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By Jeremy Glaser and James Krapfel, CFA | 10-08-2012 02:00 PM

How Secure Is ADT's Moat?

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.

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