Arlo Technologies, Inc. (ARLO) Q1 2020 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, Operator. Good afternoon, and welcome to Arlo Technologies' First Quarter 2020 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 first quarter, 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, future business outlook and the impact of the COVID-19 pandemic on our business and operations. 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 this 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 first quarter 2020 earnings call. Before I discuss the quarter, I want to take a moment to address the ongoing impact of the pandemic. On behalf of the entire Arlo team, I offer my sincere gratitude to the frontline healthcare workers and first responders that have met this virus head-on. To support them, Arlo’s donated thousands of and N95 masks and is working with caregivers to use Arlo cameras for remote patient check-ins and to reduce the risk of transmission and reduce the PCP consumption at those facilities. And as the second order effects of the pandemic impacted people's ability to feed their families, we entered a partnership with Second Harvest in Silicon Valley in Orange County to provide meals with each purchase of an ultra system, Pro 3 system or a video doorbell. And this has resulted in over 30,000 meals donated to feed those in need. I would like to thank Arlo employees for their compassion and their commitment to our business as we delivered a solid quarter. Our transition to work from home went smoothly and the team is operating at nearly 100% capacity. We have worked through the supply chain disruptions brought on by COVID-19 in the first quarter and feel our ability to deliver to demand is now largely intact. However, there remains considerable disruption and uncertainty across the channels that we sell through. Retail store closures, operational changes, and a focus on essential items have made it difficult for us to serve the Arlo customer. Considering the uncertain duration of this disruption, we have decided to withdraw our guidance for the full year. Given our near term visibility and considering a range of retail channel trajectories we are providing guidance for the second quarter. Point of sale data shows demand for Arlo products in the quarter at our previously expected levels. And if it were not for the many of our retail partners moving to a much leaner inventory model, our Q2 revenue would be materially higher. As channels returned to a more normal operational footprint and inventory model, we expect this destocking to reverse in future quarters and Arlo’s shipments to improve. Our Q2 quarter to-date visibility is also showing a strong performance on subscriptions. Christine will discuss our outlook in more detail after she reviews the quarter’s financials. I will now discuss our results and accomplishments from our recent quarter. Christine and I will walk you through the major elements including financial results for the quarter, paid subscriber growth, new products and a partner announcement. A couple of highlights from the quarter. In Q1 we reported $65.5 million in revenue just above the midpoint of our guidance for the quarter and up 13% year-over-year. As I mentioned, the team did an outstanding job delivering a solid quarter given the unprecedented disruption across the business. While we continue to invest strategically, we've remained extremely dedicated to refining our spend in the business and I'm pleased to share that we again lowered operating expenses in Q1 down $3.8 million sequentially, and down more than $6.4 million year-over-year. We will continue this focus and discipline as we move forward. We have exciting news in regard to our subscription business and the success of our new business model, which is the free trial of Arlo Smart that comes with a new camera, video doorbell or floodlight purchase. Arlo continues to attract new customers to our platform with about 230,000 added in Q1 to reach a total of 4.25 million registered accounts up 36% year-over-year. We ended the quarter with approximately 255,000 paid accounts, which is up more than 57% year-over-year. The in-quarter growth of 25,000 new paid accounts was the most in our history and up 32% sequentially. As a result, services revenue was $14.7 million in Q1 for a year-over-year growth of 31% and a record for Arlo for the third consecutive quarter. And for the first time ever, our revenue for paid accounts surpassed our prepaid service revenue, an important inflection point for the business. The driving factor behind the success is our new business model, which features a limited 90-day trial of Arlo Smart, our industry leading cloud storage and computer vision service. The first quarter of 2020 was the first time we had a material number of trials expire, and our subscription growth provides an early view into our future. Given the POS trends I mentioned earlier, we can expect to see momentum strengthen in Q2. While subscription conversion rates on our legacy business model hovered around 5%, early data indicates that the estimated subscription conversion rates for the new business model is around 50%, five zero and we're expecting a substantially lower churn rate. This order of magnitude increase in subscription attach rates will transform the business as Arlo continues to end of life legacy products that include free storage, and introduces new products that incorporate the new business model. Upcoming product launches will complete our phase out of the legacy products and channel sell-through should be nearly complete by year's end. Let's move on to those products, Arlo’s new Pro 3 floodlight camera is the first wire free integrated floodlight camera on the market and is now on sale across our channels. It combines all of the award winning features of our wire free 2K Pro 3 camera and a powerful 3000 lumens floodlight housed in a modern compact design that gives you the freedom to install it anywhere. Floodlight cameras represent up to 20% of the overall connected camera category and are growing faster than the general market. Our new offering represents a significant growth opportunity for Arlo. Within 90 days, Arlo also plans to begin production of a new camera that completes the refresh cycle of our good, better, best, core lineup and will address the fast growing $100 price segment. Both this upcoming camera and the Arlo Pro 3 floodlight include our new business model to further accelerate subscriptions. They join our existing Ultra Pro 3 and video doorbell which continue to win Best of and Editor's Choice Awards, among other accolades. Our business-to-business channel and software as a service Arlo’s SmartCloud offering continued to make progress as we diversify our business beyond retail and e-commerce. The partnership with Verisure is proceeding on schedule as we develop and integrate the solutions ahead of a wide rollout and growth targeted for 2021 as we discussed last quarter. And we're excited to share a new partnership with Kartchner Homes, which will integrate Arlo’s video doorbell into homes built over the next 12 months providing homebuyers with a premier solution in smart entry technology. Focused on building quality homes for families while offering convenience and value Kartchner Homes chose the Arlo video doorbell for its design, quality, features and compatibility with both Google Assistant and Amazon Alexa voice assistant providing homeowners with the, connected home ecosystem of their choice a benefit unique to our Arlo’s products. Homeowners will also get a free three month trial of Arlo Smart. Before I turn the call over, I would like to thank Christine for her contributions to Arlo over the past two years in her role as CFO. As we recently announced Christie will retire on June 15 2020. And I wish her well. She was instrumental in the creation of Arlo as a separate entity, and building strong teams inside the company. As a testament to Christine's team building acumen, I am pleased to welcome Gordon Mattingly, the current SVP of Finance, who will take over as Arlo’s new CFO upon Christine's retirement. Gordon is well suited to succeed her having previously served in various senior leadership roles in finance and operations at Arlo and NETGEAR over the past two decades. I'm excited to work with Gordon as Arlo’s hits this inflection point, and I'm confident he will be an excellent leader as we drive towards growth and profitability. Now I'll turn the call over to Christine for her commentary.

Thank you, Matt. In the face of unprecedented challenges, the Arlo team delivered a solid quarter with revenues just above the midpoint of guidance. As can be seen in our sequential decline and operating expenses, our restructuring activities continue to go well. And in q1, we were materially below our target of $33 million to $34 million per quarter of non-GAAP OpEx. And now on to the financials. As Matt highlighted, we achieved $65.5 million of revenue just above the midpoint of our guidance, and down 46.5% sequentially, and up 13.1% year-over-year. During the first quarter, we shipped a total of approximately 642,000 devices of which approximately 636,000 are cameras. As a reminder, beginning in Q4 of 2019, we changed 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. We added approximately 230,000 registered users to the Arlo platform in Q1. As of the end of the quarter, we had about 4.25 million registered accounts, an increase of 35.8% from a year ago. At the end of the first quarter, we had approximately 255,000 paid accounts, an increase of 25,000 in the quarter, and up more than 57% year-over-year. We're very pleased with the growth in our paid account base and believe our new business model for paid services will be a substantial driver of recurring revenue growth in the near future. Our services revenue for Q1, 2020 was $14.7 million, which is up 30.7% over last year. Our service revenue includes $1.2 million of NRE services we are providing for Verisure, along with associated costs as compared with $279,000 in Q4 of 2019. 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 first quarter of 2020 was $4.8 million, which resulted in a non-GAAP gross margin of 7.4% slightly below the low end of our guidance range. This compares to $2.7 million in the year ago comparable period and $14.9 million in the prior quarter. Our service gross margin was 36.8% for first quarter 2020. As previously mentioned, 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 as we increase the subscription attach rate, we will see the service gross margin continue to expand. In addition, our service revenue includes $1.2 million of NRE services that we are providing to Verisure, and the gross margin on those services is less than what we see in the subscription business. In Q1, operating expenses came in under our $33 million to $34 million target. Total non-GAAP operating expenses were $32.2 million, down 16.6% year-over-year and down 10.5% sequentially. In the second quarter, we expect to release two new products and shift our marketing efforts to drive online awareness bringing them more in line with the prevailing buying patterns. Given that we expect sales and marketing expenses to rise in Q2 while the balance of our OpEx components should decline. We expect that this will result in operating expenses ending up in the original target range. Our total non-GAAP R&D expense for the first quarter was $13.6 million and down $700,000 compared to the prior quarter. Our headcount at the end of Q1 2020 was 356 employees, compared to 349 in the prior 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 our 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 $1.1 million during Q1, 2020. Our non-GAAP tax expense for the first quarter of 2020 is $116,000. For the first quarter of 2020, we posted a non-GAAP net loss per diluted share of $0.34. We ended the quarter with $206.6 million in cash, cash equivalents and short-term investments, down $6.1 million sequentially to roughly equally the operating loss and the use of working capital. We were pleased with our inventory management during Q1 and improved DSOs of 83 days for Q1. Now turning to our outlook, as Matt mentioned, given the uncertainty presented by our distribution channels, we have decided to withdraw our guidance for the full year, but we will provide guidance for the second quarter based on what we know today. Our Q2 guidance takes into consideration the current state of our retail channels, which is creating a headwind to revenue. We expect second quarter revenue to be in the range of $50 million to $60 million given our revenue outlook we have high confidence in our supply chains ability to deliver. We expect our GAAP net loss per diluted share to come in between $0.53 and $0.46 per share and our non-GAAP loss per diluted share to come in between $0.46 and $0.39 per share. We would also like to give some commentary on our cash position. We believe that considering a range of outcomes for the COVID-19 pandemic, and its effect on our retail and distribution channels. We will end this year with between $125 million and $150 million in cash without tapping into our credit facility. We will continue to monitor our performance during 2020 and take prudent actions to preserve our cash. Before I turn it over for questions, I'd like to give a heartfelt thanks to all of the Arlo and NETGEAR employees, vendors, customers, investors and analysts I have worked with over the last 15 years. I've greatly enjoyed working with you, and you have made the last 15 years truly memorable. As we traverse good times and bad together. It will certainly be strange three months from now when I'm not prepping for an earnings call, but I know I have left the company in good hands with Gordon, who most of you already know. Thank you and stay safe. We can now turn the call over for questions.

[Operator Instructions] The first question comes from the line of Jeffrey Rand of Deutsche Bank. Please go ahead. Your line is open.

Just looking at gross margins, it appears gross margins are going to have to come down sequentially remodel revenue and EPS in the midpoint. What are the incremental pressures you're seeing in Q2 and how are you thinking about gross margins as we go into the back half of the year?

Yes, when we look at the gross margins for Q2, there is a couple things, one is scale, as we look on our operations. And secondly, what we see is freight, air freight specifically, is extremely high right now. And although we're using that prudently that's the majority of what you see. And there's really the scale and the air freight. As we look to the back half of the year, we're not giving guidance, but we would like to believe that as everything comes up, so does the gross margin.

Great thank you. And thinking about seasonality with - the channel destocking, do you think there could be a sharper seasonality in the back half of the year because of the restocking versus a normal period?

Yes, I think that's fair. I mean, if you look at - the way we're looking at the second half, is really on a year-over-year basis. So - for level setting, if you look at Q2 year-over-year, our guidance that we're providing today is roughly 35% down year-over-year at the midpoint obviously, due to coronavirus and some of the channel implications. We do see some recovery coming into the second half, which would accentuate the normal seasonality. And so the way we look at the second half is really year-over-year basis, take the entire second half and maybe it's 20% down on a year-over-year basis showing some recovery as we accelerate into that second half. So that would provide a little bit of additional, boost on the seasonality you would normally see as we think the year-over-year would be lower, moving from 35% Q2 to kind of a 20% in the second half on a year-over-year basis.

Your next question comes from Adam Tindle of Raymond James. Please go ahead. Your line is open.

Congrats to Christine on retirement and Gordon on the new role. Matt, I just wanted to start on services just double clicking there. I guess, what would you attribute the record ads in the quarter two, is there a way to maybe parse out how much is incremental from the Verisure partnership versus converting the existing core base of subscribers? Just kind of a little bit more granularity on the record adds in the quarter and also the sustainability of that cadence? You talked about strong performance on subs quarter to-date are we added kind of a new normal where we're going to add 25,000 a quarter?

Yes, so it's a really good question. What I would say is, especially when you look at the current quarter, and in the quarter, we just announced the biggest portion of that boost in subscribers is coming from the new business model. And I know it's something we've been talking about probably for the last two or three quarters on the calls that it's coming. And it's great to actually report real numbers underlying that. And so that 50% conversion rate compared to the last conversion rate on the legacy, which was hovering just about 5%. I mean, that's an order of magnitude change. And so as we see POS start to transition from old legacy products to new business model products, which is just starting to happen in the quarter, we just reported, you're going to see that boost. So I think it is the new normal, we are commenting a bit on the current quarter that we're seeing the strength continue. And so I would that going forward. We have done a good job at actually, mining that legacy base. We're seeing good subscriptions from Verisure as well. But the bulk of this transformational kind of change in subscriber is coming in on a quarterly basis, is coming from the new business model.

Got it, okay that's helpful. And maybe just double-clicking on the question on gross margin for Q2 if the current quarter is still strong on services, I'd imagine that should be a boost. We already thank you for the color on revenue and we know the EPS number you gave a lot of color on OpEx. I know it's a slight headwind, but the only I guess, piece of that that's missing that would be an incremental headwind would be I guess, product gross margin? Any more color I know Christine you mentioned airfreight, just we were already negative product gross margin in Q1. Are we like double-digit negative in Q2 is that kind of what we're implying here, just give me a sense of, kind of the bridge?

No, I wouldn't say that. But what I would say is in the services and we mentioned that while we're still going into all the trials on all of these products and really in Q2, we'll see more of all the - with our floodlights, it's just coming out now we'll have more products that go into the automatic 90-day trial that kind of burdens the service gross margin to. So what you will see as we're fully into the new products, which we really expect to be into that, more and more every quarter, then you're going to start to see that service gross margin rise.

Okay. I wanted to ask the U.S. distribution channel inventory is obviously very elevated. I'd imagine that somewhat related to retail closures, but maybe just a little bit color because it's just such an order of magnitude elevated and how quickly that comes down?

Sure, two things are on that. One is, it is based on the last six weeks of the quarter is the way we give our numbers and those were the slowest on the distribution channel. But I say secondly, we had some inventory in there that was going to go out for a broadcast deal in Q2. So we should see that number come down.

Got it, and last one from me. Thank you for the color on the full year of cash guidance without the credit facility I guess more near term any reversals that are going to hit in Q2, I'm just thinking that - the loss is going to slightly widen. I know Q2 is typically a weak cash flow quarter as it stands, should we be thinking about kind of a greater use of cash in Q2 than Q1 and if not, why not?

I think it what you'll see is - when you look at Q4 to Q1, you saw the accounts payable from giving how Q4 is coming down quite a bit. I don't think you'll see that big drop like that in Q2, and that should lessen, same with accounts receivable to be honest on the other side, that should make that not as big of a magnitude.

Okay, so the loss should improve sequentially then or the use of cash should improve sequentially, I'm sorry?

Yes, the use of cash won't be the same given the drop from Q4 to Q1 from a seasonality standpoint.

Your next question comes from a Hamed Khorsand of BWS Financial. Please go ahead. Your line is open.

So first off, I just want to ask you, do you have enough components is your supply chain okay and do you have the inventory to sell into the channel once they begin to restock?

Go ahead Matt.

So I am sorry, the supply chain is basically very close to fully operational. We are seeing a couple of weeks delay here and there on certain components. But based on the forecasts we have going forward we don't see a lot of issues coming from the supply chain.

Okay. And then just being able to restock the channel in time, right - are you just at the mercy of how much air freight you could allocate to?

Why I say there is no when you look at retail the reset days aren't the same as that. So there's probably a little more flexibility on that side. So we're managing both sides of that, but we're definitely seeing the supply side come back up to normal.

And because of what COVID and everything that's going on from actually selling the device, are you implementing any new promotions? Are you discounting more aggressively?

I mean, we're seeing different activity in the channel. And so, I would say we're doing some things differently, but I wouldn't say we're moving to a completely different footprint. And I'll give you an example of that obviously, Best Buy is a predominant brick and mortar shop with online. And our sales, we're predominantly through the stores obviously, that's inverted and now it's predominantly online and it's not in the stores besides the curbside pickup. So you're seeing promotional are shift in the way they're being spent. But for the most part, we're not being more aggressive. It's really around cost things like air freight and some other effects that we've had as coronavirus kind of hit the supply chain going out to the customer.

So is sales and marketing expense sustainable at current levels or will have to go back up once the COVID pandemic subsides?

Obviously, we'll take a look with some of our new products. There's some launch expenses, and then depending on Black Friday in that, but we'll manage that and depending on where it is, it should come down a little bit.

Your next question comes from Jeff Osborne of Cowen and Company. Please go ahead. Your line is open.

A couple of questions on my end. Christine, I was wondering if you could just share with us the qualitative, recognizing you're not giving guidance for the year. But what the thought process was on the $125 million to $150 million of cash which is helpful. I think last quarter was $150 million that you talked about. So obviously a $25 million difference is that all just the EBIT loss and some working capital or is there tighter measures that you've taken? It looks like headcount went up sequentially. I'm just trying to understand the puts and takes as it relates to getting to that numbers. If you give guidance, any help and backing into it would be helpful?

Sure, yes so you can see our OpEx went significantly down, even though headcount was up. So sometimes, you’re hiring someone and not spending it on outside services is actually better for the company. What I would say is we've gone through several scenarios of modeling, and this was the numbers that we come up with, and we feel very good about hitting those numbers. And so it's really just from a high range to a low range as we go forward.

Got it. And then on the Verisure NRE is there any help you can give us in the lower margin, flow through of that the $1.2 million this quarter what the cadences of that is the next three quarters of the year?

It's just pretty flat. So I mean, we don't comment on that specifically, but it's just included in the numbers. And we wanted to make sure people knew that was in there.

Okay. I just want to make sure it wasn't doubling or tripling as we ramped up into more of their territories and whatnot and train them. How is the training going in bringing on-boarding there?

I think that's going very nicely and I think that Matt comment on that.

Yes, it's everything's on track. So there's several tracks that we're actually taking with them. One is, obviously on-boarding of their running up the channel and some of the operational pieces as several, actually over 20, 25 employees of Arlo moved over. So that was relatively smooth and just needed to be ingested from an operations perspective on the Verisure side. Also, there's a lot of technology integration being done ahead of some ramp of some business with them and some other areas in 2021. And that is actually proceeding on schedule as well, which is why you're seeing the NRE payments actually flow through. So we're really happy with the way that's progressing, everything is on time. And we're going to continue to focus on execution ahead of 2021.

Got it? And then maybe Matt, the last question I had for you is on the subscription side. I know its super early, but is there any noticeable trends between product SKUs and particular say 50% is impressive that was higher than I was anticipating on the subscription side. But is doorbell above that and say floodlight or camera below, I didn't know if there's any a wide deviation in and around the 50% number based on the type of product?

Yes on a qualitative basis, there is very little change between the product, it is remarkably consistent across all the different product types we have with the data that we've got today. So it looks like it's a very solid foundation to build from. And of course, our focus now is refining the model refining the model, refining the messaging or iterating around promotions and marketing, messaging and positioning to actually increase it from here if we can. But the floor is remarkably consistent across all the different cameras that are on the new business model and the video doorbell to the example you gave.

There are no further questions at this time. I will now turn the call over to Matt McRae for closing remarks.

Thank you for joining us today. Despite the headwinds across the channel presented by the current environment, we are seeing strength in the services business driven by the new business model even as I look at the current quarter. And I'm confident our continued execution through the year will result in a more profitable, predictable company in the future. Stay healthy and safe and we look forward to engaging with many of you throughout the quarter.

This concludes today's conference call. You may now disconnect.