Security monitoring services have an interesting financial structure.  They wire up your home with anti-intrusion devices, which they monitor from a remote location.  They may charge an installation fee, which typically covers half or less of the actual installation cost.  And they charge a periodic, usually monthly, monitoring fee.

These companies have operating leverage in two ways:  a few employees can equally well monitor one or thousands of homes; and the company can charge for add-on services (like fire or medical monitoring) that cost almost nothing to provide.

A contract with a homeowner will work something like this (I’m making these numbers up):

–installation costs $2,000, of which the client pays $1,000

–the client signs a three-year contract to pay a monitoring fee of $50 a month

–monitoring expense (rent + equipment + salaries) is $10 a month.

On these figures, it takes the monitoring company about two years to recover its initial investment.  After that, a waterfall of money rains down into the monitoring company’s bank account.

This is a fabulous business to own, even though the initial negative cash flow may be daunting.

For the stock of a company like this,  however, it may not be the dream investment it may seem.

How so?

It isn’t that the early years look ugly from a profit and cash flow perspective.  It isn’t the issue of how to finance the initial investment in monitoring equipment.  Liberal accounting technique can pretty up the financials a bit, but–I believe–most holders see through this to understand the actual cash in/cash out relatively clearly.

Instead, investors concentrate on the asset value created by each new customer.  Let’s say a typical customer retains the monitoring service for 15 years (again, a made up number).  If so, and if both revenues and costs remain constant, each new customer adds something like $6,000 to the firm’s asset value.

For investors, then, the more new customers who sign up, the better.  The more existing customers who sign up for new services, increasing their asset value, the better.  That’s even though the more new customers, the uglier the near-term losses and negative cash flow will get.

Here’s the kicker:

–the fastest way for a company like this to show stellar earnings growth is to stop signing up new customers.  But that’s also the kiss of death–because it means the firm has gone ex-growth!!

…the stock fall apart.  Maybe it doesn’t go down in flames all at once.  But it suddenly looks an awful lot like a bond.  So PE contraction offsets the better earnings.

This is not how a startup works.  Usually incremental customers are profitable right out of the gate; the issue is getting enough of them to cover infrastructure costs.

It isn’t quite AMZN, either, which seems to require massive infrastructure spending just to tread water.  But I think holders take the large amount of spending on infrastructure as a proxy for future growth–just as holders of alarm companies do.

I wonder what would happen if AMZN suddenly entered the waterfall-of-money phase of its life that presumably owners are waiting for.  My guess is they wouldn’t find it as enjoyable as they thing they would.