ADT Inc. (ADT) Earnings Call Transcript & Summary

Okay. Good afternoon, and welcome. I'm George Tong. I'm really pleased to be joined by Jim DeVries, CEO of ADT. Jim, thank you for being here with us today.

Thanks for the invite, George.

And before we begin, I believe you have some safe harbor.

I do for the lawyers at ADT listing and the IR staff. Today's comments might include forward-looking statements and safe harbor provisions apply.

Fantastic. Now we're covered.

Now we're covered.

All right. So ADT operates in a relatively recession-resistant industry of residential security monitoring. In what ways would you say has ADT been defensive in nature? And in what ways has the company been exposed to some of the cyclical volatility?

Yes, sure. It's -- in many respects, it's 2 sides of the same coin, because we have some pressure on gross adds because relocations are down. And when relocations are down, we get fewer bites at the apple for new customers. The flip side of that, the tailwind is that our retention is significantly improved. We just finished the quarter -- Q2, we finished and reported, as you know, George, 12.5% attrition on a trailing 12 basis. That's as good as it's ever been. We've been hovering right around 12.5% for a couple of quarters. And no small part of that is due to fewer relocations. When customers relocate less often, those customers are stickier for us. So it's proven to be both a good guy on the retention front and less helpful on gross adds.

Right. Now very recently, ADT did make the announcement that it's going to be selling its commercial business for $1.6 billion. Can you talk about the strategic thinking behind that sale? Why it makes sense to do that and why the company is looking to unwind what it did before, which was put together residential and commercial? What's changed over the past couple of years to drive this pivot in strategy?

Sure. So 4 reasons, 4 things that I would highlight. The first is we had had a number of calls, a number of inbound calls expressing interest in the business. And because our -- because our -- the implied multiple in our stock is that we're trading for about 6x EBITDA. And we were able to sell the commercial business for about 11x EBITDA. We weren't getting some of the parts in the stock. And when we look at the multiple arbitrage, the value unlock is in the neighborhood of $750 million. So reason number one, great price value unlocking. Number two is the cash flow savings as a result of interest expense avoidance by using these proceeds to pay down debt is about a wash, maybe even a little bit positive. And so we end up with the opportunity to delever, but from a cash flow perspective, are largely in the same place. Third reason is exactly that. It's deleveraging. We were before the -- we are at 3.7x leverage before the paydown and the net proceeds will be about $1.5 billion. That will take us to 3.3x leverage. Debt and debt paydown continue to be a priority for us, but we have line of sight to a much earlier leverage ratio of in the zone of 3 or a little less than 3 than we otherwise would have. And in this environment, deleveraging for us became even a bigger priority. And then lastly, commercial was 5% of our EBITDA. And this facilitates for us the opportunity to focus on what we do best. We're a residential company. We do some work in small business. That has many characteristics that are similar to residential, but the divestiture of commercial allows for a level of focus that sort of crystallizes what we're paying attention to and what our priorities are.

Right. Makes sense. And I guess now it would be a good time to dive into the residential business. State Farm is a big part of the potential near- to medium-term growth opportunity. The company is launching joint products in 3 states with more states to come. Can you describe this joint offering that you and State Farm are putting out there into the market and how it should help the company address a bigger subscriber base, potential subscriber base of customers?

Sure. So the State Farm partnership starts with an equity investment. About a year ago, they invested $1.2 billion in our company. They bought shares at $9 a share. They own now about 15% of our organization. And there's nothing like an equity investment to align interest. Their COO, the #2 executive at State Farm sits on our Board. We are working with them very closely every day. And the purpose from a State Farm perspective in the partnership is really around claims mitigation. They lose about $2 billion a year in fire losses -- non-catastrophe fire losses; about $2 billion a year in non-catastrophe water damage. So this isn't -- this doesn't include hurricanes. It's just leaky faucets and pipes bursting and then about $700 million plus per year in intrusion. And so the name of the game for State Farm is how do we leverage the devices that ADT installs to mitigate claims. And the offering to your question, that we're extending the State Farm customers is around preventing losses. So it includes water devices, water detection devices. It includes fire and smoke alarms and it includes intrusion. We are seeking to be in the buy flow, which is an enormous new TAM for us. State Farm has 14 million households that they insure. I'm happy to report charge. We're now in 10 states and we'll be in 13 states by the end of the year. And it's not only a great partnership for a State Farm and a great partnership for us, opening up new TAM. The customer value proposition is extraordinary because State Farm will pass along some of those savings to their customers. So customers will pay less in insurance premium as a result.

You mentioned you're in 10 states now. The plan is to be 13 by year-end. And I think you're hoping to be in virtually all states by the end of 2025.

For sure. And many, many more in '24.

Many more in '24. How would you frame the timing of when you would expect to see material revenue impact from this partnership and material subscriber acquisition cost efficiencies from this partnership?

It's a little bit tough to tell. I would say we'll start to see material adds from a subscriber perspective, probably second half of next year. The approach that State Farm is taking is to test and learn. They're very methodical. The customer -- it's an organization that like us is very customer-centric. And so making sure that we're pressure testing the implementation is super important to them and super important to us. So it's taking some time to get the flywheel moving. But I'd say, once we get the flywheel moving, I couldn't be more optimistic about what State Farm has for us. It's a -- it will be the lowest SAC, the highest SAC efficiency opportunity available to us and essentially cuts out sales and marketing expense. And we expect for it to be -- for our customers to be incredibly sticky as well. The retention rate for customers at State Farm is about 90%, even a little bit higher than ours. And when customers are enjoying a premium discount as a result of the services we provide, we think that it will be an even more retentive customer.

Makes sense. Would it be possible to frame with illustrative numbers what the average cost to acquire a subscriber could be with the State Farm partnership and what the corresponding incremental revenues would be, presumably, both would be lower. The revenues will be lower and the subscriber acquisition costs would be lower, but nets out to be a benefit.

That's right. That's right. It's the highest IRR business available to us. When we look at all the arrows in our quiver, there's no higher return business than if we get this moving at scale. I'll share the unit economics with you. The -- it's roughly equivalent to a DIY model. So the equipment that we're installing is significantly less than what we would do in a normal smart home situation. There's no cameras. There's no door bells, no thermostat. It's basically what I mentioned earlier, water devices, smoke and some intrusion. But the monthly recurring revenue right now is $20. So it's far less SAC, less RMR, but when you do the math, the IRRs are really attractive. And then not unimportantly, we're using these as opportunities to upsell. So when our tech engineer goes to the home to install the water devices and smoke and intrusion, they're going with an eye towards upselling the customer to a larger system. And 65% of the time so far, we've been successful in upselling.

Got it. Which is a big number.

It's a big number. And while it's not the normal installation revenue per that we're at, our traditional installation revenue per new customer is in Q2, $1,450. This is closer to $650, $700 but because you avoid effectively all sales and marketing expense, the economics are fantastic.

Right. Now another partnership that ADT benefits from is the one with the Google. Can you describe how the Google partnership differs from the State Farm partnership and what kind of financial and strategic and operational benefits you've already seen from the Google partnership?

Yes. The Google partnership is in many respects, when we look at equity investment, when we look at this construct, we call an opportunity fund, where Google contributed $150 million for joint marketing, employee training, joint product development. State Farm did the same thing. It's a $300 million opportunity fund with State Farm and an equity investment. That was architected off of what we did with Google. And Google has been a little longer in the tooth. We signed that deal in August of '20. We're going to market as ADT + Google that helps our brand be perceived as a little more contemporary, a little more tech forward. Trucks are wrapped ADT Google. And our techs have the Super G on their shirt. And I think a proof point that I point you to, in terms of the value of the relationship is the elevation of installation revenue at the time of acquisition. As you know, we sell equipment at the time of acquisition at a margin. And so the more we can sell, the larger the offset. And the year before Google, we averaged -- 2019, the year before Google, we averaged $700 when we installed the system. In Q3, it was $1,450. Very significant increase, and we think largely very significantly influenced by the fact that Google -- it's Google branded product. One of the things, George, that you're aware of, that I point to all the time to demonstrate the value of the brand. We worked very hard for a 28% attach rate for a white-labeled video doorbell. When we first launched, it was 18%, 19%, 20% over a period of time with sales incentives and training, et cetera, we got it up to 28%. Now we have the introduction of a Google video doorbell, and it's a 50% attachment, right? We're now up to 2.3 cameras per system, and all of that is leading to record performance on revenue payback. So 2 big metrics that we're focused on: one, attrition, I mentioned that's never been better at 12.5%; and the second is revenue payback, a blunt measurement of capital efficiency, and that's at 1.9 years also never been stronger.

Right. And you're several years into your Google partnership, and you've launched products jointly, you've co-branded. What are some of the next key milestones with Google? And when would you expect the financial impact or financial contribution from Google to steady state or plateau?

Boy, we've had a great week with Google this week. I'm -- the partnership is beginning to expand into beyond Nest Hardware and beyond video analytics into AI and Google Cloud. And there are just some really exciting things coming down the road that I think will help us differentiate our product and result in really cool customer experiences that utilize the products that we now have in the home. So for example, there's been a proliferation of renaissance really in video, in cameras. Everybody wants camera. And using those cameras to effectively create in the home, a digital assistant to provide you information about what's occurring in the home is something that we're in partnership with Google able to provide. So for example, George, if you wanted to query, is anybody home? I can get an answer to that. Is my child home from school? Is my kid playing by the pool? Is my kid in the pool? All of these things you can query and learn remotely by leveraging AI and video analytics available through data gathered through the camera supercool use cases. And we're really excited to, as I said, extend the partnership beyond hardware to the Google Cloud Group.

Right? Let's talk a little bit more about attrition, which we've touched on earlier. Right now, attrition is at a record low of 12.5%. I think you gave the medium-term guide for attrition to hit 12.2% by 2025. How much of the improvement in attrition that you've seen so far is due to external factors, like you mentioned, fewer relos, relocations versus benefits from Google, lower churn or benefits from improved customer service with the thinking that the latter parts are structural in self-help, whereas the market external factors are transient?

Yes. Before we take too deep of a curtain bowl, a big factor has been relocation. Your first question or your second question about map or trend. 2 relocations has been a real help to us. That said, there are some lead indicators that give us confidence that we'll be able to continue to chip away at attrition. So when we look at our years by vintage and we look at credit score, lead indicator for a stickier customer. We feel really good about the customers that we're adding. Even more importantly, when you look at the number of devices that customers are buying, the more devices that a customer buys, the higher the inclination to retain customers that invest more upfront are stickier customers. And we've got -- we've shared some statistics where the number of customers who have 10 or more devices equipped something like half of the customers that have less than 10 devices. And for us, the number of customers that have 10 or more devices is something like double from what it was a few years ago. So there are some lead indicators that give us confidence that we'll continue to improve on the retention front. One thing I'll mention related to the -- to those goals, commercial has a little bit lower retention, a little bit lower attrition profile. And so we'll have to figure out precisely what that number is when commercial is no longer part of the organization. Right?

Yes. Makes sense. Another metric that's achieved record low levels as your revenue payback at 1.9x. Presumably, the Google partnership contributed substantially to that in terms of efficiencies in acquiring, higher attach rates of more revenues. As you think about the State Farm partnership ramping, how much further lower can the revenue payback number go?

We'll see. I think there's still some upside with Google. The most significant proof point is the one that we've been talking about with installation revenue, the amount of devices that we sell at the time of acquisition. But that's not -- we have not fully leveraged all of the product available to us in the suite of Google products. So we're selling a lot of door bells. We're selling a lot of cameras. There's still, I think, meaningful upside on thermostats. We're just getting started with Mesh WiFi, Google Mesh WiFi. So I think there's still some juice in the fruit when it comes to leveraging the Google products. And then as I mentioned earlier, I think there's still some pretty significant opportunities around stickiness as we begin to leverage a smarter system, a more helpful system using AI and video analytics.

Right. So attrition was strong, payback was strong. But if you look at gross RMR additions in the most recent quarter, they actually fell about 6.5% year-over-year. Even if you exclude the impact of the bulk sale from a year ago, this was roughly flat year-over-year. What are the factors? What are the puts and takes influencing gross RMR additions? And what are the catalysts that can get the growth to be better.

Relocation. Relocation is the #1 headwind when it comes to gross adds. Most of the other areas outside of bulk, George, we're holding serve builds are about the same. We have a deep partnership, as you know, with D.R. Horton. That's going well, and we're growing our DIY business as well. I think that there's -- I think there's 2 or 3 opportunities for us to drive additional gross adds. State Farm has to be very high on the list. As I mentioned earlier, 14 million customers, 14 million insured -- home insured, there's 45 million that we could potentially cross-sell to that our auto customers of State Farm. So the TAM at State Farm is just massive. And because it's a claims mitigation product more than a smart home automation product, it really is Newton. So I think State Farm is pretty exciting. Secondly, we have a number of new partnerships that I think are really interesting for us probably on the top of the list is one with AARP. Our customers skew a little older. Our DIFM customers skew a little older. I think it's a natural partnership with AARP. We have pretty good economics to get into that deal, and we're just starting to get traction there. I think there's some opportunity in DIY for us. That's on the growth side. The profit pool still is in DIFM. But when you look at DIY through the lens of customer lifetime value, it begins to make a lot of sense to go after DIY, probably a little more assertively than we have in the past and then grow with that customer. When that customer has an 800 square foot studio and wants to protect some of their things from being stolen, DIY might be the answer when they have a 2,400 square foot home and are interested in 15 or 20 devices in the home. We want to grow with the customer, both when they have DIY need and DIFM needs. And so I think there's some opportunities for us on that front as well. And then lastly, I think we're still in the early days of smart home adoption. I think as technology provides more and more experiences for the customer to interact with their home in a more convenient way, we'll see a proliferation of smart home opportunities.

You mentioned that State Farm has 14 million insured subscribers. How many of those subscribers are currently ADT customers?

About 20% of those customers have a security system and about 20% of those are ADT customers, but importantly, very, very few of those customers have the kinds of devices that we're talking about to prevent claims. So the vast majority of those customers don't have water devices, water detection devices. It's more of the traditional -- where we have been traditionally in Smart Home. And so most all of the State Farm customers are prospects for us to sell this claims mitigation hardware.

Right. Makes sense. And maybe sticking to the topic of subscribers. If you look at ADT's subscriber count, it's been relatively stable at 6.7 million for a number of years now for maybe 5 years. When would you expect to see that subscriber count lift? Is State Farm a catalyst? Is it Google? Is it Horton? Is it ARP? Is it something else?

Yes. It's some combination of the total. We're a subscriber acquisition business. subscribers matter to us. We want to grow subscribers. So I don't want to say this and leave you with the impression that subscriber growth isn't a goal. Subscriber growth is absolutely a goal. But what we are focused on day in and day out is our recurring revenue. And we finished the second quarter at $382 million of recurring monthly revenue. If you look back over the same 5 years that you're talking about, George, where we've basically been flat from a subscriber basis, we're not flat from an RMR basis. If you dial back 5 years in RMR, we were about $300 million. I think when we IPO-ed, we were over under $300 million 5 years ago. So we've been very successful in growing the RMR 3%, 4% a year, maybe a touch better than that in a couple of years. Not to say subscribers aren't important. We want to get after that. But I think it's worth mentioning the distinction that RMR growth has been reasonably healthy.

Right. Let's talk solar. So the solar business, most recently declined about 65% year-over-year. You mentioned some of the headwinds, including higher interest rates and then also a little bit of difficulty restarting the sales and marketing efforts after an internal pause. Can you elaborate on what's going on in the solar business and when you would expect to see operational improvement there?

Yes. We had a handful of challenges last year in solar. One of our largest -- I think our largest financing partner liquidated. We had about 3,000 customers who thought they had financing who no longer had financing, and it really gummed up the throughput. And this is a throughput business. It's all transaction revenue. And when the throughput slowed down, we were stuck with excess G&A and we turned off marketing because we wanted to protect the brand, provide great customer service. And even if we had to take it on the chin a little bit from a revenue perspective, that was okay to shore up what had become wobbly legs from an operating perspective. And that has proven to be more difficult to turn back on than we anticipated. And the number one reason why it's been difficult to turn back on is the product that we sell is most often a loan product. The customer, 10% of the time, pays cash to buy a solar system, but 90% of the time, they finance that system. They finance it through financing partners but it doesn't pencil out as frequently when interest rates are where they are today versus where they were 18 months ago. And when I compare my utility bill to the principal and interest that I have to pay using a much higher interest rate, it makes for a more difficult sale. And so where the market is beginning to shift is to a third-party-owned product where the panels on the roof are actually owned by somebody else that somebody becomes your utility provider and they provide energy costs at less than what you're paying to your current energy company. I think the -- I think we started the year industry-wide storage at about 20% of the market being this TPO product. Again, it wasn't an arrow at quiver. We didn't have a TPO product. 20% of solar systems were TPO. I think we're going to exit the year with about 60% being TPO. And so we were faced with the decision, do we buy or build because we need this product, and we landed on renting instead of building, and we're using the SunPower platform. We've negotiated good -- a sound deal with SunPower to basically leverage their chassis and we'll be going to market beginning in October with a full arsenal of what you need to sell into a residential rooftop today. So it's been the most significant disappointment in the year. Commercial was doing well until we sold it. When we sold it, we felt great about the economics. The underlying business is coming along nicely despite the headwinds of fewer relocations. State Farms' just getting started a little slower than we would have liked, but we like what I see, what we see. And I think when the flywheel gets started, it's going to be encouraging. Love the relationship with Google. Like there are so many things that are going well. Solar has been the blemish for us, and we've got to turn a kit it one way or another.

Now you've owned the solar business for over a year. Do you continue to see industrial logic for combining a solar business with a residential security business?

I think so. I think so. The deal thesis was that we're going to leverage the brand and the brand plays well. If customers trust us for a smart home, they trust us for smart energy, especially in markets that aren't exposed to solar as frequently as, say, California. The brand plays well in Des Moines. The brand plays well in Little Rock. And so we continue to have confidence in that part of the thesis. Cross-selling has been slower than anticipated. I think there's still some opportunity to go after cross-sell in a little more aggressive way than we have, especially now that the foundation is a little stronger than what it's been. And we'll test that thesis. A student buddy left to fix that business. But if the deal thesis proves not to hold water, we're not going to be stubborn about it.

Okay. Fair enough. And then last question. You're guiding to free cash flow growth this year. Free cash flow is of $600 million to $700 million. That's up 21% growth from last year. In your mind, what's the reasonable sustainable rate of free cash flow growth? And what are your capital allocation priorities for free cash flow?

Yes. So in our last earnings, we underscored -- we talked about our goal in 2025 of $1 billion. That goal is with the swaps that you're familiar with. And we continue to focus on it. A big part of that bridge incidentally between 2023 and 2025 is stemming the tide in solar. It's been a very rough year from a cash flow perspective in solar. And when we turn a kit that because the underlying business is performing as well as it is and because we're paying down such significant amounts of debt, we feel pretty good about $1 billion in 2025. In terms of capital allocation priorities, for the short term, it's about debt paydown. We have a goal to get to 3. I think more prudently, especially in this environment, it's probably a little bit less than 3. But we will -- current course and trajectory, we do the math. We like where we're sitting a year from now, and that opens up a whole bunch of capital allocation alternatives in our core business, investing in growth, maybe revisiting our dividend policy, maybe some stock buyback. Maybe we continue to do to pay down debt, but it opens up the alternatives in a much more strategic way than it does now. For now, priority 1, 2 and 3 is paying down more debt.

That's fantastic. Jim, thank you. Please join me in thanking Jim for participating in our conference.

Thanks, George.