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Takeaway: But is it real? Is it bullish? We are staying Short but recognize tougher setup into 3Q EPS

ADT spent ~$36MM acquiring two companies in 3Q, one in July and one in August. At that rate the company has typically produced about ~$50MM of inorganically derived incremental annualized revenue. For 3Q it means $4-6MM incremental M&A revenue, and for 4Q it adds $10MM, in addition to the $100MM from the fire + safety company, Red Hawk, just announced last week (see our note HERE). The Street hasn’t reflected any of this M&A in estimates which sets up for a headline beat.

ADT | Street Set Revenue Bar Too Low - ADT Cyclicality 1

In addition, although new home sales continue to decelerate Y/Y, the existing home sales indicators show 3Q18 slightly improved Y/Y % growth versus 2Q18, potentially a directional indicator for ADT recurring revenue (see chart above). Further, the company has been able to drive some sequential growth each quarter in recurring revenue, and with Street looking for $0MM in FCF for 3Q18, the company had carte blanche to spend away on SAC to drive some incremental recurring revenue growth.  

The combination means that Street revenue estimate of $1,136MM looks way light. Will that cause a squeeze? Could be.

Revenue puzzle pieces = Red Hawk means 4Q monitoring up ~$20-25MM (per Q) + Street missing the $5-10MM additional recurring this Q thanks to a splashy SAC quarter + 3Q $5-10MM incremental from M&A not reflected  

ADT | Street Set Revenue Bar Too Low - cash profitability ADT 2

WHY ARE WE STAYING SHORT?

Let’s think about this model: Spend like crazy, drive slight growth in recurring revenue, only to see it all churn away as soon as the spending stops.

The good parts? Pulse has lower churn rates than the core, potentially as low as 6-8% on a net basis. [How do we know? Look at what happened to Alarm.com’s (ALRM) net retention after the addition of Pulse (via the March 2017 Icontrol acquisition)…if anything it has slightly tightened toward 94% from 93%].

But wait…what does that imply about the churn in the larger core?! No wonder ADT is trying hard to fix this mess and drive more Pulse/Interactive mix. The problem is the system + cost for Pulse makes the company only more susceptible to disruption down the road as new models gain more traction with consumers and launch products & services with greater appeal and more robust technical systems.

And ADT knows this…which is why they are trying hard to get back into the non-residential markets! ADT is using every spare dollar plus some incremental leverage (uh-oh) to drive a foray into mostly non-recurring and lower margin revenue dollars in the commercial channel.

Contrarians will say: Ami, ADT is raising prices successfully. ADT is beating cash flow estimates. And ADT is improving profitability off a lowered base. And the stock is heavily Shorted, and now you are telling me they will beat topline?

ADT | Street Set Revenue Bar Too Low - ADT Amazon 3

My answer: This business ran out of room to grow before any kind of Amazon-Ring action. That the latter giant, and many new tech companies, want into this market just adds a great stalking horse to the Short. When does that cause contraction? Soon enough. And ADT knows it which is exactly why they are chasing their way into commercial. Look at the recent steps: 1) bought Red Hawk, used some leverage to do so, which adds some recurring (~$25MM per Q) revenue but mostly non-recurring ($75MM per Q), 2) announced a partnership with Amazon which is really a way for Amazon to disintermediate Pulse customers, & 3) replaced the CEO with deep experience in this market for a COO who is using the former CEO’s plan but who doesn’t have the same level of experience in this market.

ADT | Street Set Revenue Bar Too Low - New crushing old 4

ADT certainly isn’t firing on all cylinders. When they report 3Q net debt will be up and will go up again in 4Q to fund Red Hawk.

The company generated ~$900MM in 1H18 cash profits (NI + D&A + SBC + 1-time) and spent ~$700MM on cash SAC + capex + M&A. We see ADT as a $400-500MM FCF company supporting ~$6.6B equity and ~$9.4B of net debt. So, its ~15x FCF for a company that has a business transformation ahead to commercial, is facing a changed competitive landscape, needs to get out from under major leverage, and has an 86% seller attached to it. Who wants that?

Please call or e-mail with any questions.

Ami Joseph

Managing Director

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Yosef Vaitsblit

Analyst

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