Roy Den Hollander

1. Roy Den Hollander
SPI
1. Strategy
It’s the late eighties in 20th century America. Political correctism and bleeding
heart liberals have turned crime victims into violators and felons into victims. Dukakis and
other politicians instituted revolving door justice and placed do gooders in positons of
power in the criminal justice system. Willie Hornton was in, then he was out doing the
Clockwork Orange in-out on some suburban housewife. The police system no longer
keeps society’s malcontents in line by despensing unauthorized justice for fear of Legal
Aid suits. Businessmen, especially retailers, and citizens no longer believed the police
were sufficient to protect them, so they looked for alternatives. One of which was an
alarm system connected to a monitoring station that notified the authorities when an
emergency or crime was taking place. The system naturally deterred miscreants from
committng crimes. As a protector of property, an alarm system was added insurance, but
as a protector of the person, it could be a life saver. Today, with the election of a pot
smoking, crooked real estate developer for President, the perception of crime as a key
problem in America continues, and a market driven by fear remains viable and attractive.
In an effort to capitalize on the growing fear of crime, a group of young guys in
their twenties and thirties set up SPI to sell, install, service and monitor security systems
through a Subchapter S corporation, which avoided double taxation and indicated they
were starting small to test the waters to see how the business progressed. They targeted
the man on the front line and most vulnerable to criminals and riffraff populating our
streets -- the retailer. Most retailers are small to medium size businessmen just trying to
make enough to support their families. Most kept guns in their establishments, but with
the increased fire power being carried by the criminals and increasing attacks by the
politcally correct on the second amendment, retailers became more open to a security
system provided it was affordable. After all, retailers already carried insurance on their
property and an alarm system would just be additional protection, although primary
physical protection for them and their employees. SPI’s growth from 500 to 12,000
customers and assets from $100,000 to $80 million indicates retailers are buying the
product. Today (March 1994), retailers and citizens continue to look for protection from
various low lifes and troglodytes. And while the executives of SPI are still young, in their
thirties, they probably have as much experience as anyone in the business.
SPI made its systems afforable by providing financing to the retailer in the form of
a capital lease. SPI essentially allowed the retailer to mortgage the systems back to SPI,
which kept the legal title. SPI would install a system for a sale’s price (present value of
that part of the installment payments corresponding to the equipment) and allow the
retailer to pay off the price in beginning monthly payments over eight years. (A portion of
the installment payments included monthly monitoring and servicing fees.) SPI charged an
interest rate of 2% above prime and that rate along with the sale’sprice determined the
annuity like payments the retailer made on the equipment. As with a mortgage, each
payment included interest and principle, which reduced the lease receiveable causing the
interset revenue to decrease from payment to payment. The capital lease shifted the
economic risk of a system’s change in value over time to the retailer as compared with an
operating lease where the lessor bore the risk of a system’s obsolescence because he
would receive back the system well before the end of its predicted useful life. Since the
alarm systems comprised computers, programs and electronics the risk of obsolescence

2. was probably high when systems were first being created in the beginning years of the
dramatic growth of this industry from 1988 to 1992.
Although SPI’s capital lease had only a five year noncancelable provision with a
renewal option of three years that if not exercised would stick SPI with a system with
little residual value and require a restatement of earnings, the options were generally
exercised because the monthly payments decreased by 10% and the retailer would be
faced with the disruption of pulling out the old system and the cost of installing a new
system. In addition, customers had little bargaining power initially becasue the providers
often had a local monopoly. As part of its installation contract, SPI also required the
leasee to contract for monitoring and service over the life of the contract, which made
sense for the leasee because what other firm could better service SPI’s system and provide
monitoring. SPI in turn locked in an additional cash flow stream over the life of the
contract, eight years on a predicted useful life of 10.
The capital lease allowed SPI to recognize as revenue the present value of the
installment payments attributeable to the sale’s price of the system at the time of signing
the lease. The recognition of revenues in the first year of a lease significantly increased
SPI revenues over the amount that would have been recognized under an operating
lease ,which recognized a lesser amount of rental revenues proportional to the amount of
depreciation that occurred within a year. Of course the cash flows would not be different
because the timing of the installment payments would be the same; however, the operating
lease would have a shorter life spend in order to qualify as such and when the threat of
obsolescence is considered, SPI would have been at risk of not receiving additional cash
flows from a particular system. Furthermore, under the capital lease, SPI also recognized
at signing the entire cost of installing the system and its equipment while with the
operating lease, equipment and installation cost would be amortized to match the monthly
rental revenue. As a result, but assuming the length of a capital and operating lease
where the same, the resulting profit before tax income over the period would be the same.
The operating lease keeps the PBT income at the same amount over each year while the
capital lease reports more PBT income in the first year but then drops dramatically in the
second year from which it continues to decline because as with a mortgage, the interest
revenue decreases as the principal owed is paid down. Businesses generally desire to
recognize revenue early.
One difficulty with leasing, whether capital or operating, is that SPI essentailly acts
as a bank along with its security business. Under each type of lease, SPI must make a
decision as to the creditworthiness of its customer and charge an interest rate that
determines the monthly payments. SPI has not been doing this, rather it charges all its
customers the same rate, but all its customers are not of the same risk. In additon, SPI
bears the risk that interest rates will change and inflation will increase since payments
under both types of leases have locked in an interest rate. Furthermore, under capital
leasing, by recognizing most of a lease’s revenues up front creates the impression of a
rapidly growing company, but to continue such an appearance requires rapid expansion of
the number of new leases signed, which might also lead to financing customers with
increased risk. For SPI, uncollectible charges have predictably increased as a percentage
of net investment receiveables. On the other hand the capital lease generally locks in a
longer stream of cash flows assuming the retailer does not default and does exercise the
renewal option. SPI’s capital leasing required rapid expansion increasing the risk of
uncollectible accounts, but through 1992 the percentage is still below four, and SPI
continues to increase its provision.

3. Capital leasing required the company to rapidly add accounts in order to grow and
the quickest way to do this was by acquiring other alarm companies. Since SPI was a
Subchapter S until 1992, it could only acquire other firms by purchasing them. SPI
continues to purchase companies rather than use pooling of interests probably because of
the thin market for its shares, desire of current shareholders to retain control and the write
up of assets that reflects the economic reality that the company is growing. In addition,
the pooling of interest would result in a decrease in shareholders equity book value, which
for appearance sake, would make an equity offering difficult. SPI started to grow via
acquistion at an opportunistic time when the industry was comprised mainly of small, local
firms that were probably unaware of their true value. Another reason for growing was to
benefit from the industry’s economies of scale that reduced monitoring and servicing costs
per customer. Growing by acquisition also reduced the costs of starting a business in a
new region, which would result in 70 to 85% of an acquired firm’s customers contracting
with SPI. Given the nature of the industry and the impact on revenue of capital leasing,
which carried certain benefits, growth by acquisition seemed reasonable.
In order to finance its growth, SPI could not significantly rely on cash flow from
operations because the cash flows were spread out over time, although the income was
largely recognized up front. SPI started borrowing heavily rising its leverage to over 60%
where it remains today. As the market matured and firms consolidated, SPI had and has
no choice but to expand rapidly and nationally in order to compete with the major firms
that now control 60% of the market. Economies of scale enable large firms to sell their
systems for less than SPI. SPI may have some quality and marketing advantages, but the
quality is easy replicated by other firms sense SPI holds no patents. Assuming the deal
with Alarmco goes through, which will give SPI a presence on the West Coast, SPI will
have about $25 million in its revolving credit to finance acquisitions in Florida and Texas.
Given SPI’s high leverage, restrictive debt covenants and the fact that any new debt would
be subordinated, it is unlikely SPI will be able to obtain additional debt financing, although
it may do another equity offering but such funds would probably be used to reduce its cash
flow needs by paying off part of the revolving credit.
SPI’s run up of debt makes sense. When it entered the business, barriers were
low, but then economies of scale began deterring entry by other competitors and
threatening the viability of firms too small to meet the prices of larger firms. SPI,
therefore, realized it has to become a major, national firm to stay in the business and
benefit from economic profits above those of an open competitive market. SPI’s large
debt increases the firm’s risk, but assuming reasonble collectibility of installment
payments, the firm has locked in future cash flows with its leases. In addition, SPI will be
able to reduce some of the costs of its growth by establishing independent dealers of its
systems, which will save added cost of the setting up its own subsidaries. Besides, SPI
has no choice but to go national or sell its operations to one of the other large companies.
The maturing market, declining opportunities to expand, SPI’s high leverage and
its debt covenants require a shift from predominantly capital to operating leases. Leasees
prefer opperating leases because such deals keep a leasehold liability off their balance
sheets; and, therefore, keep their leverage low. In addition, the lessor bears the risk of the
volatility of the asset. Leasees have acquired more bargaining power as the market
changed from fragment small firms with loacal monopolies to large firms competing
nationwide. Operating leases will smooth out SPI’s revenue and PBT. As expansion
becomes limited the recognizing of much of a lease’s revenue up front will result in
declining PBT in later years as the interest payments dwindle over time and the decline is

4. not compenssted for by new accounts. Operating leases will mainatain an even level of
PBT rental income, which some of SPI’s loan covenant’s probably require, and
cosmetically looks better than dwindling income or possibly loses. The switch to
operating leases will eliminated the negative impact that resulted when Electric City did
not renew its lease. SPI had already recognized the revenues for the three year renewal
period and now it has to restate its earnings to reflect a significant loss of revenue since
the salvage value of one of these systems is small. Naturally, the stock price fell and EPS
for the year were half of what the firm forecasted. The nonrenewal by customers may be a
growing trend since customers can now bargain for better deals with other firms that
service their area. In addition computer technology and software may make systems
obsolete more quickly, so that customers, especially large ones, may find it worthwhile to
cancel a capital lease after 5 years. $20 million in SPI revenues already recognize depend
on renewals. Given the changing nature of the market and SPI’s need to expand quickly to
be able to compete, a switch to operating leases makes sense.
In conclusion, an investment in SPI would be significantly risky because of its high
leverage, its need to grow nationally in order to take advantage of economies of scale, and
the apparently necessary switch to operating leases that shifts the risk of obsolescence on
assets, which by nature become obsolete quickly, to SPI and since the leases will be for
shorter periods, the locked in cash flows will be for a shorter time, although the end
amounts may not be less. On the other hand, the purpose of a hedge fund is to mitigate
risk, and if SPI succeeds, it will be a large business in an industry with significant barriers
to entry in the form of economies of scale, enabling all the large players, with some
cooperation among each other, to reap economic profits and be fat and happy. Invest.