In preparation for our annual Barnes Buchanan Security Alarm Conference last month we worked with Security Dealer & Integrator magazine to survey companies that acquire security alarm accounts under a Dealer Program. The goal was to look for additional signs of acquisition activity in the industry during the last several years, while the economy slumped and the capital markets went into a tailspin. We were surprised at the level of activity, to say the least.
It was well known that ADT and Monitronics had grown their programs materially, that Broadview (formerly Brinks Home Security) had pushed forward, and upwards of 10 others were operating programs--but the totality of this activity had not been quantified-until now. The accompanying chart (on page 37), compiled independently by my inquiry to each of these companies, summarizes the results of the survey, which includes data from all of the major players. We selected these players based on their size and were pleased to receive 100 percent response from those companies we asked to provide this information.
As indicated, the number of accounts bought/sold under dealer programs in the U.S. for 2009 was 722,000 and the volume was up 14 percent from 2008. These are big numbers. In order to put them into context, contrast this activity with the pending sale of Broadview to ADT, a major event in the industry by any standard. Broadview has $40.5 million in recurring monthly revenue (RMR), over 1.3 million subscriber accounts (second only to ADT), and is over one and one-half times larger in RMR than the next largest player, Protection One. Broadview is also over 25 years old. The volume of accounts generated and sold under dealer programs in the U.S. for just 2008 and 2009 equals almost exactly the size of Broadview!
Not your father's program
It is clear that these programs have come a long way. Gone are the days of dealers creating accounts and simply submitting them to "the market." The pendulum has shifted to a much closer and tighter relationship between the buyer and the seller, on a longer term basis, with a much higher level of control in the hands of the buyer. Branding, pricing, credit score minimums, contract forms, equipment used and geographic focus are all typically coordinated, and the multiples paid for accounts are stratified along several variables that define the quality of the account. The result is much more of a partnership between the buyer and the seller, with tighter contractual relationships and a closer alignment of interests.
The level of sophistication in handling the mechanics of the relationship has also significantly evolved. For example, Security Networks, the fourth largest player in the space by annual volume, has a state of the art system for processing purchases that is highly automated, Internet-based and designed to move the process along quickly and accurately. Everything is designed to make the sale and customer boarding process seamless, and to inform both Security Networks and the originating dealer of the status of each account along all of the critical variables. Their purchases were up over 100 percent in 2009.
A natural division
Dealer programs have evolved principally due to three forces that influence the security alarm industry. First, there is a natural dividing point between the creation of a new alarm account, through the selling, designing and installing of a system, as well as the ongoing monitoring and maintenance of the system. Aside from some similarities of system installation and field service, the two processes couldn't be more different. The critical competencies required to manage a large, modern day central station and back room operations, with significant economies of scale, are very distinct from those required to manage a competitive sales force coupled with design and installation capability, often spread over a large geographic area. As a result, a natural bifurcation of the business has occurred with a good portion of the industry specializing in only one of these processes. Dealer programs allow this to happen more efficiently.
Second, the division along these lines allows each party to show a clearer financial picture. Operating an alarm company with an internal sales force is frustrating from a financial reporting perspective. On a fully burdened basis, most alarm companies lose money on the sales and installation process (i.e., after all sales and marketing costs, installation expenses and overheads that support the process). Additionally, much, if not all of these costs are expensed. This is not a bad thing, as the loss is effectively an investment in the high margin recurring revenues.
If, however, any given account requires an "investment" equal to 24 times the RMR and you yield a 50 percent net margin on these revenues, it takes four years to recover the investment. If the investment is expensed in year one, it is easy to see how the financial statements can quickly become misleading. This mismatch of investment and return is further exacerbated by the reasonably established market value of the account never appearing on the balance sheet. The dealer program arrangement addresses these issues, with the account originator realizing the market value immediately after the investment and the buyer putting the market value on their balance sheet, which they can then amortize over the life of the customer.
Dollars and sense
This clearer financial reporting also addresses another critical issue with which the industry struggles--the raising of capital to fund all of this activity. Depending upon the assumptions used for average RMR per account and the purchase multiple, the dealer program activity in 2009 probably required close to $1 billion. In spite of what our elected officials in Washington may think, this is a serious amount of money, particularly during a time when the capital markets have been a mess. The dealer program construct places the burden of raising this capital in the hands of the few bigger players that form the buy side of the equation and out of the hands of the hundreds/thousands of smaller companies that comprise the origination side. This makes sense. Raising capital, particularly in these increments, is often a study in economies of scale.
Given this dynamic, the dealer program construct seems a natural response, much like the evolution of the wholesale monitoring business, which allows the industry to retain the existence of smaller companies that can deliver the local touch, without the need to have the scale required to effectively operate a central station.
The future
Is the 14 percent increase in activity a sign of a fundamental shift in the industry to the dealer program model? Not necessarily. One could argue that the appearance of acceleration in growth is a bit misleading due to the timeframe surveyed. The year 2008 clearly was a time of retrenchment and also one where the buy side tightened the credit score requirements and the summer sales companies continued their shift towards retaining ownership of their originated accounts. It is probable that these factors made 2008 an unusually slower growth year. After all, it is only in the last decade or so that the dealer program model has really taken hold, and it would have inherently had to grow at a higher rate than the overall industry to achieve this size.
While surprisingly large, the dealer program activity still only involves something like one-fifth of the overall account/RMR generation activity in the U.S., and it is limited primarily to the residential market, with a smattering of small commercial accounts. Additionally, the vast majority of the industry is still in the hands of many highly capable integrated companies (i.e. those that both originate and retain their accounts), who are efficient across the full spectrum of required capabilities, including the raising of capital. So, it is likely that there is an upper limit to the overall size this model will achieve. But with a projected further 14 percent growth in 2010, it doesn't appear we are close to that limit.
If I am a capable account originator, it certainly seems an attractive option to monetize my investment in new accounts, right away. Tough, volatile capital markets, combined with greater uncertainty around attrition and customer life expectancies makes it compelling to take the money and transfer the risk. On the buy side, assuming the capital is available and you are skilled in the administration of a program, the low volatility in account acquisition costs is highly attractive, and the relatively easier ability to adjust to the changing demand for new alarm systems is attractive, particularly compared to right-sizing an extensive sales and installation force.
Overall, it is easy to see why dealer programs are attractive, on both sides of the fence. They are also a great barometer of the vibrancy of the industry and the capital markets that support its growth. If accounts totaling the size of Broadview can be created and traded during one of the toughest two years in history, this has to bode well for the industry as a whole.
Straight from the conference floor
As to how ADT's purchase of Broadview affects the market, many felt that no one would be unhappy to have one less sales person, especially as sales person with a big company name, knocking at a prospects door. With Broadview off the table, a very appealing operating company, we're unlikely to see a large outsider such as a Telco or cable company come into this industry, which could affect the capital market's interests in the RMR market. This deal and the possible sale of Protection One, divide the playing field into "the" big and the smaller alarm companies. Will this make it easier for independent companies to garner new business, affect buyer's perception of a systems value and cost? We'll see. The multiples offered to Broadview were debatably between 43 and 47.5 given some tax implications but going forward this is not the standard for what an alarm company should expect. Broadview got this multiple "because of their superior operating metric."
