Mon, 8 Oct 2012
Recent spin-off ADT has broad market share and solid competitive advantages, but several big-name telecom players also have their eyes set on the security space.
Jeremy Glaser: For Morningstar, I am Jeremy Glaser. A Tyco spin-off has created a new wide-moat firm, ADT. I'm here with Jim Krapfel. He is an equity analyst at Morningstar, and he's going to talk to us about why ADT has a wide moat and if the shares look undervalued.
Jim, thanks for talking with me today?
Jim Krapfel: Thanks for having me, Jeremy.
Glaser: Let's take a look at ADT. It's a brand name that a lot of investors are probably familiar with, but could you walk us through the business model a little bit and why it did get a wide-moat rating?
Krapfel: ADT provides home-monitoring services to U.S. and Canadian markets only. As part of the split, Tyco retains the ADT brand name for outside U.S. markets and in commercial end markets in the U.S. and Canada. So, the firm provides, as I mentioned before, home-monitoring solutions to residential and small-business customers. Customers must actually subscribe to three years to cover a substantial subscriber-acquisition cost. It takes ADT about three years to break even at each new customer, so that three-year-contract period is critical to getting into at least break-even on each new customer.
We assign ADT a wide economic moat. We think that it has three sources of the moat. One is switching costs. The three-year initial contract obviously locks up each customer. If a customer were to want to leave before the three years is up, they have to pay an early termination fee. That makes it little onerous for them. And then once even after the three years, they are unlikely to switch to a new provider given that there is going to installation charges again and they'll have to relearn a new system.
And the second source of the moat is intangible assets. ADT is very synonymous with security. It has a 25% market share in residential-home security and next largest competitor, Vivint, is only 6% of the market. So, Vivint and others don't carry the cachet that ADT does. So, a customer who thinks security is going to think ADT first.
And third is low-cost advantage. Having that superior market share is critical. ADT is able to better leverage its home-monitoring costs. Also it gets about half of new customers from other exclusive dealer network, so that provides it another avenue to grow beyond internal salesforce.
Glaser: So this business has these great competitive advantages. Why did Tyco decide to do the spin-off? What was the impetus behind that?
Krapfel: So Tyco prior to the spin had three very distinct business models, and ADT was the high-recurring-revenue portion of the business. ADT is 90% recurring revenue. It has very different capital needs. It can take out more debt. Also ADT can align management interest better, and ADT then as a stand-alone company could be an acquisition target for somebody else. ADT on its own we believe it makes more sense. So, we agree with rationale to a split up.
Glaser: So, what are some of the threats to its business?
Krapfel: Well, the long-term threat appears to be from the cable and telecom companies who have recently pushed into the home-monitoring business. Comcast right now is the biggest threat. It has spent a lot of money and has an ad budget dedicated toward its home-monitoring service launch which was just earlier this year. Early results are unknown. It hasn't released any subscriber numbers yet. So far, it looks like ADT hasn't lost any share pricing. The environment hasn't deteriorated, but we continue to watch that. Also AT&T [is another threat]. It has a major initiative to launch later this year or early next year with a nationwide home-security planned offering. Also, Verizon and others could launch in the future, too.
Glaser: How do you assess this treat then? Do you think that they are going to be very successful, that they are really going to be able to squeeze ADT? Or will ADT's competitive advantages be able to hold up?
Krapfel: Well, right now, we think there's a good chance ADT is able to maintain its lead. It's important to note that two thirds of the market is mostly composed of local and regional security providers. So, we think that any success that Comcast, AT&T, and others have will be mostly at the expense of the smaller players in the market versus ADT. And ADT has been able to grow market share over time, in the past, and we believe that any success [cable and telecom firms] have will be mostly the determent of the smaller players, not ADT. But there's a chance that given these companies' abilities to bundle home security with their other offerings as well as the marketing might that they have, they could shake up the industry and pricing environment. But that hasn't happened yet and we'll keep a close eye on that.
Glaser: How about valuation. Do these shares look cheap?
Krapfel: We have a $40 fair value estimate on ADT. Right now, the stock is about $38. So, it's at about a 5% discount to our fair value estimate. So it's not incredibly cheap. Investors looking to get in probably would want a higher margin of safety than what it provides now. It trades at about 20 times next year's earnings. So, it's definitely not cheap, but given the wide-moat nature of the firm, the 90% recurring-revenue cash stream, and the strong returns the firm generates year after year with little cyclicality, we think that premium is warranted.
Glaser: Jim, thanks for talking with me today.
Krapfel: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.