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 turn the conference over to Erik Bylin. Please go ahead, sir.

Thank you. Good afternoon, and welcome to Arlo Technologies Third Quarter of 2020 Financial Results Conference Call. Joining us from the company are Mr. Matthew McRae, CEO; and Mr. Gordon Mattingly, 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 third quarter, along with guidance provided by Gordon. We will then have time for any questions. If you've 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 COVID-19 pandemic on the 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. And 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 GAAP to non-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 third quarter 2020 earnings call. In today's call, Gordon and I will walk you through the major elements, including financial results for the quarter, paid account growth and new product announcements. Arlo's strong third quarter results serve as further evidence of the improvement we have made in the business. Accelerating paid service accounts, gross margin expansion across both products and services, a strong contribution from Verisure and our continued operating discipline combined to produce a significant improvement in profitability and further demonstrate the transformational impact of our business model transition. We delivered $110.2 million in revenue, which is up over 65% sequentially, well above the upper end of our guidance and a return to year-over-year growth. Our non-GAAP gross margin improved by 11 percentage points sequentially, as our product gross margin recovered and our service gross margin continued its upward trajectory. Non-GAAP operating expenses came in at $31.2 million, down almost $5 million year-over-year and reflected our sustained focus on operational efficiency. These results demonstrate the leverage we can generate in the business, as we shrank our non-GAAP operating loss by more than $16 million year-over-year and that in turn helped us close the quarter with a very healthy cash, cash equivalents and short-term investments balance of more than $193 million. Arlo, once again, set a record by adding 58,000 paid accounts in Q3 and ended the quarter with approximately 356,000 paid accounts, an increase of 69% year-over-year. This resulted in our fifth consecutive quarter of record services revenue at $19 million, which is up 61% year-over-year. The driving force behind the success is our new business model, which features a 90-day free trial of Arlo Smart, our best-in-class AI-powered motion identification and security service. Once the…

Thank you, Matt. I'm pleased to share that the Arlo team delivered outstanding results this quarter, with revenue coming comfortably above our expectation and showing year-over-year growth. With strong revenue performance, improving gross margins and tight management of our operating expenses, we drove a dramatic improvement in our bottom line, both sequentially and year-over-year. We also saw further evidence of the success of our new business model, with our paid account growth again accelerated. Our team's focused execution enabled Arlo to outperform expectations and deliver results that show the significant progress we're making with the business. And now, moving onto the financials. As Matt highlighted, we achieved $110.2 million of revenue, up 65.4% sequentially and importantly, up 3.9% year-over-year. Product revenue for Q3 2020 was $91.3 million, which is down 3.2% compared to last year and up 84% sequentially as retail operation improved considerably from the second quarter. And we received a solid contribution from Verisure. The third quarter revenue reflect Verisure's stocking for the holiday season. So, we expect fourth quarter revenue from Verisure to return to the levels we saw in first half. When Europe accounted for 25% of our revenue in Q3, Verisure contributed to the improvement we saw in both revenue and profitability during the quarter. And we continue to execute on plan with them. Our service revenue for Q3 2020 was $19 million, which is up 60.6% over last year and up 11.4% sequentially. The main driver of our excellent service revenue growth is our paid account growth under our new business model. Whereas for the third consecutive quarter, we have seen very strong conversion to paid subscription of Arlo Smart after the free-trial end. Our service revenue also include $2.3 million of NRE services we are providing for Verisure, along with the associated costs.…

[Operator Instructions] And your first question comes from Adam Tindle with Raymond James. Your line is open.

Okay, thanks. This is Madison on for Adam. I appreciate you taking my questions. I wanted to start on the paid subscribers. So, you added nearly 60,000 of them in the quarter, and this is an important milestone to reaching breakeven. How can we think about the sustainability of this level of paid adds? Is there anything that drove the acceleration that you'd expect to moderate? And then lastly, I know you mentioned some contribution from Verisure. Was there any Verisure contribution to the paid adds?

Hi, this is Gordon. That's a great question. I mean, certainly, we are very pleased with the paid subscriber add. I think a good thing to look at is the deck that we put online, the investor deck, which gives you an idea of the proportion of our mix of sell-through in Q3 that was associated with the new business model products. That's definitely something to look at. Obviously, we're very pleased that it was a record quarter of paid subscriber adds and we do believe that that momentum is going to continue, going forward. So - and in terms of Verisure - predominantly, Verisure at the moment is really focused on the retail channel in Europe. And obviously, Europe is impacted by COVID. So, the security camera for Verisure, we think, will start kicking in more in the latter part of next year. So, that's really the characterization of Verisure. Yes, we're really pleased with that and we do expect momentum to continue.

Okay, great. And then, just a follow-up. You talked about promotional activity increasing for Q4; obviously, that's normal, and sales and marketing spend to increase. But I was hoping you could touch on your expectations from a gross margin standpoint. Do you think products gross margin can remain positive? And then just any color on what you're expecting from the competitive environment and discounting for this holiday season? Thanks.

Yes, I'll take the first part of the question, and I'll let Matt take the second half. So, just with respect to product gross margins. Q3, we benefited from a couple of things. Certainly, scale helped and then secondly, we've largely completed the transition from the legacy product to the new business model product. That definitely helped product gross margin in Q3. I expect that will continue in Q4. You rightly pointed out; it's an extended promotional period in Q4, particularly this year with Prime Day in Q4. So, that will be a slight headwind in Q4. And then the other thing in Q4, the air freight. We think the air freight rates are going to go up a little bit in Q4. They do naturally anyway, with normal peak. Some - we are seeing peak on top of peak in Q4 with respect to air freight. So, a couple of those things combined, I still think product gross margin in Q4 will be in the low double-digits, but slightly down from what we saw in Q3.

And from a competitive set perspective, as we look at Q4, it's going to be a very unique Q4, partially because of what Gordon just touched on, with Prime Day actually landing in October and some of the more traditional retailers reacting to that and starting their promotional period earlier. What I would say, on top of that is, because of COVID and the operational requirements to kind of limit the number of people that would be in physical stores, the retailers have also decided to kind of spread the promotions over a longer period of time. What that means is we've gotten a good look at what a lot of these promotions already look like, as we sit here, already having a month under our belt. And we haven't seen anything out of the ordinary or anything unexpected from a competitive set perspective. So, we think it's going to be a normal Q4 from at least a pricing and promotions perspective, but how that is being rolled out from an operational perspective is different, because of Prime Day and because of the operational challenges at physical retail. We think we'll see more, for instance, of online sales and some of these physical retailers having a much more omnichannel quarter.

Got it. Thanks for the color, and congrats on the strong results and guidance.

Thank you.

Thank you.

And your next question comes from the line of Hamed Khorsand with BWS.

Hi, just wanted to ask you about the Q4 inventory retailers. The selling process is that fairly complete. Are you expecting refilling that inventory, and how aggressive you think you should - you think you will have to get on the promotions? I know you just said it looks normal, but do you think the inventory might be too high, just given how you guys performed in Q3 on Prime Day?

Well, so the - from an inventory perspective, we're seeing inventory still is relatively low from historical standards. So, you'll see, it's around 8.4 weeks, which is - again low. We think not only healthy for the quarter and the new operational footprint, but obviously historically, very low. So, we're watching that obviously very carefully, as we go through. We want to make sure we're balanced. But given where we are in the quarter, you're going to see us - not only have we shipped in stuff for Q4 holiday, especially with Verisure in Europe but also some here in the United States. There will be additional shipments for some of the promotions towards the back half of the quarter and a little bit of replenishment. But it will - I think it will be very similar to a normal quarter from a shipment perspective. It's more how the POS is happening at the retailer that's different, with a lot more being done online instead of in the physical store.

Does it matter for you if you end up selling more Essentials than the Pro 3 or Pro 4? Or you're just - looking just to pick up the incremental paid user?

Well, yes. So, there is a couple of things there. One is, what we've seen so far with Essential is a couple of data points. One, it seems being - it's being sold to a different customer. So, we look at Essential as playing in a new price band and allowing us to actually capture a new customer. So, that's one. Two, we're seeing relatively consistent subscriber sign up. So when you talk about our long-term business model around subscription, Essential is going to play an important component of that. So from an Essential perspective, that's where we see it kind of playing, across different channels. And it will be not only attaching a new customer to the Arlo ecosystem, but actually driving incremental subscriptions for us down the road.

And my last question was, when do you think you will hit that inflection point as far as the service gross margin starting to tick up again?

Well, to Gordon's point, and he can comment in more detail, I mean, we're seeing service gross margins pick up over the last three quarters, up to a record level this quarter. And we expect that to continue, based both on mix, but also just the performance of the business and the leverage that we're getting on the subscription business.

Yes. Just to add some color to that. As Matt said, three consecutive quarters of improvement, up from 34% approximately in Q4 a year ago, up to 48% in Q3. We're pretty pleased with that. We do expect the sequential improvement to continue, certainly for the next few quarters. And as Matt said, the mix of paid subscriptions is definitely helping that and the team has done a fantastic job on cost optimization as well, which really helps. So, yes, we expect the improvement to continue, Hamed.

Okay, thank you.

You're welcome.

[Operator Instructions] And your next question comes from Thomas Boyes with Cowen. Your line is open.

My questions. Just a couple of quick ones from me. I just wanted to get a sense if you're seeing any new trends developing - following Amazon Prime Day, as well as kind of the sales promotions that were going at Best Buy and Arlo's own store? Is there really a preference among customers for less number of cameras and they're picking up more doorbells or products, how's that really developing?

Yes, we're not seeing a big change there. We have moved a lot of our products through a base station optional skew, so that they can use the base station if they want, they get additional capabilities including local storage and other things, or they can use it now with WiFi. And that's true for three of our new Pro 4 cameras, as an example. So, that's mixing up a little bit of the skidding we're seeing at retail. But so far, we haven't seen a big shift on the number of cameras. For us, we look at doorbell and, for instance, floodlight as an incremental add above and a way to bring customers into the Arlo ecosystem. Where before, you had to come in if you were looking to buy cameras first. Now, you can come in if you're looking for a doorbell and then add the Arlo cameras later. So, it's a little early for us to tell exactly what's happening. But we haven't seen a big shift in the number of cameras per household. And you can kind of back into some of that by just looking at the number of registered accounts against the cameras and the devices that Gordon kind of reported that we sold in the quarter.

Got it. Now, for the refreshes with Arlo Ultra 2 and then the Pro 4 line. Is there any cost advantages there from a gross margin perspective, where, as you serve to come on, they have just been engineered a little bit better as far as a manufacturing angle and you should see some of that start to appear as a scheme in penetration?

Yes, there is a couple of trends inside of hardware. So, one is - the biggest thing that's contributing to the significant growth in gross margin on the product side is the transition from the older business model products and some of the older technologies to the new business model product and our newer technology platform. And that's something we've been talking about for several quarters. And with Essential, we're basically done with the Essential launch and have everything on a more modern architecture. So, that's going to contribute to gross margin from a product side, as we go forward. That's the biggest jump. I will say, obviously, we look and work extraordinarily hard on every single product from a gross margin side and look for continued improvements in cost, kind of quarter-by-quarter basis. And when we do launch a new product, there is typically some advancements that we've built into that platform. So, it's a little bit more efficient, or sometimes new feature and functionality or sometimes both. And so, it depends on what we're launching. But as you go forward, we're continuously optimizing the platform. But the biggest jump is coming from being on modern architectures and getting rid of some of the old business model product, which is predominantly done now with the Essential family launch.

Got it. Is Arlo the original Ultra still being offered with one-year bundle, or is that shifted over to the three months, as well?

All right. You'll see that sell - continue to sell-through for a little while, but it will transition to the Ultra 2 with the consistent business model to the best of our product on a 90-day trial.

Got it, thank you. Another thing is just the E911 service is obviously something that was very differentiated for Arlo. And now, that's been around for a couple of years. I mean, have you started to see any of your competitors have this feature? I am not aware of any them; if you are? And I was wondering if they haven't, why do you think that is a challenge [ph]?

Yes, it's - so, it's a good question. I think we're still definitely on the forefront, when it comes to cloud-based services for cameras and security systems. And you're pointing out one great example, which is E911, allowing somebody to - allowing us intelligently route an emergency call to the right 911 Center for where the cameras are located. I have not seen anybody else do this in a scaled way. It's actually relatively difficult to do. And we've done it as part of the - one of the original launches of Arlo Smart. In addition, we're also one of the only companies doing multiple simultaneous object detection with computer vision. That's something we can do better than anyone else including person, package, vehicle, animal, and do that in a very low latency manner and a bunch of other features inside that pack. So, we talk a lot about on the call, our innovation on a hardware device level. But you're pointing out a great area, where our innovation and our lead from an innovation perspective on the service is still substantial over the competitors in the marketplace. And of course, we're not standing still and we'll continue to innovate on that service level.

Great. I guess, just to get a COVID-19 question there. I just wanted to just double check, given the resurgence globally. I mean, there has been some talk of potential lock-downs in Europe. I just wanted to get a better sense of maybe some - any exposure to the supply chain or manufacturing capabilities more broadly, just as you look out, heading to the end of the year?

Yes, it's - I mean, it's something we're looking at, literally on a daily basis, both on the supply chain side and also talking with our channel. COVID is re-surging a bit in Europe. You rightly point that out. It's re-surging a little bit here in the United States as well. I think the major difference is this isn't a surprise at this time. And a lot of operational changes have already been put in place by our partners, both forward and backwards in our supply chain. So, I think everybody is in a much better position to deal with different lock-downs or things that are happening. Consumers are very used to buying products online. A lot of our physical retailers have gotten a lot better at selling online and have been able to kind of start to mix their business a little bit different. So, I think there's obviously risk, as Gordon pointed out, in Q4 and kind of as we look into next year and how that's going to go. But I think everybody has gotten a lot better about how to deal with it from the operational perspective. And we kind of know what to look for. So, I think it's - I think the risk is a lot more muted than it was before.

Understood, that was all for me. Thanks for the time. Congratulation, again, on the quarter.

Thank you.

Thank you.

And there are no further questions at this time. Mr. Matt McRae, I will turn the call back over to you.

Thank you. So, that concludes our call for the Q3. I want to wish everybody a happy and safe holiday, and we'll talk to you soon. Thank you, everyone.

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