Description

Thesis / Fundamentals

• Compelling opportunity given price dislocation consequent to a broken IPO

  • IPO had initial range of $17-19, deal priced at $14, and stock has traded down to $12

  • Because of weakness of legacy ADT management/business, public market has fairly negative perception of the company

• Current management is well respected throughout the industry, has created value in prior companies and is running ADT in a more reasonable and value-oriented way

  • CEO, Tim Whall, has spent his entire career in the home security business and this is his fourth private equity deal

  • Whereas legacy management lacked financial disciple and chased unprofitable subs, current management is much more focused on retaining existing accounts and attracting higher quality new accounts

    • Legacy management pursued a vicious cycle in which they brought on low quality subs, who churned quickly, forcing management to attract more low quality subs.  It was like a leaky bucket

• Business is almost entirely (over 90%) contractual, recurring revenue business with low and declining attrition

  • Typically 3-5 year contracts with average customer tenure even longer

• ADT is 5x the size of next largest competitor

  • ADT’s brand is powerful in the market with 54% of consumers saying it was the best brand

• Over the last two years, attrition has fallen from 16-17% annually to 13-14%

  • The decline has been driven by:

    • Attracting better subs

      • New subs are now required to put more money down upfront, which helps defray SAC and also incentivizes them to stay longer

      • Higher credit standards

      • Under legacy management, 1st year churn was 18%; now, it is 12%

    • Better customer service

      • Management is highly focused on operating performance metrics like call waiting time and first call resolution

      •  Management uses a Daily Dashboard that gives them granular insight into branch and individual representative performance

      • These metrics have improved substantially in the last 18 months

        • 91% of calls in 2017 were answered in less than 1 minute

        • 65% of calls in 2017 were serviced the same or next day

    • As management notes “no one wakes up and says I want to cancel/change my home security service today, so let’s not give them a reason”

  • Attrition should continue to decline as customer service improves

    • Management is focused on closing the gap between worse and better performing branches

    • Best-in-class branches can achieve attrition rates of <10%These attrition rates are among the lowest we see among subscription businesses

• MRR should increase over time

  • Pricing goes up as new customers typically come in on higher priced plans than older ones

  • Pricing per customer goes up over time as well

• Cable and telco threat of a few years ago has stabilized

  • While CMCSA is taking gross add share, they are not winning significant customers away from incumbents

  • AT&T isn’t the factor people feared they might be

• DIY is a threat over the long-term, but it’s also possible that ADT could partner with DIY players and provide the monitoring services

  • Given the strength of ADT’s brand and their built-in sales/service representatives, ADT could be an attractive partner for larger technology companies

• Commercial represents a good growth opportunity for ADT

  • While ADT enjoys 30% of residential security market, it only has 8% of the commercial market

  • When ADT was spun off from Tyco, Tyco kept the commercial business and has 37% share

    • ADT is targeting those customers to win them back

  • Commercial business has higher ARPU and is harder to disrupt than residential

• ADT should be able grow revenue LSD and EBITDA MSD

  • Expectations are for revenue growth to accelerate 100-200bps over the next few years

    • It does not seem that the market believes that

  • Management suggests they have been more focused on “right-sizing” the business over the last 18-24 months and have not been as focused on growth

    • Now that the business is more sound, they can shift attention to profitable growth

• ADT is cash generative and poised to delever from ~4x level post-IPO

  • ADT should also be able to refinance debt

  • Interest expense should decline over the next few years

  • ADT should not be a cash tax payer through the medium term

• Apollo's vested interest

  • Apollo is incentivized to get the stock price higher as they haven’t sold stock

  • Apollo owns 85% of ADT

Risks

• Home security is a competitive market with new entrants

  • DIY players may offer cheaper options

    • Technology companies like Nest may offer better devices

    • DIY could partner with 3rd party monitoring service and still offer cheaper plans

  • Cable/telco can bundle their services with their own connectivity services

• Limited growth for the whole legacy industry

  • Overall market penetration has been fairly stagnant at roughly 20%

• History of legacy ADT demonstrates this business can be easily mismanaged with deteriorating unit economics

• ADT disclosure isn’t particularly good

  • Company will not report net adds or precise account numbers

• Apollo will have to sell down, which will be an overhang on the shares

Valuation

• Given price decline since IPO, ADT stock is a compelling value

  • Particularly considering the stability of the business

• On 2019, ADT trades at ~10x EPS, 9% FCF yield and 7x EBITDA

Catalyst

We believe that if current management can demonstrate the business is healthy, and even accelerating, ADT shares can re-rate higher