TheSecurityAnalyst

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 just happened to glance at our security monitoring valuation table today — you know the one that compares six of the largest companies on multiple valuation ratios — in advance of Protection One’s first quarter report, coming Wednesday, May 14.  I was shocked, and asked myself “where have I been for the last two months?”  Well, some of you know.  What I didn’t know was what a travesty of valuation I am witnessing in one of the better companies in the industry, run by one of the better managements in industry.

Yes, we all know the story:  there is little growth (with growth in true commercial/industrial offsetting slight shrink in residential), the balance sheet is levered more than Brinks, or Securitas Direct.  And, the float of 6.5 million (Quadrangle still owns nearly 20 million shares) keeps a permanent liquidity discount on the valuation.  With that said, Protection One is a well run company, maintaining RMR of $26.5-$27.0 million, consensus EBITDA of $115-$120 million (a 32% margin is not so bad), and steady state cash flow of around $75 million.  While a 20% SSCF margin is nothing to trumpet, neither is it so bad, particularly considering that P-1 management completely turned over the wasteland of a subscriber base they initially took on, and are now doing the same with the old IASG account base, another poor cash flow performer.

What’s the point of all of this?  Well, at an enterprise/RMR valuation of 26x, an Enterprise/EBITDA valuation of under 6x the company is selling as if this were a small, badly run, untouchable enterprise.  Compare this to Brinks Home Security (if one assumes it is 55% of the enterprise value of Brinks Cos) at 48.4x RMR, or 7.5x EV/EBITDA, or Securitas Direct (yes, we know they are mainly bought out by now) of 11.8x EBITDA and 49.9x RMR.  Or better yet, let’s take a look at ADT inside of Tyco – a company that fell and rose back to respectability in about the same time frame as P-1, at 9.2x EBITDA and 43.1x RMR (assuming ADT is 52% of the value of Tyco).

OK, I’ve made my point.  With all of P-1’s low growth, leveraged balance sheet, “poor” number 3 position in the industry, and little trading there’s lots to yawn about.  But at the current price and valuation it is trading at, relative to a truly respected management and a major position in the industry, some investors must be asleep at the switch.

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.

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.  While the video industry is growing at nearly 13-15% annually these two companies have been growing at 2x-3x that rate, or slightly faster than their own subsectors.  Both companies traded at similar P/E ratio premiums to the market with 28x-30x forward 12 month ranges and 22-25x forward 18-24 month ranges.

However, those valuations recently diverged dramatically, along with stock performance, and therein lies the tale of two video companies.  Over the last several quarters, FLIR has maintained a 40% revenue growth rate amid gross margins in the mid 50’s% as demand for its Government (usually DoD related) business continued to show contract wins and growth over 40%, and the Thermographic division (used for monitoring industrial processes) maintained 15%-plus growth, even into a declining industrial market.  However, in our opinion, the big winner for FLIR has been its relatively new Commercial Vision Systems division (17% of revenues, growing over 50%), covering everything from commercial and homeland security, to maritime and commercial airplane vision, as well as building inspections.  The explosion in end user possibilities appears only limited by FLIR’s ability to find the right channel partners and market the products effectively – which is no slam dunk.  But FLIR has been helped by dramatic cost price drops in its infrared sensor costs.  So, despite the economic slowdown, the company has maintained its operating margins at 22%-23%, and the 2008 consensus P/E of 28.7x the estimates of $1.18 appear quite fair.

If Axis were only so insulated from the economy!  Axis as a brand is rapidly becoming to the world of IP camera end users what Pelco (now owned by Schneider Electric) has been to the legacy analog market.  But the economy doesn’t care about that.  With both U.S. and Western European sales slowing just a bit, top line growth has slowed from the mid-40% range down to the “tortoise-like” 35% range.  This should not be a problem were it not for a major operating expense program the company has undertaken over the last six months to dramatically increase its admired “two-channel” go-to-market strategy and to pioneer the H.264 compression technology (80% faster and more storage than JPEG and about 25% faster and more storage than current MPEG-4).  In the middle of slowing growth, this has lifted S,G&A to 26% from 24% of revenues and R&D to 15% from 13% within one year, resulting in an operating margin hit of 400 basis points to 15.7% from 19.7%, and relatively flat operating income growth.  The cause is all for the good, but we won’t see the first returns on these investments until at least later in the second half of 2008.  The effect on the stock has been predicable – a forward P/E of 28-30 has shrunk to 23.5x on consensus earnings estimates that have shrunk by 10%-15%, leaving the stock down 40% from its 52-week high, and at one point, 50% off its high.

So there rests the tale of two video companies:  one with a high, but not outrageous valuation in a niche business that seemingly is finding new uses every day, and one company continuing to invest heavily – even at the cost of its stock price – in driving a leading marketing and technology strategy that probably will work, but is not certainty.

Both companies face enormous competition from large players – FLIR from the likes of Raytheon and L-3, and Axis from Sony and Panasonic.  However, in their given niches, both companies have proven to be the leaders, with better product and better management.  We like them both.