Debt Becomes a Major Drag on Earnings for ADT

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In this segment of from Industry Focus, the cast continues their discussion of home and residential security provider ADT (NYSE: ADT).

Since its lukewarm IPO earlier this year, shares have declined more than 30% in 2018. The company's woes stem partially from its first quarterly earnings report, which surprised investors with a net loss (after adjusting for a one-time tax benefit). The culprit? High interest expense from a heavy debt burden.

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A transcript follows the video.

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This video was recorded on April 3, 2018.

Vincent Shen: 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?

Asit 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.

Asit Sharma has no position in any of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.