Arlo Technologies, Inc. Q4 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 fourth quarter 2020 earnings call. On today's call, Gordon and I will walk you through Arlo’s results for the quarter, which include an overview, commentary on paid account growth, new product announcements, and update on partnerships and financial results. We will also provide some expanded commentary on our outlook going forward based on the foundation we built in 2020. During a very tumultuous 2020, Arlo implemented a business model transition that cut across our entire organization, refreshed most of our product portfolio, launched new service plans, won more awards than any other time in our company's history, diversified our revenue through key partnerships, and optimized business operations, all while we navigated through the pandemic-induced disruptions that swept through our industry, our markets, and indeed our world. With a dramatically stronger financial foundation, Arlo is not the same company it was a year ago. We are stronger and on a new upward path. And I could not be prouder of the entire Arlo team for what we accomplished in 2020. And now on to our Q4 results, I'm pleased to share that we delivered $114.8 million in revenue at the top end of our guidance. Our non-GAAP gross margin grew by more than 10 percentage points year-on-year, while our service gross margin improved by more than 10 percentage points sequentially. In addition to our substantial gross margin expansion, our unrelenting focus on operational efficiency and excellence delivered nearly $4 million of non-GAAP operating expense reduction year-on-year. That combined performance created significant leverage in our business, improving our non-GAAP net loss by $14 million when compared with last year, and sending us well past the high end of our guidance for non-GAAP net loss per share, which came in at a loss of $0.08. Rounding out our financial metrics, our cash, cash equivalents, and short-term investments balance improved by $12.5 million sequentially. Underpinning this outstanding quarter is the continued acceleration of our paid accounts, which set yet another record as we added 79,000 paid accounts in Q4, a 36% increase over Q3. Arlo ended the year with approximately 435,000 paid accounts, an 89% increase on a year-on-year basis. Q4 was our sixth consecutive quarter of record services revenue at $21.6 million, up 72% year-on-year, and putting an exclamation point at the end of a truly transformative year. Arlo’s move to our new business model is the driving force behind the transformation and provides 90 days of Arlo Smart service with the purchase of a hardware device. Arlo Smart is our best-in-class AI-powered motion identification and security service, which enhances the product's capabilities and transforms the user experience. Upon expiration of the initial service period, we have consistently seen a 50% subscription attach rate to the paid service, a rate 10 times higher than our old business model. Sales of old business model products phased out as our relentless product portfolio refreshed and launched new products through 2020 and the beginning of 2021, virtually all of our retail sales will be products under our new business model. This success would not be possible without Arlo’s unwavering commitment to innovation. In Q4, we launched our wire-free video doorbell that brings Arlo’s best-in-class technology to a new form factor that addresses a large, fast-growing market segment. The product is clearly resonating with users and critics with tech guides calling it a “game changer” and “the one to buy” while commenting on the responsiveness and our unique image format as key differentiators. Review.com praised our wire-free video doorbell by saying it is the best smart video doorbell we've ever tested. Arlo also started the year strong by winning two CES Innovation Awards, one for our new essential indoor camera that incorporates all of our award-winning features from that product line, combined with an innovative motorized privacy shutter that directly addresses concerns around typical indoor camera offerings. The second award was given to our touchless video doorbell concept that utilizes unique proximity sensing technology to ring the doorbell with a wave of a hand instead of a physical touch, thus reducing potential spread of viruses or other pathogens via a button repeatedly used by numerous people. In December, we announced a strategic partnership with Calix that enables expanded distribution of Arlo’s award-winning products and services, where Calix will now offer Arlo’s smart security solutions to their broad network of communications service providers. These local trusted CSPs will bundle all those products and services with their other offerings such as managed Wi-Fi, addressing regional customers that may be underserved by traditional retail channels. This partnership opens up another exciting route to market across the U.S. and Canada. Our Verisure partnership continues to proceed as planned with all in-quarter milestones achieved, targeting a wider rollout as the year progresses. The partnership with Verisure includes a $500 million hardware purchase minimum guarantee over five years from 2020 to 2024 in addition to ramping paid accounts in the region. The minimum guarantee alone represents a 25% cater for the European market over the five years and the partnership serves as a great example of Arlo’s ability to execute in the B2B channel. And now I would like to hand over the call to Gordon, who will provide more insight into our financial performance, operational details, and outlook for the first quarter and full year.

Thank you, Matt. While the lockdown and supply chain disruption induced by the pandemic hampered our growth in 2020, we made excellent progress running the business and improving our P&L during the year. Even with the financial burden of the business model transition and pandemic-induced challenges in the first half, we produced meaningful margin expansion for the full year across both product and service, resulting in a 610 basis point increase in non-GAAP gross margin. We outperformed the target we laid out in our 2019 restructuring plan and lowered our non-GAAP operating expenses by more than $20 million in 2020. Importantly, our results have shown incremental improvements as we progress through the year as we transition to the new business model and begin to realize its benefits. In total, we reduced our non-GAAP operating loss by more than $14 million for the year with much of this improvement coming in the back half. A trend of sequential improvement culminated in strong results for the fourth quarter of 2020, with revenue at the high end of our guided range, considerable margin expansion, and EPS well above guidance. We ended the year with more than $206 million in cash, cash equivalents, and short-term investments, an excellent outcome given the complexity and transformation we navigated through 2020. Moving on to the Q4 financial detail, revenue came in at $114.8 million, down 4.2% sequentially and down 6.2% year-on-year. Product revenue for Q4 2020 was $93.3 million, which was down 15.1% compared to last year and up 2.2% sequentially. Our year-on-year revenue decline was largely due to Verisure's stocking in the third quarter for the European market. Our service revenue for Q4 2020 was again a record at $21.6 million, up 72.1% over last year and up 13.7% sequentially, primarily driven by our paid account growth under our new business model, from which we have consistently strong conversion for our paid subscription service, Arlo Smart, after the free trial has ended. Our service revenue also includes $2.4 million of NRE services provided for Verisure along with the associated costs, compared with $2.3 million in the third quarter of 2020 and zero a year ago. During the fourth quarter, we shipped approximately 116,000 devices, of which approximately 164,000 were cameras. 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 2020 was up $10.9 million or 73% year-over-year to $25.7 million, resulting in a non-GAAP gross margin of 22.4%, up from 20.6% in Q3 2020 and up more than 10 percentage points from 12.2% in Q4 2019. The improvement in non-GAAP gross margin came from both products and services. Our non-GAAP product gross margin came in at 14.8%, up from 6.8% a year ago, benefiting from scale across the product supply chain, lower promotional spending, and progress in the transition to products under our new business model. This is our highest margin in nine quarters. The $10.9 million year-over-year improvement in non-GAAP gross profit included improvements of $8.4 million from services and $2.5 million from product. This exemplifies the beneficial effect of the service business on our P&L. Non-GAAP product gross margin was 14% down 70 basis points sequentially due to typical Q4 promotions and up 440 basis points from 9.6% a year ago. Non-GAAP service gross margin came in at 58.9%, up substantially from 48.8% in Q3 2020 and 34.3% in Q4 2019, driven by continued paid account growth under our new business model compounded by benefits from cost-saving actions. In 2020, we successfully delivered four consecutive quarters of service margin expansion. In Q4, operating expenses once again benefited from last year's restructuring, along with our continued expense management. Total non-GAAP operating expenses were $32.2 million, down $3.8 million or 10.5% year-on-year, and up 3.3% sequentially. This was again slightly below our $33 million to $34 million guidance, but up sequentially due to the planned seasonal increase in our sales and marketing activities. We continue to believe our non-GAAP operating expenses will be in the $33 million to $34 million range each quarter this year. Our total non-GAAP R&D expense in the fourth quarter was slightly down sequentially at $12.5 million. Our headcount at the end of Q4 was 359 employees, compared to 358 in the prior quarter. Additionally, in Q4 Verisure made their contractual $14 million prepayment for future product purchases, which can be seen both in our cash balance and in deferred revenue. Our non-GAAP tax expense for the fourth quarter of 2020 was $185,000. We posted a non-GAAP net loss per diluted share of $0.08, much better than the high end of our guidance. We ended the quarter with $206.1 million in cash, cash equivalents, and short-term investments up $12.5 million sequentially and down $50.5 million year-on-year. We continue to make progress on our working capital management during Q4. Our DSO came in at 64 days, down nicely from 97 days a year ago, but up from 47 days sequentially due to seasonal dating terms with certain retailers and a shift in customer mix. Q4 inventory closed at $64.7 million, a decrease of $4.3 million over Q3 2020. Now, turning to our outlook, as is syncing across many industries, Arlo is facing supply constraints driven largely by chip shortages, which are exacerbated by elongated shipping timeframes. In this context, we expect first quarter revenue to be in the range of $70 million to $80 million as these supply constraints could limit our ability to deliver through the first half of 2021. With our current visibility, we still believe we can achieve revenue of approximately $400 million for the fiscal year as we shared last quarter. We expect our GAAP net loss per diluted share to come in between $0.35 and $0.29 per share, while our non-GAAP net loss per diluted share is projected to be between $0.23 and $0.17 for the first quarter of 2021. In Q1, consistent with the pattern we saw in Q1 2020, we will see a working capital outflow and expect our cash, cash equivalents, and short-term investments to end the quarter in the $150 million to $160 million range. We also anticipate our cash consumption to moderate considerably through the rest of the fiscal year, maintaining over $120 million in cash, cash equivalents, and short-term investments. We will continue to monitor our performance and prudently manage our operations to preserve our cash position.

Thank you, Gordon. Beyond our guidance for Q1, and our reaffirmation of our past commentary on 2021 revenue, I want to share a bit more on the trajectory of our business as we look ahead. Arlo is a different company than it was a year ago. We start this year on a solid foundation with a clear focus on what will drive our future success. The transition to our new business model was a watershed moment that redefined our path, and will continue to accelerate. While we added 200,000 paid accounts in 2020, we expect to add nearly three times that number in 2021 to reach 1 million paid accounts by our fourth quarter call this time next year. We shared with you that we see a 50% conversion rate after the initial 90-day service period ends under our new business model. As we follow cohorts over a six-month period, we see that catch rate for our subscription services is 65%. These factors should translate to approximately $100 million in service revenue in 2021 at a gross margin of more than 50%. Arlo is now a services-first company from our culture through our roadmap. I have never been more confident in our team, our company, and our path as we continue to unlock substantial value from our assets and our business model. And with that, we can open up the call for questions.

Hi, thanks for taking my question. Congrats on a good quarter. Your weeks of inventory went up in both the retail and distribution channel. It's about three weeks higher than at the end of 2019. Can you talk a little bit about the dynamics around the pandemic or holiday season that are changing your inventory, or how are you thinking about your inventory levels right now?

Hi, Jeff. This is Gordon, thanks for the question. In terms of the actual weeks of stock, just to remind you that the denomination of that calculation is the last six weeks of PLA. In terms of actual dollars of inventory, we've seen the dollars come down year-on-year. So in Q4, and certainly if you look at the distribution weeks of stock, that's really timing as shipping in and shipping out. Any delay, I think will come down as we head into Q1. Looking ahead to 2021, I think it's fair to say that we don't expect to see much of a tailwind from channel inventory sales. To your point, you're absolutely right, in that the inventory levels, both retail and distribution are a lot more normalized, a lot closer to normal levels than what we saw at the end of Q2. So we don't expect too much of a tailwind in 2021 from the channel.

Great. Thank you. Are you still seeing any increased logistical costs due to the pandemic? Is there any visibility on when these should decrease?

Yes, we are seeing that for sure. We've spoken about this quite a lot, and certainly Arlo's no different from the rest of the market. Air freight rates have remained elevated since the back end of Q1 last year, and there are no signs of that abating. That may turn around perhaps towards the back end of this year, but everything depends on how the pandemic plays out. We haven't really seen any change, and it's probably gotten a little bit worse over the last six months due to the pressure on sea freight. We are currently experiencing elongated shipping times and some degree of congestion at ports. So that side of things still continues to persist.

Great. And then just one more from me, your product gross margin grew meaningfully year-on-year in Q4. Are you seeing less need for promotional activity, or are there other factors involved?

I think it's a combination of things. The first and foremost is that we did go through the business model transformation. The gross margin profile in the first half of 2020 was very much a story of transition. As we went through that business model change, we saw an uptick in product gross margin reflecting the new technology we brought into the market, which naturally means you don't have to promote quite as much. There's also the typical seasonality in our business where 35% to 40% of business occurs in the first half and 60-ish percent in the second half. The rescale benefits have also helped product gross margin in Q3 and Q4. Looking ahead to Q1, we expect product gross margins to be in the low double digits. Yes, I think it's fair to say the new technology is definitely helping us, and we don't have to promote quite as much either.

Okay, thanks. Good afternoon, Matt. I just wanted to start on the subscriber metrics. You intend to roughly triple paid subscribers in 2021 to reach a million subscribers. Those are big numbers. I would just be curious on the color on visibility into that level, given that this is a significant step function from already healthy growth rates. Do you have some contractual visibility with Verisure and Calix? Is there an underlying growth assumption on how you're building up to those impressive goals?

Yes, it's a great question, Adam. We have high confidence in what we're seeing on the subscription side of our business. We're growing our subscriber base in a very predictable way, and we really understand that trend. We have great visibility into the subscriber growth. When we sell a product and get certain trials in one quarter, that gives us a very good idea of what's going to happen in the following quarter. This confidence extends from the partnerships we have, including Verisure, where the execution has been going well around retail and e-commerce in Europe. We're seeing a conversion rate of 50% after six months, which gives us an optimistic outlook for our growth. The direct business with Verisure will start to happen later in 2021, and we're progressing on custom products and integration with Verisure as planned. I think it's too early to call which side will be bigger in 2021, but we expect the direct business to scale as we get deeper into 2022. We're starting to build forecasts based on long lead components, so visibility there is good.

Okay, I know it's still somewhat early for the services and subscriber business, but I’d be just curious what you're learning about the characteristics of your subscriber base, specifically the lifetime value, gross churn, or retention rates. How valuable are subscribers and how sticky are they?

We haven't released some of those specific metrics yet. However, we've noted a significant increase in the conversion rate, which is 10 times higher than our previous model. Moreover, the attach rate on service climbs to 65% after a six-month purchase of hardware. We're currently seeing a much lower churn rate than our old model, but it's early in the transition, and we're optimistic about the trajectory based on the metrics we have shared.

Thank you for taking the question. This is Wahid for Hamed. Could you shed some light on which subscription level subscribers are opting for? Is it the high end, the low end, or is it a good mix?

We've mentioned that the middle plan, which is $10, is the most common choice among our subscribers. As we continue to transition our entire product portfolio under the new business model, we're also looking at ways to optimize the subscription business and potentially increase ARPU over time. It's fair to say that the new technology is definitely helping us, and we have less need for promotions. Every quarter, we have certain upsides, but it may be more difficult to chase these upsides due to supply chain slowdowns. Most of our old products stopped being built a quarter ago, and we're exiting the year with the majority of our products under the new business model.

Yes, the supply chain slowdown can impact our ability to deliver on some of the upsides, but we're diligently forecasting and managing operations to ensure we're meeting expectations for revenue growth.

Thank you, operator. I want to thank everybody for joining the call. That concludes our commentary for today. Thank you.