Alarm.com: An Undervalued Growth Business

Oct. 24, 2021 9:54 AM ETAlarm.com Holdings, Inc. (ALRM)
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Summary

  • Alarm.com is expanding its operations via M&A activity.
  • The company is intended to expand operations internationally.
  • The valuation models indicate that the stock is undervalued and can generate double digit returns.

Close-up on an automated security system at a house

andresr/E+ via Getty Images

Alarm.com Inc. (NASDAQ:ALRM) operates in an industry where it has huge total addressable market. The company is actively acquiring new businesses to expand its operations. The management has created successful moat around the business which helps to record 95% subscription renewal rate. Valuation analysis indicates that the stock is undervalued and can bring double digit returns in upcoming years.

Alarm.com offers innovative technologies and security systems for homes and businesses. The proposed solutions allow people to control their homes or offices from their phone, tablets or other devices. The software proposed by the company connects hardware devices with users via internet and allows them to control their home security cameras or IoT devices remotely. A user can get real-time alerts when somebody is in front of their door or turn on the heating system if the temperature is low at home - these actions can be done remotely using only the mobile software. That is why the subscription package of the software brings sticky recurring revenue, and creates significant moat around the business. The company has already reached 7.6 million subscribers with more than 10,000 service provider partners and with more than 100 million connected devices.

Alarm.com offers quite useful and innovative package of technologies. Its Smart Thermostat knows when the home is empty or when windows are open to correct the heating system to energy saving mode. The Smart Water Valve+Meter alerts users when there is a water leak and automatically shuts off the water to prevent waste. The software allows consumers to follow their monthly water usage and compare it with average levels used before. Video analytics catches unexpected events around homes and notifies users. It can be used to identify highly specific activities. Touchless doorbell allows users to see a person in front of the door.

Total market is expanding quite fast bringing significant growth opportunities for industry players. The global smart security market is growing at 24% CAGR since 2019 and is expected to reach $21 billion level by 2022. There are about 140 million homes in the US, while only 29 million use professionally monitored security systems. Meanwhile there are also 4 million business properties which are considered as a target market for security SaaS providers. Besides the US, the company is investing heavily to grow its business in international markets. Currently only 3% of revenues come from international markets, while the company serves in 40 countries worldwide. The company is serving in large European countries including the UK, France, Spain, Norway, Sweden, emerging markets like India, Brazil, Argentina etc. According to the management, the international market represents $32 billion opportunity. So the numbers indicate that the company has huge total addressable market to capture in upcoming years.

To gain larger market share in its industry and to expand its product base, the company is actively engaging in M&A activity. Since 2017, the company acquired 6 fast growing businesses. Object Video Labs acquisition brought AI based video analytic service for Alarm's existing client base. The platform identifies people, pets, surrounding objects and notifies users about the situation around their homes. Airdog acquisition in 2020 brings drone technology to the business which allows Alarm to incorporate drones in its security network. OpenEye acquisition in 2019 helped the company to strengthen its presence in video-based security solutions market. OpenEye has been deployed in more than 27,000 locations and has 500+ active service provider partners. So the company spent $240 million for M&A activity since 2017, which helped the business to keep its fast growth pace. Currently there is $660 million cash on Alarm's balance sheet, which indicates that the management is intended to acquire new businesses and expand growth opportunities of the company. If the management achieves to keep the ROE of 13.8% stable and squeeze the same profitability from new acquisitions then the new businesses will bring $91 million addition income recording 110% profit growth. Let alone speaking about the synergies which might multiply the potential profit.

During the last 10-year period the company was able to improve gross margins as the subscription based revenue weight is gradually increasing in total revenue. In 2011 the gross margin was 55.2%, while it improved gradually and reached to 63.2% level by 2020. The SaaS and Licensing business has higher gross margin and significant loyalty rate as the segment's gross margin was 85% in 2020 and the subscription renewal rate was above 90% level in last 3-year period. Meanwhile the hardware segment recorded a gross margin in range of 19-22% during the last 3 year period.

Alarm.com recurring revenue

Source: Alarm.com

Despite the improvement of gross margins, operating margin and EBITDA margins deteriorated in recent 10-year period. Operating margin was 24.1% in 2011 and declined to 11% in 2020, while EBITDA margin decreased from 27.3% to 14.9% during the same period.

Alarm.com margins

Source: Author's Model, Data: Finbox.com

The main reason of operating margin deterioration was increasing spending on R&D and Marketing. The R&D expense margin jumped from 8.6% in 2011 to 25% in 2020, while the marketing expense margin increased slower from 8.9% in 2011 to 12.3% in 2020.

Alarm.com R&D and marketing margins

Source: Author's Model, Data: Finbox.com

The management achieves quite healthy marketing efficiency, as in 2011-2020 period $1 spent on marketing brought higher than $1.5 additional revenue. The additional revenue to marketing expense ratio was stable in 2014-2020 period ranging from $1.5 to $2 interval. However it is worth mentioning that in 2012 and in 2013 the company was able to record substantially higher marketing efficiency in range of $2.55 to $5.4.

Alarm.com marketing efficiency

Source: Author's Model, Data: Finbox.com

Du-Pont Analysis

ALRM generates TTM ROE margin of 13.8%, which is near 7-year median margin. The margin was quite volatile as in recent years.

Alarm.com Du-Pont Analysis

Source: Author's Model, Data: Finbox.com

During the same period, net margin improved significantly reaching to 11.9% level in recent quarter, which exceeds 7-year median level of 7%. Asset turnover declined significantly as it was 1.38 in 2014 and is currently 0.59 - below 7-year median of 0.92. However the deterioration in recent quarter was due to issuance of convertible senior notes, which increased cash amount significantly. If we adjust the cash, then we get asset turnover ratio of 0.89. At the same time, equity multiplier increased from 1.5 in 2014 to 1.98 in 2021. The current multiple is higher than median of 1.59. Though increasing equity multiplier is not a good sign for financial health, however current level is in healthy range, as cash and cash equivalents exceed total debt, and the net debt is negative $-201.9 million.

ALRM stock Du-Pont Analysis

Source: Author's Model, Data: Finbox.com

Risks

The business faces significant competition threat as large technology behemoths are entering into the smart security industry. Amazon Ring (AMZN) and Google Nest (GOOG) can grab market share form Alarm, as these behemoths possess enormous amount of cash and can invest heavily to develop innovative advantages against Alarm.

There are also other competitors which have industry specific business models and are direct threats for Alarm's business. ADT Inc. (ADT) and Vivint Smart Home Inc. (VVNT) generate $4.8 and $1.6 billion revenues respectively. These players have higher spending power which indicate that they can invest higher amounts on marketing and on R&D and seize market faster than Alarm.

Valuation

To calculate the intrinsic value of the stock, we have built a DCF model. First of all we need to calculate WACC. To calculate the beta coefficient, we have regressed 5-year monthly returns of S&P 500 (SPY) against ALRM returns. As a result, we see that the R square is rather low 15.99%, and the correlation is just 39.99%. Thus the yielded beta of 1.09 is not a reliable coefficient to use in WACC model.

Alarm.com stock valuation

Source: Author's Model, Data: Yahoo Finance

Thus we use the quotient of Coefficients of Variations as a more reliable measure for risk measurement. Dividing ALRM COV of 1.91 to SPY COV 0.89 we see that ALRM's risk is 2.15 times higher than SPY's risk.

Alarm.com vs S&P 500

Source: Author's Model, Data: Yahoo Finance

We have also used equity risk premium of 4.84%, risk free rate of 1.68%. As a result, our model indicates that the WACC is equal to 11.16%.

Alarm.com WACC calculation

Source: Author's Model, Data: Finbox.com

For the DCF model, we use 20% revenue growth, 1% annual EBITDA margin improvement to 25% by 2030, and terminal growth rate of 2%.

Alarm.com assumptions

Source: Author's Model

As a result, our model indicates intrinsic value of $115.9, which we have adjusted for 10% share count growth. The result is $105 intrinsic value - 30% higher than current price.

Alarm.com intrinsic value

Source: Author's Model

We have also calculated annual return opportunity assuming 2030 price to FCF ratio of 25. Our model indicates 16.7% annual growth opportunity which is quite attractive growth opportunity.

Alarm.com WACC model

Source: Author's Model

We have also conducted scenario analysis, where we calculated the intrinsic value based on different growth and WACC scenarios. The model indicates that the current value reflects 17% revenue growth expectation, which is 8.2% lower than last 10-year revenue CAGR of 25.2%.

We have also conducted a historic valuation analysis. We have regressed 5-year TTM revenues against market caps. The model shows R square of 79.5%, which indicates that the variables are highly correlated. Using the equation generated by regression software we get an implied market cap of $4,380 which is 8.4% higher than current market cap.

Alarm.com revenues and market cap

Source: Author's Model, Data: Finbox.com

We have also regressed TTM Net Income against Market caps. As a result R square is 61.2%. Using EPS estimate of $1.79 we get $4.23 billion implied market cap which is 5% higher than current market cap.

Alarm.com net income and market cap

Source: Author's Model, Data: Finbox.com

Conclusion

Alarm.com is a great growth play as the business offers innovative security and smart home solutions. The business has developed substantial moat as the company reached subscription renewal rate of 95% in 2020. Valuation analysis indicates that the stock is undervalued and investors can earn above average returns in upcoming years. That is why we assign a Buy rating to the stock.

This article was written by

Growth Analyst profile picture
920 Followers
We invest in the fastest growing industries and pick the best players operating in these industries. We buy stocks which have potential to outperform the market in long run and bring strong double digit returns. Associated with SA contributor Seekingvalue Research

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in ALRM over the next 72 hours. 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.

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