Moats that matter
ADT benefits from stickiness and high customer switching costs, in a similar manner to cell phone subscriptions. A typical customer of ADT’s services pays an initial installation fee and subsequently, monthly fees for the remaining term of the contract which is usually three years. Contracts which expire are automatically renewed for successive 30-day periods unless cancelled; and ADT receives a termination charge for any contract cancelled prior to the end of the contract term.
Growth drivers
According to its 2012 Annual Report, ADT has an estimated 25% market share of the $13 billion North American residential and small-business security market, based on IMS research and ADT’s internal analysis. In contrast, ADT’s closest competitors such as Protection One, Monitronics International and Vivint have market shares of 4%, 3%, and 2%, respectively. Given the fragmented nature of the security market and ADT’s dominant market position, ADT Corp (NYSE:ADT) will have to either ride on the growth in the North American security market or grow through M&A, than take market share from existing competitors.
In terms of industry growth, the under-penetration of ADT’s target markets for home security services is often touted as a strong driver of growth. Based on research from Parks Associates, home security penetration is estimated at 19% of U.S. households, significantly lower than other home services such as television and Internet, which are in 70-90% of households. However, consumers are generally unaware of technological advancements in the home security market and cost savings with less expensive IP-enabled security equipment. Ironically, an internet connection at home is now viewed as more important and less discretionary than a home security solution by consumers. According to a Barrons article in February this year, ADT could potentially acquire its competitors which are mostly owned by private equity firms.
Valuation and peer comparison
ADT Corp (NYSE:ADT) currently trades at a trailing twelve month EV/EBITDA of 8.4 and a forward P/E of 27.1 based on Reuters data. Its closest listed competitor in the home security market is Ascent Capital Group Inc (NASDAQ:ASCMA). Ascent Capital owns 100% of the interest in its operating subsidiary, Monitronics International, a home security alarm monitoring company, which has an estimated 3% market share of the North American residential and small-business security market. Other companies operating in the security industry such as Checkpoint Systems, Inc. (NYSE:CKP) and Brink’S Co (NYSE:BCO) are also included for comparison purposes. Checkpoint Systems is a manufacturer and provider of loss prevention, merchandising and labeling solutions to the retail and apparel industry. The Brink’s Company (Brink’s) is a provider of secure logistics and security solutions, including the transportation of valuables, cash logistics and other security-related services.
This peer valuation exercise is made difficult by the fact that Ascent Capital Group Inc (NASDAQ:ASCMA) and Checkpoint Systems are loss-making for the past twelve months. I get around this by using metrics such as trailing twelve month EV/EBITDA and forward P/E. ADT is valued at similar levels to Ascent with both stocks trading at eight times trailing twelve months EV/EBITDA. However, ADT is profitable and has a stronger balance sheet than Ascent with a debt-to-equity ratio of 48%.
In comparison, Ascent Capital Group Inc (NASDAQ:ASCMA) is expected to remain in the red for fiscal 2013 and 2014, and is highly geared with a gross debt-to-equity ratio of 190%. With respect to other security companies which are not direct competitors of ADT, Brink’S Co (NYSE:BCO) is relatively cheaper than ADT with a EV/EBITDA of 4.6 and a forward P/E of 14.4. Checkpoint Systems, expected to be profitable in fiscal 2013 based on analysts’ consensus estimates, also trades at a lower forward P/E of 18.1. The market is apparently rewarding ADT with premium valuations for its profitability and predictable, recurring cash flows. In fiscal 2012, recurring revenue from monitoring, home/business automation services and maintenance services governed by multi-year contracts with automatic renewal provisions, represented 90% of ADT’s total revenue.
Capital allocation
Despite its short listing history, ADT has made efforts to return capital to shareholders through dividends and share repurchases. ADT Corp (NYSE:ADT) distributed two quarterly dividends of $0.125 each in Dec. 2012 and Jan. 2013, respectively, and currently sports an annualized dividend yield of 1%. On Nov. 27, 2012, ADT’s Board of Directors approved a share repurchase program authorizing the purchase of $2.0 billion of its common stock over the next three years. The quantum of share repurchases is significant for ADT’s shareholders, given that $2 billion represents more than 15% of ADT’s current market capitalization.
