ADT Inc. (ADT) Earnings Call Transcript & Summary

Hi, I'm George Tong, and I cover business and information services at Goldman Sachs. I'm really pleased to be joined by Jim DeVries, President and CEO of ADT; and Jeff Likosar, CFO. Jim and Jeff, thank you for joining us.

Thank you, George.

Thanks, George.

So let's start off at a high level with ADT. The residential and commercial security services remain relatively essential during the coronavirus pandemic. Can you talk about how the outbreak potentially alters ADT's longer-term growth outlook as well as free cash flow profile?

Thanks for the first question, George, everybody listening in today. Thanks for taking the time and interest in ADT. We're excited to share some perspective with you. And I'll start with George's first question here. So George, I'll give you some context for how we thought about COVID-19, and then share a perspective on the longer-term growth outlook and ask Jeff to comment on free cash flow profile. So we -- when the pandemic started, we made an early decision that we were going to rather than try to optimize or do the best we could or struggle to make a bad quarter, a little better. We were going to take a long-term perspective and philosophically, we went into the pandemic with a perspective that we are going to come out stronger. So rather than cutting significant costs, we offered our employees, our technicians the alternative to take a voluntary unpaid furlough. Rather than reduce our staff and our commercial operation, we made the decision that we were actually going to use the opportunity to recruit quality professionals in the commercial space. And so we were playing the long game. And the toughest part of the pandemic was when shelter-in-place was at its most prevalent restriction. That was probably in late April or early May. And as shelter-in-place eased across the country, the demand for our products came back. So the residential business, the small business customers, I think we're just about to where we were pre pandemic. The commercial space is an exception to that. We have some headwinds that we're experiencing in the commercial business. Much of that has to do with our inability to get access to the customer premises as frequently as we would like, plus capital spending is drying up a little bit. So we expect, longer term, really no impact in the high-volume space in the residential and small business space, and we're going to have some headwinds in commercial until the pandemic's completely in the rearview mirror. Jeff, on the free cash?

Yes. One point I'd add, too, it's not COVID-19 itself that we think matters for the longer term as much as some of the related effects of COVID-19, so trends towards people choosing to live. In suburbs instead of urban areas, some evidence of acceleration of millennials moving into homes, people spending more time at home and therefore, becoming more interested in home automation and smart home offerings. Those things that COVID-19 may have accelerated or contributed to, we're very optimistic about providing long-term tailwinds to our business and can't be certain exactly to what extent or even exactly how long a term. But that's why our residential business continues to perform well. So we feel really good about our long-term prospects. That's intermingled with other topics, especially the Google partnership that I expect we'll talk about today. So we had really strong first half of the year. We're excited to be at a spot where we're in a more forward growth posture over the years to come than we have been for the first few years, and we'll remain focused on optimizing the balance between our various objectives, which include retaining our existing customers, optimizing the profitability with which we serve our customers, getting more efficient in acquiring new customers and then using the resulting cash flow to find the right balance between generating near-term free cash flow versus investing in growth. And I expect we'll hit on some of those points and some of the subsequent questions.

Right. So you mentioned Google, let's go straight to the Google partnership. You announced in August that you would be entering into a long-term partnership with Google to provide smart home monitoring solutions. Could you talk about what the motivation for that partnership was, how you envision the partnership advancing operationally? And what kind of financial impact do you expect it to have on the model?

Yes, George, this is Jim. So we had first been contacted by Google in May of 2019. The first discussions took place over the summer of '19. In early 2020, we really started to get traction on just how deep this partnership could be. And over the course of the first months of this year, we negotiated a partnership that was announced about a month ago. The partnership involved a $450 million investment by Google in ADT that resulted in a 6.6% equity ownership. And then in addition to that, Google is contributing $150 million that we'll use for co-branding, joint product development and for training. We are out of the gates pretty quickly. We've got teams at ADT stood up against their counterparts at Google. Many of them are working in product and product development, engineers, developers, and then we've got marketing folks who are working on go-to-market strategy, marketing, research, branding, when we -- for when we eventually go-to-market together. So we're super excited about this partnership, as you can imagine. We think that we have incredibly complementary strengths. Google was drawn to ADT because of our brand, our distribution capabilities through 4,600 distribution professionals. Our technician workforce, 5,300 long-tenured technicians, and a culture of service. And we, of course, were attracted to Google for their brand, very complementary to ours. Their fantastic hardware, award-winning hardware, great aesthetics in the Nest hardware, and then probably even more importantly, the capability that Google brings to the table in video analytics, advanced video analytics, data analytics, machine learning, which we think that we can together leverage to really go after the fast-growing smart home market.

Got it. That makes sense. And just drilling in a little bit deeper there. If you think about the phasing of the various milestones when you expect the joint platform to be developed, how would you put a time line around all of what you just said? And how would you expect the financials to build? When do you expect to see a material financial contribution from the Google partnership?

George, this is Jeff. The way I would look at that, we've put out some materials that divides the Google partnership into 3 horizons. And start at the Horizon 3, which would be the longest term, which we've called reimagination. And that means developing, almost inventing, new ways of providing peace of mind security and smart home kinds of activities. So hard to say just because by its nature, it's meaningfully into the future. What we call Horizon 2, which will be defined by the development of an introduction to the market of new products, and I'm using the term products in its broadest sense to include hardware, physical hardware, software, the platform, the related technology which is what we're beginning to work on today, but with the target to have those new products in the marketplace in the middle of 2022. That's where we expect to see meaningful change in our growth opportunities because that positions us in a way that were attractive to a broader market, and that would be in addition to consumers who are attracted primarily to security and secondarily to home automation or smart home offerings. Now we'd be more meaningfully positioned towards customers who are predominantly or primarily interested in smart home and secondarily, security. We also will have products and technologies that we believe are more appealing. We think we'll have more pricing power, and then we'll have the power of ADT and Google together. And then if I go to what we're describing as Horizon 1, which is more near term, and that's more gradual. We expect that incrementally over the coming months and quarters we will have improved prospects, but it will be more on incremental basis instead of a trajectory changing basis. And the reason I say that is because what we will do over the coming months and quarters is integrate existing Google products with existing ADT platform and hardware. And methodically, over that period of time, you start to accomplish some of the objectives I mentioned for Horizon 2, but it will be on a gradual basis in that interim period. So what we're most excited about with Google is the long-term prospects, and then we'll make incremental progress along the way. And then you asked how does it affect our financials. So ultimately, as we get to greater growth, then that will show up as revenue. Our model is such that the revenue that we likely will generate will be recurring revenue. So as we take on a new subscriber, we'll generate revenue from that subscriber over the life of that subscriber, which we hope to measure in a number of years, even beyond any initial contract. And then the other thing we're really attracted to and excited by is we expect that our customer acquisition cost efficiency will improve. And that's because we expect that customers will be more attracted to the -- to our offering. We think it will be easier to sell. Advertising will be more powerful. We expect customers will buy more comprehensive systems. And while we subsidize the guts of the system, the ancillary devices that consumers purchase often help defray that upfront subsidy because we generally price those ancillary devices above costs. And then further, and the last point I'd make is that because we think customers will be more attractive to smart home and we'll have more comprehensive systems, we expect those customers will use their systems to a greater degree and with more frequency and, therefore, be less likely to cancel. So we think there's also a long-term attrition or retention benefit. So we're very excited overall by all the things that we expect the Google partnership will do for us over time.

Got it. That makes sense. And we've got -- I'm sure we'll be talking more about the Google partnership when we get to questions from the audience. But let's move on and talk a little bit about your nationwide rollout of your relatively new consumer financing program for new equipment installations. Can you provide a little bit of an update on the consumer uptake of this offering and how you expect the economics of the business to change over time as a result?

Yes. Sure. So one thing I'd start, just a reminder of our objectives. Investors ask us a lot about this initiative and often leave the question as you did with consumer financing, which is a very important part of the buzz. But our overall objectives are in we're to improve our overall pricing model and some of the related go-to-market processes. It was to have a simpler pricing structure, more options for the customer, easier for our sales teams to engage the customer and then the shift so that we rely less on discounting and promotions and more on selling the value and enabling consumers to select more comprehensive systems that have more devices. So instead of just the core security, there may be a thermostat or a garage opener, lighting controls, door locks, things like that. So including the ability to finance upfront, we always thought it was an important part of that. But your point is that financing is one component of a broader set of changes we made to our pricing model. So we piloted various changes over the span, most of 2019, even some of this we're doing in 2018. Very careful to test our way into those kinds of changes, including putting different financing alternatives out there. So we launched a broad pilot in 2018, initially structured as a consumer loan model, requiring every consumer to take out a loan with a third-party bank. That had some success, but it introduced some clunkiness to the selling process because the customer had to interface both with ADT and with a third party. So we were happy with what we were seeing. But we're looking for ways to overcome that. And we ultimately landed on a solution in partnership with Mizuho Bank that enables us to offer the financing to our customer in such a way that the customer's relationship remains only with ADT and then instead of the customer taking out a loan for every single transaction, you were able to package those receivables and, in partnership with Mizuho, turn them into cash in batches instead of every single individual receivable. So that's what we launched nationally. We did so in the first quarter, middle to late part of the first quarter. And we've been really happy with the results so far. So we're seeing higher install revenue, both because of less discounting and promotions, also because customers are selecting in more cases to add equipment to their orders. And it's worked really well in addition with our sales team, like a high degree of receptiveness. So we launched it right in the middle of the coronavirus dynamics you were talking about earlier. So it's hard to fully separate all the various dynamics going on at the same time. But we're definitely seeing more install revenue, and we're happy with where our volumes are for -- in consideration of that and all the other dynamics we talked about earlier. So a good start, still a little bit early, but very encouraged.

Great. And how would you say the consumer financing program impacts your subscriber acquisition cost efficiency?

So mainly, it more enables us to collect more revenue from the customer for 2 reasons at the time of installation. So one reason is my point about less reliance on discounting and promotion as the means by which our sales team seeks to sell to a customer, and instead sells more based on value of ADT, why we're -- why our service is better, our capabilities are better, our UL-certified centers, a fleet of technicians to help consumers should ever they have a problem, all those kinds of reasons instead of selling just on price and using the ability to describe the cost to the consumer in a way that is x dollars per month is helpful to position it that way. And then the second way is to enable, for the same reason, using the financing and using the context of a certain garage door opener, I can denominate that in $1 or $2 a month, helps sell more garage door openers. To stick on the garage door opener example, just for a moment. And while we tend to subsidize the cost of the guts of the system, that garage door opener comes at a margin, not a big margin, but comes out of margin. So that helps offset the upfront system cost that would either be borne by ADT. So the really short way of answering your question is more revenue at time of install.

Great. And switching gears a bit. ADT completed the acquisition of its largest dealer, Defenders, at the beginning of the year. Can you talk about benefits that you're realizing from the acquisition, what additional synergies remain and if you see further opportunities for dealer consolidation?

Thanks for the question, George. It's a great question. The Defenders acquisition for us was very much opportunistic. Defenders had grown over the years to become a very successful national dealer. And they accounted for about half of our dealer-acquired customers at the time that we acquired them. We don't have a strategy around consolidating dealers. We have no plans to consolidate or acquire additional dealers. Defenders was purely opportunistic when the company came for sale. We were eager to consolidate it for a handful of reasons. And I'll offer 3 or 4 that come to the top of the list. The first is it was an opportunity really for a more seamless experience for our customers. There was a system of interacting with customers at Defenders. There's a separate system at ADT. Sometimes the handoffs between the 2 organizations became less than optimal. And so we think from a customer experience perspective, it was advantageous to acquire Defenders. A second thing is really around the talent. The Defenders organization is stocked with excellent talent. Marketing, in particular, direct marketing, the expertise is deep. The CEO of Defenders currently is on my team and part of the executive leadership team at ADT, and a second reason for acquiring Defenders really orbits around the acquisition of talent. And then lastly, because there was so much overlap between the Defenders organization, which, as I said, has grown to become a national organization, and ADT, the synergies were pretty significant. And so we had a great economic deal in front of us as well. Happy to report the integration is on track, and everything that was outlined in the business case from a synergy perspective is on track for realization. So we feel great about the acquisition. It was a great economic transaction for us. There are a lot of benefits, secondary, even tertiary benefits, but it's not part of a longer-term strategy to integrate or acquire additional dealers.

Right. That makes sense. If we now turn a bit to revenue drivers and dive in a bit. Residential attrition improved to 13.1% in the second quarter compared to 13.5% in 1Q and 13.3% in the year ago period. And that was primarily driven by home relocations that went down, so fewer moves, and improved customer service quality. How do you expect COVID-19 to impact attrition over the near to intermediate term? How do you expect attrition rates evolve?

So we're -- I've mentioned this a handful of times. The customer retention for us, we expect to continue to improve. We are not expecting the improvement to always be linear, but we're long-term bullish over time that we can continue to make improvements on our attrition rate. The attrition that we experienced in the second quarter was pretty significant improvement. And the retention that we enjoyed, George, was just about in every area of our business. Every geography, every cohort, it was just a really good quarter from a customer retention perspective. It's hard to isolate the variable of COVID-19 and how that precisely impacts attrition. My sense, although this isn't, isn't evidence-based, it's more of an opinion, but my sense is that over time, COVID-19 wouldn't be a significant variable in the retention equation. I think it will be more driven around continuing great customer service, the frequency with which the customers use their systems, and building on a point Jeff made earlier, a system that has more devices and uses interactive and is generally a stickier service for customers than what we've always installed historically.

Also, I would remind, too -- and I mentioned this briefly earlier, but our model is to balance retention of our existing customers with the profitability of serving those customers with the efficiency of taking on new customers with the quantity of new customers we take on and optimize that equation to generate long-term cash flow and to deploy capital in a high IRR way. If we ever sought to optimize any one of those objectives, including attrition, and we're willing to sacrifice the others, we could, for sure, make attrition better if we didn't care about the profitability or all we cared about was profitability, we could do things that would make attrition worse. And likewise with the other variables. So my only point is attrition is a very important measurement for us, but we're really focused on generating high IRR uses of capital. And attrition is one of those variables, not the only one, an important one, but not the only one.

Yes. Yes, yes, that makes sense. And so where do you think attrition rates can go structurally and why?