ADT Inc. (ADT) Earnings Call Transcript & Summary

Okay. Let's go ahead and get started. Good morning, everyone. Please join me in welcoming Jim DeVries, CEO of ADT. Jim, thank you for being with us here today.

You bet. Great to be here, George.

Thank you.

The big news last week with your announcement of the new State Farm partnership. State Farm is investing $1.2 billion for a 15% equity stake in ADT in addition to committing $300 million in funding for product and sales and marketing. Can you talk a little bit about that partnership? How it came to fruition? And then also where you see the most opportunity for synergies?

I can -- I'm going to open by making my lawyers happy and reminding everyone that all the safe harbor provisions still apply. So the State Farm, we couldn't be more excited about the State Farm opportunity. It's a situation where the customer really does have a significant value add. And when the customer upside is as significant as it is in the State Farm partnership -- for the State Farm partnership, I think there's so much to work with between the organizations to drive value. The customer value proposition is so deep that it lends itself to just all kinds of opportunities for both us and for State Farm and for Google. So the partnership, we started talking probably about 6 or 8 months ago and did a pilot together with State Farm. The more we talked about the art of the possible, the larger the partnership became. And over the course of the last several months, we started talking about a deeper partnership largely modeled on what we did with Google. There was an equity investment. And in addition to an equity partnership, we have in State Farm [ vernacular ] opportunity fund of $300 million to drive product innovation, technology innovation, next-generation sensors, marketing sales activities basically to fuel the partnership to grow.

And so as you think about this partnership, how does it fundamentally differ from the one you have with Google? Presumably, it would carry some of the similar benefits of higher product attach rates, improved customer retention rates, improved subscriber acquisition cost efficiency. Perhaps you can compare the 2 partnerships and where you see similarities and where you see differences.

You bet. So both are deep partnerships. The Google partnership is one that's been in place for a couple of years. Two years ago, they invested $450 million. They have a 6% equity stake in our company. And then invested $150 million in a success fund to drive growth for Google and for ADT. The numbers on the State Farm side are just what you articulated, George, $1.2 billion investment. They'll own 15% of our company and $300 million into a fund to fuel growth. The Google team also invested into this construct that we have with State Farm an incremental $150 million. So we have a total of $600 million between State Farm and Google, and we'll use that, as I said, across a whole host of activities to drive the partnership for all 3 companies. The Google partnership is really orbits around hardware distribution for Google. We're going to market as ADT + Google. It's the first time that Google has done that. So we're wrapping our trucks, ADT + Google. Our techs will have Google on their uniforms. Our marketing teams are working together on creative to go to market as ADT + Google. We think it does great things for our brand and to be associated with such a terrific brand in Google. We have done a good bit of testing and just now beginning to get out into the marketplace with the new branding. So most of Google is about a marketing partnership, a collaboration on hardware, video analytics, data analytics to make the smart home a smarter home. On the State Farm side of the equation, it's really about transforming insurance. Homeowners insurance has been around for a long time, and it has largely been around restoration when a calamity has occurred, when a loss has occurred. And what we'll be doing jointly with State Farm is building and marketing an integrated product that has water detection devices, smoke and carbon devices, intrusion protection, installed and monitored by ADT. And also the -- we'll also have an insurance component. And so it moves from a restoration reactive product to prevent and predict -- predict and prevent product when we will do what we can to avoid a loss for the customer. But when a loss does occur, then State Farm is there to help restore their lives. And so it's what we've been calling internally sort of the circle of protection. It's about proactive protection and reactive insurance.

Right. With the Google partnership, ADT and Google jointly had a very nice time line of joint product launches and capabilities going to market with the video doorbell and with indoor, outdoor cameras, et cetera. How do you envision the time line for State Farm in terms of potential product rollout in terms of how the partnership scales over time?

Yes. So we'll start in a state or 2. The teams are working together right out of the gate, George. We have a team and a business leader identified at State Farm. We're doing the same on the ADT side, and we'll be working in deep partnership together to roll this out. I think it's safe to say that it will very much be oriented towards test and learn. The insurance business is a business that's heavily regulated at the state level. And so you have 50 different models across 50 different states. And we'll select a state or 2 to begin with our integrated product. And as we learn and refine it, we'll roll it out to additional states. I don't think it will be material for us this year. But getting into the first half of next year, I'd expect that we'll get some product in market and begin to learn and expand.

That's great. Now one of the key benefits of your partnership with Google, where it's been a couple of years now is attrition rates have improved quite nicely down to, I believe, 12.7% as of the most recent quarter, which is a new company low. Can you talk a little bit about the drivers of the lower attrition and potentially where you see that going longer term?

I will, and I'll touch on something that we're really excited about with State Farm on that front as well. So generally speaking, if you take a step back, retention has improved, the more devices that are sold at the time of installation. It's sort of intuitive, the more a customer uses their system, the more a customer is likely to retain that smart home system. The number of devices that we sell at installation continues to rise. The number of customers who use their phone to interact with the hardware in their home continues to rise. And as you mentioned, we finished Q2 at 12.7% attrition, never in our history has it been better than that. A couple of tailwinds that have been helpful for us. We lose customers, the biggest reason why we lose customers is when they relocate. And so to the extent that housing is down a bit, while we suffer the consequence of that on the new customer side of the equation, it's a tailwind for us when it comes to retention. Because of the fewer relocations, the better our retention is. The second reason for attrition is around lost competition. That has steadily improved for us. And voluntary loss has improved. We've had a little uptick, modest uptick more than offset by all the good news from the other categories but in delinquencies and non-pay has been modestly higher. But net-net, it has been a great story in terms of customer retention for us. One thing that I'll mention when it comes to State Farm that we're excited about. I think the State Farm partnership brings us growth in a more SAC efficient way. We've talked a bit, George, about what that looks like, but a secondary benefit of the partnership with State Farm is in the arena of customer retention. So for example, when a state farm customer is bundled, they have home and auto, that customer retains for an average 10-year of almost 20 years. And now when you add to the mix, a third product, if you will, this integrated product where their sensors as a third leg to the store. It's auto insurance, it's home insurance, and it's these preventative devices, preventative sensors that are in the home built into the homeowners product, we think that it will improve retention even more. And that will be an opportunity, we think, at ADT to draft on that retention. Our average 10 years, 8 years, we're pretty proud of that, but we think that the integrated product with State Farm has the potential to be even longer.

That's great. And in terms of longer-term aspirations for retention rates, I know some of your regions have retention rates as low as 11% in change, where do you hope to see retention rates go longer term?

Yes. Is it optimistic to say 0? I suppose the -- in our long-term financial plan and our long-term outlook that we shared at Investor Day, we said that by 2025, we hope to be at 12.2%, that's a blend of commercial and residential. But to your point, there are markets that are lower than that today. And we'll see where we can go. 12.2% just because that's the goal that we set out isn't the goal that we're shooting for. We'll obviously aim to improve that. We like where we're headed. There's some very strong lead indicators that give us bullishness to give us optimism number of devices sold, installation revenue at the time of sale, customer satisfaction. There's some positive lead indicators. We'll see where it comes out in the wash. But 12.2% is the '25 goal, we're aiming for better than that.

Great. Great. You touched on subscriber acquisition cost efficiency earlier in tandem with the Google partnership. Last quarter, I believe your gross RMR additions increased by about 7%, while your stack decreased by 10%. So maybe talk a little bit about what's driving the SAC efficiency and how the partnership should help further improve the efficiency?

Yes. So there's -- so the SAC efficiency, the numbers that you just shared are -- we're really proud. We're going to continue to chip away at SAC efficiency. There's a handful of productivity-driven reasons, George, that drive it. We have, I think, the best operating team in the business. Our field staff are excellent led by Don Young, who I think you've met a time or 2, is our Chief Operating Officer. They continue to make incremental shifts, incremental changes, incremental improvements to help drive efficiency from a productivity perspective. But the biggest driver in the outcome for us in Q2 was around installation revenue per new customer. We charge -- we sell product, we sell devices at the time of installation. We make a margin on those devices. And the more devices that we sell at the time of installation, the more it offsets our acquisition cost. And our installation revenue and the number of devices that we're selling at the time of installation has never been higher. I'll mention that Google having access to the Google products has been especially helpful. For example, one of the things that we've shared before is prior to selling the Google video doorbell, we sold a video doorbell that was branded ADT. We worked exceptionally hard to get an attachment rate on that doorbell for new customers up to 27%. We introduced the video -- Google video doorbell, didn't advertise heavily behind it, just put it in our product lineup. And in Q2, we had an attachment rate on video doorbell nearly 50%. I think July was a little better than that, maybe 54%, something like that. And that access to Google branded equipment, we expect to continue to drive installation revenue higher. And because of that, the SAC efficiency should continue to improve.

Right. So on that point, with respect to product attach rates, do you have metrics or KPIs that you can share as it relates to how it's improved over time with the Google partnership and perhaps how much State Farm can further improve attach rate?

Yes. So on the Google side, we really just launched the remaining products. We had been selling a handful of Google products. The voice assistant, the Mesh WiFi, some -- a product called hub, HUMAX, but we didn't have access to the full suite of products just until recently, about a month ago when we started to launch all of the Google products. So it's a little early to tell. But now we have Google outdoor and indoor camera, the floodlights, the thermostat, all of the hardware that Google makes that fits into the smart home ecosystem we're selling. So month in, doesn't a trend make. It's still early. We haven't advertised much behind it. But when we start to -- I don't think it will have the lift, George, that we had with video doorbell. A doubling of our attachment rate isn't going to happen with indoor cameras. But it will most definitely add to installation revenue per new customer, and I think ultimately improve retention.

Right Let's talk a little bit about pricing trends. Certainly, inflation and overall pricing increases are top of mind with consumers, with investors. Can you perhaps talk about what kind of pricing increases you're seeing on the residential side, compare it with the commercial side and how receptive customers are to pricing increases from ADT?

Yes. The -- like this is a sample size of one, so it's not embedded in research. But my sense is customers appreciate that we're in an inflationary environment. And on the residential side of the business, we have -- we're price increasing reasonably similar to what we have in the past, 2% 3% net kinds of price increases on a recurring base. On the commercial side, George, it's a much different story. We're seeing more significant inflationary pressure on hardware, maybe a touch more inflationary pressure on labor. And we are putting through price increases on the commercial side, sometimes in the 8% to 10% range. The customers -- we've engaged in discussions with all of our customers, our commercial customers, not unlike residential customers are cognizant of an inflationary environment. And we have good relationships. The service quality has been excellent. And generally speaking, customers have been willing, if not receptive to price increases on the commercial side.

Maybe sticking with the topic of commercial. I know in the second quarter, there were a couple of supply chain delays that impacted the rate of installation. Could you talk a little bit about that and what you're seeing with respect to the hardware procurement and how the pipeline is building? I think that the pipeline itself is actually growing, and so that portends well to future commercial.

It does. It's -- the -- so on the commercial side, we've got a couple of partners who -- on the residential side, we have a couple of partners who have been terrific. We do -- we purchase much of our hardware through Resideo. They've been -- we've been locked at the -- have joined arms. They've been a great partner. Google has been standing. And so we haven't had product delays on the residential side, largely because the partners have navigated the supply chain issues incredibly well. On the commercial side, it's been a little different story. It is a day-to-day work to get equipment. The good news is everybody in the space is confronted with the same challenges. I'd say our team doesn't view the supply chain improving in Q3, probably not Q4. We think it spills into next year. And as a result of parts delays, our backlog continues to grow. I forget the precise percent of jobs in our backlog that are delayed because of a part, but it's a big number, 40%, 50%. And once those parts start to come in, we think it's going to be a very significant advantage for us, a terrific tailwind for the business. The good news on the backlog is customers aren't canceling. So while the backlog continues to grow, and we're a little slower at installation than what we would like to be, the positive is customers are hanging in there with us. Once those parts are come in, we'll get it installed and it will be a terrific growth revenue for us.

Right. And how quickly is the commercial backlog growing, the pipeline, the conversions?

We're probably in the zone, George, of 15% a quarter on installation revenue growth, maybe a touch less than that on recurring revenue growth, but we're flirting with $400 million in installed revenue backlog. And this for a business that does -- just never -- it has never been higher than that. So again, the silver lining in the commercial space is that customers -- I'm not aware of a single customer that's canceled. And the good news is the entire industry competitors are faced with the same thing. But when it begins to unlock for us, it's going to be a real bone.

Right. Now ADT pushed into the solar category not too long ago with its acquisition of Sunpro back in December for $825 million. Can you talk a little bit about the industrial logic of combining smart home with smart energy capabilities?

Yes. So our investment thesis rested on 2 things. The first is a thesis that we could leverage our brand, the brand recognition in the solar space isn't particularly strong. And we contemplated whether ADT solar -- whether customers that trusted us for smart home would trust us for smart energy. ADT smart home is ubiquitous with smart home and security in the security space. Could we do the same thing and leverage ADT in the solar space. We did extensive market stuff across geographies. I want to say a sample size approaching about 5,000 and solar intenders, non-intenders, ADT customers, non-ADT customers, and we asked questions about their receptivity, their confidence in buying solar from an ADT branded source. And the results were incredibly positive. And so we concluded that we could indeed leverage the brand. That was the first thesis. The second investment thesis orbited around our ability to cross-sell smart home customers on solar, not only our existing 5 million or 6 million customers, but the 1 million new customers that we add each year. And I would say, out of the gate, that thesis has proven out. I think when we change from Sunpro to ADT brand and our web traffic went up about 3x. Our ability to cross-sell into our base get leads from our existing core residential smart home business has been really strong. Something in the order of 15% of the adds that we had, the new customers that we secured in Q2 were from ADT generated sources. And so we're optimistic about the growth in solar. I think we can be the largest solar company in the United States. There has been -- there's a lot of growth in that space. And then we were very much helped by the inflation reduction act, which extended the tax credits out for 10 years and at 30%. So the incentives to adopt solar will provide further -- will be an additional demand catalyst for the business.

Right. You mentioned the rate of cross-sell 15% from legacy ADT to Sunpro, the solar category. If you look at the number of solar installations in 2Q, I believe the growth was somewhere in the order of 57% year-over-year. So as you think about the rate of cross-sell and overall, the rate of growth in solar, where do you think numbers can steady state over time? Those are pretty big numbers, 50%, 60% growth.

Yes, it's -- at some stage, we'll begin to confront the law of larger numbers because 57% growth is fantastic, but it's off of a relatively small base. There's no reason to believe we'd be in the near term, George. I think it's not less than 20%. We haven't really hit the gas pedal when it comes to cross-selling. We had -- as you're aware, in Q2, spilling into Q3, we had 1 of our financing partners move into liquidation. And we had some complications from our name change from ADT -- from Sunpro to ADT Solar. And as a result of that, the throughput wasn't what we wanted it to be, and we tapped the brakes a bit and tap the breaks for the business to go slow now so we could go fast later, get our operating legs under us. And -- but longer term, to your question, 20%, 30%, I see from a top line perspective, is it quite achievable.

Right. One topic that is pretty top of mind for investors and also just broadly in services is the labor market and the potential impact a tight labor market is having on the business. Can you talk a little bit about where ADT might be seeing the impact of the tight labor market in the residential or commercial or solar businesses? Where it's being felt the most and steps potentially to mitigate against?

Yes. Anybody who is in a business with a lot of labor is feeling this pain. I'm sure a lot of companies that you interact with are, and we most definitely are as well. The offset for us to inflationary wage pressure, the largest offset for us has been in the arena of virtual service. Necessity is the mother of invention. And during COVID, when customers were uncomfortable with a technician being in the home and the technician, frankly, was uncomfortable being in a customer's home in the height of COVID, we started to really experiment with virtual service. And the way it works is the customer downloads an app on their phone and then uses that phone via streaming to be -- uses the phone to be our eyes and ears, and we have a virtual technician solve the service problem for them. During Q3, we avoided something in the neighborhood of 130,000 truck rolls. And so the savings that we realize because it's a lot less expensive to do a virtual service -- to do virtual service than it is to roll a truck. That's the reason for our margin expansion. That's the largest reason for our margin expansion, and that has been the largest single offset to wage inflation.

Right. Right. That makes sense. So we've touched on multiple parts of the business, residential, commercial solar. If you sort of step back and think about ADT's defensiveness overall in the context of the overall cycle, how would you characterize the resilience of ADT in a downturn and if things were potentially to get worse?

We think we're well positioned. The -- a couple of things to mention to you. The first is, to the extent that a downturn also involves a climate where there's more crime or the perception of more crime, not uncommon in a recessionary environment. The business tends to do well. Crime or the perception of crime are significant demand catalyst for us, first. Secondly, the -- cutting the cord, so to speak, or discontinuing a service, consumers have a lot of choices on what they're going to discontinue to save dollars and tighten their belt. And historically, the security and smart home product is one that they choose to reduce last, not first. And so it tends to be a stickier customer for us even in a recessionary environment. And then a third thing, it's a bit tangential, but as we continue to grow our relationship State Farm, I think, will prove to be beneficial for us, and that is that insurance -- homeowners insurance is a required product. And the more that we're tethered together with State Farm and the integrated product that we were talking about earlier, George, I think that bodes well for us. That bodes well for us, too.

Yes. That makes sense. So you're guiding to free cash flow this year of about $590 million at the midpoint on a full year basis. That's a pretty significant step up, somewhere in the order of 25% year-over-year growth compared to 2021. What's a reasonable growth rate longer term, steady state for free cash flow at ADT?

I'll be careful not to guide to '23 or really comment on free cash flow growth quite this early. We affirmed the cash flow guide, EBITDA and revenue on our call last time. We're looking forward to updating in November on Q3. But I'll leave it at an affirmation for this year and look forward to sharing more when it's time for next year.

Okay. Maybe higher level then, would you expect free cash flow to grow at least as fast as EBITDA? And then for EBITDA to grow at least as fast as revenue? Fundamentally, just the construct overall of performance.

I think -- I mean, at a high level, George, I think that's fair to say. It's very much influenced by mix for us. Because, for example, the cash flow mechanics. The cash flow characteristics are far different in solar than they are in commercial, than they are in our core residential business, and we'll disproportionately top line -- the incremental growth will come disproportionately from solar. And so mix muddies the water a bit. But I think at a high level, your assertion is an accurate one.

Right. Okay. Great. And maybe talk a little bit about free cash flow, capital allocation. How do you expect to deploy capital over time? What's your appetite for M&A? You pushed into solar with acquisitions. Is there further opportunity there and other capital allocation priorities that you have.

Yes, you bet. So the number 1 capital allocation alternative for us is in our core residential business. Our returns in that business are high teens all the way to mid-20s. And growth capital in residential is the -- provides the highest returns, and so will continue to be a priority for us. On the other end of the spectrum, while you never want to -- I never want to shut the door on M&A, we like what we've got right now. We -- you might see some tuck-in acquisitions here and there that are strategic for us, maybe in the multifamily space, potentially in commercial, maybe in mobile safety, but nothing sizable with so much opportunity in front of us, with Google and State Farm in our core business, with so much opportunity in front of us in solar and commercial. We're going to chop the wood in front of us. And so M&A, I would say, is not a priority for capital usage. Again, being careful number will shut the door. But as we see the world right now, it's deep M&A would be deprioritized. And what we would like to do is begin to chip away at the debt. We had committed during Investor Day to take out by 2025, $1 billion of net debt. And so from a capital prioritization standpoint, we're focused on lowering our leverage.

Right. Okay. I think that makes a lot of sense. Maybe I'll open it up to the audience to see if anyone has any questions. Any questions? We have one there.

Thanks for presenting. Very helpful. With regard to the State Farm relationship, what percentage of the ADT customer base today uses State Farm already? And that's question one. And question 2 is, do you expect any negative ramifications from the other insurers who may have ADT type customers and there may for change their approach to servicing ADT customers through pricing or whatever other mechanism you have, given it's now -- there's a competitive element involved with State Farm?

Yes. Thanks for the question. The -- so on the State Farm, I can more accurately share how many State Farm customers have security than I can, how many of our customers have State Farm insurance the number of customers we'd estimate. The number of State Farm customers that have a smart home system is in the neighborhood of 20%. And something in the ballpark of 20% of those will have ADT. Not unimportantly, because I think it speaks to the size of the TAM for us. There are about 14 -- just shy of 14 million homeowners who are insured by State Farm, 14 million. And State Farm has about 90 million policyholders, life, auto, home, some sort of bundle, but it's a very substantial company, give or take about 2, 2.5x the size of a homeowners' business as any other insurance company in the state. So it's a fantastic partner for a lot of different reasons. The cultural match George and I were talking earlier about is fantastic, very mission-oriented company. They have a keen interest in innovation, but also just the pure size of the organization makes them a great partner for us. So to answer the first question, about 20% homeowners, 20% of their insurers have smart home system and about 20% of those have ADT. On the response from other insurance companies, a little difficult to tell this early on. Many insurance companies give discounts to their customers because they have security system. I think it would be inconsistent with their objectives to discontinue that discount. For an insurance company, you want to have monitored intrusion it leads to lower claims. So I suspect that there will be an immediate response from a competitive perspective, and we'll see how it plays over time. One thing that I'll mention that's maybe a touch peripheral but not unimportant is that the agreement with State Farm allows us to continue our affinity relation, our marketing relationships with other insurance companies. We're partners with State Farm, where they're the only partner who are going to do the integrated product with. They own 15% of our company. They have a Board seat. We're excited to move forward with them on the integrated side and just them, but we will have affinity partnerships with others.

Great. Well, Jim, thank you so much for the conversation and the insights, and thank you all for joining us.

Thanks, George.

Thank you. Bye.