ADT’s ratings and Outlook reflect the company’s strong brand recognition, its national footprint and leading market position, recurring revenue base, sustainable free cash flow (FCF) generation and solid liquidity. Concerns include emerging competition from non-traditional security service providers, risk associated with operating as an independent public company, and contingent liabilities, particularly tax liabilities, related to the spin-off.
The ratings incorporate ADT’s strong competitive position as the largest residential security provider in the U.S.. ADT currently has over six million customers and a roughly 25% market share based on company estimates. ADT’s competitive position is supported by a nationwide network of over 200 branches, 4,500 sales professionals, and more than 3,800 installation and service technicians. Additionally, ADT has nearly 400 certified dealers that generate about 45% of the company’s new accounts.
ADT recently issued $2.5 billion of debt in connection with the spin-off. Fitch expects ADT’s credit metrics will be solidly in line with the ‘BBB+’ rating category. Fitch projects pro forma leverage as measured by debt to earnings before interest, taxes and depreciation and amortization (EBITDA) to be approximately 1.5x to 1.8x. Additionally, Fitch projects EBITDA to interest to be above 15x for fiscal 2012 (ending Sept. 28, 2012). Fitch currently expects ADT to maintain these strong credit metrics through 2013.
ADT’s subscriber-based business requires significant upfront costs to generate new customers. Capital expenditures, including dealer-generated accounts and bulk purchases and subscriber systems, totaled $902 million and $801 million in 2011 and 2010, respectively. Capital expenditures represent approximately 30% of annual revenues. Fitch estimates that new customers yield an average cash payback of three years.
ADT has shown the ability to generate sustainable FCF in spite of the large capital expenditures that they incur. ADT’s subscriber-based business and recurring revenue stream contribute to steady income and cash flow. Revenues have been relatively stable as approximately 89% of its annual sales are recurring in nature. ADT generated roughly $537 million and $269 million of FCF during 2011 and 2010, respectively. Fitch expects ADT will generate annual FCF of approximately $400 million-$500 million during the next few years.
ADT’s financial results tend to be more consistent from period to period (relative to Tyco and Flow Control). As a result, ADT may undertake a more aggressive financial strategy compared to its predecessor company. It doesn’t appear that ADT will employ high leverage in the near term. That said, there may be strategic reasons to increase leverage in a manner that maximizes the long-term value of ADT. Nevertheless, ADT is committed to a solid investment grade rating. Fitch will continually evaluate how management will balance demands from its shareholders while maintaining its commitment to a strong investment grade profile.
Fitch expects ADT will maintain minimum liquidity of approximately $1 billion, consisting of cash and availability under a $750 million revolving credit facility. ADT does not have any debt maturities until 2017, when $750 million of senior notes become due.
Fitch believes that ADT’s competitive position will remain strong in the near-to-intermediate term. However, ADT faces competition from non-traditional security service providers. Several cable and telecom companies have introduced interactive security services that compete with ADT. While the customer base of these companies is substantially smaller than ADT at the current time, this emerging trend could provide significant competition for ADT going forward. The penetration rate for cable and internet providers is significantly higher (60%-85% range) compared to traditional security providers (20% range). This gives cable and telecom companies a larger customer base to which to sell additional product offerings and/or bundle services at perhaps more competitive prices.
ADT is run by a well-seasoned management team led by Naren Gursahaney, who served as President of Tyco’s ADT North American Residential business segment prior to the spin-off. ADT also has leaders with extensive company and industry experience.
As part of the separation, ADT has entered into separation and distribution and other agreements with Tyco and Pentair Ltd. (formerly Flow Control). This will govern the relationship between the post-separation entities and provide for the allocation of various assets (including trademarks) and liabilities and obligations (related to asbestos, pension and tax-related matters).
ADT also entered into a Tax Sharing Agreement with Tyco and Pentair. This agreement will govern the rights, responsibilities and obligations of the three post-separation companies regarding certain tax matters. The Tax Sharing Agreement outlines each company’s share of certain tax liabilities. Tyco will be responsible for the first $500 million of shared tax liabilities. ADT and Pentair will share 58% and 42%, respectively, of the next $225 million of shared tax liabilities. Finally, ADT, Tyco and Pentair will share 27.5%, 52.5% and 20%, respectively, of shared tax liabilities above $725 million. As of June 29, 2012, Tyco has recorded a liability of $406 million related to these tax matters.
Future ratings and Outlooks will be influenced by broad economic trends, as well as company-specific activity, particularly free cash flow trends and uses and liquidity position. Positive rating actions are unlikely in the near to intermediate term as Fitch evaluates ADT’s performance and management’s financial strategy as a stand-alone company. On the other hand, Fitch may consider taking a negative rating action if there is meaningful deterioration in ADT’s financial results and management undertakes a more aggressive financial policy, leading to diminished liquidity, higher debt levels and credit metrics that are significantly and consistently below Fitch’s expectations.
Disclosure: The author has no position in any stock mentioned
