Last week, Keith Meister of Corvex Management LP reported a 5.02% stake in the recently spun-off subsidiary of Tyco (TYC), ADT (ADT). Meister and George Soros are urging management to lever up the company on cheap debt and return the proceeds back to shareholders in the form of dividends or share buybacks. Investors quickly sent the stock price up from $38 to $41 and change.
I went through Corvex’s presentation. Here are there major points.
Steady State Free Cash Flow
ADT has FCF of around $500 million. However, Corvex argues that this is an understatement because it includes money spent on customer growth acquisitions. The company routinely spends almost $500 million a year buying “dealer generated customer accounts.” It contends that “investors have gotten comfortable valuing REITs and other capital intensive industries on the basis of free cash flow after maintenance capex and then applying a multiple based on growth opportunities and return on investment.” It should do the same with ADT.
Corvex makes steady state free cash flow calculation for fiscal year 2013. The estimates are based on assumptions that EBITDA and average revenue per user (ARPU) grow at historical rates. It estimates that based on $1,707 million EBITDA, ADT would only need to spend $683 million to maintain customer revenue. Thus, their steady free cash flow estimation for 2013 would be around $1 billion. At the current market capitalization of almost $10 billon. The company trades at a price/FCF ratio of 10.
Their calculations make sense, but there are some caveats that investors should know of:
- The calculation assumes that EBITDA and ARPU will grow in FY 2013. It has grown historically in the past and there is no reason it won’t do so in the future.
- The calculation is based on constant revenue not constant number of customers. Based on their calculation, customers would actually go down year after year, but ARPU would go up year after year making up the lost revenue.
- There is no guarantee that other investors are going to value the company this way just because other industries are valued this way.
- The real FCF will still be around $500 million for fiscal year 2012. ADT is not going to spend less to acquire less dealer generated customers.
Corvex wants ADT to increase their Debt/EBITDA ratio to around 3 from 1.4 and keep it that way. If it did that, it should be able to borrow more than $2.5 billion, which could be used to:
- Return money to shareholders through dividends or stock buybacks.
- Grow through customer acquisition or M&A.
- Expect low tax rates for the coming years. ADT expects to have $1.0 billion to $1.2 billion federal tax loss carry forward at time of separation.
- Strong business model with recurring revenue.
- Under-appreciated secular growth tailwinds.
If ADT increases leverage and uses it to buy shares, Corvex believes the price of ADT could go considerably up. Their base case valuation is $55/share and upside case is $63/share based on a debt/EBITDA ratio of 3 and 3.5 respectively.
I will sit on the sideline for this investment because:
- Although, management is in talks with Corvex, there is no guarantee they are going to do anything.
- The stock price has almost gone up almost 10% since the announcement and this will have an effect on the buyback price.
- The value case is just not compelling enough. The value case is based on adding more debt to take advantage of the low interest rates. A lot of companies could do this to increase shareholder value.
- ADT is not cheap enough for the buybacks to have a substantial effect. What happens when the cost of funding goes up in the future?