Description

You can also click on the Dropbox link for the PDF version.  https://dl.dropboxusercontent.com/u/102621521/APX%20Group%2C%20Inc..pdf

Recommendation

We recommend purchasing the APX Group 8.75% bonds due 2020. This credit is a registered bond (CUSIP 00213MAD6), so it can be purchased by institutional as well as retail investors. Offshore entities can purchase the offshore tranche (ISIN USU0385PAE61). We own the bonds in our fund and it is one of the few bonds we own in our personal accounts given the shortage of attractive credits in the market today. The combination of business quality and growth, management talent, and LTV (loan-to-value) lead us to believe investors will be rewarded in 2015.

We expect the bonds to produce a return superior to what the public equity and high yield markets are likely to produce, with substantially less risk. We are “public” on the name (i.e. we have no private information); our firm is not a private lender to the company.

At a price of 85.3, the 8.75% bonds due in 2020 yield 12.3% (1040 spread to worst/maturity). We strongly believe the 8.75% bonds should be trading at par today. The company is performing well, yet the bonds trade at levels suggesting distress. Our base case assumes that the bonds trade to par in the next 12 months. Assuming this happens, the position results in a 27% return. If the bonds return to 104, one can achieve a 32% return. In order for us to be flat on the position over the next 12 months, the bonds would need to trade at a 15% yield one year out which is very unlikely given the positive business trends.

The 6.375% bonds due in 2019 have a price of 96 and yield 7.4% (560 spread). These bonds are senior to the 2020 bonds, and also are excellent absolute value. Our firm does relative value analysis across the entire spectrum of credit – the average risk incurred to achieve a 7%+ yield to maturity is much higher than the risk of the 2019 bonds. Other high yield credits with comparable yields have much higher LTVs. While there are cumulative preferred stocks yielding 7% which are not over-levered, these tend to be perpetual preferred stocks with long term interest rate risk and no total return potential. The 2019 bonds should trade closer to 6% or 101 in a year, producing a 12% total return.

Recent History

APX Group, Inc. (issuer) is the parent company of Vivint, a leading home automation/residential alarm business. In November 2012, Blackstone purchased APX Group, Inc. and two of its historical affiliates, Vivint Solar and 2GIG (“two-gig”) Technologies, Inc. for over $2 billion. The management team rolled approximately $150 million of equity into the original transaction.

2GIG was sold to Nortek for $149 million on April 1, 2013. Vivint Solar went public on September 30, 2014 (VSLR) and has a $930 million market cap. Blackstone did not ascribe anywhere near this valuation to the solar piece when it did the original deal; we have been told Blackstone ascribed around $200 million to it upon purchase. Blackstone owns about 80% of the equity of VSLR, so the original deal has been lucrative for Blackstone considering the substantial equity value in Vivint.

Since the LBO, Vivint has been investing heavily in growth. Understanding the growth economics is key to underwriting an investment since substantial capital is being directed to growth. Later we discuss those economics in some detail.

Capital Structure & Valuation

Leverage multiples are best considered in the context of SSFCF (steady state free cash flow) multiples. Security companies generally define SSFCF to be adjusted EBITDA less the cost of replacing attrition. Let us redefine SSFCF to include a penalty for maintenance capex. In this write-up, SSFCF refers to our redefined metric. On that basis, we arrive at approximately $185 million of SSFCF for Vivint. Net leverage through the 2020 bonds is, based on SSFCF, 9.7x. ADT and Monitronics trade around 12x SSFCF through their equities. So the 2020 bonds create an attractive equity-like return at a lower valuation than ADT and Monitronics, based on our assumptions. Moreover, Vivint is a superior business.

Note that leverage through the 2019 bonds is only 4.6x SSFCF. Our valuation of Vivint is 13x SSFCF. This is a premium to the public peers, and implies there is over $600 million of equity value tied up in Vivint. Note that LTV through the 2020 bonds is ~ 75%. Although leverage is significant, it is manageable. Again, this compares very favorably to what we are seeing in credit. As a side note, we have spent time with energy credits with yields comparable to the 2020 Vivint bonds. However, upon focusing on proved developed reserves and refraining from forecasting a robust recovery of commodity prices, we concluded most energy credits are not irrationally priced.

Recent Bond Performance

We became involved with the bonds in late September, shortly after they began trading down from above par. There are three primary reasons the bonds have traded down.

1. An 8-K was filed on September 9^th which stated that on September 3, 2014, a $50 million dividend was paid to stockholders. This obviously made some bondholders upset.

   1. $55 million was placed back into the company in October. This is explained in some detail on the Q3 2014 webcast.

2. When the solar piece went public (VSLR), some creditors were surprised that VSLR was not part of the credit package.

   1. This should not have been a surprise to any holder of the bonds.

   2. Even if one did not bother to read the credit documents, the 2013 10K states “Solar and 2GIG do not and will not provide any credit support for any of our indebtedness, including indebtedness incurred under our revolving credit facility, our 2019 notes or our 2020 notes.”

3. Sequential growth rates have been decreasing this year.

   1. The growth is still highly accretive, and at over 13% top-line sales growth in Q3 2014, growth is still very strong.

   2. Some of this is due to some experienced salespeople choosing to exclusively the join Vivint Solar upon Vivint Solar’s separation. Vivint’s salespeople travel more than those of Vivint Solar, and Vivint Solar was a more attractive option for more senior salespeople with families. Since new salespeople are less productive than experienced salespeople, this has temporarily hurt Vivint. At this point there can no longer be any personnel flows from one company to the other.

   3. When growth truly starts to taper, the company can generate substantial cash flow since growth investments will be tapered as well.

Vivint Growth versus Peers

Vivint has a much stronger growth profile than ADT and Monotronics. Monotronics is the primary asset of Ascent Capital (ASCMA), which was spun out of Discovery Holding Company and went public in 2008. While ASCMA stock has been volatile, the stock is where it was 3.5 years ago. The stock has fallen 15% since reporting Q3 2014 earnings, largely because it is clear growth is slowing. ASCMA focuses on a dealer model, where it relies on third parties to source and set up customers. ASCMA then purchases those customer contracts and relationships. However, the clearing prices of these deals in the market have been getting much more expensive, and thus will be less frequent given ASCMA’s discipline, implying lower growth going forward. John Malone owns about $16 million of stock, so a relatively small position for him. The management team, like the management teams of most Malone companies, is intelligent and will not overpay for deals. While 2014 sales will exceed 2013 by 20%, the bulk of the growth stems from the Security Networks acquisition which was made in August 2013 and added 200,000 accounts. Ascent has slightly more than 1 million customers.

ADT is another company which is no more valuable than it was a few years ago. ADT is expected to have about 3% sales growth and 5% EBITDA growth this year. Organic subscriber growth has been weak. Management recently guided 2015 to core 2-3% RMR (recurring monthly revenue) which includes the contribution from Reliance Protectron, a Canadian security company. Assuming modest ARPU growth, the guidance implies a modest decline in subscriber count.

While not all residential security companies have had the same level of success, the overall industry is attractive. Residential monitoring and security revenues have compounded at a 6.7% CAGR from 2000 to 2013. Moreover, industry revenues grew during each of those 13 years. The market is highly fragmented and has a penetration rate of 19%. ADT has a 25% market share, and Vivint and Monitronics each have around 4%. Protection 1 has 3%, other players are smaller. There are countless small, local security companies that compete with the large players.

We believe the two primary reasons Vivint has outperformed its peers are (1) a superior and evolving offering and (2) a sales model which is effective and has a long track record of success.

Vivint Offering

Vivint is much more than a residential security company. Vivint has expanded its addressable market considerably with the introduction of its home automation offering. The company aims to be a leading “internet of things” player. The new Vivint SkyControl panel allows a homeowner to control security, energy management, home automation, solar, wireless internet, and voice. Moreover, features which would you want to control remotely (for example, security, energy management, and home automation) can be controlled via your phone. The aesthetics of the panels are clean and modern, and customer service is excellent. Because Vivint does not outsource installation, monitoring, or customer service, customers have a high level of satisfaction. Vivint also owns the bulk of its own technology. Our diligence has also confirmed that the offering has better functionality and integration. One of our team members went to the trouble of installing Vivint in his home and researching the Monitronics offering as well as ADT Pulse.  Fortunately for Vivint, he is a good credit and now locked in a 60 month contract.

Vivint’s average revenue per user (ARPU) is at a substantial premium to its peers. Vivint is at $54.48, ADT is at $41.85, and Monotronics is at $41.36. In Q3 2014, new Vivint customers came online at $62.81 a month. Vivint’s management team has the right attitude and feels that people will pay for value created.

Below I talk about wireless and solar. Wireless and solar are not yet driving adoption of the primary security/home automation services, but they demonstrate Vivint’s comprehensive approach to serving the home, as well as the company’s innovation. Over time, wireless is expected to meaningfully drive adoption of other services.

Wireless internet is a new offering for the company with only 5,200 users. The offering in 2015 is going to be rolled out more broadly. Vivint is not initially targeting existing security/home automation customers for its wireless rollout. Vivint is selectively choosing markets, installing wireless (includes VOIP), and then aims to execute with excellent customer service. Vivint then returns to the customer at a later date and offers security/home automation as well. While we are in the early stages of this, the response to the wireless offering has been better than Vivint anticipated. This is partly due to customer dissatisfaction with the customer service of incumbent cable providers. Vivint has a very competitive offering: 50 Mbps (up and down) for a set price of $55 per month. To open up a market, Vivint puts its equipment on a tower which has a line of sight to a microhub on a customer’s home. The microhub then serves other homes in the vicinity; ideally Vivint wants 5-10+ customers within exposure to the microhub.

Vivint’s solar offering comes from Vivint Solar (the aforementioned entity which just went public), although Vivint salespeople can certainly market it. From the customer’s perspective, it is all part of the Vivint package. We will not go into this in great detail, but basically Vivint Solar conducts a consultation and then designs a solar energy system for your home. Vivint Solar obtains all the necessary permits and completes the installation at no charge. You then sign a PPA (Power Purchase Agreement), and Vivint Solar provides the maintenance at no cost. Customers who have installed the panels have saved approximately 20-30% on their power bills. Vivint Solar salespeople also facilitate sales of the Vivint product set.

Vivint also recently acquired Space Monkey, a cloud storage solution which enables Vivint users to store their data (Vivint security video and data, music, pictures, etc.) within Vivint’s home offering. Space Monkey offers both a local storage and remote network backup for higher levels of data security and redundancy. The storage solution compliments the Vivint security/home automation system as Vivint stores and analyzes real-time data, and then makes suggestions for security, energy conservation, etc.

Vivint Approach to the Market

As mentioned before, Vivint likes to control the technology development, the sales process, as well as the ongoing monitoring and customer service. Vivint’s sales process is unique, but highly effective. Vivint does not purchase accounts and does not work with dealers. However, it does incur the cost of paying commissions to a salesforce. About 75% of new subscribers come from the direct-to-home (DTH) approach, and the remaining 25% from inside sales. Vivint recruits during the year build a 2,500 DTH sales force which between April and August travels to 100 pre-selected markets through North America. Since expenses associated with the direct sales force are directly correlated with new subscriber acquisition, the company avoids a large fixed cost base with a flexible go-to-market strategy each year. Many of these DTH recruits are college students. I will also mention that Vivint is based in Utah, and many of the college students it hires are articulate and have the maturity and persistence to close sales and not get discouraged via the sales process. Vivint takes a very tactical approach to training the salesforce and choosing which homes to approach. The average FICO score of a subscriber is 717 as of 12/31/13, and 94% of subscribers are above 625.

Growth Economics

Let us focus on the unit economics. Each installation costs Vivint about $1,633. Vivint spends $15 per month in incremental costs to service the new subscriber. Maintenance capex per subscriber is $1 per month. Assuming a full tax rate and peak attrition (13.7% reached in Q2 2014, is now 12.8%), the new subscriber has a 17% after-tax IRR. We point out that attrition increased to 13.7% due to a number of subscriber cohorts (based on length of contract) coming due at the same time.

Per the company, unit IRRs are 24% - however we are using a higher attrition assumption, including maintenance capital expenditures, and also assuming taxes as the company’s calculation is pre-tax. The company has about $845 million of U.S. NOLs so it will not pay taxes in the near term, but ultimately the company will be a tax payer. The NOLs have substantial value which we are not including in our analysis.

The capex is very low (1-2% of revenues) and the company experiences negative net working capital, as it generates cash from working capital as it grows. 92% of its revenue base is recurring.

With any set of reasonable assumptions, the IRR on growth capital is attractive and well above the company’s cost of capital. Our conversations with management have confirmed that the team is laser focused on return on incremental capital and how it trends over time. The management team has also publicly stated they will quickly taper growth investments if the return profile becomes unattractive.

Lower Net Creation Cost Multiples

Vivint’s net creation cost multiple is around 28x, while it is over 32x for ADT and 34.5x for Monitronics. It is calculated by taking net subscriber acquisitions costs divided by the number of new subscribers originated, and then dividing this by average RMR per new subscriber.

No-growth Scenario

We ran a scenario assuming no growth. In this example, capital is spent solely for maintenance and to replace churn. In this scenario, even with the leverage, the company generates around $50 million of cash flow, virtually all of which is contractual. Even in a no-growth scenario, there is substantial equity value.

Risks

PE-owned entity: As mentioned above, we feel Blackstone has meaningful equity value in Vivint and is committed to the growth of the asset. If Blackstone were in harvesting mode, they would not have Vivint investing in itself to grow. Our contacts in private equity also tell us that Peter Wallace, the senior representative from Blackstone associated with the deal, is well-regarded and has a good track record. More importantly, management rolled substantial equity into the transaction, and Blackstone has structured the deal so that management has plenty of incentive to make Vivint a success.

Competition from other players, such as AT&T and cable providers: To date, Vivint has not seen any impact from these players, but this is something to closely monitor.

Competition from DIY: There are indeed do-it-yourself packages. They are functional, but inferior offerings lacking many of the capabilities Vivint provides. We have tested various DIY options and have found them to be inferior to Vivint, albeit many DIY customers are not looking for comprehensive solutions.

Funding growth via leverage: While a risk, comfort is derived from the fact that growth is very accretive (see above analysis). However, we will sell our position if we find that growth economics are no longer attractive and management maintains a high rate of investment.

ARPU growth: Management has succeeded in driving ARPU through innovation and expanded functionality. Without continued upgrades, there is a ceiling to ARPU.

Catalyst

• Continued profitable growth which demonstrates the demand for the product and the highly accretive profile of growth investments.

• Market participants realizing that they can create exposure to the industry with a lower valuation than ADT and Monitronics equity, and through a much more protected security which is priced to compound at a double-digit rate for the next 6 years.