Arlo Technologies, Inc. Q1 FY2020 Earnings Call

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. I would now like to turn the conference over to Erik Bylin. Please go ahead, sir.

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 has donated thousands of N95 masks and is working with caregivers to use Arlo cameras for remote patient check-ins and to reduce the risk of transmission and decrease the protective equipment consumption at those facilities. 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 and Orange County to provide meals with each purchase of an Ultra System, Pro 3 System, or a video doorbell. This initiative 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 many of our retail partners moving to a much leaner inventory model, our Q2 revenue would be materially higher. As channels return 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.

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 in operating expenses, our restructuring activities continue to go well. In Q1, we were materially below our target of $33 million to $34 million per quarter of non-GAAP OpEx. Now on to the financials. As Matt highlighted, we achieved $65.5 million of revenue just above the midpoint of our guidance, 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 rather than by 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, 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, resulting 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 the first quarter of 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. However, we expect that 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 normally 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, aligning them more 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, 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 and related costs. We have included these costs in our normal operating expenses, and the reimbursement from Verisure is included in other income, which 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, roughly equal to the operating loss and the use of working capital. We were pleased with our inventory management during Q1 and improved DSO of 83 days. 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. However, we will provide guidance for the second quarter based on what we know today. Our Q2 guidance considers 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 chain's ability to deliver. We expect our GAAP net loss per diluted share to be between $0.53 and $0.46 per share and our non-GAAP loss per diluted share to be between $0.46 and $0.39 per share. We would also like to give 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. 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. Thank you and stay safe. We can now turn the call over for questions.

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 are a couple of factors to consider. One is scale, as we look at our operations. Secondly, what we're seeing is that freight costs, specifically air freight, are extremely high right now. Although we're managing this prudently, that's the majority of what you're seeing in the margin compression. There's really a combination of scale and air freight costs. As we look to the back half of the year, we're not giving guidance, but we would like to believe that as volume increases, so will the gross margin.

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

Yes, I think that's fair. The way we're looking at the second half is really on a year-over-year basis. 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 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. Therefore, we consider the second half to show about 20% down on a year-over-year basis while also indicating some recovery as we head into that timeframe.

Congrats to Christine on retirement and Gordon on the new role. Matt, I just wanted to start on services just double-clicking there. What would you attribute the record additions in the quarter to? Is there a way to parse out how much comes incrementally from the Verisure partnership versus converting the existing core base of subscribers? Can you provide a bit more granularity on this record growth and also the sustainability of that cadence? You mentioned a strong performance on subscriptions quarter-to-date — are we looking at a new normal where we're going to add 25,000 a quarter?

That's a really good question. The biggest portion of the boost in subscribers for the current quarter is coming from the new business model. I know we've discussed this for the last two or three quarters, and I'm excited to report real numbers now. The 50% conversion rate compared to the legacy model, which hovered around 5%, shows a significant change. As we see point-of-sale transactions shift from legacy products to new business model products, which just started happening in the quarter we reported, we'll observe that boost in subscriptions. I believe this new trend is sustainable, and we also see good subscriptions from Verisure as well. The bulk of our growth indeed stems from the new business model.

Got it, that's helpful. Now going back to the question on gross margin for Q2, if the current quarter remains strong on services, then that should provide a boost. We have already discussed revenue and the EPS figures. My only concern might be product gross margin — any good sense on that, given that we saw negative product gross margin in Q1? Are we anticipating more double-digit negatives in Q2?

No, I wouldn't say that. While we are introducing new products, there are still trial periods that will impact our service gross margins in Q2. So I believe you will witness improvement in service gross margins as we fully integrate the new products going forward.

Understood. Also, inventory levels in the U.S. distribution channel seem very elevated, likely related to retail closures. Can you provide some insights into that order magnitude change and how quickly we can expect it to come down?

Sure. The numbers we presented are based on the last six weeks of the quarter, which were the slowest for distribution channels. Additionally, we had some inventory that was planned for a broadcast deal in Q2. So we expect that inventory levels to reduce.

Got it. Lastly, can you clarify if there are any near-term reversals expected for Q2? I'm concerned that losses may widen slightly, given that Q2 is typically a weak cash flow quarter.

When you analyze Q4 to Q1, you noticed that accounts payable dropped significantly. However, I predict you will not see that significant decrease in Q2, which should mitigate the flow.

Do you have enough components? Is your supply chain operating well? Do you have the inventory to sell once the channels begin to restock?

The supply chain is very close to fully operational. We are observing a few weeks' delay on certain components. However, based on our forecasts, we do not anticipate significant supply chain issues.

Are you implementing new promotions or discounting more aggressively due to the current selling situation?

We are seeing different activity in the channel. While we're doing some things differently, I wouldn't say we're moving to a completely different strategy. Our sales are now predominantly through online channels as opposed to physical stores, and promotions are shifting in that direction. However, we are not being overly aggressive; it's mainly a matter of cost management with air freight and other factors due to the coronavirus impact.

Regarding sales and marketing expenses, they may need to rise a little with the launch of new products, particularly with holiday seasons approaching. We'll manage this based on market conditions.

Christine, could you share some qualitative factors regarding the $125 million to $150 million cash guidance? Was this difference just due to EBIT losses and working capital or other tighter measures taken?

Our OpEx has significantly decreased, even though our headcount rose. We've prepared several scenarios and are confident in our projections for cash management. It's a range based on reasonable estimates moving forward.

On the Verisure NRE, can you provide any insight into the lower margin flow-through of the $1.2 million for this quarter? What are the expected trends for that throughout the year?

It is fairly flat going forward. We don't provide exact estimates but wanted to highlight that it is included in our financials.

Onboarding with Verisure is proceeding smoothly, and we are maintaining focus on technology integration for operational readiness ahead of anticipated business growth in 2021. 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. I am confident that our continued execution through the year will result in a more profitable and 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.