ADT’s Growth Strategy Unveils Its Underestimated Integration Business
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.