Is Your Money Safe in ADT?

Source: http://www.flickr.com/photos/mr_t_in_dc/

Source: http://www.flickr.com/photos/mr_t_in_dc/

ADT Corp. (NYSE:ADT) has an apparently sound and stable business model. The company offers security services to individuals and businesses in exchange for a regular fee. Thus, the company has a model akin to that of a subscription magazine publisher or of a television and internet provider. ADT has the added advantage of universal brand recognition and limited competition. Thus, investors looking for a stable, profitable company that returns capital to shareholders might have considered ADT Corp. But there was an incident recently that jeopardizes this thesis.

On Thursday, shares of ADT fell 17 percent after the company reported disappointing first quarter earnings. What is disturbing about the report isn’t that the numbers were weak. Rather, they reveal that management bought back nearly $1.2 billion worth of stock before the shares fell on this disappointing report — and if we dig deeper, we find evidence of foul play.

Keith Meister — founder and manager of Corvex Management LP — joined the board of ADT after purchasing 5 percent of the outstanding shares in 2012. Then, last November, ADT announced that it would buy back the shares held by Corvex Management LP for $44 each — nearly 50 percent higher than Friday’s closing price. Meister also resigned from the company’s board. The shares immediately began to drop after that point, having ended the year at $40.47.

Like the broader stock market shares, ADT fell in January. But with the announcement of weaker-than-expected earnings results, the shares plummeted, and they closed last week at $30.04/share.

In short, the company grew its revenues — most of which come from recurring sources, but it saw costs rise, so that its net income fell by 27 percent. If we compare the company’s numbers with analyst estimates, we find that it earned $0.46/share versus a consensus of $0.47, although its revenues came in at $777 million versus a consensus estimate of $842 million. The fact that the earnings miss is far smaller than the revenue miss can be attributed to the enormous share buyback.

Those investors who are considering investing in the company should find this disconcerting. In order to fund the $1.2 billion buyback, which again allowed major shareholder Meister to exit at a relatively high share price, the company borrowed well over $1 billion in just one quarter. This is a lot considering that the company’s entire market capitalization is just $5.5 billion.

Such an aggressive buyback is highly suspicious. On the surface, it appears as if ADT’s board, with Meister as its ring leader, executed a classic ‘pump and dump.’ This means that the company mislead investors and analysts who were led to believe that the numbers would be better than they thought they would be. This is a serious accusation, although I am not alone in in making it. After the press release came out, the law firm of Levi and Korsinsky initiated a class action lawsuit, claiming that there was, in fact, foul play.

Whether it is true or not is immaterial from an investment standpoint. If it is true, then the board and management cannot be trusted, and investors need to stay away. If it isn’t, then we still have to question the ability of management and analysts to predict the results of ADT’s business. This is highly problematic, as ADT’s appeal as an investment is in part its predictability.

Ultimately, I think investors need to avoid ADT. While I like the security industry, more broadly, this company has a lot of issues specific to it. Not only does it have decelerating revenue growth and falling profit margins, but it is being accused of foul play. I think, eventually, we will have a buying opportunity in ADT shares, as there is no denying that it has the most powerful brand in the home and office security system industry. However, I want to wait to make sure that there isn’t another shoe to drop before investing my hard-earned money.

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