TheSecurityAnalyst

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.

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.

 

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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. 

 

 

 

 

 

 

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…]

 

 

 

 

 

 

 

 

 

 

 

 

 

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.

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.