Why ADT Stock Is Worth Buying

ADT has a sticky business model, a reasonable balance sheet, and a well-covered and growing dividend -- and it may well be available at a bargain price.

Chuck Saletta
Chuck Saletta
Jul 21, 2014 at 7:17PM
Investment Planning

Security giant ADT (UNKNOWN:ADT.DL) may be relatively new as a public company, but it traces its roots to 1874. ADT only became independently public in 2012 when it spun off from Tyco (NYSE:TYC) as that conglomerate broke itself apart to unlock value from its parts.

While the Tyco breakup showcases just how hard it can be to maximize value in a conglomerate structure, it did open up ADT as an attractive business to own. What makes ADT so appealing is its sticky subscription model. Its customers buy a system and then pay ADT a recurring monthly subscription fee for monitoring. The upfront cost of the security system keeps people from switching, enabling high margins in its monitoring business.

The 800-pound gorilla in the room
ADT is far and away the largest player in America's security monitoring business, which gives it tremendous scale in its operations. Additionally, ADT's security services go beyond those blue signs on people's homes. The company also provides business alarm systems and home health monitoring systems, too -- with similar subscription monitoring models.

Part of what makes the alarm monitoring sticky is the cost of switching services: Once a system is in, it costs money to install a different provider's system, and that would just shift, rather than eliminate, the monitoring fees. The other key driver of the stickiness with alarm systems is property insurance discounts. Discounts can be as much as 20%, largely or even completely offsetting the monitoring fees.

On top of its current services, ADT continues to innovate. Its recent partnership with Ford (NYSE:F) will allow consumers to control parts of their houses -- like their garage doors and their thermostats -- from their cars using voice commands. That partnership is a great combination of Ford's SYNC technology and ADT's home control and security dominance, and it could add value for both companies.

That combination of scale, innovation, and a sticky business model makes ADT a company worth considering. Combine that with a great financial picture, and ADT becomes a company worth owning. It has a decent balance sheet, a reasonable valuation, and a covered dividend that already shows signs of growing in the company's brief life as a publicly traded business. Because of that combination, I intend to buy ADT's shares for the real-money Inflation Protected Income Growth portfolio.

The financial reality
ADT maintains a decent balance sheet, with a 1.5-to-1 debt-to-equity ratio, a current ratio just above 1.0, and more than $330 million in cash. The company does use debt, but it hasn't overleveraged itself to the point where a typical hiccup in the economy would be likely to derail its operations.

The company's dividend currently sits at $0.20 per share per quarter, up 60% from the $0.125 it had paid since it split from Tyco in late 2012. With a 34% payout ratio, the company has room to continue increasing its dividend, should its leadership choose to do so. While there are no guarantees that it will continue to raise its dividend, a 60% increase doesn't happen by accident. ADT sent a signal with the size of its last dividend hike that it's willing to reward its investors for the risks they take for owning its stock.

From a valuation perspective, ADT looks like it potentially trades at a bargain price. A discounted cash-flow analysis that assumes a modest near-term growth rate of around 4% estimates the company's value around $8.1 billion. That's above ADT's recent market capitalization of around $5.9 billion.

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What could go wrong?
Of course, no company is without risk. ADT just spent $591 million to buy Alliance Protection to improve its Canadian footprint. Acquisitions can be a good thing, but they often distract a company's leaders from its core operations, leaving room for competition to gain a stronger foothold.

Additionally, ADT's stock fell significantly earlier this year when it substantially missed earnings expectations and posted numbers with lousy year-over-year comparisons. Further disappointments are possible, of course, but it's in large part because of that plunge that ADT's shares today look like they could be attractively priced.

What comes next?
Once the Fool's disclosure policy allows, I intend to buy around $2,000 worth of ADT's stock for the iPIG portfolio, so long as its shares remain below $35 each. Also, to score the performance of this pick, I'm making an outperform CAPScall on the stock at Motley Fool CAPS, putting my All-Star ranking on the line along with the plan to invest cold, hard cash.

To follow the iPIG portfolio as buy and sell decisions are made, watch Chuck's article feed by clicking here. To join The Motley Fool's free discussion board dedicated to the iPIG portfolio, click here. To see the iPIG portfolio's online tracking spreadsheet, click here.