ADT is the largest home security provider in the United States, serving over 6 million customers.
In February, ADT shares appreciated after a Valentine’s Day weekend acquisition proposal from Apollo Global Management.
The private equity firm agreed to acquire ADT for cash consideration of $42 per share. Apollo intends to combine ADT with Protection1, a smaller home security company it owns.
Valuation Debate
The proposed transaction appears to settle a long-running debate among market participants over the correct approach to valuing ADT.
ADT has a complex tax and accounting differential that produced a large deferred tax asset, partly as a legacy of its 2012 spin-off from Tyco.
Like other home security providers, ADT also incurs significant upfront costs when acquiring new customers, and the existing customer base experiences high churn due to customer relocations, competition, and economic factors.
Steady State
While the industry traditionally values subscribers on a multiple of monthly recurring revenue, continual reinvestment in subscriber retention and acquisition can depress reported cash flows and make the business very difficult to value.
ADT itself suggested, somewhat controversially, that rather than focusing on reported cash flows, market participants should value the enterprise by assessing its “steady-state” free cash flow.
That’s a normalized metric that attempted to account for only the limited amount of subscriber acquisition cost required to replace customer churn.
Fair Call
ADT appeared undervalued on that basis. Although the ongoing subscriber acquisition costs limited cash flow available to equity holders, Cable Car’s analysis suggested that a normalized approach was appropriate to assess the enterprise as a whole.
ADT’s Edge
ADT shares have performed poorly in recent years, as the company attracted interest from short sellers who were skeptical of the business’ cash generation capability and response to competitive threats from cable and telecom operators and new entrants in do-it-yourself home security.
Although the industry has become more competitive, Cable Car’s research suggested that ADT’s brand awareness and monitoring scale provide durable competitive advantages.
While growth has been limited, the company has reduced attrition and improved its focus on profitability.
Risk Arb
The deal is expected to be completed in June, and Cable Car believes the merger arbitrage spread is attractive.
The transaction is not subject to any financing conditions, and by contributing significant equity and debt financing of its own, Apollo appears committed to the deal.
There is also a large reverse termination fee that mitigates some of the risk of holding a position if the transaction were not consummated.
Go-Shop
ADT also has forty days from the announcement date to seek a higher bid from another acquirer. This “go-shop” period may not result in a superior proposal, but it offers an intriguing potential for additional return.
ADT has long been rumored to be of potential strategic interest to new entrants in home security, particularly deep-pocketed cable and telecom operators like Comcast (CMCSA).
At $42, ADT’s valuation on the basis of enterprise value to recurring monthly revenue would also be lower than comparable transaction multiples in the home security industry, despite the significant, transferable value of ADT’s tax assets.
Another Bidder?
These factors suggest that the possibility of a higher bid within the next few weeks is a meaningful possibility.
If a superior proposal does not materialize, Cable Car considers the proposed acquisition by Apollo very likely to be completed on schedule.
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