A Leading Home and Small Business Security: A Spin-off Opportunity?
Anh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Note: This article erroneously referred to Monitronics as a private company. In fact the company is a subsidiary of Ascent Capital Group. The error has been corrected below.
Spin-off opportunities are always quite interesting for sophisticated value investors. In many cases, the parent companies have several businesses under their umbrellas. And they would tend to spin off subsidiaries, which are not the parents’ core businesses. The reasons for spin off might be to increase the value of both the parents and the spin-offs in the stock market, or take advantage of tax benefits. As the shareholders of the parents normally don’t like to hold strange stocks, they often sell spin-off stocks right after distribution. So in some cases, spin-off situations can offer good returns for investors if chosen carefully.
Recently, Tyco International (NYSE: TYC) has spun off its North America home and small business security and alarm service, ADT (NYSE: ADT). ADT can be considered to be the largest company in the industry with 6 million customers, 200 local alarm service centers and 16,000 workers. ADT estimated that it accounted for around 25% market share in the US. Should investors participate in this recent Tyco’s spin-off situation? Let’s find out.
Tyco currently has more than 459.7 million shares outstanding. Each share of Tyco will receive 0.5 shares of ADT common stock. So the total number of shares outstanding of ADT would be nearly 229.7 million.
Following ADT’s filing, ADT’s financial performance seems to be quite good. The annualized growths of its revenue, operating income and net income for the last 3 years are 11.4%, 13.5% and 15.7% respectively. As of September 2011, it had nearly $400 million in net income and $537 million in free cash flow. For 9 months ended June 2012, its pro-forma net income and free cash flow were $313 million and $325 million, respectively. Naturally, ADT would need significant capital expenditure, of around 30% annual revenue, to expand its subscriber base. It was a good sign that ADT has been able to generate sustainable FCF despite high capital expenditures it has to spend.
Currently, ADT is trading at $38.80 per share, with the total market capitalization of $8.92 billion. If we assumed that ADT had the same net income and free cash flow as of fiscal 2011, the market is valuing ADT at 22.3x P/E and 16.6x P/FCF.
ADT issued $2.5 billion of debt following with the spin-off. Recently, Fitch assigned a BBB+ rating for the company. It projected that pro-forma leverage as measured by debt/EBITDA to be in the range of 1.5x – 1.8x. Fitch believed that ADT’s competitive advantage would remain in the near-to-intermediate term and it would generate around $400-$500 million during the next few years.
It announced that the company intended to pay quarterly dividends on the proportionate share of the $1 per share annual dividend that Tyco was paying to its shareholders. It means the annual dividend would be $0.5 per share. At $38.80, the dividend yield would be 1.29%.
One of the key factors to look at in spin-off situations is insider ownership. Personally I would prefer heavy management’s stake in the spin-off company. It means that management will do whatever it takes to improve the company’s operating performance and efficiency, so that its stock price can increase over time.
For ADT, it doesn’t seem to be so encouraging. All 21 insiders including Directors and Executive Officers, owns only 58.9k ADT’s stock. It is worth only $2.29 million, representing 0.026% of ADT. The President of Tyco Security Solutions, Naren Gursahaney becomes the CEO and a member of the board in ADT. The company’s CFO, Kathryn Mikells is a new member as she just joined ADT in April 2012.
The direct competitors of ADT are Protection One, Monitronics International and Vivint. However, Protection One and Vivint are private companies while Monitronics is a subsidiary of Ascent Capital Group. So in a broader extent, I will compare ADT to other players in the security industry such as Checkpoint Systems (NYSE: CKP) and Secom (SOMLY). CKP has had fluctuating free cash flow over the years, and recently it generated negative free cash flow and net income. So its P/E ratio is not valid. And Secom has generated quite sustainable positive free cash flow in the last 10 years. At the moment, the market is valuing Secom at 18.2x P/E, higher than industry’s average of 13.9x but lower than ADT’s of 22.3x.
My Foolish Take
ADT seems to be a stable cash generator even after spending significant capital expenditures to acquire more subscribers. The company has an advantage of having huge market share in the home and small business security industry. However, with a high valuation and no significant ownership of its insiders, I would not consider initiating any positions in ADT now.
hoangquocanh has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.