On Jul 6, 2015, Zacks Investment Research downgraded security and protection services provider The ADT Corporation ADT to a Zacks Rank #4 (Sell) from a Zacks Rank #3 (Hold). Despite the relative weakness, the stock is currently trading at a forward P/E of 16.5x with long-term earnings growth expectation of 6.6%, which signify its inherent growth potential.
Why the Downgrade?
ADT operates in the security alarm industry, which is highly fragmented due to the low barriers to entry. Consequently, it is facing significant pricing pressure and competition on factors like product installation, monitoring and service fees. In addition, cable and telecommunications companies are also eroding ADT’s market share by expanding into the monitored security alarm industry and bundling their existing offerings with monitored security services. As such, ADT has to continually invest in R&D and similar other value drivers that act as a hedge against tough competition. This has increased its operating costs and reduced its profitability to some extent.
In addition, most states and provinces in which ADT operates have licensing laws directed specifically toward the security services industry. Increased government regulation escalates costs and restricts operations, somewhat impairing the long-term growth of its business.
Furthermore, ADT’s business strategy hinges on inorganic growth and making investments that complement its existing businesses. These acquisitions entail huge integration costs, which often become a drag on the profitability of the company. ADT also incurs significant upfront investments for expanding its customer base, including direct material and labor costs to install security and home/business automation systems, indirect sales costs, marketing costs and administrative costs related to installation activities. The economics of the installation business also varies depending on the customer acquisition channel. Consequently, ADT’s long-term profitability is dependent on long customer tenure and minimal customer attrition. These often lead to margin contractions and reduce bottom-line growth.
Over the last one-year period, ADT has performed relatively weaker in comparison to the overall S&P 500 with an average return of -2.6% compared to 5.0% for the benchmark index. A downgrade in the Zacks Rank serves as one of the triggers to exit certain underperformers at the right time to maximize portfolio returns. Selling off losers can at times be difficult, but with the continuous share price decline since mid-April, it seems to be an opportune time to get rid of this stock before more losses hit your portfolio.
Other Stocks to Consider
Some other stocks in the industry that look promising include FactSet Research Systems Inc. FDS, IHS Inc. IHS and Verisk Analytics, Inc. VRSK, each carrying a Zacks Rank #2 (Buy).
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