Are Cheap ADT Shares Just Another Value Trap?
ADT is a leading home security solutions company. ADT owns about 25% of the highly fragmented home security market for homes and small businesses, while its main competitors, Vivint and Monitronics, command a mere 4% each, and about 60% of the market is controlled by much smaller companies. ADT was spun off from industrial conglomerate Tyco International in 2012.
Many studies have shown that corporate spinoffs tend to create substantial shareholder value. But, ADT has been one of the outstanding exceptions to this trend, as its shares have badly lagged both the S&P 500 and those of the mother company since the spinoff.
The shares were ranked ninth in the list of most-shorted stocks in the S&P 500 in April.
The huge sell-off this year, as seen in the chart above, was triggered by the company's less-than-ringing first-quarter fiscal 2014 results. Although the company's recurring revenue grew by 4.2%, spurred by 3.1% growth in average revenue per customer, investors focused more on the underwhelming 0.7% net growth in the company's customer base. EPS also fell from $0.44 in the first quarter of 2013 to $0.39 in the first quarter of fiscal 2014.
Second-quarter revenue grew 1.9% year over year, while EPS grew 19.5% to $0.49. Although this wasn't very impressive, it also wasn't bad enough to warrant such a huge sell-off.
Investors have been giving the shares a wide berth, primarily because they fear that the entry of Comcast and AT&T into the home security solutions market will muddy the waters for ADT.
Comcast launched Xfinity Home Security solutions in 2011, while AT&T introduced Digital Life last year. Investors figure that these companies can easily bundle home security solutions with traditional services like cable, Internet, and voice, passing the resultant cost savings to customers. Investors attributed the slow growth in the company's customer base to competitive pressure from these giants.
ADT had a customer attrition rate of 13.9% in fiscal 2013. The company breaks down the figure this way:
- 5% of customers relocated
- 3.6% of customers failed to renew their subscriptions and were disconnected
- 3.9% left voluntarily
- 1.4% were lost to telco and cable companies such as AT&T and Comcast
Therefore, it appears as if Comcast and AT&T are not doing as much damage to the company's business as many investors fear. Moreover, the rate of new customer starts still outpaces the rate of customer churn.
In the past three years, the company won, on average, 46% of new customers that joined the market, while the rest was shared between other security companies, Comcast, and AT&T. With close to half of new available customers choosing ADT, the company's overall market share relative to rivals should improve gradually.
As a whole, the home security industry has been growing at an approximate 4.5% CAGR since 2006, and the penetration rate of home security solutions in the U.S. is still low at just 19%. This provides the company with a great growth runway.
Pulse popular with customers
ADT's new mobile app, Pulse, is the engine that is driving growth for the company. Pulse allows users to easily arm or disarm their security systems, and also offers other attractive features such as climate control, home automation, video, climate, and light control. Close to two-thirds of the company's new residential customers in the second quarter of the current fiscal year were Pulse customers.
Pulse also commands 25% higher revenue per customer than the company's other customers. Pulse customer attrition rate is just 40% of the company's other customers, reflecting the popularity of the service. Currently, Pulse makes up just 12% of the company's total customer base, giving the platform plenty of room for growth.
ADT has been aggressively repurchasing its shares since it broke off from Tyco. Investors have, however, been hard to impress, and shares have continued to slide.
ADT's biggest weakness lies in its high debt levels. The company's long-term debt clocks in at $4 billion, while its debt-to-equity ratio is 150%.
However, as long as customer retention and product pricing remains high, the company's recurring revenue and healthy margins will be adequate to keep the debt within manageable range. Moreover, the company's high percentage of recurring revenue (92%) makes it a nice cash machine, and shares yield 2.5%.
Foolish bottom line
ADT investors have been overreacting to the implied threat of Comcast and AT&T. While most analysts rate the stock a sell, bold contrarian investors should seek entry points in the beaten down shares and wait for the market to finally realize its mistake here.
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The article Are Cheap ADT Shares Just Another Value Trap? originally appeared on Fool.com.Joseph Gacinga has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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