AlarmForce: Secure growth, and the stock may be a steal

Most Canadians are familiar with AlarmForce Industries Inc., the home security company whose president, Joel Matlin, never misses a chance to scare the bejesus out of nervous homeowners.

But as pervasive as AlarmForce's commercials are, its stock flies under the radar of investors. Only a couple of analysts follow the company, which has a market capitalization of just $73-million, and on most days only a few thousand shares trade hands.

But the stock's low profile doesn't do justice to AlarmForce's strong fundamentals, fans of the company say. The business is growing at double-digit rates, has virtually no debt and its conservative accounting conceals a dirt-cheap valuation. What's more, its unique business model allows it to undercut competitors and gobble up market share.

"As we dug into the company and looked at some others in the industry, we realized these guys just have a huge advantage that we really haven't seen before," says Cory Bailey, managing partner at 3G Capital Management LLC.

He and his partner, Pavel Begun, were so impressed by AlarmForce that they've made the stock their biggest holding, both personally and in 3G, a value-oriented hedge fund with a long-term philosophy.

What do they see that others don't? For starters, AlarmForce is signing up customers at an impressive clip. In the first quarter, revenue leaped 21 per cent to $7.1-million and profit soared 20 per cent to $680,071. As of Jan. 31, the company had 82,600 subscribers, and it's aiming to carve out a new niche with the launch of AlarmCare, a product aimed at elderly consumers.

Having expanded across much of Canada, AlarmForce is now tackling the United States, focusing on North Carolina, Georgia, Ohio and Kentucky. In every market, it aims to be the lowest-price provider by installing its alarms for free and charging $25 a month for monitoring services, compared with $30 or more at competitors.

"We like to think we're the Wal-Mart of the industry. Our concept is to give the strongest value proposition to the end user," says Mr. Matlin, who projects "conservatively" that AlarmForce will double in size in the next five years.

The secret to AlarmForce's success - and the key to understanding why the stock may be undervalued - is the way it acquires customers.

Rather than make acquisitions or pay agents a hefty commission to sign up new accounts, it relies on advertising to grow organically. Whether they're watching TV in Cleveland or Calgary, prospective customers see the same commercials and call the same 1-800 number that connects to AlarmForce's Toronto office, which also serves as the central monitoring station.

The savings of this approach are significant. Mr. Begun estimates that AlarmForce spends an average of $600 to acquire a customer, compared with $1,000 or more at most competitors. But because of the way AlarmForce accounts for these customer-acquisition costs, the benefits aren't immediately obvious to investors.

In most cases, when an alarm company pays a commission to an agent or buys a customer contract from a third party, it amortizes the cost over the expected duration of the account, so earnings take only a small hit every year.

But in AlarmForce's case, all of its advertising and marketing costs are expensed up front. As a result, its earnings take the full hit right away, even though customers stay with the company for 10 years, on average.

The impact on AlarmForce's valuation is dramatic. Based on the company's 2007 reported profit of 11 cents a share, the stock trades at a trailing price-to-earnings multiple of about 54. That's rich, even for a company whose revenue is growing by 20 per cent annually.

But it's also misleading. If AlarmForce were to amortize customer-acquisition costs, as its competitors do, its 2007 profit would have quintupled to 54 cents a share, Mr. Begun estimates. Based on that adjusted number, the P/E would drop to 11 - cheap for a company growing so fast; on projected 2009 earnings, the adjusted P/E would fall all the way to 6.

"I would say that's a screaming buy," Mr. Begun says.

Looked at another way, imagine what would happen if AlarmForce were to slash its ad spending: Suddenly, its profits would soar.

"Right now, we're investing millions and millions of dollars in growing the company," Mr. Matlin says. "If we decided to stop tomorrow and say, 'Okay, we don't want to grow any more,' we could throw off a tremendous dividend."

But slowing down is the last thing on Mr. Matlin's mind. At 60, he still plays hockey twice a week, cycles and walks regularly. And he's determined to keep AlarmForce growing at a steady pace. Which means we can count on two things: Mr. Matlin showing up on our TV sets, and AlarmForce signing up a lot more customers.

By the numbers

Market cap

$73-million

One-year total return

-1%

Revenue (fiscal 2007)

$25.1-million

Profit (fis. '07)

$1.3-million

Earnings per share (fis. '07)

11 cents