I am a buyer of Monitronic’s bonds in the current ~75 context as I believe the capital structure is covered.

I am not going to provide much background on this company as this is a relatively well-known name in a well-traveled part of the market. They are the #3 player in the home security space with just under 1.0mn customers—a distant third of #1 player ADT (who enjoys ~30% share) and modestly smaller than peer Vivint. This is a highly decentralized market with tons of regional Mom and Pop players; ADT, Vivint and MONI represent the only real scale pure-play national security monitors.

I should preface this discussion by highlighting that I am not suggesting MONI is a great business.  However, as a debt investment with a near-term catalyst, MONI doesn’t need to become the next Google to generate a strong return. You just need to get comfortable that the EV covers the debt, which I very much am.

That said, there are some notable reasons to get constructive on the prospects for a near-term turn around in the business.

Improvement in dealer channel

Monitronic’s bread-and-butter customer acquisition strategy has been in the independent broker-dealer channel. MONI relies on a number of independent dealer to dial-for-dollar to acquire customers, which MONI in-turn purchases.

MONI has run into trouble in this channel in recent year for several reasons. First, MONI had several unattractive dealer contracts that resulted in elevated acquisitions costs. At its recent peak, in 2014, MONI acquired customers at a lofty 37.3x RMR. The standard term for a residential alarm contract is three years (or 36 months). The closer a company’s creation multiple is to 36x RMR, the smaller the profit the alarm dealer makes on the initial term of the contract.

Beginning the in the late-2014/2015 context, MONI began re-negotiating its relationships with high-cost dealers. This process unfortunately resulted in the company losing a relationship with Alliance Security in 2016—the company’s single largest dealer and biggest source of customers. Separately, MONI paid a $28mn fine in 2Q 2017 ($5mn paid, remainder reserved against) to settle a class-action lawsuit for violations of telemarketing laws largely attributable to this dealer. Regardless, Alliance’s contract ended in 2Q 2017, providing a significant hole in MONI’s dealer channel in the second half of 2017.

A slowdown in the pipeline of new customers provides a twin negative for this business. Obviously your sales slow when you aren’t adding new customers, but the overall attrition of your portfolio spikes as well. Because new customers deactivate at a slower rate than older customers, having fewer one-to-three years old customers will result in your pool declining at an increasing pace. This is essentially where MONI find itself right now—stuck in a heightened attrition cycle from past missteps.

v

Contributing to MONI’s current elevated attrition, in 2011 and 2012 the company purchased bulk accounts from Pinnacle Securities. Management claims these accounts have experienced “normal” 36, 42 and 60 month end-of-contracts, but the math nevertheless has resulted in higher disconnections beginning in 2015. On the most recent conference call, management asserted the final vintages of Pinnacle 60-month end-of-contract came to term in 3Q 2017 and they anticipated “normal” attrition after 2017.

Given the cost of acquiring customers, even modest improvements in attrition can yield a material improvement in free cash flow, as the chart below highlights:

The benefits of improved attrition are noteworthy.

Monitronics believes they are in the early phases of turning around the dealer channel. The company recently re-signed Skyline Smart Home Protection (beginning Jan 1, 2018), a dealer than had left them roughly three years ago, which could be a material driver of adds. On recent calls the company has repeatedly expressed their confidence in their new dealer pipeline.

Brand value

The dealer channel in general has struggled with shifts in consumer behavior as well. Broadly, a more informed customer base (due to Internet/mobile penetration) has made telemarketing less effective. This dynamic can be even more pronounced when you lack brand value.

Previously, Monitronics did not brand itself, allowing its dealers to be the name facing the customer. This strategy was, in retrospect, a clear mistake because it left Monitronics vulnerable to dealer defections. In 2016, the company rolled out the “MONI” brand. Not shockingly perhaps, the brand failed gained traction. Outside of participants in the High Yield market, how many people have heard of the name “MONI?”

In February 2018, Monitronics announced they had obtained license the BRINKS Home Security Brand from The Brinks Company. MONI claims (and outside sources have confirmed to me) that the BRINKS brand is a close #2 to ADT in customer awareness for home security. Monitronics will pay $5mn upfront (a headwind for 2018 EBITDA) and royalties going forward (initial contract term of seven years which MONI can extend “beyond 20 years”).

Even bears on this story must to concede that MONI will unquestionably benefit from being able to market securities services under the recognizable BRINKS Home Security brand: “Hello, I am calling from Brinks Home Security” vs. “Hello, I am calling from MONI.”

Improved SAC

As noted in the Attrition Math chart above, it costs MONI more than $1,900 to acquire each new customer. This numbers compares to $1,400 per for ADT. While it is unrealistic to assume MONI can reach ADT-like levels, even modest improvements would yield material FCF benefits.

As noted above, MONI’s SAC should improve from changes in its dealer channel already under way. The company’s direct solution should further lower SAC.

In February 2015, the MONI acquired LiveWatch Security for $67mn (roughly 74x ~$900,000 RMR, which included 32,000 accounts), to provide a DIY solution. Despite the eye-popping multiple, LiveWatch has grown strongly (albeit off a low base) from $14.7mn of revenue in 2015 to $28.6mn in 2017. Importantly, LiveWatch generates creation cost in the low 30x RMR, well lower than the rest of the business.

The real potential for lower SAC stems from a recently launched partnership.

Nest

In late 2017, MONI announced an exclusive partnership to provide monitoring services to the Nest brand of new home security products. MONI’s BRINKS Home Security business will leveraging Nest’s marketing and distribution efforts as well as benefit from heightened brand awareness.

Nest launched its new product through Best Buy and online beginning in November 1, 2017 and MONI began offering monitoring services in February 2018. (I have no idea why MONI wasn’t live at product launch; management has provided no color). Nest claims its Nest Secure product offers advantage over competing products because its sensor detect both motion and open/close movement. It also includes a unique fob-based mechanism for arming the system that has won strong reviews.

Consumer can purchase the Nest Secure starter kit for $499.00 and can buy add-on products (such as a two pack of digital sensors for around $300). New Nest customers are referred to MONI for professional monitoring. MONI pays a fee to Nest for providing and maintaining smartphone interface and cellular backup (similar to existing service providers), but we do not have color on the exact economics.

MONI began marketing its services for $34.99 for month-to-month and $24.99 for three year contract, but has subsequently moved to $29.00 for month-to-month and $19.00 for three year contract. Bearish observers would suggest the lowered price signals lack of market reception while a more constructive interpretation would view the change as part of price optimization efforts. We take the former view.

At risk of using a well-worn market expression, the math suggests Nest could be “game-changing” for MONI.  Nest contends it has sold more than 11 million devices since inception (https://cnet.co/2I0jAKo). If we make conservative assumptions that Nest can sell just 2mn devices within five years and that MONI captures 10% of these customers for monitoring, the free cash flow capture can be material:

We would again emphasize that we view these forecasts as achievable—if not overly conservative. In our base-case model, we have them doing much better, but the above chart just highlights the compounding potential of the Nest relationship.

Nest Secure will integrate with Nest’s category defining smart thermostats as well as its door lock, smoke detector and other products, providing expanded functionalities that other DIY products (e.g. SimplySafe) do not. Nest is, of course, also part of Google and in time, Nest Secure will likely become incorporated into Google Assistant (the company’s voice recognition technology or Siri-equivalent).

Google, AMZN and Apple are locked-in a battle for the smart speaker/home assistant space, with AMZN taking a commanding opening lead. To gain ground, Google will have to spend aggressively to develop and market new products and devices to penetrate the home, which will likely lead to enhanced functionalities and value-added features for Nest products. Nest Secure, and therefore MONI, will be able to draft off Google’s efforts to further penetrate the smart home market.

Capital Structure

MONI is the Opco of the publicly traded company Ascent Media (ASCMA), a micro-cap company that has seen a significant decline in value over time. For an overview of ASCMA, there are some legacy write-ups on VIC’s.

At the MONI level, the company has issued a $295mn Revolver, ~$1.1bn of Term Loan due 2022 and $585mn of 9.125% Senior Notes due April 2020. Additionally, at the ASCMA HoldCo, the company has $96.8mn of 4.0% Converts due July 2020:

The capital structure is rapidly coming to a head because the Term Loan has a springing maturity 180 days before the bonds. Therefore, if the company is unable to refi the Senior Notes by October 2019, both the Revolver and Term Loan become due. Effectively the entire capital structure becomes “Current” in October 2018. The clock is therefore very much ticking.

So as highlighted above, at current trading levels, you can create the total capital structure at 36.3x RMR. As an aside, leverage and EV/EBTIDA multiples are generally less relevant in this segment of the market because EBITDA fails to capture the balance of customer acquisition costs, which are a part of capex.

We’d further highlight that the balance of the company’s cash sits at the HoldCo. Management contends that they may use that cash as they please, including for repurchasing Opco debt at a discount. However, for purposes of this exercise, we are assuming the cash stays at the HoldCo level (more on this issue below). Regardless, historical transaction multiples, recent debt financing and recent public multiples imply that MONI is comfortably covered.

First, M&A in this space has historically ranged from 40-60xRMR (http://bit.ly/2D7wfcS).  A few notable transactions in the space include ADT’s acquisition of Prime Security in May 2016 for 44.3x RMR and Blackstone’s LBO of Vivint for 56x RMR in 2012. Even the low end of historical deals suggests MONI would be covered. However, it’s hard to imagine MONI—as one of only three scale national players—wouldn’t command a premium.

As another valuation data point, in September 2017 press reports indicated that Blackstone had been looking IPO its Vivint investment at a $6bn valuation (https://fxn.ws/2rqlCdk). Trailing RMR of $65,600 (https://bit.ly/2rp894X) would have implied a staggering 91.5x RMR valuation. Even at today’s levels of RMR in the $71K context would suggest a +80x RMR value for the business.

As for recent debt deals, in April, Central Security Group, a Tulsa-based regional provider of home monitoring services (predominantly operating in the central and southern U.S.) raised 1st Lien Debt through 37.6x RMR (versus MONI’s 27.2x) and 2nd Lien Debt through 43.2x (vs. MONI’s 40.9x through the HoldCo). Assuming debt holders would have demanded at least 1.5x of equity cushion, that would imply a valuation for CSG for 55x RMR. For point of emphasis, just weeks ago, the market valued the nation’s 8th largest monitoring business for greater than 55x.  

CGS enjoys materially better attrition (10.6% pro forma vs. 14.5%), but with notably lower ARPU ($38.50 vs. $44.04) and is a fraction of the size (229,490 customers vs. 962,590 and $8.9 RMR vs. $44.04). Given the greater scale and significantly greater optionality (due to relationship with Nest, etc.), MONI unquestionably should be valued higher than CGS. In short, MONI bonds are covered.

As for equity valuations, MONI’s capital structure is trading where it is (in part) because of its closest public comp—ADT. For an overview on the company, I’d refer you to obvious617’s write-up on 2/6/2018. As a quick summary, after being whisper as high as 70x RMR, ADT went public in early January at the ~60x RMR and promptly crashed, dragging the stock to current sub-50x RMR:

ADT’s current valuation partially stems from the hangover of a shitty IPO process. The company/bankers alienated their core holders by reaching on valuation. For what it’s worth, ADT has four (out of four) Buy ratings and an average price target of $14.67, which suggests significant upside from current levels. Even at current trough, ADT’s valuation implies MONI’s debt is covered.

MONI should trade at roughly 20% discount given its higher creation cost and churn metrics. That said, if MONI can achieve those same levels (admittedly a tall order), there is no reason it should trade at a discount. They are both scale players, so it’s not as though ADT enjoys a structural monitoring advantage. In the current state, a 20% discount seems appropriate, which would translate into 37.5x RMR. While not providing much breathing room, even at trough RMR for MONI and trough valuation for ADT, MONI’s debt is nevertheless covered.

Ring.com

Herein lies (at least in part) why there is an opportunity with MONI. In late February, AMZN announced it would acquire Ring.com for more than $1bn. MONI bonds traded from the high 80s, to recent lows ~70 and ADT stock declined nearly 30%, since the deal hit the tape.

Let’s begin with what Ring.com does. So Ring.com is a maker of video door bells and security cameras that provide notification or alerts to your phone. The company does not provide monitoring services (as of now at least). Ring.com therefore is a product company unlike ADT, Vivint and MONI, which are services companies.

This is an important nuance for two reasons. First, self-monitoring provides lower actual security. Let’s say you are upstairs in bed and someone is trying to break into your house, Ring.com will send you a text as a heads up. You can then, in turn, call the police. A monitored solution provides objectively higher levels of protection with automated police/fire notification. More importantly, insurance companies only provide home owners a rate benefit for monitored solutions. Ring.com therefore (at least in its current former) has a structural market limitation.

AMZN certainly has the capabilities and (with the market ascribing them essentially zero cost of capital) the means to establish monitoring services. With all of AMZN’s business initiatives, I broadly find it hard to believe AMZN purchased Ring.com to get into the monitoring business. A more likely scenario is that AMZN views Ring.com as a means of enhancing their core business.

Ring.com ultimately will provide AMZN the ability to remotely open customer doors and drop-off packages. This is very much like the deal announced last week that will enable AMZN to deliver packages to certain Volvo and GM vehicles. We believe AMZN see Ring.com not as a means to provide security services (far from the company’s core), but as a tool for remote home access to enhance its distribution.

How it plays out

Given where bonds are trading today, the market is clearly saying they don’t believe MONI can do a regular way refinancing. However, the company does have time to show progress. Again, the Capital Structure only becomes “Current” in October, giving the company two quarters to demonstrate improvement. While not ideal, the company could also let the debt go “Current” to buy themselves even more time. Regardless, given all of the operational changes underway, we believe a straight refinancing is possible—call it a 5% chance.

A more likely outcome is a restructuring in the coming weeks/months. The company does have ~$150mn of incremental secured capacity as well as $116mn of cash (mostly at the HoldCo) which could potentially advance a refi process. They would have to get a waiver from the exiting Term Loan to unlock the incremental, but they have little incentive to not cooperate.

The company will likely have takeout the HoldCo debt as part of a broader refi, which will provide the ancillary benefit of simplifying the capital structure. Using cash and new paper, the company could potentially tender for the HoldCo’s @ 80 and a portion of the Opco’s @90:

With Debtwire commenting that holders are already discussing such a solution, I would consider this the most likely outcome. MONI will publish 1Q results tomorrow. If results underwhelm, it might provide an opportunity to try such a deal. It should be relatively easy to coerce the HoldCo’s to tender, but perhaps less so for the Opco owners. Getting some of the Opco’s to agree to a below par payout is not inconceivable with BK a not zero possibility. Let’s call this outcome 30%.

An out of court deal could also entail bond holders agreeing to extend their paper with an equity component. With so little equity value currently, the math on such a trade is tough, but I’d be willing to bet Opco holders would be willing to roll @ 90 in exchange for 10% of the equity and HoldCo’s @ 80 for 1-2%. With the threat of getting layered, bond holders could have an incentive to get ahead of it. Call this a 20% probability.  

There is also a possibility that MONI will shop itself. The obvious buyer had been ADT and had its IPO not been a disaster, I am confident a deal would have been done by now. If ADT could use their stock in the 55-60x RMR, I have little doubt they would have hit a MONI bid in the 40x RMR context. ADT’s stock at trough levels doesn’t preclude a deal, but it makes it less likely. In a wildly dispersed market like this, buying nearly 1mn customers is not easy to do. Blackstone appears to be better sellers and Vivint has a different go-to-market strategy, so I don’t see them as buyers.

A private equity buyer is a possibility as well. A PE take-out would likely require a hefty upfront check (and the deal may be over equitized for a period of time), but the math still works. A PE firm would have the patience to allow the dealer channel to turn-around as well as to realize the Nest potential. A PE firm could use MONI as a platform to roll-up other Mom & Pop’s and capitalize on the longterm the digital-home/IoT trend.

Call MONI being taken out a low, but not zero chance outcome, at 20%. There would be buyers for this asset. Management would likely hang a “For Sale” sign before taking a donut in bankruptcy.

A bankruptcy would obviously be a bad outcome, but not necessarily the end of the world, particularly given the level you can buy the debt today. My simplified BK math suggests Opco’s would recover ~80 in a BK (with nothing for the HoldCo’s):

Taking the weighted average of this potential outcomes suggests bonds are worth just below 90 cents on the dollar: