On the whole, ADT (NYSE:ADT) has what should be a pretty good business model. Not only does the company have a large chunk of the residential security market, but customers sign multi-year contracts that lead to pretty reliable cash flow streams. Unfortunately, it's not quite that simple. ADT has to pay quite a lot to get those customers, the equipment certainly isn't free, and the accounting is not exactly crystal clear. All in all, it's no slam dunk that investors will feel secure with ADT in their portfolio.

Guide To Oil And Gas Plays: We've got your comprehensive guide to oil and gas shales in North America.

An As-Expected End to the Fiscal Year
ADT's first quarter as an independent company after its spinoff from Tyco (NYSE:TYC) looked pretty much as expected. Revenue rose 2% overall, with recurring revenue up a little more than 5%. Average revenue per user rose more than 4%, while net subs increased by more than 1%. Although the attrition rate crept up 30 basis points sequentially (to 13.8%), this was not altogether unexpected given ADT's recent price hikes.

Gross margin improved by three points from last year, while adjusted operating income decreased 4% on higher SG&A spending. EBITDA was a little soft, as legal expenses offset some benefits from a mixed shift toward more company-owned systems.

SEE: Understanding The Income Statement

A Simple Business That Really Isn't
In many respects, ADT's core home and small business monitoring business sounds like it should be one of those simple, ring-the-register types of businesses. Not only that, but with only about 20% penetration in North America, there should be a growth kicker as well.

Unfortunately it's just not that simple. For starters, while there are some similarities between ADT's business and those of TV service providers like DIRECTV (Nasdaq:DTV) or phone service providers like Verizon (NYSE:VZ), the differences matter.

ADT pays quite a bit to acquire customers (over $1,000 each), and many would-be customers balk at the hundreds of dollars in installation fees (after which comes a two- or three-year contract). Then there's the churn rate - over 13% of ADT's customers leave every year, which means there's no end to the customer acquisition/retention process. Last and not least, security equipment companies like Honeywell (NYSE:HON), General Electric (NYSE:GE), Tyco and United Technologies (NYSE:UTX) don't just donate their equipment to ADT.

And in some respects it gets worse from there. ADT's accounting gets pretty complicated, particularly with new customer adds. Depending on whether the customer comes through ADT or a dealer, and whether the customer or ADT owns the equipment, there are three different accounting treatments. The initial impact to operating income varies by as much as $900 between them. Due in part to how expenses are amortized, some analysts significantly adjust/modify the reported cash flow numbers. This is all well and good, but it's difficult for regular investors to track on their own.

But It's Not All Bad News
Those drawbacks aside, factors are working in ADT's favor. Although home security has nowhere near the penetration of cable TV or cell phones, it has been increasing, and a recovery in the residential housing market should improve this further. What's more, automation and the increasing use of smartphones are widening the scope of what ADT can offer its customers, and its new Pulse product/services should not only boost ARPU but also retention.

It's also worth noting that while ADT did see market share erosion during the past decade, the acquisition of Broadview has brought it back up to about 25% share - more than six times the size of the second-largest player, Protection One. Likewise, being free of Tyco may make the company a more nimble and aggressive competitor. While ADT's new Pulse offerings are quite solid, I believe the company lost some first-mover advantage on companies like Honeywell and UTX by waiting too long to roll it out, and only about 3% of the customer base currently uses Pulse.

SEE: Analyzing An Acquisition Announcement

The Bottom Line
Seeing that ADT is going to pay about a 1% dividend (in addition to a $2 billion, three-year share buyback plan) and trades at a trailing EV/EBITDA of about 8 times, I'm ambivalent on the shares. I realize other service providers like DIRECTV, Comcast (Nasdaq:CMSCA) and so on have lower multiples, but I also believe that reflects the higher market penetration rates, greater competition and more limited organic growth prospects of their markets. In other words, I think ADT is at a reasonable balance of growth, value and risk.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  2. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  3. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  4. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  5. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  6. Investing News

    How AT&T Evolved into a Mobile Phone Giant

    A third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
  7. Stock Analysis

    Home Depot: Can its Shares Continue Climbing?

    Home Depot has outperformed the market by a wide margin in the last 12 months. Is this sustainable?
  8. Stock Analysis

    Yelp: Can it Regain its Losses in 2016? (YELP)

    Yelp investors have had reason to be happy recently. Will the good spirits last?
  9. Stock Analysis

    Is Walmart's Rally Sustainable? (WMT)

    Walmart is enjoying a short-term rally. Is it sustainable? Is Amazon still a better bet?
  10. Stock Analysis

    GoPro's Stock: Can it Fall Much Further? (GPRO)

    As a company that primarily sells discretionary products, GoPro and its potential falls right in line with consumer trends. Is that good or bad?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center