Alarm.com Holdings Inc

NASDAQ:ALRM

Earnings Call Transcript 2017-Q4

[Operator]

Good day, ladies and gentlemen, and welcome to the Alarm.com Fourth Quarter 2017 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to hand the floor over to Brinlea Johnson of the Blueshirt Group. Please go ahead.

[Brinlea Johnson, executive]

Thank you. Good afternoon, everyone, and welcome to Alarm.com's Fourth Quarter 2017 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 conference call, management's discussion will include 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 expressions 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 annual report on Form 10-K filed with the Securities and Exchange Commission and subsequent reports that we file with the Securities and Exchange Commission 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 as of today's date, and Alarm.com undertakes no obligation to update them to reflect subsequent events or circumstances other than the extent required by law.

Also during the call, management's commentary will include certain 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 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 to 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 of our earnings press release, which we have posted on our Investor Relations website at investors.alarm.com.

This conference call is also being webcast and available on our Investor Relations website. The webcast of this call will be archived, and a telephone replay will be available on our website.

So with these formalities out of the way, I'd now like to turn the call over to Steve Trundle. You may begin.

[Stephen Trundle, executive]

Thanks, Brinlea, and welcome to everyone joining our call today. We are pleased to report that the fourth quarter exceeded our expectations, closing out a solid 2017. Our SaaS and license revenue in the fourth quarter was $65.2 million, increasing 39% over last year. Our adjusted EBITDA in the fourth quarter was $22.2 million, increasing 55% over last year.

During 2017, we set an ambitious agenda for the company. We worked hard to strengthen our position as the leading engine of innovation for service providers in the smart security space. We also further positioned the company to capture new growth opportunities and expand our participation in other emerging business models enabled by the Internet of Things. I want to thank our service provider partners, our ecosystem partners and our employees who all contributed to our progress in 2017.

On today's call, I want to review key developments from last year, highlight some of our recent product announcements and discuss trends we're seeing in the market. Over the course of 2017, we delivered against a robust product road map. We introduced new technology to drive growth opportunities for our service provider partners. For example, we enhanced our video service by delivering support for new indoor and outdoor cameras, including a new Slim Line Doorbell Camera, and we added engaging new features to the video experience through updates to our mobile app and web dashboard.

During 2017, we also expanded our platform to support a wider slice of the security market. This included expanding our ecosystem of commercial-grade security panels and video cameras and introducing a new system enhancement module to facilitate upgrades from traditional systems to our interactive services. Collectively, these new solutions enable our service provider partners to further appeal to commercial customers.

In 2017, we also continued to pioneer increasingly intelligent and adaptive capabilities through our data analytics program. We launched Insights Engine, which is a machine learning capability that automatically detects anomalous conditions and alerts subscribers about unusual activity in their property. We introduced an enterprise-grade business intelligence solution to help our service providers optimize their businesses and drive greater customer engagement and retention. And we established ObjectVideo Labs following our acquisition of ObjectVideo. This new team leads our research and development efforts in video analytics and computer vision technology.

And lastly, it is worth recalling that around this time last year, we were just about to close the acquisition of the Connect and Piper business units. Today, we have successfully integrated those businesses into our operations. The goals of the acquisition were to scale up our research and development operations while also increasing our distribution capacity. ADT is the largest customer of Connect, and we are pleased to have been able to expand our partnership with ADT as a result of this acquisition. As 2 of the largest players in the Internet of Things and smart home market, we are working together effectively on a number of opportunities that will allow us to create more value for the end customer while growing our businesses.

To summarize our year, we advanced our long-term vision for the business along multiple strategic fronts. We now manage more than 80 million connected devices and sensors and provide service to more than 5.5 million properties around the world.

Next, I'd like to spend some time discussing new technologies that we recently introduced in the last few months as well as some emerging technology trends in the smart home space. I'll begin with a few of our recent product announcements. At CES this January, we unveiled a mix of new hardware and software solutions for energy management. The new software capability is a solution we call HVAC Safeguards. It monitors the HVAC system and alerts service providers and homeowners to trouble conditions before they escalate into more expensive, damage or complete system failures.

Typically, consumers take a run-until-fail approach to maintaining their HVAC system. This increases the overall cost of ownership, and failures tend to happen during times of the year when heating and cooling is needed most. By feeding our Insights Engine with data from the HVAC system, the local home environment and the local weather conditions, Alarm.com can monitor performance over time and detect anomalous conditions that signal a problem.

On the hardware side, we announced a new premium version of the Alarm.com Smart Thermostat. As I have indicated in the past, we selectively design and engineer devices where we believe we can strategically address gaps in the hardware ecosystem and provide differentiated value to both our service provider partners and their customers. We developed the new Smart Thermostat specifically to automate the installation process beyond any device on the market today. Our new thermostat will automatically detect HVAC wiring and dynamically configure the device to the specific system that the technician is integrating. By reducing installation time and errors, we can lower the overall support burden on our service providers and enhance the customer experience.

As we invest in energy management technology, we are well positioned to generate growth through multiple market opportunities. In our core residential business, our service provider partners can bring a highly differentiated product to a growing market. In the commercial space, energy savings is a key value proposition of our integrated solutions. And as consumers increasingly adopt smart thermostats, our subsidiary, EnergyHub, can orchestrate more devices so that their utility customers can more effectively manage peak demand periods.

EnergyHub is already benefiting from consumers increasingly adopting smart thermostats. In 2017, customer enrollment in demand response programs managed by EnergyHub exceeded our targets. This contributed to our overperformance in SaaS and license revenue in the fourth quarter. EnergyHub has also expanded its enterprise software solution and can now manage a broader range of connected devices and distributed energy resources. This led to a recent partnership with Rheem, a leading manufacturer of heating, cooling and water-heating equipment.

Integrating Rheem's intelligent water heaters will allow EnergyHub to deliver a richer set of grid services to their utility customers. As EnergyHub continues to expand its platform solution, they could provide more value to their customers and tap into the growing adoption of a broad range of Internet of Things devices such as electrical vehicle charging infrastructure, energy storage systems and smart inverters.

I also want to discuss the emerging trend of audio devices and voice assistants in the smart home space. 2 years ago, we launched our integration of Amazon Alexa. This past year, we added Google Home, Legrand and Sonos. Our strategy for integrating our services with audio interfaces is driven by our belief that consumers want to pick and choose their device based on their own needs and preferences. We therefore need to remain open in this domain. This is similar to the successful approach we have taken with developing apps for mobile platforms. Consumers have an array of voice assistants available: Siri, Alexa, Google Assistant, Cortana and Bixby. Our goal is to deliver a uniform, seamless and secure experience across whatever interface a consumer may choose.

Where voice and mobile interfaces differ is in how our subscribers use them. Lighting control remains the most frequently used voice command with our service. It's interesting. The majority of these voice commands turn off the lights. Most of these commands happen late in the evening, likely right before bed. For most smart home interactions, subscribers who have integrated voice assistants still use mobile predominantly. For example, when we analyzed a representative cohort of users to see which interface they use to arm their security system, we found that they used mobile apps 94% of the time and voice assistants only 6% of the time. This makes sense because our users often interact with their property when they are away.

So while we see convenient use cases for voice assistants and we will continue to create more of these interactions, we believe that mobile will remain the dominant interface. Our users play significant importance on the ability to monitor and control their property from wherever they are.

As we look to 2018, I wanted to start by commenting on the recently passed tax reform act. Alarm.com has been taxed at 35% in the past, and the new tax law will, in my view, only help us compete. We anticipate allowing some of the savings generated by the tax act to flow to the balance sheet while also using some of the savings to invest more aggressively in the future of our business. By increasing our investments, particularly in R&D and marketing, we can take better advantage of the breadth of opportunities that are emerging in a world where virtually every device can be and is connected to the cloud. We believe that the tax reform act is good for our business and our investors over both the near-term and long-term horizons.

In 2018, we also see continued strength and growth opportunities in our core business. The security market continues to transform from traditional systems to interactive services. Our service provider partners are leading that charge. Service providers offer the support and expertise consumers want, and our service provider partners remain the provider of choice. We also remain focused on expanding our opportunity for growth in the commercial space in 2018. Last year, we refined and enhanced our offering for the small- and medium-sized business. Many of our service providers already addressed the SMB market. We will further expand our offering this year and strengthen our position to capture new growth as SMB properties transition from traditional systems to smart systems.

Our initiatives to develop complementary businesses and channels also gained momentum over the last year. I mentioned EnergyHub's recent expansion in the utility market. We are also developing a business in the HVAC channel called Building 36. In addition, PointCentral offers a property management solution for vacation rental properties, residential REITs and other businesses requiring an unattended access and delivery solution. We will continue to invest in our subsidiaries to support their growth and expand our overall market opportunity.

We also continued to expand our market presence globally. Interest in our services remain high, and business development activities are brisk in rest of world. We expect to add additional European markets during the first half of this year. Growth contributions from Australia and Turkey remain strong, and we were pleased to see our service provider partners in Latin America expand their use of the Alarm.com platform.

We also plan to increase our marketing presence in 2018. To oversee these efforts, we recently promoted Anne Ferguson to Vice President of Marketing and has led our partner marketing team since 2011. She has deep experience in the security channel and a strong reputation with our service provider partners. She has the right skills to direct our marketing programs and increase awareness for both our solutions and for our service provider partners. I was happy to be able to promote from within the company for this key position.

Before I turn things over to Steve Valenzuela, I also want to welcome Michelle Lee to our Board of Directors. Ms. Lee brings a deep legal background to the Alarm.com board, particularly in intellectual property. She is the Herman Phleger Visiting Professor of Law at Stanford Law School, where she teaches disruptive technology and intellectual property. Before this, she was the Undersecretary of Commerce for Intellectual Property and Director of the U.S. Patent and Trademark Office. And prior to her time at the USPTO, she was with Google where she served as Deputy General Counsel and is their first Head of Patents and Patent Strategy. I have enjoyed getting to know Michelle and look forward to working with her more.

And with that, I'll let Steve Valenzuela update you on our financial performance. Steve?

[Steve Valenzuela, executive]

Thank you, Steve, and good afternoon, everyone. I will begin with a review of our fourth quarter and full year 2017 financial results and then provide guidance for 2018 before opening the call for questions.

Starting with the fourth quarter. SaaS and license revenue grew 39% from Q4 2016 to $65.2 million. Our fourth quarter SaaS revenue included approximately $1.2 million in energy management incentives earned by our subsidiary EnergyHub, accounted for in Other segment. We recorded a seasonal revenue in the fourth quarter each year based on energy savings reported by utility partners. For the full year of 2017, SaaS and license revenue grew 36% from 2016 to $236.3 million.

Our SaaS and license revenue visibility remains high with a revenue renewal rate of 93.5% in the fourth quarter, consistent with our historical range of 92% to 94%. Hardware and other revenue in the fourth quarter increased to $23.6 million, up from $22.9 million in the same quarter last year. We continue to see strong growth of our video products in the fourth quarter. Total revenue for the fourth quarter increased 27% from the fourth quarter of 2016 to $88.8 million. Total revenue for 2017 reached $338.9 million, up 30% from 2016.

Gross margin for our SaaS and license revenue was 85.5% for the fourth quarter, up about 350 basis points from the same quarter in 2016. Gross margin for hardware and other revenue was 21.9% for the fourth quarter. This is up about 150 basis points from Q4 2016 due to product mix. Total gross margin increased to 68.6% for the fourth quarter, up about 700 basis points from the same quarter last year. The higher gross margin in the fourth quarter is due to a combination of the increase in SaaS and license gross margins and a higher mix of SaaS and license revenue, accounting for 73% of total revenue for the fourth quarter compared to 67% for the same quarter last year.

Turning to operating expenses. R&D expense in the fourth quarter was $18.9 million or 21% of total revenue, up from $12 million in the fourth quarter of 2016. We ended the fourth quarter with 447 employees in R&D, up from 320 employees at the end of 2016. Total headcount at the end of 2017 was 784 employees, up from 607 employees at December 2016.

Sales and marketing expenses in the fourth quarter were $10.9 million or 12% of total revenue compared to $9.4 million or 14% of total revenue in the fourth quarter of 2016. We expect to increase our marketing spending in 2018 to be more in line with marketing investments in prior years at approximately 14% to 15% of revenue.

G&A expenses in the fourth quarter were $13.6 million, down from $15.8 million in the year-ago quarter. G&A expense includes non-ordinary course litigation expense of $2.3 million in the fourth quarter, slightly higher than Q4 2016 expense of $2.1 million. Non-ordinary course litigation, acquisition and integration 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 $22.2 million for the fourth quarter, up 55% from $14.3 million for the fourth quarter of 2016. For 2017, adjusted EBITDA was $71.6 million, up 46% from 2016.

Before reviewing net income, let me first discuss the impact of the U.S. corporate tax reform act on our financial results. After the act was signed into law in December, we recorded a onetime tax expense of $8.8 million in the fourth quarter for the reevaluation of our net deferred tax assets resulting from the reduction in U.S. corporate tax rate. Largely due to this charge, GAAP net income in the fourth quarter was $320,000 compared to $3 million in the same quarter last year. Going forward, we expect an overall tax rate of 21% for 2018, down from our prior guidance of 35%.

We excluded the onetime tax expense for the reduction in U.S. corporate tax rate from our non-GAAP net income and EPS as we do not consider this to be part of our operating performance. And as previously indicated, we also exclude from non-GAAP the favorable impact from ASU 2016-09 accounting for employee share-based transactions that was effective Q1 of '17. This was a benefit of approximately $1 million to our GAAP taxes in the fourth quarter.

With these items excluded from our non-GAAP financial results, non-GAAP net income in the fourth quarter was $13 million or $0.26 per diluted share compared to $9.1 million or $0.19 per diluted share for the fourth quarter of 2016. Non-GAAP net income for 2017 was $45.1 million or $0.92 per diluted share, up 45% from non-GAAP net income of $31.1 million or $0.65 per share for 2016.

Turning to our balance sheet. We ended the fourth quarter with $96.3 million of cash and cash equivalents. For all of 2017, we generated approximately $57.2 million in cash flow from operations, up from $22.6 million for 2016. Our free cash flow for 2017 was $46.7 million, up significantly from $13.5 million for 2016.

Let me now turn to ASC 606, the new revenue accounting standard that we are required to adopt beginning in 2018. We have implemented this new accounting standard using the modified retrospective approach effective January 2018. We have completed our assessment, and we do not believe ASC 606 has a material impact on our revenue recognition policies. The adoption of this new standard also required us to evaluate how we account for commissions paid to employees, which we expensed as occurred in the past. Under the new standard, we are capitalizing a portion of our commission expense as an incremental cost of obtaining a contract. We also do not believe this will have a material impact on our financial results.

Turning to our financial outlook. For the first quarter of 2018, we expect SaaS and license revenue of $66.9 million to $67.1 million. For the full year of 2018, we expect SaaS and license revenue to be between $282.5 million to $283 million, representing growth of approximately 20% over 2017 at the midpoint of the range. We are projecting total revenue for 2018 to be $380 million to $382 million, which includes hardware and other revenue of $97.5 million to $99 million. We currently forecast that hardware revenue will be slightly lower in 2018 as the market shifts to embedding some modules in some control panels, which helps to drive lower cost per subscribers. Alarm.com does not provide control panels. We expected the shift of communication modules, which we believe will be partially offset by higher sales of cameras and thermostats.

We estimate that non-GAAP adjusted EBITDA for 2018 will be between $81.5 million to $82.5 million. Non-GAAP net income for 2018 is projected to be $56 million to $57 million or $1.12 to $1.14 per diluted share. And as I have indicated, we are projecting an overall tax rate of 21% for 2018 based on the new U.S. corporate tax reform act. EPS is based on an estimate of 50 million weighted average diluted shares outstanding. We expect full year 2018 stock-based compensation expense of $9.5 million to $10 million compared to $7.4 million for 2017.

We believe we are well positioned to build on our expanding market opportunity for the secure smart property in both residential and commercial sectors, and we are thankful for a strong base of service provider partners.

In summary, we are pleased with our performance in the fourth quarter and full year 2017. We are focused on executing on our business strategy and investing in our growth opportunities while continuing to deliver solid financial results.

Thank you for joining us in our call today. And with that, operator, please open the call for Q&A.

[Operator]

[Operator Instructions] And our first question comes from the line of Gabriela Borges with Goldman Sachs.

[Daniel Church, analyst]

This is Dan Church on for Gabriela Borges. In the past, you've talked about business intelligence tools helping dealers drive customer engagement and retention improve overall economics. Can you kind of give us an update on the impact this is having? I understand it is still relatively early. What are you seeing in terms of its ability to try and expand within your installed base?

[Stephen Trundle, executive]

This is Steve Trundle speaking. So we've invested through in business intelligence through time, continue to do so. It's getting more and more powerful all the time what we can do. The current emphasis is actually helping our service providers use the BI tools to actually reduce their ongoing sort of cost to serve. So being able to pick up very early when there's some sort of installation habit, for example, that's resolving and then a disproportionate number of customers having an issue later with a particular product and ecosystem, getting that feedback back to the management team very quickly so that they can adjust their processes, get more technicians trained up on whatever that device might be. So that's a particular focus. We've also used a product -- it's really not just us using it. There are service providers using it to identify what are the things -- and I've talked about this a bit in the past, what are the things that I, as a service provider, can do to drive higher engagement from my customers. And we've identified about 50 or 60 attributes that one might choose to pursue in the way they create a customer and management customer book then we've kind of boil that down to the top 5 or 6 best practices that a service provider can follow when they initiate a new relationship with a customer. And if they follow those things with some religion, they'll get a higher engaged customer that then sets at a lower level. So those are a couple of examples of how we're using the business intelligence infrastructure for the benefit of the service providers. And then there's a lot of stuff going on in really inside the offering itself, where we have a technology we call Insights Engine that I spoke a bit about just a moment ago. But I'm going to leave that for later.

[Daniel Church, analyst]

Great. And in terms -- we've seen a few announcements from Amazon and other DIY vendors. Just can you speak to the competition in the DIY market more broadly? Do you see that as potentially being cannibalistic longer term or driving smart home adoption?

[Stephen Trundle, executive]

Yes, sure. No, I mean, we've seen these really -- we've seen announcements since the beginning of time in the DIY market. We've seen new entrants like Google come in, by Nest, by DropCam, Amazon by Blink. I think we just saw an announcement before I jumped on this call from Amazon. So I think that the reality is that our customer prefers a do-it-for-me solution. They want a relationship with a service provider that's going to maintain whatever apparatus is installed in their home. They want to make sure that the smoke detector that's installed upstairs in their child's bedroom is installed the right way and is always going to work. And if it's not operational, someone's going to be able to kind of come out there and get it fixed. So we see a lot of these products emerge and generate some interest, generate some press. We think they primarily appeal to a constituency that's not our core customer, folks that are in a rental property or in a smaller property, maybe having need for a point solution. And I think our hope is that, in many ways, what the DIY products are doing is cultivating an interest in the type of solution that we can provide to them, hopefully, for their -- at some latter point in time. So if I become conditioned to believe that it is possible for me to remotely monitor my property with a given camera solution and now I move into a larger home and I want to have a lot of different subsystems all work together, we think that's where our service provider comes in. And we're hoping that a broader group of consumers will be aware of the capabilities of the solutions like the one we offer. So I don't think we've seen any real dramatic effect or any sort of predatory impact from the DIY products. I'm sure they're getting their fair share of customers, but haven't seen them dramatically affect our service providers.

[Operator]

Our next question comes from the line of Michael Nemeroff with Credit Suisse.

[Christopher Rochester, analyst]

This is Chris Rochester on for Michael. We heard from somebody in our network that ADT had the ability to upgrade Pulse customers under the Alarm platform over the air without a truck roll. Is that true? And if not, could you maybe talk about the progress in getting ADT to move over to the Alarm platform?

[Stephen Trundle, executive]

Sure. So on the first question, I stay in close touch with my friends at ADT, and I don't remember ever hearing that, that's something they have actually been able to do. It's not likely that they would upgrade an existing Pulse customer. There may be some outlier I'm not considering. But for the most part, I can't think of a scenario where they would upgrade or have upgraded an existing Pulse customer over the air to Alarm.com without some type of service visit. So I doubt that. I think that's probably just the -- probably not the case. With regards to sort of the overall relationship, I referenced it a bit in my prepared comments, relationship's very healthy. We're working on a lot of things that I think will let ADT kind of be with as the year unfolds. And we've, I think, fully integrated the Icontrol team at this point. They're very solid. The offering has been -- the existing Pulse offering, I think, has been well handled and is more robust than it's ever been. And the 2 groups are working together really on a longer-term set of initiatives now that we think will be good for both businesses, so...

[Christopher Rochester, analyst]

That's helpful. And then maybe a quick follow-up for Steve V., if I may. Looking at the adjusted EBITDA guidance, the implied margin expansion is lower than we've seen over the past couple of years. I mean, would we have seen a similar step-up in operating expenses if it weren't for the benefit in the tax code?

[Steve Valenzuela, executive]

Yes. So I think we're showing about a 40 basis point increase in 2018 guidance. If you look at 2017, right, we came in at 21.2%, which is -- 21.1%, sorry. So with the guidance we're providing for '18, we are taking that up a bit. But as Steve said on his call, we're really taking the opportunity to invest further in marketing and also in R&D. And so you'll see that -- obviously, the non-GAAP net income is, of course, going up substantially over the consensus. So we're letting some of that flow to the balance sheet. But in terms of EBITDA, where we invest in marketing, where in the past, if you look at 2017, we spent only 12% on marketing -- in sales and marketing, which was historically very low. So we're taking that up to 14% to 15%, and we're taking -- we continue to make some investments in R&D. So we think that's the right thing given the all the opportunities in the marketplace.

[Operator]

Our next question comes from the line of John DiFucci with Jefferies.

[John DiFucci, analyst]

A quick question for Steve Trundle and then for Steve Valenzuela. Steve, just a question on the commercial, and thanks for all that detail you went through and the opportunities going forward this year. Back at the Analyst Day, you had talked about introducing a new product called -- an access control product tailored to the commercial SMB market. Can you share any progress on bringing this product to market and how you think that could unfold going forward?

[Stephen Trundle, executive]

Yes. John, so it's a good question. We're anxious to sort of get that product fully generally available and announced properly. But as you saw at the Analyst Day, we've made a lot of progress. The product is in what I would call a full robust late-beta stage now, where I believe over 100 service providers are actually installing the product. We're making sure we get all the details right, but the reception has been very good. So we've been -- I've been particularly pleased, I guess, I would say, with the quality, the feedback that we're getting from service providers and really their commentary on the quality of the products. So that's all good. And I think you'll see us in the middle part of the year, if not a little before, announce that product formally and bring it to market.

[John DiFucci, analyst]

Okay, okay. Great. And I guess, Steve Valenzuela, that question that Steve Trundle talked about the benefits in what you might do with the extra cash from the lower tax rate? And I'm just curious if you can sort of quantify that in some -- in any way when we look at it across our coverage universe, just given that your front lease today, primarily in the U.S. and you are comfortably profitable and have been for a very long time. We see you as one of the few, in our coverage any way, that sees a pretty meaningful impact here.

[Steve Valenzuela, executive]

Yes. Thanks, John. Good question. If we look at the profitability of the company has delivered has been quite good, again, with a 21.1% EBITDA in 2017. But what's interesting to look at again is the way the EBITDA, we're increasing the EBITDA growth over 2017, up 40 basis points. Again, it's because of the investments we're making really are more in the marketing area, given that we're coming off of a really low, if you will, year in marketing investments. And then in R&D, we're continuing to make investments in R&D. If you look at in '17 with the acquisition of Connect and ObjectVideo, and those really helped to set us up in terms of significant opportunities with regard to video analytics, with Connect working with ADT. And so it's interesting to see the way the tax works out. EBITDA is obviously before tax, and so we're making those investments. As Steve said on his prepared remarks, we're letting some of that flow to the balance sheet and also the P&L as we're taking that income up quite a bit compared to what we've seen in the past. So we're balancing both, and we think the right thing to do is to make those investments. Given that we're really participating in a very large market opportunity with the smart home and of the Internet of Things.

[John DiFucci, analyst]

And that makes a lot of sense. I mean, we come up, though, like we had double-digit growth in free cash flow just from the tax alone. But I guess, we'll see how it plays out.

[Operator]

Our next question comes from the line of Nikolay Beliov with Bank of America Merrill Lynch.

[Nikolay Beliov, analyst]

Wanted to get an update on the international front from you guys. Exiting 2016, you were running at it before 1,000 subscribers, additions per month. What is that number currently? And generally speaking, in light of the opportunity in the domestic market, how much of a priority is international at this point?

[Stephen Trundle, executive]

How much of a priority is the international market going forward? Yes. So Nikolay, this is Steve -- pardon? I think I understood the question correctly. Steve T. speaking. So yes, I think back if we roll back to '16, I stated we had a goal of getting 4,000 a month, basically quadrupling production inside the year. That year, we were -- and then I think at the end of the year, I updated that we were just shy of that number. We kept pushing in '17 and we're, I can say, comfortably well north of that goal now. So the team is doing very well. And I think we've also turned the corner on some of the things that created latency in our ability to really expand globally, and most of those were sort of product related. Do we have the right set of ecosystem components? There are different certifications reach market. We had to get different carriers all set up. And sometimes you felt that you're taking 2 steps forward and 1 back all the time in various markets. But at this point, as we indicated, we feel very good about a couple of the early markets, which were Australia and Turkey. We're adding some European markets in the first half of this year. Our partnership with Securitas remains strong, so it's taken a little longer for us to get everything up to speed and get them rolling out, but that's going well. LatAm is going well. So at the moment, I guess, I would say we're enthusiastic about the year ahead in rest of world. We feel like this will almost certainly be our best year ever there. In terms of relative priority, because the pipeline looks good to us and because things are beginning to really move towards being even more of a contribution, I think we think that it's pretty darn high priority for us. So it's a high priority for our technology team, getting the right control panels in place is always a high priority. So I would say on a relative basis, it's in probably the top 3.

[Nikolay Beliov, analyst]

All right. And the question for the other Steve. Steve, can you give us a sense, to the extent you can, the breakdown of the 5.5 million subscribers between Alarm.com and ADT to help us with the models?

[Steve Valenzuela, executive]

Yes. So Nikolay, Steve Valenzuela here. In terms of the 5.5 million subscribers, again, most of those are residential. And I didn't hear the back part of your question. We have been increasing and seeing good growth rates of commercial, but it's off of a lower base. We talked about it at the Analyst Day that we were going to be introducing more features for the commercial market, including access control. The pilot on that is going very well, so we think that there will be good opportunity in commercial. But it's still, I would say, relatively early and it's still a small part of the 5.5 million subscribers. And most of those, by the way, as well -- again, I didn't hear the last part of the question, but if you're asking about the breakout between the international and between domestic, most of those are also domestic North America.

[Nikolay Beliov, analyst]

Yes. Sorry, about the bad connection. Actually, my question was the split there up between ADT Pulse subscribers and Alarm.com subscribers.

[Steve Valenzuela, executive]

Okay. Yes. So that's -- so the last time ADT updated that number, I believe it was about a year ago. And I said -- I believe that they said their subscriber base is over 2 million. And we don't feel that we should really be talking about ADT's numbers unless they publicly have produced that. So obviously, they've grown over the last year. And certainly, part of the 5.5 million subscriber base of Alarm.com is Connect, and a good portion of that is ADT.

[Operator]

And our next question comes from the line of Matt Pfau with William Blair.

[Matthew Pfau, analyst]

Wanted to dig a bit more into the sales and marketing investments. And so I guess, number one, why was, I guess, less spent on in terms of percentage of revenue on sales and marketing in 2017 relative to prior years. And then as you think about the investments in 2018, what are the main areas of where those incremental dollars are going? Because I guess, theoretically now that you have relationships with many of the more significant dealers, especially in North America, that you can have relationships with that would seem that there would potentially be a decent amount of leverage in the sales and marketing line item.

[Stephen Trundle, executive]

Sure. So looking at '17, the question is why we'd take it down. The reason is, at the beginning of the year, we were trying to complete a material acquisition. There was a lot of expense around that. We weren't positive 100% of exactly what all the integration expenses would be. And I think we felt like we needed to let the dust settle a little bit on that and see sort of what steady-state condition of the business would be afterwards in terms of cash flow production before we sort of open the spigot fully on marketing. At the same time, we took advantage of that opportunity to test. You're constantly running various marketing programs. And sometimes, you need a baseline how they're doing by testing what happens if you do nothing. So how many -- how much website traffic are you getting if you're not running a digital campaign? And then when you lay your digital campaign on, you can see what kind of incremental contribution it makes. So we were doing some of that in the back half of the year as well. We made a big move with sort of adding our VP of Marketing towards the end of the year. At this point, we feel like we have pretty good visibility on kind of the way the engine's working in terms of cash production, and we're therefore comfortable beginning to layer back on some sales and marketing spend, especially on the marketing side, I would say. In terms of how we deploy, we're not going to get into some sort of brand war with -- in the market. I think we're going to look selectively as we tend to do at the audiences that we want to reach. We feel like we have pretty good data on what type of person becomes an Alarm.com customer. So you'll see us be more targeted, probably more digital than sort of big-brand type of advertising. And then we do a lot with our service providers with a program we call [ NDF ], where we work with the service providers to help them with their local direct response marketing initiatives. And I think we'll continue to do some of that probably at a higher scale in 2018.

[Steve Valenzuela, executive]

And I think it's important to put in perspective again the numbers. Again, the guidance for '18 is taking up the adjusted EBITDA quite nicely up over 2017 by over $14 million -- $11 million in terms of the guidance and increasing the adjusted EBITDA percentage as well by 40 basis points. So that's -- I think there's many SaaS companies out there that would love to be at that level of profitability of 21.5% adjusted EBITDA and $82 million of adjusted EBITDA midpoint of the guidance. So I think those are very good numbers.

[Matthew Pfau, analyst]

Sure. Of course. That's helpful. And then the other thing I wanted to ask about is in terms of the guidance in your expectations for the commercial business in 2018. I guess, how -- is there a decent amount of success built into the guidance in terms of -- with the commercial business? Or should we think of commercial as more of a potential upside to the guidance that you've provided?

[Stephen Trundle, executive]

Yes, Matt, Steve. So as kind of consistent with prior practice, so we're doing a certain amount in commercial today. And there we -- with sort of an interactive smart commercial solution, but we don't have the full product that we want have in the market yet. And as I answered the question earlier from John, I think I talked about a midyear entry point for the access product. So our practice is we don't attempt to assign upside the things that are not yet really in the market, and we build our estimates and models off of things that currently have traction that we feel we can have a reasonable chance of projecting. So that's how we look at it.

[Operator]

And our next question comes from the line of David Gearhart with First Analysis.

[David Gearhart, analyst]

My first question, I wanted to ask about litigation expenses. Litigation expenses were down over $5 million in '17 versus '16, and I think some of that had to do with IP exhibits and patents and review. Just wondering if we should expect a pickup in litigation expenses in '18? And could you provide an update there?

[Stephen Trundle, executive]

Sure. Dave, Steve T. speaking. So yes, '17, there is some lulls in the activity at various points and as a result, the litigation expense was lower. I think what I would do, we can't comment specifically on what we're going to spend on there. We don't actually even know oftentimes, but I think that I would look to '16 as an indicator, as a better kind of baseline for what you'd probably should be modeling for '18.

[David Gearhart, analyst]

Okay. That's helpful. And then going back to guidance. Previously, you provided a preliminary outlook for '18, 375 to 385 in top line, 380 at the midpoint. New guidance is 381 at the midpoint, so $1 million uptick there. I would have expected a little bit more, just given the strong Q4 and you're investing more in the sales and marketing, primarily the marketing side. But would have expected a little bit more of a pickup. Can you talk a little bit about why we're not getting as much of a pickup? Is it more related to the hardware issue that you talked about or the substitution of embedded modules for that part of the business? And maybe quantify that impact to kind of better gauge where revenue could have been? That's my question.

[Stephen Trundle, executive]

Sure. Well, first, we did move it up a little bit. I think the -- early in the year, I think we also now put out a number, kind of gave you some guardrails around the hardware number. So I think what you probably interpreted from what we've put out an improved revenue mix now with the updated guidance that is important to us in terms of the mix and SaaS and license versus hardware. On the hardware side, we've never gotten overly concerned with hardware revenue. It's -- and what we're seeing is more of our service providers adopting control panels, where we'd license the technology for the radio and it's embedded on that main board of the control panel. So that's -- in terms of new installations, those that are using our radio versus the -- even the radio that we've manufactured versus using one that a third party has manufactured. As we look to '18, we see that number moving from sort of a 41%, 42% in '17, using radios that we made to sort of a 33% type of level for '18. So you see some -- and that's not a great business for us, so it's not really an upsetting dynamic. But it's a trend that has unfolded. I think, particularly in the last couple of months, we've seen a couple of guys shift their purchase habits on. So it's a little bit there. And then beyond that, I think I'd just say it's early in the year.

[David Gearhart, analyst]

Okay. And then lastly for me, you provided some commentary in prior quarters on the HVAC channel. I think you had mentioned previously 20 partners. It's early days obviously. Just wondering if you could provide an update in terms of number of partners there and what you're seeing in terms of sales activity and also cross-selling with HVAC and maybe even selling security and other offerings.

[Stephen Trundle, executive]

Sure. So yes, that effort -- don't have the exact number of new science there in front of me. But my guess is we're probably up to 40, maybe even 50 at this point. That team has been super productive for us and is really the team that produced the thermostat that we just announced at CES. So we continue to see uptake of the Alarm.com thermostat across the business not just in Building 36, but also in Alarm.com and elsewhere, which is a positive. With the HVAC channel, it's still a channel that we're enthusiastic about. I'd say we're still very, very early days. So the things in our Other segment that we talk about, I think, more mature are our PointCentral and EnergyHub, both at kind of a predictable pace at this point with Building 36 and the HVAC channel. Some of it's -- we're still trying to get them the exact right products, still working with that first set of partners, but earlier in their formation and a little less predictable still at this point.

[Operator]

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

[Jeffrey Kessler, analyst]

In the past, you've been rightly proud of the imager that you've had out there, if you want to call it the motion detector video imager that you've put in as a means of reducing -- of supplementing verification, increasing the customer experience at a recent alarm conference that we were at, a couple of your customers were talking about a new line coming out in the next several months. And I'm wondering if you could -- well, not -- you're probably not going to go into the details of the enhancements. Is this the type of thing that will further improve the ability to effectively justify the use of alarm -- professional alarm companies as verification providers. In the end, does this enhance the verification capability?

[Stephen Trundle, executive]

Yes. Good question. So we refer to that product as the image sensor. It's something we pioneered. The goal at the time of initially crafting the product was can we find a way to deliver to consumer a sensor that also takes pictures very, very inexpensively and in a way that the pictures can actually be translated via a fairly low-bandwidth cellular connection up to the central station. So that was the goal. We met that goal with the first incarnation of product. There's a new -- and if you stop and think about it, PIR has been around forever. And you sort of ask yourself, "Why would I even want an infrared motion detector that doesn't take pictures. If someone is in my home or business, I'd like to see who it is. And if the incremental cost for that is fairly modest, then that's what you should want. The product continues to work in a cell-only format, which is sort of unique. If you compare that -- there are lots of ways to get images and content out of a property, primarily with a broadband connection and video cameras. But image sensors are still well positioned for all of those properties, where either the consumer doesn't want us tethered to their broadband connection or the service provider doesn't have to mess with it. So for the product, we see it on installed on a healthy number of accounts. The new version is going to extend the battery life further, improve the image quality, give us some ability to increase and maybe even take short form of videos with the lens. So lots of different things we're doing there. And I think what you're referring to is then sent back the integration that we get with the central station is an area where it's been possible for some time. We're just sort of keep chipping away. There's 1,000 different central stations that we're actually connected to and get them up to a point that they can actually handle the content that we're able to provide when there's an alarm condition in the property. So it's a constant effort that we're engaged in. And if we get all the central sort of up to a common baseline of capability, then I think we -- that definitely helps with the positioning of our professional service providers.

[Jeffrey Kessler, analyst]

Okay. A couple of things that you got involved in toward the beginning of the year that you mentioned, but you didn't really go into very much, stuff like the group of folks that you've got from ObjectVideo. Yes, they are obviously working on analytics and things like that. Could you go a little bit more into not necessarily the proprietary stuff you probably won't talk about, but what is the goal of this team toward -- what end are they going to be used for in, again, differentiating this company from its competition?

[Stephen Trundle, executive]

Yes. So the goal is to provide an outstanding consumer experience around our video offering. And to do that, I think we need to cut down on the noise the consumer is getting the amount. I actually even test other products. The number of clips you get relative to the amount of sort of valuable content you get. That ratio should be fairly low. Right now, it's generally very high. You get lots of clips and lots of noise for the one thing that you actually want to see. So with our video analytics team, we're attempting to discern what those things are that the consumers are interested in. We're doing a lot of object classification work and a lot of sort of tripwire work to make sure that when we deliver, when we deliver a clip or even a period recording to the consumer, we can point to them -- point out the events that should be relevant for them. If we do that then the overall, especially if we can do that with low-cost cameras. So the other big challenge here some of these capabilities have been available traditionally in a very sort of high-cost format, where you're either running massive server infrastructure or you're running a fairly expensive camera that is, I mean, $300, $400 camera. So we're trying to make this possible with cameras that are going to fit a price point that our service providers tell us they can take into the residential markets successfully, and that's really the goal there.

[Jeffrey Kessler, analyst]

Okay. Most of my other questions were answered. However, if you could just go into a little bit of any developments internationally. I know you've, again, you've talked about it generally, but what are the things that you need to do to -- in addition to making energy -- in addition to making EnergyHub a contributor. You're focusing on geographic areas. Can you bring some of those things -- some of the new projects you're working on to the international arena yet? Or is it still in the stage of just making sure that the cut -- that the service groups out there, be they in Australia or in Sweden, are existently comfortable with you? At what point are you with these guys?

[Stephen Trundle, executive]

Yes. It's a good question. So we're definitely more at the early point where there is a one-two punch play that we'll have at some point where when we really feel good about -- with our service provider partners and country like Australia, we'll bring in other products that we already kind of craft and pioneered here in North America. But for now, there's so much interest in just smart home. We're doing that well. That's what the consumer wants. Doing that with the equipment that they have. But that's very much still our focus with these early relationships, and we're not getting distracted by bringing in EnergyHub or bringing in the PointCentral offering. We got enough opportunity with those here in North America at the moment. But if you roll the clock forward 5, 6 years and we get to the point that in rest of world we're sort of similarly positioned as we are here today in North America, then at that point, it makes sense to take the businesses that we've crafted in the Other segment and roll those rest of world as well. But at the moment, we're really more in beachhead mode where we're getting set up, getting people productive, getting them trained, getting supply chain straightened out and trying to drive numbers on smart home.

[Operator]

And our next question comes from the line of Darren Aftahi with Roth Capital Partners.

[Darren Aftahi, analyst]

Just if I could follow up on the marketing spend, can you kind of handicap the -- I guess, the incremental and the absolute where you kind of plan to spend that? And I guess, what I'm getting at is some of your smaller or relative installed bases, i.e., commercial and international, like what are your plans to step up spending in those segments? And then if you do plan to spend more aggressively on marketing and international, any geography you'd call out?

[Stephen Trundle, executive]

Right. So the step-up is a step-up, but it's not a dramatic step-up from where we were in sort of '16. These are -- we're talking a few million dollars, I think, in discretionary spend increase. And the focus there is, first, some additional brand work in a very targeted way against an audience that we think would have a high proclivity to take services like those offered by Alarm.com. So we'll be surgical there. That will be brand work where we're trying to drive interest in the technology so that we can then refer those who are interested back to our service providers more so that they've already heard about Alarm.com when the service provider shows up on their doorstep. Second is to do some additional local marketing with our service providers, which is a little bit more of a direct response where we're helping them get a program stood up. It might be that we actually generate the content they use, meaning the TV ads or the radio spots then they go deploy that within their own phone number and their own brand. Some work there. And then third is we're going to do a little bit more industry marketing this year than we've done. We've got some new offerings that we've alluded to on the video side, on the commercial side and on the access side. Each of those -- with each of those, we have a duty to sort of get the word out. So you'll see us spend a bit more on industry marketing back out to our service providers and to new service providers so that folks are aware of what we have in the product arsenal. And those will be really the 3 places we focus. Not so much internationally. International remains an opportunity, but probably won't be a heavy focus other than getting all of our collateral and our basic sort of marketing infrastructure in place. I don't think we'll go out and try to, as an example, dominate any given sort of Latin American country with consumer marketing. I think we'll be helping our service providers in those markets get the right infrastructure in place so they can do their own marketing.

[Darren Aftahi, analyst]

And then this is a follow-up. I mean, as you think about the cadence, you've shown pretty nice operating leverage historically and you're investing in '18. Then as we look a little bit more intermediate term, is that the cadence we should sort of expect from you guys? Or is this sort of continued operating leverage is more of a onetime step-up in chewing up your marketing spend?

[Stephen Trundle, executive]

Yes, I think we'll assess each year as the year unfolds and see how we filled up the market. But generally if there were -- directionally, I think what we've done this year, what we're projecting this year is probably congruent with what I would, at this moment, anticipate to be cadence where there's slightly more operating leverage being let out of the business. But at the same time, not -- that's coming from sort of higher revenues and improved revenue mix. And we're still pretty focused on taking advantage and being well positioned for the opportunity that we see unfolding over the next decade. So we definitely don't think we're at the point yet where we want to fully pull the operating leverage lever in the business. We're looking longer term.

[Operator]

And our next question comes from the line of Mike Latimore with Northland Capital.

[Mike Latimore, analyst]

On the commercial side of things, over the long term, is there any inherent difference in mix hardware service versus what you're seeing on the residential side?

[Stephen Trundle, executive]

Difference in mix in terms of -- commercial does have some more hardware components here. It also has a good SaaS component. I think we've talked about in the past that commercial actually has a higher ARPU because there tends to be more video, tends to be a little bit different configuration. So you tend to see ARPU on average twice as high as residential and sometimes 3x the size. So there will be more of hardware. I think as we -- as Steve talked about earlier in this call, when we talk about the guidance for the year, again, we're talking about what we know today. And so we're looking at the year and figuring out exactly the timing of when commercial will be ramping up. And so typically, with hardware, as you've seen in the past, we're fairly cautious about the numbers we give out for that in advance in terms of the guidance, right? So -- but certainly, there is a good hardware component related to commercial.

[Mike Latimore, analyst]

Got it. And then just last on the quarter you just reported, after video, what was sort of the second and third kind of additional device or sensor that was sort of in demand in the quarter?

[Stephen Trundle, executive]

Yes. So first is for what we call professional video. Second after that is lock -- door lock, and I believe third would be probably thermostat, followed closely by image sensor. And then you get down into like garage door and so many other things, but...

[Operator]

Thank you. And that concludes our conference call for today. We thank you for your participation, and you may now disconnect. Everyone, have a great day.

[Stephen Trundle, executive]

Thank you.