Description

ADT is the U.S.’s largest alarm monitoring company. I am recommending it as a short.

Short interest is currently ~14 million shares, representing 1.5% of total shares outstanding, 6.8% of float, and ~8 days of trading. Cost to borrow is General Collateral. Short interest has run much higher at times in the past. Pre-COVID, ADT was a more popular short on the thesis that competition from cable/Google/Amazon/DIY solutions would impair the business.

The doomsday competition scenario hasn’t come to pass, and ADT has further dispelled some of these competition fears by announcing (with much fanfare) partnerships with Amazon in 2018 and Google in 2020.

The Google partnership entailed Google buying a 7% stake in ADT for $450 million. Explains a freely available Bloomberg article from June 28, 2022 on the partnership:
The deal terms are vague: Google isn’t building any exclusive hardware for ADT, and there’s no subscriber revenue sharing. Google is betting it can benefit from ADT’s installer army hawking and embedding its devices as part of premium smart-home packages, enabling ADT to boost setup fees and monthly prices…For now, the companies are focused on rolling out Google’s video doorbells and Hub displays to ADT subscribers, with Nest Cams, floodlights, and thermostats to arrive in the coming months….Although Google doesn’t come out and say it, it’s clear it has less riding on the deal than ADT. A visitor to ADT’s website is greeted with a banner across the top of the page offering free installations of a Google Nest doorbell, along with a separate promo reminding customers that ADT’s system works with Google’s voice assistant. The website for Google’s Nest, by contrast, makes no mention of ADT and offers Handy Technologies Inc. and Dish Network Corp. as its “pro” installation services. Google executives have never mentioned ADT on its quarterly earnings calls.

From a short-seller’s perspective, the bright side of all of this is that market sentiment on ADT is much less bearish than it once was. Yet, IMO, it is still a mediocre business characterized by low growth (at best) and deteriorating free cash flow generation. Moreover, it is run by a highly promotional management team/sponsor (Apollo owns ~67% of the company). 

Brief Company Description
More than 90% of ADT’s EBITDA comes from its Consumer and Small Business (CSB) segment. In this segment, they have 6.4 million subscribers. They have ~25% market share in an otherwise fragmented market. 

The accounting gets complicated, but typically it costs ADT ~$1500 to sign up a new subscriber – this cost arises either from the payment made to a third-party dealer to buy the account, or from subsidizing the equipment and installation costs if ADT is adding the customer via its owned dealer network.  The typical account then pays ~$50 per month for monitoring services. The EBITDA margins on this monthly revenue (including overhead) run around 50-60%, so ADT makes ~$25-$30 per subscriber in EBITDA per month. Churn runs around 13% annually.

ADT also has a Commercial segment where they provide alarm monitoring and other security services for larger corporate customers. This segment is ~9% of Recurring Monthly Revenue (RMR) but only 4-5% of EBITDA, so not terribly important.

Lastly, ADT has a Solar segment where they install, sell, and service residential rooftop solar panels. They beefed up this offering with the acquisition on Sunpro in 2021. This is a competitive, low-margin business. EBITDA margins in this segment run <10% (EBITDA was actually negative for this segment in 2Q22) and the total Solar segment is <5% of total ADT EBITDA.

Prior to 2012, ADT was part of Tyco. In 2012, ADT became publicly-traded on its own when it was spun off from Tyco. In 2016, Apollo took ADT private, buying it for ~$7 billion (~$12 billion enterprise value). Apollo then combined ADT with Protection One and ASG (two other alarm monitoring companies that were in Apollo’s portfolio) and subsequently IPO’d the combined entity in January of 2018 at $14.00 per share (translating to ~$20 billion in EV at the IPO).

Today, the stock trades around $8 per share and carries a ~$17.5 billion EV.

ADT’s promotional mgmt team/sponsor would have you believe ADT is a high-growth company generating tons of FCF
One of my pet peeves is when a management team provides aggressive and specific long-term guidance/targets. As Yogi Berra said, “it’s tough to make predictions, especially about the future.”

If things go well, and the company achieves the guidance, that’s all well and good, but there is no positive surprise there. If things don’t go well (and they often don’t over the long-term), the company’s stock price gets doubly punished when the management team has to give in and scrap the long-term guidance.

Has ADT’s management team provided aggressive and specific long-term guidance? Yes, reader, they have. While caveating that they are “goals” and “do not represent company guidance or projections”, management has provided targets for 2025 that imply a revenue growing at a CAGR of >16%, EBITDA growing at a CAGR >7%, and FCF growing at a CAGR >17%:

Excerpted from ADT 2Q22 Earnings Presentation 

Relatedly, ADT management loves to talk about how fast their underlying markets are growing, noting in particular that their core CSB market is growing 15% annually:

Excerpted from ADT April 2022 Business Overview and Financial Modeling Presentation

Another of my pet peeves is when a management team provides adjusted financial metrics with egregious add-backs. In its calculation of adjusted EBITDA, ADT is on the aggressive side – they exclude stock comp and (serial) restructuring charges - but it’s not totally out of line. I’d argue that adjusted EBITDA for ADT probably overstates true economic EBITDA by ~10% on average.

Where the fun really starts is with ADT’s calculation of adjusted FCF. Management’s definition of FCF obviously excludes stock comp, which isn’t abnormal, but it also excludes restructuring charges, radio conversion costs, principal payments on finance leases, financing fees and payments on interest rate swaps (a form of interest expense, IMO). What I find especially egregious is their add-back of “net proceeds from receivables facility”. As of 6/30/2022, ADT has generated $380 in “adjusted free cash flow” over the last 12 months. Under a more traditional definition of FCF (cash flow from operations less capex and capitalized subscriber acquisition costs), ADT has generated $104 million of FCF in the LTM period. And under a more conservative definition of FCF (dinging them for stock comp, finance lease payments, interest rate swap payments and deferring financing costs), ADT has generated negative $68 million of FCF in the LTM period.

In reality, ADT is a low-growth business with deteriorating cash flow generation
When ADT went public in January of 2018, its Recurring Monthly Revenue (RMR) base was $335 million. Today, its RMR base is $369 million. ADT has made some acquisitions and divestitures since the IPO, and they don’t make it easy to calculate organic figures. But as best as I can piece together, it looks like organic growth in their RMR base has been $44 million over the last 4.5 years, translating to a <3% CAGR, which is below what inflation has been over the same period:

 EBITDA is about the same now as it was at the time of the IPO:

Another metric I like to look at with alarm monitoring companies “steady-state FCF”. To estimate this, I look at the LTM conversion of RMR into adjusted EBITDA before any subscriber acquisition expenses (and excluding any contribution from the solar segment) and multiply that percentage by the most recent quarter’s RMR to estimate the current EBITDA base. I then subtract the amount of subscriber acquisition spending needed to keep the RMR base flat (based on LTM churn) as well as other capex. The result is an estimate of the pretax, unlevered cash flow that their alarm monitoring base would generate if the RMR base was being kept flat:

By this metric, ADT has shrunk since the IPO:
  

ADT looks even worse based on more traditional definitions of FCF:
 

Of course, what matters is not what ADT has done in the past, but what it is likely to do going forward. While the competitive threats from DIY solutions, Ring cameras, etc. haven’t killed ADT’s business, they still represent a headwind that isn’t going away. And I suspect the post-COVID macro environment (households with lots of cash on hand and a high propensity to spend it on housing-related goods and services) has been favorable for them in a way that the macro environment going forward may not be.

ADT is currently trading around the middle of its historical valuation range
Alarm monitoring companies can be tricky to value with traditional valuation metrics. I don’t like EV/EBITDA because EBITDA between two otherwise identical alarm monitoring companies can vary substantially based on whether the monitoring company uses 3rd party dealers (and capitalizes nearly all customer acquisition costs) or uses a mix of owned and 3rd party dealer (and therefore both expenses and capitalizes customer acquisition costs). Not to mention that EBITDA leaves out most (or in some cases nearly all) customer acquisition spending, which is the largest expense for the business.

In ADT’s case, P/E is challenging because 1) ADT has changed the way it defines adjusted EPS over time and 2) based on its current method of calculating adj. EPS, it has generated negative adj. EPS in every LTM period since its IPO. Suffice it to say, ADT is not cheap on P/E.

FCF has its pitfalls for valuation too – an alarm monitoring company that is successfully growing may have depressed FCF (due to customer acquisition spending), whereas a shrinking one may have inflated FCF. Qualitatively speaking, I don’t view ADT as cheap on a FCF basis given that, despite limited growth in its subscriber base, its FCF is running at the levels charted above.

Alarm monitoring companies can also be valued on RMR multiples and steady-state FCF multiples. On that bases, ADT is currently trading around the middle of its trading range since going public:
 

I’ll refrain from making a specific valuation target for ADT. I simply think the company is expensive on P/E and FCF, and I think the underlying bases for valuation (RMR, EBITDA, FCF) are likely to grow at below-market-average rates going forward.

Key Risks
*Short squeeze/ADT becomes a meme stock (see what happened to valuation when ADT announced the partnership with Google in 2020)
*Apollo finds a buyer willing to buy ADT from them at a premium

Catalyst

• Continued mediocre growth/profitability/FCF
• Overhang from Apollo (which still owns ~2/3 of the company) looking to exit (ADT has been in Apollo’s portfolio for 8 years now)