Alarm firm’s restored distributions are a lure for investors

Aug 1, 2010

by Fabrice Taylor

prairie trader If you want to turn an income trust into an orphan, it’s simple: cut the distributions. It will be forgotten in no time as income-hungry investors run for the exits and trample one another on the way. As they run for it, the analysts slowly follow. The next thing you know, the trust is like a tree falling in an empty forest. There’s no one there to hear if it makes any sound.

But there’s an opportunity for savvy investors to make a buck when an income trust becomes an orphan. The history of trusts that have cut distributions, for instance, tends to be that they get crushed, but as management mends the business that led to the distribution cut, the units do very well. That’s in part because of a turnaround but also because the units usually fall in value when investors panic.

I think there’s one such opportunity in the First National AlarmCap Income Fund (TSX:FSN.UN). The fund was set up in 2005 to merge two residential alarm companies –
one in Quebec, the other in Western Canada.

The fund got off to a rocky start. Within about two years of going public, it had to suspend distributions because, like many funds and trusts, it over-distributed its cash and had too much debt.

In late 2008 the fund brought in a shrewd accountant named Fred Fong who rolled up his sleeves and got to work righting things. Len Sudermann, the entrepreneur who set up the fund and who is the biggest shareholder with 30 per cent of the units, stayed around to manage Western Canadian operations.

Right off the bat, the astute investor sees something to like: a board and management team that isn’t afraid to make tough decisions. It’s not every CEO who gives up the top job in the interests of the firm.

Fong wasted little time identifying the problems. First he cleaned up the corporate structure and simplified it.

Then he got to work fixing the problems in the business. The eastern Canadian subsidiary operates a little differently than its western counterpart, but essentially the alarm business consists of investing money to acquire customers – either by buying them from retailers who sign them up, or with advertising or free or discounted equipment or other incentives – and then hanging onto them for as long as possible to maximize revenues.

First National is a big player in alarms with about 92,000 customers. To put that in context, AlarmForce has about 102,000. But it makes a lot more money and is worth a lot more on the stock market – more than three times as much. That’s partly because First National has more debt, but it’s also because while it has arguably a better product, it isn’t squeezing as much money from its assets.

The fund’s most important task, in my opinion, is to reduce its subscriber churn or attrition rates. Customer accounts inevitably lapse, meaning that customer has to be replaced just for business to stay stable, let alone grow.

When we met, Fong told me that he was paying special attention to this and he’s realigned the focus to concentrate on retention. He’s also concentrating on low-cost acquisitions such as referrals, which are cheaper accounts to acquire than promotional ones.

The reason lower attrition is so important is twofold. First it keeps revenues coming in every month without the need to spend money replacing it. But more important is that the fund is also increasing the average revenue it gets per customer every month by selling more products and gradually raising rates on older accounts to bring them in line with newer ones.

This kind of growth is very cheap and relatively easy to achieve.

So far so good: revenues are stable, costs are down and profits up. The distribution was reinstated before Fong arrived but has been raised recently. There’s a lot of debt on the balance sheet but given the stabilization of the business, I suspect it will be rolled over or otherwise dealt with in a way that won’t be too damaging to investors.

The units have done well since they bottomed out, but I think this is a good business in good hands selling for a cheap price given what I see as above average growth in its distributions.

Fabrice Taylor is the Prairie Trader. He is an award-winning journalist and equity analyst.

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