Investors Need to Take ADT's Pulse

Investors Need to Take ADT's Pulse

Since its separation from Tyco International last year, ADT has given some value to its investors -- up slightly more than 10% in exactly one year. However, since riding up near $50 per share in the early months of 2013, the stock has given back the bulk of its gains, leaving investors wondering if something is wrong. In many ways, ADT is a phenomenal business -- it's a market leader (the largest security company in North America) with increasing recurring revenue (the best kind of revenue) and nearly unparalleled customer service. The problem, at first glance, appears be a matter of valuation, which allows for little flexibility in short- and near-term results. Is this the case?

Growing gains
After moving out of its parents' house in October 2012, ADT has proven that its business continues to grow and its growth platform allows for plenty of upside potential, in stock price and otherwise.

The key to ADT's future is Pulse, its version of home automation. Using its existing sales and distribution channels, ADT is finding success in its Pulse product, even with sharp competition from some big names such as Verizon and Time Warner, which have arguably better distribution channels and a more recognizable imprint in customers' homes. Home automation is still a young industry, and market penetration is well under the 25% that ADT security systems hold.

ADT is comfortably capitalized, and will be able to plow enough money into the Pulse business to continue its foray into the segment and, at the very least, maintain its market share or (more likely) grow it. Currently, more than 4% of ADT's customers are signed up for Pulse, leaving nearly everyone as a potential upsell. The promotional opportunities here speak for themselves.

Meet me out back
ADT is a cash flow machine, and these cash flows come in on the back end. Up-front expenses for the company are high regarding customer acquisition, but with an average of seven years, each customer remains so the company's gains right now are far more beneficial three years down the line -- the breakeven point for profitability.

A near-21 times forward earnings multiple makes the company look expensive, especially considering that it is not a fast grower. However, this metric does not quite tell the story. Once again, ADT's cash and earnings come from accounts acquired a few years ago. In the meantime, costs are high and earning potential looks limited and, thus, richly valued.

All in all, ADT isn't a bargain based on today's fundamentals. The Pulse growth platform, though, is quite compelling and spells for even greater cash flows in the future, which will find their way into investors' pockets. Playing on the growth of home automation and business with sound economics, ADT looks appealing today.

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