Home security company ADT (ASX:ADT) priced its initial public offering in January, and its shares have experienced a steady, downward slide since then.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Motley Fool contributor Asit Sharma profile the company that is facing changes in its industry that could end up being both major opportunities and threats to its business.

A full transcript follows the video.

This video was recorded on April 3, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, April 3rd, and I'm your host, Vincent Shen. I've just returned from sunny Austin, Texas, and I'm happy to be back in the studio with you, Fools.

Today, we're going to turn our attention to consumer and retail IPO activity in 2018 again, this time with the approximately $6 billion security specialist ADT. Joining me via Skype is senior Motley Fool contributor, Asit Sharma. Thanks for hopping on today!

Asit Sharma: Thanks a lot, Vince, for having me! It's good to be with you guys again!

Shen: I'm not sure, Asit, if you have any personal experience with the company, but my parents actually had ADT installed in our home growing up, and I'll never forget setting the alarm off by accident when I was a kid.

I fat fingered the code a few times after the alarm went off, and the police ended up showing up at my front door. I think I was maybe seven or eight years old at the time, so it was a bit of a disaster, because I think that was right around when my parents had just started to trust that I could stay at home by myself, and I think that put a little bit of a kink in terms of my plans for that. But I've had some personal experience with ADT. I didn't realize the company was quite as big as it is until we started doing our research for the show.

This company recently went public for a second time through an initial public offering. Ticker is ADT, easy enough to remember. They serve 7.2 million residential and commercial customers with security and monitoring services. That makes it one of the leaders in this space, absolutely. ADT actually priced its IPO on January 18th. From the start, the company has been running into some speed bumps. The IPO itself was originally slated to price between $17 and $19 per share, but it ultimately came in under the range at just $14, raising $1.5 billion.

At pricing, ADT had a market capitalization of $10.5 billion, but the key word there is that it had a market cap of around $10.5 billion. Even though the IPO priced below the range, in its two and a half months on the market, the stock has declined further to less than $8 per share, and that's basically cut the market cap in half to less than $6 billion.

We'll get more into the details and drivers behind some of that bearish public reception. But first, some background for the company itself. Asit, can you give listeners an overview of this company and this business?

Sharma: Sure. I have to put in one really bad pun before I begin. I was listening to you, Vince, talk about how the stock had declined, priced below expected range and descended on down. No reason to be alarmed.

Shen: [laughs] That was bad.

Sharma: We had ADT, too, for a while. I think many of our listeners should have some experience with this company. Anyway, this is in the monitored home security industry. ADT, of course, is a giant in this field. It has two primary brands, its namesake brand, ADT, and Protection One. As Vince said, it serves residential and commercial customers, about 7.2 million customers. And it does this through two channels -- direct channel sales and indirect channel sales. Direct channel sales has a sales force of about 2,900 sales consultants. In its indirect channel, it uses about 300 dealers throughout the U.S. and Canada. These are ADT-authorized dealers. Outside of that, it has about 4,600 insulation and monitoring technicians. These people are based out of 200 sales and service centers in the U.S. and Canada. One thing we all know, those of us who have had any kind of security service, it's labor intensive to install and sometimes to maintain.

Now, it has a lot of its recurring revenue through monitoring centers. That's when you get an alarm, or maybe you have a kid like Vince who fat fingers the alarm, and you have to call in to a monitoring center. It has 12 of these in North America. These are staffed with an additional 4,200 customer service reps. Something interesting about ADT that I found out doing research for the show is, it's not a manufacturer, it's just a distributor. It purchases equipment from third-party suppliers and distributors, and then it installs this equipment in your home and maintains it when it needs to.

As for competition, you've probably heard of some of these names. I read through their annual report preparing for the show. Vivint Incorporated, Stanley Security Systems, which is a subsidiary of Stanley Black & Decker, Comcast Corporation, and also companies like AT&T are edging into the business. Some of you are probably familiar with Ring Security, which we will probably talk about later in this show. That's just been acquired by Amazon. So, there's a raft of competition.

Shen: Thanks, Asit. Something else to keep in mind, too, is this recent IPO is a deal that came about after the company was taken private in 2016. The New York Times has a quick summary of how ADT came to be, from an article in 2016 that I thought was interesting. I'll quote that here. They said, "ADT traces its roots to Edward A. Callahan, the man who invented the stock ticker in 1867. When Mr. Callahan, the president of Callahan's Gold and Stock Telegraph Company, found a burglar earlier in his home, he created a telegraph-based alert system. After more than a century of acquisitions and antitrust rulings, ADT was acquired by Tyco in 1997. Tyco decided to be broken up into three units in 2012, making ADT once again an independent company." And after that, they were taken private by Apollo, and two years later another IPO, which leaves us here. 

So that deal in 2016 was a leveraged buyout, something that we talked about last week, in terms of the retail space. The Apollo deal was actually valued at $6.9 billion. So two years and a string of acquisitions and mergers later, ADT is currently playing catch-up still, in terms of the recent trading.

Going back to some of the business-focused aspects of this company, some of the things you mentioned like the customer contracts, I think it's interesting to note that the typical customer contract has a three-year term for residential customers and a five-year term for commercial ones. The big thing here is, after a customer pays an upfront fee, they also make those monthly payments for the remainder of their contract. Coupled with automatic contract renewals, as you mentioned, Asit, this business model generates a relatively stable recurring source of revenue. I think something like 90% of the top line comes from those recurring monthly payments. 

But the flip side of the equation is that onboarding customers requires installation and other costs that the company has to bear upfront as well. ADT generally, I believe, needs about three years to break even on that initial investment in a new customer. So these longer-term contracts are definitely very important, but also retaining those customers is very important. And in the company's 10-K, ADT named some of those big competitors that you mentioned. In addition to that, there's a lot of new small companies that are entering the space. As a result, if you browse the company's press releases and their announcements in their investor relations page, you'll see that management is announcing a lot of collaborations with other companies that, for example, contract for its monitoring solutions, or they're working to integrate a lot of smart home features from big tech names, even like Amazon and Samsung. So the company has definitely changed quite a bit in the past few years. Again, there's a lot of deals and acquisitions in that time, not only for Protection One and ASG, that were really critical to the formation of ADT as it currently stands, but in 2017 alone, I think there were another four or five additional smaller deals. Many of those were intended to bolster their commercial offerings. Those were followed by two more deals in just the first few months of 2018.

Coming up, we're going to take a closer look at some of the numbers behind this business, and what kind of threats and opportunities the internet of things and other consumer product innovations pose for the company's outlook.

Alright. ADT released its earnings for full-year 2017 not too long ago. They saw annual revenue come in at about $4.3 billion. At this scale, you have to think slow and steady when it comes to growth for this company. Estimates put top line growth in the low single-digits going forward for the next few years. But Asit, how about some of the other metrics that stood out to you? I think during the recent call, for example, things like attrition and debt seemed to be areas of focus. What caught your eye?

Sharma: Attrition caught my eye, first off. In this business, if you've owned a system, after some time you get competing offers, or you decide that you really don't need so much of this home security aspect. So they tend to see a pretty interesting customer attrition rate. Historically it's been around 16%. One of the positives that the company points out leading up to its IPO and since then is, it's brought that attrition rate down to below 14%. I think as of fourth quarter, it's at 13.7%. Just to translate what that might mean to the company in terms of dollars, every 100 basis points or 1% that they can reduce that attrition rate, that saves them $100 million that they would otherwise have to spend to offset a loss in revenue. So that number is very important for ADT.

But I want to walk backwards to another number which really caught my eye. In terms of long-term investors, how you look at a company's balance sheet and its prospects, we often talk about margins and revenue. Let's work backwards today from the balance sheet of this company. We'll go into a little, short bit of history on why this IPO needed to happen, then talk about the company's debt burden.

One of the reasons, maybe the primary reason, that ADT went public again is, Apollo Management decided that they wanted to keep control of the company while offloading a little bit of the debt. Vince, you and I were talking before the show, the company has roughly $11 billion in debt. We know that through this IPO, they're going to reduce that by a little bit, about 15% of that overall debt. The main burden that ADT wanted to get rid of was $750 million worth of preferred securities which they owed to Koch Industries. These preferred shares, if you're the lender, they're great, because you have priority over common stockholders, and you often get a really sweet dividend. So they were on the book in terms of interest expense for 9% on this $750 million. With the proceeds that Vince mentioned, about $1.42 billion of proceeds, the company has put $750 million in escrow to get rid of this obligation which has this 9% burden on it. It used another $649 million to redeem some other debt that was also high interest. That left the company with $60 million to pay a little bit of fees from the IPO. So all the proceeds really went to reducing debt.

The problem that ADT has is not really leverage, however. We talk a lot on the show about companies which come to market with high debt burdens. In fact, listeners may remember, just a couple of weeks ago, we talked about Hudson having sort of a large debt burden that it needed to reduce over time. ADT has that. It's not that much of a problem in terms of the size of the debt. They're leveraged about 4x their EBITDA, earnings before interest, taxes, depreciation and amortization. Not a really high number. They want to move to 3x that. The problem is, they still have a lot of debt that's high interest. There are about $3.1 billion of senior notes which carry, again, an interest rate of 9%. That's a huge interest burden. 

In fact, the company had its IPO in January, and Wall Street was surprised last month in the middle of March when ADT had its first earnings report. Analysts were not expecting a loss, but that's just what happened. The net income on the books looked pretty great. It was, I think, some $600 million. But after you took out the tax benefit that the company received -- we're seeing a lot of companies, due to the recent tax legislation, get a big tax benefit. Once you remove that, ADT swung to a small loss. The same thing happened during the year. If you look at the whole year, $343 million in net income reverts to a loss of $422 million when you factor in the debt that's there, and you take away the $764 million tax benefit. 

So just to summarize everything I'm saying, if you take away those one-time gifts from the federal government, ADT actually operates at an annual loss. It did it in 2016, and it's done it again in 2017. And I'm actually very curious to hear your thoughts, Vince -- I'm not sure it will be able to swing to a profit any time soon.

Shen: Yeah, I think that was definitely a big surprise, as you mentioned, with the earnings release a couple of weeks ago now. It's surprising to me, because I think it probably has to do with those high upfront installation costs the company has to bear. Usually, more so on the tech side, but sometimes in our consumer retail space, too, we look at these companies where they're able to generate this subscription, monthly recurring revenue that you can compare to a Netflix, for example, and some of the positives of that.

As you scale, you see a lot of benefits in terms of your profitability and things along those lines. I think that exists here, but there's the upfront costs that the company has to bear and also the attrition rate that they're trying to manage, and we know that as that improves, they see a direct positive in terms of how that bolsters their cash flow. But that's definitely something that investors have to monitor with this company as things go forward, also in terms of the debt reduction and the high balance that we often see with these kind of leveraged buyout deals when the companies go back onto the market.

We have a couple of minutes left here, and I do want to spend some time looking at the outlook for the company and also for some of its services and how that will change with some of the new technology, the do-it-yourself offerings that customers are adopting as well. For ADT, I think the biggest question, at least for the residential side of its business, is whether or not the company will be able to really compete as these do-it-yourself alternatives become more and more popular. You also have all these new smart home devices that can offer similar monitoring and protection services that could arguably make what ADT offers redundant. I'm curious what you think about the prospects for this company going forward in that regard.

Sharma: Right. Interestingly enough, Ring is such a great example of a small do-it-yourself company, which Amazon just acquired. That was one of the announcements in the last few weeks that pushed ADT's stock down. I would look at it as a real competitive threat. But interestingly enough, ADT's executive team actually likes this whole progression because they have a lock on the traditional home security market. And what they see is, smaller companies or companies that may team up with an Amazon will develop younger millennials who are interested in the do-it-yourself technology. And on the company's earnings conference call last month, the CEO, Tim Whall, described how these are often renters. ADT sees this as a progression, where you do your own security yourself in your small apartment, but when you're ready to move into a home, you need a better system. And they see themselves as a company that can merge up and partner up with companies that grab these millennials. And it's a long-term benefit in ADT's eyes.

Now, I don't know if that's actually how this will all pan out. It's a really fast-growing market. Vince, you mentioned this digitally connected market, which is yet another subset of the home security industry, that is the so-called smart home powered by the Internet of Things. That subset is growing at a compounded annual growth rate of 17% a year, so it's doubling nearly every five years. And ADT is just a little bit late to the game. As you mentioned, it made some small acquisitions to play in this space. It's open yet to see whether they will eventually benefit by scooping up companies and/or partnering with them as customers buy these new technologies, or if they'll lose out, and with that high fixed cost space, if they are destined to a low single-digit growth rate and a high debt burden, which is still going to take some years to pay off.

Shen: Absolutely. As promising as it is, I think, to see ADT embracing some of these collaborations, some of these partnerships with both the big tech companies like Google and Amazon, I kind of question whether that competitive dynamic will prove to be a long-term tailwind in terms of attracting those younger consumers. I definitely think it's a possibility, and again, we'll have to see how things bear out. But the effort that's required for a renter, for example, to self-monitor a do-it-yourself system, the various motion detectors and sensors that you can install now in your own apartment or your home, they will send a pop-up notification through to your phone when something's detected, compared to the ADT system where they have the 24/7 monitoring, they have those 12 dedicated monitoring centers in North America. But that doesn't make up for the added cost of what is essentially a middleman here between the resident knowing that something might be wrong, in terms of a smoke detector going off or an intruder on their property, and then contacting emergency services.

The company also mentions that they have a real focus right now on optimizing, for example, their customer service and offering a really good experience for customers and hoping that will be a differentiator that will set them apart from some of these competitive threats, in terms of the do-it-yourself side of the business. And I do agree with the overall premise, the idea that the DIY market will help increase the entire pool of customers and potentially lift the overall industry. And obviously ADT will have to adapt and find ways, in terms of collaborations and partnerships, to get into that.

The other part, the side of the business that I think actually sees a little bit more concrete strength is on the commercial side, that looks a lot brighter to me. That was a big part of the Protection One integration. The big thing here is, large commercial customers usually offer lower attrition rates, a shorter payback period for the company to break even. I think this explains why a lot of the acquisitions that they've made in 2017 and 2018 so far are these bolt-on, tuck-in acquisitions that are intended to support that commercial side of the business and the opportunity that it presents.

We have a couple of more minutes here. Any final thoughts from you, Asit, in terms of people who might be looking at this company, considering the downward slide in terms of the stock price and things like that, what they should be focused on?

Sharma: The good news is that the company's enterprise value to EBITDA, which we talk a lot about on this show, enterprise value being your stock market capitalization plus your debt divided by your earnings before interest, taxes, depreciation and amortization, that number is around 7x. Sox not a bad or pricey stock. That's the flip side of the steep descent since its IPO. Be cautious, investors! I would watch that balance sheet over the next couple of quarters.

My last thought is, I want to expand a little bit on something Vince mentioned. That commercial side does have some promise for this company. One of the reasons is that, the bigger the commercial enterprise, the more likely they're going to want to put the equipment on their own books. Why that's important is because when ADT sells a system to me, it sells it in such a way that it will own the equipment. It's forced to capitalize all those costs over a two to three year period that corresponds with the period Vince was mentioning when the equipment is paid off. So basically, the company can't expense that equipment all at once. Remember, it's not a manufacturer. It doesn't actually own it yet. And these are all transactions that occur over the balance sheet. But as it goes more into commercial business, it will have a higher expense on that equipment, or companies that it's selling to will own the equipment, so it'll have an even higher margin just selling its recurring monitoring services. And that could be powerful, if the company can continue to acquire smaller concerns that play in this commercial market. I do think that's a bright spot to keep your eye on over the next few quarters as you watch this. We always advise with new IPOs, you don't have to jump in on day two. You can watch these for three to four quarters, and then decide if you want to take a position or not.

Shen: Yeah. And even if you see a lot of potential in this company and the industry overall, beyond the concerns that we always have in terms of jumping into a recent IPO, definitely don't look at the recent slide as just an opportunity, a bargain, time to jump in. There's always the potential, of course, for it to go even lower. 

Definitely one that's interesting to watch, given its leadership position in the industry. But also, in terms of some of these competitive dynamics, it's something that I'm sure we'll touch base on toward the latter half of this year. Thanks, Asit, for joining us!

Sharma: Thank you very much!

Shen: Thanks, Fools for listening! People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!