Home security business Ascent Capital Group (ASCMA:US) reported 3Q earnings recently, which catalyzed an immediate 22% sell-off in the stock. Cardo Capital, the fund that originated a March 2015 short recommendation on SumZero and sat down with us for a September Q&A on the subject, continues to see its thesis play out in an accelerated fashion.
According to Michael Insel, portfolio manager at Cardo, margins for Ascent dived down to 6.1% versus last year’s 9.5%. When including the “Radio Conversion Cost” that the company needs to spend to upgrade their wireless connections at subscriber’s homes due to updated technology requirements, margins come in at only 3.6% for the year year. Insel also points out that Ascent burned $37M more cash this quarter, resulting in net debt of $1.612B versus $1.575B last quarter. The company has now burned $258mm in the past two years and stated that they will need to spend another $5-$6mm over the balance of 2015, and $20-$24mm in 2016 just for the Radio Conversion program, according to Insel.
News of the earning report drove Ascent’s bonds to new lows, which are now trading at a 16% yield (up from 11.5% in October and 10.5% in September). The stock has dropped another 28% since the September interview. That's a 57.9% total, or 72.2% annualized return since the the short thesis was first posted to SumZero in March. Kudos to Cardo Capital for the excellent pitch, and check out the full Q&A below.
In the uber-competitive home security markets Ascent Capital (Nasdaq: ASCMA, holding company of Monitronics Security) has been on a tumble. Though the decline was a surprise to the sell-side, Michael Insel had positioned his fund Cardo Capital short on ASCMA long before, and he has since reaped a 29% return. Insel developed his prediction after noticing that ASCMA's key earnings metrics incorrectly excluded important business expenses. After revising the earnings calculations Insel found that ASCMA was actually lighting fire to cash and increasing debt. ASCMA has since reported elevated customer attrition rates, causing the equity to slide. According to Mr. Insel there is still potential for further gains on the short due to ASCMA’s fundamentally weak business model.
SumZero: What about Ascent Capital initially caught your attention as a potential short idea? What was the market missing at the time?
Michael Insel, Cardo Capital: We have been following the home security space since 2004. In recent years, the home security business has become more competitive with the entrance of AT&T and Comcast, large national private-equity funded companies, and cheap online DIY solutions. Ascent, with its Monitronics brand, is the distant #2 publicly traded industry player behind ADT. Unlike ADT and the other large national players, Ascent’s model relies on purchasing accounts from third-party installers; they do not have an internal sales/installation staff. As customers churn off Monitronic's network, Ascent purchases new subscribers to replace them.
In late 2014, the company reported disappointing 3Q14 earnings. Upon revisiting our model we noticed that customer attrition had inflected higher, indicative of the fact that business was getting much tougher due to the new entrants. Attrition had increased from 11% in 2011 to 13.5%, requiring the company to spend more money just to remain at the same level of subscribers. Ascent was burning cash – net debt having increased by $200mm since 3Q13 – despite the fact that the company had not grown its subscriber base during that period. The market had chosen to focus instead on the company’s reported “adjusted EBITDA” which excludes the cost of new subscriber acquisitions. In our opinion, this cost should be considered a regular cost of doing business. On an “adjusted EBITDA” basis, the company appears to be generating $200 million of cash flow annually. When we adjust for the cost of new subscriber acquisitions, however, the company’s cash flow generation has decreased from $+27mm in 2011 to a cash burn of $-57mm in 2014.
SumZero: Can you explain how Ascent excludes important costs of doing business from its adjusted EBITDA calculations? This seems misleading.
Michael Insel, Cardo Capital: Generally Accepted Accounting Principles allow for subscriber accounts to be amortized over their expected life similar to a piece of equipment. The obvious problem with this method, however, is this is a business where 13% of your customers leave every year due to natural attrition and must be replaced. This is more of a constant use of cash flow for business generation, and less of a periodic replacement of equipment used to support a business. In our opinion, the exclusion of the costs of subscriber acquisitions in the “adjusted EBITDA” calculation results in an overstatement of the real profitability of the business.
SumZero: So does this mean investors are actively ignoring a negative cash-flow due to an industry accepted focus on "adjusted EBIDTA"?
Michael Insel, Cardo Capital: Yes, it does. As is often the case in industries which generate no free cash flow, management and sell-side analysts have an alternate preferred method of determining value. We also described in our SumZero writeup how in September 2014, the company presented a “Steady State Free Cash Flow Generation” analysis which resulted in $188mm in Free Cash Flow. What the company left out of that analysis, however, was interest expense, taxes, and additional capital expenditures that the company had averaged over the previous three years. When deducted, only $68mm in FCF is left to pay down the $1.7B in debt before equity holders see any value. Also, although management’s analysis stated that new subscriber costs should be $172mm in a steady state scenario, the company actually spent $263mm (50% greater than the company’s presentation) in the 12 months preceding that analysis – a period in which ending subscribers only increased by 1.5%.
SumZero: Why hasn’t the sell-side noticed this “adjusted EBITDA” problem?
Michael Insel, Cardo Capital: Adjusted EBITDA is the traditional method of looking at home security companies and the analysts are simply utilizing conventional wisdom. The company actually does not have much of a following on the sell-side, as only a few analysts cover Ascent. Generally in the sell-side industry, we find that analysts tend to follow management’s methodology of representing a given company’s profitability. Rarely do we find an analyst that truly thinks outside of the box and questions presentations such as adjusted EBITDA and the like. The goal generally is to figure out whether companies are able to meet stated guidance, and bigger picture trends in a business. This presents opportunity for enterprising buy-side analysts that are willing to challenge the conventional wisdom.
SumZero: So what happened to Ascent’s business model?
Michael Insel, Cardo Capital: What has happened is that the business model has been compromised by increased competition, which has led to increased attrition, and thus higher annual costs of replacing lost subscribers. As we describe in the original investment write-up posted on SumZero, Ascent is not the only sub-scale home security company that is burning cash. APX Group, holding company for Vivent, has been burning cash for the last few years and also has accumulated $1.7B in net debt. As these companies compete to try to achieve critical mass, their debt-service burdens have grown out of control. The credit ratings agencies are also starting to pay attention. On August 13, 2015 shortly after the 2Q15 earnings report, S&P, which already rates the company’s 9.125% notes at “CCC+”, changed the Monitronics credit ratings outlook to “Negative”. According to Bloomberg, the notes traded last at an 11% YTM (a 9.5% spread over the risk free rate), versus 7.5% in August 2014, indicating increased credit market concerns.
SumZero: Is Ascent’s stock still unattractive at today’s prices?
Michael Insel, Cardo Capital: Given the fact that the company continues to burn cash, it is certainly possible that the equity will be trading much lower in the future. We presented several contra-views of equity value in a range of scenarios, such as where the company decides to completely halt new customer acquisitions, or a potential purchase of the company by ADT. In all of these cases, our estimate of equity value is well below the recent price of $31/share. We modeled a scenario where the company completely stops all new acquisitions, cuts corporate overhead by 50%, and allows the existing customer base to churn off, using all cash flow to pay down debt. In that extreme (and most unlikely) scenario, it would still take the company nearly seven years to pay down its debt. At the end of those seven years, 2/3 of the subscriber base has churned off and cash flow is declining 10%/year. On an NPV basis applying a 15% discount rate we calculate a value to the equity of $11/share in that scenario.
SumZero: What key metrics should investors be paying attention to as your thesis matures?
Michael Insel, Cardo Capital: We would expect to see continued deterioration of the balance sheet with each quarter as the company continues to try to grow its way into profitability. Should subscriber attrition remain elevated, the cash burn will continue. The reverse is true if the attrition trend were to reverse, although there is nothing to suggest this will happen.
SumZero: Was execution difficult given that this is a short?
Michael Insel, Cardo Capital: The issue is not a very liquid one, trading only $2-3mm per day. That being said, we have had no problem trading in the name.
SumZero: What are the biggest risks associated with the trade in your view?
Michael Insel, Cardo Capital: The largest risk was that our method of looking at the company, while straightforward, was at odds with the traditional method of looking at home security companies. The reported “adjusted EBITDA” method, in which the cost of acquiring new subscribers is completely ignored, could both continue and prevail. Also, while Ascent is highly levered, its debt does not begin to come due until March 2018. The company has a long runway to change course. Any course change, however, was likely to be favorable to our thesis.
SumZero: Is this thesis representative of the Cardo Capital investing style?
Michael Insel, Cardo Capital: Cardo seeks to find investments, long and short, where there is something that the investment community is largely missing. This differentiated view becomes our edge in the situation. Our preference is to have some catalyst or event that will effectuate the valuation change that we anticipate. In this case, the catalyst was a combination of factors: a continuation of the status quo in which the company continued to destroy shareholder value and burn cash, a continued difficult industry competitive environment resulting in higher-for-longer attrition rates and elevated acquisition costs, and the potential that shareholders begin to wake up to the fact that the business model is destroying, not generating value.
SumZero: Where else do you see value in the market today?
Michael Insel, Cardo Capital: Cardo’s investment team is structured with senior, sector-focused analysts. In 2014/2015, we’ve been able to identify very attractive short opportunities stemming from the lack of a significant market correction over the past few years. On the long side, we have found opportunities in out-of-favor sub-sectors within our areas of expertise, as well as in stocks with a ‘harder’ event that could drive a re-valuation.
SumZero: How has your approach evolved over the years?
Michael Insel, Cardo Capital: Cardo’s edge is a function of many years of experience in each of Long/Short, Event-Driven, and Merger Arbitrage strategies. As a result, we are able to generate alpha across a much wider landscape of opportunities than other traditional long/short or event-driven equity firms. In one recent example, we invested in a fundamental long/short opportunity, which later developed into a solidly event-driven situation, and then finally agreed to a buyout upon which it became an exciting, hostile, Merger Arbitrage situation. We were able to become opportunistically involved at each stage due to our varied skillset.
SumZero: Tell me about your investing background and investing mentors and heroes.
Michael Insel, Cardo Capital: Prior to founding Cardo, I spent 12 years at Davidson Kempner Capital Management. Over my tenure at DK, I developed an investment style which combined the firm’s event-driven expertise with fundamental long/short equity investing. Starting as a merger arbitrage analyst, I later helped lead the firm’s efforts to build an event-driven, long/short equities business. I ultimately became the Portfolio Manager of that business. I attribute much of my / Cardo’s success to the investing skills and risk management approach I acquired through my experience at DK.
SumZero: What advice would you give to someone interested in pursuing investing?
Michael Insel, Cardo Capital: First, start reading. My investing career began in my high school years, reading Lynch’s “One Up on Wall Street” among other stock investment classics, and anything else I could get my hands on. Get a WSJ/Barron’s subscription and read both cover-to-cover every day/week. Second, I’d suggest building a network of mentors, the more the better. Strong relationships provide invaluable guidance when planning your career and navigating challenges. Last, only pursue investing as a career if it completely subsumes you. This is a difficult business with countless ups and downs, great successes as well as disappointments. The volatility can be intense. Only if one has the investing bug in their blood will they be able to successfully ride out the inevitable storms and maintain the course.
The above Q&A should be read in conjunction with Cardo’s original Ascent investment memo posted on SumZero.com which includes important and relevant analysis, opinions, and legal disclaimers.
SumZero is an online community of professional investors. For those who do not work on the buyside, you can get limited access to SumZero investment ideas, interviews, and more, when you join SumZero Basic here.
Investment professionals working at funds can use their credentials to become full Buyside members. Join SumZero Buyside, a research platform containing thousands of research pieces from other professional investors around the world, via the link below.