Can ADT Secure a Win for Your Portfolio?

Spinoffs have the luxury of being consistently regarded as market-beating investments, yet they still go largely ignored. The newly minted company's stock is typically gifted out to investors in the parent company, only to be discarded like day-old pizza. For value hunters, though, there is no shame in digging through the trash in search of gold. This stock came out of the IPO gates strong as a spinoff from a safety giant Tyco International -- rising up 27% on the back of a long-term recovery in the residential real estate market. Though the company is still pushing its record highs through the roof, there may be room for buyers late to the game. Here's what you need to know about ADT after its first-quarter earnings.

Alpha vs. beta
Successful stock picking is a game of generating alpha. Alpha emphasizes isolated security selection -- buying companies that, independently of the market, will generate favorable returns to investors over time. This is contrast to beta, which is market-driven returns. The easy argument for home-security company ADT is one that rides market beta. Housing, regardless of short-term fluctuations and Wall Street chatter, is on a long-term upward trend. So, using residential real estate booms as the driving factor for ADT makes perfect sense. Of course, it doesn't matter what the housing market is doing if ADT's stock is unfavorably priced. The company has had a nearly vertical climb since its IPO, and Yahoo! Finance lists its one-year forward P/E at just under 25 times earnings. Its parent, Tyco, trades at under 15 times earnings on the same basis.

So does ADT remain an attractive pick in light of its seemingly rich valuation?


Earnings up
Let's take a quick glance at the most recent earnings report, which was released at the end of January.

For the fourth quarter, the company hauled in top-line sales of $809 million -- a 1.8% gain over the prior year. It is important to note that 92% of the company's revenue came from repeat customers -- a pretty impressive figure, as recurring revenue is the ultimate goal for many companies. EBITDA rose 6.1% over the year-ago quarter to $417 million -- implying a margin of 51.5%. On the bottom line, EPS grew 7.3% from $0.41 to $0.44 per share. Free cash flow boosted up to $160 million from just $97 million a year ago.

The company's home automation effort, Pulse, is two years old but tracking better than ever. Out of new customers, 18.6% of them are using the service, which is a fresh source of revenue for the company. The home automation market is still nascent, but with ADT's nearly 25% market share of the residential home security market, it is in great position to leverage its strong brand recognition into the new line of business.

Future news
Earlier in January, ADT took out $700 million in new debt. This may have been, at least partially, due to activist shareholder Corvex Management, which holds a 5% stake in the company. Last fall, Corvex met with ADT management to push for the idea of increased leverage to maximize shareholder value via a stock buyback. The company then had little debt on the books. At the end of November, the company announced a $2 billion buyback, of which $100 million has already been purchased, with an additional $600 million coming in the next six months.

Expected fully diluted share count for fiscal 2013 should be around 230 million, down from 236 million last fall. Top-line revenue growth will probably remain in the high single digits for the next couple of years, but the bottom line should grow much faster as the Pulse line take rates continue to rise, acquisitions become streamlined into operations, and the company updates its infrastructure.

If the company can hit $1.56 billion in annual EBITDA, that gives it a current EV/EBITDA of 8.5. That would put it substantially under parent company Tyco's 12.25 EV/EBITDA.

The housing rebound does spell opportunity for ADT, but it also opens up the field to more competition. ADT's growth is hinged upon the company's ability to continue attracting customers to the home automation service. Cable companies such as Comcast are quickly rolling out similar alternatives that can be bundled with TV and phone packages. This is a worthy threat to ADT's business.

All in all, ADT is likely to be on the cheaper end of stocks, with similar growth prospects and free cash flow growth, yet its moat is not strong enough to keep it insulated from outside forces. Management guided sequential quarterly revenue growth to be down, which could present a buying opportunity if the market sells off. This is a strong company with great prospects -- just wait for the right price to come along.

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The article Can ADT Secure a Win for Your Portfolio? originally appeared on Fool.com.

Fool contributor Michael B. Lewis and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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