State Farm Likes ADT: Should You?

ADT (ADT) announced on Sep. 6 that State Farm, a mutual insurance company owned by its policyholders, would acquire 15% of the struggling security company for $1.2 billion, or $9 a share. The deal gives ADT an enterprise value of $16.7 billion.

In addition to the significant investment by State Farm, which makes it ADT’s second-largest shareholder behind Apollo Global Management (APO), the insurer is also investing $300 million to fund product and technology innovation at the company. 

At the same time, Google -- ADT’s third-largest shareholder at 6.1% as of March 30 -- is investing $150 million to help accelerate the development of some of these innovations. 

While it’s a no-brainer for ADT management and the board, investors might want to think twice before jumping on the bandwagon. 

ADT’s New Partnership Has Potential

A bright spot in ADT’s announcement is that the equity investment by State Farm won’t be dilutive to existing shareholders. 

Instead, ADT will commence a self-tender offer for 133.3 million shares of its stock at $9. Apollo, which owns almost 68% of its stock, will buy any of the shares that aren’t acquired by the self-tender offer. Google won’t tender any of its Class B shares. It will own 6% after the completion of the tender offer. 

The partnership between ADT, State Farm, and Google makes sense. 

State Farm gets a partner that it can work with to reduce its underwriting claims. At the same time, Google can benefit from the security insights of one of the world’s leading home and business security companies. 

“This partnership gives State Farm the opportunity to provide smart home technology that takes us from our ‘repair and replace’ model to a ‘predict and prevent’ mindset. These innovations will help us take the next step into the future of home insurance and add more value for our customers,” State Farm Chief Operating Officer Paul Smith said in ADT’s press release. 

There is no question that smart home security solutions help lower premiums by cutting down on the number of claims from damage from water, fire, and intrusions. That’s a given. 

ADT’s Future Growth

ADT laid out its long-term growth strategy in March at its 2022 annual Investor Day presentation. 

Part of that strategy includes capturing a large piece of the solar market. In November 2021, it announced an $825 million cash-and-stock acquisition of Sunpro Solar, one of the largest residential rooftop solar contractors in the U.S. The company was rebranded as ADT Solar. In the second quarter, ADT Solar generated $215 million in revenue. 

The company estimates it can capture 5% of the total solar market -- $23.4 billion by 2025 -- by converting less than 1% of its existing 6.6 million customers.

With the addition of its solar business, it now has three healthy revenue streams -- Consumer & Small Business (CSB) and Commercial are the other two -- to drive future revenue growth. 

Between 2021 and 2025, it plans to grow its revenue by 15% yearly to more than $10 billion. More importantly, it expects its Commercial and Solar businesses to grow faster than its CSB unit. Today, CSB revenue accounts for 70% overall. That will be closer to 50/50 by the end of 2025.

At the same time, it expects the growth to be more profitable than in the past. By 2025, it plans on generating more than $3 billion in adjusted free cash flow, allowing it to reduce its net debt by $1 billion by 2025.

It sounds very promising.

Beware the Debt Monster

Apollo acquired ADT in May 2016 for $6.93 billion. It merged ADT with Protection 1, an existing business it owned that installed security systems in the U.S.

Like many private equity deals, much of the transaction price was paid for with new debt on ADT’s balance sheet. On Dec. 31, 2015, ADT had $1.33 billion in long-term debt. One year after Apollo’s acquisition, it had $9.47 billion, more than 7x greater. 

How much had things changed over that year?

At the end of ADT’s 2015 fiscal year (September year-end), it had $3.57 billion in revenue, up from $3.41 billion a year earlier. In fiscal 2016 (December year-end), it had $2.95 billion in annual revenue, down from 2015. However, in the 12 months ended March 31, 2016 (the last quarter before Apollo acquired it), it had $3.6 billion in revenue, flat from fiscal 2015.

Since 2017, revenues have grown from $4.32 billion to $5.31 billion in 2021, a compound annual growth rate of 5.3%. At the same time, its profits have fallen dramatically over the same period. 

In Q2 2022, its total debt of $9.84 billion was 413.4x its net income. Excluding cash, its net debt of $9.73 billion was 4.2x its adjusted EBITDA. Since May 2016 and Apollo acquired ADT, its long-term debt has fallen by just $470 million. 

Free cash flow positive, it should have been able to reduce its debt to a greater degree than it had since going public in 2018. That’s a big red flag. 

However, based on its trailing 12-month free cash flow of $781 million, it has a free cash flow yield of 10.4%. I consider anything above 8% to be in value territory. 

While its debt is ridiculously high, ADT’s latest news should interest aggressive investors. It certainly puts an artificial floor price of $9 on its shares. If you’re risk averse, I still wouldn’t touch it.   

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