Has their jingle ever haunted you in the shower? https://www.youtube.com/watch?v=awwvKlzAHdw
The business (TSX: AF) is a simple enough business to understand. Basic home security at a fairly low price supported by a brand. One of us came across this Company back in 2013 and did some analysis (“too expensive” at the time). This fall we came across it again, with the share price languishing where it was five years ago, we thought it was worth a look. There has also been a bit of activity in the space with ADT, the #1 in home security, being purchased by Apollo Global Management for ~US$7B earlier in 2016. AF is the only publicly listed Canadian home security company out there.
AlarmForce was founded in 1988 by Joel Matlin. The plan was simple: 1) Offer direct to customer (i.e. no dealer) home security systems manufactured in-house to maximize margin and 2) Build a brand. To gain familiarity with potential customers, the Company invested heavily in marketing over the years, stating explicitly it is much more concerned with increasing "share of mind" than share of market. The idea was that by controlling the sales process and developing a strong brand were key to growing organically with strong margins. It worked. Subscribers grew from 48,700 in 2004 to 134,100 in 2012, reflecting a healthy 14%/year growth. Joel Matlin ran AlarmForce with an extremely long-term focus. Although AF could have significantly cut back marketing to boost any year's earnings, they likely decided the economics of every new subscriber was too good to pass up, which we agree. It also was and is run debt-free.
Then a hiccup.. In 2012 the Company announced that its Board would conduct a strategic review, including potential sale of the Company. The Board could not find a worthwhile transaction, but it also led to a falling out and the firing of the CEO. Today the Company is run by a CEO and CFO put in place in 2015, both from Brookfield Residential Property Services.
Key metrics – how is the business doing?
The first thing we did was check performance. When trying to understand how healthy AF we looked at the following:
1) Churn – What percentage of clients leave every year
2) How much it costs in advertising to get a new client
3) Gross margin ([rev-COGS]/rev) and earnings before tax margin
As shown, there are a few issues. Churn seems to have crept up from ~10% to around 14% (2015 was impacted by one-time subscriber count issue, likely adding ~2% or so). The cost of attracting a new subscriber is increasing faster than inflation (with the great 2016 YTD due to a short-term underinvestment related to a brand refresh discussed below).
New management has a different plan. Instead of in-house R&D they are now buying their sensors, panels, cameras and other security goodies from external vendors. We think that this is actually prudent. Security technology has changed a lot in the past few years and we think it will probably be cheaper, or at least more up-to-date, instead of reinventing the wheel in-house. They also seem to be putting more effort in to Canada. Again, we think this is prudent. We are a lot more friendly up here and it is just a lot less competitive than it is in the U.S. or alternatively, building up the AF brand in the diverse and massive U.S. market would just take a lot more money and a lot more work while getting less bang for your buck than in Canada. That said, a wild card issue is companies such as Rogers Communications expanding into the niche and leveraging their customer base to try and sell them security systems.
The important question - Is there a bargain here?
Let’s recap what we have:
· Weak and declining subscriber growth and margins while churn is increasing.
· New management – Can’t blame management for these issues.
· Complete brand and product refresh – Decent article here. http://strategyonline.ca/2016/09/09/alarmforce-debuts-its-brand-refresh/
· Outsourcing product development (net good, tech has changed).
Is AF a good deal at $10? We have to say who knows. The issue is that this isn’t a cigar butt play where you can buy a declining business at a fair price. New management will do everything they can to stabilize and turn the Company into the next big thing we’re sure. If that’s the case then you are buying a turnaround. A turnaround with even the most recent period churn still stuck at 14% (at least stabilized if you’re an optimist!), unclear management track record (they do seem like nice folks)
Thankfully at least it is a good learning experience for all of us. It is a reminder that sometimes you have to dig a bit deeper. A three-year fiscal snapshot would definitely not have given the same impression as the ten-year run.
We’ll keep watching this one. If the team and business plan shows signs of progress and you catch it early on this could actually be a very cheap decent stock. Based on how the stock is performing we doubt that the market is going to trip over itself to get in early (but who knows!). In the meantime, we wish them the best.