By Martha Entwistle – Security Systems News Article, May 7, 2009
ST. LOUIS, Mo.–Are you a residential security dealer selling accounts to people with low credit scores? If so, you’re probably making a bad investment according to an analysis of the relationship between credit scores, attrition and purchase multiples completed by The Edmonds Group for Security Systems News.
The study shows that, assuming an average creation cost, a customer with a credit score below 625 is not a good investment for the originator. On the other hand, if your customers have credit scores of at least 625 to 650, the account is at least worth what it costs to create. An account with a credit score between 650 and 675 is worth more than 30 times; and if credit scores are north of 700, the account is worth around 40 times.
“There have been times in the industry when the market was frothy and high multiples were being paid for any accounts,” said Henry Edmonds, CEO of The Edmonds Group. “In the current market we’re finding that there are few buyers for accounts with Beacon scores [credit scores] below 600 and a limited market for accounts with scores between 600 and 624,” he said.
Edmonds emphasized that the analysis of valuation makes a number of assumptions, and changing any of those assumptions, particularly items such as the targeted unleveraged internal rate of return, could change the valuation significantly. However, the “slope of the curve remains the same,” he said. The bottom line here is that accounts with low credit scores are “worth much less because attrition is higher regardless.”
The assumptions of valuations in this study include: a mass-marketed residential base; bulk sale of accounts versus sale of entire business; transaction includes 10 percent attrition holdback paid 13 months after closing; average RMR of $40; three-year initial contract term; $10 monthly servicing costs including monitoring, billing, collecting and service; attrition is level during any given year, but varies year to year based on contract time; and, a targeted unleveraged internal rate of return of 20 percent.
The Edmonds Group analyzed the correlation between credit score and attrition, one of the key variables in determining the value of an account base or an alarm business.
“Attrition directly impacts the internal rate of return an originator or buyer is able to achieve on their investment,” Edmonds said. “If one is not achieving a reasonable rate of return, it’s not a good investment.” He identified other key valuation drivers as: RMR and gross margin per account; geographic concentration; initial investment amount; sales practices (Was the customer oversold?); and, whether the customer a homeowner or renter.
What trends does Edmonds identify from the analysis? Buyers are less willing to buy accounts with low credit scores (below 600) and they limit the number of accounts they’ll buy in other strata. “Some buyers will accept no more than 10 percent in the 600-625 range,” he said. Buyers are stratifying the multiple paid, specifically offering higher multiples for higher credit scores. Most buyers he said, prefer longer initial term contracts because it pushes the end-of-term attrition spike further into the future. An exception to this rule is ADT, he said. “They do not like five-year contracts.”
And, finally, some buyers are requiring initial payments to qualify customers with lower credit scores. For example, some buyers “will only buy accounts in the 600-625 range if the customer has paid a minimum of $199 upfront.”
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