ADT - ADT: Surveilling The Long-Term Debt

2023-10-23 11:27:44 ET

Summary

• ADT Inc. is divesting its commercial segment to pay off a part of the company's immense long-term debts.
• The company has achieved growth in revenues and margins, but the debt balance requires the good performance to continue to satisfy shareholders.
• The current investment case is very volatile - for the time being, I am on the sidelines with a hold rating.

ADT Inc. ( ADT ) provides smart home solutions. The company has a very large debt balance, leveraging risks immensely for investors. As ADT is divesting its commercial segment to pay off a part of the debts, the company is at an interesting point in time. I believe that the market is currently pricing in some growth for the company, but not quite in line with ADT’s historical performance. The investment case is very volatile in total – because of the debt, investors need a good performance in the operations, but I believe a great performance could raise the stock price very significantly. For the time being, I’m on the sidelines with a hold-rating.

The Company & Stock

ADT provides smart home solutions to consumers and small & large businesses. The company’s plan is to be an all-in-one provider for smart home solutions with significant cross-selling opportunities, as the company currently holds a large amount of products. Currently, sensors, cameras, smoke detectors, and security systems represent the dominant portion of ADT’s revenues.

The company also sells rooftop solar panels, although the segment represents a small, shrinking and unprofitable part of the business – in Q2, the solar segment’s revenues decreased by 64% and the segment realized adjusted EBITDA losses of $37 million.

ADT is divesting its commercial part of the business for a valuation of $1.6 billion. The segment is expected to represent around $1.35 billion in sales in 2023 with an adjusted EBITDA of around $150 million. The segment represents around 21% of ADT’s sales when compared to ADT’s full-year 2023 guidance as of Q2/2023:

The commercial segment doesn’t in my opinion represent a fifth of ADT’s value, though – the commercial segment has a clearly lower adjusted EBITDA margin than the consumer and small business segment, as the divesture’s effect on adjusted EBITDA is only around 6%. I believe that the divesture is a good move, although seems like almost forced for ADT – as is to be explained later, the company’s debt balance signifies a heavy burden for ADT, and the proceeds from the divesture are likely to be used to deleverage the balance sheet.

Investors haven’t seemed to appreciate the company’s performance as a public company. From ADT’s IPO in January of 2018, the stock price has fallen by 43%:

Financials

After significant acquisitions in 2015 and 2016 skyrocketing the company’s revenues, the company has achieved a compounded annual growth rate of 13.8% from 2016 to 2022:

The company has had some small cash acquisitions in the period, but I don’t believe the acquisitions to represent a significant amount of the company’s achieved growth.

ADT has achieved a breakthrough in the company’s margins in 2022. The company’s EBIT margin went from an average of 5.4% from 2016 to 2021 and a level of 1.0% in 2021 into a figure of 11.4% in 2022:

The margin has improved further in the first half of 2023, as ADT’s trailing EBIT margin as of Q2/2023 stands at 15.9%. The achieved margin is a result of improved sales and gross profit, as well as cost takeouts – in H1 of 2023, total operating expenses were $212 million below the amount in H1 of 2022. As ADT’s revenues could grow further, the company could achieve an even higher margin than the figure achieved in 2022.

ADT’s balance sheet is riddled with debt. The company currently holds around $9.6 billion in long-term debt, of which around $0.8 billion is in the current portion. The company’s current market capitalization only stands at $5.7 billion – the debt represents most of ADT’s financing and leverages shareholders’ exposure to operations significantly. With trailing figures, interest expenses represent 42% of ADT’s operating income. ADT is in the process of deleveraging the balance sheet as the proceeds from the commercial divesture will be directed towards debt payoffs, but as the debt balance is at a very high level, paying off a significant amount of the debt should take a long time – the divesture only covers around $1.5 billion of the debt.

Valuation

To conceptualize the valuation of ADT and to estimate a rough fair value for the stock, I constructed a discounted cash flow model as usual. In the model, I estimate revenues to stay flat in 2023, in line with ADT’s guidance. After 2023, I estimate the growth to continue, although with a slower pace than historically – for 2024, I estimate a growth of 7%. After the year, I estimate ADT’s growth to come down in slow steps into a perpetual rate of 2%.

As for the margin, I estimate further leverage. ADT has achieved a great level in the company’s operations in 2022, and is leveraging the margin further with cost takeouts and revenue growth. For the current year, I estimate an EBIT figure of $794 million, around 8.5% above the 2022 figure. The EBIT margin for the year is 12.4%, one percentage point above 2022. After the year, I estimate further operating leverage and slight cost takeouts as I estimate the EBIT margin to scale to an eventual figure of 15.8%. I believe that ADT has a very good cash flow conversion, as the company has a large amount of amortization lowering the EBIT, as well as tax-lowering interest expenses.

The mentioned estimates along with a cost of capital of 9.24% craft the following DCF model with a fair value estimate of $5.28, around 16% below the price at the time of writing:

The weighed average cost of capital of 9.24% is derived from a capital asset pricing model:

In the past twelve months, ADT had $433 million in interest expenses. With the company’s outstanding interest-bearing debt balance, ADT’s interest rate comes up to 4.53%. ADT is in the process of deleveraging the debt as quickly as possible through the divesture as well as cash flows. I still estimate a high long-term debt-to-equity ratio of 50% as the company’s payoffs should be slow with the immense amount of debt.

I use the United States’ 10-year bond yield of 4.91% as the risk-free rate on the cost of equity side. The equity risk premium of 5.91% is Professor Aswath Damodaran’s latest estimate made in July. Yahoo Finance estimates ADT’s beta at 1.68 . Finally, I add a small liquidity premium of 0.25% into the cost of equity, crafting the figure at 15.09% and the WACC at 9.24%, used in the DCF model.

Takeaway

Currently ADT’s investment case is very volatile. I believe the company is trying to deleverage its balance sheet as quickly as possible through the divesture of the commercial business that sells solutions to large businesses, but the debt is still very much higher than the proceeds from the divesture. If ADT proves to continue its path on growing sales as well as margins, the stock could be a fantastic investment. On the other hand, if the company doesn’t grow, I believe the stock price could still see significant downside; for the time being, I have a hold-rating.

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