This New Spinoff Begs Your Attention

This company has many of the great, oft-cited Warren Buffett requisites – a wide moat business and simple, sustainable business model, and is trading at a discount to its intrinsic value given its growth prospects. What's better, it's also a member of the spinoff crew -- a group that historically outperforms. IPOs are no longer on the radar for many investors, given the seemingly never-ending IPO flop market, but this one need not scare you. This company has been around for over 100 years, makes over $3 billion annually, and still has double-digit growth prospects. Now that I have your attention, let's begin.

Introducing a company you already know
Since making its grand entrance onto the New York Stock Exchange after 138 years of being in the home security business, ADT (NYSE: ADT  ) , which went public on Monday, is up almost 8%.

ADT is the largest home security provider in the United States, with over 16,000 employees serving 6 million customers. The company is the top competitor in a phenomenal industry. Security systems are essentially commodity products -- making price and marketing efficacy the most important traits. ADT has more customers than any other home security company and isn't likely to lose more than a few to its competition. Since 2009, revenues have risen 43%. Customer count has risen nearly 34%. One more statistic, and perhaps most important, is the 56% gain in cash flow from operations over the last three years.

While one can find recent IPOs with faster growth and juicier numbers, this is simply a superior business. Ninety percent of ADT's customers are recurring, and attrition rates have dropped a percentage point since 2009 to 13% per year. The company strongly benefits from the fact that it breaks even on a customer after only three years, and for the duration of the relationship is cash flow positive. Two years ago, the company bought competitor Brink's (NYSE: BCO  ) home security division for roughly $2 billion. This move helped secure ADT's position, representing a quarter of the entire home security market.

The situation
ADT was spun off from Tyco (NYSE: TYC  ) . Tyco has slowly been divesting itself of assets, itself becoming a more nimble, efficient home protection and industrial products business. ADT benefits from the housing rebound, regardless of when exactly that occurs. There are two factors to keep in mind with the housing situation and ADT's advantage. New home starts are still at multi-decade lows. With this fact in mind, and given the growth of the U.S. population, one can safely assume the number of newly built homes is only going to rise. These homes will likely be wired for alarm systems, as is now common practice.

The second point worth noting is that if the economic recovery continues to come about slowly (if at all), people will be less encouraged to upgrade to a new home, and instead opt to remodel their existing home. When remodeling, owners will often turn to alarm systems as they are a cost-effective way of raising the value of a house and lowering insurance premiums.

These points have been made before for a company that has already seen substantial gains from the current housing climate. Fortune Brands Home and Security (NYSE: FBHS  ) , itself a spinoff, has been a fantastic holding and is poised for further growth driven by its brands such as Moen faucets and Masterlock security products. ADT should experience similar growth in its niche of home security products.

The risks
Given that security systems are a commodity item, ADT is subject to intense competition. Its success in obtaining and retaining customers is dependent on competitive pricing schemes, effective promotions, and adapting to technological change.

Telecom giants such as AT&T (NYSE: T  ) have been rolling out home security and automation packages to existing customers in an attempt to lure a portion of the home security market over to their side. This is a formidable threat to ADT, but I believe that the company's name is synonymous with home security and will that it will be the first company on the mind of most potential customers.

The prospects
For a company like this, I like to look at the price-to-free cash flow to view the company from an owner's perspective -- how much cash comes to me at the end of the day. For ADT, its price-to-free cash flow suggests a market price of over $40 per share, today. This means that if investors want to see a 5% return on free cash flow compared to market cap (sometimes referred to as owner's earnings), those investors would be willing to pay around $40 per share. So if the company continues to increase cash flow in the future, it will lead to share price appreciation because investors will pay more for more earnings over the long term. When the future is taken into account, this number only goes higher.

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Fool contributor Michael Lewis owns none of the stocks mentioned above. You can follow him on Twitter @MikeyLewy. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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