Why? ~10% downside to our original target, + Street set the bar confusingly low, + 3 strong quarters at hand (4Q17-2Q18).
Note: Confusion from lack of disclosure can drive the stock both up and down.
Items that remain squarely in the bear case:
Revenue acquisition is costly, lack of penetration curve means opportunities are over-competed, service has negative l-t exposure as false positives to real alarms are 99:1 in an era of intelligent computing, the stock is expensive, disclosure is weak, exposed to new entrants who may use software automation to change the game, + new competitors may flip ADT’s best strength into an albatross, seller owns 85% of the stock, and lastly, historically consistent d-d% churn rate on the service you use ‘to safeguard your family’ kinda points to the obvious.
Additional points:
- Tortured P+L will make it hard for investors to understand misses or beats.
- Changes from old ADT to new ADT include:
- Accounting/definition of recurring revenue
- Churn
- Revenue from contracts monitored but not owned
- Customer count
Word to Churn Defenders:
- Notice the churn rate started improving literally the month (May 2016) in which they closed the deal to go private. Do you really think the qualitative, non-linear changes they are making to improve the service of the company were in place and had effect from Day 0 of the acquisition, do ya? And what are you modeling for revenue from contracts monitored but not owned? Why did the balance sheet change so much on carrying value of customer contracts versus dealer relationships? And, keeping it simple, why don’t they disclose any kind of like-for-like numbers for quarterly revenue, net churn, or standalone ADT customers?
Valuation premise:
There may not be enough disclosure to wisely forecast FCF. The $814m of YTD 2017 unlevered FCF, for example, includes some junk that can’t just be extended forward. But…hypothetically, if we did, just to take their version of a good # about which they were proud, and we annualized it and gave it ~10-12x multiple as bottom of the range where maybe it gets attractive, and 20x as nosebleed shortable, it would put the risk range at $3-15, the midpoint of which puts us at ~$9, right at our original price target. As we grow OCF in the coming quarters we can look out and see the top end of the range extending a bit higher to $16, or using Street to ~$19, but the bottom of the range stays in the single digits. We see valuation today as ~18x EV/FCF on 2018…we wouldn’t touch it long until it looked like 10-12x…and even then, aren't there better things to own without an 85% seller? In the short term, we accept that beating Street revenue for 3 straight quarters (4Q17-2Q18) will shock some folks out of the Short.
3 Good Quarters: how do we know?
Because we took the high end of 4Q17 as real (guidance was given out two weeks after the quarter closed), and we asked:
How is 4Q17 revenue up 8% y/y?
Management will talk about growth. The sell-side will gush. Analysts who are Short may have to swallow hard to explain to their PMs why this company managed to put up HSD% y/y growth. The S-1 was careful not to disclose quarters, but you can back into 4Q16, so everyone will know that ADT put up a big organic growth rate in 4Q17.
Before you freak out (if you are Short), or dance for joy (if you are Long), let me add to the twist: revenue may notch a d-d% y/y quarter or two off the easiest comps before facing a flattening growth curve into 2019. That’s our point: 3 good quarters. And yeah, we knew this going in, and highlighted it in the BB (HERE). But 3 good quarters at close to ~30x FCF when they were playing with the truth in the IPO, versus now at ~17-18x FCF (still rich) but about to beat easy Street estimates…the setup just isn’t as strong.
Ami, you haven’t answered yet: HOW?
How? They bought it. Plus there are easy comps.
To get this quarter's ADT recurring revenue, you start with revenue based capex. ADT buys dealer accounts (dealer generated customer accounts) and invests in (buying) their own directly acquired accounts via subscriber system assets. The capex dollars convert to incremental forward revenue, within a range. And net of churn, of course.
Last word
The lack of penetration curve in home security means the market grows with new homes built, or something like 1-2% for home security on a historical CAGR basis. (This fact is partially masked by some low quality market prognosticators who offer a much brighter but false version of growth, and is then resold by some sellsiders in their notes when they don't have time to investigate on their own.) The low growth rate means ADT sales people are often trying to convert territory that has been sold and resold already. Worse, ADT's authorized dealer channel at times may steal accounts from ADT or undercut ADT direct sales on pricing. The over-competition happens due to the lack of organic market growth available. We think growing DiY and growing pressure from new software entrants will make this dynamic even worse. And thanks to the churn factors, ADT can not turn off the capex spigot when growth slows. If anything the company will need to increase capex to chase even fewer revenue dollars...and it is a heavily levered balance sheet...with a seller poised to let go of 85% of the equity over the next 2-3 years. Which means every pop in the stock will face a stone wall.
But in the meantime, the Street set the bar way too low, the math on capex to revenue y/y leads to HSD% or low D-D% topline growth for 1-3 quarters, and will confuse people who are not doing the math, even though the two year CAGR will remain solidly low s-d%. That's the problem with lack of disclosure: it sows confusion in both directions.
For now, we are moving ADT to the sidelines, and will come back and Short when the setup is better.
