Description

AlarmForce (AF CN) is a North American residential alarm monitoring company.  Like ADT (owned by Tyco), Broadview Security (CFL, formerly Brinc's), Protection One (PONE), AlarmForce competes in a fairly fragmented industry where the top 10 market participants enjoy less than a 40% combined market share). AlarmForce is still run by Candian founder Joel Martin, who sold a commercial security business in the 80s, created AF in 1988 and grown it organically since from zero to over 100,000 subscribers paying a little over $25/month. AlarmForce is a widely recognized brand name in Canada, where the company was "incubated" until 4 years ago when it entered several attractive US markets.

In a nutshell, the thesis boils down to several major points:

a)      Sustainable cost advantage: the company markets directly to its customers through TV and radio (with the CEO as its spokesman) instead of buying customers from dealers. As a result, AF can pass these savings on to customers and profitably charge $25/month when ADT charges $35-$40. Importantly, incumbents can't afford to lower prices to match AF at the expense of existing margins.

b)      Tremendous incremental economics and a rare opportunity to invest capital at high returns: we estimate total subscriber acquisition costs at $662/customer (vs. over $1000 for competitors) at 90% incremental margins. With an average customer life of 7 years, the after-tax IRR is 26%. The alarm industry overall is very lucrative, with recurring revenues, 80% gross margins, and adjusted EBITDA margins in excess of 50%.

c)      Overly conservative accounting and resulting valuation: unlike most competitors, AlarmForce expenses all of its SAC immediately and takes an upfront hit on earnings, so in periods of high growth earnings are depressed. Because of that, the company today trades at 6.2x EV/EBITDA after accounting for growth, and 3.2x if you back out marketing expense to get at steady-state EBITDA. 3.2x for a business with these economics and long-term prospects is as close to a no-brainer as you could hope to get in a non-distressed situation. Keep in mind that the EBIT and TV/EBIT metric above is adjusted for growth and approximates steady-state numbers. The CEO has indicated that if growth proved unprofitable, he would shut off the marketing dollars and pay "enormous dividends" from free cash flow.

d)     Favorable market-related dynamics: Relative obscurity among investors due to small market cap, low float, and Canadian listing. Management doesn't market the company to institutional investors at all.

There are several ways to think about the business and long-term opportunity. A comparison with GEICO is not out of place. Although alarm monitoring is not a government-mandated service, it does have the key benefit that regular home insurance policies provide discounts for customers with installed alarms. Like GEICO, the company has very low market share, a very long runway for growth, hard to replicate cost advantages, and compelling incremental economics.

The cost advantages are probably the most important to understand, as the rest of the business is fairly intuitive. AF does not acquire any of its customers from third-party commissioned dealers, as do its competitors. Rather, CEO Joel Matlin has opted for a measured, profitable long-term growth model, where he markets to consumers directly through TV/radio ads and retains 100% of the relationship as a result. AF has just one call center in Toronto which handles all alarm monitoring for US/Canada. The company also has full vertical integration on equipment, which they develop in Canada and manufacture themselves in Asia. This also allows for rapid innovation and deployment of new technologies, the most notable of which is two-way voice (enables the AlarmForce employee to speak inside the house when a burglar enters as opposed to just sounding an alarm). The company has also been working on consumer video-surveillance technology which should be introduced soon. All of these things are made possible by in-house development and manufacturing. Importantly, the direct-to-distribution model is hard to difficult for incumbents to duplicate, as it would displace the very distributors who have the relationships with customers today and provide current growth.

As a result of the cost advantage inherent in AF's business model, the same product can be offered at substantially lower cost. AlarmForce's companywide gross margins for 2008 were 78%, a testament to the high quality of the business and low ongoing requirements. The alarm business has proven itself to be recession-resilient over the cycle, as is evidenced by growth in EBITDA from $7.4mil in 2008 to almost $10mil this year. All of the growth the company has experienced has been organic and self-funded, without having to tap debt and with past debt being retired very quickly through free cash flow generation.

The CEO is extremely conservative in terms of capital structure, with a net cash position of $5.5 million. Considering the recurring revenue nature of the business, the balance sheet is clearly underlevered, which artificially increases the cost of capital. Joel believes that "slow and steady wins the race" and would rather grow more slowly than expose the company to leverage risk that has caused problems for some competitors over time.  Frankly, I disagree with him on this point, as the total lack of leverage unnecessarily inflates the cost of capital for the business. To Joel's credit, though, he did buy back stock when the stock dipped into "stupid cheap" category in the $3s. Nonetheless, a private equity buyer (Joel would sell the company at the right price) would absolutely see the capital structure as an asset, considering how easy (relatively) it would be to borrow against. A strategic acquirer or a financial sponsor with portfolio companies in the industry would also have the benefit of pricing power as the book of business was brought to "market" pricing.

As regards growth, the sky is the limit.  When the company entered the US, it essentially doubled its potential market size just by entering markets like Atlanta and Columbus. Since then, the number of customers has grown from 49k at the beginning of 2005 to 100k today. Joel thinks he can grow the company from 100k to 250k within 3 to 5 years. Although an ambitious goal, he has proven his ability to deliver on aggressive targets in the past (5 years ago he told another investor that he will double the size of the company), but even if he falls short and does 200k within 5 years, this will prove to be a very attractive investment.

One of the catalysts I see is that as the company grows and gains visibility in the US, it should get a multiple more commensurate with its quality and its growth. One thing is clear - a maintenance free cash flow yield near 20% prices in a path for the business that is vastly different from the likely very positive path it will continue to take over time.

Catalyst

Rollout of video surveillance product

Continued growth in subscribers and recurring monthly revenues

Growing visibility and exposure to institutional investor base