We currently see a rare opportunity to purchase ADT Inc. (ADT, Financial), a company with the majority market share in the security industry, at distressed prices. We believe that such a low valuation is irrational, and the probability of permanent capital loss is minimal.
ADT operates in a highly fragmented industry and is expanding into the commercial security market, which has higher margins and profitability. These developments are sweetened greatly by the negative market response to the public offering. The initial range was between $17 and $19 but lowered to $14 due to a lack of enthusiasm for ADT Inc. With the price languishing in low single digits, there is great implausibility in this broken initial public offering. Below will be listed other factors that may further increase the margin of safety.
Why the opportunity exists
- The market is worried about the DIY risks and the 3G upgrade costs.
The market is worried about the DIY risks and the 3G upgrade costs.
- ADT has a very large amount of debt of 4.1x Ebitda.
- The price has gone down more than 60% since listing, so recency bias may have afflicted investors.
- The offering was set at a time when negative market conditions had just begun (January 2018).
- Investors still have memories about the incompetence of old management since it was only private for two years.
Investors still have memories about the incompetence of old management since it was only private for 2 years.
Capital structure
The company is laden with debt as seen from a debt-Ebitda ratio of 4.1 and debt-equity of 2.34. This is very problematic of course but due to the stability of its business model, it should be able to repay the capital and interest safely. Also, it has issued $1.5 billion of new first lien notes in April to repay $1 billion second lien notes and $500 million first lien term loan, creating a little bit more than $35 million of annual cash interest savings. Moreover, it has converted $725 million of variable rate debt to fixed, bringing the fixed-to-variable debt ratio to 93%/7%. These actions would help stabilize and reduce interest expenses.
Due to such a large debt load, ADT’s stock price should be rather volatile, leading to higher rewards to the more emotionally hardened investor and provide for ample opportunities to dollar cost average. The more conservative investors should be reassured that in the fourth-quarter 2018 presentation, "[Management] expect[s] to continue to place a high priority on debt paydown as a use of excess free cash flow."
This would be a form of enhancing shareholder value by de-risking ADT, which would increase share prices.
Management has also been wise by announcing a share repurchase program meant to provide a catalyst that may eliminate the undervalued nature of this stock. Their actions are held up by them saying, "[We] believe our stock to be attractively valued at recent levels."
This means that they are not pump-up-the-stock-price management, that they care about shareholder value creation. According to the 10-K, they will allow ADT Inc. to repurchase up to $150 million of shares of common stock through Feb. 27, 2021. However, the $150 million has almost been spent. There are no official plans for another buyback, but they have said in the earnings call, "[We are] also looking for opportunities to return capital to shareholders to drive shareholder value in that could include additional repurchase or reauthorizations it could include changes to our dividends."
The dividend reinvestment plan initiated would also generate $90 million in savings this year since Apollo, which owns around 82%, has elected to join the plan, which means that the $90 millions can now go to other needs like debt repayment and reinvestment. Its dividend payout is very strong at 0.09 to free cash flow, so there are no concerns about reductions or anything of that nature.
Competitive advantage
Despite the risks of the last two centuries, ADT has held its ground quite firmly since 1874, when it was formed, inspired by a burglary of the inventor of the stock ticker, Edward A. Calahan. In that year, he amalgated 57 small telegraph companies to form the "American District Telegraph." After 145 years of operation and countless mergers, the current ADT still exists and is a fixture in the minds of all Americans. Everyone recognizes ADT security as reliable and safe, something familiar. A 2017 survey stated that ADT brand had approximately 95% brand awareness, and nearly half of ADT customers surveyed did not consider any other security alarm provider during their purchase process This brand name isn’t going to disappear from people’s minds tomorrow, or even the next decade.
As management so aptly said, "No one wakes up and says, 'I want to cancel/change my home security service today.'"
Also, it is by far the largest security company in the U.S. and Canada, with 30% market share in the residential security market and a size that is estimated to be five times the next largest competitor. This allows it to leverage its large pool of skill and economies of scale, both when addressing the residential market or the business market, in which it is now expanding. On average, when one uses something at home, one would trust using it in business. Furthermore, the Customer Guru net promoter score for ADT is 11, which is considered good. To give an example, McDonald's has a score of -8 while Netflix, which has a massive moat, has a score of 13, marginally better than ADT.
Tailwinds
Cash flows and attrition rate
The security industry is very recession resilient with strong recurring cash flows for two reasons: People don’t normally change their security, and one can get lower fees with their insurance provider if they have security. Further, their free cash flow is normally quite stable since 90% of revenue is contract-based and ADT contracts are very long term, lasting 36 months, and if terminated before the end, a fee of 75% of the monthly fee is charged.
The new management put in place by Apollo seems to be quite adept too. This is evident in the gross customer attrition rate, which has improved to 13.3% due to the competence of current management. Their updated guidance has indicated that it should remain between 13.1% and 13.4% this year. This is mainly occurring in the dealer side of things and should be a short-term impact, but management stresses that the churn rate will not go down quickly. This is because they are trying to balance the key performance indicators and trying to hit their free-cash-flow target while not increasing the attrition rate. Their plan is to enter market(s) with higher returns, which unfortunately have higher attrition rates.
Example: Residential attrition is 13%, while commercial is around 15%.
Commercial security market
The recently completed acquisition of Red Hawk, a provider of fire security systems, helps ADT strengthen its foothold in the commercial security market. This marketplace has higher structural penetration rates and a wider moat than the residential market, which would prove accretive to free cash flow in the long term, as its investments in this division pay off more profitably with an average revenue payback of approximately 2.3x versus approximately 2.6x in the residential market. (For ADT, each 0.1x improvement equates to $60 million in annual savings.) Its success in the commercial security market can be seen in two recent events: 19% organic revenue growth last quarter and a contract with a national retailer to furnish more than 1,000 stores with ADT’s security systems. VIC members may be wary that the first event is an anomaly. Management agreed too in the latest earnings call and said it expected revenue growth to range from between 4% from the last quarter and 19% from this quarter. Even so, the median of 11% is rather respectable.
Developments
ADT has also engaged in three excellent developments that should have a material impact to free cash flow in the long term.
The first of these is the partnership with Amazon for Alexa Guard. By now, it has around 15,000 customers and is exploring more use cases with Amazon to widen the customer range. Since this collaboration has begun only in the second quarter, management said succintly, "It's not yet material."
The program allows ADT customers to enhance its home security via audio detection, which would add another layer of protection that most competitors do not have. Moreover, with this partnership, ADT should be able to leverage Amazon’s substantial competitive advantage and marketing and distribution abilities.
The other partnership is a future pilot program with Farmers Insurance to offer ADT’s professional home security and smart home solutions. The insurance company is the fifth-largest home insurer in the country, so plenty of growth should come if the pilot scheme is successful. It may not sound spectacular, but it reflects that the residential market is not saturated. Hence, ADT’s biggest division should not suffer secular decline due to DIY systems as many bears may say.
The final development is a five-city pilot program with the merchant partnership platform of the Citizens Financial Group. It is a consumer finance scheme that provides funds for the upfront costs needed when installing ADT’s security plans. This would unlock the door to reach many prospective clients that may not have been able to install ADT equipment due to liquidity constraints. The SAC costs would also be lower, since more revenue would be collected at the time of installation, meaning that the lifetime value of a subscriber would be lower. Further, with financing, more comprehensive packages could be sold. Therefore the outcome would be higher revenues and free cash flow. In the earnings call, management said, "Early indications have been encouraging ... [with] strong unit economics [and] meaningfully higher upfront revenue."
This sounds promising, but they are still refining the pricing model and customer experience in the cities the pilot operates in. If successful, it would be positive for long-term growth and efficiency. Like the other developments, it is long term, and the national launch should happen in 2020.
Headwinds
DIY threat
One of the major issues that bears of ADT seize upon is the rising threat of DIY systems like Nest. Many do choose to switch, but a good number stay with ADT because of its professional installation and expert monitoring. When a break-in occurs and the owners do not notice, the authorities will be notified immediately. For many DIY systems, one often must call the police by themselves, which is annoying and delays the progress of justice. Even so, it is true to say that many customers are switching to DIY systems. Thus, ADT has acquired a DIY platform, LifeShield. That would greatly hedge ADT against the DIY risk. This $25 million acquisition would allow a mechanism whereby ADT could address the approximately 80% of U.S. households with professionally installed security and add a less capital-intensive, low revenue payback income channel. However, the percentage of revenue it contributes is not much. Nonetheless, it still diversifies the revenue stream. We expect more acquisitions like this in the future, in addition to the normal tuck-in acquisitions. A positive point of LifeShield is that the current CEO, John Owens, will be joining ADT too, meaning that this isn’t just a get-rid-of-something sale. Further, the type of customer that uses DIY is very different from an ADT customer. Their average credit scores are of a much worse quality than ADT customers, and they are fine with a less comprehensive sort of security. This tells us that the market is worrying too much about this issue.
Radio conversion costs
Another serious risk facing ADT is the phasing out of 3G and CDMA communications equipment that are essential to the functioning of 4M of their customers’ security systems. They are projecting that the hardware costs should amount to less than $90 per site, totaling a range of $200 million to $325 million over three years. That is a material cost and will most definitely impact the bottom line, but even though it is in the execution stage, it's still negotiating with suppliers, the communication companies and vendors to try out new alternatives that should hopefully lower these upgrade costs. It is also taking advantage of the 6,000 to 7,000 service calls it gets every day to upgrade radios, which would upgrade more than 50% of the radios.
If you do the math, the time needed is not much: 1.8 million (½ subscribers who need upgrades) divided by 6,500 servicings (midpoint of the number of service calls) = 276 days.
With many of those radios upgraded already with half being done as a secondary service, we believe the market’s worrying that the conversion would stretch over 2022 is unfounded. Also, it would only impact the years from now till 2022. That would affect three years of free cash flow, not the 10 years or so that the market normally discounts to present value. Even if the market is pricing it correctly, if we buy soon, that risk would be discounted already. When we utilize reverse DCF, Mr. Market seems to be implying that he thinks that ADT’s cash flow will decrease by around 17%, which is rather absurd.
Bad customer experience
Several people decry the customer experience provided by ADT. However, on reviews.org, they commented on wide range of plans and products available for any customer, from a basic plan to a crenellated mansion. In addition, they praised ADT’s professionalism in monitoring their houses and businesses. Nevertheless, they complained first and foremost about the price. They said that it was probably the priciest on the market, but they think that it's worth it due to the superior collection of services that come with a Pulse plan. To us, this might not be a bad thing since it would indicate pricing power. We think that thereforethey have stable gross margins in the upper seventies and FCF margins among the low twenties. The customer experience was reflected to be "unpredictable," due to the many third-party contractors they use. That is probably the most existential threat that may increase the gross attrition rate.
Intrinsic value
We shall utilize a discounted cash flow model to calculate intrinsic value since ADT operates in a predictable industry. However, ADT currently has a rather volatile cash flow record due to short-term needs that occurred after the offering, so we shall normalize its free cash flow.
To start, we will calculate the average FCF margin:
(Only two years and trailing 12 months since only two years since management by Apollo)
2017: 20.36%
2018: 23.67% Average: 22%
TTM: 21.98%
From the average computed, we will apply it to the revenue of $4.861 billion:Â
Which equals to $1.069 billion in normalized free cash flow
Divided by shares outstanding of 739,891,705
Normalized free cash flow per share = $1.45
The free cash flow per share value, however, still includes the non-recurring and extraordinary charges. Therefore the math below will adjust the normalized free cash flow.
The charges below are simple rare charges or benefits.
Advisory and other costs: $5.46 million
FX losses/(gains): $93,000
Loss on extinguishment of debt: $669.11 million total adjustments
Merger, restructuring, integration and other: $699 million = $307.44 million
Income tax benefit: $(228.48 million)Â
Financing and consent fees: $384,000
Radio conversion costs are assumed to be between $200 million to $325 million over three years. We take the midpoint as the value of $262.5 million. Moreover, such infrastructure costs should occur every 10 years due to new technology, so we adjust accordingly.
[262.5 million divided by 10] = minus $262.5 million every year
Please note that amortization, depreciation and capex are included in the normalized free cash flow.
Hence,
$1069.42M+$30744K= $1100164000 in adjusted normalized FCF
Divided by shares outstanding of 739,891,705
Adjusted normalized free cash flow per share = $1.49
Bear Case
This scenario assumes that ADT management fails to create shareholder value and that its market share shrinks. Moreover, it gives no value to any industry tailwind that may affect this company and full value for all the headwinds. In other words, we are trying to kill this business.
We assume -10% each year for eight years due to the threat from DIY systems. The growth rate is approximately the inverse of the projected growth of the security industry. We also assume no terminal growth. In addition to these inputs, the discount rate is at 12%. We plug all this into a discounted cash flow model, the estimation for intrinsic value is $5.04. If we buy at current market price, we have around a 10% margin of safety.
Base case
The assumptions in this scenario are estimated by projecting residential growth at 3%. Since the commercial market should grow faster, we assume it adds an extra 2% to that, adding up to a total of approx. 5% CAGR.
So now we will extrapolate the normalised earnings 5% for 8 years and a 5-year terminal growth of 2%. This like above takes a relatively stringent discount rate of 12%. From such inputs, the value calculated is $12.4. From current prices, one can receive a total return of about 170%.
Bull case
On the more optimistic side of things, we take the inputs more cheerfully. Using our most bullish analyst projection of 8% assuming all developments bear fruit. We then extrapolate that five years into the future with a 2% terminal growth rate for five years. Then, we discount back at 12%, as were the scenarios above. From this data we use the DCF model and receive an intrinsic value of $14.4.When translated into a free cash flow multiple, we are only paying 7x FCF for an excellent business. With a large nearly 70% margin of safety, ADT could be a 3three-bagger.
Conclusion
ADT Inc. is a massively undervalued broken IPO that has expanding margins, excellent free cash flow and growing returns on invested capital. The market is pricing it as if it were in distress with a negative growth rate of -17%. The facts are contrary to such assumptions due to new developments and accretive acquisitions that increase free cash flow. Moreover, it is in a largely resilient industry that will provide strong cash flows, allowing the debt pile to shrink. Even if we attempt to destroy ADT as a going concern, we still have a margin of safety of 16%, indicating that our chances of permanent loss of capital is nil. Our analysis shows that in more realistic terms, intrinsic value should range in the very low teens, meaning that ADT could double in price. With conservative assumptions, these intrinsic values are very achievable.
Disclosure: No material position but have advised others.Â
