TheSecurityAnalyst

I am gratified by the encouragement and response from the several thousand unique visitors to the site TheSecurityAnalyst.com since I started it in May.  Since being picked up by Seeking Alpha at the end of June, I have been swamped with requests for a listing of the earlier blogs on the industry that are not currently on the website.  So here is the complete listing of our blogs in reverse chronological order.

 

07/02 – In An Economic Slowdown, Government Contracts Become Important for the Security Industry.  Four security companies demonstrating good growth in a bad economy, thanks to strong Government contract flow: FLIR, L-1, ICx Technologies, and China Security & Surveillance.  (Note:  ICx announced today yet another contract for its “Cerberus” surveillance towers, this time its first from the Secure Border Initiative).

 

06/29 – Has Single-Sign On Finally Hit “Prime Time” With Security End Users?  We may be at the inflection point of improved technology and enterprise end user demand for single-sign on solutions as part of the convergence of physical and logical security systems.

 

6/26 – China Security & Surveillance: Go-to-Market and Strategic Leadership in Security in China.  The leading domestic security company in China has developed a huge advantage (no channel conflicts between its manufacturing, installation, integration and monitoring businesses), in the world’s fastest growing security market (independent of the Olympics).

 

6/23 – “REAL ID” Controlled by a Foreign Entity?  Safran S.A. Bids Against L-1 for Digimarc’s ID Business.  With all of the hoopla over personal privacy and REAL ID, we just thought it a bit odd that an foreign entity, 30% owned by a foreign government would bid against L-1 for Digimarc’s ID (drivers license) business.  Oh well, at minimum they forced a competitor to pay $50 million more.

 

6/18 – Guest Blog: Risk of Critical Failure in Monitored Alarm Industry.  Guest blogger, and long-time monitoring industry consultant Lee Jones emphatically warns against industry laxness regarding false alarms and the looming threat of non-response without verification.  His point:  “The alarm customer and the police, the two most critical segments of the infrastructure, have been abused. We believe the alarm industry is losing the loyalty of both parties. Without the loyalty of the customer and the police, the entire infrastructure as we know it today, could collapse. “

 

 

6/15-6/16 –  Do Not Ignore L-1 Identity Solutions As the ID Market Grows.  The identification market (along with biometric technologies) is now sprinting in its growth and here is the undisputed market leader – like it or not.

 

6/12 – Stanley-Sonitrol: Strategically Smart, But with Franchisee Relationships to Fix.  Stanley Works is becoming a legitimate security systems integration threat to the likes of Siemens, ADT, and Securitas Systems (recently renamed Niscayah), with its acquisitions of HSM Security and now, Sonitrol Management (the leading brand for verified, quick response by police).  However, Stanley has also acquired some very frayed relationships with Sonitrol’s significant franchisee system, which will have to be fixed.

 

6/10 – ADT’s Growth Strategy Unveils its Underestimated Integration Business.  ADT now comprises the largest single entity of any of Tyco International’s revenues and over half of its EBITDA.  We think Wall Street analysts are missing a key development underlying ADT – its already well-regarded and now growing systems integration business.

 

6/4 – BHS Steady State Cash Flow Still High, per SEC Filings.  As a follow-up to our June 2 blog, with the SEC filing by Brinks Home Security on its proposed spin out from Brinks, several investors asked us to recalculate the 2007 steady state free cash flow of the company (SSCF being the most important metric besides attrition).  Taking on its own corporate overhead, BHS SSCD for 2007 falls to 178.5 million (36.8% margin) from our previous estimate of $191.3 million (39.5%).  However, that is still way above the margin of any other public monitoring company and virtually the highest of any public or private company.

 

6/2 – Sonitrol: Can the Vaunted Franchise System & Brand Hold Together?  With rumors in the industry that the Sonitrol business was close to being sold by its private equity owners, we issued a warning to any buyer of this verified alarm leader:  Fix the relationship with the franchisees.

 

6/2 – Brinks Home Security:  A Brief Look at “The Surprises.”  On May 30, BHS filed a “Form 10” with the SEC, representing its preliminary pro forma financials as well as its ongoing relationship with Brinks Inc.  Along with the financial pro forma’s, there are two “surprise” issues which popped up in the filing (you have to dig to find them):  (a) the loss by BHS of its “Brinks” brand in three years and (b) the royalties that BHS has been paying to Brinks – over $30 million in 2007 — which were formerly not reported (or at least never seen by me).  The ongoing royalty payments fall dramatically, however.

 

5/13 – Somebody Needed to Love Protection One.  Protection One has a great management that has fixed a disaster and stabilized the company, the third largest monitoring business in the U.S.   However, a thinly traded stock, lack of growth and a balance sheet that won’t allow a lot of acquisitions has investors snoozing on this name.  We still think investors may be asleep at the switch on this one.

 

5/13 – Video Standards That May Finally Mean Something.  On May 12, a consortium of Axis Communications, Sony and privately-held Bosch – three of the leading names in video surveillance, formed a group aimed at developing a standard for the interface of network video products. Currently, while there are video compression standards (MPEG-4, and the new H.260), there is no global standard defining how network video products such as cameras, video encoders and video management systems should communicate with each other.  Note: This blog actually generated a lot of comments around why it has even taken this long for open systems to emerge in video, along with skepticism that proprietary video systems (which are maybe good for individual companies, but bad for overall industry growth), can be “overcome” any time soon.

 

5/13 – FLIR Systems and Axis AB:  A Tale of Two Video Technology Companies.  Axis Communications (Axis AB, based in Lund, Sweden) and U.S. based FLIR Systems are the two leading companies in their respective technological niches in the $7 billion video surveillance industry.  Axis is the leading provider of IP network video cameras, while FLIR is the leading provider of infrared cameras for surveillance and thermographic (temperature control) use.  Unfortunately, for Axis, a couple of its key commercial markets are slowing due to the economy – and hurting its stock.  Fortunately for FLIR, its Government business is booming, as is the rapid expansion of infrared in non-military use – helping its stock.  We like both companies; investors will have to talk to their analysts to make their own timing choices.

 

The writer current holds positions in L-1 Identity Solutions, ICx Technologies, and is considering a position in China Security & Surveillance.

It is ironic that we have been writing for years that Government contracts are very important for the security industry, but ultimately most of them –even the largest – should mostly serve as beta-tests and reference sites for what should be a much larger industrial/commercial and institutional market.  Over the long term we believe commercial/industrial contracts are steadier and involve greater recurring revenues.  But, of course, during economic slowdowns it might just be a big help to depend on those Government contracts.  Some of the companies we have written up in our blog are doing just that – accelerating their Government business.  Whether it is the slow, but inexorable movement to improve identity management here, or protect sensitive domestic installations and ports, or to protect troops in the war theater, the companies that are winning these contracts (especially those smaller companies winning subcontracts and branding themselves in the process) are actually doing quite well in a bad economic environment.

 

Below we detail four security companies in the security industry, three on which we have written blogs, and one which we covered in a “past life,” which are likely to at least meet, and possibly beat estimates or management guidance, simply because their Government  contract momentum is so strong.

 

FLIR Systems.  The first, and perhaps most obvious beneficiary to Government contracts in the security industry this year is FLIR (see “FLIR and Axis AB: A Tale of Two Video Technology Companies,” published May 13).  Although our long-term investment case on FLIR is built on lower sensor costs accelerating demand in commercial, security, and civilian markets, it is military orders that have driven the stock up (37% year-to-date), and analysts’ estimates with them.  Indeed, one might speak of an avalanche of military orders, eight since late May, including the largest, a $358 million revision to an IDIQ (indefinite delivery indefinite quantity) order for the U.S. Army.  The orders range from infrared cameras on military vehicles, Coast Guard helicopters, surveillance airplanes in Colombia, medium-range thermal binoculars, and sensors to go on sensor-studded 8-10 story towers that the Army wants to have in Iraq and Afghanistan to protect each company of soldiers.  Those orders are part a two-year, $1.5 billion program called Base Expeditionary Targeting and Surveillance Sensors-Combined (BETSS-C).  FLIR’s current consensus estimates are $1.27 in 2008 and $1.46 in 2009, but that consensus is rising even as we write this blog.  The only questions for FLIR are what is the proper P/E on 2009 estimates, and are those estimates taking into account the tough growth comparisons they will now face for 2008.  For analysts, there is always something to gripe about.

 

ICx Technologies.  Another beneficiary of the BETSS-C program is ICx Technologies (ICXT), a company which we have covered in the past, but only now are writing the first blog, has also just won a series of new contracts.  ICx, though small (consensus estimates are $180 million for 2008), has nevertheless become the leading independent provider of small explosive/radiological/biological detection equipment, radar and infrared surveillance technologies, and “integrated solutions” combining the above.  ICx’ announced on July 1, that it had won a $14 million contract under BETSS-C for its “Cerberus” surveillance towers on which the sensor technologies from other companies (like FLIR) will be mounted.  Given the size of BETSS-C, we doubt this is the last order we will hear regarding ICx and FLIR.  However, ICx is also far more than its towers – indeed most of the attention from the investment community centers around its “Fido” handheld explosives detection devices, including its unique patented ability to detected hydrogen peroxide—based liquid explosive, where in May it won a $5 million contract from the military (Robotics System Joint Program Office). Nevertheless, ICx has just shocked at lot of folks when its Solutions division also won a $15.6 million contract at the end of June to manage an “intelligent transportation system: for Orange County, California.  The ICx contract includes installation of a real-time, bus-arrival passenger information system, preliminary design of a signal priority system and signal system enhancements to improve arterial operations.   Analyst consensus for ICx are for revenues of $180 million in 2008, with a GAAP loss of $0.72 per share and breakeven EBITDA.  Consensus estimates for 2008 are for $238 million in revenues, $0.10 per share in earnings, and EBITDA of $33-$35 million.

 

L-1 Identity Solutions.  We have recently written in-depth about L-1 Identity Solutions (ID), the leading provider of identification solutions (“Do Not Ignore L-1 Identity Solutions as the ID Market Grows,” published June 15).  We strongly believe there will be consolidation among several of the long lineup of  U.S. and international identification programs now being implement and that L-1 (with the Digimarc acquisition in hand) will have a major role in many as a subcontractor or as a prime contractor.  Moreover we refuse to believe that the  highly publicized ID programs — PassCard program at the national level and Real ID at the state level — are going to be limited to their current budgets in the $220-$350 million range.  We are convinced there will be far greater dollars spent in these “regional” and “state-by-state” programs than what is budgeted today…  Finally the consolidation of identification programs should affect nearly all domestic initiatives from HSPD 12/24, to PassCard, to Western Hemisphere Travel Initiative, to US-Visit, to TWIC, Real ID, to Sarbanes-Oxley, to HIPAA, and war theater and defense identification.  We also believe there will be consolidation of Gulf States national identity programs, Latin American voting and ID programs, and even to Indian tax card and ID programs.  To get to the heart of the matter, we believe that both the “updated” drivers license and military identification programs are going to have a positive effect on L-1’s results in 2008.  Indeed, the company announced on June 27, a $5 million contract delivery for its HIIDE (Handheld Interagency Identity Detection Equipment), the company’s well regarded multi-modal biometric (iris-face-finger) handheld ID unit (customer not announced, but we assume it is the U.S. military), which we also assume will have follow-on orders.  Company management has guided to $670 million of revenue in 2008 (all numbers are pro forma, assuming the acquisition of Digimarc on January 1, 2008), EBITDA of $110 million, and a backlog of $1 billion.  Most recent analyst consensus GAAP estimates are for $0.15 in 2008 and $0.35 in 2009.

 

China Security & Surveillance.  Finally, we would again mention China Security & Surveillance (CSR) as a perfect example of a company where Government programs are driving revenues, even within a country that is trying to slow its economy down (“China Security & Surveillance: Go-to-Market and Strategic Leadership in Security in China,” published June 26.)  Although over half of the company’s revenues are in the commercial sector and subject to a planned slowdown in China, the percentage of growth from Government programs is growing rapidly.  While the company has won large contracts in the cities of Yinchaun, Jining and Qungzhou City, our sources believe there will be a series of $10+ million-sized contracts coming over the course of 2008 into 2009 which will be more typical of the types of contracts to be won.  The company just won its first two projects in Beijing, and we believe that government projects, once scaled up and proven out will lead to more commercial projects as well.

 

The author has a position in L-1 Identity Solutions and ICx Technologies, and is considering taking a position in China Security & Surveillance.

Note:  Our blog below on China Security & Surveillance may appeal to a more limited audience than our previous blogs on monitoring and identification.  For those of you on our new, expanded list, please look at these other blogs as well before indicating that you want to be taken off the distribution list entirely.

On the heels of a follow-up report by the Security Industry Association (which very conservatively projects Chinese security industry spending by 30% to $11 billion in 2008, we have contacted three independent sources just back from viewing Chinese commercial and government security installations to check just which companies appear to lead the Chinese market. Our sources remind us that the government-sponsored China Public Security Guide estimates the 2008 market at over $26 billion – bigger than the SIA study, but to us clearly less independent.  Our sources are convinced that China Security & Surveillance (CSR:NYSE) has major advantages in the mid-sized China security surveillance market and should be a company to watch closely.

We have done background work on a number of Chinese security companies. While we find two of the companies, a leader in fire systems and the other, a leader in geospatial surveillance software, interesting in their own right, they are both much smaller than our focus in this blog – China Surveillance & Security (CSR) – China’s leading domestic security surveillance company, and our Chinese researches reiterate that this is the company to watch.

With management guided revenues of $380 million in 2008, CSR is more than the leading homegrown security company in China – it has go-to-market advantages that are not appreciated by non-security analysts who are looking only at the stock valuation, or only at the financials. The company has won numerous contracts in China’s growing “Safe Cities” program (video surveillance of dome 600-plus cities), and its contracts are growing in size, having moved from the sub-million size to the multi-million size just within the last year. While the company has won huge contracts in the cities of Jining and Qungzhou City, our sources believe there will be a series of $10+ million-sized contracts coming over the course of 2008 into 2009 which will be more typical of the types of contracts to be won.. The company just won its first two projects in Beijing, and we believe that government projects, once scaled up and proven out will lead to more commercial projects as well. We would note that commercial security still constitutes over 50% of revenues.

Finally, just so everyone understands, CSR is already the (a) largest indigenous systems integrator in China – we note another five very small companies as competitors, (b) largest security product manufacturer in China – we note one significant Chinese video technology manufacturer as a competitor, and (c) largest non-government monitoring company in China (even though this last revenue category is barely at the double-digit million level at this point, but with literally no other private competitors). This would be like combining Siemens Building Technologies on the integration front, with Honeywell on the equipment front with ADT on the monitoring front in one company operating exclusively in one country. It could never happen in the U.S. or Europe, because the service and monitoring companies would never buy from Honeywell, and the equipment companies would never sell to Siemens and ADT, because of channel conflicts. However, it can, AND IS, happening right now in China via CSR.

So, what do prospective competitors in China, and public investors in CSR’s stock have to wrestle with?

Pluses:

• CSR has created a unique company in the security industry, no other security company we know of controls its manufacturing, distribution, installation & integration, and finally, its monitoring business. China’s lack of an existing security channel infrastructure has allowed CSR to create such a business.
• The Chinese security industry is not being driven primarily by the Olympics, even though it is a real factor. The industry is being driven by a Five-Year plan that intends to provide video surveillance and monitoring to the 600 largest cities in China (“The Safe Cities” project), and State Ordinance 458 to rid gambling, bar and karaoke establishment of “unsavory” business practices. The Olympics are coincident with the Five-Year plan, not a substitute for any of these security programs. Indeed, even as many businesses in China slow down to accommodate dislocations caused by the Olympics, our sources have come back saying the government-sponsored security projects are showing absolutely no deceleration.
• The company has the potential to become the major integrator, with major long-term monitoring contracts, favored by investors. The equipment brands CSR has bought have generally been the brands most consistently spec’d by its commercial and government customers. As time goes on and the company builds its REAL brand around installation, integration and monitoring, the equipment brands can be almost seen as a separate company one day, or even spun out.
• Our sources tell us that the company is becoming very successful in becoming the security installation and equipment brand of choice in mid-size Chinese cities for both commercial and government end users. CSR is also well ahead of any domestic competitors in forming joint ventures and partnerships with Asian companies outside of China.
• Although companies like Honeywell, IBM and Siemens and General Electric are the primary participants in the Olympics (and for the very largest Safe City installations), we believe that for to maintain share in China, particularly as the middle government and commercial market grows (according the SIA report), they are going to have to increasingly deal with CSR and its widening regional partnerships and advantageous go-to-market position.

Minuses:

• The company is not covered by major investment banks in the U.S. (BNP Paribas just initiated coverage), which has allowed traders to take advantage of volatility in the stock. Some of this volatility emanates from negative reports written by the successor to the old CIFRA organization which did not like the way the company recognized revenues, nor recognized pro forma earnings in place of more conservative reporting. While the company management has slowly learned what investors accept and don’t accept in reporting numbers, we also believe that the company’s position in China in winning new contracts with increasing long-term contractual cash flows will make this negative arguments irrelevant.
• The company’s corporate management needs to beef up. Mr. Guoshan Tu, Chairman and CEO, is a highly successful entrepreneur and was prescient in setting up over 40 distribution points around China for the integration business – before selling any product. He is clearly very market savvy, but lacks a pedigree in security. Terence Yap, who has assumed the role of vice chairman and chief financial officer, appears to be working 28 hours per day, and probably needs more personnel in the financial side so he can concentrate more on operations.
• The company must integrate its brand among the many equipment acquisitions it has made, but do it in a way that evolves the brands into CSR without worker or end user frictions. One of the key elements in doing this is the creation of an major manufacturing campus near Shenzhen, where most of the product company employees will work. This site is key to integrating cultures and personnel and brands. So far, the final papers have not been signed for this site, although our spies from China tell us there is already activity there. Nevertheless, the campus was announced nearly a year ago and the delays in finalizing the moves of the product companies is frustrating.
• The company needs to somehow refinance or rid itself of two convertible debt issues totaling some $110 million, whose conversion features are great for the private equity paper holders, but onerous for the company. These converts were issued when the company was much smaller, seeking growth, and someone stepped up with capital. However, for this size company, it becomes very expensive and dilutive capital – the GAAP accounting for the issues is impossibly harsh — (not to speak of the hedging/shorting that goes along with the issue) and management should find a way to unburden itself of these issues, without blowing up the balance sheet. Free cash flow was positive for the first time in 2007, but at $18 million did not overcome the $82 million used to acquire companies. The company will have to improve its free cash flow in 2008.

Conclusion:

While we cannot comment on the stock and price targets, clearly we believe this is a company security industry and investment industry professionals should be watching. With the above pluses and minus, we would reiterate that China Security & Surveillance is the only security company that we know of that has no legacy channel conflicts and can manufacture, install, integrate, distribute and monitor security equipment and systems on its own to a very large market. That in and of itself is neither good nor bad, however a combination of qualities has convinced us that CSR has enormous advantages over local competition and has a potentially lucrative future. With consensus estimates (we would include the dilution from two convertible debt issues) at about $1.00-$1.05 for 2008 (an estimated P/E of about 14x), and with estimated EBITDA for 2008 at $65-$70 (EV/EBITDA of less than 10x), I believe these are reasonable valuations relative to the balance of pluses and minuses we tote up on this Chinese industry leader.

On June 2, we put out a blog that industry scuttlebutt had the Sonitrol Management Corp. (owned by three private equity firms) being on the block for sale, with Stanley Works having the inside track .  The main point we tried to make was that whoever bought Sonitrol Management would need to deal with a deteriorated franchisor-franchisee relationship – a relationship that has been important to the branding of Sonitrol with responders as THE verification monitoring company (please read our June 2 blog on Sonitrol for full details on the company).  We would reiterate this point to Stanley Works’ Convergent Solutions divisional management — to take note of the generally unhappy franchisee group in Sonitrol.

Transaction Seems Reasonably Priced.

The announced transaction was that Stanley will buy Sonitrol Management for $275 million in cash.  We believe that Stanley could gain yet another highly regarded brand, and complement its installation, and data-intensive HSM monitoring businesses.  $275 million is about 48.2 times the $5.7 million of recurring monthly revenue generated by Sonitrol Management.  But that does not really tell the tale of the tape.  Sonitrol Management receives what we have estimated to be nearly $4.0 million of annual royalties from the franchisees (equaling another $333,000 of very-high margin fees per month), plus over $9 million of products sold by franchisees (which we would value at a much lower multiple).  So let’s just assume for the sake of argument that the products business is worth $25 million and we take it out of the price (maybe we are giving it too much value).  If the above calculation holds, Stanley is paying $250 million for $6.033 of high margin monthly revenue ($5.7 million of RMR, plus $0.33 million of monthly recurring royalties).  That is about 41x RMR and much more reasonable, given that the trading in Sonitrol franchisees has been at 40x or below.

This is Not Your Ordinary Franchise System

So, on the surface, Stanley is getting a premium brand with police (and most end users) for a reasonable price.  However, as we noted in our June 2 blog, anyone who buys Sonitrol must take into account the franchise system, which may be unlike any group we’ve encountered before.   There are Sonitrol franchisees that have only known Sonitrol monitoring and may never sell their businesses.  Given the past difficulty in integrating the Sonitrol audio system with anything else a monitoring did (there are still “special” Sonitrol rooms inside a much broader based monitoring company), many transactions were done solely “within the family” and at multiples that were 10%-30% lower than commensurate RMR valuations – and that was before the more aggressive stance by Sonitrol Management on right of first refusal, as a way for it to grow.  

Most important, no other franchise network that we know of (including businesses outside of security) has developed the near cult-like status that gives Sonitrol franchise meetings as near as a religious camp out.  There are even rifts between those franchisees who are “pure” Sonitrol providers and those who dare to sell other services and products.   

However, since not all is going smoothly in Sonitrol franchisee land these days, a situation which may or may not have been able to be avoided, given the intensity in which some of the franchisees believe in their business.  A lot of the relationship problems began under Sonitrol’s ownership by Tyco and just got worse when three private equity firms bought the business in 2004.  Admittedly, had I been the buyer of the Sonitrol Management Corp., and in private equity, I too would have been focused on cutting costs, trying to build up a national accounts program, and buying up franchisees under right of first refusal.  This would in and of itself create tension, but why am I seeing this level of franchisor-franchisee tension? Again, I don’t know where all the current friction is coming from, but something in the always critical franchisor-franchisee relation is amiss.   Sonitrol cannot become more successful – without a major downward ratchet in size — with franchisees ready to bolt, if the new buyer pushes a centralized policy without repairing these relationships.

Conclusion:  Sonitrol’s new buyer has a great opportunity to build its commercial industrial brand, but first needs to talk to the franchisees, set out a strategic policy that either fully includes them or sets them free.  The current state of affairs is unsustainable.

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Sonitrol Factoids:  Tyco sold Sonitrol Management Corp. in 2004 for $125.5 million, to a group of private equity investors, including Spire Capital, Carlyle Venture Partners, Wachovia Capital Partners.  At the time of the acquisition, the management company claimed about $85 million in revenues.  Now there is $125 million ($5.7 million in RMR), much of the increase coming from seven acquisitions.  Total system revenues are closer to $225 million and haven’t changed that much over the last five years.  About 45,000 of the 125,000 users are and owned by Sonitrol Management Corp., and the rest by franchisees.   Nevertheless, it is fair to say that Sonitrol Management has become significantly larger and more profitable in the last four years.  There are over 100 direct national sales reps (and increasing number) and over 110 franchise locations (a decreasing number).  

 

 

 

I am warning readers:  This is going to be a long blog on ADT Worldwide.  While I have received good, meaty feedback on our mainly monitoring-related blogs over the past few weeks, I have also been getting some static, prodding me to write about more end-user, technical issues such as ID authentication and management, and PSIM (the new buzzword: physical security intelligence management).  So don’t be surprised to see more offerings from me on the likes of L-1 or Cogent around the issues of TWIC/US-Visit/WHTI/REAL ID, and international ID cards, as well as some blogs around end user reactions to public companies like Flir and Axis and private companies like Imprivata, Vidsys, DVTel, Milestone, and CoreStreet.  In the meantime, we will finish up this recent spate of blogs on the monitoring side with a fairly lengthy offering on the largest U.S.-based company in the monitoring industry:  ADT Worldwide.

 

One year ago, we could not have written this blog – enough said.  ADT is the single leading entity inside of Tyco International and by far the most important segment for investors, since it constitutes well over 50% of 2007 and estimated 2008 consensus EBITDA for the entire corporation. We have known many of the line and senior managers of this $7.6 billion division for longer than any other s, and indeed ADT was the first company we covered (1983), and the operating management remains candid with us about the alarm monitoring, asset protection, video and integration businesses.  Over the last year, we have also gotten to know Naren Gurshahaney, President, ADT Worldwide, and John Koch, President ADT North America in presentations that have made to us, and in presentations I have made to them.  The “alarm guys” might be a little skeptical of two executives coming in from outside the industry (and remember I too as a young guy was weaned on ADT by assuming that executives like Carey and Brualdi and Snyder knew just about everything there was to know in the industry).  The fact is, outside-the-box thinking is seemingly exactly what ADT has been in need of, and seems to be exactly what is slowly turning this battleship around. 

 

In short, we are convinced that the U.S. alarm monitoring business is finally turning with continuing lower attrition rates and with the seeds for much higher margins in its commercial business, with a still inconsistent, but positive direction for Europe.  Yes, we have already written, that while the larger residential competitors already know this, smaller monitoring competitors in the U.S., at their own risk, still view ADT residential as some bumbling giant.  That attitude may have to change.  However, even though residential is competing better, with better service and less attrition, in our view view, the key right now for ADT has been a business I am sure the “multi-industry” analysts who cover the public stock only know as “installation.”  Indeed, what ADT’s competitor’s know as its “Integration” business (not yet on any line in the P&L) is the company’s secret weapon to both increasing its lower-than-average margins in the commercial business and building the brand back up to industry premium levels.  It is the undetected gem  (is it $700 milllion or is it $1.5 billion ??) inside the company, right now.  We will get back to this key point in a minute.

 

ADT Basics.

Let’s step back just a little for one minute and review why we should be writing about ADT, even though Tyco is heavily covered on Wall Street by multi-industry analysts.  First some stats:  In fiscal 2007 ADT Worldwide accounted for $7.6 billion of revenue or about 41% of Tyco’s total.  EBITDA of $1.47 billion was over 50% of Tyco’s total.  Recurring monthly revenue, not public, we estimate at about $320 million.  Net attrition was 12.3%.   ADT’s U.S. health is an important touch point for all U.S. security companies, given its 33%-plus share of the domestic market (by conservative measures).  While ADT is very important to the “branding” of the U.S. security industry, it may be still a couple of years before European metrics improve to the point where the company is truly competitive with the locals.  In Europe, ADT faces heavy competition from Securitas Direct on the residential side, Prosegur in Iberia on the commercial side, local service providers all over the continent, and significant regulatory hurdles that exist country by country.  Even Group 4 Securicor sees selected opportunities to compete in monitoring.  In addition, sales, integration capabilities, and general go-to-market strategies between Tyco’s security business and its fire installation and service business (Simplex Grinnell, Wormald, et.al.) installation and services businesses have improved, but are still far from “seamless.”.  Finally, ADT must improve it “brand” from the “depths” of 2001-2002 – something that it has done very well recently, but on which it still needs to work.  This is more complicated than simply making customers happier, lowering attrition, and winning important contracts.  The company also must contend with many former employees (some now running competitor companies) and former dealers who for good or bad reasons continue to either bad mouth the company as if attrition were still 17%,  or belittle its capabilities to change — simply because it is so big.  This can be overcome with time, and overcome by simply executing.  But within the $150 billion security industry, it is still a task which ADT management must work on. 

So ADT still has its challenges.  Yet, several internal metrics, particular to the security monitoring industry (ranging from our calculations of attrition, revenue per sub, creation multiple, our version of steady state cash flow margin, also appear to be improving.   In sum, ADT may not have the highest margins in the industry of the majors in the industry, but those margins do have the advantage of having a long way to go and going in the right direction.  For investors, this may be a perfect situation to consider, given the improving trends in brand name, internal metrics, and financial performance.

 

WHY IS SYSTEM INTEGRATION IMPORTANT TO THE BRAND AND TO THE METRICS?

Since John Koch’s ascendancy to be president of ADT North America, he has consistently spoken about ADT’s need to take leadership in the systems integration business – essentially because that is where the rubber is meeting the road in larger installations.  The rise of the Chief Security Officer (CSO) in Fortune 1000 companies is driving more centralized focus and buying of security systems that must be interoperable across branches and involved functions (ID authentication, precise exception event analysis, video monitoring) way, way beyond traditional monitoring.  A small group of integrators and we believe, even HSM (now part of Stanley) had wrested this perceived capability away from ADT in the marketplace, several years ago, but our end user contacts convince us that within the last 18 months this momentum has been reversed for the positive.  . 

 

We credit the systems integration group and its executive for this turnaround.  But we also believe that ADT’s “world view” of what systems integration should be – specifically North America President John Koch’s view of what constitutes the elusive “systems integration” business are signs that ADT is beginning to “get it.”  Koch has already presented several times at industry panels, so we are assuming by now the organization is being put in place to create .  Koch views the complexity of integration in five levels (not including “Level 0,” which is vanilla installation being done today.  Over the next several years, the company expects to participate increasingly in the top four segments, where there is more value added (and profit).

 

 

ADT North America’s View of the Integration Business

 

C           L E V E L  O F  I N T E G R A T I O N               

                                                    5-Business Process

O                                                Optimization Supported

                                                  By Physical Security

M

                                         4-Physical Security

P                                         & Business Application

                                              Optimization

L

                                 3-Physcial Security

E                                 & IT Infrastructure

                                      Integration

X

                     2-Multiple Security

I                     Products Integration

 

T           1-Same Security Products

              Category Integration

Y

0-    Security Products

          Installation

Source: Company presentation

SAMPLE

It is ADT’s intention to maintain a business model that services the top four levels of security systems integration.  Gurshahaney and Koch understand that most installers and integrators are still mired at levels 2 and 3, at best, where 20%-30% gross margins are unfortunately too common and 40% gross margins are too rare.  They also understands that the first step for the industry is consistently getting to level three – which requires new generations of hires across the industry that can talk with their IT counterparts.  Getting to the top two levels are just that – targets to achieve – in an industry that by necessity must be conservative.

 

With the focus on integration, was not a shock, therefore, that this past April, Tyco International announced that ADT Security business had reached an agreement to acquire FirstService Security, a division of FirstService Corp. in Canada, for approximately $187 million.

 

FirstService Security — ranked as No. 7 on SDM Magazine’s 2007 Top Systems Integrators Report — operates under the Security Services & Technologies (SST) brand name in the United States and under the Intercon Security brand name in Canada. Since ADT does not readily give up its integration numbers separately to anyone — SDM included.  We can only surmise that this is due to the huge grey area of what is defined as installation and what is defined as integration, as well as which recurring revenues come from pure integration.  And if ADT were to report these numbers, would the Wall Street analyst community even care, relative to the competitive information that would be let out of the bag.  (With that said, we would urge the company to break out the numbers, anyway).  Nevertheless, it will be interesting to see how ADT is ranked as an integrator in 2008 (it was number 4 in 2007, estimated at $782 million by SDM).

 

In fiscal 2007 the two First Service divisions generated $177 million of revenue (+18%) and $10.6 million of EBITDA (+38%). The growth included acquisitions, as we estimate that organic growth was closer to mid-single digits. Last twelve months revenues were about $200 million. However, at a 6% EBITDA margin, there appears to be significant room to grow profitability, relative to high single and low double digit margins in the industry. The acquisition price values the transaction at what is estimated to be ales ($200M+ last twelve months) and we estimate at ~10-11x forward EBITDA.

 

With that said, the acquisition might be mildly accretive in the first full year of ownership, but increasingly accretive down the road as ADT combines it with its own integrations business.  We repeat that we think the competition underestimates ADT “integration” in terms of its prospects – witness the recent win at the Port of Richmond, which was a surprise to a couple of competitors. We think the integration business could improve the current ADT North America commercial operating margin of ~12% as Tyco leverages its existing base of projects and customer relationships as well as purchasing and back office efficiencies.

 

Finally, we see a real possibility for increasing the recurring revenue and service percentage of the two First Service companies , which right now is just 20% of total revenues.  We will be mildly interested to see what ADT does with Intecom’s guarding business ($60 million revenues).  Granted, ADT does participate in this business line in other regions, but we are skeptical that they would keep it in North America, particularly with a couple of potential buyers, like Brinks or Garda in the same region.

 

We will return, with more on ADT, at a later time.

 

 

A couple of smart investors asked if I calculated the forward steady state cash flow of Brinks Home Security, based on its new filings with the SEC.  Smart alecs!!!  Seeing as how I am not in the business of projecting estimates and price targets, nor giving out buy-sell-hold recommendations, for now, that is not possible.  However, based on the new SEC Form 10 filings by Brinks Home Security Holdings, we have looked at what is reported pro forma for 2007, and adjustments for 2007 “steady state cash flow” generated by BHS in 2007 should be down slightly from “consensus” numbers out there.  Steady state cash flow is a more accurate reading of the profitability of a security monitoring company’s recurring base of business, with the one caveat that it does not account for new growth initiatives.  Recurring monthly revenues ended 2007 at $37.1 million, while as we noted in our last blog on Brinks Home Security, EBITDA was $196.6 million.  However, recurring monthly revenues, in and of themselves, do not indicate the profitability of that revenue stream, while EBITDA can be affected by accounting conventions, such as how much internal accounts vs. acquired accounts and what percentage of customer acquisition costs go to the balance sheet versus the P&L.

 

___________________________________________________________________

Brinks Home Security Steady State Cash Flow Calculation for 2007

 

                                                                              Old                         New

                                                                                              2007       2007PF

 

Total revenues ($ millions)                                            484.4      484.4

Recurring Operating profit                                           208.9      168.9

Pro forma adjust (decline in fees to Brinks)                 27.2       27.2

D&A                                                                                      50.4       50.4

Amortization of Deferred Revenues                             (34.2)     (34.2)

Recurring EBITDA                                                        302.8      290.0

 

Investment in New Subscribers                                    (92.2)     (92.2)

Deferred Subscriber Acquisition Costs                     (23.8)     (23.8)

Deferred Revenues from New Subscribers                 47.4       47.4

Capital Expenditures                                                 (177.8)    (177.8)

Total New Cash Subscriber Costs                          (246.4)    (246.4)

 

Disconnects (millions)                                             0.082       0.082

Installations (millions)                                             0.181       0.181

Disconnects as a % of Installs (and costs)            45%         45%

 

New Subs Cost to Replace Disconnects (45% of

 Total new cash sub costs in 2007)                          111.5       111.5

 

Steady State Cash Flow (recurring EBITDA,

  Minus Replacement Costs)                                    191.3       178.5

 

Steady State Cash Flow Margin                           39.5%       36.8%

­­­­­­­­­­­­­­­­­­­­­­­____________________________________________________________________

 

 

Typical trading multiples for monitoring metrics in larger companies are 40x-50x RMR, 8.5x-10x EBITDA, and 9x-12x steady state cash flow.  Transaction multiples are commensurately higher, about 50x-60x RMR (again, limited to larger companies), 10x-13x EBITDA, and 11x-14x steady state cash flow.

 

Regardless of the adjustment downward in SSCF margin, to 36.8% from 39.5%, based on the filing, BHS still maintains the highest steady state cash flow margins we know of in public companies, and there are only a few private companies that can compare.  This is pretty impressive stuff, and a tribute to Peter Michel building the business in the 1990’s and Bob Allen continuing to build the business in the 2000’s.   ….now can we get back to discussing those royalty payments and the 3-year limit on the brand name…..???  

 

[…and while I am on a jag, I repeat: Why is Protection One, selling at such an unfair multiple to its peers? – There may be a lot of good partial reasons, described in our earlier blogs, but they don’t and shouldn’t add up to the valuation disparity we see -- particularly with the confidence the security industry has in P-1’s management team.  I just wish the financial community would loosen up on this thinly traded stock…]

 

 

 

 

 

 

 

 

 

 

 

 

 

Sonitrol is truly one of the iconic brands of the security monitoring business.  It is fair to say virtually no other brand has gained as much respect with third-party responders (i.e., police departments) as has Sonitrol, and I continue to believe that with the verification issue not going away, guaranteed police response – because police believe in the brand — within a reasonably short period of time (under ten minutes) is a value-added that cannot be underestimated.  Sonitrol, with its proprietary audio monitoring technology and its move into IP video monitoring has certainly maintained its brand value with responders and kept end users happy.  Gross attrition is 8%-9%, low for a company of its size, and the average customer life of over 13 years is up there (Brinks, in residential, claims about 14 years).  Of course, with an original, proprietary technology that requires a separate monitoring system, there is little organic system-wide organic growth, and transaction multiples for Sonitrol accounts do not exceed the industry averages.  Still, the Sonitrol brand is one of the most respected in the industry and the Sonitrol Management Corp. and its big franchisee system is one of the most fascinating stories in the traditional monitoring business.

 

There is a point to all of this, but first, just a couple of stats to prove that we remain somewhat up to date:

During the 1990’s, until 1997, Sonitrol Management Corp. (the franchisor) was owned by the U.K.’s largest monitoring company, Automated Security Holdings (ASH).  After Tyco/ADT bought Automated Security Holdings in 1997, it basically did very little to disturb the status quo (but did not grow the business, or really provide new incentives to franchisees) until it sold Sonitrol Management Corp. in 2004 for $125.5 million, to a group of private equity investors, including Spire Capital, Carlyle Venture Partners, and Wachovia Capital Partners.  Kevin Dowd, who we knew well as the former CEO and President of Checkpoint Systems, replaced Chris Cobb as the CEO of Sonitrol Management, with the transaction.  At the time of the acquisition, the management company claimed about $85 million in revenues.  Now there is $125 million ($5.7 million in RMR), much of the increase coming from seven acquisitions.  Total system revenues are closer to $225 million and haven’t changed that much over the last five years.  About 45,000 of the 125,000 users are owned by Sonitrol Management Corp., and the rest by franchisees.   Nevertheless, it is fair to say that Sonitrol Management has become significantly larger and more profitable in the last four years.

 

We have been fascinated by Sonitrol and its franchise network for over 15 years, since the days of  us covering Sonitrol Corp.’s then-owner, Automated Security Holdings (ASH) and its predominant equipment provider, Advantor and its own iconic owner, Harry Flemming.  Even though franchisees back then resented the close relationship between ASH’s chairman, Tom Buffett, and Flemming, who controlled a proprietary product that limited Sonitrol’s integration with other monitoring technology, they at least seemed to accept that Flemming believed as strongly in Advantor’s product to Sonitrol, as Sonitrol’s franchisee’s believed in  their own businesses.   This love-hate relationship at least was semi-functional.  Clearly, that relationship seems to have been frayed since the acquisition of ASH by Tyco/ADT in 1997.

 

Now to the nub of this blog:  There is fairly strong evidence throughout the monitoring community that Sonitrol may be on the selling block, and we’d be remiss in not reminding the likely buyers that putting the frayed franchisor-franchisee relationship in better stead should be considered as high a priority as what the ultimate price is.  Our recent forays into the hinterlands to visit multi-brand security monitoring companies – some of whom happen to also be Sonitrol franchisees, shows us that there is indeed discontent with a whole host of items ranging from the structure of the royalties, to right of first refusal, to the overall franchise arrangement.  This discontent is deeper than what we encountered when ADT sold Sonitrol Management and it is FAR deeper than when Automated Security Holdings owned Sonitrol 15 years ago.  Potential buyers of Sonitrol Management should be prepared to deal with franchisees, particularly those that are willing to simply move to other technologies, now that alternative audio and video verification technologies exist.

 

The names of the likely Sonitrol Management buyers are, well the same names we’ve been hearing for a lot of transactions lately:  Siemens, UTC Security, Stanley, Niscayah (Securitas Systems), with what we believe to be Stanley having the inside edge.  The commercial focus, the high regard for the brand all would have attraction to any of these players.  Niscayah could increase its 30%-40% recurring revenue percentage and begin to emulate the Stanley model, following the latter’s acquisition of HSM.  Stanley, for its part, could gain yet another highly regarded brand, and complement its data-intensive HSM business.

 

However, like we noted above, anyone who buys Sonitrol must take into account the franchise system, which may be unlike any group we’ve encountered before.   There are Sonitrol franchisees that have only known Sonitrol monitoring and may never sell their businesses.  Given the past difficulty in integrating the Sonitrol audio system with anything else a monitoring did (there are still “special” Sonitrol rooms inside a much broader based monitoring company), many transactions were done solely “within the family” and at multiples that were 10%-30% lower than commensurate RMR valuations – and that was before the more aggressive stance by Sonitrol Management on right of first refusal, as a way for it to grow.  

 

Most important, no other franchise network that we know of (including businesses outside of security) has developed the near cult-like status that gives Sonitrol franchise meetings as near as a religious camp out.  There are even rifts between those franchisees who are “pure” Sonitrol providers and those who dare to sell other services and products.

 

However, since not all is going smoothly in Sonitrol franchisee land these days, a situation which may or may not have been able to be avoided, given the intensity in which some of the franchisees believe in their business.  Admittedly, had I been the buyer of the Sonitrol Management Corp., and in private equity, I too would have been focused on cutting costs, trying to build up a national accounts program, and buying up franchisees under right of first refusal.  This would in and of itself create tension, but why am I seeing this level of tension?  Again, I don’t know where all the current friction is coming from, but something in the always critical franchisor-franchisee relation is amiss.   Sonitrol cannot become more successful – without a major downward ratchet in size — with franchisees ready to bolt, if the new buyer pushes a centralized policy without repairing these relationships.

 

Conclusion:  Whoever is the ultimate buyer of Sonitrol, take this little piece of advice:  please talk to the franchisees, and make them feel wanted.  It will make for a lot better company future.

 

 

 

 

The Brinks Company is spinning off its Brinks Home Security (BHS) unit, and on May 30, BHS filed a “Form 10” with the SEC, representing its preliminary pro forma financials as well as its ongoing relationship with Brinks Inc.  Along with the financial pro forma’s, there are two “surprise” issues which popped up in the filing (you have to dig to find them):  (a) the loss by BHS of its “Brinks” brand in three years and (b) the royalties that BHS has been paying to Brinks – over $30 million in 2007 — which were formerly not reported (or at least never seen by me).

 

 First, as insinuated by management, and expected by me, pro forma operating income for 2007, net of expenses not allocated to the Brinks Companies anymore, declines a bit  – to $98.8 million from $116.7 million – a decline of $17.9 million.  We would expect similar declines in our EBITDA ($234 million), and steady-state cash flow ($190 million) results for 2007.  Again, the decline is due to unallocated corporate expenses now being allocated.

 

 One technical accounting discovery (the following all related to the FASB’s Staff Accounting Bulletin No. 104, which frankly has only served to confuse the numbers on long-term contracts like alarm companies, not help investors, in my humble opinion):  We would note that the company categorizes the “amortization of deferred revenues” related to active customer accounts — $34.2 million in 2007 — as a non-cash item already reflected in net income.  While this was already subtracted out of our steady-state cash flow numbers for 2007, we considered it outside of the net income calculation previously.  We will have to determine with management, whether this also should be subtracted from EBITDA.  The other deferral items (“deferral of subscriber acquisition costs” and “deferred revenues from new subscribers”) are still considered outside of net income and are not considered in the EBITDA calculation.

 

 OK – now to the good stuff!!  Brinks Home Security notes that under its “brand licensing agreement,” it has been paying 7% in North America and 3% outside of North America to use the Brinks name.  This will be reduced to 1.25% for the next three years, and is reflected in the filing’s pro forma’s by increasing operating income by $27.2 for 2007.  Great, guys, thanks for telling us that Brinks Home Security was paying Brinks 7%  or about $33 million in 2007– now that they are splitting off.  This was not an inconsequential amount.  Well I guess if Brinks armored was funding Brinks Home Secuirty during its first eight years of life, BHS can only return that favor.  Oh, and by the way, this makes for an even more compelling case for BHS as a excellent company.

 

 So, we also learn that after three years Brinks Home Security is going to have to find itself a new name.  A great brand, Brinks Home Security, will have to go by the wayside.   I will accept suggestions for a brand that can even come close to what BHS has now.  In addition, after five years, Brinks Inc.’s non-compete in the alarm monitoring industry ends (I would assume they would target the commercial space, if they were to enter).  Obviously the Brinks brand has been a contentious issue during all the debates and consultations over splitting up the company over the last two years.  But, I guess, if Brinks Home Security is no longer going to be part of the corporate fold, they are not  entitled to keep a brand name that is golden in residential circles.  Oh well, at least I assume they will do better at renaming themselves than Securitas Systems did in “re-branding” itself Niscayah.

 

 One final observation:  I have know Bob Allen, the president and CEO, and Steve Yevich, CFO for years, and believe they are top notch executives.  Brinks Home Security – or whatever it will be called – will be in good hands.  

 

 

 

 

 

 

 

We know most industry (and all financial) observers’ eyes glaze over when we talk about standards.  But there is something going on in the video industry that may just be very important.  Yesterday May 12, a consortium of Axis Communications, Sony and privately-held Bosch – three of the leading names in video surveillance, formed a group aimed at developing a standard for the interface of network video products. Currently, while there are video compression standards (MPEG-4, and the new H.264), there is no global standard defining how network video products such as cameras, video encoders and video management systems should communicate with each other.

 

This is potentially huge for the growth of the video market, even though it may cost some manufacturing companies with proprietary technologies some well-guarded revenues.  Yes, we have seen the Government begin to create “standards” with the HSPD-12 program and its related FIPS 201 standard.  And perhaps more important, the Security Industry Association (SIA) is actively promulgating a set of standards (OSIPS) for video and access control.  However, it is one thing to have government and industry groups saying what should be done, and it is another for the very companies that usually fight standards in the security industry – the manufacturers – to get together to push them through. 

 

The big winners – if these standards are accepted – are (1) “the market,” which can be expanded just as the IT market was with standards, (2) the video-access software platform companies, like Lenel, DVTel, On-Net Security, and Milestone who have been screaming for a standard communication interface, and (3) the more IT-savvy security systems integrators who would now be able to plan a system with enterprise end users and not have to create multiple custom projects within one installation like they have to now.  Congrats to Axis, Sony and Bosch – now let’s just hope the other manufacturers with an axe to grind will support this initiative.