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.

Once again, our move to switch our blog “away” from monitoring and back to technology is being delayed by one more article – this time, an article from a distinguished industry guest, Lee Jones.  When I started as an analyst in 1983, I asked who was the most respected consultant in the industry at the time to help me out.  Lee, who still runs Support Services Group, was that person.  He has sent me his new paper on the “Risk of Critical Failure in the Monitored Alarm Industry,” which focuses on his concern around the potential loss of police response and customer loyalty by today’s leading monitoring companies.  These are critical issues facing the industry today and have implications for my blogs on Brinks, ADT and Stanley’s acquisition of Sonitrol.  I know there will be many in the industry and some end users who will disagree with the severity of Lee’s comments (I don’t agree with everything), but the issues he brings up are critical to a wide range of executives, consultants, and investors in the industry.  Below, with permission, we reproduce Lee’s provocative paper in its entirety. 

 

Risk of Critical Failure in Monitored Alarm Industry

For the first time in over 50 years, the participants in monitored alarm security are at risk of “critical failure”. Very similar to the current sub-prime mortgage crises. 

“Critical Failure” occurs when a failure causes other participants to be unable to complete their tasks in the expected manner. 

The weakest link, or the “critical failure” in traditional alarm services, is public police response and customer loyalty. It is going away or already gone. 

The critical failure in monitored alarm security is the customer expectation that “help” will come to the site when the alarm system calls for help (a/k/a burglar alarms or intrusion alarms). Security providers now know that “help” will NOT arrive in a timely manner for most of their paying customers. Millions of alarm users are paying for services not rendered. 

 

The primary participants in an alarm system are:

• alarm user… the customer.
• sales and installation agent.
• monitoring source.
• billing & collection agent.
• contract owner/investor.
• warranty and service provider.
• private response.
• local police. 

All of the listed participants could be coordinated from the same firm that is totally integrated, like ADT, or Brinks, or HMS, or Alarm Detection Systems. Or, because the alarm industry is still highly fragmented, eight or more independent firms could be involved. Some of the participants may not even be aware of each other. All participants are sharing the same $20-40 monthly fee for residential, or $25-100 monthly fee for commercial. Collectively we are an industry of 30 million monitored customers generating over $12 Billion recurring revenue annually… which is now at risk. 

Not unlike the sub-prime mortgage market, alarm customers often cannot identify the participants. For example, (a real customer) had their system installed by Sterling Security, which was sold to Alarm Data, which was sold to Masada Corp, which was sold to Regent Corp, which was sold to InterCap, which was sold to Ameritech, which was sold to Cambridge, which was sold to Tyco/ADT. Most of the buyes had a different monitoring source with different monitoring software, and used a different source for billing and collection. Each of the alarm contract owners had a different set of investors. One of the firms in this chain securitized a big bundle of nameless alarm contracts, just like sub-prime mortgages. Another example is bunch of alarm customers that are within a chain of 10 different owners, ending with ProtectionOne/Quadrangle, which also included securitized

bundles of contracts.  

Here are just three of the risks:

·        A critical part of the basic infrastructure of TPM is the ability to operate seamlessly across hundreds of municipalities. That standardization is going away, or already gone.

·        A critical part of the basic infrastructure of TPM is emergency response to the site when cause of alarm in unknown. That customer expectation is going away, or already gone.

·        A critical part of the basic infrastructure of TPM is that alarm users have absorbed financial responsibility for false alarms. A trend is moving toward the monitoring source, not the alarm user, absorbing that operational and financial responsibility.

 

The customer is paying for a $20-50 service that is outsourced to TPM for $3-8. The noted “risks” have removed most of the operational and financial benefits and resources of TPM. Severe pressure on customer loyalty includes false alarm fees. The $Billions collected by municipalities from alarm users/customers can be translated into a price increase for a reduction of service.

 

The alarm customer and the police, the two most critical segments of the infrastructure, have been brutally 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.

 

Without the long term loyalty of our customer, high churn is probable, and the market value of the contract (revenue stream) is at risk.  Without the loyalty of the police (emergency response) high churn is probable and the market value of the contract is at risk. 

 

The consequences to investors includes the specter of a legacy liability for deceptive business practices, or worse, consumer fraud.

 

Perspective of the police. Why they do not like us, nor trust us.  After several decades of street experience and lots of documentation with alarm systems and alarm companies, the public sector has determined that calls from most alarm monitoring sources do not qualify for emergency police response, because nearly 100% are error. Most police departments have already lowered the priority from an “emergency status” to a “courtesy status”, which means the time of arrival could be 20 minutes to several hours, or not at all. Plus, the customer or the monitoring firm could be paying fines or fees for the call. 

 

Many police departments believe traditional monitored alarm systems are already outdated, or obsolete, because site inspections are still necessary to determine IF an emergency exists, not because of an emergency. Nearly all calls from monitoring firms are nuisance calls for site inspections, not emergency calls.

 

We believe the alarm industry is experiencing the Kodak Syndrome. An industry leader, Kodak, spent decades of time and its fortunes defending their core business, rolled film, while outsiders developed the digital photography business. Kodak almost disappeared, however it recovered by adopting change rather than fighting it.

 

Fighting police departments by Alarm Associations has been counter-productive and highly destructive. Thousands of Association Members and their counterparts may have been mislead. For example, fighting against formal verified response simply forced wide scale “de facto verified response”, wherein police priority for calls from alarm companies is lowered to a courtesy site visit, or not at all. Or alternative Zero Tolerance programs are put in motion.  Millions of alarm users are restricted from emergency police response. Alarm Associations have been a major contributor to the deterioration of police loyalty.

 

How does the alarm user get emergency response to their alarm system? 

How does the monitoring source deliver emergency response to their customers? 

How do the police interact with alarm users if alarm systems do not qualify for response?

 

Said differently, how do we restore the loyalty of the police and the customer?

Several suggestions:

• Inform your existing customer of their emergency response status in their community with your service. This disclosure can mitigate deceptive business practices (if no emergency response, or slow response, they need to know it). Seek guidance from your legal counsel.
• compare private response with local public response and offer that alternative to your customer.
• consider updating site and monitoring technologies that will remove the need for site inspections to determine the cause of alarm. The cost of several false alarms could offset the costs of the retrofit.
• consider trading your customer contracts for like contracts in a more favorable jurisdiction.
• reduce the expectations of some customers to a customer “notification” service.
• encourage Alarm Associations to support, not fight, local police departments in their efforts to practice Zero Tolerance for False Alarms, including Verified Response (VR simply provides public disclosure of a silent defacto VR program). Remember, the police do not need us, but we need them.
• develop a business model that will provide end-to-end responsibility for your customer security, without police intervention, unless a 911 type emergency is determined.
• (be creative, do it now) We all know there is a huge long term need for private security all over the globe. If you do not provide it, someone else will, like the Kodak Syndrome.

 

- – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – -

Lee Jones, founder of Support Services Group, is a 35 year veteran of the alarm security industry. Depth of knowledge evolved from contributing to the problem via operating alarm companies and consulting with industry leaders of all sizes in strategic planning, mergers and acquisitions due diligence, market development. Now committed to the solution, Zero Tolerance For False Alarms. Lee can be reached at 949-361-3300 or leessg@att.net. 

 

 

 

 

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.

- – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - -  – - – - – - – - – - – - – - — – - – - – - – - – - – - – - – - – -

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).