AlarmCap: A broken trust well on the mend

In the great annals of broken income trusts, AlarmCap stood out with astonishing prominence. It went public in 2005 to finance the acquisition of a bigger rival and promptly crumpled under the weight of its over-distribution.

While the market cap imploded - early investors bought a one-way ticket from $12 per unit to $2 - the underlying business, in security alarms and monitoring, didn't suffer nearly as badly as that travail suggests. Investors are starting to take notice, and there's an opportunity to make a nice return with relatively little risk.

The fund hired accountant Fred Fong to turn things around in 2008. Business-wise, Mr. Fong is a bore. He likes to count nickels. He is moderate. He aspires to stability and steady, cautious growth, and he moves with the urgency of a snail. In other words, he's just what the doctor ordered.

Monthly distributions were cut completely then restored to two cents before Mr. Fong arrived. Since his arrival, they're up 25 per cent, giving the units a yield of almost 7 per cent. If all goes according to plan, they are heading higher, slowly, over time.

First National's business is kind of like the oil industry: Oil producers strive to acquire reserves at a price that's lower than what it costs to produce them. In security, the game is to sign up customers for less than the cost of servicing them. In both cases, the asset base depletes and has to be replaced. Oil is produced and sold, while security customers also disappear by not renewing or moving or changing providers or dying.

On the asset front, First National has some work to do. Customers, at last count, were at just over 91,500, and that number's been declining slowly for a couple of years or more. Revenues, though, were down only slightly year-over-year while EBITDA (earnings before interest, taxes, depreciation and amortization) was up a little. Distributable cash was up sharply. These are the hallmarks of the early part of the turnaround: corporate restructuring and cost control. The upshot is higher distributions and a higher unit price. The fund is generating cash (there's $11-million in the bank) and paying down debt.

The next phase, Mr. Fong explained to me when we met, will be reducing churn, adding more customers and selling them more services. Technology helps. More and more customers like to be able to use their cellphones to monitor their homes. There's money to be made selling them that service.

Mr. Fong is also changing the way customers are acquired. It's nothing revolutionary; it's just minding the store. It's reasonable to assume the customer count will stabilize and even climb. And it's also reasonable to assume the fund can get more revenues from customers. Alarm Force, a competitor, gets more from its customers.

In terms of value, First National has an enterprise value - debt and market cap - of about five times earnings before interest, taxes, depreciation and amortization. Alarm Force, with no debt and better growth and profitability, is at about seven times. So the basic theory is that if First National can continue to turn things around, investors will benefit from more cash flow and a higher multiple. This will take time but seems achievable.

One word of caution: If you are very bearish on the housing market, you should take into account that home sales correlate closely with demand for home alarms. The fund has already felt the impact of the slowing market for housing, but things could get worse.

The last time this column looked at a broken income trust was in May when we touted the merits of Menu Foods, which, we argued, would either continue to do well or get taken out. It was bought, and investors earned 25 points on their investment in less than three months. It's unlikely that First National gets taken out that soon but eventually that will probably happen. In the meantime, astute buyers can make some coin.