The ADT (ADT) Naren K. Gursahaney on Q1 2016 Results - Earnings Call Transcript

| About: The ADT (ADT)

The ADT Corp. (NYSE:ADT)

Q1 2016 Earnings Call

February 02, 2016 8:30 am ET

Executives

Timothy J. Perrott - Vice President-Investor Relations

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

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

Analysts

Jason Boisvert Bazinet - Citigroup Global Markets, Inc. (Broker)

Saliq Jamil Khan - Imperial Capital LLC

Ronnie Weiss - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Shlomo Rosenbaum - Stifel, Nicolaus & Co., Inc.

Jane Zhou - Morgan Stanley & Co. LLC

Jeffrey T. Sprague - Vertical Research Partners LLC

Operator

Good day, ladies and gentlemen. Welcome to The ADT Corp. First Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. As a reminder, this conference call may be recorded.

I would now like to turn the call over to Tim Perrott, Vice President-Investor Relations. You may begin.

Timothy J. Perrott - Vice President-Investor Relations

Thank you, and good morning to everyone, and thank you for joining us for our call to discuss ADT's first quarter results for fiscal year 2016. With me on the call 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 actual results to differ from these forward-looking statements are set forth within today's earnings release, which was furnished to the SEC in an 8-K report, and in our Form 10-Q for the year ended December 31, 2015, which we expect to file with the SEC later today.

In our first quarter 2016 earnings release and slides, which are now posted on our website at adt.com 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 that 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 commentary this morning. Please note that unless otherwise mentioned, references to our operating results exclude special items and these metrics are non-GAAP measures.

Now, let me turn the call over to Naren. Naren?

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

Thanks, Tim, and good morning, everyone. Thank you for joining our call today. I hope you had a chance to review our earnings press release we issued earlier this morning that highlights our results for the first quarter of 2016. This morning, I'll discuss our key performance highlights and accomplishments for the quarter. Then Mike Geltzeiler will provide additional details on our financial and operational performance.

We're off to a solid start to 2016, delivering improvements in our financial results and operational metrics, and setting the stage for subscriber growth and higher free cash flow generation in the future.

We also made great progress on our future growth platforms as we continue to invest in our traditional business, expand in adjacent markets and target the unpenetrated residential market with exciting new products, services and partnerships. Our continued focus on customer retention and quality growth fueled our results, reinforcing that we're pursuing the right strategies and priorities in an industry that's showing more opportunities for growth than ever before.

Beyond the Q1 financials, we have a lot of exciting things going on across our business, several of which we showcased at the International Consumer Electronics Show last month. At CES, we announced our new Security-as-a-Service offering, initiated several new partnerships and demonstrated how our ADT services can integrate with many popular IoT devices, including life safety products, wearables and connected home hubs.

We're relatively preparing for the launch of this LG Smart Security device that will allow us to target a very large segment of previously untapped residential customers. Our commercial and health businesses continue to exhibit strong growth and represent significant upside opportunities for our business.

Before I discuss the details on our progress for the quarter, I think it's helpful to reflect on the path we've been on for the past few years. Since we became a public company over three years ago, we made steady improvements on operating performance as we benefited from the initiatives we deployed to enhance our operations and strengthen our competitive position and to generate quality growth. Our strong performance last year was the result of executing the plan we launched in 2014 and, at the core of this plan, was improving customer retention, which remains our number one priority.

I view this year as the continuation of this focus as we use enhanced tools, leverage deeper customer insights as a result of better analytics and adopting even more disciplined sales approach to move into the next phase of our quality growth plan that is designed to further improve retention, generate strong financial results, and yield better free cash flow in the future.

Slide number three highlights the details of our key operational and financial performance in the quarter. Solid execution of our plans drove a year-over-year improvement in attrition, an increase in ARPU, a reduction in SAC, and improvements in cost to serve. These operational improvements provided a foundation for better financial results in the quarter, as we delivered revenue growth and increases in EBITDA, margins and bottom line results, especially when adjusting for some of the non-recurring items in the quarter. Mike will cover more details on both our operational and financial performance in a few minutes.

On slide number four of our presentation, we highlight the continued strong performance over the past 12 months on four key metrics that are affected by the competitive environment. Over the past year, we have driven a 70-basis point improvement in customer retention, increased the average price paid by newly added customers, and reduced our creation multiple by 1.4 times.

Overall, gross adds were essentially flat to last year, as we drove an increase in production in our authorized dealer channel, which was offset by a decrease in our direct sales channel as we rolled out the next phase of our quality growth plan in this channel. This phase has even more selective customer targeting and increased customer upfront requirements with the goal of improving the quality of customer accounts we are adding in order to further improve retention and drive the desired return on investment. I'll share some additional details on our efforts in this area in a moment.

Slide number five highlights some of our key accomplishments related to the three pillars of our strategy that I've discussed on previous calls. Over the next few slides, I'll discuss each of these elements of our strategy, starting with our actions to target the non-traditional residential market.

As I mentioned earlier, we continue to be excited by the opportunity and are encouraged by the progress we're making towards entering a large segment of the unpenetrated residential market; a market that represents approximately 50 million potential new subscribers in the U.S. We had our best ever showing at CES where we showcased our new services and development partnerships that we believe will be a source of considerable growth for ADT over the next few years.

A summary of our progress in some of the key announcements we made at CES are shown on slide number six. We announced the launch of ADT Canopy, our new Security-as-a-Service offering that allows us to secure more residences as well as mobile on-the-go customers. This service integrates ADT's professional monitoring services with many popular IoT devices, including life safety products, wearables and connected home hubs.

Under ADT Canopy, we initiated new development partnerships with leading consumer electronics and life safety companies that will allow us to extend our professionally monitored services and increase our market penetration.

In our booth, we also demonstrated some of the functionalities of the all-in-one security device we developed in partnership with LG Electronics. LG Smart Security, our first consumer product secured by ADT Canopy and designed specifically for the unpenetrated residential market. It integrates professional monitoring with a plug-and-play security device. We expect to launch this product in the early spring.

The ADT Canopy business model required very little upfront investment by ADT to on-board new customers, enabling us to offer very attractive pricing and a no-term contract. This will help us attract new customer segments, while generating an attractive return for our shareholders.

We have also accelerated our expansion into adjacent markets, leveraging our monitoring and field sales and service capabilities as well as our strong brand awareness to increase penetration and gain share in these markets.

As shown on slide number seven, our expansion efforts in Business and Health contributed to our results, with strong subscriber growth in both of these channels. In ADT Business, which comprises the small business, national accounts and commercial market segments, we delivered double-digit subscriber and revenue growth, while continuing to invest in new products. We're very encouraged by our position and the response we are receiving in this market, as this market represents a $24 billion market opportunity for ADT.

In our health channel, we're investing in new distribution channels and drove a 30% increase in gross adds, generated net customer growth during the quarter, and increased recurring revenue by over 7%. In our traditional business, we improved operational performance and began rolling out the next phase of our quality growth plan.

During the quarter, we took actions to further improve the quality of the subscribers we are adding to our customer base through our direct residential sales channel. Several of these actions had an immediate impact on our key operating metrics, including higher ARPU and lower SAC and creation multiples, which are good indicators of quality revenue growth for the future.

With additional insights from our customer analytics and better tools to manage our sales force, we are adding customers with improved retention characteristics and under more favorable terms for ADT. We're confident these changes will translate into further improvements in attrition in the future.

I'd like to spend a few moments discussing our progress on our quality growth plan and how this translates into future shareholder value. Slide number eight shows some of the key actions we're taking in our journey to improve customer retention.

In 2015, we took several steps that included introducing credit for tenure screening in our direct sales channel to identify and filter out credit-challenged customers. We also deployed a new order management platform, strengthened our customer analytics capabilities and invested to improve the customer experience.

While our tenure screening efforts filtered out approximately 4% of our gross adds in 2015, these efforts contributed to a 100-basis point reduction in customer attrition as well as improved creation multiple and higher ARPU.

In 2016, we've begun implementing the next phase of our plan, which includes further tightening customer screening requirements and optimizing customer offers to help improve ROI through increased customer upfront payment requirements and greater use of more efficient lead generation vehicles. We're also embedding these new sales requirements into our electronic order entry tool to help ensure that our sales force is delivering the right solution to the right customers.

Finally, we're deploying our customer life cycle management strategy to ensure customers have access to new innovations and are able to adopt these to keep their systems state-of-the-art. All of these efforts are aimed at improving customer retention and customer economics. And while these actions have contributed to lower gross adds in our direct sales channel and contributed to a net customer loss of 20,000 subscribers during the quarter, it's important to recognize that this is a conscious decision to forego sales opportunities that do not meet our criteria and would likely result in poor returns for our shareholders.

We're confident our strategy and actions will improve customer quality, lead to better sales characteristics, increase Pulse and Pulse Automation take rates and significantly improve customer economics over time. Ultimately, they'll allow us to deliver further improvements in retention and customer return on investment, drive higher margins and increased cash generation.

On slide number nine, you can see the impact these actions have had on some of our key operating characteristics for customers added via our U.S. direct residential channel. New and resale ARPU was up nearly 6% over last year, as we drove more Pulse and increased the percentage of customers using Pulse Automation which has better retention characteristics.

Our efforts to increase the customer's upfront payment requirement and higher Pulse Automation take rates led to a 20% increase in installation revenue per customer versus the previous quarter. Our customer analytics show that when a customer had more invested in their system, they tend to stay with us longer. Creation multiple also improved as we continued to be disciplined in our sales approach and lowered our subscriber acquisition cost.

In essence, we're not chasing certain leads and sales just to grow gross adds. In addition, we're signing up more of our customers on our automated billing program, ADT EZ Pay. We believe all of these positive characteristics of our new customers in this channel will lead to a future reduction in attrition and better returns.

Increasing Pulse penetration and take rates continues to be an important element of our quality growth program. On slide number 10, you can see that nearly 60% of our total gross adds during the quarter were Pulse units, up from 53% a year ago. In our residential direct channel, the Pulse take rates for new and resale unit was 66%, while 77% of all new residential customers added via this channel were Pulse customers.

In our dealer channel, the Pulse take rate ramped up to 55% from about 50% last year. And in our small business channel, the Pulse take rate was 43%. We not only increased the Pulse take rate but also moved the percent using automation features to almost 60%, driven by the quality growth program and aided by our Nest partnership.

In addition to new Pulse sales, we also upgraded about 48,000 existing customers this quarter, including some customers we upgraded while converting them from 2G radios. Pulse upgrades allow us to provide additional services to our existing customers and yield higher ARPU. In addition, these upgrades allow us to enhance the customer experience and enter into new contracts with these customers. We now have approximately 1.6 million customers, with total interactive customers now comprising about 25% of ADT's total customer base.

As we've discussed on previous calls, Pulse customers continue to demonstrate better retention characteristics than traditional security customers. Our analysis also showed that retention further improves when customers choose automation features such as thermostats, light switches, door locks, and cameras. Equally as important, our initial data also showed that the resale rate, the rate at which we signup a new customer who moves into a home where Pulse Automation is already installed, is higher compared to the non-Pulse customers.

Now, let me turn things over to Mike to provide some additional details on our financial and operational performance for the quarter.

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

Thanks, Naren. Our company performed well in 2015, meeting or exceeding all our major financial and operational goals and building a foundation for an even better performance in the future. We are confident and excited about the initiatives we are pursuing with quality growth, our investments in commercial and health channels, the upcoming launch of the LG all-in-one offering in our ADT Canopy service.

Many of these initiatives and the underlying improvements in our fundamentals have yet to be reflected in our stock price, which has been further impacted by the volatility of the financial market. As of this call, we're trading at near historic lows and multiples from recurring revenue at 36 times, EBITDA at 5.5 times, and our price-to-cash earnings ratio is less than 10 times.

All these financial metrics are poised to improve in fiscal 2016 and we're also guiding for growth in free cash flow driven by lower attrition. With our dividend increase that's set to begin in February, our stock also offers a yield above 3%. The issue driving the volatility of the market is beyond our control, but our managing team is committed to remaining focused on what we can control, successfully executing our strategy for future profitable growth. We remain confident in our ability to deliver another strong year of improvements in both our operating metrics and financial performance in 2016.

Now onto Q1 performance, slide 11 summarizes our GAAP and non-GAAP financial results for the quarter. In the first quarter, recurring revenue, which accounts for approximately 93% of our total revenue, grew to $833 million from $825 million last year, and total revenue increased by $13 million to $900 million. Total revenue growth was higher than our recurring revenue growth as we are selling incremental products and services to our core offering as well as growing our commercial presence.

When adjusting for the 15% decline in the Canadian dollar, total revenues increased by 2.7%. Q1 reported operating expenses before special items were up 3% over last year, including a 6% increase in depreciation and amortization. As I mentioned in our Q4 call, the first quarter was impacted by six extra days of expenses relating to the change from a 4-5-4 to a calendar quarter, as well as the negative impact related to the previously disclosed change in how we account for dealer payments for leads generated through our marketing efficiency program. This is the last quarter of the negative impact of the marketing efficiency program. As we first reported the change in Q2 2015, we made a year-to-date adjustment for the way we account for these payments.

The additional six days of expenses in the quarter and the impact of the marketing efficiency program accounted for $19 million of our growth in expenses. Excluding this, cost rose by less than 1% year-over-year. Besides depreciation, the increase in total expenses was driven by the growth of Pulse and investments in our commercial expansion and other new offerings, offset by our cost reduction initiatives and some favorable FX.

EBITDA before special items rose $4 million to $457 million. This amount included the $22 million negative impact for the previously mentioned change in the way we account for the marketing efficiency program, the extra six days, as well as the negative impact of approximately $5 million due to the decline of the Canadian dollar. Adjusting for these three items, EBITDA before special items was $26 million or nearly 6% higher than last year. EBITDA margin before special items for the quarter was 50.8%, down slightly from Q1 2015, due entirely to expense items discussed earlier.

GAAP EPS was $0.39 per share for the quarter. Excluding special items, non-GAAP diluted EPS was $0.49, which includes an unfavorable impact of $0.07 per share relating to the prior mentioned marketing efficiency program, extra days and FX. This compares to non-GAAP diluted EPS of $0.51 per share last year. Using our cash tax rate versus our book rate of 32%, diluted earnings per share before special items was $0.71 for the quarter.

Finally, slide 11 also details our special items for the quarter. In Q1, we incurred $24 million of radio conversion cost as we successfully converted 124,000 2G customers, a portion of which we were able to up-sell to ADT Pulse. We also incurred some integration expenses in Canada and restructuring charges. As of this call, we have less than 300,000 2G customers remaining to convert, down from 1.6 million when we announced the program. We're ahead of plan and expect to be virtually complete by fiscal year-end.

Turning to the operating leverage, slide 12 shows gross adds and average revenue per unit for the quarter. Overall, total company gross adds were 259,000, relatively flat versus last year, with gross adds in our direct channel down by 8%, offset by a 10% increase in dealer gross additions, which includes a bulk account purchase of about 3,000 accounts.

We continue to make progress in our Business and Health channels, where gross adds were up 11% and 32% respectively. Our enhanced focus on quality growth, combined with enhanced tenure screening, created some constructed headwinds in our U.S. direct residential channel overall, but resulted in improved new customer characteristics and better financial results.

We will continue to use data analytics to drive our customer acquisition practices to attract the right customers with the right promotions. And once installed, we're committed to enhancing the customer experience. We feel this is the recipe for lower future attrition.

Pricing remains healthy in our business as we continue to grow both the average, new and resale ARPU. Higher Pulse take rates with greater automation combined with growth in our business channel has driven higher ARPU. New and resale ARPU in the first quarter was $48.52, an increase of 2.6% or nearly 4% in constant currency over the prior year, while ARPU for our overall customer base was $42.87, an increase of 2.7% year-over-year. When adjusting for the Canadian FX impact, average revenue per unit was up by close to 4% over last year.

Our quality growth strategy is driven by our focus on improving customer retention, growing free cash flows and returning ADT to net subscriber growth. Slide 13 shows the progress we have made on customer retention. As previously communicated, we will only report customer unit attrition as this is a key metric for measuring attrition for resi and business account. Our unit attrition remains at 12.2%, matching our lowest levels since becoming a public company.

On a year-over-year basis, unit attrition improved by 70 basis points. Improvements are led by the progress we made in gross attrition, reducing non-pay and voluntary disconnects, coupled with a 13% year-over-year increase in resale. Relocations moved slightly higher this quarter as housing market continues to improve, but this is more than offset by attrition improvements and higher retail. We remain committed to our full year guidance of reducing net attrition below 12% by year-end and 11% over a multi-year period.

Slide 14 outlines our quarterly financial results for recurring revenue margin and SAC creation multiples, two efficient key areas that we've been working hard to improve. In the first quarter, recurring revenue margin at our existing customer base improved by 20 basis points to 66.6% compared to 66.4% last year. We improved margins despite the expense anomalies discussed earlier and incremental investments in our commercial expansion, launch of our all-in-one DIY product and the ADT Canopy service.

SAC remains an area of opportunity for our company, and we continue to build on the momentum of 2015. Last year, we consistently lowered SAC through marketing efficiencies, implementation of electronic contracts, and rollout of our TS panel. And these investments continue to drive efficiencies in these areas.

In the first quarter, our combined net creation multiple improved by 1.1 times to 30.6 times, while the net creation multiple in our direct channel fell to 30.5 times, a 1.4-time improvement from last year. Total company net SAC fell below $1,500 despite increased higher Pulse Automation take rates and growth in our small business and commercial channel. Continued execution of our cost reduction initiatives and productivity improvement combined with our quality growth plan and healthy ARPU growth positively impact our cost to acquire new customers in the future.

Slide 15 details the components of our first quarter free cash flow results. The chart segregates cash flow into cash generated from existing customers and cash invested to secure new or upgrade customers to our interactive services. Reported free cash flow for Q1 was $26 million, up $12 million versus Q1 last year, and free cash flow before special items was $45 million, down $1 million versus last year.

The slight decline in year-over-year free cash flow is driven entirely by a double-digit million-dollar increase in annual employee incentive compensation payments relative to fiscal 2015. The unfavorable working capital was mitigated by the $8 million growth in pre-SAC EBITDA.

Overall, SAC investments were relatively flat this quarter at $423 million, driven by higher levels of Pulse upgrades, offset by lower SAC across both channels. Standard adoption of TS panel, more efficient marketing spend and increased upfront installation revenues all contributed to the lower SAC. In Q1, we're able to reduce the average SAC per unit on a year-on-year basis to $1,484 from $1,500.

Slide 16 details the calculation of steady-state free cash flow. We've consistently made improvements in our steady-state free cash flow results over the past five quarters. This metric captures the following key drivers of our business, pre-SAC EBITDA, SAC, creation multiples and attrition. Steady-state free cash flow before special items was $938 million, up $45 million versus prior year.

Slide 17 details our capital allocation and debt levels for the quarter. Our long-term leverage target remains at 3 times EBITDA and both our trailing 12-month leverage ratio remains flat at 3 times EBITDA and 2.4 times trailing 12-month debt to pre-SAC EBITDA. These ratios remain flat to last year despite the fact that our EBITDA results were negatively impacted as a result of the change in how we're reporting the marketing efficiency program, the calendar change and FX.

In Q1, our total cost of borrowing remained below 4% and our debt continues to trade at favorable levels. Our last two debt offerings both trade at premiums to their issuance price. Having a low cost of borrowing is a great advantage because it allows us to invest in growth and also return capital to our shareholders.

Our board has announced a third consecutive annual increase in our dividend, increasing the quarterly payment to $0.22 per share effective with the February payment. During the quarter, we repurchased approximately 1 million shares at an average price of $30, enabling us to reduce the diluted ending share count to 166 million.

Let's move to slide 18 which highlights the 2016 outlook we previously issued. We remain committed to these objectives and believe we have the right plan and initiatives in place to reduce attrition, increase free cash flow, and realize net customer growth. We expect to accelerate our revenue growth as the year progresses, driven not only by subscriber growth and lower attrition, but also by some targeted, high-quality account acquisitions, our expansion into commercial and health markets, and the launch of new services in the non-traditional residential market through LG Smart Security and ADT Canopy.

EBITDA will continue to be driven by improved subscriber quality, lower attrition, and high ARPU, cost efficiencies and synergies from the Protectron integration. We also remain confident driving attrition below 12%.

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

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

Thanks, Mike. As you heard, we're off to a good start to the year, delivering solid operational metrics and financial results. More importantly, we're aggressively pursuing our strategy of quality growth, leveraging better insights and better tools to target the right customers and sales characteristics. We continue to be excited by the investments we're making to grow our commercial and health businesses. And while we're still in the early stages of penetrating these markets, we're encouraged to see the impact of our actions beginning to show through in our results.

And finally, we continue to make good progress in our efforts to penetrate the large portion of the residential market that also cares about security, but has not been interested in our traditional offerings. The enthusiasm we saw at CES from both customers and partners reaffirms our commitment to this market and our belief that ADT is uniquely positioned to play a major role in providing monitored security services to this market, and doing so with attractive terms for customers and returns for our shareholders.

With that, we can open up for questions. Nicole, can you provide the instruction for those who wanting to ask a question?

Question-and-Answer Session

Operator

Yes. Thank you. Our first question comes from the line of Jason Bazinet of Citi. Your line is now open.

Jason Boisvert Bazinet - Citigroup Global Markets, Inc. (Broker)

Thanks so much. Just on slide 18 of your deck, regarding the outlook for 2016, I know you said you're confident you can still hit those metrics. But when I go through the Q1 results, it seems like on every – on almost everyone, if not all of them, you're sort of off to a pretty slow start. So, can you just provide as much color as you can in terms of what are the various puts and takes that will allow you to hit the full year numbers?

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

Sure, Jason. It's Naren. Why don't I go ahead and start with that. From a revenue perspective, again, the short fall in gross adds and the net customer loss does provide a little bit of challenge. But, clearly, we had planned on a ramp as we go through the year. The ramp-up in our commercial business, the ramp-up in our health business, the launch of all of the new services around ADT Canopy, and the LG Smart Security product are in the back half of the year. And clearly, we do see some opportunities for some good high-quality bulk account purchases that were part of our strategy. We didn't see much in Q1, but we have some things that we're evaluating that we feel very good about.

Jason Boisvert Bazinet - Citigroup Global Markets, Inc. (Broker)

Okay.

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

From an EBITDA perspective, I think we're – we got very good momentum. We're tracking ahead of our plan through the first quarter. Free cash flow, again, when you take out some of the unusuals on the year-over-year comparison, again, we're tracking favorably to where we expected to be in the quarter and that will ramp up as we go through the year.

Attrition, again, we're 70 basis points improved from last year, while we're flat sequentially. All of the changes that we're making relative to quality growth will have a back half of the year impact, and I feel very confident about being sub-12%.

And again, finally, the total subscriber base with the ramp-up in health, the ramp-up in commercial, some quite high-quality bulks and then the new additions that we see and the better retention in the back half of the year should still put us in a good position to deliver on a net subscriber add for the year in 2016.

Jason Boisvert Bazinet - Citigroup Global Markets, Inc. (Broker)

Okay. Thank you very much.

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

Great. Thanks, Jason.

Operator

Thank you. Our next question comes from the line of Saliq Khan from Imperial Capital. Your line is now open.

Saliq Jamil Khan - Imperial Capital LLC

Great. Thank you. Hi, Naren. Hi, Mike.

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

Hey, Saliq.

Saliq Jamil Khan - Imperial Capital LLC

Hey, guys. Could you talk a little bit about what your strategy is with ADT Canopy over the next 12 months and how you view the current partnership with LG and how that could potentially evolve as well?

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

Yeah, again, the LG Smart Security product will be the first kind of the launch product associated with ADT Canopy. At CES, we had the opportunity in our booth and in the LG booth to demonstrate some of the functionality that it can use as a stand-alone security device as well as a home automation hub, and we were able to demonstrate that. The current plan is for that product to be launched in the spring. LG is kind of controlling the launch schedule based on the retail cycles that they support. So, as soon as that's launched that will be, in essence, the launch of Canopy.

We announced a lot of new development partnerships at CES for a variety of different products, including life safety products. You saw on the slide Kidde and Roost, two of the premier partnerships we've got there, as well as wearables, looking at smart watches, where you'd be able to have to a panic button type of application on the device as well as a lot of different smart home hubs that have the ability to send a signal to notify you about an event and those signals would be sent to our monitoring centers.

So, again, back half of the year, we expect to be launching more Canopy partnerships and launch that service offering to a variety of customers in that 80% of residences that we don't support today. I think, the LG partnership, they're already talking about what the Gen 2 and Gen 3 product will be as follow-ups to the Smart Security device.

Saliq Jamil Khan - Imperial Capital LLC

Got it. I believe that the ADT Canopy solution is a very good way to continue to penetrate the overall marketplace. That obviously continues to expand as well. But what do you believe could be a competitive response to ADT Canopy?

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

Like you said, I look at it and see more partnerships than I see competitors there. Most people are looking at what we bring to the table as an enhancement of their current offering. So, at this stage, I'm looking more on partnerships and how we take really good products and make them even better by adding professional monitoring services to those products.

Saliq Jamil Khan - Imperial Capital LLC

And lastly, could you talk a little bit about your view and actions on implementing labor-saving technologies that could further reduce the overall cost profile?

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

Again, the big one that we're still rolling out is on the TS panel, which is a complete wireless device. So it adds the peripherals wirelessly. We've got some new apps that make the installation process better. We're rolling out new tools. This past year was really focused on our sales force with the order management platform as well as the year before, the Salesforce.com to make us more efficient in our marketing and how we push leads down to our sales force.

This year, you'll see more going to our service and installed techs, where we're giving them more capabilities and requiring them to call back into the centers much less frequently. So, again, I think we're looking at every aspect of our processes either in our centers and in the field and looking at where there are opportunities to automate, but then also enhance the customer experience. We don't want to automate at the expense of our customers.

Saliq Jamil Khan - Imperial Capital LLC

Mike – Naren, I'll just get one more in, then I'll hop back in the queue. Given ADT Canopy, how will you ensure that you can not only retain those customers but also transition them to the larger ADT Pulse platform, which potentially comes with a much higher ARPU?

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

Yeah. Well, that's exactly the strategy. So, we want to engage with customers much earlier than we would have before they buy that house that would logically be a candidate for Pulse. So, we're really – the way we want to do that is through that user experience. While the look and feel is different from Pulse, there are many similarities and we engage with that customer, we build that relationship, so it should be a natural migration as they go from renter to owner as they go from apartment to house.

Saliq Jamil Khan - Imperial Capital LLC

Great. Thank you, guys. And I know that Jeff wishes that he could've been on the call today also.

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

Great. Thanks, Saliq.

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

Thanks, Saliq.

Operator

Thank you. And our next question comes from the line of Ronnie Weiss of Credit Suisse. Your line is now open.

Ronnie Weiss - Credit Suisse Securities (USA) LLC (Broker)

Hey. Good morning, guys.

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

Good morning.

Ronnie Weiss - Credit Suisse Securities (USA) LLC (Broker)

I just want to touch on the net subscriber growth for the year. With the additional screening requirements you guys just did – have been doing, it kind of hurt the adds in Q1, I'm just wondering why this wouldn't continue to kind of depress those numbers throughout the year as the tightening kind of continues.

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

Well, again, within the residential – we got to isolate that. If you look at our gross adds by business, by channel, U.S. dealer was up 10%, Canada, as Mike mentioned, was up 22%, business was 11%, health, over 30%. So, it's really just our U.S. direct residential channel and that's where we're implementing all of these changes.

You got to understand, it is a...

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

[Resales] were up 13%.

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

Right. So, it's really just...

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

Resi direct new is where the changes are.

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

Yeah. This is a change for our sale force. Clearly, our sales force has adopted and adapted to changes in the past. They understand now exactly the kind of customer that we're looking for. And with their self-gen activity, they'll be pursuing that. Our leads will be more focused on those type of customers. And again, I think we'll be getting – continue to accelerate growth in all the other channels, plus the addition of ADT Canopy, plus some selective high-quality bulk account purchases. We're still confident that we'll hit our goal of being net add positive for the year.

Ronnie Weiss - Credit Suisse Securities (USA) LLC (Broker)

Okay, great. And then just on the Pulse penetration rates starting to – not flatten out, up 600 basis points, but year-over-year starting to decline, just wondering where that kind of – the mature level you guys see and kind of when that starts to happen and when we see an actual leveling out of the penetration rates there?

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

Yeah. I think you got to separate the new from the retail – excuse me, resale. The new rates are 77% in the direct channel, ramping up nicely in the dealer channel. But, clearly, we still have some headway compared to our direct channel. Resales, we're going to continue to be selective there. Where the economics make sense and we see good quality resale customers, we'll make the investment to upgrade the existing system that's in the home to Pulse.

But I think they'll be a natural cap there, I think, one, based on the quality of customer and, candidly, the customers' desires. In many cases, they're doing it for insurance purposes and they simply want to activate the existing systems in there and not incur additional cost for the upgrade. Hopefully, we'll get the opportunity to upgrade them over time, and that's why the Pulse upgrade program is also important. So, I still think that there's a little bit of headroom there, particularly on the dealer channel and we're working through the opportunity with that.

Ronnie Weiss - Credit Suisse Securities (USA) LLC (Broker)

Great. Thank you.

Operator

Thank you. Our next question comes from Shlomo Rosenbaum of Stifel. Your line is now open.

Shlomo Rosenbaum - Stifel, Nicolaus & Co., Inc.

Hi. Thank you very much for taking my questions. Could you just comment a little bit about the LG product launch? I know it's supposed to be launched last year and then got pushed out to early first quarter, and now pushed out again to the springtime. Can you talk a little bit about what's going on with LG over there? And how much of your plan to achieve a subscriber growth for the year is contingent on the LG product rollout?

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

Well, two things, Shlomo. One is, we had originally talked about a holiday season launch and when we worked with LG, they identified some opportunities to further enhance the product that we have designed. We've been working with them on some enhancements to the software platform. So, when we decided not to pursue the holiday season, the plan was to launch in the spring. When you look at retail, which is – this will be a retail product, it's either the holiday season or the next logical season for a product like this is dads and grads, which is in the springtime.

So, we said we would announce the program and have that present in CES, both ADT have that as well as LG in their booth, and we're very – we feel very good about how we showed and the feedback that we got at CES.

As far as the customer growth and how that contributes to our net customer growth, that is not in our plan for net customer growth. We have that and we're going to report those separately, but we don't want to meld the two together, because the economics are very different, the attrition characteristic could be very different. And again, this is low to no SAC product, so we should measure them differently, and that's what our plans are. So, when we said we'd be net subscriber growth that was the traditional business plus health, plus Canada, plus commercial and that expansion.

Shlomo Rosenbaum - Stifel, Nicolaus & Co., Inc.

Okay. So, this is not going to – this doesn't make a difference one way or the other in terms of increasing the subscriber rate? That's the message there?

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

It does – it clearly will grow our subscriber base and we want to do that. It was not part of the guidance we gave about being net subscriber positive during the year.

Shlomo Rosenbaum - Stifel, Nicolaus & Co., Inc.

Okay.

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

This is recurring revenue and there are subscribers and we ought to grow this number significantly. What we're saying was, we weren't using that in our guidance. So, there's no reason why one would consider these subscribers as well. And then, clearly, our growth will be based on top of the growth that we have from our core business.

Shlomo Rosenbaum - Stifel, Nicolaus & Co., Inc.

Got it. How many of the 48,000 Pulse upgrades were 2G conversions that you guys migrated up to Pulse?

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

I'd say about 10% of 124,000 indicated that we did this quarter where Pulse upgrades.

Shlomo Rosenbaum - Stifel, Nicolaus & Co., Inc.

So, about 14,000?

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

Yeah, 13,000.

Shlomo Rosenbaum - Stifel, Nicolaus & Co., Inc.

Okay. And then in terms of the bulk buys, are they all 3Gs already now or why is now a time that's becoming more attractive in the market? Is it because there are no more 2G radios that are being installed? I know we went through just a period just for many players in the industry over the last year, year and a half there just weren't a lot of bulk buys because of that.

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

Our bulks, the ones we did this quarter happen to be in Canada. Protectron has always had a very strong program in this area of tucking in small businesses or small bulks. We look at the bulks very aggressively, which is why we were not hit largely in that in the past year. We clearly want to first and foremost look at the attrition in the accounts because we are buying in the accounts.

There is – as the market gets priced more appropriately, it is a legitimate way to bring in new customers, we have a directed sales force, we have dealers, and there are others who produce interactive accounts that we could purchase. So, we absolutely look at the interactive percent of the population and, of course, look into whether they have 2G problem too.

I think the most important thing, when you think about smart growth is we want to pursue growth that we feel addresses the return on investment and the customer economics we're looking for in a business. Instead of chasing it in the direct side with many maybe an uneconomical marketing program or particularly going out, taking chance on a customer who may or not last three years, in a bulk environment, if you do your homework, you can ensure the quality of the customer base you buy does meet those financial terms and economics. If they don't, we won't buy it and I think we've passed on a number.

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

And I think that's the key, Shlomo. It's not necessarily a change where there's so much more available. People understand exactly what we're looking for and what we're willing to buy, what we're not willing to buy, so they're bringing us better quality stuff. And to Mike's point, we're diligent supporters that they are good quality. And if the quality and the economics make sense, we'll consider it.

Shlomo Rosenbaum - Stifel, Nicolaus & Co., Inc.

Okay. And then is the platform for Canopy the same platform that you guys have been using with Icontrol or is that a separate platform?

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

No, it is a separate platform that we spoke about.

Shlomo Rosenbaum - Stifel, Nicolaus & Co., Inc.

Got you. Thank you very much.

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

Okay. Thank you.

Operator

Thank you. Our next question comes from the line of Jane Zhou of Morgan Stanley. Your line is now open.

Jane Zhou - Morgan Stanley & Co. LLC

Hey, guys. Thank you for taking my question. So, I guess, quickly on the enhanced credit screening, I think it was rolled out in early 2015. So, can you maybe quantify some of the benefits you see from this program up to today? And do you have any plan to roll it out to the dealer channel as well?

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

Well, again, two things, Jane. One is, what we implemented in 2015 was a major contributor to our ability to reduce our customer attrition by 100 basis points last year. Even in Q1, we're 70 basis points better on a year-over-year basis. What we're doing now is further tightening up the screen, not necessarily just looking at credit, but looking at other characteristics of the sale, looking at renters versus owners, looking at how much money they're investing upfront, so it's a variety of – the screening we're doing now has a...

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

Before there was an initial screen and determine whether there was a check or not. Now, we're doing full check. The dealer historically has had a higher credit score than accounts we'd like to deal with. The dealers, because of the chargeback program, already go through full credit scores before they present an account to us. And I think what we're doing is sort of bringing the direct channel up to the standard of what we historically have purchased from the dealers, so...

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

So, they – so, Jane, to clarify Mike's comments, the dealers have always had 100% credit screening for the past several years. So, they've already adopted some of this – the screening part of it.

Jane Zhou - Morgan Stanley & Co. LLC

I see. That's helpful. I guess second quickly on the ADT Business, I think it's going to be an increasingly important part of ADT. So, can you maybe just talk about the current contribution from ADT Business to your recurring revenue, total customer base, gross add maybe, and also how does business customers' ARPU and attrition differ from the residential customers?

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

Yeah. We don't report ADT Business as a separate segment, so we don't break out the details. But I think we've talked in the past, it was north – it's about 0.5 million customers. So, from a customer base, you can kind of get a feel for how relevant it is. And again, that's the U.S. piece of business. That customer base is growing and it tends to run at higher ARPU than our traditional residential business.

So, it's an important part, but to your point, it will be a much more important part as we continue to expand that across our entire footprint. But it's a huge market that we're talking about. I mentioned in my comments, it's a $24 billion addressable market for us. So, I agree completely with your comment that it has a potential to be a much more impactful part of our results.

Jane Zhou - Morgan Stanley & Co. LLC

Okay. Got it. Thanks for the color. I'll get back in the queue. Thanks.

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

Thanks, Jane.

Operator

Thank you. And our last question from the line of Jeffrey Sprague of Vertical Research. Your line is now open.

Jeffrey T. Sprague - Vertical Research Partners LLC

Thank you. Good morning, gentlemen.

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

Good morning, Jeff.

Jeffrey T. Sprague - Vertical Research Partners LLC

Hey. A couple of loose ends, a lot of ground covered. On the credit screening, I'm wondering if you've been able to kind of step back and look at kind of the potential population of customers, whether it be U.S. household, et cetera, and determine kind of the size of that potential customer pool and where your penetration is relative to that. Kind of all gets around this question of with the tighter screening can you actually grow net accounts with that approach.

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

Yeah. Jeff, that's going into a lot of data. We feel that there is still a very large market out there of customers who own their homes with a very attractive credit score. And again, the incremental screening we're doing this year is not just around credit scores. It is the broad characteristics of the sale. Again, we think – again, when you look at the industry at only 20% penetrated in total and you look at the quality of credit scores and homeowners, there's still a big market out there for us to pursue.

So, I'm not worried that we're overly limiting the market opportunity by being that selective. I think when you look at the analysis that Mike and I now have been able to see from our teams, you see a portfolio that performs very well, and we've talked a lot about that, but we see specific tranches of customers that weren't as attractive returns. And if we can screen those out and impact the overall quality of that customer base, the returns get significantly better as that quality improves.

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

And I think one thing I'd add is, so we're not really – there's no customers that we would not sell to. I think that's a misnomer. I think what the issue is with the credit screening was to sit there and identify those customers that we wouldn't sell the high-SAC subsidized offering to. So, as we identified somebody and maybe they get screened out in the process, we have, first off, we have programs, in fact, a number of those companies or individuals have chosen to put a deposit down or to do things that would sort of mitigate the credit issues.

So, there are still terms with which we might sell them. Secondly, we have a whole group of people looking at product, anywhere from this LG product to a high-end Pulse, if somebody is maybe of less economic means and needs a security system, if we could produce a lower SAC offering, we would certainly sell it to them.

So, really, we don't think that we're screening out customers per se. We just don't want to sell a heavy, subsidized, high SAC offer to someone who has less than desirable credit. But if they're willing to put more money upfront or potentially create a lower SAC type product offering, we could ideally meet their needs and we like to provide security to everyone.

Jeffrey T. Sprague - Vertical Research Partners LLC

Okay. That makes sense. That's a good distinction. On the LG related rollout, can you give us just a little color on how you see the revenue model actually playing out? Is there a little bit of revenue to ADT on the LG hardware sale? And any early expectations of what might be kind of a normalized monitoring fee associated with that offering?

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

Yeah. So, Jeff, for the product itself, that is a – it is an LG sale and LG will make the money, whatever profit there is on that along with the retailer and the retail channel that we're using. ADT makes all their money on the service on the back-end. Our plan is to offer a free period to get customers familiar with our services and see the benefit of the services. And then, we have a very affordable rate that's really, I'd say, in the area of about half of what we charge a traditional customer.

Again, we're able to do that because our SAC is very low on this. Really, the SAC that we're talking about is the investment we made in developing the software, plus the free trial period that we're offering, as well as possibly some permitting and licensing depending on what jurisdiction that they're in. So, we're going to make all our money on the back-end.

Jeffrey T. Sprague - Vertical Research Partners LLC

Great. Thank you very much.

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

Thanks, Jeff.

Operator

Thank you. And I'm showing no further questions at this time. Ladies and gentlemen, that does conclude today's program. You may all disconnect. Have a great day, everyone.

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

Thank you.

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