TEXT-S&P cuts ADT Corp's CCR to 'BBB-', outlook is stable
Overview -- U.S. residential and small business alarm monitoring company ADT Corp. announced that its board of directors authorized a $2.0 billion share repurchase program over three years, expiring in November 2015. The company intends to finance the program with debt and free operating cash flow, which will result in an increase in leverage. -- We are lowering the corporate credit rating on ADT to 'BBB-' from 'BBB'. -- We are also lowering the short-term rating to 'A-3' from 'A-2'. -- The stable outlook reflects ADT's clear market leadership position and our expectation that its recurring revenue model will result in consistent free cash flow generation. Rating Action On Nov. 27, 2012, Standard & Poor's Ratings Services lowered its corporate credit and senior unsecured ratings on Boca Raton, Fla.-based residential and small business alarm monitoring company ADT Corp. to 'BBB-' from 'BBB'. At the same time, we lowered our short-term rating on ADT to 'A-3' from 'A-2'. The outlook is stable. Rationale The downgrade reflects ADT's plan to repurchase $2.0 billion of shares over three years, which it intends to finance with a mix of debt and cash flow. We believe the planned repurchase indicates a more aggressive financial policy that will result in adjusted leverage in the mid-3x area, compared with about 2.7x as of Sept. 30, 2012. The rating on ADT reflects the company's "satisfactory" business risk profile (according to Standard & Poor's Ratings Services' criteria definitions), characterized by its leading market position and strong brand recognition. ADT's presence in the highly competitive U.S. security alarm monitoring industry, with high customer attrition rates, somewhat offsets these business strengths. The rating also reflects ADT's "significant" financial risk profile, which we have revised from the previous "intermediate" assessment. ADT's business risk profile is satisfactory. The company has strong brand recognition, scale, and a leading market position in the residential alarm monitoring industry. It is currently approximately 6x larger than its next-largest competitor, and we expect it to retain its market share in the near-to-intermediate term. In addition, favorable industry growth trends (even during a recession) and significant revenue visibility provide support for our business evaluation. Business risks include a relative lack of revenue diversification (since ADT mainly serves residential markets in the U.S and Canada), as well as the emergence of new competition as cable companies have become more active in the alarm monitoring space. In addition, ADT currently has a somewhat above industry average attrition rate of 13.8% in the 12 months ended September 2012. However, we expect that additional revenue from price increases will offset revenue lost due to attrition. As of September 2012, ADT reported last-12-month revenues of $3.2 billion, a 3.8% increase from the prior-year period. We expect a low- to mid-single-digit revenue growth in 2013 due to growth in average revenue per user (ARPU), resulting from increased adoption of ADT Pulse, as well as expansion of offerings in home automation. We expect adjusted annual EBITDA margins to be about 30% in the near term. We also believe that an increasing mix of higher margin home automation products, combined with annual price increases, will contribute to ADT's profitability measures over the longer term. Our assessment of the company's management and governance is "satisfactory". We revised our view of ADT's financial risk profile to "significant" from "intermediate," reflecting an increase in expected pro forma adjusted debt to EBITDA to the mid-3x area in 2013 from 2.7x in September 2012. Our adjusted EBITDA reflects the ongoing purchase of customer accounts necessary to offset attrition and is reduced by deferred costs related to customer account creation. Cash flow metrics are consistent with a 'BBB-' rating, however we expect that they will be at the low end of the range for several years. We expect the ratio of free operating cash flow (FOCF) to adjusted debt to be in the low-double-digit area over the next two years. Standard & Poor's notes that ADT's willingness to issue a material amount of debt to finance a share repurchase program represents a significant departure from the more prudent financial policies that supported the prior ratings. However, we believe that ADT will scale back its debt-financed share repurchase activity if it experiences unexpected operating shortfalls. Liquidity We view ADT's liquidity as "adequate." We expect ADT to generate sufficient operating cash flow to fund capital expenditures of about $1 billion annually, which includes dealer-generated customer accounts and subscriber system assets. However, we expect that the company will use the FOCF that it generates to fund dividends and share repurchases rather than to repay debt. Liquidity sources consist of approximately $234 million of cash on hand as of Sept. 30, 2012, reliable free cash flow generation, and availability under the $750 million revolving credit facility. Other relevant aspects of ADT's liquidity, in our view, include the following: -- The company intends to repurchase $2.0 billion of shares over the next three years. -- We expect sources of cash to exceed uses by more than 1.2x for the near term. -- Net sources are likely to be positive, even if EBITDA declines by 20%. -- The current rating does not incorporate any material business acquisitions. -- We believe ADT could absorb low-probability, high-impact shocks. Outlook The stable outlook reflects ADT's clear market leadership position and our expectation that its recurring revenue model will result in consistent free cash flow generation. We could lower the rating if adjusted debt to adjusted EBITDA is likely to remain above the 4x area on a sustained basis because of weaker operations or incremental debt taken on to support increased shareholder returns, acquisitions, or accelerated growth plans. A higher rating would be unlikely for the near-to-intermediate term, based on current leverage levels, and our expectation of additional debt-financed share repurchase activity in 2014 and 2015. Upside rating potential would not be considered until the company reduces adjusted leverage such that debt to EBITDA is in the mid-2x area on a sustainable basis. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Use Of CreditWatch And Outlooks, Sept. 14, 2009 -- Criteria Guidelines For Recovery Ratings, Aug. 10, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- 2008 Corporate Criteria: Rating Each Issue, April 15, 2008 -- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008 Temporary contact numbers: Katarzyna Nolan (917-679-5491); Martha Toll-Reed Ratings List Downgraded To From ADT Corporation (The) Corporate Credit Rating BBB-/Stable/A-3 BBB/Stable/A-2 Senior Unsecured BBB- BBB Commercial Paper A-3 A-2 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. 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