Daily Volume: 5.3MM shares or slightly more than $15MM per day

Shares: 365MM

Price: SEK 20.80

MV: SEK 7.6B

Net Debt: 0

Fx (SEK/USD): 7.2466

USD MV: $1.05B

A recent spin-off, Securitas Direct (SDIRB.ST) is a European consumer alarm company that has organically grown its subscriber base at 20%+ per year for the last five years; yet it is currently trading at less than 6x next year’s steady-state EBITDA. The company has zero debt, a simple business model, high returns on invested capital, and highly recurring cash flows. SDIRB also has the dominant alarm brand in Europe, with an installed alarm base of 762,000 as of the end of Q2, which management believes that it can grow at 20%+ for the next five years.

 

SDIRB’s valuation metrics appear “reasonable” or even “high” in the eyes of most of the European analysts publishing on the company. However, the company’s earnings are suppressed because each new customer acquired by SDIRB results in an immediate and one-time SEK 2,000 reduction in EBIT. The reason why investors can currently purchase SDIRB so cheaply is because the company’s recent and rapid subscriber growth are understating reported earnings.

 

 

Of the 200MM homes in Europe only 7.5MM, or roughly 4% of households, have installed alarm systems. The penetration rate is expected to grow by 0.4% each year. As a comparison, North America has grown from 7% in 1988 to 18% in 2003, and this number expected to be over 20% by the end of 2006. While it may be a stretch to assume that Europe could get to 20% any time soon, a penetration rate of 10% (representing 150% growth) is certainly a reasonable assumption. The combination of SDIRB’s dominant market share with the fact that Europe is dramatically under penetrated results in a huge opportunity for growth. SDIRB has roughly 10% of this market but is taking 25% of all new installations in Europe. Analysts widely expect that the company can continue to grow 20% per year for the next five years.

On average, each subscriber pays around SEK 242 per month or roughly SEK 2,900 per year. Management states that the company generates slightly under 50% margins, which translates into SEK 115 in recurring monthly EBITDA per alarm, or SEK 1,400 per year. The company has been able to raise prices roughly in line with inflation every year, and this price increase drops directly to the bottom line. For the home alarm industry, EBITDA margins are usually north of 30% and are occasionally higher than 50%. Brink’s Home Security, for example, has EBITDA margins consistently more than 45%, net of installation costs.

 

One of the reasons that margins are so high is that SDIRB’s installed base of 762,000 gives the company incredible leverage. To put its size in perspective, the five largest monitored alarm companies in North America in terms of number of alarms are ADT with 5.2MM, Protection One with 1.0MM, Brink’s with 921,400, Monitronics with 450,412, and Slomin’s Security with 215,315. Furthermore, analysts and management expect the company to cross the one million alarm milestone at some point in 2007.

 

Every time that SDIRB acquires a new customer, the company spends SEK 10,000. Of this amount, the customer contributes half, or SEK 5,000, which the company simultaneously recognizes both as revenue and as an expense. The other SEK 5,000 is paid by the company: SEK 3,000 for the alarm system, which is depreciated over five years, and SEK 2,000 for marketing and overhead, which is expensed immediately. As a result of this last charge, each additional new customer has a negative SEK 2,000 impact on EBITDA at the time of installation.

 

	One-Time	Recurring	Combined
Installation	5,000	-	5,000
Recurring	-	2,900	2,900
Total Revenue	5,000	2,900	7,900
Commission	(5,000)	-	(5,000)
Marketing & Overhead	(2,000)	-	(2,000)
Recurring Costs	-	(1,500)	(1,500)
Total Costs	(2,000)	(1,500)	(8,500)
EBITDA	(2,000)	1,400	(600)
Depreciation	-	(600)	(600)
EBIT	(2,000)	800	(1,200)
EBITDA Margin	(40%)	48%	(15%)

 

Obviously, valuing a company that is expensing rapid growth can be challenging. For SDIRB, this issue is further complicated by the various different assumptions used between home security companies. Brink’s Home Security, for example, depreciates their alarms over a period of 15 years, which is much closer to approximating the economic life of an alarm than the 5 years conservatively used by SDIRB.

 

 

Steady-state EBITDA allows investors to assess the earnings power of a monitored alarm business assuming that the company keeps its installed base flat every year by only adding enough new alarms to replace annual churn. The chart below shows what an average SDIRB customer would generate if the company chose only replace its 6% churn per year. In this steady-state scenario, reported EBITDA margins would increase to 40%.

 

	One-Time	Recurring	Combined
Installation	300	-	300
Recurring	-	2,900	2,900
Total Revenue	300	2,900	3,200
Commission	(300)	-	(300)
Marketing & Overhead	(120)	-	(120)
Recurring Costs	-	(1,500)	(1,500)
Total Costs	(420)	(1,500)	(1,920)
EBITDA	(120)	1,400	1,280
Depreciation	-	(180)	(180)
EBIT	(120)	1,220	1,100
EBITDA Margin	(40%)	48%	40%

 

 

Most of the 10 analysts covering SDRIB are valuing the business on a forward multiple of earnings, and given the current EBIT margin of only 6.6%, this myopic focus on a P/E multiple is incredibly misleading. While their DCF valuations are producing implied valuations of SEK 30-40 per share, the analysts are severely (and almost randomly) heavily discounting their DCF valuations in order to suggest a price target that results in a socially acceptable P/E multiple.

 

Assuming the company hits its 2007 target of one million customers, SDIRB’s shares are trading at 5.9x steady-state EBITDA of SEK 1.280B and 11x steady-state net income of SEK 687MM (assuming a 34% tax rate and SEK 60MM per year in maintenance capital expenditures). This price is even more appealing when one takes into consideration the fact that the company should be able to continue increasing its earnings at the rate of inflation every year.

 

Another way to look at the company’s valuation is on a per alarm basis. Assuming a 34% tax rate, a 10 year average life, and an 8% cost of capital, I calculate the NPV of a single subscriber at approximately SEK 7,000. If SDIRB decided not to grow after reaching 1MM installed subscribers in 2007, its installed base of alarms would be worth SEK 7B (more than SEK 19/share). This is a very attractive price for a profitable and dominant franchise business projected by management to grow 20% in 2008 and another 20% in 2009.

 

SDIRB also has zero debt, and this is due to the fact that when it was spun management assumed that all FCF would be used for growth into the foreseeable future. If growth ever does slow down, the company's steady FCF stream should be able to support a substantial amount of leverage. Until then, every SEK that the business makes is being reinvested into growth at a 3.5 year payback period (EBITDA/Invested Capital).

 

One could easily justify a share price of SEK 30 in one to two years. If management accomplishes its guidance through 2008, the company should have an installed base of approximately 1.2MM alarms which would be worth SEK 23 per share (7,000 per alarm divided by 365MM shares). It would not be outrageous to assume that the company can continue to grow after 2008, but I will let other investors determine the price that they are willing to pay for the growth that may occur after this point in time.

 

 

Management recently startled investors by announcing that EBIT margins, which had formerly been in the 9-10% range prior to the spin-off, would be a mere 6.6% for 2006. These lower margins are almost entirely associated with one-time separation charges. These charges are expected to spill into 2007, where management guided to EBIT margins of 7.5%, but should be finished by 2008 where management is guiding to EBIT margins of 8%.

 

2006E EBITDA: 620 (6.6% EBIT margin)

2007E EBITDA: 800 (8.0% EBIT margin)

2008E EBITDA: 950 (8.5% EBIT margin)

 

The numbers above represent my best attempt at adjusting analyst estimates downward to the new margin expectations. I have already suggested that EBITDA is not an optimum metric for a company that expenses its growth because it significantly understates steady-state earnings power, but these numbers suggest that the company is trading at a very reasonable relative valuation. Comparable companies with far less attractive growth prospects tend to trade in the 8-10x forward EBITDA range. At the current price, the business is selling for 9.5x estimated 2007E EBITDA of 800MM.  

 

 

Management is compensated for accomplishing its 20% growth goals for the next three years, while keeping the payback period below 4 years and churn below 6%. I should note that the executive team will not get its equity plan in place until sometime between November 2006 and April 2007.

 

 

Website:
securitas-direct.com/en/

 

Road show presentation:
www.securitas-direct.com/upload/Presentation_Capital_Markets_Day_061406.pdf

 

Prospectus:
www.securitas-direct.com/upload/Prospectus_en.pdf