Alarm.com Holdings, Inc. (ALRM) Earnings Call Transcript & Summary

We're 8:40. So ready to kick off this morning, Mike Funk from BofA mid-cap software analyst. Thank you all for being here with us this morning. Really happy to have Steve Valenzuela from Alarm.com with us as well. So Steve, thank you again for being here.

Great to be here. Thanks for having us.

Yes. I wanted to kind of open with the question just to highlight maybe the differentiation of Alarm.com relative to other enterprise software companies because the last 12 months, you've been hearing a lot about enterprise IT budget compression, sales cycle, elongation. Alarm.com is unique to your primary market is actually the residential security market, right? So not facing the same macro headwinds. So maybe just kind of give us a baseline and walk us through the Alarm.com model, and maybe even as a bullet point the last Quarter 2 results and the trends that you have been seeing and the differentiation.

Yes, sure. Thanks, Mike. So Alarm.com has a recurring SaaS model that we provide a SaaS operating system, and I'd like to call it the operating system because we go to market through over 11,000, what we call service providers. These are independent dealers who every day are out there, they're doing the selling, they're doing the installation. Alarm.com is providing them the software that we host at our data centers, and we actually manage that data center for those service providers. So we have 11,000 plus service providers, over 9 million and subscribers. About 8 million of those subscribers are domestic -- residential subscribers about 0.5 million are international and about 0.5 million are commercial. And when you think about the Alarm.com model, so we're a B2B2C business, highly recurring SaaS model. What we do is we charge for residential, for example, to give you a sense of the model, we charge the service provider a monthly recurring fee, the ARPU based upon the system that the end subscriber has. So it can vary anywhere from a base system interactive system where they might just have the security system. They might have a thermostat, and for that base system, we might charge the service provider $5 per month. For a complete system with interactive AI with cameras, with thermostats, we might charge a service provider $8 per month. The service provider, in turn, charges the residential customer anywhere from $35 to $85 per month. The sweet spot is typically around $50 to $55 per month. So that's residential. Again, that's where the company started many years ago. About 5 years ago, we entered into the commercial market. We started it with SMB and that did very well. And we took our residential model essentially in our residential system. We work with small restaurants in the neighborhood. We work with coffee shops and modified our system to really provide the same kind of security system for a commercial business with some nuances. For example, auto alarming at night time because a lot of businesses found their employees would not turn on the alarm when they left. So a number of features like that. But -- so for commercial, the opportunity is quite significant. It's new to us. For commercial, we get a higher ARPU, anywhere from $10 to $20 per month per subscriber. And the service provider charges up to $100 or more per month. That's for the SMB portion of commercial. About 3 years ago, we acquired a company called OpenEye that got us into the enterprise. And this is similar to enterprise software. It's still a highly recurring SaaS model. But here, we're selling to, like, think large franchisors, think of theme parks in Disneyland, Florida without naming the customer. But these are large companies that are really looking at putting in maybe thousands of cameras. And so that business has done very well for us. It's grown about 25% year-over-year. When we acquired the business 3 years ago, it was more of a term license model because they were a startup company. They were not public. They didn't have as much cash, and so they were charging more on a term license basis. We converted that model to a SaaS model. And so last quarter, for example, that business generated $2.4 million in SaaS revenue for the quarter, which is up 100% year-over-year. And so we're seeing good growth there. And one of the things that's really helped us over the last 4 years, 5 years actually, and has kind of been unknown or not highly publicized, and now it's all the rage is AI. We actually acquired a company in [ Western ] Virginia that was doing AI work for the government in January of 2017 called Object Video, we took that -- those video analytics team. It's about 20 PhDs in video analytics. We supplemented that team and we came out with our AI system, which really provides smart alerts, provide smart features, so be able to distinguish between a person, animal and a vehicle. For example, for residential customers, you could send smart alerts, you could set up how often you want the alerts, where you want the alerts. And for commercial customers, we've adapted that as well to provide a lot of key features like line counting. Imagine if you have 4 or 5 Chick-fil-As in an area which line -- which drive-through is getting longer wait times. You can move employees to that location because your AI system is providing you that indication of that information. So Alarm.com is expanding that team. We actually acquired just a company -- just recently acquired a company called Vintra that actually, I think, is based in Redwood City, with people, Redwood City, California, with employees in Spain that have a lot of IP related to AI for commercial, a lot of capabilities to be able to do a lot of different things for commercial. And imagine if you have thousands of cameras and you have a school, and you have 1 person monitoring these cameras. If you have smart alert capabilities and you have someone who's the AI system can tell if there's movement that isn't normal and can track that person and provide smart alerts. Imagine the value of that. So we're continuing to invest in AI. That's a big area for us. But think about Alarm.com as a very diversified business that started in residential, expanded the commercial, added AI, added video. This last year, we did was $840 million in revenue, $147 million in EBITDA. So a very profitable, very cash flow profitable business. Highly recurring, it's not the kind of business you're going to wake up one morning and there's going to be a lot of change in the guidance because it's very predictable. So it's not like long sales cycles. I would say though that the commercial enterprise segment does have longer sales cycles because you're dealing with customers who are looking at putting in thousands of cameras and thinking about an average life of 10 years plus. In the residential side, it's actually faster sales cycles but still the lifetime there is about 8 to 10 years as well. So high recurring, high renewal rate. Last quarter, we reported renewal rate of 93%. And it's been around 94% to 93% for the last 4 or 5 years, so very consistent. So I think that's probably a good...

No, that was a greater review, Steve. One do like the stock is the recurring nature of the revenue stream, less macro sensitive than other software companies, but you touched briefly on some of the growth drivers. You named a few, right, whether it is thermostat or video or some of the AI-related products, can you walk us through the growth levers for the business, whether it is incremental penetration of the TAM, right? New products like video, home monitoring. And then how important is commercial for driving top line growth?

Yes. So those are all very good points. The commercial is very, very important to us because it's a relatively new area. And one of the things interesting about commercial is the TAM is very large. It's about $4 billion, $5 billion in the U.S., about the same internationally, and it's fairly underpenetrated for what Alarm.com does. So Alarm.com invented the interactive security system prior to Alarm.com. You had a land-based security system. You would come home, punch in your keypad and that was your security system. And if somebody cut the landline, you would have no security system.

I remember that.

So we invented the radio module, which made the system cellular based. And so based on being able to have that cellular connectivity that provides a lot of features that we can actually monetize. And so one of the things we've done over the years is we've come out with new features, new capabilities where we actually charge more. So again, the example, we're a base system, like a base commercial system, we would charge the end subscriber. We would charge a service provider [ $100 ]. We also have access control, where we charge about $4 per door. And you can imagine some companies can have multiple doors or maybe even 100 doors. Now that business is relatively new. So that's a growth driver for us as part of the commercial segment. So again, commercial TAM very large. A lot of commercial customers actually have security systems that are not the interactive one, they're a legacy one that they're converting to interactive because a lot of insurance companies require the commercial business to have a security system, but most of those are, again, are the legacy, not the interactive that Alarm.com provides. So we're benefiting both from the overall growth of the market for commercial as well as customers converting to interactive security systems. And let's face it, the world isn't getting any safer. So businesses need intelligent security systems not only to see what's happened, but hopefully to actually prevent things occurring that are not good, [ bad things ] from occurring. So the opportunity in commercial is large. The opportunity internationally is also large. So that's another growth driver for us. We got it to international about 5 years ago as well. And right now, today, international is only about 4% of our revenue but it's growing about 25% to 30% per year. So it's also growing faster than North American residential. And we're going to market internationally, similar to how we go to market in the U.S. and North America through identifying the service providers in those countries. And some of them are coming to us and saying, look, we have these installed base of legacy systems, and we're looking at a make versus buy and instead of us trying to develop our interactive security system, we're going to work with Alarm.com to convert those subscribers to interactive and be able to retain those subscribers.

Is penetration of professionally monitored residential. Is it lower internationally than U.S.?

It's -- yes.

Why is it? Is it cultural or technology differences? Why is it lower internationally?

Yes, it's a good point. Yes, some of it has to do with the cellular networks. So again, in the different countries, we have to work with like Vodafone and Orange and different cellular networks. And some of it has to do with the technology. Some of that has to do with the privacy standards, which are much higher in some cases internationally. And so we've had to overcome that in a number of various countries by coming out with our own radio modules unique to that country, converting it to cellular...

Spectrum is different.

The spectrum is different. Different relationships in each country. And so it's been a process. But -- now I think we're in over 60 countries, and so we're starting to see that growth. But it does take longer internationally. One thing that is interesting, and I haven't actually looked at this very closely. But if you look at the growth curve of Alarm.com residential. In 2012 and 2013, we had like 1 million subscribers. And then I think it was 2013, we hit 2 million and we kind of hit the inflection point. So we haven't hit the inflection point yet on international. But I think if you overlay those growth curves, I think international is probably ahead in terms of the life cycle from when we started compared to residential North America. So I think that's encouraging. Now it's still a ways off. I don't want to make any commitments is all of a sudden going to go to 25%, 30% in the next year. But that we think the opportunity is for international to represent about to 25% to 30% of our revenue at some point. Again, it's 4% today. 3% a year ago, so it is growing faster.

And in the 25% to 30% of revenue, I mean, that assumes I guess what for penetration internationally, like similar to the U.S. or below U.S. levels?

It's a good point because, again, internationally, there are a number of legacy providers out there that don't have interactive. And so the question will be what penetration, what will be the adoption. We have to also have some technology a communicator. And in fact, we just acquired a company in Poland called EBS, that we're working with an international communicator that we think will accelerate the international adoption. Because of the technology, you have to have this communicator that actually helps to have those international service providers be able to quickly adopt Alarm.com. But it will be interesting to see how quickly that learning curve, that adoption is. It can potentially be faster because, again, these service providers in various countries, some of them have millions of subscribers on their legacy system. So the opportunity for us by having the right communicator, the right technology, the right cellular relationships allows us to help that service provider convert their subscribers to interactive. And the question would be, why would they do that? Why wouldn't they just try to do it themselves? Part of it is that they're trying to keep their subscribers and everybody is hearing about smart home, smart home. And so the service provider knows for them to keep their customers, they've got to adapt and they've got to adapt quickly. So a number of years ago, there was a whole thing about smart home and is that really happening? Well, smart home is definitely happening not just in North America but also internationally.

Sure. Makes sense. So I think another growth driver we've talked about is video and video attach rate, right? I think you mentioned ARPU earlier, video is accretive to ARPU. Can you walk us through where we are today with video penetration, video attach rates? And then third part of the question would be that when people generally add video? Is it existing customers adding video when they upgrade? Or is it driven more by, say, home sales and moves in the initial installation?

Yes. So video definitely is a very good driver for us because we charge more for video. So if an end subscriber has video, we'll charge a service provider $1 or more for that end subscriber, if they have video analytics, we'll charge another $1 or $2. So that's how we get from the $5 to $8 per month that we charge a service provider. In terms of the adoption of video, this last quarter, the video attachment rate was around 46%. A year ago was in the low 40s. What's interesting, too, is of that 46% of new subscribers that got video, 98% of them got video analytics, which makes sense because video analytics is the AI system that really gives you smart alerts, smart capabilities. And so we see that video adoption continue to increase. For commercial, the video attachment rate is actually higher. You can imagine for commercial, they have to have video. And we've recently just taken our video analytics team and worked with our enterprise commercial team to add AI capabilities to the commercial enterprise segment, which is relatively new. And so we think there's a lot of opportunity there. We've also recently just announced that we will start supporting third-party cameras for commercial. And the reason that's important is because if you think about a large business, they may have hundreds of thousands of dollars of installed base of cameras. They don't want to have to throw -- they don't want to throw those out. And so ours by us being able to -- and we want the SaaS, the hardware is interesting, but we make a low margin on the hardware. We really want that recurring SaaS. And so by being able to support the third-party cameras, we could get faster adoption from commercial customers and save them money and they can become subscribers of Alarm.com much faster, and we get that recurring revenue.

No, it's a good point. I want to talk about the competitive environment. I know at least a year or 2 ago, the ADT relationship. Well, it's top of mind with [indiscernible] partnership with Google, correct, to develop home monitoring security in partnership with them. So maybe just refresh us on the relationship with ADT, how we should think about that going forward, and then just a broader competitive environment and who you're seeing, who is most competitive and why you have a right to win.

Yes. So I'll start with the competitive side. So we're kind of like Switzerland, right? When you look at all the different service providers, ADT brings CPI systems and 11,000 others, where their operating system. And so they all compete with each other. We don't compete with ADT. They're our customer. We do compete with Resideo, which was spun out of Honeywell. They're really our main competitor for the service providers. There was also Vivint, which is now acquired by NRG that was kind of the competitor -- more of a competitor of ADT and our service providers. But when you look at the competitive environment overall, you had Amazon acquired Ring a number of years ago, right? So we -- honestly, we haven't seen any impact from that, really maybe fewer doorbell or doorbells sold -- doorbell camera sold. But other than that, there's been no impact in terms of service providers, losing service providers. The one thing that did occur is a good customer of ours, ADT, which is about 15% of our revenue, did enter into an agreement with Google about 3 years ago, which is very public, where Google invested $1.1 billion plus in ADT. The good news is we have a great relationship with ADT. They're a good customer of ours. We actually entered into that relationship with ADT back in 2017 when we acquired the Icontrol business. That was a company based in Silicon Valley that was providing the Pulse network for ADT, which was effectively the interactive system competing with Alarm.com. And so we acquired the business. ADT was very supportive of a lot [indiscernible] business because the Icontrol business was not keeping up with Alarm.com. So that got us a relationship with ADT. We then spent a couple of years with ADT, taking our solution and adapting it for ADT. It's still our, what we call our [indiscernible] operating system technology, but it has nuances for ADT. That's called command and control, and ADT is installing that and selling that. The agreement with ADT is when they come out with what they call ADT plus for professional install, ADT will pay us a license fee for every subscriber that goes on ADT plus. We will continue to operate and manage those subscribers that are on ADT Command and Control and Pulse for their natural life, which is 8 to 10 years. So it's a long agreement and recurring revenue stream. And so we'll sell less hardware, of course, because Google Nest is providing hardware for ADT, which, again, we don't make of margin on hardware for residential. And so we feel good about the relationship.

So then the initial knee-jerk market reaction that ADT was going to cut the cord and go to 0 overnight. Simply misplaced.

That's it happens.

Yes, your point about the ongoing relationship very much an annuity stream from that relationship. That's really the fact of the matter.

That's exactly right. And then also, I think it's important to point out, this is also public, but 3 years ago, when the relationship was announced, the intention, ADT intended to come out with the ADT plus, which is for the professional in stock because there's also a DIY version, which we're not involved with that was supposed to come out at the beginning of 2023. That was pushed back to the second quarter of 2023. And I think the latest is that ADT has publicly said on their call that now it's coming out in the fourth quarter of 2023. So there have been some delays. I mean, what we do, if you think about Alarm.com for 20 years, we've been developing and modifying our security system and third-party integrations. It's very complex. You've got all these different control panels you've got to interact with. You've got all the like sledge locks, Lutron lights, garage door openers, so many different interactive. API as we've had to work with to interact with these third-party devices who we don't make all the hardware. As a matter of fact, the radio module we invented, we've now licensed that to control panel manufacturers because if you typically look at a security system, there's typically a control panel on your wall. And nowadays, they have a camera on there. We don't make that. So -- but we make the radio module. We've licensed that in the control panel. And so there's third-party devices that sensors, even thermostats that we interact with, that we don't need to provide that hardware. We do provide hardware for the residential customers for cameras mainly and also some for commercial because of the AI system and the capabilities that, that provides. But again, the margin on hardware typically is in the mid-20%, 25% range for residential. For commercial, it's closer to 35% to 40% range. On the SaaS, the recurring revenue what I like to call the gift that keeps on giving because it's 85% to 86% margin. That's really our focus is that recurring revenue. So we try to price our hardware as low as possible and reduce the barriers to entry, varies to customers to buying to be able to allow the customer to become a subscriber because we know once they become a subscriber, their subscriber anywhere from 8 to 10 years typically.

Sure. Lifetime value is very high.

Very high will do that one time and its 61 or something. I haven't done it recently. So may be a little different, but...

Probably still in the same range, I would think, right.

It's still same. Yes.

Competitive environment, I still want to talk about that. DIY has grown in interest and prevalence in the last several years. Is DIY a direct competitor to your business? Are you seeing market share loss to DIY?

I think it's not a direct competitor and it's not mutually exclusive. So our service providers will go into some homes and they might have a Nest thermostat or they might have a ring doorbell, but they still want a complete security system. So for our business, for the middle to upper income subscriber for residential, it's generally not something -- they're not looking at spending their weekends installing a DIY system. Now there are some folks out there that love DIY. They do it themselves. They want to climb the ladder and put up cameras and do the wiring and everything. Generally, we find that not to be the case for our subscribers. And so DIY has existed for many, many years, over 10 years, and we've continued to grow during that period. I will say that DIY is probably increase the awareness of security system because, obviously, you see the ads, right? A lot of ads on TV stuff. So I think from that point of view, I think it's possibly been helpful because it's created the awareness of the smart home. And for like -- in some cases, maybe rental houses or apartment houses, you might have a DIY system. You might not have an Alarm.com system, although we do have a multifamily solution as well. That's a small part of our business. But -- so I would say the DIY generally is not what we consider a competitive threat directly.

No, it's a great -- it's a great point. And while I have you here, Steve, as a CFO, I wanted to talk about how we should think about margin profile going forward in the next several years, potential to expand margin. You already talked about 80% plus in the software side and obviously lower on the hardware. So margin profile potential to increase free cash flow. How we should think about that? And then finally, we all care about, too, is this returns to shareholders and how we assure should think about returns to us.

Yes. So the margin profile, SaaS is 85%, 86% margin, gross margin, very predictable, very consistent. Hardware has kind of moved around a year ago hardware was impacted by the supply chain dynamics we had to air freight in a lot of hardware cameras. So our margin got to -- for hardware got to 11%. So this last quarter, we were up to about 23.5% gross margin for hardware. So we're probably going to be in that mid-25% range for hardware going forward. So that's obviously very helpful. The overall margin in the past, we've been able to have an EBITDA margin of 20% plus. And in fact, before we were public, we were in the 30%-plus range. This last 5 years, I would say we've been investing quite a bit, especially in R&D, given all these growth drivers. And so we've gone from 22% of revenue in R&D to 29%. That's not sustainable forever, right? At some point, R&D has to come down to a more normalized range like I would say, 12% to 14%. So at some point in the future, as R&D investment comes to a normalized range, we should be able to see that impact on EBITDA margin to get back up to the higher levels. But the question is exactly when that would occur is hard to say. But there is a lot of leverage in the model. I mean, we could be in the plus 30% margin range today for EBITDA but it would be at the cost of the investment in the -- in commercial and international in AI and demand response for Energy Hub. And so all these areas we're investing in, we think, are paying off. We're seeing good growth from those areas. Those barriers are growing over 25% year-over-year. But you're right. At some point, the EBITDA margin will go back to where it was before we went public.

Okay. And then the use of cash, right? I mean assuming healthy top line growth, margin expansion, cash flow generation. How do you think about use of cash?

Yes. So use of cash, we have done acquisitions. Generally, those have been smaller acquisitions. So we did EBS, which cost us about $10 million of cash in Q1. We did Vintra. I think Vintra was about $7 million of cash think that was in Q4. So generally those have been smaller acquisitions. Last year, we did do a stock buyback. We used about $80 million of our cash to buyback our stock of about 2.7% of our stock. Beginning of this year, the Board did authorize another $100 million of stock buyback over the next 2 years. And so those are some of the uses of cash. We do generate cash because the company is quite cash flow positive. One of the challenges, of course, you may have heard about is this new tax law, Section 174, which penalizes companies that have R&D investment and it requires basically to capitalize R&D, and so it accelerates your tax. So that actually has hurt our cash a bit. That's costing us $40 million to $50 million of our cash this year because of the need to pay that tax. At some point, it neutralizes and evens out. There is some talk of that being repealed. But if you look at our operating cash flow and our free cash flow ex this tax effect, it's been -- operating cash flow has been around $80 million to $100 million on a normalized year. Last year was also impacted by the supply chain where we bought a lot of inventory ahead of time. But in normal times, we should be able to generate, let's say, $60 million to $80 million of free cash flow per year. We don't spend a lot of money on capital equipment. Generally, it's for servers and it's for office fit outs. So usually, our CapEx is about $10 million per year on a normalized basis.

Okay. That's a great overview. We have about a minute left, not a lot of time, but I want to give you a chance but the AI roadmap. You already discussed a couple of the products that you have today, but maybe the roadmap going forward, and how AI can be ARPU accretive.

Yes. AI is a huge opportunity for us. And like we doubled down with Vintra, the company we just acquired. So there's a number of capabilities and feature sets that we're working on. For residential, there's a number of use cases detecting people. When somebody goes swimming pool for commercial continuing to identify and quickly being able to identify unusual patterns, and being able to track when there is an unusual pattern. We also have a business we acquired called Shooter Detection Systems, which has kind of been stealth, but we think there's a lot of opportunity there, combining it with a commercial offering, combining it with being able to do predictive analytics when there's unusual activity and the shooter detection will detect gunshots, combining that with new light where it provides notification the first responders. And so we're putting all this together, we think it will be a compelling solution both for schools, for government, for companies, for campuses for malls. And so using all that. So we're definitely doubling down on AI.

That's a great point. Steve, thank you again so much for being here.

Thanks, Mike. Great to be here. Thank you very much. Thank you all.