ADT: Is This Security Company Setting Up For A Short Squeeze?

| About: The ADT (ADT)

The ADT Corporation (ADT) caught my eye recently on a broad scan of the market. ADT provides electronic security for home residences along with other related monitoring services. The company has been in a bit of a dry spell of late as seen in the chart below. Since the earlier part of this year, the stock has been channeling lower. However, the company recently established a multi-year bottom and has begun to shape a base which could possibly lead to a breakout in the near future.

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However, what remains a rather interesting concept is that ADT has begun an extended campaign to change its capital structure. In late 2012, ADT felt increasing pressure from its investors to start buying back its company stock. The charge was led by Corvex Management LP and Soros Fund Management LLC. These investors stated that low interest rates combined with ADT's robust cash flow resulted in a highly under-leveraged balance sheet.

Whether or not management caved in to these demands, what is clear is that the company has since initiated a very shareholder-friendly policy of buying back shares. In November 2012, a three-year $2 billion share repurchase program was approved by the company's board of directors. In January 2013, the company further emphasized this effort with an accelerated share repurchase program which was completed in April 2013. Over this time period, the company repurchased 12.6 million shares for a total cost of $600 million.

ADT Shares Outstanding Chart
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ADT Shares Outstanding data by YCharts

Seen in the graph above, the effect of this program appears to have had little impact on the company's stock price. Nevertheless, by reducing the share count, the company was able to partially bolster its earnings-per-share. It also reduced the cash outflows in future dividend payments.

However, the most interesting chart to me is the relatively large short interest that has continued to grow since ADT became an independent public company. In October 2012, the company was spun off from Tyco International (TYC). As shown in the graph below, the company's short interest was approximately 24.25 million shares on October 15, 2013. This has steadily risen over the past year. On November 15, 2012, the short interest was a mere 2.92 million shares. This represents an increase of 730% over the year. All of this occurred during a time in which the company was aggressively buying back shares.

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Fundamentally, ADT continues to perform well and with much stability. Revenue for the ADT Corporation has grown from $3.11 billion in 2011 to $3.23 billion in 2012. Over the same time period, net income grew from $376 million to $394 million. Over the last three quarters, this steady growth has continued. Net income grew quarter-over-quarter as the company posted numbers of $105 million, $107 million, and $113 million sequentially.

ADT now trades with a market capitalization of $8.93 billion. The company has total assets of $9.66 billion and currently carries total liabilities of $5.2 billion as of the quarter ending in June 2013. In September, the company carried through with its plans to further leverage itself in order to buy back stock and possibly expand through acquisitions. The company priced an offering of $1 billion in 6.25% senior notes due in 2021.

Final Thoughts:

The market doesn't appear to understand that ADT operates in a very stable industry. The company's cash flow has been very consistent. This can be seen by its performance since its spin-off from Tyco in 2012. Above all, the company has been leveraging itself in order to reshape its balance sheet and take advantage of this reality.

The aggressive share buyback program coincides with a growing short interest. This appears to have played a large part in the company's stagnating share price. The cover ratio as of October 2013 has now grown to 9.8 days compared to 1.5 days in November 2012. If ADT can find a proper catalyst, it is possible that it could spark a short squeeze. My attention will be focused on the upcoming quarterly earnings announcement.

Disclosure: I am long ADT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.