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On Jan 8, we initiated our coverage on The ADT Corporation (ADT - Analyst Report) with a Neutral recommendation. The sideline stance is based on its balanced business model with a diversified product portfolio and customer base, while the stock remains vulnerable to gross margin pressures and stringent government laws and regulations.

Why Neutral Recommendation?

With a wide array of products to cater to a broad spectrum of customer needs, ADT has a strong footprint in the large and growing residential and small business security market. The product portfolio of the company includes some of the most respected, trusted and well-known brands in the industry. As reputation and reliability serve as the two key elements in the decision-making process while purchasing home and small business security and automation services, ADT has a distinct advantage over rivals with its well-recognized and reliable brands. The depth in product portfolio, strong brand identity and a well-diversified customer base offer an unrivalled competitive advantage to ADT.

The company believes monitored security and home/business automation services remain under-penetrated in North American households. In addition, rising concerns about crime and security issues (especially by an aging population), increasing customer interest in lifestyle and business productivity, and technology advancements are likely to support the higher penetration of interactive services and home/business automation. As such, the company envisions significant growth potential and intends to capitalize on this opportunity by leveraging on its efficient operating model and lower technology costs over time. These would then enable the company to considerably reduce the cost of basic installation and services, thereby making it affordable for a wider market acceptance by a larger portion of households and businesses. We remain encouraged with such inherent growth prospects of the company.

A bulk of the monitoring and home/business automation services and a large portion of the maintenance services are governed by multi-year contracts with automatic renewal provisions, which generate significant recurring revenues for ADT. This insulates the company from the volatility in the market and enables it to invest for a healthy organic and inorganic growth. Mergers and acquisitions continue to play a pivotal role in ADT’s growth over the years. Periodic investments for improvement of the direct sales force and complementary distribution channels should also enable ADT to retain and capture additional market share to fuel its growth engine.

Reasons for Concern

On the flip side, ADT faces significant pricing pressure and competition as the security alarm industry is highly fragmented due to low barriers to entry. The company witnesses significant competitive pricing pressures on installation, monitoring and service fees. In addition, cable and telecommunications companies are also eroding its market share by expanding into the monitored security alarm industry and bundling their existing offerings with monitored security services. As such, ADT has to continually invest in R&D and similar other value drivers that act as a hedge against tough competition. This increases its operating costs and reduces its profitability to some extent.

In addition, the operations of the company are subject to various federal, state, provincial and local laws and regulations in the U.S. and Canada in areas such as consumer protection, occupational licensing, environmental protection, labor and employment, tax and other laws and regulations. In addition, most states and provinces in which ADT operates have licensing laws directed specifically toward the security services industry. Increased government regulation escalates costs and restricts operations, somewhat impairing the long-term growth of its business.

Other Stocks That Warrant a Look

ADT currently carries a Zacks Rank #2 (Buy). Other stocks that are worth a look in the industry include Nielsen Holdings N.V. (NLSN - Snapshot Report), Verisk Analytics, Inc. (VRSK - Snapshot Report) and McGraw Hill Financial, Inc. (MHFI - Analyst Report), each carrying a Zacks Rank #2 (Buy).

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