Security: ADT JAN 16 2016 40.00 CALL
Date of first purchase: March 24, 2014
I am buying call options on ADT expiring in 2016 because I think the business is significantly undervalued and the expected value of its LEAPS is attractive. Each option is $1.34 at a strike price of $40. I estimate the business is actually worth $44 to $60 per share. This implies that at ADT’s current market capitalization of $5.3 billion it is being priced at a 36% to 53% discount to its intrinsic value of $8.2 billion to $11.2 billion. This margin of safety should allow generous room for error if in the long run I have incorrectly assessed the true value of ownership.
ADT is North America’s leading provider of home and small business monitored security services. At 139 years old, it is also the largest and most well-known brand in this fragmented and growing industry. It serves roughly 6.5 million customers, which is 22% total market share, roughly six times the size of its next largest competitor. Its residential customers are typically owners of single-family homes, while its small business customers include retailers and small-sale commercial facilities. With 92% of its revenue recurring in nature, it has attractive earnings and operating stability. This is because its new accounts typically have an initial term of three years with automatic renewals for successive 30-day periods. Moreover, ADT’s average customer relationship is seven years, longer than many of its newest competitors have been in the industry. The perceived threat of these new competitors led to a 30% drop in the price of ADT shares since the beginning of 2014.
America’s telecom giants are expanding into the home automation segment of the monitored security alarm industry, bundling new services in this field with existing offerings of broadband, television, and phone connectivity. And in some instances, they are significantly underpricing the automation component of such bundles. Comparing ADT’s results with its competitors’ efforts reveals the threat to be overstated so far. For example, in calendar 2013, cable industry behemoth Time Warner Cable added 32,000 subscribers to its IntelligentHome offering that competes with ADT’s similar Pulse home automation service. In the last three months of 2013, ADT added 231,000 customers overall, 36.5% of whom purchased Pulse. In other words, roughly 84,000 people in three months chose ADT over the 32,000 who chose IntelligentHome in an entire year. Yes, ADT’s new competitors bring with them hefty balance sheets and strong cash flow production. And ADT has recently increased its leverage to repurchase shares, limiting its financial flexibility. However, ADT has no maturities of debt until 2017 and over 75% of its total debt does not mature until after 2021; and with $300 million to $400 million in average free cash flow, ADT has the funds necessary to meet its fixed obligations and competitive capital needs. And management is putting its money where its mouth is. After the company retired 20%of its outstanding stock over the past year, eight different ADT officers and board directors have in aggregate purchased more than $700,000 of stock with their own funds at current prices.
I am thus purchasing ADT’s LEAPS because the margin of safety in the company’s equity greatly favors the probability of gains versus the potential for loss at expiration. The pricing and expiration date of the options should allow ample room for error or adversity if I have wrongly appraised the true worth of owning ADT or if the business’ brand strength and cash generation do not soon outshine recent fears of new competitive threats in its marketplace.