Ladies and gentlemen, thank you for standing by. At this time, all participants are in a listen-only mode. [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 Second Quarter 2023 Financial Results Conference Call. Joining us from the company are Mr. Matthew McRae, CEO; and Mr. Kurt Binder, 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 second quarter, along with guidance for the third quarter and full year provided by Kurt. We will then have time for any questions. If you've not received a copy of today's release, please visit Arlo's Investor Relations website at investor.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 our potential future business; operating results and financial condition, including descriptions of our revenue, gross margins, operating margins, earnings per share, expenses, cash outlook, free cash flow and free cash flow margin; guidance for the third quarter and full year of 2023; the rate and timing of paid subscriber growth; the transition to a services-first business model; the commercial launch and momentum of new products and services; strategic objectives and initiatives; market expansion and future growth; the effect of our brand awareness campaign on future growth; partnerships with various market leaders and strategic collaborators; continued new product and service differentiation; and the impact of general macroeconomic conditions on our business, operating results and financial condition. 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 discussed on this 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 second quarter 2023 earnings call. Arlo has completed the transformation to a service business, as evidenced by the underlying drivers of our outstanding financial performance. Paid accounts grew 55% year-over-year to 2.3 million subscribers. Service revenue grew 54% year-over-year, reaching a record $50 million and our annual recurring revenue grew 66% year-over-year to $194 million. We also achieved a record service gross margin of 75%. All of these metrics are substantially ahead of where we hoped to be when we rolled out our long-range plan a little more than a year ago. This service acceleration is partially attributable to the pricing strategy Arlo implemented in Q4 where we brought down hardware pricing and raised subscription service pricing. While this rebalancing of value reduces product revenue and gross margin, it generates incremental product demand by lowering the barrier of entry for the Arlo solution and substantially increases service revenue with no material impact on churn. This inelasticity in the subscription pricing is the truest testament to the value our services provide our customers. Diving in a bit deeper, average revenue per user for retail and direct paid accounts is up roughly 24% when compared to a year ago. This in turn has pushed the lifetime value of a retail and direct paid account over $700. What's more, even though the current number is small, households that have the new Arlo Security System show an ARPU that is an additional 60% higher, which highlights a clear avenue to drive ARPU up over time. This services performance and the excellent execution by the Arlo team drove our overall results for the quarter. Revenue came in at $115.1 million, which was at the top end of our guidance, and we delivered…

Thank you, Matt, and thank you, everyone, for joining us today. I will start by sharing some financial details and an overview of the business for Q2 2023. Revenue for the second quarter came in at the top end of our guidance at $115.1 million, roughly flat sequentially and slightly down year-over-year. While revenue was relatively consistent year-over-year, the composition of that revenue changed dramatically. In the most recent quarter, service revenue was 44% of total revenue, while last year, it only accounted for 28% of the total revenue. This shift is reflective of our services-first strategy as well as our new pricing strategy. We are extremely pleased with our services revenue and ARR growth, which helped to deliver revenue at the top end of our guidance range and contributed to Arlo generating non-GAAP operating profit in Q2 of $5.4 million or 5% operating margin and $11.5 million in free cash flow or 10% free cash flow margin. Our service revenue for Q2 was another record at $50.3 million, an increase of $17.5 million or 53% year-over-year and an increase of $6.4 million or 15% quarter-over-quarter. This growth was driven by our subscription price increases and the addition of 245,000 paid accounts in the quarter. This number reflects a catch-up in the number of paid accounts in our European region, which was being underreported by Verisure in previous quarters. Our normal net paid account run rate remains in the 170,000 to 190,000 range. But we expect this catch-up to continue over the next couple of quarters as Verisure works through their system correction. This does not impact any related financial metric and is limited to the net paid account number only. Our installed base continued its growth trajectory and reached 2.3 million paid accounts in Q2. As mentioned earlier, service…

Your question comes from the line of Hamed Khorsand with BWS. Your line is open.

Hi. So first question I had was, could you just talk about this inventory issue with Verisure? How much inventory do they have? And why are they being so cautionary? And then also, if you could also provide a little bit more understanding as to what this catch-up is and why is it noncash and how do you find out about it?

Yes. I think what we're seeing with Verisure is very similar to what we saw with retailers in the retail channel. As an example, at the end of last year, where they're really managing their inventory to a target number and Verisure, we see doing that this year. The exact amount, we don't know, but we can see them managing their inventory down. And we have visibility into a much longer forecast with them. As you know, we have a great long-term partnership with them. So we can see that recovering after they're going to hit whatever target they're trying to hit internally. So I think it's very similar to what we saw the retailers do at the end of last year and now they're going through that same cycle today, this year. On the catch-up, it was roughly October of last year. That's not when we saw it, but that's when it started. The product, meaning the cameras that are being installed or being installed at the location, at the household, which means, we do a cost-plus model, so the cost in our cloud are accurate. We mark that up. We charge them like we've talked about in our pricing model with B2B customers. But the actual count of the household or the paid accounts was not being incremented correctly. So Verisure is pushing firmware updates out to what they call their central units to fix that over time. And so that's where you can see some of the catch-up this quarter. And we think that they'll continue to roll that out through the end of the year. So we'll see a little bit more catch-up each quarter. If you back out, just to give you an example, if you back out the catch-up we saw this quarter, we were at kind of the high range of our normal range of adds for the quarter anyway, so call it 185-plus thousand accounts for the quarter before Verisure's catch up as they deploy firmware and roll that out.

And the follow-up I had was in Q2 as far as hardware is concerned. How much of the revenue was sell-in as far as the Prime Day is concerned and what are you seeing as far as activity-wise now that Prime Day is over? Are you seeing the attach rates still stay at around that 50% mark you've been talking about for a while?

So the first part, I'll answer that, Hamed. We saw that there were a couple of factors impacting this quarter. First, we did see sell-in fairly strong as a result of the promotional activity that we've been embarking on for the better part of the last 6 or 7 months. As a result of that, the natural seasonality played in our favor for Q2, but compounding that was the fact that we did have a fairly significant load-in for Prime Day. I'm sure Matt will touch on this a bit more, but Prime Day was a great success for us. And we've also seen similar load-in for a couple of other key retailers like, for instance, Costco. So it was a relatively strong quarter as it relates to the load-in for those retailers. The retailers for the most part, had a good inventory level here in the U.S. And so we do expect, especially in the second half, that the demand will continue to be promotional.

Yes. And just a follow-up on the second part of your question around customer sentiment. Kurt touched on it, and we touched on it in the script. Prime Day was strong, and that is a kind of continuation of what we've described as, I think resilience in the last couple of quarters around consumer demand. Our pricing strategy is definitely driving consumer demand. I think demand is relatively strong. We do have good inventory levels in the channel. You can see our inventory actually came down. So we're bringing in more product. So we're feeling pretty strong around how the consumer is reacting to our pricing strategy, our value proposition across multiple channels. Prime Day was a great example of that. And we have a very robust plan across multiple channel partners in the second half. So we're excited about the household formation we're going to see going into Q3, really Q4 going into 2024 around what that's going to mean for future service revenue.

Your next question comes from the line of Jacob Stephan with Lake Street. Your line is open.

Hey, guys. Congrats on the results. And thanks for taking my questions here. So I'm just kind of wondering, when I think about the holiday stocking period coming up here, inventory levels stable sequentially, what have those initial conversations been with kind of the U.S. big box retailers, the Best Buys, the Costcos? And just any color on that would be helpful.

Yes. So planning for a second half promotional period actually starts at nearly the end of last year and gets a little bit more specific, and I would say, detailed as we go into Q1. So a lot of the planning for this has been in Q1, and we've been in, obviously, execution mode. I think both Kurt and I commented that we have a new product line launching that we're very excited about coming in this timeframe, and so some of that will load in Q4, a lot of it may load in Q3. And some of them, when we look ahead and how much of that lands in Q3 versus Q4, that has to do with freight and other things. In speaking with the retailers, the sentiment right now is relative optimism, I would say, for the second half. And that's around both, I would say, in general, despite some concern about consumers. They're seeing relatively good foot traffic, and we're seeing relatively good sales. And then I would say, specifically around Arlo, the success we've had in the first half of this year, our pricing strategy generating additional sales for them in the segment. And I can tell you, it's pretty clear that Arlo is actually capturing share in the market. So I would say there's a relative maybe cautious optimism in just the general consumer market from the big box retailers as we planned for the second half together over the last 6 months. But I think there's specific excitement around Arlo, what we're doing, our pricing strategy, our new products that are coming out and the plans that we have both on a placement level but also a promotional level in the second half.

Okay. Got it. And maybe just touching on kind of the Verisure channel destocking. So the 10-Q had roughly $39 million in backlog as of June 30. So is this destocking coming after kind of the quarter end here so that maybe that $39 million in backlog might be lower than that, or was that incorporated into the Q2?

Yes. No, I wouldn't read into that too much, Jacob. I think that right now, from what we're hearing and we're working with Verisure on a week-to-week basis but they have a clear inventory target that they are going to hit for the end of this year. And that's been factored into the PO placement that you're currently seeing. Just to give you an overview of what we're seeing, right now, we have the $500 million commitment from Verisure. We're about $400 million sitting as of today. And we do see a path to well exceeding that almost by the second quarter of next year. So we also see that the end market demand in the EMEA region is still pretty resilient. So although they're kind of destocking and working to hit a specific inventory target for the end of the year, the demand still looks to be very healthy and resilient, especially going into Q1 of next year. So we don't feel like there's any major concerns around the end market demand that's out there.

[Operator Instructions] Your next question comes from the line of Jake Norrison with Raymond James. Your line is open.

Thank you so much. Good quarter, guys. Firstly, I just want to start from a higher level. Can you talk about and give us a sense internally where you're seeing mix of products versus services, particularly as we look to fiscal '24? How high do you think this can go and maybe any visibility as to when that might cross over the 50% mark?

Yes, great question. So we've been focused on driving the overall percent of our services revenue higher with the overall combined revenue. As we pointed out in our prepared comments, this quarter, we hit the 44% mark, which was fantastic. As you know, that service revenue is generating around the 75% gross margin. And we were super pleased with the fact that overall --on an absolute dollar basis, gross margin covered our entire non-GAAP operating expense for the quarter. So that was a big milestone and a milestone I think we had kind of communicated before, but it was probably positioned to be more of a Q3 or Q4 event. So we were super pleased we were able to do that in this quarter. As we look forward in terms of our overall revenue mix, we think, for the full year, we will be at or above that 40% target. And then going into 2024, we will be moving rapidly up towards 50%. Our goal over the long-term is probably somewhere between 50% and 60%, and we have a clear line of path to that. But it will take us a little time, ending this year at say plus 40% and then moving quickly from 40% to 50% towards the end of next year.

Okay. That was very helpful. And then last one for me, another sort of high level. How are you guys thinking about channel mix as we enter 2024? And maybe just any guardrails around how low retail and e-commerce -- you're willing to go there?

Yes. It's more a question of the relative growth between the two. So give you a little history. When we spun from Netgear a while back, 83% roughly of our revenue was from what we would call traditional retail. So retail e-com and the like. Now it's closer to maybe 40%, 45%. So a lot of that was a strategic initiative internally to diversify our revenue base, and we saw some significant opportunity in what we call strategic accounts or B2B partners, obviously, Verisure being the largest of those partners. So it's to me, both will grow. We are seeing growth in the retail channel now. As we mentioned earlier on the call, we feel we're capturing share in some of those traditional retail channels and our pricing strategy is working. And we're seeing growth across in the long-term across new strategic accounts and existing strategic accounts. So as far as what the balance will be, it's a question around relative growth between the 2. And I would say there's significant opportunities on the strategic account basis, and that might drive additional growth or higher growth on a relative basis as you look out over the next 12 to 24 months. But on the retail side, again, the market is actually flat to down right now, and we're growing. So we always try and grow our retail and direct account markets faster than the market, and we're being very successful at that. So I don't have a hard number for you, but I would say there's additional upside on the strategic accounts just because there are so many potential opportunities over the next 12 to 24 months.

Your next question comes from the line of Rian Bisson with Craig-Hallum. Your line is open.

Hey, guys. Rian on for Tony. Thanks for taking my question. Just to kind of clarify on the subscriber add with the Verisure catch-up. I guess kind of netting out that Verisure catch-up and looking kind of throughout the year, are you still -- I mean, for next quarter and for Q4, are you still expecting kind of that 185,000 paid subscriber adds per quarter, I guess, how does that look going forward?

Yes. So our normal runway, I think, stays the same. And what I mean by that is what we're organically generating from multiple channels is somewhere between 170,000 and 190,000 paid accounts a quarter. And that's kind of the range that we've communicated. I think that's still true. Although like I said in this quarter, I think we were probably on the high end of that range. We had a successful quarter on paid accounts. Then you add on additional catch-up. So this quarter, we were closer to 240,000, 245,000 paid accounts. I think we'll see similar catch-up. Again, it can be plus or minus as we go into quarters and depending on how many firmware upgrades they do as we roll through the rest of the year. But again, those aren't adding financial metrics like service revenue. It's just a catch-up of the absolute value of number of accounts because of under accounting of those paid accounts. So I think when you're modeling it from a financial perspective and service revenue, that 170,000 to 190,000 range is the right way to think about it. And then just know there's some catch-up happening on the paid account number, but it's not affecting the underlying financials.

There are no further questions at this time. And this concludes today's conference call. Thank you for attending. You may now disconnect.