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.
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.