“Well, an edge means something like the ADT deal, which is the largest deal on last year's buyout. That was a $15 billion deal. Our edge frankly was that we already own two security alarm companies and when you put it together with ADT, it generated about $200 million of low-hanging fruit synergies. We also have an edge in the management of one of our companies, which was considered the best management in the industry, had come from ADT, and therefore they knew the company extremely well.”
(Apollo CEO Leon Black, 12/7/16)
ADT fired CEO Tim Whall last night. With that move, we imagine the board is hoping to close the door on the poorly executed IPO, and the ongoing weak performance of ADT shares since going public. The new CEO…was his right hand man in charge of running operations. We don’t anticipate major changes. And, aside from appeasing some large shareholders with a bloodletting, what could Tim Whall really have done? Consumers have a choice now when they buy home security. Their choices include, among other options, contract-less monitoring and a lack of onerous upfront installation fees. ADT is stuck spending $300MM in cash subscriber acquisition per quarter, in order to generate ~$5-6MM of incremental quarterly monitoring revenue. Yikes. That is perhaps the worst use of cash we have seen from across the landscape, and because the change in ADT’s core market has just begun, the pressure will only mount and force ADT’s residential business into full retreat over time.
Grading Tim Whall
If anything, we think ADT’s ~$290MM of GAAP FCF in 1H18 is better than expected. The company has benefited from a lack of one-time charges, and from some one-time gains, but the cleanup should continue into 2019 likely putting 2019 GAAP FCF modestly above 2018. Our net modeling pictures ADT with $300-400MM cash to spend per year above and beyond the dinky dividend or the margin eroding M&A program. The extra cash gives them wiggle room, and if we can think of a bull case, it is the narrow patch of FCF growth currently underway and stretching through to 1H19. Heavily shorted with FCF growing, could create the kind of squeeze that we think we have already started to see on some days.
Classic Value Trap
If Bulls can maybe bask in a bit of extra FCF today, they really should be looking ahead at the uses of that cash. ADT needs to fund a business model transition away from residential and towards commercial, all while de-levering from net debt of $9.4B (pro forma), escorting Apollo’s 86% equity holding out the door, and defending their under-siege residential business. Today ADT is split 85/15% in favor of residential, so the path is going to take a long time, or cost a lot of money, or both. In the process, margins come under pressure as SG&A normalizes next year, D&A extends with the acquisition program, and incremental revenue from M&A and Installation & Other tilts the model towards lower margin revenue.
And all of this already trading ~15x next year’s unlevered FCF. It isn’t really all that cheap. Heavily shorted? Considering the limited float, yes. But tiny relative to a float that is about to open up.
In sum, it’s hard to find a company under more pressure than ADT. Product options for residential home security buyers have multiplied, and the new approach is cheaper, more sophisticated, contract-less and features low or no cost installs. ADT’s core residential market is moving away from them. This is a permanent problem for ADT. The company’s answer is to make a model transition into commercial, which will be expensive, takes time, and does not prevent the death of their residential business.
From here, the short-term outlook (~2 quarters) seems a bit easier for ADT: a large peer is shedding subscribers at a fair clip, and YTD FCF (GAAP) is above where we had estimated, giving the company a bit of wiggle room. Extra cash means ADT lives to play another day, and for now that may force some short covering.
But as the pressure increases in the residential market, and as we increasingly move into a negative secular penetration curve for ADT’s model, growth in monitoring revenue will be harder and harder to come by. Consider: most of it is thanks to price increases which make ADT even more vulnerable to the disruptive forces in the market.
Contrarians have been buying ADT shares. We get it: one of the few broken equities in the last couple of years, with a strong brand, and commanding position in its market. But ADT is the definition of value trap. Price increases are giving the company a bit more wiggle room with cash flow, but it ends when residential subscribers begin the process of slow, permanent erosion. Believers in “steady state” free cash flow will have a tough time trying to find the cash as the company even today has something close to a 15% churn rate on a unit basis.
POSITIVES:
- Heavily shorted
- GAAP CF has been surprisingly ok (1-2 more positive puzzle pieces that can help)
- The path to $300-$400MM of annual excess FCF over dividend and M&A requirements gives the company some wiggle room
- Weaker subs numbers from #2 Brink’s (Formerly Moni) takes some pressure off ADT
- And commercial growth rate is somewhat of a positive
NEGATIVES:
- Residential product displacement in terms of technology, business model, and cost structure, which is a sandtrap that will ensnare ADT’s resi business (85% of monitoring) over time (detailed extensively in our 8/2 Black Book: ADT | [Still] Under Pressure)
- A negative secular penetration curve for residential monitoring
- A business model that requires ~$300MM of Quarterly SAC to generate $6MM of Quarterly incremental revenue?!
- An unfortunate habit of obfuscating numbers by changing definitions (with Pulse the most recent sacrifice)
The path forward to the good business, commercial, will require hefty M&A to make it big enough to matter. Forward margins are likely to be under pressure as D&A climbs, SG&A normalizes, and the business mixes more towards lower margin acquired installation and other revenue. The company’s hoped-for adventure into Smart Home doesn’t seem to be working as their own statistics imply a lack of progress.
Net, the battle lines on ADT are short term improvement in FCF on the bull side, pitted against medium and l-t secular negatives on the bear side.
Please call or e-mail with any questions.
Ami Joseph
Managing Director
