Description

We are baffled by the valuation at which ADT is trading and recommend shorting the stock here at $38.50 / share.

 We recognize that seemingly everyone loves this stock and that this is a non-consensus call.

 We have followed TYC and the security alarm industry for years, and while we think it’s a good business, we don’t think the valuation is justified at current levels.

 This is a valuation short; no particular catalyst, just proper price discovery as the market gets its arms around the newly spun-off ADT stock.  The spin-off was completed on September 28 and regular-way trading began this past Monday, October 1, 2012.

 What the market sees:

• recurring-revenue business model
• low penetration of the product (20% of households nationwide)
• high EBITDA margins (50%) and extremely high incremental margins (75%)
• interesting growth opportunities via Pulse, SMB and home healthcare
• beneficiary of a recovery in the housing market
• NOL’s that result in cash tax rate of 6-8%
• a new spin-off
• all this in a stock trading for less than 7x EBITDA

 What we see:

• ADT’s EBITDA is artificially inflated relative to its Free Cash Flow due to its accounting treatment for customer acquisition costs
• Much of the cost of acquiring new accounts is capitalized and therefore does not show up in EBITDA
• Capex is 30% of revenue for this business
• the resulting free cash flow that is generated from $1 of EBITDA is much lower compared with virtually every other business model with which investors are familiar
• As for the NOL’s, we value them on a tax-affected, present value basis and do not capitalize them as part of ongoing free cash flow
• On this basis, ADT trades for 36x 2012 Free Cash Flow and 29x 2013 FCF
• Can someone please tell us why this is a cheap stock at 29x 2013 FCF?
• Even if we do run deferred taxes through the cash flow statement (effectively capitalizing them), ADT is trading for 20x 2012 FCF
• On an RMR basis (recurring monthly revenue), ADT trades for 47x
• As for the business fundamentals, the industry penetration rate has been ~20% for many years and not showing any sign of accelerating
• The SMB growth story has also been touted for years; nothing new here
• Housing market recovery won’t move the needle
• While a new home sale creates an opportunity for a new alarm sale, it also can result in the disconnect of an existing system
• And while Pulse is a great product, as the breadth of the product offering expands, so too does the competitor base, namely telecom and cable companies; although their competitive impact has been negligible thus far, bulls on ADT seem dismissive of this risk

 Our view of fair value:

• We think fair value for ADT is 30-35x RMR, which implies a share price of $23 - $28 today (27-40% lower than current levels)
• A year from now at 30-35x RMR, ADT would be worth $25-$30 per share (22%-36% lower than current levels)
• Broadview Security (CFL) traded for ~29x RMR for the brief period it was a public company
• CFL was the best company in the business and a bite-sized acquisition candidate
• It was acquired by TYC in Jan 2010 for 42.5x RMR
• Our 30-35x RMR fair value estimate for ADT still implies ~18x FCF

 RMR Multiples

• RMR is the convention by which security alarm businesses are valued within the industry
• There’s been a lot of (mostly small-sized) M&A in this industry over the years, and the best way to value targets was based on their recurring revenue
• Since different security alarm companies use different capitalization policies for new customer acquisition costs, comparing on an EBITDA basis doesn’t make sense
• Also, since most acquisitions involve porting over the acquired company’s customer base without any of the overhead, revenue was a more relevant metric
• RMR also makes it easy to compare valuations between acquisitions of full alarm companies and acquisitions of just customer accounts being sourced from dealers
• Historically, corporate acquisitions have been done in the space for 30 – 60x RMR with the average ~45x
• As noted above, ADT acquired CFL for 42.5x RMR
• Why should ADT trade at a premium to takeover multiples as a standalone public company? 
• We think the odds of ADT getting acquired are less than 10% (see discussion of LBO prospects below).

 Unit economics

• Units typically cost ADT $1,100 net upfront cash cost to install (including sales commission and net of customer installation revenue)
• Average ARPU across the entire portfolio is $39 / month right now.  Mid-range package is $36 today but higher-end Pulse offering can be $65 / month
• Incremental margins are extremely high: 75-80% as the cost of adding an incremental user to shared monitoring centers is virtually costless
• Attrition has been running at somewhat elevated levels due to the economic environment; I assume 12% attrition over the long-term
• This economic model results in after-tax, unleveraged returns of 8-10%
• So, why does this business deserve to trade at 29x forward free cash flow?

 Dispelling other myths

• Myth #1: ADT is a bond-like investment
• We have heard some bulls on ADT frame the story as an under-leveraged, bond-like investment. 
• That if management were to lever up and increase the dividend pay-out, then ADT’s equity could trade on a yield basis
• We find these arguments un-compelling for two simple reasons 
1. This has been a very conservatively managed business historically; there is no indication that management wants to (or should) turn the company into a highly-leveraged yield vehicle
2. ADT already trades at a 3% free cash flow yield.  Where is the upside?
• Myth #2: The free cash flow generation is masked by growth investments in new subs
• According to this thesis, if only ADT were to stop spending so much capex acquiring new customers, the free cash flow would explode and the true value would be revealed
• Sounds great, but ADT currently churns 13% of its customers per year, which amounts to ~825k customers (technically, ADT defines churn as a % of recurring revenue, not customers)
• So, just to keep the business flat, ADT has to acquire 825k new customers a year
• If they can acquire new accounts from dealers for 30x RMR and the average ARPU continues to be $39 / customer, then that’s $965mm of “Maintenance Capex” per year; only $120mm of capex is true growth capex (and then there’s ~$35mm of corporate capex bringing to total to $1.1bn on EBITDA of $1.7bn)
• Myth #3: ADT is an LBO candidate
• The math simply does not work
• Assume $40 deal price, 5x of debt, 36% equity ($4.3bn equity check)
• Further assume, 5% revenue CAGR and modest margin expansion
• Finally assume a 6.5x EBITDA exit multiple (which is 47x RMR, btw)
• This results in a whopping 10% IRR.  That’s at a $40 deal price.
• Also, if a deal were done at a 20% premium to current market, that would imply a $13bn+ transaction.  We haven’t seen too many of those happening lately.

 Business Description

• ADT is the largest residential security alarm company in North America
• ADT’s consoles protect homes and small businesses from intrusion (burglars) and fire
• If an alarm is tripped, ADT automatically notifies local police or fire department
• Market leader in large, highly-fragmented market with relatively low penetration rates
• ADT is #1 in North America with 25% market share, next largest player has only 4% share
• Security alarm systems are only present in ~20% of households (vs. over 80% for cable / satellite)
• As of June 30, 2012, ADT had 6.45mm customers with an average ARPU of ~$39
• Estimate ~6mm residential customers, 400k small business
• 90% of revenue is recurring

 Positive Attributes of the Business

• Recurring revenue stream
• Highly fragmented industry with low household penetration rate
• Home insurance subsidy
• Most home insurance policies offer a discount if you have a home alarm system; typically ~$10 / month
• Positive mix impact from growth in ADT Pulse
• ADT’s new Pulse offering is an interactive system that allows users to control many features of their homes (security, lighting, thermostat) remotely via PC, smartphone or tablet
• Monthy cost for a Pulse package can be ~$65, depending on features
• Potential, although low probability, strategic takeover candidate for telecom / cable companies

 Risk / Reward

• At $38.50 / share, we think further upside to ADT shares is limited
• If ADT were to trade at 50x RMR a year from now, the stock would be worth $46 / share (15% move against the short position)
• We think this valuation is ridiculous, and implies a 34x forward FCF multiple
• We just don’t think this is realistic
• If it trades at our target 30x-35x RMR, the stock will be worth $25-$30 / share (22% to 36% lower than current levels)
• At these levels, ADT would still trade at ~20x LTM FCF, ~18x Fwd FCF
• The biggest risk to our thesis is that ADT becomes more aggressive with deploying its balance sheet either by acquiring new subs at a faster rate or by acquiring a competitor with a few points of market share
• While such transactions would accelerate growth, our math suggests even a $1bn acquisition would be no more than 5% accretive on an RMR-basis 
• So we think realistically, a short position in the stock results in $9-$14 upside, with less than $5 downside

 Feedback welcome.

• We strip out the after-tax present value of the NOLs when calculating valuation multiples (i.e. give credit for NOL's on the balance sheet but not capitalize the cash tax shield on the cash flow statement);
• We also adjusted the 2012 cash flow statement to strip out the benefit of the cash tax shield for comparison purposes; so that's a pro forma number, not what will actually be reported
• We adjust historical and forward EBIT/EBITDA for restructuring costs, integration costs and pro-forma dis-synergies associated with the spin-off from TYC.  See the Appendix to recent investor day slides for full reconciliation.  Note that even though the company has guided to $30-$50mm of annual dis-synergies, we have only assumed $25mm because of TYC management's history of giving conservative guidance
• The Broadview Security acquisition was completed in May 2010, hence the strong increase in reported financials in 2010 and 2011

Catalyst