Moody's Investor Service assigned a Ba2 rating to the new senior unsecured note issuance by The ADT Corporation (ADT). Proceeds from the new issue are expected to be used to retire $400 million, which are currently outstanding under its $750 million credit facility.

Moody’s rating is deemed to have speculative elements and indicates the presence of substantial credit risk. As ADT’s capital structure has debt only in the senior unsecured form, the credit rating of the notes directly reflects the credit risk of the company.

Moody's also affirmed the company’s Ba2 Corporate Family Rating ("CFR"), a Ba2 rating for all existing senior unsecured debt, and a liquidity rating of SGL-2.

Ratings Rationale

The company’s speculative rating reflects increasing debt balances and a lower covenant cushion. Further, the company had drawn more than half of its borrowing capacity under its revolving credit facility to fund its recent $517 million acquisition of Reliance Protectron, Inc. The buyout also lowered its cash balances, further impacting its liquidity.

Apart from the rising financial leverage, ADT’s rating was also negatively impacted by inconsistent financial policies. Ever since its spin-off from diversified conglomerate Tyco International Ltd. (TYC) in Sep 2012, the company has introduced new share repurchase programs and expansion strategies, thus changing its leverage targets frequently.

According to Moody's, ADT’s leverage as of fiscal year-end 2014 has increased to 3.1x, significantly up from 2.1x twelve months ago. The company’s financial covenants limit its leverage to 3.5x, and while Moody’s expects ADT to comply with the same comfortably, its covenant cushion has undoubtedly weakened. The company’s volatile financial policy and aggressive leverage targets create some degree of uncertainty in its strategic risk levels.

As far as liquidity is concerned, the company has strong free cash flow generation prospects. Moody’s expects ADT to generate annual free cash flow of about $125 million over the next couple of years. However, regular increases in dividend payouts and continued share repurchase activity will probably restrict any meaningful cash buildup.

Outlook

ADT’s ratings could be negatively impacted if its debt levels increase without a corresponding boost in earnings. Additionally, higher attrition rates or deteriorating liquidity could hurt the ratings as well.

The company’s ratings could receive an upgrade if it leans towards more conservative financial policies and sustains lower debt levels.

Strategic Risks

The company, a leader in the high-potential residential-alarm-monitoring space has displayed a strong focus on growth, complementing organic growth strategies with accretive acquisitions. However, it faces increasing pressure from non-traditional security service providers, which are launching interactive security services that compete with ADT’s offerings. For example, tech giant Google Inc. (GOOGL) has ventured into this arena by acquiring connected device company Nest Labs.

ADT has aggressive expansion plans for the future as it leverages its competitive positions and explores new growth opportunities. These strategies might lead to higher leverage. Furthermore, the company could face integration and financial risks if it pursues acquisitions amid an industry backdrop of intensifying competition and mounting investment needs.

Conversely, if the company is able to integrate the acquisitions well, it will be able to capitalize on economies of scale and likely cost synergies.

ADT presently sports a Zacks Rank #3 (Hold). A better-ranked stock in the business information services space is LifeLock, Inc. (LOCK), carrying a Zacks Rank #1 (Strong Buy).

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