With Dow 10,000 still in the glazed eyes of many investors, we can't help but be nervous. "What can go wrong?" is the first question you should ask when looking at any investment, and that question is particularly pertinent at these valuation levels. When things are going wonderfully is exactly the time to pay attention to what you own.
That brings us to a war story about a stock where things "seemed" to be going well but a closer look opened up a can of worms:
. We bought it in 1996 at what became an adjusted cost basis of 2 and sold it a few months ago at 11, after taking a $7.50 cash dividend out to boot. The stock closed Monday at 3 7/8, after a 50% drop Friday due to a terse announcement about restating earnings because of a disagreement with the
Securities and Exchange Commission
regarding accounting policies. A good sale is like good putting: You don't get the oohs and aahs of the big drive off the tee -- like that of buying
100 points ago -- but there is a nice, quiet smugness about making a 14-footer for birdie.
For brief background, Protection One is now the second-largest provider of electronic alarm-monitoring services, primarily to the residential market. The beauty of this business in our eyes is that it sports cash-flow (meaning earnings before interest, taxes, depreciation and amortization, or EBITDA) margins of 40%, it has a nice predictable cash flow coming in monthly and the reinvestment rate needed to maintain this cash flow is pitifully low.
We originally got started in the industry with an investment in
, the No. 1 player, in the early 1990s. ADT was selling at a ridiculously low price in the aftermath of accounting problems and management credibility issues. But the company finally straightened itself out and was eventually bought by
at a tidy price.
So in 1996, when
called and asked if we would like to meet the management of Protection One during an equity road show, we were interested. We knew the industry and were impressed with the company's management. But what really caught our attention was that the secondary was being priced at levels 40% below where the stock was trading when the deal was announced. While the market at the time was tough, we said out loud how ticked off we would be if we were already shareholders -- but since we weren't, it wasn't our problem. After the deal, the stock quickly went up 40% and we were happy.
Protection One's plan was to aggressively step up the consolidation of the industry, which at the time was led by ADT with only 7% of the market. Protection One could buy competitors or subscriber accounts generated by a dealer network at three to four times cash flow and finance them by selling stock and debt at seven and eight times cash flow, a spread that creates value for the Protection One shareholder. By focusing on in-market subscriber additions, the breakeven for a new customer was about three years, a fairly reasonable proposition when the average customer stayed seven or eight years.
But as some other players got into the same game -- notably
-- and as the sellers got wind of the game, the prices started rising. By then, Protection One was making acquisitions at five to seven times cash flow and effectively financing these with equity at 10 to 12 times cash flow, still a value-creating arbitrage for Protection One shareholders. The company was also run fairly leveraged, not inappropriate given the steady cash flow of the alarm business, and that magnified the returns for its shareholders.
So Far, So Good
Phase one ended with Western Resources effectively taking control of Protection One in November 1997 with an offer of $7.50 a share in cash and a merger with Western's own alarm business. That left a much-larger publicly traded entity that was to be run by the original Protection One team. We thought we were happy, but that's where the trouble began.
First off, Western Resources now owned 81% of the public Protection One, which meant that the stock would never trade with a takeover premium. Even worse, Western Resources had to maintain its 81% ownership for tax reasons. So Protection One had to issue extra stock every time it did a deal (so that Western could maintain its stake) or Western had to go into the open market and buy stock, creating an artificial floor under the shares.
We then witnessed an increasing pace of acquisitions at prices that seemed to be stretching the limits of both good taste and our ability as analysts to make sense of the numbers. Worse, we couldn't "see" the evidence that the acquisitions were being effectively molded in, because the next deal came before the results of the former deal were in.
The final insult came when we were once again called by Morgan Stanley for a secondary offering. This time, we were the shareholders being bagged, as management insisted on doing the deal despite our howling, even though the stock had traded 40% off the levels at which the deal was first announced. The net effect was that Protection One had just paid 11 times cash flow for an acquisition and was selling stock to pay for it at eight times cash flow, effectively destroying shareholder value.
The Game Is Over
This is a classic problem, which some companies just don't understand. The Protection One press releases touted major gains in size, but the fact was that while EBITDA cash flow had increased sixfold in four years, the number of shares outstanding had increased 13-fold in the same period. So where, we ask, are the shareholders' yachts?
We had a nice chat with Western Resources management in regard to the situation, and we sensed that they weren't too happy either. We also spent some time on the phone with a number of smaller alarm dealers, some of whom confirmed they were sitting around waiting for Protection One to implode so they could pick up its customers. In other words, the management team that could successfully run a $100 million company seemed to have no idea how to run a $1 billion company. It took the stock a few months to rally following the secondary offering, and we were gone.
After that, more warning signs came from the company: The CFO left, and the founder and CEO resigned a few months later. These are obviously not signs of good things to come and signified that Western Resources' patience had probably run its course. Then, last week, Protection One announced that the SEC was forcing a restatement of its 1997 and 1998 earnings. The specific issues appear to be minor, but their occurrence holds much more importance for a company that has grown as quickly via acquisition as Protection One. Once your financial statements lose credibility, it takes a long time to get your multiple back. Just ask
From Insult to Injury
But the kicker, and something that holders of Tyco International should also be attentive to, was that the Protection One press release noted that the SEC was looking hard at the industry's practice of amortizing subscriber acquisitions costs over a 10-year period. While it appears that Protection One has not done anything terribly different than other industry players, a more conservative approach -- which would amortize customers over a shorter period of time -- would wreck Protection One's entire business model and balance sheet and make what were marginable acquisitions seem like lunacy.
And don't count on Western Resources bailing you out of Protection One soon. By maintaining a majority -- but not 100% -- ownership it is able to forestall utility regulators who would love to get their mitts on what is now unregulated cash flow. If it bought the rest of Protection One in what would probably be a steal somewhere down here (and believe me, we're looking at it again), it risks entangling some of its proposed utility acquisitions.
The moral of this story is to watch carefully what you own. Most companies don't go bad all of a sudden. The signs are usually there if you're paying attention, and annoyingly, they seem very obvious after the fact.
Jeffrey Bronchick is chief investment officer of Reed Conner & Birdwell, a Los Angeles-based money management firm with about $1 billion of assets under management for institutions and taxable individuals. Bronchick also manages the RCB Small Cap Value fund. At time of publication, neither Bronchick nor RCB held any positions in the stocks discussed in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bronchick appreciates your feedback at