Fitch Affirms ADT's IDR at 'BBB-'; Outlook Stable

NEW YORK--(BUSINESS WIRE)--

Fitch Ratings has affirmed the ratings of The ADT Corporation ADT, including the company's Issuer Default Rating (IDR), at 'BBB-'. The Rating Outlook is Stable. A complete list of rating actions follows at the end of this release.

KEY RATING DRIVERS

ADT's ratings and Outlook reflect the company's strong brand recognition, its national footprint and leading market position, recurring revenue base, free cash flow (FCF) generation and sufficient liquidity. Concerns include emerging competition from non-traditional security service providers, risk associated with operating as an independent public company, and contingent liabilities, particularly tax liabilities, related to its spin-off from Tyco International, Ltd. (Tyco).

The ratings also reflect management's willingness to undertake a more aggressive financial strategy after becoming an independent company in 2012, as well as management's evolving financial strategy.

LEADERSHIP POSITION

The ratings incorporate ADT's strong competitive position as the largest residential security provider in the U.S. ADT currently has over 6.6 million residential and small business customers throughout the U.S. and Canada and a roughly 27% market share based on company estimates.

Fitch believes that ADT's competitive position will remain strong in the near to intermediate term. However, ADT faces competition from non-traditional security service providers. Several cable and telecom companies have introduced interactive security services that compete with ADT. While the security service customer base of these companies is substantially smaller than ADT at the current time, they have started to grow their market share. This emerging trend could provide significant competition for ADT going forward.

SIZEABLE CUSTOMER BASE

ADT ended the June 2015 quarter with about 6.6 million subscribers, flat compared with its fiscal year-end 2014. For the latest-12-month (LTM) period ending June 26, 2015, ADT added 1.05 million new customers (excluding bulk acquisitions) compared with gross customer additions of 989,000 during fiscal year 2014. Gross customer additions increased by 60,000 or 8.4% during the nine months ended June 26, 2015 due to greater direct and dealer channel production, including incremental customers related to the Protectron operations acquisition.

Attrition rates have improved over the past two years, declining from 13.9% during FY2013 to 13.5% during FY2014 and 12.4% for the LTM period ended June 26, 2015. The majority of customer attrition is driven by relocations associated with the housing recovery and non-pay customers. The company continues to take action to improve the tenure of its customers, including expanding the roll-out of tighter credit screening policies as well as strengthening resale efforts and customer loyalty programs, and driving increased penetration of ADT Pulse automation, which exhibits better retention characteristics.

The average revenue per customer (ARPU) increased 0.7% or $0.30 per customer to $42.50 (on a trailing 12 months basis ended June 26, 2015) due to the additions of new customers at higher rates, largely driven by an increase in ADT Pulse customers as compared to total customer additions, as well as by price increases on the existing customer base, partially offset by lower ARPU associated with the Protectron acquisition. Fitch expects ADT's ARPU will continue to increase modestly as the company expands the take rate of its Pulse offering.

On Sept. 29, 2014, ADT's non-competition and non-solicitation provisions associated with its separation from Tyco expired, and as a result, the company is no longer prohibited from competing in the commercial security market. The company has launched light commercial services to expand into the mid-sized commercial market. Management estimates that this increases the company's commercial addressable market by 4 times to roughly $10.4 billion.

CAPITAL INTENSITY

ADT's subscriber-based business requires significant upfront costs to generate new customers. Capital expenditures, including dealer-generated accounts and bulk purchases and subscriber systems, totalled $1.37 billion for the LTM period ending June 26, 2015. Total capital expenditures were $1.27 billion, $1.20 billion and $1.09 billion during fiscal years 2014, 2013 and 2012, respectively. Capital expenditures for the LTM period represent approximately 38.4% of LTM revenues compared to 37.2% during FY2014. Fitch expects capital expenditures will approximate 35% - 40% of annual revenues in the next few years. Fitch estimates that new customers yield an average cash payback of three years.

RESILIENT BUSINESS MODEL

Approximately 90% of ADT's annual sales are recurring in nature, resulting in steady income and relatively stable cash flow. ADT generated $25 million of FCF (Cash flow from operations less capital expenditures and dividends) for the LTM period ending June 26, 2015 and posted $119 million, $348 million and $406 million of FCF during fiscal years 2014, 2013 and 2012, respectively. (ADT did not pay dividends in fiscal 2011 and fiscal 2012 and paid $112 million of dividends in fiscal 2013, $132 million in fiscal 2014 and $142 million for the June 26, 2015 LTM period.) Fitch expects a FCF margin of 1.0% - 3.5% in the near to intermediate term.

CREDIT METRICS

Fitch calculated debt to EBITDA was 3.0x for the LTM period ending June 26, 2015 compared with 3.0 at fiscal year-end 2014 (ending Sept. 26, 2014) and 2.0x at the end of fiscal 2013. Interest coverage was 8.6x for the LTM period ending June 26, 2015 compared with 8.9x in fiscal 2014 and 14.5x in fiscal 2013. In the intermediate term, Fitch expects ADT's leverage will settle at or slightly below the company's target of 3x debt to EBITDA.

SOLID LIQUIDITY POSITION

ADT has a solid liquidity position with cash of $69 million and $555 million of borrowing availability under its $750 million revolving credit facility that matures in June 2017. Fitch expects ADT will have continued access to its revolver as it has sufficient room under the financial covenant requirements of the revolver. Fitch expects the company will maintain liquidity of approximately $400 million - $600 million, consisting of cash and availability under its revolver over the intermediate term. ADT does not have any debt maturities until 2017, when $750 million of senior notes mature.

EVOLVING FINANCIAL STRATEGY

Following its spin-off from Tyco in September 2012, management was committed to a strong investment grade rating and put in place a capital structure that reflected this profile.

Then in November 2012, ADT initiated a $2 billion share repurchase program over a three-year period that was funded by debt and FCF. As part of this strategy, the company increased its leverage target to 2x and reiterated its commitment to an investment grade rating.

In July 2013, the company once again changed its financial strategy and increased its leverage target to 3x. In November 2013, ADT's board increased the company's $2 billion share repurchase program by an additional $1 billion, expiring on Nov. 26, 2015.

ADT used proceeds from the incremental leverage to invest in growing its core business, increase operating efficiency, and pursue accretive acquisitions to complement its organic growth, as well as return excess cash to shareholders in the form of dividends and share buybacks. Since the end of fiscal year 2012, the company has increased debt by about $2.7 billion. This incremental debt, together with cash on hand and about $535 million of FCF generated during 2013, 2014 and so far in 2015, was used to repurchase $2.78 billion of stock and fund $680 million of acquisitions.

These shifts in strategy create some uncertainty regarding the stability of management's financial policies beyond the near term.

SHARE REPURCHASES AND DIVIDENDS

ADT repurchased $164 million of stock during the first nine months of FY2015 (ending June 26, 2015). By comparison, the company repurchased $1.38 billion of stock during fiscal 2014 and $1.24 billion during fiscal 2013.

On July 17, 2015, ADT's board approved a new share repurchase program up to $1 billion of its common stock which is incremental to the remaining amounts authorized to be repurchased under the current share repurchase program expiring on Nov. 26, 2015. The new share repurchase program expires on July 17, 2018. ADT currently has $1.192 billion ($192 million under the existing plan and $1 billion under the newly approved plan) remaining under its share repurchase authorization.

ADT declared initial quarterly dividends in November 2012 and paid $112 million of dividends in fiscal 2013, $132 million in fiscal 2014 and $142 million for the June 26, 2015 LTM period. In November 2013, ADT's board approved a 60% increase in the company's quarterly dividend to $0.20 per share from $0.125 per share starting in January 2014. On Jan. 8, 2015, ADT's board authorized a 5% quarterly dividend increase to $0.21 per share starting in January 2015.

CONTINGENT LIABILITIES

As part of its separation from Tyco, ADT has entered into separation and distribution and other agreements with Tyco and Pentair Ltd. (formerly Tyco's Flow Control segment). ADT also entered into a Tax Sharing Agreement with Tyco and Pentair, which governs the rights, responsibilities and obligations of the three post-separation companies regarding certain tax matters.

In July 2013, the IRS issued Notices of Deficiency to Tyco based on audits of the 1997 through 2000 tax years. The IRS has disallowed interest and related deductions for certain intercompany debt totaling $2.9 billion and indicated that Tyco's former U.S. subsidiaries, including ADT, collectively owe $883 million of additional taxes plus penalties of $154 million. If the IRS is successful in asserting its claim, it would have an adverse impact on interest deductions related to the same intercompany debt in subsequent periods (2001 - 2007) totaling $6.6 billion.

Tyco has advised ADT that it strongly disagrees with the IRS position and is contesting these proposed adjustments in the U.S. Tax Court. Should the IRS successfully assert its position, the amount assessed would have to be in excess of $1.85 billion, including other assessments for unrelated historical tax matters Tyco has, or may settle in the future, before ADT would be required to pay any of the amounts assessed based on the existing tax-sharing agreements. No payments with respect to these matters would be required until the dispute is definitively resolved.

During the quarter ended June 26, 2015, the U.S. Tax Court, at the request of the IRS, has agreed to defer the trial date that had been set for February 2016. The new trial date has not been set by the court but is expected to be rescheduled for later in 2016.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:

--Low- to mid-single digit revenue growth during fiscal years 2015 and 2016;

--FCF margin of about 1%-1.5% during FY2015 and 2.5%-3.5% during FY2016;

--EBITDA margins of about 50% during fiscal years 2015 and 2016;

--Debt/EBITDA approximates 3.0x and interest coverage reaches about 8.4x by year-end 2015;

--Liquidity of $400 million to $600 million, consisting of cash and revolver availability.

RATING SENSITIVITIES

Future ratings and Outlooks will be influenced by broad economic trends, as well as company-specific activity, particularly FCF trends and uses, debt levels and liquidity position.

Positive rating actions are unlikely in the near to intermediate term, given limited flexibility within the rating for higher leverage. However, a positive rating action is possible if a change in financial strategy results in a management commitment to leverage 2.5x or lower as well as a free cash flow margin of 3.5x or higher.

On the other hand, Fitch may consider taking a negative rating action if there is meaningful deterioration in ADT's financial results, including low- to mid-single-digit recurring revenue declines and EBITDA margins consistently falling below 50%, leading to leverage levels sustaining above its 3x leverage target. Additionally, negative rating actions will also be considered if management again undertakes a more aggressive financial policy triggering debt funded shareholder friendly activities and leading to diminished liquidity and higher debt levels. In particular, negative rating actions could occur if ADT's leverage is materially above its 3x target on a consistent basis.

FULL LIST OF RATING ACTIONS

Fitch has affirmed ADT's ratings as follows:

--IDR at 'BBB-';

--Revolving bank credit facility at 'BBB-';

--Senior unsecured debt at 'BBB-'.

The Rating Outlook is Stable.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=989566

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=989566

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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