The ADT Management Discusses Q2 2014 Results - Earnings Call Transcript

Apr.30.14 | About: The ADT (ADT)


Q2 2014 Earnings Call

April 30, 2014 8:30 am ET


Timothy J. Perrott - Vice President of Investor Relations

Naren K. Gursahaney - Chief Executive Officer, President and Director

Michael S. Geltzeiler - Chief Financial Officer and Senior Vice President


Shlomo H. Rosenbaum - Stifel, Nicolaus & Company, Incorporated, Research Division

Ian A. Zaffino - Oppenheimer & Co. Inc., Research Division

Jeffrey T. Kessler - Imperial Capital, LLC

Jiayan Zhou - Morgan Stanley, Research Division

Charles Clarke - Crédit Suisse AG, Research Division

Leon G. Cooperman - Omega Advisors, Inc.

James Krapfel - Morningstar Inc., Research Division


Good day, ladies and gentlemen, and welcome to the Q2 2014 ADT Corp. Earnings Conference Call. My name is Parita, and I'll be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. I would like to turn the call over to Mr. Tim Perrott, Vice President, Investor Relations. Please proceed.

Timothy J. Perrott

Good morning to everyone, and thank you for joining us for our call to discuss ADT's second quarter results for fiscal year 2014.

With me on the call is today are Naren Gursahaney, ADT's CEO; and Mike Geltzeiler, ADT's CFO.

Let me begin by reminding everyone that the discussion today contains certain forward-looking statements about the company's future performance, which are subject to the risks and uncertainties and speak only as of today. Factors that could cause the actual results to differ from these forward-looking statements are set forth within today's earnings release, which was furnished with the -- to the SEC in an 8-K report, and in our Form 10-Q for the quarter ended March 28, 2014, which we expect to file with the SEC later today.

In our second quarter 2014 earnings release and slides, which are now posted on our website at and on our Investor Relations app, we have provided a reconciliation of the company's non-GAAP financial measures to GAAP. We urge you to review the information in conjunction with today's discussion.

For those of you following on the webcast, we will be using this slide deck to supplement our call this morning. Please note that, unless otherwise mentioned, references to our operating results exclude special items, and these metrics are non-GAAP measures.

Now I'd like to turn the call over to Naren. Naren?

Naren K. Gursahaney

Thanks, Tim, and good morning, everyone. Thank you all for joining us. It was a very active quarter for ADT, and we have a lot to cover on today's call. I'll provide you with highlights of our results for the second quarter, followed by a review of the progress we're making against our priorities.

Before I do that, I would like to provide a few comments about where we are at the midpoint of the year and the opportunities that we see for our company in the future.

We've made significant progress in the first half on our plans to achieve our vision for ADT. Our vision is rooted in extending our leadership position in the security, life safety and home automation markets, enhancing the value of ADT services and executing upon our priorities to drive strong returns.

The common denominator in every aspect of our vision is to create a customer experience that is second to none, and the actions that we are taking are moving us in the right direction.

Some of this progress is beginning to bear fruit in certain areas of our business. However, the full effect of our efforts has yet to be reflected in our results.

That said, I point out that there's a lot happening beneath the surface that is positioning us to create significant value in the future.

I would put this progress into 3 categories: operational, financial and strategic. From an operational perspective, we're taking the steps necessary to improve the customer experience, and we're executing our plans to drive better net subscriber growth in the future through our initiatives on attrition, one of the most important value drivers in our business, and through initiatives on strengthening our sales efforts.

We've made organizational and process changes to help address the 2 biggest drivers of attrition: relocations and non-pay customers. We're rolling out our enhanced credit screening initiatives on a national level to further improve the quality of new customers we bring on and continuing to focus on our relocation and resale opportunities.

And to sharpen our focus, I've appointed an executive to lead our efforts full time to capture both opportunities when a customer relocates, recapturing the home or business and the customer in their new home or business location.

In addition, my entire executive leadership team is reviewing our customer disconnect performance and our attrition initiatives on a weekly basis to make sure our efforts get the resources and support they need.

On the sales front, although gross add performance is not at the level we expected in the first half of the year, we are continuing to take actions to improve our lead generation flow and to enhance the ability of our sales force to drive more self-generated business. We've accelerated the process of immersing the self-gen culture into our sales organization and refined our compensation structure to reinforce this behavior, playing to our strengths and better utilizing our local sales force to drive results.

We've also made progress in improving the health of our dealer channel, achieving better alignment on the sales mix we believe will benefit us in the future.

Additionally, we strengthened our leadership team in these areas, adding a new Chief Marketing Officer and a new head of our dealer channel, both playing key roles in our future growth.

While it will take some time to see the full impact in our net subscriber production, we believe the steps we have taken place us on the right path.

From a financial perspective, we're making good progress on cost and capital deployment as we continue to execute our strategy of investing in growth, improving margins and returning capital to shareholders. Our cost efficiency initiatives are beginning to have a positive effect on margins and on our bottom line results. We've improved G&A expense management, and our total G&A costs have flattened, despite growth in revenues and layering in the Devcon acquisition. We are continuing to take a balanced and prudent approach to deploying capital, investing in growth opportunities to generate stronger returns and returning capital to shareholders in the form of share repurchases and dividend growth.

From a strategic perspective, we're taking the right steps to improve our core business and enhance our service portfolio through continued product development, strategic partnerships and M&A. This is an aspect of our business that I'm very excited about and I believe will provide tremendous value in the future. The evolution occurring in our industry creates numerous growth opportunities in our traditional business, as well as several adjacencies, and we are investing in these opportunities to enhance the value of the services we offer and to expand our influence in securing, not only our customers' premises, but also their personal and digital lives.

In the first half of the year, we made several advancements in Pulse, including developing a new Pulse wireless product platform, a voice app and remote garage door management capability.

We're continuing our work with McAfee to create a platform to protect our customers' physical and digital assets and will soon be expanding our commercial relationship with State Farm to include resale and health opportunities.

And this morning, we announced a major acquisition to strengthen our core business in Canada, and I'll discuss this investment in greater detail in a few minutes.

So at this point of the year, while I'm not yet satisfied with our gross adds performance, I do see progress, and I believe the actions we are taking to build upon our foundation will position us to take our business to a higher level in the future.

Now I'd like to turn to the highlights for the second quarter, as summarized on Slide #3 of our presentation.

In the period, we made good progress on our initiatives, improved our financial results and stabilized revenue attrition sequentially. However, gross adds remained challenging, flat sequentially in the quarter. And as a result, we do not expect to reach our revenue target for the year, excluding any revenue impact from the acquisition we announced today.

I want to comment briefly on each of these areas, starting with our financial highlights. Overall, from a financial perspective, we grew EBITDA, drove better bottom line results and generated stronger cash flow. The progress we made on our cost efficiency initiatives was one of the drivers behind our improved results. Revenue was up, but only modestly over last year, related to our slower gross add traction in the first half. However, we did continue to show a healthy increase in ARPU.

EBITDA margins improved significantly, approaching our goal for the year, and our bottom line results improved, as evidenced by a 20% increase in diluted EPS for the quarter.

The free cash flow we generated in the quarter grew by 1/3, and diluted EPS using our cash tax rate was also up significantly. Mike will walk through more specifics around our financial results later in the call.

Operationally, we stabilized revenue attrition sequentially and made improvements in our cost structure. However, gross adds traction was not at the level we expected. Total gross adds were flat sequentially and down versus last year, as many of the changes we are making to our sales approach have yet to have a full impact on our results.

The competitive environment remained unchanged from Q1, and we are continuing to refine our strategies in response. We increased our voice in the market while remaining disciplined with our advertising spend, yielding leads that were consistent with the prior quarter. Our close rates in our direct channel remained healthy.

We also strengthened the quality of our dealer channel during the quarter and implemented our self-generation playbook and increased self-generation sales compensation to improve sales production over the remainder of the year.

It's also worth mentioning that poor weather across much of the country did have some negative impact to our sales and installation results in both channels.

The success of Pulse continues to be an important driver behind our results, as Pulse take rates continue to increase across all channels for new system sales, and Pulse upgrade activities also grew nicely.

As you can see on Slide #4, 44% of our total gross adds during the quarter were Pulse units, up from 36% last quarter and 23% a year ago.

In our direct residential sales channel for new and resale units, our take rate was over 50%, which was almost 9 percentage points higher than the prior quarter and up 18 percentage points over the same quarter last year. And nearly 2/3 of all new residential customers we're adding to our network are Pulse customers.

In our Small Business channel, the Pulse take rate was over 37%, up over 12 percentage points compared to the second quarter of last year.

In our dealer channel, the Pulse take rate ramped up significantly in the second quarter to almost 36%, from about 29% last quarter and 11% last year.

Another positive this past quarter was the improved mix of Pulse products sold. We sold more of the higher-end, home automation solutions as a percentage of the total, highlighting not just the opportunities we have in selling Pulse, but also the opportunity within our Pulse mix.

In addition to new system sales of Pulse, we upgraded over 18,000 existing customers this quarter. This was almost 1.5x the number we did in the same period last year. Our Pulse upgrade efforts allow us to provide additional functionality to our existing customers and yield higher ARPU. In addition, these upgrades allow us to enter into new contracts with these customers, generate attractive returns and enhance the customer experience.

We currently have over 700,000 Pulse customers, representing about 12% of our total customer base, showing that we still have a tremendous opportunity to further increase Pulse penetration.

On the strategic front on Slide 5, we've made significant progress on our initiatives, enhancing our position and adding to our capabilities.

First, we announced our agreement to acquire Reliance Protectron, a growing security services firm in Canada, with a total customer base of approximately 400,000 residential, commercial and contract monitoring accounts, generating about USD 11 million in recurring monthly revenue.

This compelling financial and strategic transaction is an attractive opportunity that complements our Canadian business, fits well with our strategic objectives to strengthen our core business and adds to our capabilities. Protectron has a high-quality subscriber base with industry-leading attrition performance and longer tenured contracts, with about 2/3 of their new account growth on 5-year initial contracts and approximately 60% of their total base still under contract. Their highly capable management team has a solid history of generating strong net subscriber growth through both their direct sales channel and through its very productive dealer network of over 50 authorized dealers.

We are paying approximately USD 500 million for Protectron, which, based on its current recurring monthly revenue profile, equates to approximately 46x RMR. This measure excludes the profitable nonrecurring revenue the company generates.

The transaction will be financed with a mix of cash on hand and existing lines of credit. Also, this deal creates an opportunity for operational and administrative synergies, leading to a more streamlined cost structure and will be run by a dedicated team in Canada reporting directly to me. In summary, this transaction provides many of the benefits of a roll-up, in a very attractive and stable market for ADT. Pending necessary regulatory approvals, we expect the transaction to close in the fourth quarter.

I'll follow up with some additional comments at the end of the call. However, now I'll turn it over to Mike for a more detailed review of our operational and financial results.

Michael S. Geltzeiler

Thanks, Naren. As Naren mentioned, our second quarter results improved versus Q2 2013. We grew EBITDA, increased free cash flow and delivered better bottom line results. Although subscriber growth remains a challenge, I feel we are striking the right balance between customer adds and customer retention to return the business to net subscriber growth.

We are also finding the right balance between investing in growth and streamlining installation, customer care and administrative activities to enhance profitability. This quarter, we continued to invest in our business organically and through M&A to strengthen our core and extend our leadership position, all while continuing to return capital to shareholders by shrinking our capitalization. Our balance sheet remains strong, as evidenced by our success this quarter in issuing $500 million of 5-year debt at a very competitive 4 1/8% interest.

In summary, we remain encouraged that the fruits of these efforts will be more evident in the second half of fiscal 2014.

Now let me go into more detail on our 5 valuation drivers, as well as the financials. Moving first to Slide 6. Customer gross adds were flat sequentially and remained a challenge in the second quarter. Gross adds in our direct channel declined slightly, due to an expanded rollout of our enhanced customer screening process, continued pressure on lead generation, as well as some negative impact related to the poor winter weather throughout the country. We're continuing to expand our lead generation activities, including a larger focus on self-generated leads, which improved about 10% on a per rep basis in our residential channel.

In addition, we continue to divert some of our sales and installation resources to focus on Pulse upgrades for existing customers.

Gross adds in our dealer channel were down compared to last year, excluding bulk purchases, driven primarily by a lower number of dealers. If you recall, in last year's second quarter, we had a 34,000-account bulk purchase, while this quarter, we bought about 2,500 accounts.

Bulk account purchases are just one of the 4 ways we can require accounts. In the past, bulks were a greater part of our strategy to grow the business and supplemented production in both our dealer and direct channels. In today's environment, we believe bulks are a less attractive option for a variety of reasons, namely, many of the available accounts will at some point need to be upgraded to 3G and/or interactive services, and as a result, it may be more likely to attrit. Furthermore, these purchases do not come with a growth engine or potential synergies, as they would with a full company acquisition, which puts pressure on future net subscriber growth. Therefore, we will be more selective with bulks and continue to skew our focus towards acquisition and upgrading our existing customers. We continue to implement the dealer initiatives we outlined during the Investor Day, including taking actions to align dealer activities with our growth objectives.

While sales in our dealer channel did grow 5% sequentially this quarter, the initiatives will take some time to have a more positive effect, and we expect they will contribute to better growth results later in the year.

We've restructured our dealer organization under a new senior executive, and the team remains committed to return this channel to growth.

The continued success of Pulse helped fuel ARPU growth for new and existing customers. In the quarter, new and resale ARPU was $46.08, an increase of 4.3% over the prior year. ARPU of our overall customer base, as of the end of the quarter, was $41.05, an increase of 3.2% year-over-year.

Roughly 30% of the gain in average revenue per customer was due to the richer mix from new customer additions, including new Pulse sales. The remainder was from price escalations to existing customers. These gains were partially offset by the addition of Devcon customers, many of whom pay a lower rate as part of a homeowners association. But remember, these homeowner association accounts also have significantly lower attrition rates, and as a result, very attractive financial returns.

Average ARPU growth was 3.8%, excluding the impact of the Devcon acquisition. The ARPU for new Pulse customers continues to be about 25% higher than non-Pulse accounts, providing a long-term tailwind for the company as our customers continue to adopt Pulse.

Slide 7 shows account attrition calculated 2 ways: revenue attrition and unit attrition. Net revenue attrition, which is a stat we've been reporting since our spin from Tyco, was flat quarter sequentially for the first time since the spin at 14.2%. Revenue attrition remains above prior year levels. We're beginning to see evidence that the housing market has begun to stabilize, as relocation disconnects have been in decline for 2 straight quarters. We are aggressively implementing all the customer retention actions that we previously communicated, including tighter credit screening, enhanced resale efforts, improved non-pay procedures and pursuing Pulse upgrades.

As we discussed, our strategy for 2014 is to focus on the levers we can control to stabilize attrition around year-end 2013 levels and eventually go lower.

Also, on this slide, we're introducing unit attrition, which we believe is a more meaningful view of attrition and is more closely aligned to how we measure attrition internally. This metric measures unit attrition for our Residential and Small Business clients.

Unlike the revenue attrition metric, for units, we're excluding health and contract monitoring unit attrition, as these businesses require no or considerably lower levels of SAC.

Trailing 12-month unit attrition was 13.7% for the quarter, up 10 basis points versus Q1, and compares to 13% in Q2 prior year.

Revenue attrition was implemented prior to the separation with Tyco, when ADT had large commercial accounts, and it made more sense to look at revenue lost versus units lost.

On a go-forward basis, we'll be reporting both revenue and unit attrition in parallel, but will likely move to reporting solely the unit attrition metric beginning next fiscal year. This aligns us more closely with the rest of the industry.

That said, unlike our competitors, we continue to count relocated customers who sign up for service in their new location, both as a disconnect and a gross addition, rather than as a contract [ph] attrition.

Slide 8 details the recurring revenue margin on our existing customer base, with 66.6% for the quarter, up 60 basis points versus prior year, due to the operating leverage created from higher recurring revenue and the effects of our cost efficiency program.

On a per-unit basis, cost to serve was up less than 1% to $13.37 per month versus prior year and was down sequentially, despite a higher percentage of our base with Pulse and the inclusion of Devcon.

Net creation multiple for both the direct and dealer channels combined, excluding the net impact of Pulse upgrades, was up 13% versus last year. The year-over-year deterioration is related to the lower level of gross additions for the fixed cost components of SAC to be spread, as well as a lower percentage of installation cost recovery in terms of the upfront installation revenue recouped from the customer. This is typical as our customers move up the value chain towards home automation.

Although we expect Pulse take rates to continue to increase, we expect creation multiples to decline to more normal levels over the course of this year, as direct production improves and the cost efficiency programs take effect, as evidenced by the 1% decrease in the net creation multiple on a quarter sequential basis.

Specific examples of initiatives to reduce SAC include the optimization of paid search between ADT and our dealers, which was completed this quarter, and the launch of electronic contracts and the planned hardware efficiencies, which will go live in the second half.

We remain committed to the cost efficiency program outlined during Investor Day, which calls for a 10% overall reduction in the cost to serve per subscriber by 2016, including $50 million reduction in G&A and a onetime reduction in net creation multiple by 2016.

SAC improvements will accelerate once the Pulse take rates stabilize year-over-year.

Turning to Slide 9 and our results for the quarter. Recurring revenue grew by 2.2% to $773 million and accounted for 92% of our total revenue. Recurring revenue was up 2.8%, excluding the impact of FX from a 9% decline in the Canadian dollar. Although the lower Canadian dollar is impacting current period revenues, we do feel it is opportunistic, given the timing of the Protectron acquisition.

Total revenue was $837 million, up 1.9% over the second quarter of last year, or 2.4% at constant exchange rates. EBITDA was $431 million, up 5.4%, or $22 million, over prior year. EBITDA margin was 51.5%, an increase of 170 basis points year-over-year. While gross SAC P&L expenses were down over 5%, cost to serve remained relatively flat year-over-year.

Growth in EBITDA was offset by higher D&A expenses of $23 million, primarily from the increase in investments in Pulse and home automation.

In addition, we added $1.5 billion of debt since last year, which contributed to higher interest expense, but also contributed to a 16% reduction in diluted shares outstanding.

EPS before special items was $0.49, up $0.08 to prior year and $0.06 sequentially. In Q2, our book tax rate before special items was 35%, and our cash tax rate was only 8.5%. Earnings per share before special items, using our cash tax rate, came in at $0.69 for the quarter, representing a 10% increase over the prior year period.

Looking at special items for the quarter, consistent with our guidance, we incurred expenses related to the separation from Tyco and the cost associated with upgrading 2G radios, 2 of the must-do items on our priority list for 2014. These costs were $4 million and $6 million, respectively.

We also incurred $9 million in merger, restructuring and other costs, as we begin to accelerate our cost efficiency program and sunset some of our legacy IT systems as we migrate our subscribers to the new platform.

We also incurred a special noncash tax item related to a pending pre-spin 2005 to 2007 IRS audit adjustment that resulted in a $13 million charge to tax expense. This item reduced our NOL carryforward and was not a current period cash item.

Special items totaled $26 million in the quarter versus a $12 million benefit last year, as last year's results included a $15 million benefit associated with the tax sharing agreement with Tyco.

Turning to Slide 10, let me focus your attention on our free cash flow and steady-state free cash flow. Cash flow from operations was $422 million, a 5% increase from Q2 last year, despite paying higher incremental interest on our outstanding debt this quarter. This is primarily due to higher EBITDA and improvements in working capital related to the timing issues impacting Q1.

Capital expenditures for the quarter were $304 million, with all but $21 million of that investment going towards new subscriber adds. This compares to $322 million of total CapEx in the second quarter of last year.

Direct channel customer subscriber CapEx increased, reflecting higher Pulse penetration and greater volume of Pulse upgrades, whereas dealer channel CapEx declined due to the lower level of gross additions.

Included in the dealer CapEx are bulk purchases, of which we spent $2 million this year versus $36 million last year.

Factoring all of this, free cash flow before special items for the quarter was $121 million versus $91 million last year and $68 million in quarter 1. Despite the significant investments in acquiring new customers, this business generates strong cash flows.

Our steady-state free cash flow for the quarter was $786 million versus $936 million in last year's second quarter and $787 million in the first quarter. This metric is heavily skewed by current quarter pre-SAC EBITDA, creation multiple and last 12 months' attrition. As we lower creation multiples and attrition in the second half, steady-state free cash flow will improve accordingly.

Slide 11 addresses our capital allocation and debt levels for the quarter. In terms of optimizing the capital structure, we issued $500 million in debt during the quarter, increasing our leverage from 2.6x to 2.7x on a trailing EBITDA basis. We ended the quarter with $332 million of cash on the balance sheet. We expect to fund the Protectron acquisition later this summer with cash on hand and from our existing credit facility.

Even with this transaction, we expect to be below our leverage target of 3x on a pro forma basis, enabling us to pursue a flexible, balanced capital allocation plan, including investing in organic growth, making acquisitions and returning capital to stakeholders in the form of dividends and share buybacks.

In terms of dividend growth, we paid out $37 million in dividends during the quarter versus $25 million in Q1 2014, reflected in the 60% increase to our quarterly dividend. We continue to make progress against the 3-year, $3 billion share buyback program.

During the quarter and through April, we repurchased approximately 6.7 million shares for $200 million, in addition to completing the ASR, which reduced our share count by another 2.9 million.

Although the diluted weighted average share count for the quarter was 183 million shares, we ended the quarter with an estimated 178 million shares outstanding after dilution, a reduction of 24% in the share count since inception of the program.

In fiscal 2014, we've repurchased $1.35 billion in shares, at an average price of $38.49 per share. And there's approximately $400 million remaining on the share buyback authorization.

Turning to Slide 12, I wanted to provide you a little more color on our second half expectations and full year guidance. Overall, for the first half of the year, we're running light on revenue growth. We've approached our EBITDA margin target for the year and we're running behind our steady-state free cash flow.

Our guidance is always to assume some level of nontraditional growth through bulks or tuck-ins. Consolidating Protectron into our operations will impact our results and these metrics in the fourth quarter and for the year.

For revenue, although we expect sequential improvement in the second half in both sales channels, the weakness to gross adds in the first half now places our recurring revenue and total revenue growth to be below our 4% guidance on a constant dollar, constant portfolio basis. Based on our current outlook, we're lowering our recurring revenue guidance for the year to a range of 3% to 4% on a constant dollar basis. This guidance assumes Protectron is fully in our results by the fourth quarter.

Regarding EBITDA margins, we've nearly reached our margin target by the second quarter. With the continuing benefit of cost efficiencies offset by investments we are making in growth and innovation, we expect margins to remain at these levels next quarter. However, margins in Q4 will be lower once we begin to consolidate Protectron into our results.

And as I stated earlier, steady-state free cash flow is highly dependent on current quarter EBITDA, creation multiple and last 12-month attrition. We are running behind on this goal, given the slow first half in customer adds, higher Pulse take rates and greater skews towards automation, which increased cash utilization in the near term for better returns in the future years, but do we do expect improvements in the third quarter. Protectron will add incremental steady-state free cash flow once consolidated.

Given the distortion from the addition of this new business, we have provided on the bottom of Page 12 a set of guidance metrics on a standalone ADT for the second half of this year.

On gross adds, we're expecting sequential improvement in the second half in both sales channels. Attrition percentage should improve in the second half as we continue to execute upon our churn initiatives.

With continued cost efficiencies and solid ARPU results, we're expecting to lower the creation multiple for our direct channel. Recurring revenue growth on a constant dollar basis will be lower than the first half, related to the effects of slower subscriber traction earlier in the year, and we're expecting improvement in the second half for steady-state free cash flow.

Now I'd like to turn the call back over to Naren.

Naren K. Gursahaney

Thanks, Mike. I know we've covered a lot of information today. Overall, we're executing our plans, and our team remains focused on delivering results and improving our position for the future.

Our balanced approach to growth is the right path, as we are increasing our focus on adding high-quality subscribers and reducing attrition and not just growing solely for the sake of growth.

Before we open up the line for questions, I wanted to quickly recap our progress on the priorities we laid out for this year at our Investor Day meeting back in December.

The first priority was to stabilize attrition. While we expected some headwinds in the first half of the year, I'm encouraged by our performance this quarter, as we are starting to see the impact of our retention improvement initiatives, and we expect to see further improvements in attrition in the back half of the year.

Our second priority was to optimize our indirect channel. During the second quarter, we continued to drive improvements in the quality of our authorized dealer channel, adding to our subscriber growth. With our new leadership in place and an improved mix of dealers, we are positioned to drive better growth in the second half of the year.

The third priority was to meaningfully improve our margins. Our EBITDA and recurring revenue margins in Q2 are reflective of the progress we have made, and we still continue to focus on improving efficiencies in margin rates and SAC, while making smart investments to strengthen and grow our business, which leads me to our fourth priority, investing to grow organically and via M&A. As we've discussed, we're continuing to invest to strengthen Pulse and establish new partnerships to expand our customer base. In addition, the Protectron acquisition brings us new capability and strengthens our position in the important Canadian market.

We are energized by what we can accomplish in the second half of the year and committed to delivering results.

With that, I'd like to open up the line for questions. Parita, can you provide the instructions for questions?

Question-and-Answer Session


[Operator Instructions] Your first question comes from the line of Shlomo Rosenbaum from Stifel.

Shlomo H. Rosenbaum - Stifel, Nicolaus & Company, Incorporated, Research Division

I want to focus on 2 items. Number one, the discussion of the ability to generate new subscribers. In the last quarter, you talked about some disruption in the market in the lead generation. It seems like you guys feel a little bit better about that now. If you can just elaborate a little bit more on what you're expecting over there and what might have changed or what you guys have changed and how you expect that to play out. And then I have a follow-up.

Naren K. Gursahaney

Okay. So I'll answer that, this is Naren. First, as we mentioned on last quarter's call, we saw a significant increase in advertising spend by some of our new competitors and that had an impact, kind of at the top of the funnel from the lead generation perspective. I'd say that, that has stabilized. We have not seen an increase, and in fact, we might have seen a modest decrease in advertising levels for some of these new players. At the same time, we have increased our spend. We have increased our over cost -- overall cost significantly, but we've taken more dollars, more of our working dollars, through advertising, and we've established efficiencies elsewhere. At the same time, we are continuing, as Mike talked about and I mentioned in the last quarter call, driving our self-generated activities. Again, I think this is an advantage we have over the new competitors in that we have this field sales force that is capable of supplementing the leads that we provide them with their own local relationships in the market, and we saw some improvements on that during our second quarter, and we expect to continue to grow that aspect of the business as we move forward.

Shlomo H. Rosenbaum - Stifel, Nicolaus & Company, Incorporated, Research Division

Okay. And then just moving to subscriber acquisition costs. There -- if I just go through the slide deck, it looks like at least the SAC required to maintain things flat is only up about $5. Is there anything else that's being excluded from that number? Or is there another way I should look at that? And then just from a longer term, I know there's things that you guys are testing from an operational standpoint. Can you just give us a little bit more detail on what exactly is going on or what you expect to roll out in the next few quarters in terms of making the installation a lot smoother and quicker installation and how you expect that to improve the SAC cost?

Naren K. Gursahaney

Sure. Maybe I'll ask Mike to answer the first part and then I can talk a little bit about some of the initiatives we have in place.

Michael S. Geltzeiler

Yes, so what we talked about in the slide deck is the -- that -- I mean, we gave you the weighted average kind of SAC cost or creation multiples for both channel dealer and direct. And I'm not sure about the $5 number, but clearly, we're spending more, 13% more on the dealer side than last year and 18% more on the direct side than last year on subscriber acquisition costs, excluding the upgrades. The higher cost, as we said different, is no different than the first quarter, and we're continuing to see really positive trends in this regard. It's higher automation, higher Pulse. Clearly, we're putting in more equipment and the labor costs are higher. When customers are looking for that, we also get a much higher return in price, as I said, on average 25% more for our Pulse customers. So I think -- we are pleased to see that the -- we are expecting SAC to come down. There are efficiency opportunities. We've taken some actions during the quarter, including some changes to our capacity and our cost base there. But with the Pulse take rates rising and the automation incidents rising, even getting a sequential improvement on direct SAC was a positive step in the first -- towards that. And as I mentioned, one day, when we do get to a point where we have the exact same mix of customers, new customers, coming in on Pulse or automation than the previous period, I think you'll see the full effect of the reductions. I'll let Naren talk about some of the reduction ideas.

Naren K. Gursahaney

Yes, Shlomo, specific to the installation side, as I mentioned in my comments, we've developed a new wireless product platform for our Pulse offering, which streamlines the installation process and allows you -- allows our installers to just be more efficient in how they install the product. We're in the friends and family pilot, and in fact, I had the system installed in my house a couple of weeks ago. And when I looked at the installation time for the system they installed versus our traditional Pulse systems, it is significantly lower. Now it is a little bit higher product cost, but we offset the higher product cost with -- we more than offset the higher product cost with lower labor cost and lower time. And the time, I think, is clearly a savings for us financially, but it's also a customer satisfier. They clearly don't want people in their homes doing installations for a long period of time, so we do get a customer sat benefit out of that process as well. In addition, we are developing and implementing new automation tools around the provisioning process and around other aspects of the installation process. We've got a pretty broad suite of things we're doing. And then as Mike mentioned, we've also got things that come outside of the installation process, our e-contract, what we're doing to become more efficient in our lead generation and our online activities also add to the total SAC benefits that we're seeing.

Shlomo H. Rosenbaum - Stifel, Nicolaus & Company, Incorporated, Research Division

Okay. Can you just point us to where -- did you have that in the slide deck, where you saw -- where you showed the growth in SAC? I was just referring to kind of the average weighted SAC costs that it took in the steady-state free cash flow, but you referred to something else. Can you just point us to where that is?

Timothy J. Perrott

Page 8.

Michael S. Geltzeiler

Yes, well, Page 8, we're showing you the SAC creation multiple improvements, but we'll cover that offline.


The next question comes from the line of Ian Zaffino from Oppenheimer.

Ian A. Zaffino - Oppenheimer & Co. Inc., Research Division

First would be on the acquisition up in Canada. Help us understand how that sort of fits into your footprint there. How did this deal come about? Was it negotiated? Did you go to them? Or did they go to you? Can you just kind of help us understand how you arrived at that price?

Naren K. Gursahaney

Yes, well first, let me kind of get through the strategic aspects of it. This was a company we've known for years. We've competed against them. We have a lot of respect for the capabilities they have from a management perspective, from their sales, both direct and dealer channel. And as we learn more through the acquisition process, some of the practices they have around customer retention, so it's a very high-quality asset, one that we've known about in the past. This was a negotiated deal between us and the private equity owner that we've been working on for the past several months. But again, I'm very excited. As far as how it complements us in the marketplace, again, we both have a footprint that comes across Canada but where their strengths and their headquarters are more in Québec, where we have a stronger footprint in Ontario and also in the West. So I think from a footprint perspective, there clearly are some complementary advantages, as well as both their sales channel and their, both direct and dealer, I think there's a lot of complementary aspects of this acquisition.

Ian A. Zaffino - Oppenheimer & Co. Inc., Research Division

Okay. And then I know you touched on a little bit of the weather in the quarter. Was that -- I guess, how much of kind of the headwind would be attributed to the weather per se, other dynamics going on? I'm just trying to kind of disaggregate between the 2 drivers.

Naren K. Gursahaney

Ian, I'm not going to use the weather as an excuse for us. I mean, I look at it and say everyone in the industry, everyone in every industry basically, had to deal with the weather challenges. I would say we did have more office closures in the second quarter of this year than we saw both in the first quarter, as well as the second quarter of last year, because we just could not get to one, our offices and then two, our customers, and we probably saw more install cancellations from a customer perspective. But again, at this point in time, it's our responsibility to overcome things like that.


The next question comes from the line of Jeff Kessler from Imperial Capital.

Jeffrey T. Kessler - Imperial Capital, LLC

As you know, might expect, I know Dan and I know Protectron pretty well. And I'm wondering, first, there is a bunch of SG&A up there and I'm thinking in terms of the way you presented this, this seems to be somewhat dilutive in some way at the very beginning. How long is it going to take you to take out and integrate the, well, the office, the admin, the stuff like that and make it a net contributor to the arrow, so to speak, that Mike had up in his slide?

Michael S. Geltzeiler

Yes, I mean, I'll take that. Look, I think, as Naren mentioned, this are 2 complementary businesses. They both are pretty large scale. We both have about 800 or 900 employees, so we're excited about the brand. They have a large dealer network, so I think we're going to proceed slowly but intelligently on this. The -- there definitely is some administrative synergies, a lot of them are with the U.S. Even our business today is supported almost, run almost as a branch of the U.S. rather than as a Canadian business. So that's what excites us the most, of really creating a standalone Canadian business with the right resources there, taking advantage of the market opportunities in Canada. I think, right now, we're in the regulatory process. We need to get approval, and I think we'll be laying out more information. As far as the accretion, dilution thing, I mean, you're probably -- your -- what you said is accurate. From a cash point of view, it's accretive kind of initially, because of the purchase accounting and some of the intangible amortization, and there's a couple of things on the deferred side that sort of go away and you got to rebuild. They'll be -- it will be dilutive in the sort of first year or so, but with the synergies and with the growth projections and with what this deal does for both companies, I think it helps revitalize our Canadian business, as well as we think we bring things to the table that can help them grow. We see this quickly getting to be EPS accretive as well.

Jeffrey T. Kessler - Imperial Capital, LLC

Okay. I know that Protectron's had a pretty good self-generation culture in and of itself. And I'm wondering, did that play at all into your consideration? And how do you, let's say, imbue some of the stuff that you're doing down here with what they've been doing up there on a self-generation lead basis?

Naren K. Gursahaney

Yes. Well, again, Jeff, the deal isn't expected to close for a couple of months. So once we get in there, we'll be able to dig deeper. But clearly, their self-generation capabilities plus their attrition management capabilities were 2 of the attraction. And then -- and again, that's why, look, going back to Mike's discussion about bulks versus acquisitions, acquisitions like this bring a lot of capabilities with them that can help us, not just in that market, but can help us in our core U.S. market as well.

Jeffrey T. Kessler - Imperial Capital, LLC

Okay. Your cash tax rate was up a little bit, it's about 8%. I'm wondering how -- what affects the cash tax rate to make it go above 5%. And is this an anomaly or is this something that we should be looking at to go back down? Or is it just going to remain at around 8%?

Michael S. Geltzeiler

Yes, thanks for the softball question. So I mean, cash is cash, right? We remain with the 5% to 7% long-term rate. We were only 3% in the first quarter. In this particular quarter, we had some estimated tax payments we had to make, federal, and a onetime payment we made to Canada. So sometimes, some quarters, you get 9% or 10%. Some quarters, you pay no taxes in cash, but 5% to 7% will be the cash taxes for the year.

Jeffrey T. Kessler - Imperial Capital, LLC

Okay. One of the things that you haven't talked about and you remain conspicuously quiet about on this call -- on the report is your SMB program and the setting up of your verticalization. And do you have -- are you guys ready to go, effectively on October 1?

Naren K. Gursahaney

Well, I guess, there's 2 pieces to that, Jeff. As far as our SMB business, we're continuing to invest in growing that business. We have vertical strategies within our SMB business, and we launched a vertical bundle around retail and have seen a lot of really good success around that. We will be rolling out additional bundles in that, in the Small Business side. Post October, Mike handed me a note -- food and beverage is the next focus area for our bundles within the existing SMB portfolio. We are in the process of putting together our strategy for post-separation -- or excuse me, post the expiration of the non-compete, but I don't think we're in a position to talk about that in any detail right now.

Jeffrey T. Kessler - Imperial Capital, LLC

Okay. Finally, one final question. I might have other questions, but I'll keep them offline. I've noticed that once -- a number of your small competitors in the security industry have actually gotten -- once they've gotten to penetration rates in their interactive wireless systems that are up around 50%, 60%, 70%, they begin to get efficiencies in that business that allow even -- that allow them to offset the cellular costs, even without the, some of the new electronic and hardware things that you're doing. The question is, is, where did -- do you -- can you figure out -- have you figured out a point at which you need a Pulse penetration rate for you to gain enough efficiencies to offset the, effectively the increased cellular cost?

Naren K. Gursahaney

Yes, Jeff, I mean, I guess when I look at the increase in cellular costs, that's not a big driver of our cost increase. When I look at traditional versus Pulse, again, we have cellular backup or cellular primary on our traditional security systems, generally, we're riding on the broadband backbone in the homes. We're not putting in a separate broadband connection for the Pulse offering. Our cost increases tend to be more on the service side, because it is more complex from a diagnosis, although we're developing tools to help that, and then also some of the license fees that we pay to our partner, which we have an investment in.

Jeffrey T. Kessler - Imperial Capital, LLC

Okay. Quick -- one quick final question and then I'll get off, and that is, there's been an avalanche of articles about DIY, and let's just say, standalone products, and we've even written about a lot of this stuff, too. Do you have any strategy? Do you have any interest in getting involved in those markets, particularly those city or apartment markets that are taking these standalone products and making them part of a monitored system?

Naren K. Gursahaney

Well, again, our strategy has always been focused on how do we increase the penetration for monitored security beyond that 20% range, where the industry has been for years, so we're looking at all different ways to be able to expand the size of the pie and I'd say more to come on that front. Clearly, the value that ADT brings is in that monitored security and the home automation piece. So we'd be looking for something, products and solutions that are consistent with our business model and our overall strategy.

Jeffrey T. Kessler - Imperial Capital, LLC

All right, great. And just one final thing, congratulations to Dan. I've known him a long time.


The next question comes from Nigel Coe from Morgan Stanley.

Jiayan Zhou - Morgan Stanley, Research Division

This is Jiayan Zhou filling in for Nigel. So we're just hoping maybe can you provide some color on the Protectron business in terms of maybe margin profile? And you also mentioned there are some nonrecurring revenues. So how sustainable [ph] is the recurring revenue portion? Anything will be helpful.

Naren K. Gursahaney

Well, what was the last part, how...? I didn't hear.

Michael S. Geltzeiler

In nonrecurring.

Naren K. Gursahaney

I'd say 2 things. One is, as Mike mentioned, this will be, in the short term, dilutive to our business, so their margin rates, again, this is not a public company, so there's not a lot of public information. Because of their scale, they don't run at the same margin rates that we do. But again, hopefully, as we combine the businesses and achieve the combined scale of the businesses, we can improve those margin rates over time. And they do have some commercial business that is of a nonrecurring nature, but it would be more what you would see in traditional commercial businesses.

Michael S. Geltzeiler

When you value in the company, there is some -- I think what we like to do is, given that we're in this regulatory review and it's highly unlikely that we close or start to report this before the fourth quarter, I think on the third quarter call, when we're further along in the process, we'll provide a little more financial guidance.

Jiayan Zhou - Morgan Stanley, Research Division

Sure, understood. Maybe just one quick question also on Protectron, not sure if the information you can provide. So attrition seems to be lower than ADT average, which will be beneficial. What about ARPU? Do they generate average lower ARPU than ADT average?

Naren K. Gursahaney

They are lower than the ADT average, but maybe a little bit more consistent with what we see in Canada, and Canada has always run at a slightly lower ARPU there. So it's a little bit lower than Canada, but not a big difference there.

Michael S. Geltzeiler

Part of it being lower is we do see an opportunity to increase the incident of automation. They are selling automation, but we think when we combine the 2 companies together, there'll be a greater opportunity to grow that ARPU and to sell higher-value products in Canada.


The next question comes from the line of Charles Clarke from Crédit Suisse.

Charles Clarke - Crédit Suisse AG, Research Division

Two-part question on Pulse and then just one follow-up. The first on Pulse, are you guys holding the $50 price for new Pulse customers? And then secondly, you guys, today -- I mean, if I really look at the SAC today, we're talking about 45% blended take rate for new customers are Pulse customers. And when we're looking at voluntary attrition today in your attrition bucket, nobody coming off contract is a Pulse customer. And then really, you guys have talked about the benefits of Pulse, kind of in how you get better utilization out of the system and that hopefully kind of after year 3, you will see, with Pulse customers, a much better kind of impact on voluntary attrition, because they'll be getting use out of the system. If I look at the attrition number today and all the voluntary attrition, you can imagine the people coming off contract, none of those are Pulse customers. In which year should we see kind of -- should Pulse start to kind of make an impact? If it does benefit the voluntary attrition, when is really the turning point for attrition from that aspect?

Michael S. Geltzeiler

I mean, it's really a mix issue. I mean, we're up to 12% of our customers. I mean, up until this quarter, it was 8% or 9%. So I think to your point, the statements you made are accurate. I mean, we're just getting -- some Pulse customers now that are around the 3-year period. But usually, we're seeing stickier, obviously, retention with Pulse customers. I think the only time we tend to lose them is when there's a relocation. And exactly our belief is we can't get people on the automation fast enough if they're prepared to pay the higher ARPU. It's not for everybody.

Naren K. Gursahaney

Yes, I think Mike hit the nail on the head. When you look at it, Charlie, we launched the product back in late 2010. So over the last, I'd say, 6 months is when the first wave of customers started to come off of contract and that's when it would start to have the impact. Clearly, the higher-end automation systems have better retention characteristics because those are the ones that tend to engage the customer even more than just being able to arm and disarm and get alerts sent to you. And that, if I recall correctly, in our early days of the launch, we were probably north of 80% level 1, so 20% in the higher-end automation and that's continued to grow. So I think as we move forward is we should see a bigger and bigger impact, as you pointed out, in that voluntary area. And then also, as we do more upgrades, the upgrades, again, should have an opportunity in the shorter term as we do them, but again, that's a relatively small piece of our overall 6.5 million, 6.4 million customer base.

Charles Clarke - Crédit Suisse AG, Research Division

Is the -- the $50 still holds?

Naren K. Gursahaney

Yes, we're still holding right around $50.

Charles Clarke - Crédit Suisse AG, Research Division

And then when we talk about Canada, just as a question just in terms of the overall market, I saw just revenues in 2010 were just a little over $200 million, last year $185 million, so it doesn't seem like a -- at least kind of within your statement, a market that's grown a lot for you. It just kind of -- and this business almost -- this acquisition almost doubles your business in Canada. So looking at that, is there something about the Canadian market or there's just been a lack of focus? Or how would you kind of highlight that, that Canada is a good market for you guys?

Naren K. Gursahaney

Yes, Charlie, I would say it's a good, attractive market with some very attractive characteristics. You're absolutely right, has not been a big growth and that has purely been focus. As Mike mentioned, we've really historically run Canada almost as a branch or extension of our U.S. business. And I'll just give you one example. We didn't roll out Pulse into the French-speaking part of Canada until earlier this year, even though -- again, and that was just the focus of investment, of building those French capabilities into the solution, into all of our collaterals and supporting materials. I think just having greater scale there with a local management team that will be reporting directly to me will bring greater retention and greater focus on that market.

Michael S. Geltzeiler

And allow our Residential and Small Business, the U.S. team, to focus on the growth in the U.S. and not be distracted by that additional market.


Your next question comes from the line of Lee Cooperman from Omega Advisors.

Leon G. Cooperman - Omega Advisors, Inc.

I apologize if this question was asked before because I had to leave the call for a while. But I've asked this question numerous times in the past and I'm going to ask it again, because to me, it's probably one of the more important questions that we're dealing with as investors in the company. I look at a company's buyback program and evaluating the management decisions no different than I would value planned equipment decisions, investment decisions, acquisition decisions, et cetera. You guys have brought back a s***load of stock at very inappropriate prices, as far as I can see. I would like to understand what analysis has been done to justify paying $44.05 to Corvex or the current price of $38.49 for the $1.4 billion that you bought thus far this year. Are you highly confident that the price you're paying are realistic? And for those of us not selling, and therefore, enlarging our ownership of the company, that you're making the right decision for management that own stock, the board that own stock and shareholders that are not selling, and therefore, enlarging their ownership of the company? Because this is the largest investment you're making in terms of -- you could look at simply I'm giving money back to shareholders and I could care less what I pay, or we're doing it because we think we're leveraging the return to the long-term investors. So if you could really dwell on this, because your acquisition decisions are not as much as you're spending on stock repurchase and your planned equipment investment is not as much as you're paying on stock repurchase. So this is your biggest investment. I'd like to know how much thought is going into your biggest investment.

Michael S. Geltzeiler

Okay. Well, first, I mean, I think our biggest investment remains our investment in new subscriber growth. So I think people are underestimating that. We're making a similar investment in our future by every day bringing in new subscribers, paying dealers for new subscribers as well. But I think it's clear in both cases, including the Protectron transaction, that we believe in our business. We believe in our, the sustainability of our business. We believe in the valuation of the business. We talked about a lot -- I mean, we have to prove it and we're going to have to prove it with the results. But from almost every valuation metric, us compared to our peers, we're selling at a discount. I think it's because people feel attrition is rising and we feel it's going to come down. And so we believe in our plan. We believe in our ability to grow adds. We believe in our ability to obtain margins and generate a good return on the invested capital and -- first, we were talking about $44, now we're buying, the average for this year, shares of $38.49. And I think that our belief, which is why we're doing it, we are in the market to buy back shares, is that the company is worth more than that and we will execute the strategy and improve that with lower attrition, with growing eventually net subscribers again and getting an appropriate valuation on the business once we can get the marketplace's confidence that the business...

Leon G. Cooperman - Omega Advisors, Inc.

Well, that's the question I'm really kind of asking you. There was -- I kind of personally believe that 90% of publicly traded businesses, and particularly ours, because of our franchise, has 2 values: the so-called auction market value, which is the price you and I pay for 100 shares or 1,000 shares; and so-called private market value, a price the strategic or financial investor would pay for the whole business. Do you believe a strategic or financial investor will be paying more for this business if they were to buy it, than you're paying in your stock repurchase program, including the $44.05 that you paid in that large purchase? That's the question. And have you done enough analytical work to feel comfortable in that view?

Naren K. Gursahaney

Lee, I'll answer the second part of that question rather than the first part of the question. We've done a lot of analytical work. We also worked with our advisors, our bankers, and we believe in the long-term value of this company. What a strategic or financial buyer would pay, you'd have to talk to them. I wouldn't speculate on what others might see in this thing. When we valuate this company, the value of the portfolio, the value of the production engine, the future opportunities we see, we feel that the valuation is significantly higher than where it is.


The next question comes from the line of Jim Krapfel from Morningstar.

James Krapfel - Morningstar Inc., Research Division

Just want to get your outlook for the dealer SAC. With the new competition out there in the marketplace, are they utilizing the dealer channel to any extent? And are you seeing in general just more competition for customer accounts from dealers?

Naren K. Gursahaney

No, Jim. I would say the increase that we're seeing in dealer SAC is really driven by 2 things. One is the alignment of the incentives. We want our dealers selling Pulse and selling higher-end automation. And we've aligned the incentives to drive them in that direction. And then two is just the fulfillment of that strategy. As their Pulse take rates grow, SAC will grow, because we pay a multiple of recurring revenue -- excuse me, the recurring revenue that they bring. So I think that's completely consistent with our strategy on the dealer side. I think the paring down of the dealer portfolio was really focused on giving us better quality dealers who's business incentives are aligned with ours, which is selling Pulse and driving high-quality, stickier customers.

James Krapfel - Morningstar Inc., Research Division

Okay. And then just a second question quickly. The industry growth rate hasn't really accelerated to the extent that you and others in the industry had expected, especially with the advent of home automation. Are you seeing any signs of an improvement here? What do you see going forward?

Naren K. Gursahaney

No, again, there's not great industry data out here, because most of the companies in the space are private, so we're kind of limited from that perspective. But I agree with the thesis there, I don't think we've yet seen the significant acceleration as a result of home automation. But I still think that there is an awareness issue that is continuing to grow. And clearly, some of these new competitors coming in and increasing their advertising spend, driving overall awareness, I think we've all said all along, that, that will be the benefit. That, that's the piece we're going to watch very closely and I think we're going to continue to look at other ways to increase that penetration.

Timothy J. Perrott

Great. Well, thank you, and we're going to end our call here, Parita. Thanks everyone for joining the call and we'll talk to you soon. Thank you.


Thank you. Thank you, ladies and gentlemen, for your participation in today's conference. This concludes the presentation, and have a good day.

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