Description

APX Group (aka “Vivint” or “APXSEC”) 2023 Note trades at ~80 and offers a 7.625% coupon, 14%+ YTM and more likely a ~20% 2-year-yield-to-par. As compared to ADT which trades at >40x RMR and Ascent / Monitronics (inferior biz model that’s currently being restructured at ~34x RMR), Vivint is a superior mousetrap (100% internally generated leads, and proprietary technology as well as early leader in 3^rd party financing leading to reduced subscriber acquisition costs) and can be created for less than 28x RMR on our 1-year frwd estimate. Vivint is a leading provider of home security and home automation “smart home” technology with ~1.5MM customers (door bells, cameras, monitoring pads etc.) Vivint was purchased by Blackstone in 2012 and operates a unique business model: 1) it internally generates 100% of sales leads via direct to home (door to door selling) and internal sales (sales rep outreach, customer demand pull) and 2) manufacturers proprietary equipment with an R&D budget of ~2-4% of revenue annually.  As a result of its differentiated sales model, APXSEC has generated superior unit economics vs peers with subscriber growth of ~15% per annum, lower normalized attrition (12 – 12.5% per annum) and lower creation multiples (first to lead with 3^rd party financing) = resulting in a lifetime value that is well in excess of both ADT and Monitronics.

Similar to others in the industry, Vivint offers monthly-pay monitoring contracts typically 3-5 years in duration w/ most on the longer-end. Monthly monitoring costs range from $39.99 to $49.99 depending on the complexity of the system (i.e. the number of components in the home) and the company has rigid underwriting standards with and average customer FICO score of >700. Vivint was founded by Todd Pederson who remains highly active in the company today (runs the direct-to-home sales channel) and is a ~10% equity holder. Ultimately, we think Vivint is a “great house on an okay block” – while the home monitoring industry has exhibited only modest growth per annum historically, the company’s +40% subs and +100% EBITDA since the buyout reflects its attractive value proposition to consumers, leading status within the “connected home” (NOT a single trick “home monitoring” business) and our analysis suggests the company’s unit economics are superior to peers resulting in a lifetime value that is well in excess of peers (see below, Monitronics @ ~1.1k per sub, ADT at ~1.6k and Vivint at ~2.1k).

As discussed in more detail below, the opportunity is primarily related to the general industry negativity – ADT’s failed IPO and Monitronics’ bankruptcy have put a dampener on the industry and Vivint is dragged into this mix even though they have a differentiated business model. Over the past 14-months, the APXSEC 2023 notes have traded off by >20 points (105 – 107 context through March 2018) and yet the KPIs have tracked favorably. The outlook has continued to improve (on our estimates, the “creation value” through the 2023 note is less than 28x RMR on our 1-yr forward estimate) and APXSEC has more than enough liquidity. Notably, in 2016 an investment group led by Peter Thiel and Solamare Group (Mitt Romney) invested an incremental $100MM into the business used for growth initiatives (not a return of capital to Blackstone) showing support around the equity.

Capital Structure:

Vivint was acquired in 2012 for ~$2BB including ~$800MM equity from the sponsors Blackstone and Summit Growth Partners. We estimate Blackstone’s commitment was ~$550MM. Vivint Solar was subsequently spun out of APX Group – Blackstone took ~$50MM off the table as part of the secondary offering and today controls 62% of Vivint Solar which equates to $550MM of value based on the current share price. Consequently there is some risk to our investment as Blackstone has effectively taken all of their money off the table however our conversations with management suggest the sponsors are committed to the investment and believe they are sitting on a 2-3x return opportunity.

The 2020 unsecured notes are the last remaining debt from the LBO with the remaining tranches issued over the past 7 years largely to fund growth. With regard to covenants, co has a 4x secured incurrence test (excludes revolver) which is largely tapped out following the April 2019 issuance of the 2024 notes to fund a partial refi of the 2020s. Based on our 2019 estimates, we think the company will free up an additional ~$300MM under this basket by YE which could be used to facilitate a more comprehensive refi of the 2020 balance and fund an estimated ~$100MM FCF burn in 2019.

Why the opportunity:  3 primary drivers:

1)   Industry / Competition: Since 2017/2018 there has been a number of new entrants into the home monitoring market particularly DIY offerings from the likes of Simplisafe, Nest, and Ring (Amazon), among others. The value proposition in DIY is a lower upfront cost (<$500 for top package from Simplisafe vs ~$1,000+ for Vivint) and typically lower monitoring costs (~$25) or offered as a self-monitored system. The crux of the bear thesis on “professional home monitoring” at large is that the business model is capital intensive and subject to disruption.

a.       We have conducted numerous industry checkings on this threat – the key takeaway being that while DIY is growing as a % of the home monitoring mix, 1) the buyer of DIY is a fundamentally different customer, 2) the average FICO score of a DIY buyer is meaningfully lower than Vivint’s (industry expert suggested 550-600 average vs. ~700 Vivint) which is not a core target of Vivint and in fact a FICO score that would likely not even meet their underwriting standards and 3) DIY might in fact be expanding the TAM for home monitoring (not necessarily cannibalizing). Further to the last point, there is a strong possibility that Vivint partners with a larger tech player given their brand recognition, unique product offering and the fact that their products current tie into many third-party smart “Silicon Valley” home products.

b.      Additionally, it’s worth highlighting that Vivint offers a uniquely different value proposition to its customers than the likes of ADT and Monitronics that are more 1-trick ponies with “home monitoring” only. Vivint sells a “connected home” offering attracting a higher-FICO consumer. While this might be a point of debate, the evidence to date is sound w/ 1) subscriber growth that is well in excess of “home monitoring”, 2) attrition rates below “home monitoring” comps, and 3) lower acquisition costs than most peers (internal sales force is one of the key drivers of this as Vivint doesn’t have to pay up for 3^rd party leads.)

2)   FCF / reliance on capital markets: In April 2019, Vivint did a partial refinancing of its Dec 2020 notes with ~$450MM left outstanding. We have a hard time seeing how the 2020s bring the structure down especially in light of ~$500MM incremental secured capacity by 2019 year-end (~$300MM 4x secured test assuming $630MM 2019E EBITDA + $150 other secured buckets + $60MM super priority carve out). Additionally, though unpalatable, we think the company would accept a mid-teens rate on an unsecured deal with favorable NC terms if it successfully bridged the final necessary debt raise and bridged a maturity wall. Lastly, though more speculative, management has indicated that Blackstone would be supportive if need be to help address the 2020 maturity.

a.       Since the Blackstone buyout in 2012, Vivint spent ~$3Bln on sub acquisition costs (SAC = attributable SG&A + equipment) with total FCF burn over the same period of ~$1.8Bln and total debt increasing from $1.5BB at the LBO to ~$3.1BB PF for the recent partial refinancing. Vivint’s historical model financed 100% of SAC on-balance sheet which amounted to approximately ~$2,000 per sub and created a strain on cash flow despite solid sub growth at attractive ROI. In light of near-term maturities, the market has become increasingly wary of Vivint’s FCF profile and we think is ascribing a “show me” story to management’s stated goal of exiting 2019 at a position of self-funding growth. We also think there is a tug-of-war dynamic between the credit and equity story as the sponsors likely want to continue sub growth at a double-digit pace in order to garner an associated growth multiple despite the credit market sending a message that FCF should be top priority.

b.      In 2017 Vivint put in place a Flex Pay model whereby the equipment portion of the sale (est. $800) is financed by Citizen’s Bank. In effect, Citizens provides Vivint with cash upfront at the time of the sale for the cost of the equipment (plus a margin) and the customer pays two bills, one to Citizens for the equipment and one to Vivint for the cost of ongoing monitoring service. The net impact has been a reduction in SAC from ~$2,000 to $1,142 as of Q1’19; management thinks they can get this sub-$1,000 as on-balance sheet accounts are replaced by the second look financing partner. We estimate Vivint will burn ~$100MM FCF in 2019 – showing sequential improvement throughout the year – and be in a position to be FCF-generative in 2020E which we think will alleviate the market’s biggest concern with the credit today.

3)   KPI cracks: Q1’19 represented a slowdown in the sub growth engine; total adds were -14%. Part of the YoY decline is noise related to the exiting of the Best Buy retail channel which accounted for 8k adds in Q1’18 but the market is focused on the ~flattish apples to apples growth after +15% growth in 2018. Part of the hiccup we believe is due to the rollout of the “second look financing” which the company initiated late last year in an effort to ween off of high-SAC on-balance sheet contracts (<20% adds 2018 vs. >30% 2017 with plans to fully exit the structure by YE 2019). Management attributed part of the slowdown to the natural learning curve of sales reps to sell the new structure. We think there is validity to this as the company saw a similar issue in 2017 upon the rollout of Citizens financing – 2017 DTH sub adds were down 17% before rebounding back to normalized 176k adds in 2018. Mgmt. believes mid-teens growth ex-retail is still achievable for the year and it is worth noting that management bonus payments kick in at levels higher than this.

a.       Attrition is the other pressure point after ticking up +200bps vs. 11-12% historical. The crux of the issue here is the natural overlap of the subscriber cohorts; ~14% of the pool is coming to end of term in 2019 vs. 6% in 2018 which creates a natural tension point in the business. Looking past 2019, the end of life pool in 2020 is 8%. Again we look back historically and note that in 2016, 12% of the pool was end of term and attrition climbed as high as 12.9% before settling back down to 11% in 2017 when the term cohort reverted back to 6%. We expect attrition to normalize in the mid-12% range.

Next steps – why compelling: 

We believe Vivint is at the trough of a perfect storm right now: 1) ADT and Monitronics have soured investor appetite to the home monitoring industry, 2) Vivint’s growth engine is being questioned given short-dated HY credit with a bit of a story. We believe the business has temporarily been placed in the penalty box and the yields (~14% YTM and ~20% 2-yr-to-par) are attractive especially as we think the Vivint will address the 2020 maturity in short order, the KPIs are tracking and the business has adequate liquidity. Ultimately, Vivint is a good business with a stretched balance sheet. We have difficulty seeing how Blackstone walks away from their equity especially as Vivint is on the cusp of a meaningful inflection in its funding profile (transition to FCF positive), KPIs tracking and multiple avenues to value realization (even applying a consistent multiple to ADT yields a ~$1.5Bln+ equity value (we believe a more reasonable RMR multiple is 45 – 50x which would imply a ~2-2.25Bln equity value junior to the ~3.1Bln of debt. Among the three key controversies we highlight above, we think investors will get favorable clarity on two (KPIs and FCF) over the next two quarters which will in turn validate that the threat around the third controversy is more perceived than real. As this becomes more evident to the market, there should be a re-rating of Vivint’s risk profile.

Catalyst

- Evidence of FCF turning positive (by YE 19E)

- Addressing the 2020 security (next 6-months)

- Strategic investment or partnerships (next 2-yrs)