Securitas Direct presents a unique opportunity to invest in a dramatically undervalued and misunderstood company that we believe can be worth more than double its current price in one year. Additionally, we believe the downside in this investment to be extremely limited.  Securitas Direct might not appear particularly cheap at first glance, but after digging beneath the surface, it is clear that GAAP accounting substantially obscures the value of this attractive business.

 

The company was spun-off from Securitas AB in Sweden in the fall of 2006, and since then, the Swedish analyst community has largely failed to properly assess the economics and the value of the business.  Management has recently purchased stock in the open market, reflecting their belief in a deep undervaluation.  Additionally, their options strike at a level that is 50% higher than the current market price.

 

The stock is currently trading at a heavy discount to intrinsic value due to the fact that GAAP accounting significantly understates the economic earnings power of the business as we will later explain.  By our estimates, Securitas Direct is trading at only 6.4x its adjusted EBIT and is worth conservatively 37SEK+ in one year, providing for upside of 100%+ from the current price of 18.50.  We also believe that there is a significant margin of safety provided by the value of the company’s installed base of customers and the company’s unlevered balance sheet. 

 

Securitas Direct was originally written up on VIC a year ago, so please refer to that write-up for helpful background and discussion.  We will provide our own summary along with updated thoughts on the situation and valuation.

 

Securitas Direct was spun-off from Securitas AB in September 2006 and is the leading provider of security alarms to consumers and small businesses in the Nordic countries and Western Europe.  The company has leading market shares, high returns on capital, predictable recurring cash flows and significant growth opportunities.  The company’s key markets are Spain (54% of 2006 sales) and Sweden (19% of 2006 sales), with the remainder of its sales coming from Norway, Denmark, Finland, France, the Netherlands, Belgium and Portugal.  The company has leading market shares in its key markets on the order of 20-35%, and overall, management estimates that it has a 25% share of new monitored alarms installed in Europe.  The company was founded in 1988 and has enjoyed impressive customer growth since its inception.  The potential for growth remains significant with an estimated 4% penetration of monitored alarms in Europe vs. approximately 20% in the U.S.

 

The economics of Securitas’ business are actually quite simple: the company installs an alarm at a total cost of approximately 11,400SEK ($1,700) (8,300 for installation costs and 3,100 for equipment) and charges the customer an installation fee of 5,400SEK ($800), for a net cash investment in a new customer of 6,000SEK ($900).  Securitas then receives monthly fees from the customer of 250SEK ($38) and incurs total operating costs per customer per month of 124SEK.  This results in monthly per customer cash flow of 126SEK and annual cash flow per customer of 1,488SEK at a 50% margin.  In essence, the company is investing 6,000SEK in a customer to receive an annual pretax cash stream of 1,488SEK resulting in a 4-year payback.  The average customer life for the company historically has been approximately 10-11 years, so these economics result in aftertax, unlevered IRRs of almost 20%. 

 

These seemingly simple economics are obscured by the GAAP financials of the company.  The existing base of customers is accounted for as you would expect (the company receives monthly revenues and expenses its operating costs), but the new customers complicate the picture.  When the company adds a customer, it recognizes the installation fee of 5,400SEK as revenue and expenses 8,300SEK of the installation cost immediately resulting in an operating loss of 2,900 per new customer (the remaining 3,100SEK is capitalized and depreciated over 5 years).  Given the operating losses generated by a new customer, the company’s consolidated earnings are significantly depressed as it adds customers.  The level of earnings understatement is proportional to the pace of the company’s customer growth (i.e., the more customers the company adds, the worse the reported financials look), despite the fact that adding customers is a high ROIC proposition.  Given that the company has been growing customers at around 15-20% per annum, this impact is dramatic. 

 

We have summarized the GAAP calculations in the table below using rounded numbers for simplicity and basing it on our estimate for end of 2007 customers of approximately 950,000.

 

 

 

Given that the GAAP numbers distort the reported financials, it is helpful to analyze the financials on a steady-state basis to evaluate the earnings that are generated from simply keeping the customer level flat.  To calculate steady-state earnings, we start with the cash flow that is generated from the existing customer base and we subtract the costs to replace the number of customers that are lost to a normal level of churn.  We believe that Securitas’ current customer base can generate 1,063SEK of pretax income and 712SEK of net income into perpetuity (with ~2% pricing increases per annum).  We have outlined our numbers in the table below.

 

 

 

Below is the current market valuation of Securitas Direct:

 

Price                            18.50SEK

Shares                          365

Market Cap                 6,754

Net Debt                      43

Enterprise Value           6,797

 

The company is trading at only 6.4x steady-state EBIT and 9.5x unlevered steady-state earnings.  In our opinion, this is a dramatic undervaluation and at a minimum, even in a no-growth scenario, this earnings stream should be worth at least 15x based on a cost of capital of 8.5% (note that Swedish/Euro interest rates are comparable to the US and that these cash flows should be highly leverageable at a low interest rate) and a growth rate equal to inflation of 2%.  At a multiple of 15x we would arrive at a value of 29SEK per share which is 57% above the current price.  We see that upside without the benefit of any leverage, and in addition, we have completely ignored the company’s ability to grow – which it has been doing at a high rate for 20 years at a very attractive return on capital.  In order to get a sense for what the company is worth given its significant growth opportunity, we put forth some financial projections below along with a target valuation based on 11x steady-state EBIT and 16x earnings.

 

 (a) Churn is adjusted for 6,419 cancellations in Spain that were due to closer monitoring of the portfolio.

 

At 11x EBIT and 16x net income, Securitas is currently worth 32SEK per share and would be worth 37SEK per share in one year, providing for upside of 100%.  Even if it takes 3 years to reach our projected target valuation, you would still earn 40% annual returns!  We have also included our estimate of a DCF value for Securitas which you will see is significantly above our target value.  The key point is that the present value of the growth opportunity is significant and warrants a much higher multiple than 16x earnings, but you don’t even need to believe that to earn great returns.  We haven’t included all of the DCF detail because it gets slightly cumbersome, but we’ve laid out the general assumptions below. 

 

DCF assumptions:

-         9% WACC

-         2% inflation rate

-         Penetration rate of European alarms doubles to 8% from 4% over the next 15 years and then grows at 1%

-         Securitas’ market share increases from about 12% to 17% in the next 15 years and then it eventually reaches 20% in the very long term (these assumptions imply a 6% customer CAGR for the 15 years beyond 2010)

-         The payback period remains at 4.0 years

-         The churn rate trends up over time

 

Continued Undervaluation.  We believe that the company is undervalued largely because of its accounting, which is not going to change any time soon.  In addition, most sell-side analysts have either ignored the accounting issue entirely and focused on a meaningless P/E number or actually do a DCF only to then apply an arbitrary discount to get back to a reasonable P/E.  Mitigating the risk of continued undervaluation is the fact that the GAAP and steady-state financials will converge over time as customer growth slows and reaches maturity.  In the shorter term, the company looks attractive on a reported EBITDA basis as it trades at 7x 2008 EBITDA and EBITDA is growing at nearly 20%, so if one holds that multiple constant you should still earn a very attractive return.

 

Management Missing Targets / Credibility.  At the time of the spin-off, management laid out the following operating targets for the company:

-         Cancellation rate < 6%

-         Payback period < 4 years

-         Net customer growth > 20%

 

Since the spin-off, the company has not attained these targets, which has created disappointment for some analysts and investors.  Management has explained that these targets were effectively internal “stretch” operating goals and should have been more accurately described as such as opposed to being taken as “guidance.”  Management has now effectively guided to mid to high-teens customer growth and they are confident that the cancellation rate will get back towards the 6% range over time.  In terms of credibility, it is worth noting that senior management has been buying shares in the open market at the current price or higher over the past few months. 

 

For what it’s worth, we view this guidance/target situation as an unfortunate miscommunication and chalk it up to growing pains as a public company.  From our interactions with management, we have come away highly impressed and believe that they are smart, driven and understand their business and the true underlying value of the company.  In addition, it’s worth noting that our operating case and valuations are not dependent on management beating any of these targets and, in fact, slower growth will actually close the accounting gap more quickly.