This note is a follow up to our SHORT ADT Black Book presentation published August 2 (link HERE).
YOUR (MOST COMMON, PARAPHRASED) QUESTIONS
1. Why are you so focused on SAC ratios?
SAC ratio is key to the myth of improvement. Management shows some darn happy, improving churn numbers. And correctly they show that – in theory – improving churn means the company can keep SAC high and drive net revenue growth or drop SAC and keep revenue flat while improving FCF. Our analysis demonstrates the company’s theory does not apply to them.
We stumbled on this because we use the SAC ratio to test our forward revenue trajectory. Our model combines price changes, Pulse additions, and SAC efficiency (broken out into dealer channel / direct channel). We use SAC ratios to test whether our estimates are consistent with the company’s trajectory. The company has maintained that the metric is improving. We contend it does not appear to be improving (see our analysis in the BB, HERE).
Wait, it gets worse. The delta between Gross and Net Churn was partly (50%) comprised of customer re-acquisitions (i.e. homes with already installed ADT equipment that turn the service back on). This line of revenue began in May 2016 when ADT offered a discounted service ($20 per month) to those with pre-installed equipment. With little to no SAC involved in said revenue, it is a high ROI path. The success of ADT bringing down the Gross to Net churn gap implies that this revenue line item has been a success, which should have led to improvement in the ratio of SAC to gross new revenue (i.e. more revenue coming in with no or little incremental SAC).
Unfortunately, that didn’t happen.
Because when you strip out this revenue line item, the rest of the business, i.e. the traditional core approach to customer acquisition got worse. We estimate SAC efficiency has declined, net of this revenue line item. Wow. That’s terrible, and maybe indicative of a declining secular demand curve.
2. Is this the quarter to press?
We think 4Q18 and 2019 look terrible, but 2Q18 / 3Q18 should see topline inline/a bit light, and GAAP FCF somewhat ahead. If people discount ahead the stock will go down on this earnings as the stock is trading over 20x un-levered FCF so there is some degree of expectation.
We go through our detailed fundamental assumptions in the BB, but if you want the slides associated with our modeling assumptions, just ask us and we will send (). We tried to keep the BB slimmer this time, so that people could go through it quickly during EPS season.
3. Can you share your estimates relative to Street for revenue / FCF?
At the midpoint of our scenarios we are -4% below Street topline estimates for 2019. We think management will have to return to the M&A program to the tune of $125-200MM by January to fill in $175MM+ missing revenue relative to current Street expectations. On 2Q/3Q we are more or less in-line with a range of +0-1% ahead for 2Q and 0-2% below for 3Q.
On FCF we are a bit ahead for 2Q-3Q as we think the company tightened belts from SAC to working capital etc. to make 3 large exogenous cash payments in the April to July period. The evidence? They suspended the M&A program despite it being critical to revenue growth, and despite facing increasingly tougher Y/Y comps in 2H18 and 1H19.
On the current business model, we think the company can earn in the $450MM+ range for GAAP FCF, this year or next. We don’t see much improvement in that rate from 2018 to 2019 until 2020, when they can yield benefit of the post May 2019 refinance window for a portion of the remaining 9.25% bonds down to some lower lever (7%?). In 2019 the benefit would likely be overwhelmed by the cash penalty to refi (equal to face plus 4.625%).
Other than that, the business model is stuck somewhere between SAC & Churn and cash flow has benefited from positive contribution from working capital, which was not a continuously positive phenomenon in the last period of being public.
Bottom Line:
The business model is under pressure. The company must choose between revenue growth and FCF, can’t have both. The market they are serving is changing rapidly, the technology is shifting from service (i.e. labor) to automation (software), the customer acquisition costs of the new businesses in the space are two orders of magnitude smaller, and ADT is acquiring to fill revenue holes by adding in the SMB commercial segment, while its largest business (NA residential) deteriorates.
Please call or e-mail with any questions.
Ami Joseph
Managing Director
