Financial outlook improves, but challenges remain

Outside financial institutions take a wait and see approach while lenders that traditionally deal with the industry continue
Sunday, February 1, 2004

While certainly not the doom and gloom scenario of the recent past, observers of and participants in the financial sector related to the security industry are still cautious about where things are headed, especially as they relate to financing alarm dealers.
“The financing environment for alarm companies is challenging,” noted Gregory Bortz, senior vice president-investment banking at Lehman Brothers.

The public markets, he said, have not been receptive to alarm companies, but rather have taken a wait-and-see attitude.

The problem, Bortz said, is that the “dealer concept has created concerns for the market” as quality problems have surfaced. Alarm companies should have all the characteristics that a financial company looks for, he said, such as recurring revenue. “But for whatever reason, problems plague the industry.”

As a result, he said, lenders that deal specifically with the security alarm business have remained the best source for funding. “They are comfortable with it,” Bortz explained. “They understand it and they know what to look for.”

Demand changes
At SLP Capital, Barry Epstein, senior vice president, said there remains a demand for capital and “we expect new loan growth for 2004 to be higher than 2003.” The demand has changed, however, because there are fewer high-volume alarm dealers in the marketplace and the smaller ones “don’t have the financial statement for a loan program.”

Instead, he said, SLP’s business will come primarily from acquisition financing and refinancing. The acquisition market isn’t as overheated as it was in the past, Epstein noted, “but there are always people selling,” which results in a steady base.

The industry has undergone a fundamental change in the way its loans are being underwritten. The 1990s saw underwriting and lending based primarily on collateral values rather than cash flow from operations. This has changed with the exiting or tightening of credit standards by banks and other lenders. “Lending now is done primarily on a cash flow basis. Without a dominant buyer, the deals must work solely on their own,” he said.

Epstein said he doesn’t see much upward movement on multiples, which have come down as the number of buyers has thinned. “The primary determinant for buyers in the past was the number of bidders,” he explained. “Now it’s attrition and cash flow.”

Valuation model returns
Growth through acquisitions is also the route Dan Linscott of Financial Security Services Inc. sees alarm companies taking this year. “The market has returned to a valuation model that provides smaller alarm companies with the opportunity to grow through acquisitions if the senior debt is available,” he said. Linscott noted a properly structured acquisition of quality accounts “can provide all the cash necessary from the acquired accounts to service the acquisition debt, to assimilate the accounts as well as to monitor and administer the accounts.”

He said FSS is involved in negotiating debt financing with several dealers with acquisition targets in the $40,000 monthly recurring revenue range. “A more rational market is again making this type of transaction available,” he noted.

While seeing a bit of optimism in his crystal ball, Paul Sargenti, president and chief executive officer of SAFE Financial, said he still believes “we have nervous capital markets.”

More institutional lenders have exited the alarm dealer asset sector than have entered it, he said. And while there are still some robust banking lenders, the “continued trials” of some of the alarm companies “hasn’t driven confidence in the market,” he said.

He said finance companies “will be here to take care of small to mid-size borrowers.”

Michael Jones, president of ProFinance Associates, concurred that the availability of capital is lower, which is in line with the market in general. “There are not as many success stories as the industry would hope,” he said.

Low multiples have made institutional lenders nervous about overlending, he said. “The banking and lending markets have been tight, and I don’t see that easing,” Jones said.

Where SAFE’s Sargenti does see some positive movement, however, is the influx of equity sponsors “who look at this sector as an opportunity.”

Private equity funds, he said, are coming into the market, having viewed security monitoring contracts as an attractive asset class.

This group is also eyeing investment in systems integrators, manufacturers and the vertical security market.

The success of some IPOs is also encouraging to the security market, although overall the security industry hasn’t been a strong player in the IPO market, Sargenti said.

“IPOs need scale to be successful,” he explained, and outside of the large security companies that are already public, most just don’t have the size to warrant an IPO.

Lehman’s Bortz noted the climate is good for IPOs vs. previous years. “Generally,” he said, “the IPO markets have a positive turn about them. Companies that couldn’t get public in 2000 can in 2004. If you have a decent company in any (security) subsector, you can have an IPO.”

Homeland Security, both the movement within the government and private sector to spend money and the overall visibility it brings to security, is looked upon as a positive factor in an otherwise conservative fiscal outlook.

“Homeland Security will make more people aware of security and that should help the industry overall,” said Pro-Finance’s Jones.

Sargenti said there has been much anticipation associated with Homeland Security but the benefits “haven’t quite been realized yet.”

Still, he said, “we see more money coming into the security sector because of Homeland Security.” That spending, he said, is directed toward securing airports, public buildings, dams and transportation systems.

Some venture capital companies have initiated funds that are focused on Homeland Security, banking on the continued growth of this sector.

Mike Steed, managing director of Paladin Capital Group, which operates the Paladin Homeland Security Fund LP, said he foresees “extraordinary growth (for security-based funds) and for the next several decades.”

Paladin, he noted, views security as a four-pronged approach to a terrorist attack - prevention, defense, coping and recovery. As a result, he said, many companies, products and services can be incorporated into the fund.

In fact, he noted, more than 600 companies have sought investment capital, with the deals coming in at about 10 per week.

The fund, which has six companies in its portfolio now, including VistaScape Security Systems, a provider of video surveillance software solutions for airports, harbors and power plants, will eventually hold 20 to 30 companies, Steed said, each receiving investments of $10 million to $20 million.

Government spending for Homeland Security, Steed noted, should be about $35 billion a year, with states deploying a multiple of that “and corporate America three times that.”

He said companies that are potential investments range from those providing functions covered in government budgets related to airport and port security, as well as those providing a product or service in the private sector that can also fill a need in Homeland Security. A final group, he said, are “companies that have newer, yet untested products and services.”

Mark Maloney, principal at Paladin, also asserted that the private sector is going to be ramping up its security as well. Corporations, he said, need to ensure continuity in their own infrastructure and protect against “severe vulnerability.”

Managing Partner Mark Thaller, who heads up Patriot Venture Partners LLC, another Homeland Security-focused venture fund, said investors should keep an eye on the services market within the security sector. “People are hiring and using existing products to better provide physical/visual surveillance,” he explained.

He said he is already seeing companies pick up smaller service and integrator firms to take advantage of economies of scale.