Description

We like investing behind John Malone companies and believe we have an under the radar Malone story with upcoming catalysts, a management team that is shareholder friendly, and a defensive business one can comfortably own in all economic cycles.  We believe this opportunity exists because there is no sell-side coverage, trading volume is thin, the story is relatively new, and investors are not focusing on steady state free cash flow.  We think a long position in Ascent Capital offers base case upside of 25% today, upside of 50% if management takes a few easy steps towards value creation, and potentially a double if management can do everything they intend to, which is not far-fetched.  The sheer number of value creation combinations mgmt can pursue make us believe at least 50% upside is a likely outcome.

ASCMA is a long because it owns Monitronics: a good quality, highly recurring FCF business that should generate 50m + of "steady state" free cash flow to the holding company by FY June 13' under its current capital structure.....  But management would like to deploy the rest of their unencumbered cash (230m) into another LBO that could take the holding company free cash flow to 80-90m if they can acquire another franchise at similar equity return levels.  In addition, there are steps within Monitronics management may take to create more value that we are not including.  These include monetizing real estate assets, utilizing a holding company NOL, recapping Monitronics with higher leverage, and mitigating tax leakage.

Background:

Ascent Capital is holding company backed by John Malone and run by Bill Fitzgerald of Liberty Media that was spun out of Discovery Holdings in September 2008.  Ascent Capital's business is in dramatic transformation; it recently divested most of its money losing media assets and purchased a residential alarm monitoring business, Monitronics, for 1.2B using 300m of holding company cash and 100m of external financing.  Monitronics is secured entirely by its own assets and the capital structure is separate from the holding company; it does not encumber the parent.  Monitronics was purchased from Abry Partners who owned it for ~10 years.  It was one of the longest holdings in firm history and they wanted to recognize the gain sooner than later (they tried in 08 but the market collapsed).

Today, Ascent Capital owns:

• 1) Monitronics: a stable growing, asset light, recurring FCF business, 3yr contracts, 70% EBITDA margins
• 2) 230m of net, unencumbered cash.
• 3) 2 other hidden assets: Real estate (50m) & an NOL (NPV 25-50m)

Management plans to highlight the story during their first road show sometime this fall, and based on commentary in filings and the last earnings call we think ASCMA may take the following value creating steps:

• a) Recap Monitronics (we believe an additional turn to half turn is possible)
• b) Deploy the remaining cash into a large acquisition using significant leverage at "mid to high 20s pre tax ROEs"
• c) Monetize the other "hidden assets"
• d) Enhance Monitronics tax characteristics

Monitronics is a good business

Monitronics is a residential alarm monitoring business with an asset light model that was previously owned by the private equity firm, Abry Partners.  They do not own the dealer installation network like their peers.  Instead they provide a nationwide monitoring platform and outsource maintenance and installation to a network of exclusive mom and pop dealers.  These dealers also acquire new accounts and sell them back to Monitronics with long term contracts in place; 3 years on average with some out 6 years.  The result is a remarkably stable, low capital intensity and highly leverageable model in that cap ex is partially discretionary based on how fast management wants to add gross accounts.  On average, Monitronics is buying 80-85% of the accounts their dealers generate today but has flexibility to ratchet that up or down. 

The dealer based model is much harder to do successfully than one might imagine, which is why Monitronics is well known in the industry as being the best dealer based operator.  The two primary reasons are a) the dealer network has considerable churn given these are often mom and pop operations b) new account quality can be difficult to control.  This has limited the number of entrants in the space over the years.  There are really only 2 or 3 noteworthy players who compete with a dealer model and the only one with more scale than Monitronics, ADT.  ADT buys accounts from dealers as a subset of their business to hit growth targets when their internal generation model falls short, but not as a primary focus.  Countless industry participants have told us that Monitronics has built a unique and hard to replicate franchise.  Mom and pops can often create an account for $1,000 then turn around and sell it within a few days to Monitronics for $1300 to $1400.  Dealers sell the accounts rather than keeping them because most of the mom and pops do not have the capital to build a monitoring network, or to finance the working capital of owning the contract outright.  Banks do not finance mom and pop security dealers at attractive rates and small dealers know their expertise is in installation and maitenance.

US Alarm industry has good characteristics:

The industry is fragmented outside of the top 3 or 4 players with 60% share held by small operators and households in the US ~ 20% penetrated.  Once installed, customers rarely disconnect and typically this occurs when they move; families move less during recessions.  There are moderate switching costs involved and include notifying the local law enforcement office and insurance you have switched providers plus the hassle of having to be at home for a new provider to hook up their system.  It is analogous to the cable industry in that once you choose a provider rarely does a customer think about switching.  This is also evident in the price increases, which average 3 to 5% a year.

Valuation is quite attractive:

We believe the correct way to value Monitronics is by looking at the steady state free cash flow they can generate by the June 2013 fiscal year, or, by spending enough cap ex to hold subscribers flat at that point in time.  The last FY results we have are from June 2010 with EBITDA of ~186m and ~130k gross accounts added with an 11% churn rate, implying ~60k net adds.  We believe if Monitronics can continue to add 130k accounts a year at -1,375 in cap ex per account acquisition (slightly above the 3 year average cost per acquisition of -1,300), 80% incremental EBITDA margins, 3% ARPU growth per account, and an 11% churn the free cash flow should look like this:

FY10       FY13E

EBITDA                                 186          260

Interest                                                  -57           -60

Taxes                                                      -2             -20

WC                                                         3              0

CFO                                                        130          180

Capex (PPE)                                           -4             -4

Capex (replace churning subs)          -96           -123

"Steady State FCF"                            30m        53m       

 Capex (grow sub base)                       -80           -55

Reported FCF                                       -50          -2m

Holding company cash burn                              -3m

(-1.8m MRQ EBITDA, and falling)

We believe Monitronics can continue to grow accounts and keep churn moderated for a number of years.  Due to the quality of the business, June 13' steady state FCF deserves at least an 8% yield (50 / 8% ) = 625m in equity valuation. 

Furthermore, we believe the 230m of net cash that is not encumbered by the debt of Monitronics and held at the holding company level should be valued separately as management plans to use it for buybacks, dividends, or further LBO like acquisitions. 

230m + 625m = 855 / 14.3m share out = $60 in a base case with annual free cash flow growth of 15% a year thereafter + before other value creative steps are taken by management.

There are other steps management may take to create value they have actively discussed in the last conference call.  These include:

• 1) 50m of real estate assets on the books, or ~$3.50 a share that mgmt is actively trying to monetize
• 2) Improve tax leakage (Malone companies are very good at mitigating taxes)
• 3) Recap monitronics with another half to full turn of leverage to put into buybacks for future M&A
• 4) 75m NOL held at Monitronics that should protect near term FCF and is not factored in above FCF

We believe it is management preference to use the 230m in unencumbered net cash for further M&A.  If one assumes the cash they deploy can generate levered ROEs similar to that of their Monitronics purchase steady state free cash flow could climb to 80-90m, which would imply ~ $74 stock, or 50% upside.  A combination of tax savings + share buy backs could also take the upside to over 50% without M&A. 

A combination of other steps could take upside to 100%.  A recap of monitronics + sale of real esate assets could free up enough cash to allow a larger LBO, which could take steady state free cash flow to 120m before utilizing tax strategies.  In this scenario, an 8% yield on 120m of FCF would imply $105 share price, or slightly more than a double.  We know for a fact that Ascent Capital was trying to buy Bresnan Communications, but was outbid by Cablevision for 1.4B. 

Current churn and CAC vs history:

The key drivers for the business are churn and customer acquisition cost.  Historic churn can be obtained in Ascent Capital filings in addition to Monitronics filings when they had public debt back in 02-06.  Churn was elevated in prior years averaging 12-13%, but based on discussions with mgmt we believe the current 11% churn rate more closely resembles the appropriate churn rate of the business going forward and management alludes to this in their last conference call.  The reasons for this are a) 08/09 churn was impacted by a botched summer purchase program from 05/06 whereby dealers used teenagers to go door to door selling alarm systems during their summer recess and signed up very low quality accounts b) management has rapidly improved the average credit score over time c) mgmt has tweaked the billing / cancellation process to improve churn.  In a no growth mode, it is worth mentioning that over time the average remaining account should logically have a longer life.  So, even if reported churn approaches 12% we think steady state churn is indeed lower due to this dynamic of having a larger % of the account pool representing tried and true subscribers. 

Recent comparables:

Industry participants like to use multiples of monthly recurring revenue to value security businesses, but this metric is flawed and does not capture the free cash conversion of the different models.  While it is not a dealer based model, pre-credit crisis Securitas Direct was bought by PE for a 6.5% steady state free cash flow yield, with less growth than ASCMA.  Securitas was recently re-bought by a consortium of PE funds for 14x ebitda (the multiple of steady state free cash flow is not known for the recent buyout, but it is certainly low). 

Catalysts:

Management plans to conduct a road show sometime this fall and communicate the story to investors.  We think they may highlight metrics such as steady state free cash flow that should help investors value the story appropriately. 

Management:

We have heard good things about the management of both Monitronics and Ascent Capital.  The monitronics team is rumored to be the best in the industry and alarm dealers respect them a great deal.  At Ascent Capital, Bill Fitzgerald and John Orr are savvy and seem shareholder friendly.  Both also have option packages that strike at $48, so they are incented appreciate the equity.  Malone sits on the board and has the majority of voting shares. 

Risks:

There is potential refinancing risk.  90% of the subscriber accounts are currently held by a securitization facility that must be refinanced by July 2012, or the interest rate goes up 500bps and it begins to pay itself down with free cash flow from the business (PIK non-cash at first).  While the headline is scary, we do not think this poses much risk.  Management has 60m of liquidity at the parent today in the form of a revolver to fund continued account growth and could tap new facilities with significant liquidity we understand.  The unencumbered cash is a last resort for underwriting growth.  The risk of refinancing is not so much can it be accomplished, but more so when is the best time to refinance and can they hold out for a 700bps or lower fixed rate for 6 years, which is their goal. The securitization does not mature until 2035 +. 

The second, but also small risk in our view is that cable companies are trying to enter the security business.  They have tried in the past and failed but this time they seem more dedicated to giving it a go.  Numerous participants do not view it as a threat because consumers dislike working with cable companies and if they advertise the service it should spread awareness.  The alarm industry does very little advertising today.  The launches are also limited in scope at the moment. 

Disclosure:

We and our affiliates are long Ascent Capital (ASCMA) and may long additional shares or sell some or all of our shares, at any time.  We have no obligation to inform anybody of any changes in our views of ASCMA. This is not a recommendation to buy or sell shares.  Our research should not be taken for certainty.  Please conduct your own research and reach your own conclusion

Catalyst

Management plans to conduct a road show sometime this fall and communicate the story to investors.  We think they may highlight metrics such as steady state free cash flow that should help investors value the story appropriately.