THE HEDGEYE EDGE
Our bear case for ADT (ADT) rests on seven key points:
- ADT has a non-existent home security service penetration curve (from ~19% penetration of US homes in 2010 to ~20% in 2017).
- The company’s false alarm problem has not been mitigated, which puts it at a major risk of technological disruption.
- The company cites annual industry growth of 7-8% … meanwhile ADT has grown organically ~1% per year since 2011.
- Each incremental ADT partner and integrator removes the customer’s association with the ADT brand and its benefits.
- The company’s self-proclaimed opportunity to sell sophisticated cybersecurity in the commercial realm is likely out of its reach.
- True FCF is considerably lower than storybook, and cash taxes should be a factor now, as net operating losses can only protect 80% of the annual tax bill.
- Sticky service means growth mainly through acquisition of smaller players and their contracts.
4Q 2017 EARNINGS RECAP
After going public in mid-January, ADT (ADT) reported 4Q 2017 Revenue of $1,106m, up 5% y/y, above Street at $1,092m but below our # of $1,132m. Our number reflected the high end of the company’s own guidance. Recall that the guidance was given in 2018, after 4Q17 had already closed.
Question: How do you miss the high end of guidance on your first quarter when the guidance was given after the quarter closed?
The bull case rests on ADT’s “contractual recurring revenue” but churn continues to be a problem. The company reported churn of 13.7%, a 200bp improvement sequentially, but again below the high end of guidance and a slowdown in the rate of improvement relative to the first three quarters of the year.
Taking a step back, we looked at the linearity of churn improvement and compared that to the non-linear operating improvements the company is making. Does it smell fishy? It does.
Why do the churn numbers matter so much? Because ADT’s business model doesn’t make much sense. It costs the company >$5 to purchase $1 of incremental new revenue.
DEBT & DIVIDENDS
The company only has ~$127m gross cash on the balance sheet but they just announced a ~$115m dividend program. What’s the point? It amounts to a 1.4% dividend yield. No one will buy the stock for that yield, and there goes $115m per year that could have been good for paying down debt.
FCF guidance is $500m for 2018, above Street at $485m, but that is x-items which means it isn’t real FCF. In 2017, for example, they had $180m of special items…a bunch of which likely recur into 2018. A company with huge debt, now promising a dividend, and valuation that will be FCF based does not get a pass on x-items for valuation sake especially when said items are recurring in nature.
LONG TERM DISRUPTION NEEDS CHEAPER VALUATION AS OFFSET
Growth will peak, management will buy a cyber security company like McAfee, the balance sheet will not improve, and you will be paying so that the KOCH brothers can exit, and so that the private equity owners can quietly slip out the back door while you foot the bill for de-levering.
By the way, we are now only ~3 months away from the Apollo lockup expiration…
ONE-YEAR TRAILING CHART
