ADT's Stock Has Been Orphaned; In Need of New Home

By: SumZero Staff | Published: November 08, 2012 | Read Comments (3)

Full adt3
ADT

At first glance, ADT's core line, residential & small business monitoring, doesn't look very exciting. Organic rev growth has recently averaged 3% and there is significiant customer churn, much of it driven by residential and business relocation. Significant capex is required to direct sales efforts and install new customer equipment.

But 90% of revs are generated by recurring monthly service fees paid by middle and upper income homeowners with assets to protect. Services are important and valuable -- safety & security of family and property -- likely considered non discretionary relative to many other home services like cable or wireline -- proven as market continued to grow during recent downturn. And the market for security services remains under-penetrated (only 19% of US households) compared with other home services. Similarly, only 50% of the 5.5M US small biz locations employ active monitoring services, with ADT controlling only 14% of mkt.

Churn(attrition) has been in the 13-14% range. Due to high subscriber acquistion costs, each 50 bps reduction results in ~6ยข add'l EPS. ADT maintains focus on reducing churn by targeting high value, high service customers, improving the relocation process and promoting "customer for life" idea across sales force.

Several recent trends are working in ADT's favor:

- Intersection of Demographics & Techology: an aging population desiring independent living and being cared for by remote providers; younger generation has grown up with smartphones and expects connectivity to be part of life experience

- Crime & Its perception: while many people always perceive 'rising' crime rates (despite it being in long term decline nationwide), another feature has entered the picture -- reduced police presence in many communities has become a reality. Desire for extra layer of security has increased.

-Small business demographics are evolving -- increasingly remote work locations and entrepreneurs like ability to monitor operations remotely "Employee productivity is on the rise because they know I am watching"

Economics of ADT Accounts

ADT makes an upfront investment when acquiring accounts, then earns a recurring rev. stream from subscribers. This capex generates avg IRR in the mid-teens, with accounts reaching break even CF after 2.5-3.0 yrs. and 7 yr avg tenure (most customers commit to a 3 yr contract[2 yrs in CA], with ADT entitled to an early termination fee in the event of cancellation. High FICO scores are targeted and ADT has the right to reject accts from orginators, limiting default rate)

Once acquired, customer accounts have very low marginal expenses(beyond the fixed costs assoc with maintaining monitoring staff at 6 locations in N. Am.) and ADT generates EBITDA margins currently in the mid 40's with service mgn near 70%

Valuation

ADT expects TTM: $3.2B of rev and $1.6B of adj EBITDA ..Using very modest assumptions, we can reach $1.7B of expected 2013 adj. EBITDA. Further considering that ADT has extremely predictable, recurring CF's, we can expect the mkt to value these much as they do a REIT or MLP(using FCF after maint. capex) and assign a 10X multiple to this portion of the FCF stream.

Furthermore, ADT expects to have $1.0 NOL cfwd at time of separation and the ability to accelerate certain tax deductions. Although complete info on tax position has not yet been made available it is reasonable to assume they will be able to maintain 6-8% cash tax rate for at least the next 6 yrs

At current capitalization and conservative assumptions regarding subscriber and ARPU growth, ADT is worth at least $55. If they decide to modestly increase leverage(as suggested by recent activist filing), it will be likely to reach $60.

To date, the Sell side seems cool to ADT's prospects, focusing on a change in capitalization as the primary catalyst to create value. One HF strongly agrees with the strategy -- last week, an activist investor filed a 13-D to encourage the company to lever its capital structure and focus on several clear growth opportunities:

http://ssb.brand.edgar-online.com/fetchFilingFrameset.aspx?FilingID=8877762&Type=HTML

SUMMARY

Being relatively easy to model and owning a unique franchise with an established reputation, ADT has multiple paths to reach increased value via achievable rev. growth from the existing subscriber base and B/S recapitalization. Currently, this orphaned equity is likely mispriced due to unclear plans announced at the time of the spin, complex accounting and lack of true comps.

Comments

  • Shayne John November 09, 2012 edit |

    While I am long the common, the $55-60 target price is difficult to reconcile with the statements of 10x FCF and $1.7b EBITDA.

    ADT generates circa $500-500 mn in FCF. We can disregard Corvex's statement that FCF is understated by another $500mn in account acquisition costs, because that's ongoing capex which ADT needs to keep the sub count ticking.

    230mn shares, and $550mn in FCF in '13 is at most 2.40-2.50/share. The market can probably take it to a 5% FCF yield or 20x FCF. A FCF yield lower than 5% is improbable since this is a cyclical business with some natural limits to pricing power with competition from mom-n-pop providers in local markets. You can't gouge the sub base by raising prices by 10% every year. That gets the stock to $49-50, without re-jiggering the capital structure.

  • Jay Siegel November 09, 2012 edit |

    Biz is pretty sticky -- if churn can be improved, even marginally, capex will be reduced as its heavily tied to mktg expenses. Greater clarity in this area(SAC) will help inv. get comfortable.

    You cannot gouge the base, but you can improve ARPU by rolling out Pulse -- and uptake improving among newer subs.

    Glad you agree with the long case even absent changes to B/S

    We'll all know more when they announce on 11/27

    BTW, are you on SZ??

  • Shayne John November 23, 2012 edit |

    Not on SZ, Jay.

    Since you have a liking for spin-offs (I presume), have you looked at Mondelez?

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