Brinks Home Security Holdings (CFL)
(Guest Commentary by Rick Konrad – September 18, 2009)
Dear Subscribers and Readers,
Note: I am taking my CAIA (Chartered Alternative Investment Analyst) exam tomorrow and thus really appreciate Rick “filling in” for me tonight! Unfortunately, one of Rick's close relatives had a medical emergency earlier tonight – so Rick's commentary will be brief (thank goodness things turned out okay). Again, I appreciate your patience.
For those who had wanted to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary. Rick is a regular guest commentator and usually writes for us every third Wednesday of the month. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick will discuss the home security industry and a company that he especially likes within the industry – Brinks Home Security (CFL). Rick asserts that Brinks Home Security is an interesting and compelling pick in this environment given its stable cash flows, low churn rates, low capital expenditures, and decent valuation (Rick lays out his valuation analysis by comparing CFL to the cable and satellite TV companies' business models). Without further ado, following is a biography of Rick:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Wringing Hands Not Rolling Up Sleeves” for his last guest commentary). Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog. You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
In an economy that may technically be out of recession but anecdotally still suffers from uncertainty, it seems to me that predictable, recurring revenues should carry more value. One company that I find intriguing that seems to have reasonable predictability is Brinks Home Security Holdings (CFL).
CFL is the second largest alarm monitoring company in the US with just over 1.3 million subscribers. This represents an 8% market share. The company covers 90% of US zip code locations as well as Western Canada.
CFL was spun off from the Brink's Company (BCO) which is the leader in what it describes as “secure logistics services”, the Brink's truck as well as a variety of other cash handling and ATM services. The spin-off, which occurred in October of 2008 was done unusually, debt-free.
CFL has a limited three year license to use the “Brink's “ name and intends to spend some $70-$120 million to introduce a new brand, its just announced Broadview Security.
The company has some unique competitive advantages:
- High Switching Costs and Low Disconnect Rates: Players in this industry and especially CFL benefit from high customer captivity. In fact, the symbol CFL represents the company's view that a customer is a Customer For Life. Customers tend to stick with the service provider if levels of customer service are good and CFL is considered by many to be the highest quality in the industry. CFL's disconnect rates have been in the range of 6.0%-7.5% over the last 15 years, significantly lower than its peers. Almost 50% of disconnects are due to household moves. Comparable disconnect rates for ADT, the market leader are 8-10%. I believe there are two distinct sources of such low disconnect rates:1) High Levels of Customer Service and 2) Highly disciplined customer acquisition- Unlike its competitors, CFL has grown organically through its history. It has not made a single acquisition.
- Scale Advantages and Brand Recognition: There are high fixed costs of marketing in this business. CFL spends about 20% of revenues on marketing for new customer acquisitions that it can spread over a much larger base as compared to most of its competitors. While it's relatively easy to start an alarm monitoring business (as indicated by presence of thousands of players), there are very few players with the scale and brand recognition of CFL. Its long track record of exceptional customer service has further helped it grow through word of mouth. For most of last 15 years, CFL has acquired more customers that is has lost each year (unlike ADT) despite competitors cutting prices. About 75% of its customers were acquired through its own direct response sales force with less reliance on dealers. CFL's subscriber base has never declined year over year.
CFL has been quite transparent in explaining the economics of its business to analysts. CFL earns an after tax internal rate of return of 17% on a customer installation. The typical subscriber signs a three year contract. The key to profitability is avoiding attrition and no one in the industry has been better.
I think interesting comparisons can be drawn with other consumer in-premise services such as cable and satellite. Typically, the CFL customer pays about $32 per month for the service. Compare this with cable at somewhere around $120 or satellite at around $100. Though gross profit margins of CFL are around 46%, cable enjoys higher profitability at around 60%. Yet churn for CFL is only about 8% whereas for cable it tends to run in the low 20's. CFL customers have 3 year contracts, cable, usually are month to month. Direct TV has gross margins of about 49% but churn here is also quite high at 18%. Contract duration varies.
The industry penetration for home security systems is about 22% of all homes in the US. Cable and satellite penetration is much higher. The upfront investment in each subscriber is around $1250 for home security which is higher than the $700 investment a satellite subscriber represents but there is almost no infrastructure spending that is required for CFL beyond the initial investment. As well, cable and satellite can be impacted by programming costs. The regulatory environment for CFL is almost non-existent.
Cable does have the advantage of being able to leverage its existing systems with new services such as high speed Internet, and voice, as well as digital video recorders or video on demand. Satellite on the other hand is limited to essentially a video only service.
CFL in particular has a significant opportunity to extend its growth into the commercial market, which, at $8 billion, is larger than the $6 billion residential market. Commercial at this point represents only 6% of CFL's base.
Looking at the valuation of CFL based on its subscriber base, at current prices, the value of a CFL subscriber is about $1,060 in terms of Enterprise Value. Comcast subscribers are valued at $2,700 per subscriber EV and DirecTV at about $1,500. Given the lack of infrastructure maintenance, the long term nature of customer relationships (despite the three year contract, on average most customers stay for seven years) and the relatively low penetration of homes, one could argue for a higher valuation for a CFL customer compared to the cable or satellite analogs.
There are incremental growth opportunities for CFL such as environmental and video monitoring that leverage CFL's existing infrastructure. As well, revenue/subscriber, currently at $32, continues to increase. New customer ARPU is averaging nearly $37, owing in part to enhanced services, and CFL continues to boost rates on its existing base, of which 45% is on “autopay.”
Technologically, most customers' alarm services connect through landlines, however, the move away from landlines is a positive for CFL. The company has capabilities to install GSM/wireless based equipment that garners higher prices and translates into higher returns. The company can "piggyback" on the customers' internet network, while only paying a small fee to its carrier, AT&T, on the cellular side.
In its analyst day presentation yesterday, CFL outlined the unit economics of its business as well as the historical view of subscriber operations. Please check this link.
Free cash flow conversion of net income has been excellent at 116% for the trailing twelve month period. Despite the recession, despite fears of housing's weakness, revenue growth for the trailing twelve months has been 6%. Trading at an EV/EBITDA multiple of 7.5 times, I think CFL still represents an attractive opportunity in a growing franchise that has terrific recurring revenue characteristics.
Disclaimer: I, my family and clients do not have a current position in CFL.