Revenue (RMR) and Steady State Cash Flow (SSCF) basis – this analysis assigns the company essentially no value for its premier franchise nor its potentially significant growth. We take the recent substantial volume of insider purchases as evidence that management is very confident in the health of their franchise and the undervaluation of CFL stock.

 

We believe the extreme undervaluation of CFL equity is the result of four primary factors: 1) general market sentiment – i.e. many companies are currently cheap and have become cheaper; 2) spin-off dynamics – the forced selling that seems to have characterized the stock’s movement following the spin-off is common for spin-offs; 3) perception of the company as a consumer discretionary business – we believe shorts have been attracted to the stock; 4) complicated financials – unless one understands the business model, the true economics of the company are masked.

 
Excluding $125mm rebranding liability Including $125mm rebranding liability
Shares outstanding 45.8 Shares outstanding 45.8
Price  $          16.00 Price  $          16.00
Market cap  $          732.3 Market cap  $          732.3
Debt                    -  Debt                    - 
Cash                54.4 Cash                54.4
Rebranding liability                    -  Rebranding liability              125.0
Enterprise value  $          677.9 Enterprise value  $          802.9
RMR (as of 9/30/08  $            39.8 RMR (as of 9/30/08  $            39.8
Multiple of RMR 17.0x Multiple of RMR 20.2x
Subscibers (as of 9/30/08) 1285.3 mm Subscibers (as of 9/30/08) 1285.3 mm
Per subscriber   $        527.43 Per subscriber   $        624.68
            

Business Description:

 

CFL is the second largest provider of home security monitoring services in North America. CFL’s major competitors include ADT (part of Tyco corporation), Protection One (NASDAQ: PONE; private equity firm Quadrangle Group owns 46.62% of shares outstanding), Monitronics International (private), and Stanley Convergent Security Solutions (part of Stanley Works, NSYE: SWK).

 

CFL’s business model is straightforward. CFL makes an up-front cash investment to install their system at the customer’s location and then provides monitoring services to those customers based on mid to long-term contracts. CFL estimates net cash investment (i.e. net of subscriber installation fees) for a system to be ˜$1,100.[1] The company then seeks to recoup their investment though monthly subscription revenues generated from the monitoring services they provide. In the vast majority of cases, monitoring services are governed by initial three-year contracts that contain automatic renewal provisions on an annual basis (usually for an additional one year). The company claims that “our cash break-even point per site is typically reached in less than four years after installation.”

 

Presented below are two analyses of economics underlying a residential installation, as well as the usual cash flow and accounting treatment for such an installation:

 

 

Per Residential Installation  Cash Balance Sheet P&L
Installation fees/revenues  $     300 Deferred Liability  $   300  $       -
Costs and Expenses:
Installation  $     825 Capitalized Asset  $   825  $       -
Sales (related to installation)  $     125 Deferred Asset  $   125  $       -
Marketing, other sales and admin  $     450  $       - Expensed  $   450
Total costs  $  1,400
Net Investment per Installation  $  1,100 Net assets  $   650 Expensed  $   450

 
Upfront selling & system costs GAAP   Cash
Sales & commissions Capitalized                 (125)
Hardware & labor Capitalized                 (825)
Marketing & overhead Expensed                 (450)
Total cost of installation    $         (1,400)
Customer payment Def. Revenue                  300
Net cost of system    $         (1,100)
 
Ongoing Fees & Expenses Monthly   Annual
Monitoring fee (ARPU)                  30                  360
Monitoring marginal cost                   (3)                   (36)
Profit per sub  $              27    $             324
 

As of September 30, 2008, CFL served 1,285.3mm customers. Single family residences make up more than 90% of the company’s customer base. The company also has ˜60,000 business customers which comprise ˜5% of its customer base. Multi-family residences make up the balance.

 

CFL is regarded as the gold-standard in the home security monitoring industry. That sentiment has been echoed repeatedly by industry experts we have spoken with, as well as through reading industry trade magazines. The primary differentiator for CFL is its customer retention levels. CFL has, for many years, shown the lowest disconnect rate – often by a substantial margin – amongst the major players in the industry. We believe CFL’s industry leading customer retention rates speak to two important facets of the company’s business: 1) the discipline and ownership CFL takes to its customer acquisition process - most significantly, CFL has high credit score standards for its customers, and requires, on average, an upfront $300 installation fee for new subscribers, creating a sense of ‘equity’ in the system for its subscribers[2]; 2) the level of customer service CFL provides for existing customers. Critically, unlike any of the other major security monitoring companies, CFL’s growth – since inception – has been entirely organic. All of the other major players have grown by rolling up smaller companies and consolidating the industry. CFL’s strategy has ensured consistency in its customer acquisition process (as well as the underlying home security units), resulting in a much higher quality customer base. The company anticipates that such discipline should enable the company’s customer base to remain resilient during this downturn.

 

Industry overview:

 

The home security monitoring industry remains extremely fragmented. The top five companies (ADT, CFL, Protection One, Monitronics, and Stanley Works) control ˜42.1% of total industry RMR. However, the top 100 companies control only ˜56%. Beneath the top 100, there are an estimated ˜14,000 regional and local security monitoring companies that control the balance of industry RMR.

 
2007 2007 % of indsutry
Company Subscribers RMR RMR Comment
Brink's Home Security 1,223,800  $        37.2 5.3% Mostly residential (95%)
ADT 6,000,000  $       219.0 29.2% Evenly split between residential and commercial
Protection One 880,262 (1)  $        26.7 3.8% Shifting to commerical, 30% multifamily
Monitronics 548,034  $        17.0 2.4% Mostly residential (90%)
Stanley Security Solutions 252,953  $        10.0 1.4% Mostly commerical (70%)
(1) Excludes wholesale subscribers
 

It is estimated that penetration rates for electronic security systems in single family homes is 17%-22% in the US and 12%-17% in Canada. For that reason, CFL, along with others in the security monitoring industry, believe there exists a large long-term growth runway ahead of it. Secular trends such as an aging population, a more security conscious population, and new technologies should assist in driving industry growth.

 

Historical numbers:

 

The data below highlights the key figures for the company going back to 1993. We believe the two most important metrics are growth in RMR and annualized disconnect rate. With regards to growth in RMR, it is important to keep in mind, again, that this growth is entirely organic. With regard to disconnects rates, we view the relative consistency of the company’s disconnect rates across fifteen years in varying economic environments as a strong positive.

 
1993 1994 1995 1996 1997 1998 1999
Revenue  $     89.0  $   109.9  $   128.9  $   155.8  $   179.6  $   203.6  $   228.7
y/y growth 25.78% 23.47% 17.27% 20.84% 15.26% 13.37% 12.34%
EBIT  $     26.4  $     32.4  $     39.5  $     44.9  $     52.8  $     53.0  $     54.2
EBIT margin 29.65% 29.50% 30.64% 28.80% 29.43% 26.05% 23.70%
Capex  $     26.4  $     34.1  $     47.3  $     61.5  $     70.9  $     81.7  $     80.6
D&A  $     14.4  $     17.8  $     21.0  $     30.1  $     30.3  $     36.6  $     49.9
EBITDA  $     40.8  $     50.2  $     60.5  $     75.0  $     83.2  $     89.7  $   104.1
EBITDA margin 45.77% 45.70% 46.95% 48.13% 46.32% 44.04% 45.52%
EBITDA - CapEx  $     14.3  $     16.2  $     13.3  $     13.5  $     12.3  $      8.0  $     23.5
EBITDA - CapEx margin 16.11% 14.71% 10.30% 8.64% 6.83% 3.93% 10.28%
MRR  $       5.9  $       7.3  $       9.0  $     10.7  $     12.9  $     15.1  $     16.8
y/y growth   22.84% 23.69% 18.93% 20.69% 17.15% 11.26%
Subscriber data (in '000s):
Beginning of period 216.6 259.6 318.0 378.7 446.5 511.5 585.6
Installations 59.7 75.2 82.6 98.5 105.6 113.5 105.6
Disconnects, net -16.8 -16.7 -22.0 -30.7 -40.6 -39.5 -47.9
End of period 259.6 318.0 378.7 446.5 511.5 585.6 643.3
y/y growth 19.61% 22.53% 19.06% 17.92% 14.56% 14.47% 9.86%
Net adds 42.9 58.5 60.6 67.8 65.0 74.0 57.7
Annualized disconnect rate -7.06% -5.79% -6.32% -7.44% -8.48% -7.19% -7.80%
Y/Y change in installation 17.12% 25.90% 9.89% 19.24% 7.19% 7.44% -6.95%
Y/Y change in disconnects 12.14% -0.57% 31.62% 39.44% 32.28% -2.82% 21.39%
Y/Y change in net adds 15.98% 36.27% 3.68% 11.90% -4.15% 13.85% -22.06%
Capex per installation  $  442.12  $  453.05  $  571.81  $  624.33  $  671.47  $  719.63  $  763.26
2000 2001 2002 2003 2004 2005 2006 2007
Revenue  $   238.1  $   257.6  $   282.4  $   310.4  $   345.6  $   392.1  $   439.0  $   484.4
y/y growth 4.11% 8.19% 9.63% 9.92% 11.34% 13.45% 11.96% 10.34%
EBIT  $     54.3  $     54.9  $     60.9  $     71.2  $     80.8  $     87.4  $   100.3  $   114.8
EBIT margin 22.81% 21.31% 21.57% 22.94% 23.38% 22.29% 22.85% 23.70%
Capex  $     74.5  $     81.3  $     86.9  $     98.0  $   117.6  $   144.6  $   157.8  $   177.8
D&A  $     32.0  $     36.8  $     43.9  $     47.9  $     51.5  $     58.1  $     67.6  $     77.7
EBITDA  $     86.3  $     91.7  $   104.8  $   119.1  $   132.3  $   145.5  $   167.9  $   192.5
EBITDA margin 36.25% 35.60% 37.11% 38.37% 38.28% 37.11% 38.25% 39.74%
EBITDA - CapEx  $     11.8  $     10.4  $     17.9  $     21.1  $     14.7  $      0.9  $     10.1  $     14.7
EBITDA - CapEx margin 4.96% 4.04% 6.34% 6.80% 4.25% 0.23% 2.30% 3.03%
MRR  $     18.0  $     19.2  $     21.1  $     23.3  $     26.1  $     29.1  $     33.1  $     37.2
y/y growth 7.14% 6.67% 9.90% 10.43% 12.02% 11.49% 13.75% 12.39%
Subscriber data (in '000s):
Beginning of period 643.3 675.3 713.5 766.7 833.5 921.4 1,018.8 1,124.9
Installations 82.0 90.9 105.8 121.9 146.0 167.3 175.0 180.8
Disconnects, net -50.0 -52.7 -52.6 -55.1 -58.1 -69.9 -68.9 -81.8
End of period 675.3 713.5 766.7 833.5 921.4 1,018.8 1,124.9 1,223.9
y/y growth 4.97% 5.66% 7.46% 8.71% 10.55% 10.57% 10.41% 8.80%
Net adds 32.0 38.2 53.2 66.8 87.9 97.4 106.1 99.0
Annualized disconnect rate -7.58% -7.59% -7.11% -6.89% -6.62% -7.21% -6.43% -6.97%
Y/Y change in installation -22.35% 10.85% 16.39% 15.22% 19.77% 14.59% 4.60% 3.31%
Y/Y change in disconnects 4.38% 5.40% -0.19% 4.75% 5.44% 20.31% -1.43% 18.72%
Y/Y change in net adds -44.54% 19.38% 39.27% 25.56% 31.59% 10.81% 8.93% -6.69%
Capex per installation  $  908.54  $  894.39  $  821.36  $  803.94  $  805.48  $  864.32  $  901.71  $  983.41
 

Recent operating data with supplementary information:

 

    Nine Months
  2008   Ended September 30
2007   Q1 Q2 Q3   2007 2008
       
Revenue  $     484.4    $  127.8  $  133.9  $  135.4    $  358.4  $  397.1
y/y growth        
       
Profit from recurring services  $     169.0    $   56.8  $   60.2  $   55.7    $  152.4  $  172.7
Margin 34.88%   44.44% 44.96% 41.14%   42.52% 43.49%
Investment in new subscribers  $      (95.9)    $  (24.8)  $  (24.7)  $  (23.5)    $  (67.9)  $  (73.0)
       
EBIT  $       73.1    $   32.0  $   35.5  $   32.2    $   84.5  $   99.7
EBIT margin 15.09%   25.04% 26.51% 23.78%   23.58% 25.11%
D&A  $       77.7    $   20.6  $   21.8  $   21.5    $   57.4  $   63.9
EBITDA (from recurring services)  $     246.7    $   77.4  $   82.0  $   77.2    $  209.8  $  236.6
Margin 50.92%   60.56% 61.24% 57.02%   58.54% 59.58%
       
Impairment charges from subscriber disconnects  $       50.4    $   11.9  $   12.8  $   16.7    $   37.9  $   41.4
Amortization of deferred revenue  $      (34.2)    $    (8.6)  $  (11.4)  $  (10.5)    $  (25.6)  $  (30.5)
Deferral of subscriber acquisition costs (1)  $      (23.8)    $    (6.3)  $    (5.8)  $    (5.8)    $  (18.0)  $  (17.9)
Deferral of revenue from new subscribers (1)  $       47.4    $   12.0  $   11.6  $   10.7    $   35.8  $   34.3
CapEx:        
Security systems  $    (165.2)    $  (43.2)  $  (42.4)  $  (42.3)    $ (124.9)  $ (127.9)
Other  $      (12.6)    $    (2.6)  $    (1.9)  $    (2.9)    $  (10.3)  $    (7.4)
       
RMR  $       37.2    $   38.3  $   39.3  $   39.8    $   36.3  $   39.8
       
Subscriber data (in '000s):        
Beginning of period 1,124.9   1,223.9 1,249.6 1,271.5   1,124.9 1,223.9
Installations 180.8   44.6 44.2 42.7   136.7 131.5
Disconnects, net -81.8   -18.9 -22.3 -28.9   -61.4 -70.1
End of period 1,223.9   1,249.6 1,271.5 1,285.3   1,200.2 1,285.3
y/y growth        
Net adds 99.0   25.7 21.9 13.8   75.3 61.4
Annualized disconnect rate -6.96%   -6.11% -7.07% -9.04%   -7.03% -7.42%
Average number of subscribers 1,176.1   1,236.4 1,261.4 1,279.1   1,163.8 1,259.0
(1) Current year receipts

 

‘Discretionary’ extent and leverage to new homebuilding:

 

Discretionary extent

 

From the various industry experts we have spoken with, the view we have received is that the industry is relatively recession resistant. Those industry experts contend that for an existing home owner, a security system is viewed only minimally as a dictionary item; rather, most homeowners view it much more as a utility. Certainly, we do not believe home security occupies the same status as electricity, gas, or water. Simultaneously, we do not believe it shares status with wholly discretionary items. With a monthly cost of ˜$31, most homeowners are likely to find alternative paths to cost savings than cutting off home security monitoring services. Additionally, given concerns of increasing crime rates that often accompany economic downturns, industry experts believe there some a counter cyclical effect to the impact an economic slowdown will have on disconnect rates.

 

Despite this issue’s fairly qualitative character, historical data largely supports the above view. From 2000-2003, CFL’s annualized disconnect rate averaged 7.29%. That compares very favorably to the company’s 15 year average from 1993-2007 of 7.10%. According to data compiled by industry insiders, in previous recessions annualized disconnect rates moved up 50-75 bps. However, current data shows disconnect rates moving up 100-200 bps in some regions. Cautiously, therefore, operators in the industry believe this recession is likely to see disconnect rates move up 75-150 bps nationwide. However, those same people believe that that CFL is likely to be on the lower end of that range due the discipline it exercises in its customer acquisition processes.

 

As the recent data shows, CFL’s disconnect rate moved up materially in Q308. In the consolidated Q308 10Q, CFL explained this was the result of three factors: 1) most significantly, disconnects were impacted by in increase in customer requested cancellations and customer moves to rented housing – the company believe this is related to the slowing economy; 2) increased cancellations of contacts at certain multi-family housing residences – the company explains these multi-family contracts were cancelled as apartment projects realized they no longer needed to offer amenities to lure residents[3]; 3) increased technical subscriber reconciliation adjustment – these relate to estimates the company had made in previous quarters of customers who disconnected and which the company anticipated would move into a new residences where they would reestablish their subscription. From our understanding, we believe the latter two factors are more one-time in nature. Normalized for those two factors, CFL’s disconnect rate for Q308 would have been 8.1%.

 

For the full year, CFL is currently projecting 2008 disconnect rate would be 7.5%-7.8%. Management has also guided to mid-single digit subscriber growth, revenue growth of ˜10%, and double-digit operating earnings growth. They stated that “looking forward to 2009, we expect to achieve continued growth in subscribers, revenue and operating profit.” The company recognizes the impact the economic slowdown, but stated repeatedly on the call that they haven’t seen a “sea-change” in the number of people choosing to disconnect for purely financial reasons.

 

Housing impact:

 

According to CFL “we believe that household moves, whether involving newly constructed housing stock or existing homes, drive more than 50% of our new customer volume in any given year.” For that reason, CFL’s top-line growth obviously benefits from robust new home construction. Mitigating that, however, is the fact more than 50% of disconnects are also the result of household moves. Historically, therefore, the company has benefited in times of reduced residential moves – while new installation growth slows, disconnect rates decline as well. Currently, the company believes it is reaping those benefits, although the amount of moves from homes to apartments is offsetting much of the benefit of people not moving homes. Management has indicated that assuming move outs to apartments subside, they should see benefits from across the board decline in household moves.  

 

Model and Valuation:

 

The security monitoring industry benchmark for valuation is primarily Recurring Monthly Revenue (RMR). To account for differences in customer acquisition costs and disconnect rates, those numbers – based on recurring revenue operating margin assumptions – are usually translated into a Steady State Cash Flow (SSCF) model. The idea of a SSCF model is to arrive at the free cash flow a company could generate assuming it signed up new subscribers at the same rate as existing subscribers disconnected (instead of investing above and beyond the disconnect rate in new installations). The primary levers in the model are 1) attrition rate; 2) subscriber acquisition cost.

 
Actual Based on 
2007   2008
   
Number of Subscribers (000's)    
Beginning 1,124.9   1,223.9
Installations - Internal 144.6   78.3
Installations - Dealer 36.2   19.6
Installations - Total 180.8   97.9
Disconnects (81.8)   (97.9)
Ending 1,223.9   1,223.9
Average number of subscribers (calculated) 1,174.4   1,223.9
Net Adds 99.0   0.0
   
Subscriber Metrics    
Attrition Rate -6.7%   -8.0%
Net RMR Growth Rate 8.8%   0.0%
% Change in Installations 3.3%   -45.8%
Percentage of Installations done by Dealers 20.0%   20.0%
% of Installations - (Total) to Replace Disconnects 45.2%   100.0%
% of Installations - (Internal) to Replace Disconnects 56.6%   125.0%
   
ARPU    
ARPU ($) - "Given"  $              30.39    $              31.30
ARPU ($) - "Calculated" Below 30.39   31.30
   
RMR ($000's)    
Beginning  $      33,095    $      37,194
   
Installations - Internal            4,294              2,416
Installations - Dealer            1,073                 604
Installations - Total                  5,367                    3,020
Disconnects           (2,407)             (3,020)
   
RMR due to fee increases            1,139              1,116
Ending  $      37,194    $      38,310
Reconcile to:  10K Ending RMR          37,200    NA 
Average RMR          35,144            37,752
   
RMR Metrics    
Attrition Rate -6.8%   -8.0%
Net RMR Growth Rate 12.4%   3.0%
% Change in Installations 6.4%   -43.7%
% of Installations - (Total) to Replace Disconnects 45%   100%
% of Installations - (Internal) to Replace Disconnects 56%   125%
   
Operating Assumptions:    
Billable Service Percentage 5%   5%
Net Margin on Recurring & Service 62%   63%
Installation Fee (internal)  $      371.00    $      382.13
Gross RMR Creation Multiple - Internal 30.6x   31.0x
G&A Load on Creation Multiple - Internal 7.0x   7.0x
Dealer RMR Burdened Acquisition Multiple 38.1x   38.0x
   
Net investment per installation - excluding G&A (internal)  $     (908.38)    $     (956.22)
G&A contribution to net investment per installation (internal)  $     (166.24)    $     (172.74)
Net investment per installation - Internal  $       (1,074.62)    $       (1,128.96)
Net investment per installation - Dealer  $   (1,131.02)    $   (1,172.14)
Weighted average net investment per installation - total (exlcuding G&A)  $     (952.91)    $     (999.41)
Weighted average net investment per installation - total (including G&A)  $   (1,085.90)    $   (1,137.59)
   
INCOME STATEMENT BY ACTIVITY & BEFORE DEFERRAL AND CAPITALIZATION ACCOUNTING    
   
Monitoring & Service Activity    
Revenue derived from RMR  $     421,733    $     453,027
Billable Service Revenue          22,200            23,847
Recurring & Service Revenue  $     443,933    $     476,874
Costs 145,163   152,596
Net Cash Contribution  $     276,570    $     300,431
   
Sales & Installation Activity    
Revenue  $      53,661    $      29,932
Costs       (185,049)         (104,833)
Gross Cash Contribution  $    (131,388)    $     (74,900)
Less: Allocated G&A Expense         (30,056)           (16,913)
Net Cash Contribution  $    (161,444)    $     (91,813)
Net RMR Creation Multiple 37.6x   38.0x
   
Net operating cash flow (NOCF)    
NOCF Pre Dealer RMR Acquisition Costs (includes G&A)  $     115,127    $     208,617
Less:  Estimated Dealer Account Purchase Costs         (40,898)           (22,953)
NOCF  $      74,229    $     185,664
   
Steady-State Cash Flow    
Net Cash Contribution from Sales & Installation  $    (161,444)    $     (91,813)
Multipled by:  RMR Added Internal to Replace Disconnects 56%   125%
Cost to Replace Disconnects         (90,487)         (114,767)
Plus:  Net Contribution from Monitoring & Service        276,570          300,431
Steady-State Cash Flow  $     186,084    $     185,664
   
Current Valuation (excluding $125mm rebranding liability)    
EV as amultiple of SSCF 3.6x   3.7x
EV as a mutliple of EOP RMR 18.2x   17.7x
Current Valuation (including $125mm rebranding liability)    
EV as amultiple of SSCF 4.3x   4.3x
EV as a mutliple of EOP RMR 21.6x   21.0x
 

Below is a sensitivity table for the company’s RMR and SSCF valuation based on a range of attrition rates – as the sensitivity table shows, even at attrition levels substantially higher than anything the company has previously experienced, CFL equity is currently trading at implied cash flow yields of at least 16% and at huge discounts to valuation multiples for precedent industry transactions.

 

Excluding $125mm rebranding liability
Attrition
Rate 2008 2009 2010 2011 2012 2013
8.00% EV as multiple of SSCF 3.651x 3.578x 3.473x 3.372x 3.274x 3.179x
EV as multiple of EOP RMR 17.695x 17.180x 16.679x 16.194x 15.722x 15.264x
9.00% EV as multiple of SSCF 3.957x 3.885x 3.772x 3.662x 3.555x 3.452x
EV as multiple of EOP RMR 17.695x 17.180x 16.679x 16.194x 15.722x 15.264x
10.00% EV as multiple of SSCF 4.319x 4.250x 4.126x 4.006x 3.890x 3.776x
EV as multiple of EOP RMR 17.695x 17.180x 16.679x 16.194x 15.722x 15.264x
11.00% EV as multiple of SSCF 4.753x 4.691x 4.555x 4.422x 4.293x 4.168x
EV as multiple of EOP RMR 17.695x 17.180x 16.679x 16.194x 15.722x 15.264x
12.00% EV as multiple of SSCF 5.285x 5.234x 5.082x 4.934x 4.790x 4.651x
EV as multiple of EOP RMR 17.695x 17.180x 16.679x 16.194x 15.722x 15.264x
Including $125mm rebranding liability
Attrition
Rate 2008 2009 2010 2011 2012 2013
8.00% EV as multiple of SSCF 4.325x 4.237x 4.114x 3.994x 3.878x 3.765x
EV as multiple of EOP RMR 20.958x 20.348x 19.755x 19.180x 18.621x 18.079x
9.00% EV as multiple of SSCF 4.687x 4.601x 4.467x 4.337x 4.211x 4.088x
EV as multiple of EOP RMR 20.958x 20.348x 19.755x 19.180x 18.621x 18.079x
10.00% EV as multiple of SSCF 5.115x 5.034x 4.887x 4.745x 4.607x 4.473x
EV as multiple of EOP RMR 20.958x 20.348x 19.755x 19.180x 18.621x 18.079x
11.00% EV as multiple of SSCF 5.629x 5.556x 5.394x 5.237x 5.085x 4.937x
EV as multiple of EOP RMR 20.958x 20.348x 19.755x 19.180x 18.621x 18.079x
12.00% EV as multiple of SSCF 6.259x 6.200x 6.019x 5.844x 5.674x 5.508x
EV as multiple of EOP RMR 20.958x 20.348x 19.755x 19.180x 18.621x 18.079x
 

Lastly, it is also possible to look at CFL through a ‘run-off model’ in which we assume that the company makes no further investment in new subscribers, but simply manages its existing customer base. Even assuming rather draconian attrition rates for a number of years out (until the entire customer base has exited), our models indicate that CFL would generate well in excess of $1bn in FCF on a discounted basis over that time. We have discussed both our SSCF as well as run-off models and their assumptions with CFL management. They acknowledged that they have run similar models with similar assumptions, and their conclusions are a large part of why they have been aggressive buyers of the stock at current levels.

 

Acquisition and recapitalization candidate:

 

We believe CFL is an extremely attractive acquisition candidate for either a strategic or financial buyer.

 

Presented below is a table of recent acquisitions. The average RMR multiple for the acquisitions is 47.6x; the average SSCF multiple is 12.7x.  Not included in the comp table is the March acquisition of leading European operator Securitas Direct. Securitas Direct was purchased for 50x RMR, 14.3x SSCF, and 11x EBITDA.

 

Sonitrol ASG to Voxcom IASG to
Data Brinks   to Stanley   Parthenon   to UE   P1  
Date 2007 Q208 Q407 Q207 Q207
RMR ($ 000s) 37,194 5,364 2,800 3,200 4,400
OPERATING METRICS:
Gross RMR Attrition Rate ("Net" for Brinks) 6.7% 9.5% 12.0% 15.4% 14.0%
Net Internal Growth Rate 8.8% 4.6% 6.5% 10.4% 0.0%
Billable Service Revenue % 5.3% 8.5% 15.9% 5.0% 5.0%
Net Margin RMR & Service 62.3% 56.4% 56.4% 63.8% 50.0%
Net RMR Creation Multiple 37.6x 28.8x 31.0x 30.2x 33.7x
Steady-State NOCF       186,084         24,738         11,514         10,842           6,961
Steady-State NOCF Adjusted to Brinks RMR       186,084       171,533       152,943         10,842         58,841
PURCHASE PRICE:
Multiple of RMR 51.3x 50.0x 57.0x 33.0x
Multiple of SSNOCF 11.1x 12.2x 16.6x 20.9x
TYPE OF BUYER:
Consolidator in Industry X       X   X  
Financial         X          
Strategic                    
HSM to Guardian Coastal to Adelphia to CSG to Honeywell
Data Stanley   to Devcon   Devcon   Devcon   GHP   to GTCR
Date Q107 Q106 Q405 Q105 Q105 Q204
RMR ($ 000s) 9,100 1,500 1,300 1,100 1,600 8,365
OPERATING METRICS:
Gross RMR Attrition Rate ("Net" for Brinks) 11.0% 12.0% 11.0% 14.0% 10.0% 13.2%
Net Internal Growth Rate 4.0% 5.0% 5.0% 0.0% 10.0% -4.3%
Billable Service Revenue % 14.0% 13.0% 8.0% 5.0% 3.0% 14.6%
Net Margin RMR & Service 53.0% 57.0% 55.0% 55.0% 67.0% 49.2%
Net RMR Creation Multiple 20.0x 18.0x 30.0x 32.0x 28.0x 17.2x
Steady-State NOCF         45,959           8,354           4,976           2,695           8,770         37,606
Steady-State NOCF Adjusted to Brinks RMR       187,846       207,143       142,380         91,126       203,870       167,210
PURCHASE PRICE:
Multiple of RMR 60.0x 45.0x 40.0x 38.0x 62.5x 39.0x
Multiple of SSNOCF 11.9x 8.1x 10.5x 15.5x 11.4x 8.7x
TYPE OF BUYER:
Consolidator in Industry     X   X            
Financial                 X   X
Strategic X           X        

 

Based on the average 47.6x RMR multiple, CFL’s fair value is $39.85-$42.58 per share (based on RMR as of 9/30/08); based on the 12.7x SSCF multiple, CFL fair value is $52.30-$55.04 per share (based on 2008E SSCF).[4] Again, given the premium nature of CFL’s franchise and business model, we believe – in a normal environment – that it would deserve a premium to the precedent transactions (of course, in the present environment, multiples for the group are likely down).  

 

Possible strategic buyers include its four main domestic competitors, as well as European based Securitas Direct. The advantage of a strategic acquisition is that it will enable CFL to avoid having to undergo its rebranding campaign [see later in report]. Without question, the current EV/subscriber figure for CFL of $527.63 is substantially below the RMR creation multiple for any security monitoring company in the US. The opportunity to acquire the second largest and highest quality customer base at large discount to creation cost is no doubt a very compelling proposition for strategic buyers.

 

We believe as well that financial buyers are likely looking closely at CFL. The industry experts we spoke to stated plainly that CFL is wildly undervalued and that they have no question private equity firms such as KKR, Blackstone, GTCR, Quadrangle Group, and other are looking closely at a possible deal. Of course, financing remains extraordinary tough in this environment. However, two elements of CFL’s story give us confidence that it could attract debt financing: 1) by those lenders who work regular with security monitoring companies and understand the industry, the business model is viewed as very defensive; 2) CFL’s current capital structure is excessively underleveraged (i.e. there is no leverage). Accordingly, we believe a financial buyer could purchase the company with a minimal equity investment. According to a leading industry investment banker, market leverage multiples on an RMR basis are typically at the level of RMR creation multiple – i.e. north of mid-20x RMR. On an enterprise value basis, CFL currently trades at 16.5x RMR. As industry banker put it “you could borrow against CFL’s subscriber base for less than the company is currently trading.” We have heard that even in this environment traditional lenders to the security monitoring industry such as LaSalle Bank (now part of Bank of America), CapitalSource, and others are lending at 20x+ RMR. Additionally, the banker we spoke to is currently shopping three deals at 40x-50x RMR.[5]

 

Given the amount of leverage the company could handle, we believe the possibility exists of CFL choosing to recapitalize the company and use the proceeds to buy-back a large amount of stock and/or pay a special dividend (we realize this is likely unrealistic for the time being and on its recent conference call, CFL management said it does not believe the time is prudent to pursue such a course, with which we agree - however we do believe this is an opportunity down the line). For a public company, a debt load of 10x-14x RMR would be entirely reasonable. Assuming a recapitalization at those multiples, CFL could pay a special dividend of $8.70-$12.17 per share. Protection One, the only other publicly traded pure play security monitoring company, currently trades at 25.0x RMR. It is leveraged on a net-debt/RMR basis of 18.0x RMR. Everyone in the industry recognizes that CFL’s operations are vastly superior to those of PONE. In Q308, PONE peeked out an operating margin of .98% and showed a 12.70% annualized disconnect rate.[6]

 

Insider options and insider ownership:

 

The data below highlights two important elements of the CFL story: 1) Insiders are well incentivized to see the stock at meaningfully higher levels – the CEO has zero options currently in the money, and the CFO has only a very small amount which are negligibly in the money. 2) Insiders – especially the CEO and CFO – seem to be keenly aware of how undervalued the stock currently is; in past few weeks, both officers, as well as other executives, have made material purchases of the company stock.

 

CEO and CFO options holdings:

 

 

Vest Expiration Strike
Name Position Date Date Options Price
Robert Allent CEO 7/13/2007 7/13/2012 26,010  $     24.72
Robert Allent CEO 7/13/2008 7/13/2012 26,010  $     24.72
Robert Allent CEO 7/13/2009 7/13/2012 26,009  $     24.72
Robert Allent CEO 7/12/2008 7/12/2013 26,010  $     28.59
Robert Allent CEO 7/12/2009 7/12/2013 26,010  $     28.59
Robert Allent CEO 7/12/2010 7/12/2013 26,009  $     28.59
Robert Allent CEO 7/10/2009 7/10/2014 26,010  $     28.78
Robert Allent CEO 7/10/2010 7/10/2014 26,010  $     28.78
Robert Allent CEO 7/10/2011 7/10/2014 26,009  $     28.78
Total/average       234,087  $     27.36
Stephen Yevich CFO 7/8/2005 7/8/2010 7,432  $     14.66
Stephen Yevich CFO 7/8/2006 7/8/2010 7,431  $     14.66
Stephen Yevich CFO 7/8/2007 7/8/2010 7,431  $     14.66
Stephen Yevich CFO 7/1/7706 7/7/2011 7,432  $     16.06
Stephen Yevich CFO 7/7/2007 7/7/2011 7,431  $     16.06
Stephen Yevich CFO 7/7/2008 7/7/2011 7,431  $     16.06
Stephen Yevich CFO 7/13/2007 7/13/2012 7,432  $     24.72
Stephen Yevich CFO 7/13/2008 7/13/2012 7,431  $     24.72
Stephen Yevich CFO 7/13/2009 7/13/2012 7,431  $     24.72
Stephen Yevich CFO 7/12/2008 7/12/2013 7,432  $     28.59
Stephen Yevich CFO 7/12/2009 7/12/2013 7,431  $     28.59
Stephen Yevich CFO 7/12/2010 7/12/2013 7,431  $     28.59
Stephen Yevich CFO 7/10/2009 7/10/2014 7,432  $     28.78
Stephen Yevich CFO 7/10/2010 7/10/2014 7,431  $     28.78
Stephen Yevich CFO 7/10/2011 7/10/2014 7,431  $     28.78
Total/average       111,470  $     22.56

 

Recent insider purchases:

 

 

Cumulative 
Cumulative  Shares
Name Position Date Shares Price Cost Owned
Robert Allent CEO 11/4/2008 31  $    19.90  $              616.75 15,031
Robert Allent CEO 11/5/2008 700  $    17.94  $         12,558.00 15,731
Robert Allent CEO 11/5/2008 600  $    17.96  $         10,776.00 16,331
Robert Allent CEO 11/5/2008 3,100  $    17.97  $         55,707.00 19,431
Robert Allent CEO 11/5/2008 100  $    17.98  $           1,798.00 19,531
Robert Allent CEO 11/5/2008 200  $    17.99  $           3,598.00 19,731
Robert Allent CEO 11/5/2008 2,800  $    18.00  $         50,400.00 22,531
Robert Allent CEO 11/12/2008 403  $    14.87  $           5,992.61 22,934
Robert Allent CEO 11/12/2008 800  $    14.88  $         11,904.00 23,734
Robert Allent CEO 11/12/2008 100  $    14.89  $           1,489.00 23,834
Robert Allent CEO 11/12/2008 400  $    14.90  $           5,958.00 24,234
Robert Allent CEO 11/12/2008 2,597  $    14.90  $         38,695.30 26,831
Robert Allent CEO 11/12/2008 100  $    14.90  $           1,490.25 26,931
Robert Allent CEO 11/12/2008 300  $    14.91  $           4,471.50 27,231
Robert Allent CEO 11/12/2008 300  $    14.91  $           4,473.00 27,531
Robert Allent CEO 11/14/2008 100  $    15.61  $           1,560.96 27,631
Robert Allent CEO 11/14/2008 1,300  $    15.61  $         20,292.87 28,931
Robert Allent CEO 11/14/2008 1,100  $    15.61  $         17,171.00 30,031
Robert Allent CEO 11/14/2008 1,100  $    15.61  $         17,171.00 31,131
Robert Allent CEO 11/14/2008 1,400  $    15.65  $         21,910.00 32,531
Robert Allent CEO 11/17/2008 300  $    16.38  $           4,914.00 32,831
Robert Allent CEO 11/17/2008 1,900  $    16.40  $         31,160.00 34,731
Robert Allent CEO 11/17/2008 2,300  $    16.48  $         37,904.00 37,031
Total/average     22,031  $    16.43  $       362,011.24  
Stephen Yevich CFO 11/6/2008 100  $    17.27  $           1,727.00 7717
Stephen Yevich CFO 11/6/2008 600  $    17.28  $         10,368.00 8,317
Stephen Yevich CFO 11/6/2008 1,100  $    17.29  $         19,019.00 9,417
Stephen Yevich CFO 11/6/2008 100  $    17.33  $           1,733.00 9,517
Stephen Yevich CFO 11/6/2008 100  $    17.34  $           1,734.00 9,617
Stephen Yevich CFO 11/7/2008 3,000  $    16.80  $         50,400.00 12,617
Stephen Yevich CFO 11/12/2008 300  $    14.46  $           4,339.32 12,917
Stephen Yevich CFO 11/12/2008 100  $    14.48  $           1,448.00 13,017
Stephen Yevich CFO 11/12/2008 4,600  $    14.50  $         66,700.00 17,617
Total/average     10,000  $    15.75  $       157,468.32  
Shgawn Lucht Sr. VP 11/6/2008 100  $    17.02  $           1,702.00 513
Shgawn Lucht Sr. VP 11/6/2008 1,243  $    17.04  $         21,180.72 1,756
Shawn Lucht Sr. VP 11/6/2008 157  $    17.07  $           2,679.99 1,913
Stacey Rapier Sr. VP 11/6/2008 1,000  $    17.00  $         17,000.00 1000
Robert Trotter Sr. VP 11/11/2008 1900 15.105  $         28,699.50 1900
Robert Trotter Sr. VP 11/11/2008 390 15.12  $           5,896.80 2,290
Robert Trotter Sr. VP 11/11/2008 110 15.15  $           1,666.50 2,400
Total/average     36,821  $    16.20  $       596,638.57 50,461

 

Rebranding:

 

Since CFL’s founding as a subsidiary of BCO, the company has used the Brink’s name in its operations. Per this agreement, CFL was charged a royalty by BCO since 2000. The royalty was equal to 7% of gross US revenue and 3% of foreign (Canadian) revenue.

 

 

Period Royalty
2005  $      27.0
2006  $      30.1
2007  $      33.2
First 6 months of 2008  $      17.8

 

According to the spin-off agreement, effective upon the date of the spin-off, CFL will have the right to use the Brink’s name for three years, during which time the royalty will be reduced to 1.25% of gross US and foreign revenues. After those three years, the company will no longer have the right to use the Brink’s name.

 

Resultantly, CFL plans to initiate a rebranding campaign. In the spin-off document, the company states that they “expect to incur significant new costs associated with establishing and marketing our new brand, and we anticipate that these costs will be in excess of the reduced licensing fees during this period.” According to our calculations, the aggregate reduction in licensing fees over the three years is likely to be ˜$90mm. In the management presentation associated with the spin-off, the company estimated that the cost of the rebranding campaign would be $100mm-$150mm over the 24-36 month period from the introduction of the new brand. As a note, the company has explained that the $50mm in cash BCO contributed to CFL at the spin-off was in part to help with the costs of rebranding.

 

So far, CFL has presented no concrete plans for the rebranding campaigns. They have only revealed that they engaged Landor Associates in September 2008 to help create a comprehensive brand strategy, and that they anticipate introduction of the new brand in mid-2009.

 

We see the risks attached to rebranding – both from a franchise risk perspective as well as the possible financial impact – as the largest risk/uncertainty surrounding CFL. The industry experts we have spoken with believe the same. While the industry view seems to be that CFL should prove successful in rebranding itself, this is mere speculation supported by widely held positive views of the company and management.

 

Additionally, it is probably appropriate to apply a “rebranding liability” to a valuation of the company. Unless CFL is purchased by a strategic buyer, it will have to spend a meaningful amount of money to support the rebranding initiative. Assuming we apply a rebranding liability of $125mm, CFL is currently trading at 20.2x RMR – still a massive discount to precedent transactions. 

 

Risks:

 

1)      Attrition rate far in excess of historical recession levels

2)      Lack of discipline in customer acquisition standards

3)      Generally poor capital allocation decisions

4)      Mishandling of rebranding operation

 

Catalysts:

 

1)      Spin-off forced selling ebbs

2)      Investment community begins to understand true economics of the business (general realization of value)

3)      Results demonstrate defensiveness of business

4)      Strategic or financial buyer



[1] In its spin-off document, the company sates: “[F]or the last several years, our average up-front cash investment per installation, including amounts expensed and capitalized, has ranged between $1,250 and $1,450. This amount does not take into account customer down payments, which generally range between $280 and $340 per site. Including these payments, our net cash cost per new installation in 2007 was ˜$1,100. Net cash cost per installation does not vary significantly between company-sourced and dealer-sourced subscribers.”

[2] In its spin-off document, CFL states plainly that “In order to obtain customer who are less likely to disconnect, we seek to attract customers with solid credit scores and the willingness to pay reasonable up front-fees.”

[3] On the Q308 conference call, CFL management explained: “Right now, demand for apartments is very high. When demand is high for apartments and occupancy rates are high, a lot of properties don’t feel the need to have to offer extras because they don’t need to have much differentiation in the market. When apartments have high vacancy rates, we’ve been able to sell in and use our services as an amenity.” The company went on to explain that in Q308 “a big lump” of multi-family contracts rolled off and chose to disconnect. Management added that the company has ˜22,000 multi-family customers who will be up for renewal over the next four or five years. The company expects that some will choose to disconnect and some will choose to stay, but it is currently difficult to project the impact. 22,000 customers represents 1.75% of CFL’s customer base as of 9/30/08. Importantly, CFL has previously stated that it no actively pursues installation growth in this market segment.

[4] The range of values is based on (low end) including the $125mm rebranding liability and (high end) excluding the $125mm rebranding liability.

[5] Currently, the banker is bringing three deals to market. 1) Virtually no debt – high-40x RMR; 2) 5x-10x RMR debt – mid-40x RMR; 3) 24x RMR debt – low-40x RMR.

[6] For first nine months of 2008, PONE generated an operating margin of 2.11% and an annualized disconnect rate of 11.80%. For the same period in 2007, PONE generated an operating margin of 5.08% and an annualized disconnect rate of 10.80%.

Catalyst

See above
    sort by   Expand   New

    Description

    Summary:

     

    In the good ‘ole days, the VIC board might have loved the idea of anunlevered spin-off in a niche industry with complex financials trading at a gross discount to its fair value. We think that even in this market such an idea can work out extremely well and we believe Brink’s Home Security (CFL) is such an investment. With a net cash position and a current valuation of 17.0x recurring monthly revenue, 3.7x steady-state cash flow, and 3.1x EBITDA (that is after expensed investments in new subscribers – 2.1x before), we believe an investment in CFL offers tremendous upside potential and a firm margin of safety. [Note, share price used throughout this write-up is $16, closing price as of Friday.]

     

    Thesis:

     

    Brink’s Home Security (CFL) was recently spun-off from The Brink’s Company (BCO), and began trading as an independent equity security on 11/3/08. CFL is the premier company in the electronic security monitoring industry – a space we believe is relatively recession resistant and which possesses long-term growth prospects. At its current price, CFL is trading at what we believe represents roughly 1/3 its intrinsic value on both a Recurring Monthly Revenue (RMR) and Steady State Cash Flow (SSCF) basis – this analysis assigns the company essentially no value for its premier franchise nor its potentially significant growth. We take the recent substantial volume of insider purchases as evidence that management is very confident in the health of their franchise and the undervaluation of CFL stock.

     

    We believe the extreme undervaluation of CFL equity is the result of four primary factors: 1) general market sentiment – i.e. many companies are currently cheap and have become cheaper; 2) spin-off dynamics – the forced selling that seems to have characterized the stock’s movement following the spin-off is common for spin-offs; 3) perception of the company as a consumer discretionary business – we believe shorts have been attracted to the stock; 4) complicated financials – unless one understands the business model, the true economics of the company are masked.

     
    Excluding $125mm rebranding liability Including $125mm rebranding liability
    Shares outstanding 45.8 Shares outstanding 45.8
    Price  $          16.00 Price  $          16.00
    Market cap  $          732.3 Market cap  $          732.3
    Debt                    -  Debt                    - 
    Cash                54.4 Cash                54.4
    Rebranding liability                    -  Rebranding liability              125.0
    Enterprise value  $          677.9 Enterprise value  $          802.9
    RMR (as of 9/30/08  $            39.8 RMR (as of 9/30/08  $            39.8
    Multiple of RMR 17.0x Multiple of RMR 20.2x
    Subscibers (as of 9/30/08) 1285.3 mm Subscibers (as of 9/30/08) 1285.3 mm
    Per subscriber   $        527.43 Per subscriber   $        624.68
                

    Business Description:

     

    CFL is the second largest provider of home security monitoring services in North America. CFL’s major competitors include ADT (part of Tyco corporation), Protection One (NASDAQ: PONE; private equity firm Quadrangle Group owns 46.62% of shares outstanding), Monitronics International (private), and Stanley Convergent Security Solutions (part of Stanley Works, NSYE: SWK).

     

    CFL’s business model is straightforward. CFL makes an up-front cash investment to install their system at the customer’s location and then provides monitoring services to those customers based on mid to long-term contracts. CFL estimates net cash investment (i.e. net of subscriber installation fees) for a system to be ˜$1,100.[1] The company then seeks to recoup their investment though monthly subscription revenues generated from the monitoring services they provide. In the vast majority of cases, monitoring services are governed by initial three-year contracts that contain automatic renewal provisions on an annual basis (usually for an additional one year). The company claims that “our cash break-even point per site is typically reached in less than four years after installation.”

     

    Presented below are two analyses of economics underlying a residential installation, as well as the usual cash flow and accounting treatment for such an installation:

     

     

    Per Residential Installation  Cash Balance Sheet P&L
    Installation fees/revenues  $     300 Deferred Liability  $   300  $       -
    Costs and Expenses:
    Installation  $     825 Capitalized Asset  $   825  $       -
    Sales (related to installation)  $     125 Deferred Asset  $   125  $       -
    Marketing, other sales and admin  $     450  $       - Expensed  $   450
    Total costs  $  1,400
    Net Investment per Installation  $  1,100 Net assets  $   650 Expensed  $   450

     
    Upfront selling & system costs GAAP   Cash
    Sales & commissions Capitalized                 (125)
    Hardware & labor Capitalized                 (825)
    Marketing & overhead Expensed                 (450)
    Total cost of installation    $         (1,400)
    Customer payment Def. Revenue                  300
    Net cost of system    $         (1,100)
     
    Ongoing Fees & Expenses Monthly   Annual
    Monitoring fee (ARPU)                  30                  360
    Monitoring marginal cost                   (3)                   (36)
    Profit per sub  $              27    $             324
     

    As of September 30, 2008, CFL served 1,285.3mm customers. Single family residences make up more than 90% of the company’s customer base. The company also has ˜60,000 business customers which comprise ˜5% of its customer base. Multi-family residences make up the balance.

     

    CFL is regarded as the gold-standard in the home security monitoring industry. That sentiment has been echoed repeatedly by industry experts we have spoken with, as well as through reading industry trade magazines. The primary differentiator for CFL is its customer retention levels. CFL has, for many years, shown the lowest disconnect rate – often by a substantial margin – amongst the major players in the industry. We believe CFL’s industry leading customer retention rates speak to two important facets of the company’s business: 1) the discipline and ownership CFL takes to its customer acquisition process - most significantly, CFL has high credit score standards for its customers, and requires, on average, an upfront $300 installation fee for new subscribers, creating a sense of ‘equity’ in the system for its subscribers[2]; 2) the level of customer service CFL provides for existing customers. Critically, unlike any of the other major security monitoring companies, CFL’s growth – since inception – has been entirely organic. All of the other major players have grown by rolling up smaller companies and consolidating the industry. CFL’s strategy has ensured consistency in its customer acquisition process (as well as the underlying home security units), resulting in a much higher quality customer base. The company anticipates that such discipline should enable the company’s customer base to remain resilient during this downturn.

     

    Industry overview:

     

    The home security monitoring industry remains extremely fragmented. The top five companies (ADT, CFL, Protection One, Monitronics, and Stanley Works) control ˜42.1% of total industry RMR. However, the top 100 companies control only ˜56%. Beneath the top 100, there are an estimated ˜14,000 regional and local security monitoring companies that control the balance of industry RMR.

     
    2007 2007 % of indsutry
    Company Subscribers RMR RMR Comment
    Brink's Home Security 1,223,800  $        37.2 5.3% Mostly residential (95%)
    ADT 6,000,000  $       219.0 29.2% Evenly split between residential and commercial
    Protection One 880,262 (1)  $        26.7 3.8% Shifting to commerical, 30% multifamily
    Monitronics 548,034  $        17.0 2.4% Mostly residential (90%)
    Stanley Security Solutions 252,953  $        10.0 1.4% Mostly commerical (70%)
    (1) Excludes wholesale subscribers
     

    It is estimated that penetration rates for electronic security systems in single family homes is 17%-22% in the US and 12%-17% in Canada. For that reason, CFL, along with others in the security monitoring industry, believe there exists a large long-term growth runway ahead of it. Secular trends such as an aging population, a more security conscious population, and new technologies should assist in driving industry growth.

     

    Historical numbers:

     

    The data below highlights the key figures for the company going back to 1993. We believe the two most important metrics are growth in RMR and annualized disconnect rate. With regards to growth in RMR, it is important to keep in mind, again, that this growth is entirely organic. With regard to disconnects rates, we view the relative consistency of the company’s disconnect rates across fifteen years in varying economic environments as a strong positive.

     
    1993 1994 1995 1996 1997 1998 1999
    Revenue  $     89.0  $   109.9  $   128.9  $   155.8  $   179.6  $   203.6  $   228.7
    y/y growth 25.78% 23.47% 17.27% 20.84% 15.26% 13.37% 12.34%
    EBIT  $     26.4  $     32.4  $     39.5  $     44.9  $     52.8  $     53.0  $     54.2
    EBIT margin 29.65% 29.50% 30.64% 28.80% 29.43% 26.05% 23.70%
    Capex  $     26.4  $     34.1  $     47.3  $     61.5  $     70.9  $     81.7  $     80.6
    D&A  $     14.4  $     17.8  $     21.0  $     30.1  $     30.3  $     36.6  $     49.9
    EBITDA  $     40.8  $     50.2  $     60.5  $     75.0  $     83.2  $     89.7  $   104.1
    EBITDA margin 45.77% 45.70% 46.95% 48.13% 46.32% 44.04% 45.52%
    EBITDA - CapEx  $     14.3  $     16.2  $     13.3  $     13.5  $     12.3  $      8.0  $     23.5
    EBITDA - CapEx margin 16.11% 14.71% 10.30% 8.64% 6.83% 3.93% 10.28%
    MRR  $       5.9  $       7.3  $       9.0  $     10.7  $     12.9  $     15.1  $     16.8
    y/y growth   22.84% 23.69% 18.93% 20.69% 17.15% 11.26%
    Subscriber data (in '000s):
    Beginning of period 216.6 259.6 318.0 378.7 446.5 511.5 585.6
    Installations 59.7 75.2 82.6 98.5 105.6 113.5 105.6
    Disconnects, net -16.8 -16.7 -22.0 -30.7 -40.6 -39.5 -47.9
    End of period 259.6 318.0 378.7 446.5 511.5 585.6 643.3
    y/y growth 19.61% 22.53% 19.06% 17.92% 14.56% 14.47% 9.86%
    Net adds 42.9 58.5 60.6 67.8 65.0 74.0 57.7
    Annualized disconnect rate -7.06% -5.79% -6.32% -7.44% -8.48% -7.19% -7.80%
    Y/Y change in installation 17.12% 25.90% 9.89% 19.24% 7.19% 7.44% -6.95%
    Y/Y change in disconnects 12.14% -0.57% 31.62% 39.44% 32.28% -2.82% 21.39%
    Y/Y change in net adds 15.98% 36.27% 3.68% 11.90% -4.15% 13.85% -22.06%
    Capex per installation  $  442.12  $  453.05  $  571.81  $  624.33  $  671.47  $  719.63  $  763.26
    2000 2001 2002 2003 2004 2005 2006 2007
    Revenue  $   238.1  $   257.6  $   282.4  $   310.4  $   345.6  $   392.1  $   439.0  $   484.4
    y/y growth 4.11% 8.19% 9.63% 9.92% 11.34% 13.45% 11.96% 10.34%
    EBIT  $     54.3  $     54.9  $     60.9  $     71.2  $     80.8  $     87.4  $   100.3  $   114.8
    EBIT margin 22.81% 21.31% 21.57% 22.94% 23.38% 22.29% 22.85% 23.70%
    Capex  $     74.5  $     81.3  $     86.9  $     98.0  $   117.6  $   144.6  $   157.8  $   177.8
    D&A  $     32.0  $     36.8  $     43.9  $     47.9  $     51.5  $     58.1  $     67.6  $     77.7
    EBITDA  $     86.3  $     91.7  $   104.8  $   119.1  $   132.3  $   145.5  $   167.9  $   192.5
    EBITDA margin 36.25% 35.60% 37.11% 38.37% 38.28% 37.11% 38.25% 39.74%
    EBITDA - CapEx  $     11.8  $     10.4  $     17.9  $     21.1  $     14.7  $      0.9  $     10.1  $     14.7
    EBITDA - CapEx margin 4.96% 4.04% 6.34% 6.80% 4.25% 0.23% 2.30% 3.03%
    MRR  $     18.0  $     19.2  $     21.1  $     23.3  $     26.1  $     29.1  $     33.1  $     37.2
    y/y growth 7.14% 6.67% 9.90% 10.43% 12.02% 11.49% 13.75% 12.39%
    Subscriber data (in '000s):
    Beginning of period 643.3 675.3 713.5 766.7 833.5 921.4 1,018.8 1,124.9
    Installations 82.0 90.9 105.8 121.9 146.0 167.3 175.0 180.8
    Disconnects, net -50.0 -52.7 -52.6 -55.1 -58.1 -69.9 -68.9 -81.8
    End of period 675.3 713.5 766.7 833.5 921.4 1,018.8 1,124.9 1,223.9
    y/y growth 4.97% 5.66% 7.46% 8.71% 10.55% 10.57% 10.41% 8.80%
    Net adds 32.0 38.2 53.2 66.8 87.9 97.4 106.1 99.0
    Annualized disconnect rate -7.58% -7.59% -7.11% -6.89% -6.62% -7.21% -6.43% -6.97%
    Y/Y change in installation -22.35% 10.85% 16.39% 15.22% 19.77% 14.59% 4.60% 3.31%
    Y/Y change in disconnects 4.38% 5.40% -0.19% 4.75% 5.44% 20.31% -1.43% 18.72%
    Y/Y change in net adds -44.54% 19.38% 39.27% 25.56% 31.59% 10.81% 8.93% -6.69%
    Capex per installation  $  908.54  $  894.39  $  821.36  $  803.94  $  805.48  $  864.32  $  901.71  $  983.41
     

    Recent operating data with supplementary information:

     

        Nine Months
      2008   Ended September 30
    2007   Q1 Q2 Q3   2007 2008
           
    Revenue  $     484.4    $  127.8  $  133.9  $  135.4    $  358.4  $  397.1
    y/y growth        
           
    Profit from recurring services  $     169.0    $   56.8  $   60.2  $   55.7    $  152.4  $  172.7
    Margin 34.88%   44.44% 44.96% 41.14%   42.52% 43.49%
    Investment in new subscribers  $      (95.9)    $  (24.8)  $  (24.7)  $  (23.5)    $  (67.9)  $  (73.0)
           
    EBIT  $       73.1    $   32.0  $   35.5  $   32.2    $   84.5  $   99.7
    EBIT margin 15.09%   25.04% 26.51% 23.78%   23.58% 25.11%
    D&A  $       77.7    $   20.6  $   21.8  $   21.5    $   57.4  $   63.9
    EBITDA (from recurring services)  $     246.7    $   77.4  $   82.0  $   77.2    $  209.8  $  236.6
    Margin 50.92%   60.56% 61.24% 57.02%   58.54% 59.58%
           
    Impairment charges from subscriber disconnects  $       50.4    $   11.9  $   12.8  $   16.7    $   37.9  $   41.4
    Amortization of deferred revenue  $      (34.2)    $    (8.6)  $  (11.4)  $  (10.5)    $  (25.6)  $  (30.5)
    Deferral of subscriber acquisition costs (1)  $      (23.8)    $    (6.3)  $    (5.8)  $    (5.8)    $  (18.0)  $  (17.9)
    Deferral of revenue from new subscribers (1)  $       47.4    $   12.0  $   11.6  $   10.7    $   35.8  $   34.3
    CapEx:        
    Security systems  $    (165.2)    $  (43.2)  $  (42.4)  $  (42.3)    $ (124.9)  $ (127.9)
    Other  $      (12.6)    $    (2.6)  $    (1.9)  $    (2.9)    $  (10.3)  $    (7.4)
           
    RMR  $       37.2    $   38.3  $   39.3  $   39.8    $   36.3  $   39.8
           
    Subscriber data (in '000s):        
    Beginning of period 1,124.9   1,223.9 1,249.6 1,271.5   1,124.9 1,223.9
    Installations 180.8   44.6 44.2 42.7   136.7 131.5
    Disconnects, net -81.8   -18.9 -22.3 -28.9   -61.4 -70.1
    End of period 1,223.9   1,249.6 1,271.5 1,285.3   1,200.2 1,285.3
    y/y growth        
    Net adds 99.0   25.7 21.9 13.8   75.3 61.4
    Annualized disconnect rate -6.96%   -6.11% -7.07% -9.04%   -7.03% -7.42%
    Average number of subscribers 1,176.1   1,236.4 1,261.4 1,279.1   1,163.8 1,259.0
    (1) Current year receipts

     

    ‘Discretionary’ extent and leverage to new homebuilding:

     

    Discretionary extent

     

    From the various industry experts we have spoken with, the view we have received is that the industry is relatively recession resistant. Those industry experts contend that for an existing home owner, a security system is viewed only minimally as a dictionary item; rather, most homeowners view it much more as a utility. Certainly, we do not believe home security occupies the same status as electricity, gas, or water. Simultaneously, we do not believe it shares status with wholly discretionary items. With a monthly cost of ˜$31, most homeowners are likely to find alternative paths to cost savings than cutting off home security monitoring services. Additionally, given concerns of increasing crime rates that often accompany economic downturns, industry experts believe there some a counter cyclical effect to the impact an economic slowdown will have on disconnect rates.

     

    Despite this issue’s fairly qualitative character, historical data largely supports the above view. From 2000-2003, CFL’s annualized disconnect rate averaged 7.29%. That compares very favorably to the company’s 15 year average from 1993-2007 of 7.10%. According to data compiled by industry insiders, in previous recessions annualized disconnect rates moved up 50-75 bps. However, current data shows disconnect rates moving up 100-200 bps in some regions. Cautiously, therefore, operators in the industry believe this recession is likely to see disconnect rates move up 75-150 bps nationwide. However, those same people believe that that CFL is likely to be on the lower end of that range due the discipline it exercises in its customer acquisition processes.

     

    As the recent data shows, CFL’s disconnect rate moved up materially in Q308. In the consolidated Q308 10Q, CFL explained this was the result of three factors: 1) most significantly, disconnects were impacted by in increase in customer requested cancellations and customer moves to rented housing – the company believe this is related to the slowing economy; 2) increased cancellations of contacts at certain multi-family housing residences – the company explains these multi-family contracts were cancelled as apartment projects realized they no longer needed to offer amenities to lure residents[3]; 3) increased technical subscriber reconciliation adjustment – these relate to estimates the company had made in previous quarters of customers who disconnected and which the company anticipated would move into a new residences where they would reestablish their subscription. From our understanding, we believe the latter two factors are more one-time in nature. Normalized for those two factors, CFL’s disconnect rate for Q308 would have been 8.1%.

     

    For the full year, CFL is currently projecting 2008 disconnect rate would be 7.5%-7.8%. Management has also guided to mid-single digit subscriber growth, revenue growth of ˜10%, and double-digit operating earnings growth. They stated that “looking forward to 2009, we expect to achieve continued growth in subscribers, revenue and operating profit.” The company recognizes the impact the economic slowdown, but stated repeatedly on the call that they haven’t seen a “sea-change” in the number of people choosing to disconnect for purely financial reasons.

     

    Housing impact:

     

    According to CFL “we believe that household moves, whether involving newly constructed housing stock or existing homes, drive more than 50% of our new customer volume in any given year.” For that reason, CFL’s top-line growth obviously benefits from robust new home construction. Mitigating that, however, is the fact more than 50% of disconnects are also the result of household moves. Historically, therefore, the company has benefited in times of reduced residential moves – while new installation growth slows, disconnect rates decline as well. Currently, the company believes it is reaping those benefits, although the amount of moves from homes to apartments is offsetting much of the benefit of people not moving homes. Management has indicated that assuming move outs to apartments subside, they should see benefits from across the board decline in household moves.  

     

    Model and Valuation:

     

    The security monitoring industry benchmark for valuation is primarily Recurring Monthly Revenue (RMR). To account for differences in customer acquisition costs and disconnect rates, those numbers – based on recurring revenue operating margin assumptions – are usually translated into a Steady State Cash Flow (SSCF) model. The idea of a SSCF model is to arrive at the free cash flow a company could generate assuming it signed up new subscribers at the same rate as existing subscribers disconnected (instead of investing above and beyond the disconnect rate in new installations). The primary levers in the model are 1) attrition rate; 2) subscriber acquisition cost.

     
    Actual Based on 
    2007   2008
       
    Number of Subscribers (000's)    
    Beginning 1,124.9   1,223.9
    Installations - Internal 144.6   78.3
    Installations - Dealer 36.2   19.6
    Installations - Total 180.8   97.9
    Disconnects (81.8)   (97.9)
    Ending 1,223.9   1,223.9
    Average number of subscribers (calculated) 1,174.4   1,223.9
    Net Adds 99.0   0.0
       
    Subscriber Metrics    
    Attrition Rate -6.7%   -8.0%
    Net RMR Growth Rate 8.8%   0.0%
    % Change in Installations 3.3%   -45.8%
    Percentage of Installations done by Dealers 20.0%   20.0%
    % of Installations - (Total) to Replace Disconnects 45.2%   100.0%
    % of Installations - (Internal) to Replace Disconnects 56.6%   125.0%
       
    ARPU    
    ARPU ($) - "Given"  $              30.39    $              31.30
    ARPU ($) - "Calculated" Below 30.39   31.30
       
    RMR ($000's)    
    Beginning  $      33,095    $      37,194
       
    Installations - Internal            4,294              2,416
    Installations - Dealer            1,073                 604
    Installations - Total                  5,367                    3,020
    Disconnects           (2,407)             (3,020)