Alarm.com Holdings, Inc. (ALRM) Q2 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Alarm.com Q2 2018 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 follow at that time. [Operator Instructions] And I would now like to introduce your host for today’s conference, Mr. David Trone, Investor Relations

Thank you. Good afternoon, everyone, and welcome to Alarm.com’s second quarter 2018 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. Management’s discussion during the call today will include forward-looking statements, which 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 or any other similar statements are intended to identify such forward-looking statements. These statements are subject to risks and uncertainties, including those contained in our updated Risk Factors section of our most recent quarterly report on Form 10-Q filed with the Securities and Exchange Commission and subsequent reports that we file with the Securities and Exchange Commission from time to time that could cause actual results to differ materially from those contained in the forward-looking statements. Please note that these forward-looking statements made during this conference call speak only of today’s date, and Alarm.com undertakes no obligation to update these statements to reflect subsequent events or circumstances, except to the extent required by law. Also during this call, management’s commentary will include non-GAAP financial measures and provide non-GAAP guidance. Management believes that use of these non-GAAP financial measures provides an additional tool for investors to use in understanding the company’s 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 website at investors.alarm.com. This conference call is also being webcast and is also available on our Investor Relations website. The webcast of this call will be archived, and a telephone replay will also be available on our website. With these formalities out of the way, I’d now like to turn the call over to Steve Trundle. You may begin.

Thanks, David, and welcome to everyone joining our call today. We’re pleased to report another solid quarter that exceeded our expectations. SaaS and license revenue in the second quarter was $71 million, up 20.4% from $58.9 million in Q2 of 2017. Our non-GAAP adjusted EBITDA in the second quarter was $23.4 million, up 47% over last year. Our service provider partners continued to compete effectively in the market and were more successful in the second quarter than we anticipated. Most potential residential and business customers continue to demonstrate a preference for a professional-grade smart security solution that comes with the commitment to ongoing service and support from a reputable provider. I want to thank the Alarm.com team as well as their service providers for their contribution to our positive results. This is the first quarter in our company’s history that we have exceeded $100 million in total revenue. On today’s call, I want to update you on a few of our business initiatives and recent product introductions. As most of you know, we continuously integrate new hardware and peripheral devices into our ecosystem. This gives us an ever improving set of intelligent, useful and convenient capabilities for the subscriber. It also equips our service providers with an expanding set of solutions to market and sell. This quarter, we launched a new smarter heating control solution that integrates a number of new devices. It provides an easy retrofit for boiler systems that are popular in Europe. The hardware kit includes a new EU version of the Alarm.com Smart Thermostat as well as third-party devices for managing hot water cylinders and individual radiators for room-to-room temperature control. Domestically, we introduced the integration of the DSC iotega from Johnson Controls. The iotega is a versatile headless security control panel for residential installations. We also expanded our portfolio of smart locks with the addition of the Yale Assure, Kwikset Convert as well as the August Smart Lock Pro for customers who don’t want to change their existing door hardware. Earlier this year, we introduced the Danalock V3 for the European market. As we grow our ecosystem, our service providers tend to expand the range of solutions that they offer so they can service more of the market. Next, I want to talk about the home builder program that we announced during the second quarter. As I have mentioned on previous calls, new homebuyers tend to have a high adoption rate on smart security and automation systems. Many of our service providers work with builders and their local market, and one of our goals is to help facilitate these partnerships. Our program gives builders a full range of support through efficiently deploying smart home solutions in new home communities. The best-in-class hardware products in our ecosystem allow builders to tailor solutions to the target buyers and the design aesthetic of a given community. Working with one of our service provider partners, builders can also minimize the risk and cost of deploying new smart home technology. Our service providers manage the required product inventory, install and configure the systems and then service the systems through years after the builder has delivered the property and move-in has occurred. Early in the second quarter, we also launched our new commercial platform, Alarm.com for Business, including our new Smarter Access Control solution. I discussed this initiative on our last quarterly call and, I want to give a brief update on our progress. As a reminder, our commercial platform integrates interactive security, video surveillance, access control and energy management into a unified, intelligent solution. It’s designed to address the needs of small and medium-sized businesses. We see a meaningful opportunity for our service provider partners to attack this segment in both the domestic and international markets. Since launching our commercial platform in April, we have initiated marketing, sales and training activities to increase awareness with our service provider partners. While interest is strong and sales are beginning to flow, it was not the reason for our outperformance in the second quarter. It typically takes a longer period of sustained solid execution to get our partners comfortable with routinely selling and installing new products like the Alarm.com commercial platform. Next, I want to touch on marketing. As we discussed on our last call, we proceeded to execute our plan to increase our marketing presence this quarter. We are focused on a couple of things in our marketing initiatives. First, we want to properly launch and raise awareness for our commercial platform. There, we are focused on the security channel. Second, we want to better position our service providers and our technology with home and small business owners. Here, we are focused on the consumer. We are educating them about the value of our more robust integrated solution and our go-to-market approach. Our message often distinguishes the benefits of working with our service provider partners. We believe that these efforts help our service providers as they engage in sales discussions with potential customers. I also want to update you on some of our longer-term growth initiatives. Beginning with our international business, we see continued progress and momentum. We reached the total of 100,000 active international accounts during the second quarter, not including Canada. Today, we have 151 active service provider partners in 37 countries outside of North America. Our services are currently localized for 40 countries. This quarter, our services launched in South Africa through ADT Fidelity. ADT Fidelity is the leading security provider in South Africa, with approximately 35% of the residential intrusion market. We also continued to expand in Europe through our partnership with Securitas and others. Our European presence now includes Spain, the Netherlands, Ireland, Belgium, Sweden and Norway. One other new partnership I want to highlight is our relationship with Aviva. Aviva is a large European insurance company with more than 33 million customers globally. They will introduce Aviva Smart Home, a professionally installed and monitored smart home security solution in Ireland this fall. Our partnership with Aviva is built around a first-of-its-kind application for IoT services. Many insurance providers have offered discounts and affinity programs for smart home security products. Aviva sees a broader opportunity in offering an Aviva-branded and customized solution that is tailored to their policyholders. With our full scope of advanced property protection capabilities, Aviva’s solution can take preventative action to reduce claims while also generating more customer engagement. To give you a better feel for the growing breadth of our global presence, our updated investor deck now includes a list of some of our key service providers, along with links to some of their marketing assets. We founded the company based on the idea that people universally value peace of mind and protection for their loved ones. It’s gratifying to see the diverse range of brands that are echoing this message and the values of our technology to a growing global market. We also operate several growing subsidiary businesses that we report in our Other segment. This includes PointCentral, Building 36 and EnergyHub. Their SaaS and license revenue grew 59% in the second quarter. EnergyHub recently announced that it will manage National Grid’s full-scale bring your own device demand response program. National Grid is one of the largest investor-owned utilities in the world with more than 3 million homes in its target market in the Northeast. The program will leverage the breadth of EnergyHub’s Mercury platform by including multiple device categories, including residential battery energy storage. We continue to see solid ongoing progress with all of our long-term growth initiatives. We will continue to update you as these efforts further develop and contribute to our growth trajectory. To summarize, we’re pleased with our performance this quarter, thanks again to our service provider partners and the Alarm.com team for their hard work and to our investors for their faith in our business. And with that, let me turn things over to Steve Valenzuela. Steve?

Thank you, Steve, and good afternoon, everyone. I will begin with a review of our second quarter 2018 financial results and then provide guidance for the third quarter and our raised outlook for the full year of 2018, before opening the call for questions. SaaS and license revenue in the second quarter grew 20.4% from the same quarter last year to $71 million. This includes Connect software license revenue of approximately $10.2 million for the second quarter compared to $8.5 million for Q2 2017. This is the first full quarter for Connect revenue and the comparable year-ago period as we closed the acquisition of Connect toward the end of Q1 2017. Our SaaS and license revenue visibility remains high with a revenue renewal rate of 94% in the second quarter, at the high end of our historical range of 92% to 94%. Hardware and other revenues in the second quarter was $33.5 million compared to $27.1 million for Q2 2017. The increase in hardware sales in the second quarter was primarily due to an increase in sales of our video cameras and, to a lesser extent, an increase in sales of thermostat and our system enhancement modules. Q2 is typically our strongest quarter for hardware sales going into the summer selling season. Total revenue of $104.5 million for the second quarter grew 21.5% from Q2 2017. SaaS and license gross margin for the second quarter was 84.5%, consistent with our gross margin in the sequential quarter, and down slightly from the same quarter last year. Hardware gross margin was 24% for the second quarter compared to 21% for the same quarter last year. We expect hardware margins to moderate in the future, consistent with our historical range of 20% to 22%. Total gross margin was 65% for the second quarter, comparable to the same quarter last year. Turning to operating expenses. R&D expenses in the second quarter were $21.5 million compared to $20.1 million in the second quarter of 2017, as we continued our planned investment in R&D, given the significant opportunities we see in our markets. We ended the second quarter with 466 employees in R&D, up from 429 employees in the same quarter last year. We expect to add more employees in R&D in the third quarter as university hires come on board. Total headcount increased to 828 employees compared to 750 employees at the end of Q2 2017. Sales and marketing expenses in the second quarter were $14.6 million or 14% of total revenue compared to $11.9 million or 13.8% of revenue in the same quarter last year. As we previously indicated, we are investing in sales and marketing to promote our new Alarm.com for Business and Smarter Access Control products, and we initiated more general marketing programs designed to raise the stature and awareness of service providers who offer Alarm.com. We plan to continue these investments in the second half of 2018, consistent with our prior guidance for sales and marketing expense to be approximately 14% to 15% of total revenue for 2018. G&A expenses in the second quarter were $18.1 million compared to $13.5 million in the year-ago quarter. G&A expense includes non-ordinary course litigation expense of $6.1 million in the second quarter compared to $1.3 million in Q2 2017. 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 $23.4 million in the second quarter, up 47% from $15.9 million in the same quarter last year. In the second quarter, GAAP net income increased to $10.7 million compared to $9.9 million in the year-ago quarter. Non-GAAP adjusted net income increased to $60.8 million in the second quarter compared to $10.7 million for the second quarter of 2017. Turning to our balance sheet. We ended the second quarter with $106 million of cash and cash equivalents. In the second quarter, we generated approximately $11.7 million of cash flow from operations with $8.6 million in free cash flow. We prepaid about $10.9 million to secure component supply in the first half of 2018. We expect to convert most of these prepayments to cash in the second half of 2018. Moving to our financial outlook. We expect Q3 SaaS and license revenue of $72.2 million to $72.4 million. We are increasing our expectations for full year 2018 SaaS and license revenue to be between $286 million to $286.5 million, up from our prior outlook for SaaS and license revenue of $284 million to $284.5 million. We are also raising our guidance for total revenue for 2018 to $388 million to $390.5 million, up from our prior guidance of $381.5 million to $383.5 million. This includes our increased guidance for hardware and other revenue of $102 million to $104 million, compared to our prior guidance of $97.5 million to $99 million. We expect Q3 hardware revenue to be sequentially lower than Q2, coming off a seasonably strong Q2. We also expect hardware revenue for Q4 to be seasonally lower than Q3, consistent with historical trends. We are increasing our expectations for non-GAAP adjusted EBITDA for 2018 to be between $85.1 million to $85.9 million, up from our prior guidance of $82.5 million to $83.2 million. We expect adjusted EBITDA to be lower in Q3 and Q4 compared to Q2, reflecting our planned investments in marketing and R&D, which is in line with our full year guidance. We therefore expect Q3 adjusted EBITDA to be sequentially lower than Q2, and Q4 to be seasonally higher than Q3 by approximately 7% to 8%. We are also raising our guidance for non-GAAP net income for 2018 to $59.4 million to $59.9 million or $1.19 to $1.20 per diluted share, up from our prior guidance of $57 million to $57.5 million or $1.14 to $1.15 per diluted share. This is based on our non-GAAP tax rate of 21% as we have previously indicated. EPS is based on an estimate of 50 million weighted average diluted shares outstanding, and we expect full year 2018 stock-based compensation expense of $11.5 million to $12 million. In conclusion, we are pleased with our performance for the first half of 2018. We are excited about the opportunities ahead for us and our service providers. We are continuing to invest in our business to capitalize on the expanding opportunities enabled by the Internet of Things and the intelligently connected property. Thank you for joining us on our call today. And with that, operator, please open the call for Q&A.

[Operator Instructions] Our first question comes from Nikolay Beliov with Bank of America.

Hi, thanks for taking the question. If you can please give us some more color on what caused the outperformance in the quarter.

Hey, Nikolay. Steve speaking. Yes. I think that what we saw is dealers are generally feeling positive about their markets. They’re feeling fairly positive about the economy. And I think we saw some just increased purchase levels of the same product portfolio. So as I noted in my comments, not really driven by the commercial launch but just the broad range of cameras, the thermostat, all – higher sales than we anticipated. I think our service providers want to make sure that they’ve got product on the shelf going into the summer and that they’re well-equipped. So those are not really a specific answer I realize, but those are some general trends that I guess we saw.

Okay. And a follow-up to the equivalent. So Steve, 20% subscription revenue growth, clearly, very strong. You’re guiding to 17% in Q3. Is there other seasonal factors you’re baking into guidance? Or is it being conservative?

Well, we always have to consider there could be SLA requirements that we have to be careful when we guide. I think if you look at Q2, when we guided Q2 SaaS, the growth was also about 17% year-over-year, and we came in at 20%. Now that being said, we just have to be cautious with our guidance here. There are things that could occur that have occurred in the past that could affect our SaaS revenue.

Got it. And my last question is for Steve Trundle. Steve, you are the first one seller, then you were the first one to adopt LTE. Any preliminary thoughts on how 5G might change your business and how you guys can take advantage of that?

Yes. So there are number of things on the networking side going on right now. There’s 5G, there’s CATM and then there’s low ra – or low-frequency long range, mesh wireless networking. And we’re working in all sort of three of those domains. I think the more immediate impact that we’ll see is really CATM, which is a low-powered version of LTE that you can envision enabling us to reach locations where there may not be a power supply, there may not be a hub, et cetera. So there’s a fair amount of focus there as well as on CATM, there’s a more modest cost structure in both the equipment and on low volume data transport prepayments. With 5G, I think 5G is a little further out. I think, though, the ambitions we have around 5G are to be able to give our service providers a wider range of flexibility when they go in and sell in high-bandwidth IoT devices like high-def video cameras. So there, I think, we’re waiting on the bandwidth and the cost and really the deployment. Sometimes, these marketing terms, by the way, get kicked around years in advance of when they’re actually in market. And we’re only as good as the breadth of the deployment of these technologies. But with 5G, our hope will be that if you’re a service provider and you’re installing a new home that doesn’t yet have, for example, a consumer in there with a broadband connection and you want to enable all the services so that you can confirm their home is done, you could do it with a 5G version of our product set and even accommodate the higher bandwidth parts of the application. So those are a few of the things that I think we’re excited about there.

That’s helpful. Thank you.

Our next question comes from Adam Tindle with Raymond James.

Okay. Thanks, and good afternoon. First question for Steve Trundle. I know there’s been a lot of noise in the competitive landscape this quarter. So I just wanted to ask if you saw any level of customer pausing ahead of the Amazon Ring security product in the quarter, or impact so far in Q3 now that, that’s completely go live? And I’d imagine, a little based on your results and guidance, but wanted to confirm, and maybe if you could help sort of tie that in to comparing this versus your early experience with Google’s Nest acquisition years ago?

Yes. Good question, Adam. I don’t want to appear cavalier, but in both cases, both the Nest thing years ago and then the most recent announcement, the biggest impact was really the number of questions we got at the time of announcement and some time we invested in answering the questions. In terms of what our service providers see in the market, we haven’t seen any impact. I think the quarter is evidence that they’re feeling pretty good about their markets and their customer base hasn’t evolved in any way from either the Nest stuff or the Amazon stuff. And I think that’s just consistent with what we stated, which is we really think the market is pretty broad and there are different segments of the market. There are folks that are looking to add a device to their apartment, and then there are other families that are worried about the overall quality protection and safety in their property and want to really invest in their home. And we cater to the latter crowd. I think that’s probably who we’ve been catering to through the years, and that group, we haven’t seen any changes in their behavior.

Okay. That’s helpful. And then, maybe just as a follow-up, I wanted to touch on guidance as well. In the back half, the EBITDA margin is coming down a little bit after a very strong first half, and you alluded to some of the reasons for that. I guess, the question would be the SaaS growth line is also implied, the slow to kind of the mid-teen sort of a level on a year-over-year basis. Why wouldn’t we see an acceleration if the investments start increasing, or maybe there’s an aspect of timing here where the growth comes later that we might not fully appreciate. Just any help on kind of the dislocation between those two things. Thank you.

Yes. Adam, that’s definitely some timing. As we’ve talked about for the commercial, it just take time to really have that roll through the dealers to have the service provider partners get trained. And so it’s fair to say there’s not much of that in the 2018 guide. Also, we have to take into account, too, from a revenue point of you, as I indicated, typically, you see seasonality for hardware, for example, coming down – being seasonably slow, especially in the fourth quarter. And then, we have to take into account for SaaS and license. We have to, when we guide, factor in that there can be some disruptions that can occur, like SLA requirements that we’ve seen very occasionally, but it has happened in the past. So we have to factor that in. And then, when you look at EBITDA, we are increasing our investment in sales and marketing and we’re increasing our investment in R&D. So if you look at kind of the first half of 2018, we didn’t have a full complement of R&D hires, especially now that university hires have come on board. So we’ll have more folks in R&D in the second half of the year. And from a sales and marketing point of view, Q1 was fairly light on sales and marketing. Q3 and Q4 will be higher on sales and marketing, consistent with our guidance for overall sales and marketing for 2018 to be about 14% to 15% of revenue. That said, we did increase the guidance for adjusted EBITDA for the year quite nicely. And if you look at the 2017 adjusted EBITDA, we came in at about 21.1%. And with the midpoint of the guide here of about $85.5 million for adjusted EBITDA for 2018, we’re taking that up to 22%. So almost 100 basis points.

Understood, makes sense. That’s helpful, Steve. Thank you very much.

Thanks, Adam.

Thanks, Adam.

Our next question comes from Matt Pfau with William Blair.

Hey, guys. Thanks for taking my question. And just wanted to first hit on the insurance partnership that you signed with Aviva. So I guess, interesting first that the first partnership that you signed, at least that I’m aware of from the insurance perspective, is in the international region. So maybe you can touch on how that evolved? And then, I guess, more broadly, what’s the opportunity for additional insurance partnerships? And how many of these may you have in place already?

Sure. I think, in some cases, we opined that the – on the insurance side, that the international markets oftentimes have slightly different regulatory environment, and at times, we’re seeing just more innovative kind of concepts outside of the U.S. as it relates to insurance. So Aviva, I think, it really occurred because they had a team that thought differently about what they could do with the IoT and how that might relate to the way they render services and premiums to their customers. And what’s different about it is just the concept of a branded Aviva offering with a focus on encouraging or highly encouraging deployment of pieces of technology that actually have the potential to reduce risk premiums. So they are still working with a local service provider, and that service provider has also been very kind of progressive in the way they put this program together. So we’re excited about it. We don’t – it’s early days and it’s too early to know just how well they’re do – they’ll do, but I would say they’re very committed to it and they appear to be doing something that very novel in our view. And we’ll be thrilled if we saw adoption of similar types of programs elsewhere, particularly in partnership with our service providers. It’s too early, though, for us to say that we got a full pipeline of similar types of deals across the globe. We don’t. We’re in discussions with various other parties that kind of have similar attributes that we of course would be. But we’re going to focus on Aviva in the near term, and make sure we do everything we can to help them be successful with the program.

Got it. And then, last one for me. Maybe you could just give us an update on what the video uptake of new customers is looking like and how that has trended versus prior quarters, given part of the hardware outperformance in the quarter was due to the video cameras. And then, I believe, at least your slim line video Doorbell Camera has been on back order with most dealers for quite some time. So it seems like demand there has been healthy. So maybe just an update on the video uptake.

Yes. You definitely did your research. So I’d say, quarter-over-quarter, the video attachment was really sort of consistent. If you look back over kind of a longer continuum of time, video attachment has trended up certainly since if you go back into the 2015 and 2016 time frame. And then, also, we’re seeing a higher percentage of the base. I may have commented this on a prior call, but a higher percentage of base coming back and saying I’d like to add video to my system now, so some sales into existing customers also happening now. In the second quarter, as you noted, and unfortunately, we have to acknowledge, we did have some supply chain issues particularly around the video camera for the door slim line product. And I would say that hampered some of the attachment of video that we might have otherwise seen in the second quarter, but not in a way that affected our results.

Got it. That’s it for me, guys. Thanks a lot.

Thanks.

Our next question comes from John DiFucci with Jefferies.

Thank you. I have a question for Steve Trundle and then a follow-up for Steve Valenzuela. Steve Trundle, my question is on the builder program. I just want to make sure that I understand this. These relationships are still going to be owned by the service providers, the relationships with the builders themselves? But you also said in the press release when that came out that Toll Brothers are already uses Alarm.com. So in that case, is Toll Brothers the acting service provider? Or is there some – are there others involved depending upon where homes are being built throughout the country? And I guess, my last question is related to that is, how do you encourage that? Like how do you – if – and I believe you always want to have those service providers involved, so I believe they’re probably going to – that’s going to be the answer, but how do you get those guys to really – this is all new for them, there’ll be new relationships, how do you make it happen?

Yes. So good set of questions and it requires that I distinguish Toll Brothers from some of the other builders. So let me start with that and then come back to kind of the broader vision for builders. Toll Brothers is a bit unique in that they’re actually a service entity themselves. So they own a security division. They have for years. This isn’t a new thing. They made a decision some period of time ago that they would operate a security division that services their model homes as well as their new customers. And therefore, they’re more like – I think they bought a security company probably to enable that. They’re more like a traditional service provider to us that is just highly affiliated with a builder, being – meaning Toll Brothers. But I would put them in a little different bucket than other builders where the builder is not simultaneously engaged in being a security service provider. And this program that we’ve announced is more focused on a vision of getting builders to specify into every home some piece of the Alarm.com ecosystem or multiple pieces of the Alarm.com ecosystem. And ideally, it’s not a buyer option. It’s something that just comes with the home. And luckily, we encourage it some, but the consumer is encouraging the builder to make – the builder needs to distinguish a new home from a legacy home, and an integrated set of smart home components can be a distinguishing characteristic that’s attractive to the consumer. So the demand is there from the builder. And then, the trick is for us, I think, we benefit from a fairly fragmented service provider base, but at times, it makes us – difficult for us to put on sort of a unified face to a builder, particularly a national builder. So in this case, we’re not servicing, no. The service provider is always brought in to the relationship or the builders introduce the various service providers and then the service providers compete for the relationship. But we’re really more focused on with the builder, marketing and selling the merits of our platform and the versatility of the platform to scale from simple smart home applications like automating lights and the thermostat and the garage door to moving on up and to an integrated automation and security solution to moving on up with integrated audio, energy, video and automation. So we’re promoting the merit to the technology. If the builder then adopts and standardizes on the Alarm.com ecosystem, it benefits all of our service provider partners. And they, in turn, work with the builder to iron out the mechanics. And they add a lot of value to the builder as well. And as I put in my comments, they derisk the smart home process for the builder. And we have partners that are national in scale that can work with national builders and we have local partners that work with locals. And we’ve put a few setups in place to make it more valuable for our service providers to compete with us for that builder business.

Okay. That’s great. That all makes sense and that’s clear. And I guess, Steve Valenzuela, I would’ve thought that cash flow would’ve increased year-over-year. It would’ve been a little stronger than it was this quarter, not that – it’s flat year-to-year. But it – and it looks like accounts receivables jumped. And I don’t know, can you just help us understand what’s going on in cash flow in this quarter? I know we shouldn’t look at it just on a quarterly basis, but we hope you could also do that.

Sure, John. Yes. So we did prepay about $10.9 million for inventory in the first half of the year for component supply. Some parts are becoming long lead time and we talked about some of supply disruption with our video doorbell. So we wanted to prepay that. So that came out of cash and it’s not converted yet. We do expect to convert most of that to cash in the second half of 2018. So I would expect that the second half of 2018’s free cash flow should be higher than the second half of 2017, with the caveat that litigation-related costs are not predictable, and those, of course, affect cash. But if you look at – as you pointed out, if you look at the first half of 2018, we have free cash flow of about $9 million. A year ago, we had $19 million. So if we didn’t have the prepayment of inventory, we would have been about flat. And for the second half of 2018, if you look at it compared to 2017, we had about $28 million of free cash flow for 2017. So I expect that to be up, let’s say, about 10% to 12% 2018 – for the second half of 2018 for free cash flow, again, with the caveat not all factors are easily determinable when it comes to cash flow.

Yes. But like you said, it would’ve been flat. But even then, I would have thought it would grow. I mean, the business is doing really well and earnings are growing. And like I said, you did have working capital here that was – I’m not sure why accounts receivable jumped in this particular quarter. It jumped by a lot more than it usually does, at least it looks on a seasonal basis.

What happened there, John, was we had a strong outperformance in the hardware sales, and so what happened is that tended to be more nonlinear toward the end of the quarter. So our AR DSOs were 46 days in Q2 compared to 43 days Q1 of 2018, and we expect that to convert to cash in the second half, in Q3. So that’s why we’re guiding or indicating for the second half of 2018, the free cash flow to actually be higher in the second half of 2018 compared to the second half of 2017. So that was a temporary – when you have such hardware sales versus SaaS, which is tends to be linear, hardware is not as linear and that affects your AR and your DSOs because if we have more of those sales back-ended, you don’t have time to collect within the payment period. So it’s more of a timing difference. So hopefully that helps you.

Yes. That’s helps a lot, Steve. Thank you very much. Nice job guys.

Thanks, John.

Our next question comes from Jeff Kessler with Imperial Capital.

And Steve, about a year ago, you absconded, or I should say, bought a whole bunch of talents from ObjectVideo, all their human assets, so to speak. And since then, we haven’t heard much about them. You’ve been hiding them somewhere on sand or rock, without us even – they’ve been obviously doing some work for you, but I’m just wondering if you could update us the types of things that are coming out of video analytics, skunkworks at Alarm.com?

Sure, Jeff. Yes. So we’re very pleased with the team, obviously, that we were able to acquire from ObjectVideo. And we’re kind of in between skunkworks and deployment at this moment, I would say. So our goals for video analytics have been really to make the quality of the alerts even more relevant to the consumer and to make sure that we’re recording things that matter. And by being intelligent and training a set models around video, we can be more intelligent in the delivery of content to the consumer. And the bigger, the more data you have in those models, the more model powerful the model become. So that’s kind of what we’re trying to achieve there. And I guess, the update is we’re testing externally certain amounts of optionality right now and are not going to put it into our standard offering until such time that it’s ready, but we’re making progress. I’d love to have it out already, but we don’t. But the team is heads down working hard against the set of internal deadlines to get a release of our residential analytics package out this year.

Okay. Your other businesses were up 59%. And I realize you’re talking about a small number, but could you give us some more color with regard to those businesses since they obviously could become material at some point in the future?

Yes. So I think I highlighted a bit more on EnergyHub in my comment. They recently won a nice deal with National Grid. Their business is expanding from being really a thermostat-driven type of DVR program to being a program that enables a utility to manage load coming from a wider variety of consumer devices, including, I think, I put in the note or in my comments, even battery chargers where being selective about – or battery being selective about what time you actually recharge a residential battery can have a meaningful impact on load for utilities. So they’re managing a whole array of diverse forces in the field. The business is clicking along. I think, we’re beginning to realize the vision we have for EnergyHub when we acquired it. And the other one is PointCentral is focused on unattended access and at times unattended delivery, but really drilling down and focused on making it easier for people who are going on vacation and going to be staying in a vacation home or making it easier for a REIT that owns a lot of rental properties to remotely manage energy consumption, temperature and really awareness and access of all of those properties. So they’re not really delivering a security solution per se, but there’s – they’re evidence of a need – they’re evidence of us taking the platform, which is primarily sold as a security platform and position it more as a base IoT platform for certain vertical applications that have more nuanced requirement. And PointCentral is building on that and they’re a big contributor to that number. And then, the last one I talked about the past in that segment is our HVAC business. And I’m still at the point where I have to say the same thing, which is that business is still more in its nascent phase where we’re seeing demand but we’re building a channel. And what we’re trying to do there is take the concept of remote monitoring and apply it to everyone’s HVAC system and protect people from outages, help the service provider know when a unit may need service, that sort of thing. So all are kind of novel concepts and making good progress, I would say.

One of the – I guess, one of the questions that are being asked a lot is about, I would say, technology that is being developed inside the monitoring center itself, more analytics obviously, eventually moving toward AI, which some people think of as a threat to the traditional dealer if everything else is equal and everything else is a commodity. Is there a way for you to work with the technology that is being developed or spent on monitoring centers given that a lot of your clients are going to have to probably upgrade their own monitoring centers over time?

Right. So kind of two parts. One, is AI a threat to the traditional business of our service providers? And we don’t believe it is. We think it enhances the range of capabilities that our service providers can yield to a consumer. And at the end of the day, the reason – one of the reasons we’re successful is if the customer wants service first. And service sometimes can be AI. But more often than not, it’s more rudimentary. It’s I need someone to come get this thing working in the next day or two. So our guys – our team is good at that. With regard to how we partner with the central stations, yes, we’re always open to leveraging the assets that a central station has in a way that would result in better functionality for the consumer. You have to keep in mind that the data though coming in, the volumes of data coming into Alarm.com pretty significantly exceeds the volumes that would typically become an end to a central station for the same account. I mean, we’re basically dealing with every event and every video fragment. And if you’re trying to train an AI model, there is some merit in training it with a large volume of data because the model becomes actually more effective and more predictive. So I would think, in most cases, we’re going to be pushing some intelligence down to the central station and then hopefully providing them the tools needed to react to that intelligence and deal with it in the most coherent way with the consumer. But there may be cases where we can benefit from a model sitting in the central as well.

Okay. Thank you. And one quick final question. With regard to the commercial business, can you talk in terms of real life practices where some of your clients are, where you would like them to be? Are there a group that are further ahead of others in taking on the commercial product? And there – is there a group that is essentially coming on and taking a little bit longer to do this? Where are you – how was that – how is in practice this coming down here in terms of time as well?

So I would say that it’s consistent with what we’ve seen with other products in terms of the adoption cycle. There are a set of early adopters that tend to be very entrepreneurial companies oftentimes run by a single owner, and so these are what we would call our carriage. Some people refer to them are carriage straight dealers or smaller dealers. They’re typically the fastest adopters of anything because they can make a decision very quickly. One person makes a decision, they move out. So we’re seeing that the most – and by the way, that’s kind of good for us because those folks tend to be very hands-on and they also tend to be fairly vociferous with their feedback. And so we’ve got a set of more than 100 early adopters, I believe, that are selling not just commercial but the commercial integrator with access solution. The feedback has been very positive and we’re looking – watching kind of the repeat sales. So not do they just sell one, or they sell one every week, they sell every two weeks, et cetera. And then, the sales cycles that takes longer and take more training more work tend to be the larger service providers that will evaluate things, will take more time to consider where they’re going. And those are all – those discussions are probably about where we thought they would be, which is we’re in discussions but it just takes some time to kind of break through inertia and drive change in a larger service provider. So most of the adoption, thus far, has been from the smaller partners we have.

Thank you. Our next question comes from Gabriela Borges with Goldman Sachs.

Good afternoon. I appreciate you letting me to ask a question. On the ARPU, I’d love to get an update, either from Steve Trundle or Steve Valenzuela, on what you’re seeing directionally in the residential piece of the business as you get more attach rates on new functionality? And is there any update on the mix that you’re seeing in the ADT channel from customers coming on board on Alarm.com versus Connect, given the benefits that it has of an on-premise system? Thank you.

Sure, Gabriela. So I’ll start and Steve can help me if I need it. But with ARPU trends, we haven’t seen any significant change there. The internal dynamics are still pretty much the same, which are that we’re continuously kind of evolving the capabilities and sometimes new capabilities like commercial are – won’t yield a higher ARPU than our basic residential services. So at the same time, there’s always price pressure on the residential services. So the combination of sort of continuing to try to drive more value to our service providers and the higher-volume residential segment offset by higher ARPU coming in from either enhanced services like video or from commercial has resulted in more or less a steady-state kind of ARPU trend. And the second part of the question was regarding ADT’s plans and their transition or not. And I guess, I’d say there, probably what I’ve said in prior quarters, which is we’re aligned with ADT, working together obviously, especially on the technology side. We think they have – are taking a set of kind of exciting steps, and we don’t want to usurp the message. We think that ADT will message it’s kind of plans for what it’s going to bring to market in due time when they’re ready and we’re going to leave it to ADT.

That’s helpful. And a follow-up, if I may, for Steve Valenzuela as well. I wanted to revisit the hardware outlook. Your comments on seasonality made a lot of sense. I also wanted to look at it maybe on a year-over-year basis. I think, guidance implies a little bit of a decline in the second half year view. It seems counter to the trajectory of pretty consistent growth if I look back a couple of years. How should we think about the trajectory of hardware business from here? And is there any reason why it would actually decline year-over-year? Thank you.

So it’s very possible too that some of the Q2 hardware sales may have been pulled forward from Q3. So we can’t tell that for sure because given the supply shortages. So we just have to be aware of that from a guidance point of view. But typically, if you look in the past, and it is hard to tell because there are new product introductions and there are timing things occur that could skew that, but if you take that out, typically, Q4 is usually our seasonably weakest quarter for hardware. So if I was modeling this, I would probably look at Q4 to be about 10% lower sales in Q3 2018. If I was doing the model, we’ve given you the annual guidance, I think you can model it that way. So that’s – because that’s the way I would look at this. Again, hardware, we just have to be careful with when we guide because it’s not recurring. It’s not necessarily predictable. There’s so many things that occur in the past. We introduced new cameras. We introduced new commercial cameras and so that can kind of skew. We try to take that out when we give guidance and we try to think, okay, what’s the steady-state, what’s reasonable not trying to guide with all the different fluctuations that occur quarter-to- quarter. Overall, the trend, as you’ve seen, we’ve taken the guide up on hardware for the year because it is actually very hard to guide on a quarterly basis.

I appreciate the color, thank you.

Thank you.

Our next question comes from David Gearhart with First Analysis.

Hi, good afternoon. Thank you for taking my questions. My first question is just in regards to the litigation expense nice – actually not nice but a sequential increase from here. You said in your earlier remarks that it’s hard to predict with litigation expense. How should we model the year? Can you give us some sort of baseline to model for the rest of the year?

Yes. The hardest questions, David, are questions about litigation expense because we can’t really telegraph – not in our interest or shareholders’ interest to telegraph exactly what we may be doing on the litigation side. And – but I guess what I’d say at a very high level is there’s a bit of a lull in 2017, and we think that 2018 will look a little more like 2017. When we’re all-in, we don’t think that what you saw in the second quarter is indicative, at least at the moment, of any kind of one-time blip. It’s probably more indicative of the fact that various matters are progressing at a point where there are costs that are higher as we go through sort of the ebb and flow of these matters.

Okay. And then, you’ve talked about SLA agreements and having to kind of put that in your guidance and forecast that. You’ve been public for a while now. Every quarter, you’ve exceeded the high end of your SaaS and license revenue guidance. Just wondering if you can give us some sense of how often these SLA issues where it would violate an agreement occur and roughly how much you’re sizing those so we can maybe kind of get a sense for it and how that’s factoring into guidance?

Well, there are a few different variables that can come into play that are sort of volatile and probably three or four different variables. And I would say, roughly, this is an approximation, but one out of every – we hope that they don’t happen at – there’s a negative outcome on negative outcome on one of these variables, you hope that not all three sort of align in the same quarter and we don’t discount to that point. But we do have to allow for the possibility that something could occur. And I would say, one out of every four quarters or so, something does occur. And that causes some unpredictability in the SaaS and license revenue stream. And our goal is to make sure that a modest fluctuation driven by one or two SLA variables doesn’t sort of lead people to lurch. So we have to – or leave them surprised. So we have to account for that. And if everything goes well, then we do outperform slightly. But anyway, that’s probably about what I – how we think about it, I guess, I would say.

Okay, that’s it from me. Thank you for the color.

Thank you.

Our next question comes from Brad Reback with Stifel.

Great, thanks very much. Just real quickly back on litigation. Can you remind us what the – sort of the key issues here, what the key cases that are sort of progressing and when you expect trial?

I think, most of our litigation that’s material would be in our public financials and probably the full update when the 10-Q goes up, we would refer people to that just because we’re limited in how much we can say about any current litigation on a call like this. But there are several different matters on the IP front, I think, that are reflected. There’s a little matter. There’s – I think there’s one other one that’s in the 10-Q. And we’re always dealing with sort of trolls that sometimes make it on the 10-Q, sometimes don’t. There is couple of TCPA matters, I think, one of them being bigger than the other that is approaching litigation. So I guess what I’d say is those – that’s probably about it right now. We’re on – we’ve got a body of IP matters that our legal team is handling, and then a body of – and in some cases is assertive and then a TCPA matter, and probably would just say the best situation we can provide there is going to be what we disclose in the 10-Q.

Great, thanks very much.

Thank you.

Our next question comes from Mike Latimore with Northland Securities.

Hi guys, Matt Shea on for Mike. First question, how much SaaS revenue did the Other category contribute? And how fast was that growth?

Other – this is Steve Valenzuela. The Other segment accounted for about $2.9 million of SaaS revenue in the quarter and it grew 59% year-over-year. The other thing we should note is that the Other segment as a total revenue now accounts for 7% of our total revenue, including hardware, whereas a year ago, it accounted for 6% of our revenue. So we saw 100 basis point increase in contribution from our Other segment.

Okay, great. And then when might ObjectVideo officially launch a video analytics service? And will there be separate offerings for the residential versus business segments?

Sure. I’ll be disappointed if we don’t launch video analytics this year with residential segment. And I’m not sure exactly – there will eventually. Or there will be slightly different flavors for commercial. You can imagine that different commercial verticals have different analytic use cases. So I would expect that through time, there will be some more niche- oriented – commercially oriented analytics packages, but we’re focused right now on the broadly applicable base analytic package for residential customers, and we expect to have it in market this year.

Thank you. Our next question comes from Jack Vander with Maxim Group.

Hey guys, great quarter by the way. In response to an earlier question, you mentioned that the overall ARPU changed too much. But if I were to try to zone in on the Connect portion, revenue is up 20% year-over-year from that business. Can you split that, those drivers up between subscriber strength and ARPU just directionally?

We don’t really break out Connect ADT is a customer there and a few other customers, but we don’t want to get into details because ADT has their business. And they’re a public company. If we start breaking out that detail, it would be, I think, sensitive to them. So we provided the breakout of the total revenue for Connect for software license revenue of $10.2 million in the quarter. But in terms of breaking it further down, we probably shouldn’t be doing that.

Okay, just a follow-up with the ADT Fidelity partnership. This – I guess, you guys said 35% share of the residential intrusion market. How large is the South American – or South African intrusion market relative to the U.S.?

Yes. So not nearly as big as the U.S. market. On a relative basis, I would probably say, it’s probably 5% to 10% of the U.S. market in terms of TAM in that country alone. So my recollection, I have to look at my notes, my recollection is you’ve got around 12 million households and you’ve got a take rate there, you have a wider disparity of demographics and you have a take rate of residential security services of between 10% and 15% and then, of that TAM, folks taking residential security services, ADT Fidelity, which by the way, is not part of what we say ADT in the U.S., a different company. ADT Fidelity is the same brand and is a relic of when Tyco owned ADT and international ADT, but ADT Fidelity is a different sort of stand-alone independent company, and that’s roughly what I would say the TAM is that 35% there of that number.

Okay. That’s helpful. And then, just real quickly, was – with the partnership there with Alarm powering ADT Fidelity’s residential offering, is the idea is that it would be like a slow uptake of Alarm’s core platform providing the back end system for that? Or is it an all-in-one kind of overnight change?

No. We wish it were the latter but it’s not. We haven’t figured out how to do that. So it will be a long- term partnership where we’re focused on with ADT Fidelity servicing that market, and you’ll gradually see or we will gradually see that engine crank up and begin to produce as they sell new systems and then, over a longer period of time, upgrade existing systems.

Thank you. Our next question comes from Darren Aftahi with Roth Capital Partners.

Yes, thanks for taking my question. On international, I think you called out 100,000. Could you characterize how fast it grew in 2Q versus 1Q? And then, on the homebuilder program, I know you called out Toll Brothers is having a sort of their own service arm. But can you talk about just the general sales cycle for trying to gauge more the national builders?

Sure. So let me start with international. I think, international, we just – what we see is slow, steady quarter-over-quarter sequential growth. Occasionally, there will be a step event if we bring on a new market and a service provider is particularly active in that market. But largely, we’re just sort of continuing to chip away at things, add markets. Frankly, fix problems at times, deal with problems. It’s not a – the path of rendering global security services is not one without some potholes, so smooth over the potholes and try to maintain our relationships and let it build over time. So I don’t remember Q-over-Q international, but I would just say that it’s – each quarter is higher volume than the prior quarter. With regard to the builders and those sales cycles, this is a new initiative for us, where we made a determination that we needed to do a better job interfacing with our partners to builders and we needed to promote the platform to builders ourselves, always with the service provider along. But these – and there’s nothing really, if you think about what we’re selling, we’re not asking the builder for a check. We’re asking them to make the most prudent decision in choosing the platform they want to put in their properties. And then the check is going to one or several of our service providers. So these are sales cycles that are sort of a cross between selling and marketing. And I would say that builders, the length of the cycle is a function of the size of builder. Again, if you got a local builder that’s building four or five homes a month, they can do very quick sales cycle. And oftentimes, our service provider handles that entirely without our involvement. If you have a national, like some of the ones you mentioned, you have to catch them at the right time and catch the right person, and that’s a six-month-plus type of sales cycle.

Great, thank you.

Well, ladies and gentlemen, there are no further questions at this time. This does conclude today’s presentation. You may all disconnect and have a wonderful day.