ADT Inc. (NYSE:ADT) Q3 2022 Earnings Conference Call November 3, 2022 10:00 AM ET

Company Participants

Elizabeth Landers - Senior Director of IR

James DeVries - President and CEO

Kenneth Porpora - EVP and CFO

Conference Call Participants

George Tong - Goldman Sachs

Toni Kaplan - Morgan Stanley

Brian Ruttenbur - Imperial Capital

Ashish Sabadra - RBC Capital Markets

Philip Shen - ROTH Capital Partners

Operator

Greetings, and welcome to the ADT Third Quarter 2022 Earnings Conference Call. [Operator Instructions]

It is now my pleasure to introduce your host, Elizabeth Landers, Senior Director of Investor Relations. Thank you. You may begin.

Elizabeth Landers

Thanks, operator, and good morning, everyone. We appreciate you joining ADT's third quarter 2022 earnings call. Speaking on today's call will be ADT's President and CEO, Jim DeVries; and our EVP and CFO, Ken Porpora. Jim will provide an overview of our recent performance and how this links to the mission and long-term strategy we laid out at our Investor Day in March. Ken will then cover our financial performance. [Operator Instructions].

And with that, I'll turn the call over to Jim.

James DeVries

Thanks, Elizabeth. Good morning, and thank you to everyone for joining us on our earnings call today. ADT released our strong third quarter results this morning, driving top line growth 22% to $1.6 billion, and generating adjusted net income of $83 million or $0.10 per share. Our quarter also resulted in improved adjusted EBITDA, up 12% year-over-year and strong adjusted free cash flow. For another consecutive quarter, our recurring monthly revenue balance, or RMR, is at record levels, and we lowered our revenue payback to a best-ever 2.1 years.

Customer retention also continues to improve with gross attrition at a record low of 12.6%. As our results demonstrate, consumer demand for ADT's products and services remain strong. We are effectively growing our business, driving innovation, building brand loyalty and improving capital efficiency.

A highlight for the quarter was the announcement of ADT's new partnership with State Farm. Together, we are committed to revolutionizing the value proposition for home insurance policyholders by leveraging smart home technology to detect and mitigate losses related to water, fire, intrusion and other home ownership risks.

The combination of ADT and State Farm creates a one-of-a-kind partnership, two legacy brands, each possessing over 100 years of trust and experience with a common mission and vision centered on protecting our respective customers.

Our partnership's aspiration to bring state-of-the-art protection to State Farm's 14 million-plus customers, reducing the risk and severity of common perils for homeowners, delivering measurable net loss reductions for State Farm and accelerating subscriber and revenue growth for ADT.

Additionally, to advance and enable the partnership, State Farm has committed up to $300 million towards product innovation, technology and marketing. Our teams have already begun cross-functional work streams on our first integrated offering, and we anticipate having a pilot offering in several key markets in the spring of 2023.

Underscoring their confidence in our partnership, State Farm made a $1.2 billion equity investment in ADT, and we also welcome State Farm's Chief Operating Officer, Paul Smith, to our Board of Directors. Both our companies are aligned and committed to a long-term strategic and mutually beneficial partnership. As of today, State Farm is now our second largest owner at 15%, and Apollo's position is currently just under 55%.

ADT's third largest owner is Google, who has committed an additional $150 million in success funds towards growing this new line of business. Related to Google, our Google partnership is continuing to show tangible benefits to our results. Customer preference for Google Nest products is driving stronger demand for these branded devices compared to our previous white label offerings.

For example, Google Nest Doorbell attachment rates are now more than 50%, nearly double what we experienced with non-branded products. In August, we expanded our Google Nest offerings to include indoor and outdoor cameras, as well as the latest Google Nest thermostats. We're now realizing a greater than 30% uplift in cameras per home versus our baseline.

Notably, each month, we're seeing sequential improvements in residential installation revenue per unit as our marketing and advertising ramps up on all these products and as our sales teams gain more proficiency with our new product offerings. We remain committed to delivering a superior experience for our customers, which we strongly believe has underpinned the success we've achieved so far.

With the customer experience as our North Star, our next milestone will be in the first quarter. This particular launch is a meaningful one as it will include our ADT+ app and self-setup of the ADT product suite, including Google Nest offerings. The new ADT+ app will also integrate Google Nest video capabilities.

Our joint marketing and advertising campaign will now begin in 2023, a campaign which will be partially funded by the first $50 million tranche of Google success funds. Ken will share more specific details in a few minutes, but strong demand for Google Nest products is a key contributor to our improved revenue payback and SAC efficiency. Overall, we are very pleased with how the consumer and small business segment is performing.

I'll spend just a few minutes now on ADT Solar and ADT Commercial, two smaller but significant segments that play important roles in the future growth of our ADT portfolio. Approximately a year ago, we announced our Sunpro deal and launched ADT Solar. The overall solar market remains robust, with industry revenues expected to grow nearly $30 billion by 2030. The recently passed Inflation Reduction Act is definitely a positive for this market, providing more affordable access to renewable energy for more customers.

While we're working through some near-term pressures on the business from rising interest rates and operational integration, we remain bullish over the horizon for ADT Solar. We are confident demand is there and will grow. It's imperative on us to stay disciplined, to deliver operationally on converting that demand and to obtain financial returns on that growth.

Within the third quarter, we were encouraged with Solar's September exit rate, demonstrating EBITDA profitability. That said, within our Solar segment, we're taking a noncash goodwill impairment charge that Ken will share more details on. Our near-term goal is to position ADT Solar as the premier operator in the solar market and to improve our margin profile as we close the year.

Finally, turning to ADT Commercial, this segment is continuing to perform well, with revenues up 12% in the third quarter and 9% year-to-date. The exceptional service provided by our commercial team continues to result in big wins, particularly within national accounts. We're also seeing very strong retention rates in this segment. Through a combination of pricing actions and cost initiatives, we've been able to fully offset margin headwinds from inflation and part delays.

Our commercial segment has been affected by supply chain challenges more than any other part of our business, which you're seen partially reflected in our installation backlog growing by 25% year-over-year to $445 million. Overall, it was a terrific quarter for the Commercial segment and team. Summarizing, ADT maintained strong momentum in our business, and we continue to produce growth in revenue and earnings.

We remain on track to meet our guidance metrics for the year, and we're taking that momentum into 2023 where we will again look to grow revenue, grow earnings on an absolute and per share basis and grow cash flows, advancing us towards our 2025 goals. All of this success is a direct reflection of the hard work and dedication of our 22,000 employees and our 200-plus dealer partners.

I want to thank all of them for what they do for ADT and for our customers each and every day. I'm now going to turn the call over to Ken Porpora. As many of you know, just after last quarter's call, we announced Ken's promotion to CFO. I am pleased to officially welcome him to our earnings call in this new role.

Congratulations, Ken, and handing it over to you.

Kenneth Porpora

Appreciate that, Jim. Thank you, and thank you, everyone, for joining our call today.

As Jim indicated, we have solid momentum across the business, and we are extremely pleased with the results delivered by our team in the third quarter. Total company revenue was $1.6 billion, up 22% versus prior year, including the benefit of our solar acquisition. Excluding solar, our revenue grew approximately 8%.

Our recurring monthly revenue, or RMR, subscriber base grew to $372 million or 4% year-over-year, a record for the company and a strong reflection of the benefits of our higher average pricing, growth initiatives and improved customer retention.

Adjusted net income was $83 million or $0.10 per share, an improvement from a loss of $54 million last year. Stronger revenue and margin expansion translated into higher adjusted EBITDA, which increased 12% versus prior year third quarter and is up 11% year-to-date. Our GAAP results included two notable noncash special items.

First, a $158 million noncash charge associated with our tender offer, where the proceeds from State Farm's equity investment were used to repurchase an equal number of shares offsetting any dilution. For accounting purposes, this was considered a financial instrument. Based on the share price at closing of the tender, we'll see a partially offsetting noncash gain in Q4 of $95 million. The second special item was $149 million noncash goodwill impairment charge associated with our Solar business.

This charge is based on the Solar segment's operating performance and reflects changes to macroeconomic conditions. Moving to our segment highlights. Our consumer and small biz, or CSB segment, delivered total revenue of $1.1 billion, an increase of 7% or $75 million versus last year. This performance was driven by a 5% increase in monitoring and services revenue, resulting from higher average pricing, subscriber growth initiatives and improved customer retention.

CSB adjusted EBITDA increased by $63 million or 12%, and was driven by this increased revenue combined with strong cost performance. EBITDA margin expanded year-over-year by 200 basis points for the third quarter and nearly 300 basis points year-to-date.

Our virtual service program is continuing to drive high levels of customer satisfaction in addition to significant cost efficiencies. This initiative is allowing us to service our growing subscriber base by using technology and remote video as an alternative to more costly in-person visits. We have completed over 650,000 virtual services this year, and in-person service tickets decreased by 26% in the third quarter versus the prior year.

Turning to our Commercial segment. We delivered solid revenue growth of 12% to $314 million. Our sales remained strong. However, supply chain delays are driving a growing backlog. We view the growing backlog of the pipeline for future revenue and margin as supply chain continues to decongest. Commercial adjusted EBITDA was $34 million, reflecting a double-digit margin rate as our increased revenues in this segment were partially offset by some inflation-driven challenges.

Our Solar segment posted revenue of $179 million and an adjusted EBITDA loss of $6 million, driven by installation delays associated with a third-party lender's insolvency in the June quarter and cost inefficiencies from lower install throughput. With these near-term pressures on the business and additional headwinds from rising interest rates, we have taken several recent actions to improve operating margins in Solar.

These include process improvements in scheduling and labor planning, workforce rightsizing and pricing adjustments. And as Jim mentioned earlier, we're starting to see the improved margin benefits in recent results. Switching our attention to cash flow. Adjusted free cash flow is $145 million, up from $62 million last year on higher recurring revenue flow-through and lower net subscriber investments, partially offset by higher cash interest.

Our core ADT adjusted free cash flow is essentially on plan for the year, with outperformance in the consumer business, offsetting Solar pressures. The recent sharp rise in rates, however, is pressuring our cash interest, which will be approximately $20 million higher in the second half of the year, compared to the first half of the year.

We are nearly fully hedged on our variable rate debt, though this offsetting benefit flows through cash from financing activities, and therefore, outside of adjusted free cash flow. This cash flow geography is an important contributor to why our 2022 free cash flow guidance is trending towards the lower end of the range, while our revenue and EBITDA is trending towards the higher end.

Our top priority for cash is capital efficient growth. We delivered meaningful improvement in net subscriber acquisition cost efficiency in the quarter as we achieved 11% lower SAC spend, while growing our overall customer base by 2% to more than 6.7 million customers. A big improvement driver was a 22% increase in installation revenue per unit, a measure we've seen trend higher as our Google Nest product rollouts have progressed. Another critical capital allocation priority is strengthening our balance sheet.

We've lowered our net leverage ratio to four times this quarter, down from 4.4 times at year-end 2021. As a reminder, our goal is to have that ratio at or below three times by the end of 2025. During the quarter, we repaid $80 million against our revolving credit facility, ending the quarter with no outstanding revolver borrowings.

We also entered into a new debt commitment letter for up to $600 million of term loans under a senior secured term loan A facility. We expect to use the proceeds of this facility, together with cash on hand, to repay next year's $700 million maturity. With this action, we have now addressed all of our significant maturities in 2023.

Our manageable debt maturity schedule, combined with our strong recurring revenue mix and limited variable rate exposure reduces balance sheet risk and makes our company more resilient against rising interest rates and any potential recession.

I'll wrap up now so we can transition to Q&A by simply sharing that we are very pleased with ADT's performance this quarter, and I, too, would like to add my personal thanks to our entire team. As Jim mentioned, our performance to date gives us confidence in achieving our full year guidance, and importantly, meeting the long-term goals that we laid out at our Investor Day.

Operator, please open up the call to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from George Tong with Goldman Sachs. Please proceed with your question.

George Tong

Hi thanks, good morning. I wanted to start with State Farm. Congrats on the partnership. Can you talk about your milestones with going to market together with joint product offerings? When you expect to see the benefits from that partnership materialize? And how you expect jointly to deploy some of the co-investments into products and marketing?

James DeVries

Sure, George. It's Jim. Thanks for the question. So a little bit of background on State Farm. I'll share a couple of high-level comments, and then for context and then get to your specific questions. As you know, State Farm invested $1.2 billion, now owns 15% of our company. The opportunity fund that you referenced is $300 million. That will be invested together to advance the partnership.

Paul Smith, the Chief Operating Officer at State Farm, has joined our ADT Board, already providing value. We're thrilled to have him in the boardroom. The vision for the partnership, George, is to evolve homeowners' insurance from purely restoration to include prediction and prevention to avoid losses. And we'll be going to market with an offering that we call Circle of Protection, that is intended to reduce losses related to water and intrusion and fire and smoke.

We had our first kickoff session a couple of weeks ago with State Farm and Google and ADT executives. We're setting up a governance structure to manage the opportunity fund. We're planning to offer that Circle of Protection product that I just mentioned in two or three states in the spring of 2023.

The objective of those pilots is test and learn as we prepare for a wider launch across the country. It's a bit early to comment on the financial impact that it will have for us in 2023. But we're, as you would expect, super excited to have State Farm as a partner. And we think that this partnership unlocks new TAM for ADT. We're excited to get started.

George Tong

That's very helpful. And then as a follow-up, you delivered record attrition rates in the quarter. Can you discuss trends contributing to that improvement and whether those trends are persistent and whether you expect additional improvement down the line?

James DeVries

We - so the retention step for us, we always move a little bit from quarter-to-quarter. As we've commented before, and as you know, George, it won't be linear for us. That said, we continue to be bullish about this metric. Quarter ended at 12.6%, that's a record for us, an improvement of 10 bps from last quarter, 80 bps better than Q3 of last year. October was solid for us as well. There's some modest headwind from nonpaid cancels.

I mentioned this on our last call. But because nonpay is a smaller percent of total cancels, the positive momentum in all the other categories is more than enough to offset it. To highlight the point, net canceled accounts for us, George, for nonpay was approximately 4,500 accounts higher in Q3 of this year than Q3 of last year.

So every customer matters. We don't want to lose anybody, but in the brand scheme, nonpaid cancels are a pretty modest number for us, and there are just a host of positive indicators related to customer retention. The devices sold at time of installation are up pretty significantly. We're getting more and more sophisticated in our save offers.

Our service backlog is at a record low. There's an uptick in credit scores in both our dealer and direct channels. We've seen improvements in voluntary and lost competition results. And then as with last quarter, very importantly, the macro environment is leading to fewer relocations. And so that continues to be a tailwind for retention. So it's a good story for us, and we're feeling optimistic, long term, about customer retention.

George Tong

Very helpful. Thank you.

Operator

Our next question is from Toni Kaplan with Morgan Stanley. Please proceed with your question.

Toni Kaplan

Thanks so much. I know you mentioned, Ken, the free cash flow expected to be towards the lower end of the range, and you talked about the $20 million higher cash interest expense. So it sounds like that's the main driver there. But is there anything else that's leading you to expect a little bit later for your cash flow?

Kenneth Porpora

No, Toni, that's the interest piece in the second half versus the first half is the main driver. You could see some of the trends that we've talked about, the operating performance, the EBITDA performance flowing through from each of the segments. We're happy how the business are performing. But the - we just couldn't offset the interest piece.

But the reminder on the interest piece, we do have that fully hedged. So we're getting the benefit of those hedges that we put in place years ago. It's just happening in the financing section. So when we think about true cash flow, we feel really good where we're at. It's just the adjusted free cash flow what we're measuring here, does include the higher interest in the second half of the year.

Toni Kaplan

Great. And then Jim, on the Solar, the installations obviously below last year, you called out the macro environment, also the financing partners and solvency, which you had mentioned last quarter. So I know you have a couple of new partners there. I guess, how long should we expect Solar to be a little bit of a drag? How quickly does that turn around and start growing like you had expected originally? Thanks.

James DeVries

Sure, Toni. Thanks for your question. Yes, in many respects, we're slowing down in Solar now so we can go faster later. We're navigating the operating challenges. As you just mentioned, the liquidation of a major financial partner was a speed bump for us. I'm pleased with the progress we're making. Each successive month is - we're building an operating engine that's stronger. The investment thesis is still intact. The brand is helping drive volume, conversion rates are up. We're excited about a relationship with Lowe's that's just getting started.

So I feel good about our ability to grow this business. And when I think about the year to come, in many respects, I think we'll deliver in 2023 what we had intended to deliver in 2022. The financial results are below expectations, but each of those issues that we're trading a log jam and throughput are being addressed. And I expect us to deliver in '23 what we anticipated in '22. So another few months of shoring up operations, and we should be in good shape.

Toni Kaplan

Terrific, thanks.

Operator

Our next question comes from Brian Ruttenbur with Imperial Capital. Please proceed with your question.

Brian Ruttenbur

Yes, thank you very much. Great quarter. First of all, on the competitive front, can you talk a little bit about what you're seeing in terms of competition, one tangent you could go down, there's a couple you could go down, but Vivint recently announced their cutting ties with Alarm.com. I know that you're moving forward with Google. Can you talk about anything legacy that you have with Alarm and what your plans are moving forward?

James DeVries

So - thanks for question Brian. On the - I can't speak to Vivint and on Alarm. I'm not sure of what their plans are or the relationship. For us, Alarm.com has been a great partner. We made the decision a year or so ago that we were going to build our own platform, something we call ADT+. We're super excited about it.

We'll roll out that product in very early 2023 for DIY, in midyear for DIFM. And that is the platform that we'll use for new customers rather than continuing to use the Alarm.com product. We'll still have a relationship with Alarm. They will continue to support our existing customers. And we have a long-term contract with the organization that we're satisfied with. But ADT+, by midyear next year, will replace them for all DIY and Pro Install customers.

Brian Ruttenbur

Great. Then as a follow-up on a different tangent, what are your plans in terms of going into other areas out there? You've gone solar, you've gone insurance, you've got a great customer base. Can you give us a glimpse into directions that you may be thinking about in terms of additional services you may be selling into your existing base?

James DeVries

I would say the - all of the tools for growth are available to us. We feel great about the setting of the pens, the State Farm relationship - the State Farm partnership is going to be massive for us. You know how optimistic we are about Google. And so for us, it really is an execution game more than a foray into any new areas. We're excited about our JV with Canopy in auto security, I think, opens up some new TAM for us. But outside of what's before us, Brian, it's a focus and execute game and leveraging all the tools that we now have to help us grow. So I don't anticipate a new foray or a new area.

Brian Ruttenbur

Great, thank you very much.

Operator

[Operator Instructions] Our next question comes from Ashish Sabadra with RBC Capital Markets. Please proceed with your question.

Ashish Sabadra

Thanks for taking my question. I just wanted to focus on the Consumer segment. Have you seen any kind of elongation in the sales cycle or any change in the attach rate or the products that are getting adopted by the consumer on the security side?

James DeVries

Thanks, Ashish, for the question. I'd say, I mean, there's not a fundamental change. We're continuing to see a renaissance in video. The number of cameras, indoor and outdoor cameras, video doorbells, the customers' desire continues to increase. The Google products are selling well. I had mentioned earlier, Ashish, when George asked about attrition, a positive trend that we're seeing is the customers are just asking for more devices.

This year, for example, a number of new customers with 10 or more devices in their system is actually double what it was last year. And it is - it bodes well from a retention perspective. And it's why you're seeing record installation revenue per unit and a lower revenue payback as a result of it. The demand for devices to fill out the smart home ecosystem just continues to grow for us. So that's probably the most substantial trend that I'd see.

Kenneth Porpora

Ashish, it's Ken. If I could just add on a tiny bit to what Jim just said. We talked about IRPU of 22% year-over-year. Last quarter, we talked about around $1,200 as our average in our residential segment. We saw another $30 pop this quarter. So we continue to see this nice inching up of the installation revenue per unit. And as a reminder, we just launched the indoor-outdoor cameras for Google in the month of August. We probably got maybe a quarter - I'm sorry, half a quarter benefit from some of the new devices that we're offering. So we like the trends, and we continue to see the upside in IRPU as it helps out our SAC efficiency.

Ashish Sabadra

That's great color. Maybe just a follow-up, a similar follow-up on the commercial side. How much of the business is tied to new business starts versus existing businesses? Have you seen any kind of slowdown or elongation of sales cycle on the commercial front?

James DeVries

So Commercial is hitting on many cylinders. Q3 was solid for us. Revenue up 12% against a very good Q3 last year. EBITDA, up significantly. We have, like a lot of businesses, Ashish, our Commercial business has some supply chain constraints that are impacting backlog and elongating the sales cycle. Installation backlog now for us is at $445 million. That's a record, and $100 million of that is associated with parts delays. So it's a longer sales cycle, but we're not seeing cancellations out of the backlog.

Everybody has the same parts issues, and so customers are hanging in there with us. Lots of irons in the fire. We have new verticals that we've talked about a handful of times, super excited about energy, education. We have some big wins in Oregon, Texas, I think, Kentucky recently. Government, we're starting to get some traction. There's some interesting work in innovation that I'm pretty excited about. So net-net, we feel good about the business. The leadership team is outstanding. The supply chain organization at ADT is managing supply chain as best as we can, and the business is doing really well.

Kenneth Porpora

Ashish, if I could - one of my favorite charts is, to add on that what Jim was just talking about, if I rattle off the last four quarters for Commercial and EBITDA, which is one of the measures we look at for the business, $16 million, $24 million, $31 million, $34 million, so we love the shape of that chart. I'm not saying that every quarter will be linear like that, but we like the momentum in the business, even with the current congestion going on within supply chain.

Ashish Sabadra

That's very helpful color, thank you.

Operator

Our next question is from Philip Shen with ROTH Capital Partners. Please proceed with your question.

Philip Shen

Hi guys thanks for taking my questions. First one is on what you think the shape of revenues look like as we get through '23? I know you haven't provided a full year guidance or anything, but I was wondering if you could help us understand. Do you see a reacceleration from a quarterly standpoint on a year-over-year perspective in Q1 or 2? Or do you think we need to wait till back half until we see some reacceleration of the business?

James DeVries

So I'd say, generally, we see '23 consistent with our 2025 Investor Day plans. The only aberration to that would be that the revenue expectation that we had for Solar this year will be largely pushed to 2023. But outside of that, I'd say the overall shape of the pie and the allocations between CSB, Commercial, and Solar are very much consistent with what we shared at Investor Day.

Philip Shen

Okay. Do you have a sense - can you share which quarter you think EBITDA flips back positive? Can we see it in Q4? Or do you think it's more likely first half next year?

Kenneth Porpora

Phil, we're not giving specific guidance for Solar, even the timing of it. But we were encouraged, as Jim mentioned in his prepared remarks, that in the month of September exit rates, we saw EBITDA profitability for Solar. So we're happy with the turnaround we have there and the actions that the team has put in place give us confidence to improve that margin profile going forward. So we'll talk about it in our next call, kind of our '23 guidance, and add a little more color there. But for now, I think the prepared remarks cover the trending for Solar.

Philip Shen

Great. And then historically, you guys have been working with the loan companies as a financing source. To what degree with the IRA being pretty rich for the lease and PPA options? To what degree are you opening up to potentially partnering with a lease company that could provide potentially healthier economics with the ITC adders?

Kenneth Porpora

So Phil, we're looking at all the options there. We think diversity in the loan portfolio is important given some of the volatility in the marketplace. We do have some great partners in this space that have been there for us. But we are - I think the word there is diversity. As we think about 2023 and making sure we have the flexibility to move quickly in these different opportunities.

So I won't share much more about our specific diversity plans, but know that we think of our lender partners as key partners, but we want to make sure that we have the diversity to grow the market with our - aligned with our plans, and we think the financing piece is a very critical component, even subject with the benefit of the IRA and the greater tax incentives, the financing piece is critical for such a large installation and purchase for the consumer. So we know that partnership is critical.

Philip Shen

Great, thank you both. I'll pass it on.

Operator

We have reached the end of our question-and-answer session. I would now like to turn the floor back over to Jim DeVries for closing comments.

James DeVries

Thanks, operator. We've got great momentum in the business, catalyst for growth with State Farm and Google partnerships. We're optimistic about finishing the year strong. We're confident in our long-term strategy and the goals presented during our Investor Day. And I'd again like to extend my appreciation to our ADT employees and dealer partners for an outstanding quarter.

And thanks again, everyone, and have a great day.

Operator

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.