SD&I Cover Story: Building RMR

Nov. 5, 2014
Get first-hand knowledge from industry experts on how to leverage recurring monthly revenue to ultimately increase your company’s value

Recurring monthly revenue (RMR) is a fickle little anomaly of the security industry. Everyone’s trying to get more, perhaps not fully understanding the ramifications of what’s involved.

RMR takes into account many factors, including cash flow and margins from existing customers, creation costs, attrition, loaded labor, market proposition, competition, technology and accounting metrics. But with thorough due diligence, literally and figuratively, the security dealer and systems integrator can leverage RMR to increase company value — for financing, mergers and acquisitions, equity transactions — and simply to boost the overall health and viability of the company.

Some businesses are a natural for generating RMR, like alarm monitoring, a security mainstay; however, that too has dwindled due to market saturation and competition. Previously high margins from hardware and equipment installations have also descended into single digits. Some firms — generally larger integrators — continue to garner larger, project-based revenue streams that add cash flow to the equation; but most installing companies have taken a step back from the boxes and instead go for regular, predictable cash flow.

The Value Proposition

Envysion, located in Louisville, Colo., is an RMR star, gaining customers with a value proposition of enabling companies to consistently follow through with their brand promise using video intelligence and associated managed services. In 2006, Envysion launched with a goal of creating a video platform that would eliminate the barriers of traditional video surveillance and transition the service into a broadly utilized and powerful strategic management tool providing actionable insights to businesses. Today, “Envysion Insights” ties video to critical company data, providing operators instant and actionable intelligence that ultimately allows these businesses to dramatically increase their profitability.

Envysion has experienced great success in securing financing by staying close to its innovative video intelligence model and accompanying RMR. The company recently secured financing as part of its recapitalization with Parthenon Capital Partners, setting the stage for continued long-term growth. Parthenon Capital Partners is a mid-market private equity firm with offices in Boston and San Francisco.

Michelle Shewchuk, chief financial officer, is responsible for Envysion’s financial performance and all aspects of accounting operations, strategic financial planning, cash management and capital markets. Shewchuk says everything the company does is based on creating a strong recurring business model — from basic security surveillance, to business intelligence and data gathered from video managed services. She says that the company provides monthly financial information to its financiers and equity partners, conducting a full financial audit annually.

“RMR is a powerful business model,” Shewchuk says. “RMR and company value go hand-in-hand. The reason we have the debt facility in place is because of the power of our recurring business model. When you have double-digit growth rates on a recurring revenue model and can demonstrate strong customer retention, lenders are more willing to extend funds and allow you to borrow against the future revenue streams to fund working capital needed to secure that revenue. That access to capital has allowed Envysion to grow.” 

The Darling of Security

“RMR continues to shine as the apple with which lenders and buyers want a bite,” comments Barry Epstein, president of Vertex Capital Corp., Dallas. “From a lender’s standpoint, they loan on a multiple of RMR. As credit has eased, the multiples have increased and non-bank lenders have entered the industry, making loans at much higher multiples with higher interest rates. While equity players look for RMR on the alarm side, they view it differently from an integrator standpoint. Integrators with RMR don’t necessarily trade for higher valuations, but they do increase the buying pool, as buyers like the ‘sticky’ revenue that will be there year after year.”

Epstein says that while it is always better for dealers and integrators to have long-term RMR contracts as it ties up their clients, buyers do not necessarily pay more for the longer term. “The industry view is the contract is an ‘Evergreen’ and will renew regardless of whether the term is one, three or five years,” he says.

Will Schmidt, managing director of the Security Lending Group of CapitalSource, St. Louis, concurs that banks and investors look favorably on the long-term value and stability that comes from high levels of accretive recurring revenue. “The predictable cash flow provided by these contracts significantly lowers the risk to lenders and allows equity investors to pay a higher purchase price due to the lower earnings volatility,” Schmidt says. “However, it is important to note that the unique accounting challenges presented in this industry means that not all lenders or equity investors fully understand the cash flow dynamics in a growing RMR company, so additional time may be necessary to educate newcomers to the space.”

The New Look of RMR

In the past, recurring monthly revenue was relegated primarily to monitoring contracts. Companies could count on the regular revenue, which was especially healthy when tied to a multi-year agreement. But that was before monitoring became commoditized and prices plunged. It is still solid RMR, but today, other avenues of gathering predictable cash flow have entered the scene, such as home automation, energy management and home health (PERS). And new areas of RMR will continue to flood the industry as it transitions to the role of service provider.

Schmidt says CapitalSource is bullish on new services, and considers itself creative in lending to RMR businesses with unique or emerging sources of cash flow. “Most lenders are focused on traditional digital monitored alarms,” he says. “We look at video monitoring, managed access control and the more advanced interactive home services. The lending community is evolving with newer technologies as well and is following those trends.”

Schmidt says there absolutely are different values applied to the various forms of recurring revenue. “Typically, the better the margins, the more valuable the RMR,” he says. “For example, services that can be leveraged from an operating perspective such as digital monitoring have very high margins and are more valuable than services that require field visits such as service, maintenance and test and inspection services.”

Michael Barnes, founding partner of Barnes Associates, a St. Louis-based consulting and advisory firm that specializes in the security alarm industry, is well-known for his metrics on RMR and company valuations. Barnes agrees that the biggest change in the industry is the broader diversity of the underlying services associated with RMR.

Not All RMR is Alike

“On one end of the spectrum, you could have RMR associated with a large commercial managed video system, integrated into a PSIM platform (Physical Security Information Management) with highly sophisticated prompts and protocols, with a large installation cost subsidization component, and including maintenance…all the way down to just basic monitoring for an entry level residential system,” Barnes says.

Capital providers, Barnes says, have learned that not all RMR is the same, and are looking for a more nuanced view into the classic four big issues:

1. Who the end-users are and how the system fits their overall security needs;

2. The margins associated with the RMR and other related revenues;

3. The probable attrition profile; and

4. The open market value of the RMR and the company as a whole.

Barnes adds that the industry’s focus on differentiation is not new. “The market has a long history of distinguishing between differing types of RMR, including monitoring, maintenance, residential, commercial, system rental, etc. — with most of these factors having fairly well-understood dynamics and resulting values,” he says. “It is the material increase in the number of new factors and services, and their relative newness that has caught the market a bit by surprise.”

Barnes says the broadening of the underlying services associated with RMR has everyone scrambling to develop an educated and appropriate view as to value. “Ultimately, the market wants to be efficient, so values can migrate to a number that is truly expressive of the present value of the future benefits. Some of the new services are yet to have a sufficient history to where these factors can be easily defined, and therefore the market is making educated guesses, which are typically conservative,” Barnes says. “For instance, there is clearly developing evidence that many of the new interactive services — particularly over non-POTS communication circuits — result in lower attrition. To a degree, this is offset by some additional costs, but generally the market is trying to acknowledge the enhanced value, although it doesn’t seem to be fully there yet.”

Overall Valuation

New services also bring a greater emphasis on internal sales mechanisms and RMR. That is, how effective is the company at originating new RMR, both in terms of cost and volume? This capability is often material to the overall valuation. “For example, when Vivint recently traded, its high-valuation multiple was as much about their growth engine as it was their existing customer base,” Barnes says. "Lenders and investors will often have slightly differing views on this issue, with the lenders taking a more conservative approach and leaning more on the value of the existing RMR base, while an investor may have a higher focus on the RMR origination and growth dynamic.”

John Robuck, senior director of Capital One Bank, Chevy Chase, Md., says RMR continues to be a primary metric for company valuation. Capital One provides senior-debt financing to companies in the security industry, typically for acquisitions, mergers and recapitalization. “Contractual revenue is extremely attractive,” Robuck says. “Whether it is a bank or a lender, one of the first things we investigate is how much and what type of RMR the company has.”

Robuck says RMR is a key driver of valuation: “Valuations for various types of RMR such as VaaS, managed services, patrol, service and inspection depend on the contractual terms, customer diversification, and the margins,” he says. “Monitoring margins are typically very high; however, these other classes of RMR can have comparable margins for the best-run businesses. Another thing we look at is whether or not service and maintenance agreements are bundled with monitoring — ultimately adding value.”

 Robuck advises that contracted revenue streams are critical when it comes to company valuation and purchasing businesses. “There are compelling consolidation economics for acquirers of RMR. For example, you have fixed business costs and a buyer is able to add only minimal incremental costs to those established fixed costs — the impact on the cost structure of the business overall is minimal, while the RMR has grown, resulting in stronger profitability,” Robuck says.

According to Henry Edmonds, founder and president of The Edmonds Group LLC, St. Louis, the key determinants of company valuation for a strategic buyer or private equity investor include market conditions, transaction size and key performance metrics. The key metrics for alarm transactions (and other recurring revenue businesses) are customer margins, attrition rate, creation costs and growth rate. Editor’s Note: Read more about attrition rate in Amy Kothari’s article on page 28 of this issue.

 The Edmonds Group is a specialized investment banker focused on recurring revenue businesses with decades of experience in the security alarm/PERS markets. “Calculation of purchase price is typically based on a buyer’s view of expected cash flow discounted at their targeted rate of on return,” Edmonds explains. “Key performance metrics allow a buyer to forecast expected cash flow. The better the information a buyer receives about a target company, the more confident they are in what they are getting and the higher the value they are likely to give. It follows that dealers must have the ability to provide solid data on key metrics if they are going to maximize value.”

“RMR is a good measure of the outcome, but it does not drive value — key metrics like strong margins and low attrition do. It is not the multiple that drives value, it is the cash flow,” Edmonds adds.

Phil Atteberry, president of PBA Business Solutions LLC, in Chicago, says one challenge is that many smaller companies still cannot fully grasp the move away from project-based revenues to regular cash-flow and its metrics. “A lot of companies still focus on the one-offs, and generally there is no long-term value associated with those projects,” Atteberry says. “It is difficult when they are simply doing projects and not gaining RMR. RMR can bring long-term viability and profitability to the company. As pressure continues to bring pricing down, an RMR foundation inside your business can help pull in additional profits.”

When considering company valuation, Atteberry says he looks at the overall ratio of RMR — service revenue vs. project revenue. “RMR in the security industry now looks more like an IT service company,” he says. “As an additional bonus, companies with this expertise can take advantage of technologies for remote and managed access to eliminate field service calls.”

RMR is essential for anyone in security today, he advises. “With RMR, EBITDA goes up and you can better leverage those accounts for financing. Smaller companies can also be more agile when it comes to creating more RMR, so it is definitely an opportunity for them and they can transition to the services mentality more easily,” Atteberry says. “There is also the ability to use profits from RMR to offset the projects that may have to be delivered at a lower price.”

Start the Process

CapitalSource’s Schmidt advises security companies to start preparing for a sale today, even if they do not plan to sell for another 20 years. “It is much easier to build and manage a company that has strong systems and reporting then to hastily put these elements in place on the eve of a sale,” Schmidt says. “It will improve your ability to manage the business, reduce risk and provide you with better access to capital, which may be critically important at some future date.”

Edmonds adds that at the end of the day, it is all about generating cash flow and proper documentation. “Having good data lowers uncertainty for lenders,” he says. “You may say your attrition is 10 percent, but perhaps you do not have the data to back that up. The less uncertainty, the closer you can get to a higher valuation.”

Deborah O’Mara is the owner of DLO Communications and a veteran of the systems integration industry. She can be reached at 847.384.1916 or [email protected].