Alarm.com Holdings, Inc. (ALRM) Q3 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to Alarm.com's Third Quarter 2017 Earnings Conference Call. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the call over to Mr. Jonathan Schaffer with the Blueshirt Group. Sir, you may begin.

Thank you. Good afternoon everyone and welcome to Alarm.com's 2017 third quarter earnings conference call. As a reminder, this call is being recorded. Joining us today from Alarm.com are Steve Trundle, President and CEO; and Steve Valenzuela, CFO. Before we begin, a quick reminder to our listeners. During today's call, management may make forward-looking statements, which may include projected financial results or operating metrics, business strategies, anticipated future products and services, anticipated investment and expansion, anticipated market demand or opportunities and other forward-looking statements. These forward-looking statements are based on our current expectations and beliefs, and on information currently available to us. Statements containing words such as anticipate, believe, continue, estimate, expect, intend, may, will and other similar statements are intended to identify such forward-looking statements. These statements are subject to risks and uncertainties, including those contained in the Risk Factors section of our most recent quarterly earnings report on Form 10-Q filed with the SEC and subsequent reports that we file with the SEC, that could cause actual results to differ materially from those contained in the forward-looking statements. Actual results and the timing of certain events may differ materially from the results or timing predicted or implied by such forward-looking statements, and reported results should not be considered as an indication of future performance. Please note that these forward-looking statements made during this conference call speak only as of today's date, and Alarm.com undertakes no obligation to update them, to reflect subsequent events or circumstances, other than to the extent required by law. Also during this call, management's commentary will include non-GAAP financial measures and non-GAAP guidance. Management believes that use of these non-GAAP financial measures provides an additional tool for investors to use, in understanding company performance and trends, but note that the presentation of non-GAAP financial information is not meant to be considered in isolation, or as a substitute for the directly comparable financial measures prepared in accordance with GAAP. Reconciliations between GAAP and non-GAAP metrics for our reported results can be found in the financial statement tables of our earnings press release, which we have posted to our Investor Relations web site, at investors.alarm.com. This conference call is being web cast and is also available on our Investor Relations web site. The web cast of this call will be archived on our web site, and a telephonic replay will be available through November 15. So with these formalities out of the way, I'd now like to turn the call over to Steve Trundle. You may begin.

Thanks Jonathan and thanks to everyone for joining our call today. I am pleased to report that we continued to deliver solid results in the third quarter. Our SaaS and license revenue was $61.9 million. This is an increase of 39% from a year ago. Our non-GAAP adjusted EBITDA was $19.5 million, up 65% from a year ago. Turning to the business updates; we are coming off another successful partner summit. This is a three day event that we hold each October. We invite both our service provider partners and our ecosystem partners. At the event, we present our latest products and services, providing glimpse of our R&D roadmap clarities, and discuss market trends. Most importantly, the partner summit provides our team, an opportunity to hear from our service providers and how our solutions are performing in the market. Most of our service providers are doing very well, and heard about particular strength from our large base of smaller and highly local dealers. These folks sometimes describe themselves as even being too busy. The average customer is feeling better about the economy, as evidenced by last week's report, that the consumer confidence index has reached its highest level since December of 2000. This increased consumer confidence is beginning to drive more builder activity, and our smaller dealers often have a number of local builder relationships. Increased confidence, along with better technology is also causing the typical customer to purchase a bigger smartphone system, than was the case a couple of years ago. Our smaller dealers tend to perform well in an environment, where the customers wants a larger system, with a more highly customized installation. So we are seeing strength there. My overall take from talking to our service providers, is that customer demand for a cleanly installed and complete smartphone system, powered by Alarm.com, remains strong. The timing of our partner summit also gave me the opportunity to speak to our service providers, engage their reactions to the competitive new products, that have hit store shelves ahead of the Christmas retail season. I do not sense that any of our service providers were overly concerned, as they have long seen similar retail kit offerings in the marketplace. Our customers generally prefer the peace of mind, convenience, and most importantly, the security that comes from a complete solution, that is professionally installed and supported by our security service provider. My conversations also reinforce that our R&D investments are focused on the right areas for our service providers and their customers. We laid out a number of roadmap initiatives to create new user experiences, enable more capable video based services, and generate additional growth in the smarter business category. As we deliver these capabilities to our service providers over the next 12 months, we will talk about some of them further on these calls. I also want to highlight a few of the capabilities that we released with the platform during the third quarter. We added two-way audio functionality to our indoor residential cameras. We also released updates to both our mobile and our Apple TV applications. We further differentiated our video doorbell solution, by taking advantage of integration opportunities, that only exist, when a single holistic platform underlies the smart home. Alarm.com doorbell users can now see who is at the door, speak to that person, and then temporarily disarm the security system and unlock the door, all from a single interface. We also added humidity control to our thermostat solution. Leveraging humidity sensors already on the Alarm.com smart thermostat, subscribers can now create a set point for both the temperature and the humidity level in their property. Alarm.com intelligently balances the two set points to automatically provide comfort and efficiency, while also maintaining an environment, that will help prevent mold formation. This feature will especially benefit customers to use Alarm.com for second homes or multiple business locations. And as most of you know, we also focus heavily on delivering partner tools and applications that our service providers use to more effectively service their Alarm.com subscribers. We are also making some nice enhancements in this area. We are introducing a new video camera installation tool, that intelligently guides installers through the camera setup process, by automatically adapting the factors, such as the wireless network environment, and the experienced level of the technician. A less experienced tech will be walked through some basic initial steps during installation, and these steps will be skipped, when guiding more experienced technicians. These types of tools, when combined with our turning program, are allowing us to help our service providers gain confidence and become more efficient, when installing and servicing more complete smart home and smart business systems. On the training side, we have seen dealer participation in the Alarm.com academy, increase 140% over the last year. For the last couple of years, we have also operated our Alarm.com certified technician program. Techs who complete nine core required courses, are able to earn their certified technician badge. To-date, more than 3,000 service technicians have completed this full training curriculum, and are actively servicing the market, as Alarm.com certified technicians. There are two reasons we focus so heavily on both service tools and training for our service providers. We want to reduce the likelihood, that an end subscriber needs service, but make sure that when they do, our service providers are well equipped to efficiently respond. This year, we have seen a positive confirmation that we are making progress on these goals. Our service providers have continued to increase the attachment rate of advanced devices on systems they install, while our support call volume on a per installed device is on pace to drop about 20%. The increase in attachment rate of advanced devices is being driven by both new and existing accounts. We defined advanced devices as either home automation devices, like smart thermostats, locks and lights; or any type of video camera. The attachment rate of advanced devices on new accounts created in the third quarter, increased 17% over the same period last year. We are also seeing the base of Alarm.com subscribers, gradually add new devices to their already installed systems. This has been particularly true with video. Among the cohort of subscriber accounts that were created in 2015 and that have video services today, nearly 30% added video services to their system, sometime after the initial installation. This is evidence that our service providers are moving to take advantage of opportunities to increase the lifetime value of their customers, who are serviced by our platform, and this is a positive trend for our business. In summary, I am pleased with the results, that the Alarm.com team and our service provider partners delivered during the third quarter. We made solid progress, expanding our platform, to extend our leadership position in the smart home space, while continuing to produce consistent financial results. And with that, I will hand things over to Steve Valenzuela. Steve?

Thank you, Steve, and good afternoon everyone. I will begin with a review of our third quarter 2017 financial results, and then provide guidance for the fourth quarter and our raised outlook for full year 2017, before opening the call for questions. Starting with our review of the third quarter; SaaS and license revenue grew 39% from the same quarter last year to $61.9 million, which includes the contribution from Connect we acquired March of this year. Our SaaS and license revenue visibility remains high, with a revenue renewal rate of 93% in the third quarter, consistent with our renewal rate last quarter. Hardware and other revenue in the third quarter was $28 million, an increase of 21% year-over-year. This increase was largely driven by strong sales of our video cameras. As we have mentioned on last quarter's call, we introduced new video cameras and a new version of our video doorbell in the second quarter. Total revenue for the third quarter increased 33% over the same quarter of last year to $90 million. Gross margin for our SaaS and license revenue was 85% for the third quarter, up about 200 basis points from the same quarter last year. Gross margin for hardware and other revenue was 21% for the third quarter, this is up about 50 basis points from Q3 2016, and down about 60 basis points sequentially due to product mix. Total gross margin was 65% for the third quarter, up about 350 basis points from the same quarter last year. The higher gross margin in the third quarter, is due to a combination of the increase in SaaS and license growth margin, and the [indiscernible] mix of SaaS and license revenue, accounting for 69% of total revenue for the third quarter, compared to 66% in the same quarter last year. Turning to operating expenses; R&D expense in the third quarter was $19.3 million compared to $11.5 million in the third quarter of 2016. We ended the third quarter with 443 employees in R&D, up from 304 employees a year ago. Sales and marketing expenses in the third quarter were $10.4 million or 12% of total revenue, compared to $10.7 million or 16% of total revenue in the same quarter last year. G&A expenses in the third quarter were $13 million, down from $14.8 million in the year ago quarter. G&A expense includes non-ordinary course litigation expense of $1.9 million in the third quarter, compared to $3.1 million in Q3 2016. Non-ordinary course litigation expenses are part of our adjusted measures, and are excluded from our measurement of our non-GAAP financial performance. Non-GAAP adjusted EBITDA increased to $19.5 million in the third quarter, up 65% from $11.8 million in the same quarter last year. In the third quarter, GAAP net income was $15.1 million compared to $2.6 million in the year ago quarter. Our tax provision in the third quarter was a favorable benefit to net income in the amount of $5 million. This tax benefit is primarily due to a $6.1 million favorable impact in the third quarter from the new accounting standard; ASU 2016-09, accounting for employee share based transactions. Under this new accounting standard that we adopted at the beginning of 2017, we are required to recognize the tax windfall benefits in the quarter that employees exercise stock options, and this will cause our GAAP effective tax rate to vary from quarter-to-quarter. Non-GAAP adjusted net income was $13.3 million in the quarter, compared to $9.3 million in the third quarter of 2016. We have now excluded from non-GAAP net income the $6.1 million tax windfall benefit I just discussed, resulting from employee stock exercises, as we do not consider this as part of our operating performance. Excluding the tax windfall benefit, our effective tax rates used to compute our non-GAAP net income for the three and nine months ended September 30, 2017, were 23.5% and 27.4% respectively. Turning to our balance sheet; we ended the third quarter with $84.6 million of cash and cash equivalents. In the third quarter, we generated approximately $13.8 million in cash flow from operations and $11.9 million of free cash flow. For the nine months ended September 30, 2017, we generated $31 million of free cash flow, up from $5.4 million for the same nine month period in 2016. On October 6, shortly after the end of the quarter; we replaced our existing debt facility with a new facility, increasing our loan capacity to $125 million, up from our prior facility of $75 million. This new debt facility provides us increased flexibility at reduced interest rates. Our debt balance remains unchanged at $72 million, as we have not done any additional borrowings under the new facility. The term is for five years to October 2022, replacing our prior revolver, this term was set to expire November 2018. In addition to our existing banks, which are Silicon Valley Bank and Bank of America Merrill Lynch, we added JPMorgan and PNC Bank to our banking syndicate. Let me now turn ASC 606, the new revenue accounting standard that we are required to adopt beginning in 2018. We currently plan to implement this new accounting standard, using the modified retrospective approach. We are in the process of reviewing the impact, if any, on our financial results. While we have not finalized our review of our major service provider contracts, we have not identified changes at this time, that we believe, would result in a material impact to our revenue recognition policies for the Alarm.com segment. However, this is still under review. We are also in the process of reviewing our customer contracts for our subsidiary, that we report in our other segment, and assessing if there are any accounting changes for their revenue under 606. Also under 606, we are required to evaluate our commissions expense, and capitalize commissions whose benefit can be attributed to a term that is longer than one year. We currently expense commissions as incurred. We have begun to evaluate our commission agreements, and believe we will need to change the accounting for some of our commissions and amortize them over a term longer than one year. We will report final changes required for the new standard in our 10-K for 2017, that we will file in the first quarter of 2018. Moving to our financial outlook; we expect Q4 SaaS and license revenue of $63.7 million to $63.9 million and we are increasing full year 2017 SaaS and license revenue to be between $234.8 million to $235 million. This compares to our prior outlook for SaaS and license revenue for 2017 of $233.3 million to $233.8 million. We are also raising our guidance for total revenue for 2017 to $332.8 million to $334 million, up from our prior guidance of $326.3 million to $327.8 million. This includes our raised guidance for hardware and other revenue of $98 million to $99 million. We are also increasing our expectations for non-GAAP adjusted EBITDA for 2017 to be between $68.5 million to $69 million, up from our prior range of $66.5 million to $67.3 million. We are also updating our guidance for non-GAAP net income for 2017, to exclude the impact of the tax windfall benefits, due to employee stock exercises. Excluding this tax benefit, our updated guidance for non-GAAP adjusted net income for 2017 is $43.2 million to $43.7 million, or $0.87 to $0.88 per diluted share, and if the tax windfall was included, then it would have added approximately $12.5 million to 2017's non-GAAP net income, or $0.25 per diluted share. EPS is based on an estimate of 49.4 million weighted average diluted shares outstanding. We expect full year 2017 stock based compensation expense of $7 million to $7.5 million. Finally, while it is too early to spend much time on 2018, as we still have to execute on the rest of 2017 and report results for the full year, I did want to provide a very early perspective on 2018. Putting aside any changes related to the adoption of ASC 606, the new revenue accounting standard, we are comfortable with total revenue of $375 million to $385 million for 2018, in line with current consensus. We believe we are well positioned to build on our expanding market opportunity for the secured smart property, in both residential and commercial sectors, and we are thankful for a strong base of service provider partners. We will provide our initial guidance for 2018, when we report our fourth quarter and 2017 financial results in the first quarter of 2018. In summary, we are pleased with our performance in the third quarter, and we are focused on executing on our business strategy, and investing in our growth opportunities, while continuing to deliver solid financial results. Before we open the call to questions, we respectfully request that each person ask only one question per analyst, so that we can accommodate all of our analysts in the time allotted for this call. Thank you for joining us on our call today. And with that operator, please open the call for Q&A.

[Operator Instructions]. And our first question comes from the line of Nikolay Beliov with Bank of America. Your line is open.

Hi. Thanks for taking my question. Thank you for the 2018 preliminary revenue guidance. How should we think about the margin profile for 2018 directionally, and what are the puts and takes that you guys are considering, before you provide the actual guidance?

Hey Nikolay, this is Steve Trundle. Yeah, as you look to 2018, or at least as we look at it, I have said this before, the margin profile is something we have quite a bit of control of. So it's really a business decision, more than it is something, where we are reacting to any particular sales activity. And currently, I think what you are saying is a little bit of a drift. We have talked about a long term range in the 20% to 25% sort of bucket, and we have been drifting up the pad, and I would imagine that type of a trend may stay intact. But we will be looking for ways that we can invest to maintain the growth rate. So we are not going to pull too hard at this time on the margin lever.

Yeah, with the 2017 guidance, we are coming at a 20.6% adjusted EBITDA, and that's up from 19% in 2016. So you have seen us over the last three years, every year, the adjusted EBITDA has gone up. Not to say, we continue at that rate. Just to be clear.

Thank you.

Thank you, Nikolay.

Thank you. And our next question comes from the line of Michael Nemeroff with Credit Suisse. Your line is open.

Hey guys, this is Alex Hu on for Michael Nemeroff. Congrats on the really strong results and thanks for taking our question. Steve T., just curious, as you look at your business over the next let's say, 12 to 18 months. Among the initiatives you just commented on or have in place, whether it be new products, services international opportunity, the commercial channel, integration of Icontrol, like what excites you the most? What do you think could potentially drive the largest near term upside and maintain the momentum we have seen since our IPO? And how is Alarm positioned to capitalize on that opportunity versus some of your peers? Thanks.

Thanks Alex. Good question. I get excited about a lot of things, but I would say, my roots are in technology. So I get probably most excited about the pipeline right now that we have and the enthusiasm that our partners, our service providers have expressed for that pipeline. So I alluded to some of this in my prepared comments, things we are doing with -- to improve the -- really, really improved video experience. Things we are doing to drive some new user experience is up, and things we are doing to expand the growth opportunities that our service providers have in the small business category. So in each of those cases, there is some interesting new development that we are investing in and we are excited about. At the same time, some of the other things you alluded to, the ongoing work that we and the Icontrol team are doing, to support the base of customers that we inherited with that acquisition. Still has a lot of opportunity that I hope to be able to seize upon in the next 12 to 24 months. And then international is still an area where we are growing, each month, seeing some growth there, and I say that and the business hasn't totally kicked in yet internationally yet either. As I have said in the past, it's profitable on a P&L basis, but as one of the major components of the growth, it's not there yet. So I see some reason to sort of be excited and look forward to driving more activity there next year.

Great, thank you.

Thank you. And our next question comes from the line of Gabriela Borges with Goldman Sachs. Your line is open.

Great, good afternoon. Thanks for taking my question, and congrats on the solid results. For Steve Trundle, if you don't mind, coming into the year, we talked about on organic growth rate being in the upper teens, and now with the initial look into 2016, coming in right around the mid to high teens levels, would love to get your thoughts on organic normalized growth rates in the core business in the U.S. Where do you feel we are, with respect to the S-curve, in terms of adoption on the home security, smart security side? Is the S-curve even the right way to look at it, or any high level thoughts to normalize growth from here would be helpful? Thank you.

Yeah. So I think, yeah you are pointing out [ph] sort of how we are looking at 2018 and in terms of where we are in the S-curve. I think, obviously the company is bigger than it was last year. We have absorbed the material acquisition that we are growing off of at this point as well. As you get bigger, you will see some temperance of the overall growth, that you are growing off of a larger base. But if we look kind of at the overall market, I think one way we had been asked about it in the past, is sort of what inning are we in. And I think if we look at sort of the percentage of homeowners putting business aside for a moment, if we just look sort of residential, and extrapolate out where we are in terms of the adoption cycle, I think it's reasonable to assume that, at least when we talked about our service providers that all security subscribers will be smartphone subscribers at some point in the future, and that's very much the trendline, it's intact. There may be a handful, who don't -- believe it or not, don't use mobile devices, and therefore are happy with the technology that has existed for the last 30 years. But for the most part, at least what we are seeing as we talk to service providers, everyone is adopting smartphone, and yet, if we look at Parks [ph] data and data from other sources, we are probably only about one-third penetrated at the moment, within that kind of narrowly defined TAM. So I would say, we are probably third to fourth inning, if we use that as sort of a basis, and then once we fully penetrate sort of existing TAM, if we assume no TAM expansion, then we will see those -- we will reach sort of a steady state. But we also believe that the TAM will continue to grow, and then of course, we are doing some things around the edges to expand our addressable market as well, and those are very early inning type of initiatives.

Absolutely. Thank you for the color.

Thank you.

Thank you. And our next question comes from the line of Matt Pfau with William Blair. Your line is open.

Hey guys, thanks for taking my question. Just wanted to maybe get a better understanding in terms of -- Steve, you talked about how you are seeing or at least your dealers are seeing the demand for more customized expanded smart home deployments. How has this impacted your ARPUs that you are receiving per customer, if at all? And then I guess, as you think about the business longer term, should we expect to see an improvement in retention rates or any other sort of material financial changes from that trend? Thanks.

Yeah. Good question Matt. Yeah, definitely as we -- I think I alluded particularly to the very local dealers that are benefitting from a lot of larger, sort of customized installations, and certainly in our case, when a customer adds video services to their solution, that's a higher ARPU customer, than a customer that is just taking sort of smart home without video. We don't try to push a lot of ARPU on what I would call traditional home automation types of capabilities. So someone that wants to be able to tie their lights to their security system, that's not really an ARPU generator, that's just a convenience feature, that we think adds to customer stickiness. So on that front, it's not a big ARPU driver. On the video piece it is. What we are seeing in general, is yes, it's helping us maintain ARPU probably very slight increase in ARPU. But I look at it more as a way to provide more value for the same price. The service providers are telling us they are in a very competitive market. The customer is looking to get value for their dollar. And we therefore, in support of service providers, look to provide more value for sort of the same relative costs, and I would call the -- sort of the increase in services that we are seeing, give this away to kind offset some discounting and other things that we do, to try to make sure that the service provider still have high value offering in the marketplace. So that's kind of how those are working together, I would say. Then some of the activity on the side, with small business and otherwise, also help us drive a little bit of ARPU growth.

Got it. Thanks guys.

Thank you. And our next question comes from the line of John DiFucci with Jefferies. Your line is open.

Hi, this is Julian Serafini on for John DiFucci. I had a question about something that Steve Trundle talked about a little bit earlier. You had talked about some of the small resource providers. And I guess I was wondering on your new customer acquisition; would you say that most of your new customers that are coming from these small resource providers instead of the bigger ones, who seem to be, I guess, struggling a little bit in terms of customer additions in the marketplace, is that a fair assessment or like could you quantify, I guess, like where your customers are coming from?

Hey Julian. It's a good follow-up. So yeah, the larger service providers are still doing well, and I didn't mean to discount sort of their effectiveness in the market, if I did. But in terms of our mix, I mean, the way we look at it is, the folks I was referring to today, would be sort of about 40% of our new account production. These would be folks that are either highly local or regional, and have been a source of strength. And then the larger players still represent about 60% of our new account production.

Okay, thank you. That was helpful.

Thank you. And our next question comes from the line of Tavis McCourt with Raymond James. Your line is open.

Hey guys. Thanks for taking my question. Steve V., I just had a couple of follow-ups for you on the accounting front. So if I look at the Q4 guide, it looks like the non-GAAP tax rate you are using is something approaching a 100%, if I am reading that right, I guess, a confirmation of that. And then what should we be using as a go forward GAAP and non-GAAP tax rate with the stock option tax changes? And then secondly, thanks for the clarification on 606, and I guess, I just wanted to confirm that I heard it right. As of this time, we don't expect a material change, but you may end up capitalizing some commission expenses, but I guess, what you are saying is, that's probably small enough not to qualify as being material. Is that the right way -- is that the message you are trying to get across?

Hi Tavis. Good questions by the way. So on the tax rate, I think last quarter, we talked about this new accounting standard for an employee's share based payments and our companies are doing it in many different ways. We really decided that the best way to treat that on a non-GAAP basis, was really to take it out of our tax rate. So if you look at our non-GAAP tax rate for the year, we are projecting about 30% tax rate. For the GAAP tax rate, because of this, employee share based payments now having to go through the P&L, versus how it used to grow through equity, we are projecting a benefit of 39% to 40% benefit tax to GAAP. Now going forward, I would caution that we usually like the model beyond the year at about a 35% tax rate. Now we know there is discussions about a new corporate tax rate, and we can't predict that. But I would say, to be safe, both for GAAP and non-GAAP, I would say to be in the 35% tax rate. So hopefully, that addresses your questions on the tax. And I did want to make sure that to clarify, again, with the guidance for the year for non-GAAP, it is different than what we did last quarter. If we were to include the non-GAAP in our guidance for the year, our non-GAAP net income would have been $56 million and $1.12 per share. So just want to make sure, people understand that. And so I think that covers your questions on the tax. Let me now go to 606; so there is only so many things that I can say at this point without discussing -- clearing [indiscernible]. But I will say that, we have gone through our major service provider contracts on the Alarm.com segment, and we did say that we do not see any material changes at this time. We obviously have to go through an audit. 606 is a huge, huge new accounting standard that is causing a lot of companies to spend a lot of work on, and we are spending a lot of time on it. The good news is, we are accounting for our revenue for our service providers on a ratable basis, and under the prior guidance which is 605, the new guidance 606, is pretty much the same revenue recognition. Now I will caution that to say, we haven't got through the audit yet, so I just want to be careful there. But that's where we believe we are right now. With regard to our other subsidiaries within our other segment, that's less than 6% of our revenue. So we are still working through that, whether or not there will be some change. That will still need to be determined. But again, it's a smaller part of our revenue. The good news is, the major portion of our revenue, we believe, will simply be accounted for under the same methodology we have been doing a lot. Now your last question was on commission; now commissions is one area we are still assessing, but a lot of people don't realize that there is actually a large impact under the new revenue standard for commissions; because as part of 606, you'd have to take your commission's expense, and you'd have to figure out the portion that benefits more than one year, and of course, we incent ourselves in terms of adding new dealers as well as new subscribers. And so those typically -- a good portion of their commissions actually benefit more than a year. So there will be an impact from that. I would not say, it will not be immaterial, it would probably be a significant impact, but will also have to also take back the commissions going back for the contract. So the net effect will be -- will need to determine, there will be some commissions in the prior year, as we move forward. Commissions in the current year, 2018, that will be amortized over a longer period. So the net of all this, is that, there is no change to cash, right? So where cash generation doesn't change, yes our P&L will change a little bit, but the important point is really, from a cash point of view, 606 doesn't impact cash.

Great. And so just to make sure I heard that, on the tax rate for next year, no reason to assume anything different on a non-GAAP basis at this point versus what we were assuming before, which is kind of the mid-30s?

That's right. I would just assume mid-30s. Now if there is new legislation, we will be happy about that. But I would say to be safe right now, just assume mid-30s.

Great. Thanks a lot.

Sure. Thanks Tavis.

Thank you. And our next question comes from the line of Jeff Kessler with Imperial Capital. Your line is open.

Thank you. Thank you for taking the question. You talked about some of the services at the edges, which are beginning to impact the revenue of some of your, well basically, some of your smaller and mid-sized service providers, ranging -- and I am assuming, that it ranges everywhere from the beginnings of Telehealth to on the -- if you want to call, on the large scale side and the enterprise side, and as an EnergyHub. Could you go through two or three or four of these products and services at the edges, that you think have the potential to impact, perhaps the second half of 2018 into 2019?

Yeah. This is Steve. Steve T.

Hi Steve. Hi Steve.

So I was alluding to EnergyHub, which you referenced. I think EnergyHub is kind of on a positive trajectory. So I don't know that it's a trajectory -- we obviously bit of a positive trajectory as well, so it won't be a giant surprise to us, if we keep having progress on some of these things and on the edges, but we have that effort, which is a demand response and really edge device management software platform called Mercury 3, that's out now. And then we talked in the past about our PointCentral business, which is focused on vacation rental properties, as well as MDUs. They continue to make progress, and we think that will continue on next year. We have talked about our HVAC oriented business called Building36. That one is still in it's -- in more nascent phases, but we are hoping to see more progress there over the next 12 months. So those are three other things; and then in the core business, when we think about the smaller service providers. I think expanding the footprint of what we actually bring to market for them. So in particular in the past, I talked about the SMB segment and how traditionally we have been very focused on the residential segment, but how the number of service providers, who service both sides of the markets, we even have homeowners, who also own businesses and have asked for a more innovative experience there. So on that front, that's mostly new, that's not a part of the business that we can model off a historic trajectory, and I think will be contributing to what see next year in sort of the core business.

Commercial as well has a -- there was a question about ARPU. Commercial typically has a 2X ARPU to residential. And while we are still early on commercial, it's about 5% or 6% of our subscribers, as we introduce more features, we think there is opportunity there as well.

So at the moment, 5% to 6% of subs are in that basket?

Yes, that's right.

Okay, great. Thank you very much.

Thanks Jeff.

Thank you. And our next question comes from the line of Howard Smith with First Analysis. Your line is open.

Yes, thank you for taking my question. Good evening. I wanted to ask questions piling up a little bit on Building36 specifically, and you mentioned the new thermostat, our feature with the humidity and the like; and I am curious if that thermostat is in any way tied into Building36, or if you keep those, what you are doing for your traditional security network in Building36 completely separate? Maybe you could address how those might work together or not?

No, they do sort of work together. Howard, it's a good question. It's that team that works with actually set of HVAC partners, that designs the thermostat, that designs and implements. For that matter, the thermostat, that works with Alarm.com. On the Alarm.com side of business, we work with a lot of thermostats. So we are willing to work with others, but we have the one that's designed, particularly for service providers to be able to easily install and to work very well, and that's one that is an Alarm.com thermostat really felt by the Building36 team. So a lot of the knowhow actually comes from that team, and they gather that by working directly with the folks that are in the HVAC business. In terms of what the consumer experience is, it is absolutely the case that a consumer that's benefitting from the Building36 service, may at some point say, hey, I'd like to leverage the assets that exist in my home or business. For the purposes of energy management, I'd like to have those assets actually work with my security apparatus. And at that point, that customer would shift more than likely, and go to one of our service providers, and become their customer. But again, using the thermostat that was already installed by the HVAC guys. So it's an effort we have underway to make sure that on some of the core devices like thermostat, we are ceding the market with devices sort of early, and the incarnation of the customer's life, and then creating hopefully downstream opportunities for our service providers to come in and work with some devices that are already integrated in the Alarm.com ecosystem.

Great. Appreciate the color. Thank you.

Thank you, Howard.

Thank you. And our next question comes from the line of Nehal Chokshi with Maxim Group. Your line is open.

Yeah. Thank you. So I think you have talked about in the past, that there is an opportunity to have ADT push future interactive security subscribers towards that core alarm platform versus the Icontrol platform, so I am talking about the Pulse subscribers in this case? And that would result in an ARPU lift for Alarm, and that the drivers for that decision is better lifetime, at effectively the same cost for ADT, but would represent lift for Alarm. So I have got two questions here, so sorry for the length here; but first, ADT appears to be successfully driving up customer satisfaction, using the Protection1 brand, load of customer service, and thereby the lifetime value. So, is the assertion of higher lifetime value somewhat diminished by this success? I'd like you to address that? And then the second thing is that, given that ADT is focused on reducing costs and thus, pushing alarm for new Pulse subscribers, would likely require similar overall costs of what ADT does, and what ADT pays, when considering all-in. I'd like to understand, how this transition, if it does happen, will be accretive from an operating profit per user to Alarm perspective?

Hey, Nehal. So this is Steve T speaking. I may have to break that one into a couple of parts. And obviously, in the case of a specific customer, I can't necessarily present their data. But I think I understand the two parts; first is, your comment that you are seeing from other sources that, customer satisfaction with a large customer of Icontrol, which purchased ADT, is actually on the increase already. And that would be a positive thing, that would be attributable to their effectiveness in operating the business and focusing on customer service. And I think that's -- from what I have heard, that is actually true. I don't think that undermines the likelihood that, providing the customer an even more advanced solution in the future, whether based on the -- what we call the Icontrol connect platform or the Alarm.com platform, I don't -- in both cases, I think, to the extent that we improve the customer experience and deliver ever increasing reliability and capability to the customer, I do believe and data suggests that the lifetime value of the customer will increase even further, because they will use their system more and they will become more sticky. So I don't think whatever that customer may have done to improve customer service thus far, is -- in any way, conflicts with the possibility of driving further lifetime value in the future. I think the second part of your question was about the way that --

The economics around -- I think that was -- you were asking your question about, if the customer was going to move from Connect or add new subscribers from Connect on to Alarm.com, what the costs would be. And we have talked in the past about this, that with Connect, the customer has to do with the hosting, they have to pay the cellular fees. They have to pay their people, they have all of the support as well. With Alarm.com, our dealers have that provided for them by Alarm.com, so we have talked about the cost difference. The ARPU is obviously higher for Alarm.com, because of all the services that we are covering, we are paying on behalf of the dealers. So I would venture to say, and this is still to be determined, but we feel pretty strong, given the synergies that we have and a large base of subscribers, with customers on Connect, that would add new subscribers on Alarm.com, they would not have to pay these costs that they are currently paying out of pocket for hosting for the data centers, the servers, the telecommunications charges, their support people. So given the synergies, I would venture to say, and I would expect, that the customer would realize some cost synergies and benefits, as well as Alarm.com, so it would be a win-win-win. Of course, Alarm.com's ARPU would go up compared to what Connect customers are currently paying. But again, those customers would have a benefit, we believe, given the synergies.

Thank you.

Thank you. And our next question comes from the line of Darren Aftahi with Roth Capital Partners. Your line is open.

Hi. This is Dylan on for Darren. Thanks for taking the questions and thanks for some of the colors on fiscal 2018 outlook. Just to sort of add on to that a little bit; could you may be talk about some of your top priorities for 2018 and where you will be investing a little bit? I know you mentioned the margins are ticking up a little bit, they are not quite at that long term range. So just a little bit color on top priority in 2018? Thank you.

This is Steve T. speaking. So I think, some of the top priorities will be to continue to build out the businesses that exist in the other segments. We'd also want to continue to look for R&D synergies between the Icontrol business that we acquired, and the Alarm.com business. And when I say, their R&D synergies, they don't necessarily mean reducing R&D spend, what I mean is, delivering even more to the market, looking for ways to avoid redundancy and take advantage of the unique skills that exist at both places. Then we get to sort of in the market; I think you will see us probably refocus a bit on marketing, and in 2018, both what we do in tandem with our service provider partners, and then also, some education of the consumer. So that's a place where we have not focused as much in 2017, that I expect to shift some focus to in 2018. And then executing on the things in the product pipeline, that we are excited about, particularly, that relate to expanding our presence in the small business segment, expanding the capabilities, and therefore, hopefully the attachment of our video offering, and then making sure, we are delivering on our promise to our international customers, that are out there, trying to grow their business, and we certainly have work to do there as well. So those will be -- a few of the areas that I think will be top priorities in 2018.

Thank you.

Thank you.

And our next question comes from the line of Mike Latimore with Northland Capital Markets. Your line is open.

Hi. This is Rishi for Mike. Thanks for taking my call. Could you explain, what caused the sequential decline in SaaS gross margins in the quarter?

I am going to let Steve Valenzuela handle that one. Steve?

The SaaS gross margins, you are talking about I think 50 basis points?

Yeah.

Yeah. That's a pretty small change quarter-over-quarter. I think keep in mind, in the SaaS business, there is the other segment as well, and there are some timing differences in various programs with our other segments, EnergyHub, PointCentral, and I think that's probably the main driver. But if you look at SaaS, year-over-year the gross margin is up over 200 basis points. So I think it's more of a timing issue. I would expect that SaaS gross margin in the 85% to 86% is a reasonable margin going forward. If you look at a year ago, it was 82%, 83%. So we have seen a nice increase in our SaaS gross margin.

Thanks.

Thank you. And we have a follow-up question from the line of Jeff Kessler with Imperial Capital. Your line is open.

Thank you. There is a lot of talk and a little bit of action, with regard to the increase in the number of, let's call, an increase in the amount that communities are charging for repeated or even first time false alarms, and potential in certain cities, potential increases from the time for responders. If the system -- if the alarm or the incident is not verified, what are you doing, particularly, with some of your smaller providers, to make sure that when verification is needed in those cities that kind of require it, or where police response is really deteriorated, because too many false alarms, because of too much DIY and things like that coming into the mix. What are you doing to start helping them, be able to better verify or provide services that would increase the verification capability?

Yeah Jeff, that was a good question. So I think that you are correct, that a number of communities are reacting in kind of an adverse way to the mountain of false alarms, that a lot of these sort of security in a shoebox type of offerings are generating, as folks take home things they bought, at a retail store and try to install it. So we are hearing about that; I think our service providers actually kind -- in kind of an odd way, they actually like seeing a little bit of that dynamic, and because it in some ways, benefits them, it leads the customer back to getting a system from someone that has installed hundreds, if not thousands, and knows how to make sure these things are not generating a ton of false alarms. So it's not necessarily a negative trend. And then it brings us to, like things that are particularly interesting, that we are doing with the product itself. And as an example, a customer can actually see images and/or video from their home, and then acknowledge that the alarm is true or false, directly from their mobile app, before the central station actually ever initiates a dispatch. And in that case, we will generate a cancel back to the central station, and that will flow through and we avoid a lot of the false alarms, especially when we are getting kind of a higher attachment of some of these video elements. And when I say video elements, that kind of brings me on to products I have always been excited about, which is the product we call the image sensor, which is a low cost motion detector that actually includes a camera that takes pictures, anytime it's triggered at an alarm state. And there again, we can get that data -- that contextual data directly to the consumer, and give them an opportunity to call off the alarm and all of that sort of wire. They don't even have to take a phone call, they simply hit the cancel button and the alarm goes away. So I think it's probably good for us. It give us a chance to be innovative. I think doing things, another one that's associating individual sensors. So peripheral sensors with actual cameras, to be able to map that layout, such that when there is an intrusion on a given point in a property, we are getting to the operator in the central station, the video, sort of the right video for that type of intrusion, gives us a place where we can do interesting things with software, to make the whole apparatus better, and hopefully make it -- something that creates less anxiety for the consumer, and so it is a dynamic. It's one that actually think is probably positive for our business, and hopefully an area where we can really help our service providers persist.

Okay. Thank you very much.

Thank you.

Ladies and gentlemen. This concludes today's question-and-answer session. Thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a great day.