Description

Monitronics Senior Notes – Jan 2016

Monitronics is Ascent Capital Group’s (ASCMA) OpCo

Buy Monitronics 9.125% notes due May 2020 at 78.  Off ~20 points over the LTM period, these notes offer a 12% current and 17% yield to worst, with short effective maturity.  I think bonds are covered through par, but for the sake of establishing a one year price target, say 92 at year-end 2016, for a ~28% total return with downside protection.

Monitronics is the nation’s #2 Home Security operator with 1.1mm subscribers and 600+ exclusive dealers.  The Company generates $360mm of EBITDA, $45mm of recurring monthly revenue and burns ~$70mm of cash.  The burn is not good, but with $315mm in liquidity and several operational headwinds abating; bonds should feel good about the 31x RMR attachment point versus private markets well north of 40x.  Ascent is likely worth more dead than alive, and I see potential events given a lower share price and activist investor, but think bonds trade higher regardless given the yield and value characteristics.  As to why:

1)      Discrete Operating Drivers Improving

2)      Good Credit Documentation

3)      Attractive Valuation

4)      Potential Event-Driven Situation

5)      Improved Technicals

Stanley339 wrote up Ascent in 2012 and there have been several discussions on ADT.  This idea is security-specific, so please follow up for company (my estimates are nothing special; comes down to normalized attrition) or industry thoughts (I worry about MSOs and RBOCs, but also see don’t see them destroying industry economics).  As John Malone has exited and the stock under-performed, sell-side coverage has waned, but Imperial and BaML cover the sector actively.

For starters, the capital structure:

• $315mm revolver due Dec 2017 ($185mm drawn)
• $691mm term loan B due Mar 2018
• $550mm term loan B-1 due April 2022
• $585mm unsecured OpCo notes due April 2020
• $104mm HoldCo convertible bonds due July 2020
• 12.3mm A shares and 0.4mm B shares for $145mm market cap
• $128mm cash (most at HoldCo, some at OpCo)
• Collectively, that’s $1.8bn of enterprise value (below)

For that EV you get 1.1mm subs generating $42 in recurring monthly revenue (“RMR”) or $45.5mm of consolidated corporate RMR.  In a more traditional sense, Ascent generates $360mm of LTM EBITDA.  What are these assets worth?

• Comps trade primarily on RMR and Steady-State Free Cash Flow (“SSFCF”):
• Why not EBITDA? – Some companies expense subscriber acquisition costs (“SAC”) while others capitalize, so GAAP numbers require adjustment to compare.  Add back SAC to EBITDA and treat as an investing cash flow.
• ADT and Vivint trade for 5x and 7x pre-SAC EBITDA
• RMR – Given comparable attrition rates and unit operating costs, a proxy for recurring monthly cash flow.
• ADT and Vivint trade for 38x and 35x (through bonds, closer to 50x through equity)
• Precedent transactions have gone for 45-60x RMR
• SSFCF – Adjusts for aforementioned accounting differences.  Start with EBITDA, then adjust for required capital outflows to maintain a flat subscriber base (RMR * churn * creation multiple) and then deduct cash taxes
• ADT and Vivint trade for 10x and 15x SSFCF

Key Points:

1)      Discrete Operating Drivers Improving – Bonds traded down in 2015 for a number of company-specific issues.  Taken individually, these issues are explainable, but together strain credulity for an already complicated situation.  Let’s take them one-by-one:

·         Churn – Industry net unit attrition averages 12-12.5%, driven by moves or the expiry of initial contracts.  Most contracts have 3-4 year initial terms, so upon expiry, churn spikes for customers that want to leave, leveling off through years 7,8 and 9.  Pinnacle Security, a bulk purchase of 120k subs completed in 2012, is experiencing these same issues, driving ~100bps increase in churn (see Exhibit C)

·   Mitigant – The average FICO score is >715, subscribers are diversified by state and region, and checks confirm good customer hygiene.  Put another way, the spike is timing-related and temporary.  Expect more and better disclosure regarding to at least partially address market concern.

·   Mitigant – I also look to ADT and Vivint, both of whom average 12-12.5%, and experienced similar one-time issues in 2013 and 2014.  Securities traded up as churn improved.

·         Dealer Network – Monitronics has no physical sales force, but relies on ~600 exclusive nationwide dealers to originate, install and then sell contracts.  The base is concentrated, with the top 10 driving >50% of gross installations.  One of the larger dealers went bankrupt in 2015, driving weaker-than-expected gross installations.

·   Mitigant – Stepped up dealer support and monitoring should help, but these are small businesses operating in competitive environments. 

·         Bulk Pricing – Contractual dealer originations are supplemented with periodic ‘bulk’ purchases (e.g. Pinnacle), however, higher pricing coupled with EV degradation has made bulk purchases uneconomical and slowed growth.

·   Mitigant – Tightening credit conditions increase industry cost of capital, and should impact creation multiples, especially in the lower middle market where PE has been active.

·         Other Operational Changes – Pinnacle switched billing system providers in 2015, driving churn ~20bps higher.  The industry is also dealing with higher operating expenses as nationwide 2G networks phase out, and in-home cellular radios upgraded.

·   Mitigant – Billing system conversion in the rearview mirror; 20bps churn headwind that will not repeat.

·   Mitigant – 2G Network upgrade seems to be going fine, albeit with $20mm of incremental operating expenses in 2016.

·         New CEO – Long-time CEO Mike Haslip retired in early 2015, and Jeff Gardner hired as CEO in Sept 2015.  Telecom investors may remember Gardner from Windstream.  I’m concerned about Gardner’s capital allocation history; he overspent at Windstream and did a poor job of integration.

·   Mitigant – With Ascent shut out of the capital markets and shares down 75% LTM, the Company is focused on de-leveraging versus external growth.

2)      Good Credit Documentation – Monitronics is highly leveraged at 4.9x EBITDA or 37x RMR, but has very little capacity to add incremental debt.  The Credit Facility caps total leverage at 5x, whereas Unsecured Bonds are tighter, capping total leverage at 4.75x.

3)      Attractive Valuation – Bonds create the Company for 31x RMR versus the last eight years’ precedent transactions’ median 53x EV / RMR.  Apollo purchased Protection One in May 2015 for $2bn or 51x RMR.  Accordingly, I believe these notes have meaningful downside protection in a number of scenarios.

4)      Potential Event-Driven Situation – The subscriber base, dealer relationships and monitoring platform are valuable assets.  One could make the argument that these assets are worth more dead than alive, and maybe we might be nearing that point.  Notable small-cap activist Okumus has taken an 11% stake and filed a D in December 2015.  HoldCo CEO Bill Fitzgerald is well aware of the strategic optionality.

5)      Improved Technicals – This is a decent-sized bond within a sleepy structure once dominated by ETFs and insurance companies.  20% of the issue traded in 2015, primarily into hedge fund buyers.  As these sellers clear out, bonds are re-establishing a floor in the mid-high 70s.

Valuation

·         I triangulate around par bond coverage using a couple of different metrics:

o   Implied Subscriber Value – 12.5% normalized attrition * $44.50 RMR less $8.50 operating costs and with a 35x creation multiple = $1,900 value per sub.  $1,900 * 1.1mm subs = $2bn of EV

o   Steady-State Free Cash Flow – $45.5mm RMR * 12.5% normalized attrition * 35x creation multiple = $200mm of steady-state FCF.  12.5x SSFCF = $1.9bn of EV

o   EV / RMR – 42.5x RMR = $1.9bn of EV.  42.5x is admittedly just a number but numerous precedent transaction comps suggest private market values of 40-50x

·         Overall – The situation is weird, and industry in transition, but bonds drive significant yields with meaningful downside protection.  At 11% current and 16% yield to worst, you’re well-compensated for these risks

·         Bond-Specific – The bond market, simplistically views leverage and yield on a yield per turn (of leverage) basis.  The nearest comp, Vivint trades at 250bps, versus Monitronics at 320bps.  This relationship actually inverted in 2H 2015 due to aforementioned technical factors; Monitronics has historically traded ~500bps tight to Vivint.  250bps * 4.3x net leverage = 11% targeted yield, or a 91 bond price.

Exhibits

Exhibit A – Capital Structure

Exhibit B – Monitronics (white) versus Vivint (green)

 [Not coming through, will paste in Q&A - but Moni has historically traded ~500bps tight to Vivint, expect some normalization]

Exhibit C – Pinnacle-Related Churn (expect more and better disclosure on the matter)

 [Also not coming through, will paste in Q&A.  Source doc on IR website - breaking out consolidated churn, and then backing out Pinnacle]

Exhibit D – M&A Comps

Catalyst

Improved disclosure around Pinnacle churn

Lapping of one-time issues

Short maturity

Potential sale / event-driven situation