By Drew Weitz
The ADT Corporation (ADT) is the leading provider of monitored home security service in the United States and Canada. The company possesses the strongest brand in the security industry, evidenced by its 6.5 million residential and small business customers – more than five times the number of its next largest competitor. In addition to traditional alarm monitoring, ADT is expanding its offerings to include interactive services (e.g. remote arm/disarm) and home automation services (e.g. climate/lighting control, physical lock/unlock of doors) for an incremental fee. The company was spun-off from Tyco International (TYC) in September 2012.
The Attraction of Subscription Businesses
As investors, we are qualitatively drawn to businesses that are leaders in their industries and possess strong competitive advantages. Quantitatively, we also look for companies that consistently generate strong, predictable and growing streams of cash beyond what is needed to reinvest in the business. Subscription models, characterized by customers (often under contract) that pay on regular intervals, often provide such predictability. Our investments in pay TV companies are examples of the marriage of these two traits. We believe that ADT, too, fits this bill. As described above, it is the undisputed heavyweight of the industry with the most trusted brand and scale that drives lower costs than competitors. New customers sign an initial three-year contract and pay monthly for service, creating a business with roughly 90% recurring revenue and highly visible cash flows. Thanks to their large subscriber base, the cash generated is more than sufficient to purchase equipment for new installations and compensate third-party authoriz ed dealers for accounts generated. Lastly, these predictable cash flows support ADT's ability to prudently issue debt. Excess cash and debt capital allow management plenty of flexibility to play offense.
Customers are Taking ADT's Pulse
For years, industry growth has been slow and steady, if somewhat unexciting. Thanks to the proliferation of Internet- connected consumer devices, however, the company is enjoying a renaissance. ADT's interactive and home automation service, dubbed Pulse, allows customers to remotely control lighting, adjust thermostats, monitor security cameras, or lock and unlock their doors in addition to simply arming or disarming a security system. Consumer response to the product has been strong: although only 8% of ADT subscribers have Pulse today, nearly one-third of new sales include the additional functionality (and higher price tag). Furthermore, the company estimates that roughly 20% of the installed base has interest in upgrading to automation services. Pulse's 25% higher monthly fee and positive impact on retention more than offset the increased equipment and installation costs. Adoption by new customers and upgrades by existing subscribers will drive the mix of Pulse accounts higher over time, providing a multi-year earnings benefit to ADT.
Attractive Opportunities Attract Competition
No strangers to the benefits of subscription businesses themselves, pay TV and telecom companies have entered the market, looking to bundle home security and automation services with their video, broadband and telephony offerings. Their entrance is coincident with a period of elevated account attrition for the company, raising warning signs for investors and sending ADT's shares lower. New competitors, however, do not appear to be the culprit for ADT's higher attrition. Indeed, results for the last 12 months indicate that ADT has gained market share, while the modest gains made by pay TV and telecom companies have been at the expense of small, subscale firms. Instead, higher turnover in the housing market has led to greater account termination as subscribers change residences. ADT hopes to turn this challenge into an opportunity to both follow the old subscriber to their new address and sell service to the new occupant of the former premises. Furthermore, the company has taken steps to improve the long-term value of new subscribers, including tightening credit standards and optimizing its third-party dealer network by eliminating those not committed to following ADT's Pulse strategy. In the short run, these actions have a negative impact on attrition by reducing the number of new customers available to offset losses. However, we believe this will be more than offset by a greater lifetime value of the prospective subscriber base.
What Matters Most is Value per Share
Investors initially cheered ADT's separation from Tyco, bidding its shares up from the high $30s to over $50 in short order. However, as attrition rose and new customer growth fell below expectations, shareholders sold just as quickly. Despite these disappointments, in its first 16 months as a public company, ADT will have used its excess cash flow and balance sheet capacity to buy in nearly 20% of its own equity at reasonable prices, thereby driving a substantial increase in business value per share . Going forward, the pace of capital returns will likely diminish as management looks to prioritize investment in the growth of its business. Indeed, the specter of cable and telecom competition combined with the need to invest in new home automation services may drive a wave of consolidation of smaller players that lack the scale to keep up. At the right prices, we would expect (and encourage) ADT to participate, driving additional business value growth.
With the stock back in the high $30s, the recent growth in ADT's business value per share makes today's valuation a more attractive buying opportunity than a year ago. Compared with our current estimation of ADT's business value in the low $50s, we believe the company's shares represented an attractive investment for our shareholders