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ADT Must Find a Way to Reverse This Trend

ADT (UNKNOWN: ADT.DL  ) is the largest security company in North America, with approximately 6.5 million customers. Being the largest company in any industry is a plus, as it often means a strong market-share position. However, it doesn't guarantee that the company is heading in the right direction.

A happy separation
Last year, Tyco (NYSE: TYC  ) separated into three different companies: ADT, Pentair (NYSE: PTR  ) , and Tyco International. The goal was for each company to establish industry-leading positions and unlock more value for shareholders. ADT is up approximately 2% year to date, which isn't anything to get excited about, but at least it yields 1.20%. Tyco and Pentair are up approximately 19% and 28% year to date, respectively, and they yield 1.80% and 1.60%. Tyco is now focused on global commercial fire and safety, and Pentair offers services for waters and fluids. 

Tyco relies heavily on commercial construction, and it has positioned itself in emerging markets. The company's strong cash position and cash flow capabilities should allow it to grow organically. However, it can also grow inorganically through acquisitions. For instance, it recently acquired Exacq Technologies, a video management systems company, for $150 million in cash. Tyco expects this acquisition to add $75 million in annual revenue. At this point in time, you might be considering an investment in Tyco without even bothering to read about ADT, but that wouldn't be a recommended course of action. Before we get to ADT, let's first take a quick glance at the other separated company, Pentair. 

Pentair has positioned itself in high-growth areas, especially India, China, and Brazil. With the increasing infrastructure needs in these countries, this should pan out well for the company. Additionally, Pentair has a strong history of positive earnings surprises and dividend hikes, both of which investors appreciate. Additionally, Forbes recently rated Pentair 96 of 100 on its 2013 "100 Most Innovative Companies" list. With 1,300 engineers with various backgrounds and expertise, as well as 800 U.S. patents, this ranking seems to be justifiable. It's possible ADT is even more appealing, even if for different reasons, but that's not a promise.   

Out on its own
The key word to remember when studying ADT is retention. Without retention, ADT fails, simply because it takes three years for the company to break even on a customer. This is why ADT is so adamant about superior customer service and high-quality products.

If a customer is retained, then ADT can rely on recurring monthly fees, which by the way, have increased. In Q3 2012, the average monthly revenue per customer stood at $38.86. In Q3 2013, it increased to $40.08. Of course, this wasn't going to make customers happy, but it had to be done.

Customer attrition has been increasing. For example, the customer attrition rate in Q3 2012 was 13.2%. In Q3 2013, it increased to 13.8%. Since this is only a small sampling, consider that the customer attrition rate was 12.7% on Sept. 30, 2012. The trend is heading in the wrong direction. It's unlikely that this is the fault of ADT. The company's products and services are known to be top of the line. It's more likely that ADT has been the victim of cost-cutting by consumers who are more nervous about their fiscal situation that they had been in the past. Regardless of the reason, it's a negative trend.

If you only looked at revenue, which increased 2.3% to $833 million in Q3 year over year, you would think that the company was hitting on all cylinders, but the increased revenue is primarily tied to price escalations on existing customers and higher rates on new customers, not gross customer additions, which fell from 291,000 in Q3 2012 to 276,000 in Q3 2013.

Tyco and Pentair are moderate-risk, high-potential plays. They're only considered moderate-risk, opposed to low-risk, because they're not likely to hold up well if emerging markets stop emerging, the global economy slows, and the broader market falters.

ADT has managed to grow despite a consistently increasing attrition rate. This is an indication of strong management. On the other hand, it's difficult to fight against industry trends over long periods of time. With consumers cutting costs at every angle possible, ADT doesn't look to be a better investment option than Tyco or Pentair. None of these stocks is resilient, but Tyco and Pentair present more upside potential.

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