To judge the impact of this news flow on its merits, let’s first look at the investment thesis of ADT as I covered the stock at the start of the year in this article. Of course, a deal with Google is a very welcome development and certainly is better than competing against Google, yet while initial enthusiasm is great, the real work only starts now.
ADT – The Business
In January, I concluded that shares of ADT were not safe yet after the company announced a bolt-on acquisition at the start of the year, continuing its role as a consolidator in a fragmented market. I was pleased with the revenue growth, yet concerned about high leverage and adjusted earnings numbers which complicate the picture.
The same high leverage and complicated earnings numbers made ADT a tricky investment since I first considered the shares when they went public in January 2018. Since that offering shares gradually fell from an IPO price of $14 to lows of $5 in August 2019 to trade around $6 and change at the start of the year.
In terms of the business, ADT claims to be the largest security firm in North America which is looking to play a consolidating role in what remains a fragmented market, even as the company itself holds a 30% market share. Scale in installations and maintenance is key in this market, with medium to long-term contracts providing solid visibility for future cash flow.
The company is incredibly profitable if you get misled by EBITDA metrics as it reported EBITDA of $2.3 billion on sales of $4.3 billion for the year of 2017, with those numbers available when the company went public. The company was awarded a $19 billion enterprise valuation at the offer price, roughly split in half between equity and net debt, valuing the company at 4 times sales and 4 times EBITDA.
The issue is that D&A charges run at $1.9 billion, leaving just $470 million in EBIT left at the time of the offering which is a big issue as a $9 billion net debt load results in interest expenses which ”eat” up pretty much all profits. Thanks to some acquisitions the company grew 2018 results to $4.6 billion in sales and $2.45 billion in EBITDA. Late 2019 the company announced a $550 million sale of ADT Canada, followed by a $381 million acquisition of Defenders early in 2020, the acquisition of the largest independent dealer of the company.
In March of this year, the company reported its 2019 results with revenues up 10% to $5.13 billion, in part driven by dealmaking. Adjusted EBITDA improved just $30 million to $2.48 billion. Net debt stood at $9.6 billion which results in a 4 times’ leverage ratio as the earnings numbers remain highly complicated. The company managed to narrow GAAP losses by $0.24 per share to $0.57 per share as adjusted earnings improved 7 cents to a loss of $0.09 per share.
The numbers are highly distorted because of the huge depreciation expense including subscriber assets and acquisition costs. Hence, the company focuses heavily on free cash flow in its reporting as a key metric for investors to focus on, with adjusted free cash flow up 10% to $590 million. This is the reason why investors have not been too concerned with sales for 2020 being stagnant around $5.0-$5.3 billion. The company guided for EBITDA to fall substantially to $2.17-$2.25 billion yet at the same time guided for free cash flows to improve to a midpoint of $650 million. Shares still traded around the $6 mark early March when the company reported the 2019 results.
First quarter results were reported in May with revenues up 10%, yet adjusted EBITDA fell from $621 million to $539 million, as adjusted losses increased from $0.02 per share to $0.09 per share. Free cash flow for the quarter improved by two million to $173 million and that is despite additional interest payments paid during the quarter, yet net debt only increased further to more than $9.8 billion.
The company maintained the 2020 sales guidance, cut the EBITDA guidance by $75-$100 million, yet maintained the free cash flow guidance at $650 million, although the range of outcomes has been widened as a result of the inherent uncertainty of the current environment. Given that the company has been showing resilience in the first quarter, shares did rebound from a Covid-19-induced lows and traded around the $8 mark.
While ADT was guiding for free cash flow around $0.85 per share and shares trading at a 10 times’ free cash flow multiple, low free cash flow multiples reveal that investors might be concerned about the debt overhang as well as the potential disruption of its business (model). Yet at once, there has been a very pleasant surprise.
ADT is partnering up with Google’s Nest to provide an integrated set of security solutions, providing customers with a fully secured home. As part of the deal, Google will invest $450 million in ADT and in exchange obtain a 6.6% equity stake in the business.
With a share count of 759 million shares by the end of the first quarter, and knowing that Google obtains a 6.6% stake, it reveals that Google will obtain about 52 million shares at the closing price before the news has been announced. Both companies will invest $150 million into co-marketing, product development and training with Nest responsible for hardware and ADT for installation and security solutions.
Investors are wildly enthusiastic as shares are up by two-thirds to $14 and change, up more than $5.5 per share. Including the to be issued shares this represents about $4.5 billion in value being created on the back of a stock deal which is exactly 10 times smaller. Investors seem to feel that this could be a breakthrough and rather is an attempt of big tech to collaborate and use ADT’s ecosystem, rather than to try to compete it away.
While it is far too early to see if this deal rally becomes a game-changer, as that requires two willing partners, I am certainly very positive on this as successful execution could at the start overcome leverage and continued decline concerns, and at best be a start of a big recovery for the company and its stock.
The question is if Google is really committed to ADT or this is merely a test to get a glimpse into the business and over time pursue this market on its own, or perhaps even acquire the entire company. Right here and now I am very positive on the deal, although it is hard to grasp as such how much success and odds of success is priced in after such a massive move, which makes that I am watching current events unfold from the sidelines.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.