Arlo Technologies, Inc. (ARLO) Q4 2019 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session [Operator Instructions] I would now like to turn the conference over to Erik Bylin. Please go ahead, sir.

Thank you, Gabriel. Good afternoon, and welcome to Arlo Technologies' Fourth Quarter 2019 Financial Results Conference Call. Joining us from the company are Mr. Matthew McRae, CEO; and Ms. Christine Gorjanc, CFO. The format of the call will start with an introduction and commentary on the business provided by Matt, followed by a review of the financials for the fourth quarter and full year, along with guidance provided by Christine. We'll then have time for questions. If you have not received a copy of today's press release, please visit Arlo's Investor Relations website at www.arlo.com. Before we begin the formal remarks, we advise you that today's conference call contains forward-looking statements. Forward-looking statements include statements regarding expected revenue, gross margins, operating margins, tax rates, expenses, future cash outlook, our partnership with Verisure, continued new product and service differentiation and future business outlook. Actual results or trends could differ materially from those contemplated by these forward-looking statements. For more information, please refer to the risk factors discussed in Arlo's periodic filings with the SEC, including the most recent annual report on Form 10-K and quarterly report on Form 10-Q. Any forward-looking statements that we make on this call are based on assumptions as of today, and Arlo undertakes no obligation to update these statements as a result of new information or future events. In addition, several non-GAAP financial measures will be mentioned on the call. A reconciliation of the non-GAAP to GAAP measures can be found in today's press release on our Investor Relations website. At this time, I would now like to turn the call over to Matt.

Thank you, Erik, and thank you everyone for joining us today on Arlo's fourth quarter 2019 earnings call. Before I discuss the fourth quarter, I want to take a moment to address the outbreak of the coronavirus. First and foremost, our thoughts are with the people who are being impacted by the spread of the virus as well as the associated quarantine. At Arlo, we are seeing an impact to our first quarter, although our products are manufactured outside of China, numerous key components are sourced from the effected region and we are now seeing a shortage in these components quickly reduce our anticipated supply. The second quarter will also be impacted from the continued component shortages and delay of several new product launches. We are working closely with all of our manufacturing partners as well as many of our component vendors as the factories work on recovery plans. We are also working with our channel partners on shelf dates and are developing options to maximize our performance through these unanticipated headwinds. The impact from coronavirus is temporary and we expect to return to our original growth trajectory in the second half of 2020. Christine will provide more specifics on the financial impact in her comments. With that, I will now move on to discuss our results and accomplishments from the recent quarter. Christine and I will walk you through major elements including financial results for the quarter and full-year, closing of our definitive agreements with Verisure, launch of Arlo SmartCloud, our Privacy Pledge, new product recognitions and the announcement of our first Floodlight Camera. Let's start by talking through some highlights for the quarter. In Q4, we achieved $122.4 million in revenue, near the high end of our guidance for the quarter and up slightly year-over-year. Service revenue was $12.5 million, which represents a year-over-year growth of 17% and a record for Arlo for the second consecutive quarter. For the full year, Arlo reported revenue of $370 million. While this was a decline for the year, Arlo returned to slight growth in Q4 despite our supply shortage and we expect to continue that momentum into 2020. Expense management was a top focus as we lowered OpEx sequentially each quarter in 2019 and with our restructuring we are on target to achieve further savings in 2020. Arlo added about 324,000 registered accounts to the Arlo platform in Q4 to reach a total of nearly 4 million total registered accounts, up 41% year-over-year. More importantly, our paid account base continues to grow at a faster pace and reached approximately 230,000 paid accounts, up more than 60% from a year ago. As a reminder, this growth does not yet include paid accounts that we were expecting from Ultra, Pro 3 and Video Doorbell customers that received a limited free trial of Arlo Smart. Based on early data, we remain confident that when the trial period for Arlo Smart lapses, there will be a further acceleration in the growth of paid accounts through 2020 expect a more fulsome report on this subject on our next earnings call. On December 30, we closed our strategic partnership with Verisure, a fast growing leading provider of professionally monitored security solutions with more than 3 million customers in 16 countries across Europe and Latin America. Verisure paid Arlo $50 million for Arlo’s European commercial operations, covering marketing and distribution of Arlo products and services. With this agreement, Verisure also committed to purchase a minimum of $500 million of Arlo products over the next five years to be distributed through first multi-channel go-to market for a consumer security experience. Clearly, this partnership has immense financial and strategic implications for Arlo. It will diversify our revenue on both a regional and channel basis. It raises the forecast growth in Europe from 5% CAGR to 25% CAGR over the next five years and all deployments through Verisure’s direct channel will have a one-to-one attach rate to Arlo Smart services, which will further accelerate our recurring service revenue. Overall profitability in Europe is expected to improve over the life of the deal and importantly the deal has substantially strengthened our liquidity. With about $75 million in total proceeds and our strong cash management, we closed the fourth quarter with $256.7 million in cash, cash equivalents and short term investments, a record high for the company and a sequential increase of more than $100 million. After closing Verisure, we announced Arlo SmartCloud, a SaaS version of our Arlo Smart service platform. SmartCloud is a comprehensive service offering that brings together our expertise across artificial intelligence, computer vision, multi-object detection, audio analysis, scaled storage, real-time events and ecosystem integrations to manage vast fleets of cameras and provide the kinds of customized alerts our Arlo Smart users have come to rely on. Formalizing our intent to grow the partnership and B2B side of our business, this unique offering delivers reliable and scalable cloud services to any company or communities making Arlo the ideal choice for those looking to bring intelligent security solutions to market. Verisure provides a great first commercial example of SmartCloud’s value and proves our ability to diversify our business to further accelerate our service revenue growth. I would also like to touch on our newly announced Privacy Pledge. At Arlo, we believe in a users' right to privacy and control of their personal information, a belief that’s underscored the design of our products and services since day one. In light of increasing attention on privacy concerns regarding the treatment of user data, our Privacy Pledge reaffirms our commitment to these principles and clearly differentiates Arlo from others in the industry. Arlo is a company purely focused on providing security solutions that respect and protect our users’ personal information. We don't collect or retain information that is not required to provide the survey. We don't sell data and we are not in any other business that would pull us from our core mission of helping users protect what they care about most. The response from our users, our partners and our retailers has been overwhelming and we will continue to provide leadership on this front. Our clear stance makes Arlo not only the ideal company for consumers to trust for their personal security, but also the ideal company to partner and integrate with to bring solutions to market. Moving onto products. Last quarter we launched our first integrated Video Doorbell that captures the convention – what conventional Video Doorbells can't. Our unique smart entry solution utilizes an industry-leading square aspect ratio camera lens with an extra wide 180 -degree field of view. This lets users see the visitors from head to toe, including packages left at their front door, solving the biggest complaint users have with existing products on the market. With HD resolution and clear two-way audio, the Video Doorbell delivers direct to mobile video calls for faster response time and comes with a three month trial of Arlo Smart that lets users to get personalized alerts such as packages – package detection, so users can quickly reply or take action. We believe this powerful combination creates the most sophisticated doorbell on the market and provides another lever to drive future paid subscriptions for Arlo. And we received numerous accolades to bolster this belief, but none clearer than CNET Editors' Choice award with CNET claiming that “Arlo just ousted nest as their favorite Video Doorbell.” CNET named it the best Video Doorbell for 2020. And of course our other recently released product, the Pro 3 continues to impress homeowners and industry experts alike. In January at CES 2020 the Arlo Pro 3 continued its award winning momentum and was named an Innovation Award Honoree. Additionally, Pro 3 had garnered editor's choice awards across CNET, PC Magazine, TechHive, Digital Trends, and Gotta Be Mobile. We are honored that the Pro 3 was praised by TechHive as quote one of the absolute best indoor/outdoor security cameras you can buy. By CNET, as the best security camera of 2020 and quote the outdoor home security camera to beat, and Gotta Be Mobile as the quote smart home security system that strikes the perfect balance between image quality, smart features, flexible installation and price. Further expanding on our Pro 3 line of best-in-class cameras, we announced our all new Arlo Pro 3 floodlight camera, the first wire-free integrated floodlight camera on the market, featuring class leading bright LEDs, an integrated 2K HDR camera, 160-degree field of view, two-way audio, custom lighting configurations, a rechargeable battery, and a built-in siren and a compact modern form factor that provides the ultimate in place anywhere protection. The Arlo Floodlight Camera joins Ultra, Pro 3 and our Video Doorbell and including a free three month subscription to Arlo Smart our powerful cloud-based AI and computer vision based subscription service. The Floodlight Camera was recognized as a CES 2020 Innovation Award Honoree and won the best of CES awards from bestproducts.com and Popular Mechanics and the top tech CES award from Digital Trends. The industry action to this new product announcement has also been extremely encouraging and Business Insider remarked Arlo is the gold standard for security cameras, so I have no doubt that it's new product Arlo Pro 3 Floodlight Camera will be an excellent device. Furthermore, Gear Patrol called the Floodlight Camera, I quote seriously steroidal floodlight for the security-conscious. The Floodlight segment of IP cameras is growing faster than the market as a whole and as you can see these numerous accolades speak volumes on Arlo’s product differentiation, ease of use, and promising growth opportunity. Now I'll turn the call over to Christine for her commentary on our restructuring plan, our activities to add cash to the balance sheet, our fourth quarter and full-year results and our guidance for the first quarter and full-year.

Thank you, Matt. Before I discuss the financials in detail, I would like to highlight that we closed the fourth quarter of 2019 with $256.7 million in cash and cash equivalents and short-term investments, which is a sequential increase of more than a $100 million. This cash increase is largely a result of the agreement we completed with Verisure, which increased our cash balance by approximately $75 million and prudent balance sheet management. Additionally, the team did an outstanding job managing working capital, which contributed to the sequential cash increase. First, with the sale of the European business and associated inventory, we added $55 million to the balance sheet. Additionally, in Q4, we received a prepayment of $20 million from Verisure for products to be purchased by them in 2020, which will show up as an increase in deferred revenue along with the $2.5 million prepayment for engineering development services. The gain on the sale of our EMEA commercial operations is reported as $54.9 million in our consolidated financial statements. Note that this number includes $50 million received for the sale of the EMEA commercial operations, $4.9 million for the sale of existing inventory in the EMEA distribution center as well as various working capital adjustments including the write-off of EMEA deferred service revenue as well as the $4.6 million de-recognition of goodwill associated with the EMEA business. As can be seen in our sequential decline in operating expenses, our restructuring activities continue to go well and we are still on the path to get down to a quarterly run rate, $33 million to $34 million per quarter of non-GAAP operating expense by the end of the second quarter of 2020. We’ve recorded approximately $600,000 of restructuring expenses during Q4 2019. Given these successes, we did not need to draw down our line of credit. I would also like to note that beginning Q4 of 2019 we will change our metric definitions to registered accounts and paid accounts from registered users and paid subscribers. We believe this more accurately describes our metrics given the Verisure transaction where we are now paid by Verisure for our EMEA accounts as opposed to individuals or businesses. More detailed information can be found in the supplemental information in our press release. And now onto the financials, as Matt highlighted, we achieved $122.4 million of revenue in-line with our guidance and up 15.4% sequentially and up 0.2% year-over-year. During the fourth quarter, we shipped a total of approximately 1.4 million devices of which approximately 1.3 million are cameras. We added approximately 324,000 registered accounts to the Arlo platform in Q4. As of the end of the fourth quarter, we had about four million registered accounts an increase of 40.9% from a year ago. Growing our registered account base is critical to growing our recurring services business, which we believe will help improve both our margins and our revenue predictability. We are very pleased with the growth in our paid account base and believe our new business model for paid services, which we introduced with Ultra and have also included with Pro 3 and the Video Doorbell and we'll continue with future product introductions will be a substantial driver of the paid account base and recurring revenue growth in the near future. This new business model gives the user a rich experience with Arlo Smart for a trial period and at the end of that trial period, there is no rollback to free storage. For services revenue for Q4 2019, was $12.5 million, which is up 16.9% over last year. From this point on my discussion points will focus on non-GAAP numbers. The reconciliation from GAAP to non-GAAP is detailed in our earnings release distributed earlier today. Our non-GAAP gross profit for the fourth quarter of 2019 was $14.9 million, which resulted in a non-GAAP gross margin of 12.2% within the range of guidance. This compares to $5.6 million in the year ago, comparable period and $11.4 million in the prior quarter. Our service gross margin was 34.3% for the fourth quarter 2019, our service gross margin is burdened by the cost of the free Arlo Smart trials under the new business model as well as the accounting carve out for the free basic service. But we do expect that once we increase the subscription attach rate, we will see the service gross margin expand. Total non-GAAP operating expenses came in at $36 million, which is down 4.6% year-over-year and down 0.04% sequentially. Our total non-GAAP R&D expense for the fourth quarter was $14.3 million and down $800,000 compared to the prior quarter. Our head count at the end of Q4 2019 was 349 employees compared to 406 in the prior quarter. The decrease in head count is equally from our restructuring efforts as well as those employees that transferred over to Verisure at the end of the quarter. We agreed to provide Verisure with transition services as they start to operate the European commercial business. These transition services include training time with Arlo employees, systems costs as well as some outside service costs. We have included these costs in our normal operating expenses and the reimbursement from Verisure is included in other income and was approximately $800,000 during Q4 2019. Our non-GAAP tax expense for the fourth quarter of 2019 is $284,000. For the fourth quarter of 2019, we posted a non-GAAP net loss per diluted share of $0.26. As I previously mentioned, we ended the quarter with $256.7 million in cash, cash equivalents and short term investments up $102.9 million sequentially. Aside from receiving cash from the closing of the Verisure deal, we continue to be very focused on managing our cash position and we’re pleased with our inventory management during Q4 and improved DSOs of 97 days for Q4. Now turning to the outlook, we expect revenue in the first quarter to be in the range of $60 million to $70 million. As Matt mentioned, coronavirus is impacting our business on the supply side as our vendors do not have sufficient quantities of the required components to fulfill our demand because the component factories are operating at considerably reduced output. Additionally, in the second quarter we have new product introductions planned that we believe will be impacted by the component shortages as well as delayed delivery of some of the manufacturing equipment from China. To take this into account, we have built in an impact of between 5% and 10% to our original revenue expectations for the first quarter and are expecting an impact between 20% and 25% for the second quarter. We are of course working closely with our partners as we navigate through this. For the first quarter we expect our GAAP gross margin to come in between 6.1% and 9.4% and our non-GAAP gross margin to come in between 8% and 11%. We expect our GAAP net loss per diluted share to come in between $0.44 and $0.47 per share and our non-GAAP loss per diluted share to come in between $0.33 and $0.36 per share. We expect our GAAP and non-GAAP tax expense to be approximately $400,000 for Q1 2020. For the full-year we expect revenue between $370 million and $400 million and a non-GAAP operating loss between $65 million and $75 million. Please note however, that we will have the benefit of about $3.5 million for the year in other income for reimbursement for transition services from Verisure. For the full-year, we expect some of the inventory reduction and working capital benefit we accrued in 2019 to reverse itself out in 2020. But we believe that we will end the year with more than $150 million in cash and cash equivalents and with that we can open the call to questions.

[Operator Instructions] Your first question will come from the line of Adam Tindle of Raymond James. Please go ahead.

Okay, thanks. Good afternoon. I just wanted to start Matt, you talked about the trial period of Ultra Pro 3 Video Doorbell customers still coming that lapsing and potentially accelerating growth of paid accounts, which would obviously be exciting. Just hoping for a little bit more color on the data that you guys are looking at to support that view, just from an outsider's perspective, we look at units shipped versus paid subscribers for a sense of attach rate improving and it's not, but just acknowledge that you obviously have more visibility than us. So curious on what's kind of driving your confidence behind that statement, what data you guys are looking at internally?

Yes, for the last couple of earnings calls and quarters, we've been conveying our confidence that, that the attach rate will go up especially on the new business model and actually being driven by the new business model, which to your point is exactly Ultra Pro 3 Video Doorbell so far. We obviously get a lot of internal data and like I said in the script we have some initial data that it allows us to remain very confident as we go forward, but I think we'll hold a more fulsome report in sharing a more statistically relevant and larger sample size for the next quarter's earnings.

Okay. That's fair. I guess maybe another question on services, if I could. I know it's just to key part of the story obviously. And you have grown revenue nicely, I think north of 20% for a couple of years now. But gross profit dollars are essentially flat during that time and margin is in decline that – that services margin decline accelerated in Q4. I think Christine alluded to some of the reasons behind that, but just maybe bigger picture comments on why margin isn't improving with scale, given it's kind of counterintuitive to us in a services business and maybe how Verisure is going to impact that with the one-to-one attach rate.

Right. So Adam when we look at this quarter, we have always we've been carving out from the old products and then we have all of our new products are basically still on free trial, Pro 3 came out during Q4. Our Video Doorbell came out during Q4 and they have three months trial. So those end sort of late in Q1 and then also Ultra. So once we start kicking in people paying for services, you'll see the margin increase there. And then also as we not as we're not selling anymore the older products with all of this free storage, you'll see that too. And then obviously with Verisure, when we start to see a larger attach rate, especially in their direct channel in a one-to-one attach rate, that will also give us those economies of scale that you're talking about and increase the margin. So, we think it's got quite a bit of a way to increase over time.

Is that $500 million of revenue that you identified related to Verisure the one-to-one attach rate on services, is that at consistent services gross margin as you've been experiencing or is there a way for us maybe to think about the impact because it obviously sounds like a pretty interesting opportunity just trying to help what the margin impact is going to be from it.

Absolutely, that's hardware revenue. On top of that, we are paid when any of Verisure’s customers use our service and Arlo Smart and that will be on top of that. And so both of that 500 million, both as in the retail channel and in the direct channel, and we're not really giving a breakdown. And to be honest, we're not sure exactly what that breakdown will be going forward, but we're, we're very much, they're very much looking forward to selling this in their direct channel.

Okay, got it. One just quick last clarification. Does your 2020 guidance include any benefit that you're expecting from Verisure in any way you can help us with the timing of when that's going to hit, I assume maybe Q3, Q4 more so? Or is it just the magnitude and timing related to Verisure in 2020 guidance?

Yes. On the last call, we had mentioned that most of the Verisure impact will start in 2021. So when we talk about the European growth, for instance, going from 5% CAGR to 25% CAGR, a lot of that will actually start to phase in 2021 with this year being around transition integration and getting both channels and some of the products ready for full deployment through them, especially on the incremental channels beyond the retail channel that they purchased.

Got it. That's helpful. Thank you.

Yes.

Your next question will come from the line of Jeffrey Rand of Deutsche Bank. Please go ahead.

Hi. Thanks for taking my call. Just on the gross margin for Q1 is that – how much of that is being impacted by the coronavirus and how do you kind of look at your gross margin trajectory throughout the year?

So it is affected because of some of the fixed costs that are in there and as we're bringing over less materials, those fixed costs become a bigger piece of that or are they hit the gross margin a little bit on that. And then also, you know, potentially we'll end up spending a little bit up more on freight if we do try to air freight some stuff in that as it comes over once it – once the factory starts having a bigger output. And as we look towards gross margin then it should get better towards the back half of the year. Q4 is always a little bit less depending on what we decide to promo.

Got you. Thank you. And the lost revenue in the first half of 2020, is that something you expect to recover some of it in the second half or is that just mostly lost revenue?

I would say we're working daily on mitigation plans to try and recover as much as possible. But in reality, especially on a component shortage when you're losing those POs and replenishment at the retail channel, most of that is lost and we'll get the recovery from a growth trajectory back in the second half. Also when you do a new product launch, which we have several that we’re kind of targeting the spring reset may get pushed out into Q3. Those stocking orders will move over, but again any in quarter replenishment and sales that you're having you won't get back. And so that's why we're looking at that and being very transparent about the impact we see for the first half and what we think will actually happen in the second half for 2020.

Understood. Thank you.

Your next question will come from the line of Hamed Khorsand of BWS Financial. Please go ahead.

Hi. Could you just clarify the component shortages you're seeing? Is that different from what you were talking about last quarter that impacted Q4?

Yes.

Absolutely. These are factories that were – obviously, they were shutdown for Chinese New Year and normally that's a week. Some of them are just coming back online this week and they're coming in anywhere at 20% to 40% capacity because a lot of the cities have had separate shutdowns. There are quarantines before they can get in the factory. So even though we manufacture outside of China, a lot of our components are coming from China and we are literally on the phone with them every day talking, but those factories are coming back up to speed slowly as their people come back to work slowly.

Are you able to source anything outside of China right now?

We do already source some things outside of China, which is good, but a lot of the major components are still sourced in China.

And this impact that you're talking about in Q2, is this from products that you're planning to release or is this products that you've already released that you’re – the impact that you’re expected?

It'll be a little of both, but we do have some new product introductions. We talked about the Floodlight already and there is a few more and it will slow those down a little bit as we're doing the builds and getting the tooling and all that depending on how we move forward with that.

And could you clarify the comment you made earlier in your statements about the Q2, the 20% or 25% impact, is that to revenue and would that mean that revenue would be actually down sequentially in Q2 versus Q1?

It is to revenue. And it’s probably not quite down, probably slightly up.

Okay. All right. Thank you.

Sure.

And your next question comes from the line of Jeff Osborne of Cowen and Company. Please go ahead.

Yes. Good afternoon. Most of the questions I had have been asked, but just a couple of quick ones on my end. Can you give us a sense of on the service margins? What the target is at scale or as Verisure kicks in?

I mean, we're obviously targeting, we'd love to see 50% and above, but we'll continue to make our way back to that. And we do believe as we get this attach rate up with our new business model with Verisure, we have a lot of catalysts to really move this thing forward.

Makes sense. Is there any way to book in the attach rates? I know you don't want to give specifics until the next call it sounds like, but is there any kind of a minimum and maximum or any commentary you can make on cameras versus non-cameras? What you're seeing in terms of attach rates itself?

Not at this time. I don't think there's enough data for us to really comment on that. But again, as I mentioned in the script, the early data we have is, is reaffirming our confidence and we’ll provide a lot more on the next call.

Got it. And then just a couple of other smaller ones here, I might've missed it, but did you give the NPD share this quarter and how it compared to the third quarter?

No, we didn't. NPD changed some methodology a couple quarters ago. And so, there's no way to really provide an apples to apples comparison. So we don't comment on the market share from that perspective anymore, at least from a numerical perspective. We do – obviously, we've had a lot of product introductions. We've been trying to share a lot of the product reviews. And we know ASPs. We did a great job holding ASPs quarter-over-quarter going into Q4. So the quarter was kind of progressed as expected and we think we did very well in the quarter, especially given the supply shortage we talked about on the previous call.

Got it. And the last question I had is just the – can you – you mentioned the change in headcount sequentially with the restructuring. Can you remind us on what the employee count that went to Verisure was?

Right. So we came down about 57 headcount quarter-over-quarter and it was about 26. It was an evenly split the difference, right, I think 26 was Verisure and the balance was part of the restructuring.

Got it. Thank you. That's all I had.

Sure.

You’re welcome.

There are no further questions at this time. This concludes today's conference call. You may now disconnect.