Description

‘Discretionary’ extent and leverage to new homebuilding:

Discretionary extent

From the various industry experts we have spoken with, the view we have received is that the industry is relatively recession resistant. Those industry experts contend that for an existing home owner, a security system is viewed only minimally as a dictionary item; rather, most homeowners view it much more as a utility. Certainly, we do not believe home security occupies the same status as electricity, gas, or water. Simultaneously, we do not believe it shares status with wholly discretionary items. With a monthly cost of ˜$31, most homeowners are likely to find alternative paths to cost savings than cutting off home security monitoring services. Additionally, given concerns of increasing crime rates that often accompany economic downturns, industry experts believe there some a counter cyclical effect to the impact an economic slowdown will have on disconnect rates.

Despite this issue’s fairly qualitative character, historical data largely supports the above view. From 2000-2003, CFL’s annualized disconnect rate averaged 7.29%. That compares very favorably to the company’s 15 year average from 1993-2007 of 7.10%. According to data compiled by industry insiders, in previous recessions annualized disconnect rates moved up 50-75 bps. However, current data shows disconnect rates moving up 100-200 bps in some regions. Cautiously, therefore, operators in the industry believe this recession is likely to see disconnect rates move up 75-150 bps nationwide. However, those same people believe that that CFL is likely to be on the lower end of that range due the discipline it exercises in its customer acquisition processes.

As the recent data shows, CFL’s disconnect rate moved up materially in Q308. In the consolidated Q308 10Q, CFL explained this was the result of three factors: 1) most significantly, disconnects were impacted by in increase in customer requested cancellations and customer moves to rented housing – the company believe this is related to the slowing economy; 2) increased cancellations of contacts at certain multi-family housing residences – the company explains these multi-family contracts were cancelled as apartment projects realized they no longer needed to offer amenities to lure residents[3]; 3) increased technical subscriber reconciliation adjustment – these relate to estimates the company had made in previous quarters of customers who disconnected and which the company anticipated would move into a new residences where they would reestablish their subscription. From our understanding, we believe the latter two factors are more one-time in nature. Normalized for those two factors, CFL’s disconnect rate for Q308 would have been 8.1%.

For the full year, CFL is currently projecting 2008 disconnect rate would be 7.5%-7.8%. Management has also guided to mid-single digit subscriber growth, revenue growth of ˜10%, and double-digit operating earnings growth. They stated that “looking forward to 2009, we expect to achieve continued growth in subscribers, revenue and operating profit.” The company recognizes the impact the economic slowdown, but stated repeatedly on the call that they haven’t seen a “sea-change” in the number of people choosing to disconnect for purely financial reasons.

Housing impact:

According to CFL “we believe that household moves, whether involving newly constructed housing stock or existing homes, drive more than 50% of our new customer volume in any given year.” For that reason, CFL’s top-line growth obviously benefits from robust new home construction. Mitigating that, however, is the fact more than 50% of disconnects are also the result of household moves. Historically, therefore, the company has benefited in times of reduced residential moves – while new installation growth slows, disconnect rates decline as well. Currently, the company believes it is reaping those benefits, although the amount of moves from homes to apartments is offsetting much of the benefit of people not moving homes. Management has indicated that assuming move outs to apartments subside, they should see benefits from across the board decline in household moves.  

Model and Valuation:

The security monitoring industry benchmark for valuation is primarily Recurring Monthly Revenue (RMR). To account for differences in customer acquisition costs and disconnect rates, those numbers – based on recurring revenue operating margin assumptions – are usually translated into a Steady State Cash Flow (SSCF) model. The idea of a SSCF model is to arrive at the free cash flow a company could generate assuming it signed up new subscribers at the same rate as existing subscribers disconnected (instead of investing above and beyond the disconnect rate in new installations). The primary levers in the model are 1) attrition rate; 2) subscriber acquisition cost.

Below is a sensitivity table for the company’s RMR and SSCF valuation based on a range of attrition rates – as the sensitivity table shows, even at attrition levels substantially higher than anything the company has previously experienced, CFL equity is currently trading at implied cash flow yields of at least 16% and at huge discounts to valuation multiples for precedent industry transactions.

Lastly, it is also possible to look at CFL through a ‘run-off model’ in which we assume that the company makes no further investment in new subscribers, but simply manages its existing customer base. Even assuming rather draconian attrition rates for a number of years out (until the entire customer base has exited), our models indicate that CFL would generate well in excess of $1bn in FCF on a discounted basis over that time. We have discussed both our SSCF as well as run-off models and their assumptions with CFL management. They acknowledged that they have run similar models with similar assumptions, and their conclusions are a large part of why they have been aggressive buyers of the stock at current levels.

Acquisition and recapitalization candidate:

We believe CFL is an extremely attractive acquisition candidate for either a strategic or financial buyer.

Presented below is a table of recent acquisitions. The average RMR multiple for the acquisitions is 47.6x; the average SSCF multiple is 12.7x.  Not included in the comp table is the March acquisition of leading European operator Securitas Direct. Securitas Direct was purchased for 50x RMR, 14.3x SSCF, and 11x EBITDA.

Based on the average 47.6x RMR multiple, CFL’s fair value is $39.85-$42.58 per share (based on RMR as of 9/30/08); based on the 12.7x SSCF multiple, CFL fair value is $52.30-$55.04 per share (based on 2008E SSCF).[4] Again, given the premium nature of CFL’s franchise and business model, we believe – in a normal environment – that it would deserve a premium to the precedent transactions (of course, in the present environment, multiples for the group are likely down).  

Possible strategic buyers include its four main domestic competitors, as well as European based Securitas Direct. The advantage of a strategic acquisition is that it will enable CFL to avoid having to undergo its rebranding campaign [see later in report]. Without question, the current EV/subscriber figure for CFL of $527.63 is substantially below the RMR creation multiple for any security monitoring company in the US. The opportunity to acquire the second largest and highest quality customer base at large discount to creation cost is no doubt a very compelling proposition for strategic buyers.

We believe as well that financial buyers are likely looking closely at CFL. The industry experts we spoke to stated plainly that CFL is wildly undervalued and that they have no question private equity firms such as KKR, Blackstone, GTCR, Quadrangle Group, and other are looking closely at a possible deal. Of course, financing remains extraordinary tough in this environment. However, two elements of CFL’s story give us confidence that it could attract debt financing: 1) by those lenders who work regular with security monitoring companies and understand the industry, the business model is viewed as very defensive; 2) CFL’s current capital structure is excessively underleveraged (i.e. there is no leverage). Accordingly, we believe a financial buyer could purchase the company with a minimal equity investment. According to a leading industry investment banker, market leverage multiples on an RMR basis are typically at the level of RMR creation multiple – i.e. north of mid-20x RMR. On an enterprise value basis, CFL currently trades at 16.5x RMR. As industry banker put it “you could borrow against CFL’s subscriber base for less than the company is currently trading.” We have heard that even in this environment traditional lenders to the security monitoring industry such as LaSalle Bank (now part of Bank of America), CapitalSource, and others are lending at 20x+ RMR. Additionally, the banker we spoke to is currently shopping three deals at 40x-50x RMR.[5]

Given the amount of leverage the company could handle, we believe the possibility exists of CFL choosing to recapitalize the company and use the proceeds to buy-back a large amount of stock and/or pay a special dividend (we realize this is likely unrealistic for the time being and on its recent conference call, CFL management said it does not believe the time is prudent to pursue such a course, with which we agree - however we do believe this is an opportunity down the line). For a public company, a debt load of 10x-14x RMR would be entirely reasonable. Assuming a recapitalization at those multiples, CFL could pay a special dividend of $8.70-$12.17 per share. Protection One, the only other publicly traded pure play security monitoring company, currently trades at 25.0x RMR. It is leveraged on a net-debt/RMR basis of 18.0x RMR. Everyone in the industry recognizes that CFL’s operations are vastly superior to those of PONE. In Q308, PONE peeked out an operating margin of .98% and showed a 12.70% annualized disconnect rate.[6]

Insider options and insider ownership:

The data below highlights two important elements of the CFL story: 1) Insiders are well incentivized to see the stock at meaningfully higher levels – the CEO has zero options currently in the money, and the CFO has only a very small amount which are negligibly in the money. 2) Insiders – especially the CEO and CFO – seem to be keenly aware of how undervalued the stock currently is; in past few weeks, both officers, as well as other executives, have made material purchases of the company stock.

CEO and CFO options holdings:

Recent insider purchases: