Arlo Technologies, Inc. Q3 FY2021 Earnings Call

Ladies and gentlemen, thank you for your patience. I would now like to turn the conference over to Erik Bylin. Please proceed.

Thank you, Erik, and thank you all for joining us today on Arlo's third quarter 2021 earnings call. Once again, the Arlo team exceeded expectations across all metrics as we continue to navigate the unprecedented supply chain challenges many companies are facing globally. Total revenue increased by 1% year-over-year, service revenue rose by 42% year-over-year, and total paid accounts surged by 146% year-over-year. Despite the added costs from pandemic-related supply chain disruptions, non-GAAP gross profit dollars increased by over 10% year-over-year, significantly surpassing top-line growth. To provide further clarity on our services business, we reported our annualized recurring revenue (ARR) at $80 million in Q3, a growth of 103% year-over-year. Our ARR, driven by our new business model, is now the fastest growing and highest margin segment of our total services revenue, representing the annualized recurring service revenue from our paid accounts. ARR excludes prepaid service revenue, such as legacy carbon revenue from our previous business model and NRE service revenue from strategic partners. Looking ahead to Q4, I foresee our team's strong execution continuing, even as we may face peak supply chain challenges. Arlo is raising guidance for Q4, for the full year, and for our year-end cash balance. Our annualized recurring revenue is expected to grow by more than 100% again in Q4, and we aim to provide a more detailed report on this topic during our fourth quarter earnings call. Reflecting on Q3 results, revenue exceeded the top end of our guidance at $111.1 million, marking the ninth consecutive quarter of record service revenue at $27 million. We added 182,000 paid accounts, a record number, which represents a 25% sequential increase and a 214% year-over-year growth. To put this into perspective, under our legacy business model, it took us over two years to achieve the same number of paid accounts that we added in just the third quarter. The continued acceleration of our services business, which accounted for 64% of our non-GAAP gross profit dollars in the quarter, helped to more than offset over $3 million in incremental air freight costs compared to last year, contributing to a total non-GAAP gross profit increase of $2.4 million, or more than 10% year-over-year. Arlo outperformed our guidance for non-GAAP net loss per share, which stood at a loss of $0.08. Additionally, we have managed to lower our non-GAAP operating loss by an impressive 76% year-over-year in the first three quarters, bringing it down to $14.7 million in 2021. Our cash, cash equivalents, and short-term investments totaled a healthy $166.1 million. With our current cash position and financial trajectory, we expect to reach profitability without the need for additional capital. Our transformation into a services company has powered these impressive Q3 results and is also driving us toward our long-term goals. On October 18, we surpassed 900,000 paid accounts and believe we are on track to reach our goal of 1 million paid accounts well ahead of our year-end earnings call. As mentioned earlier, service revenue in Q3 was $27 million, putting us on a clear path to exceed our forecast of $100 million in service revenue for the year. Our new Arlo Secure service plans are central to this strong performance. Arlo Secure includes features such as computer vision-based object detection, AI-based audio detection, interactive notifications, animated event previews, secure cloud storage of video up to 2K resolution, and 24/7 premium support. Arlo Secure Plus, priced at $14.99 per month, includes all of the Arlo Secure features, enhances cloud video storage resolution to 4K, and provides a 24/7 emergency response service that allows direct requests for fire, police, or medical assistance, along with access to a security expert in emergencies. Under our new business model, which includes a free 90-day trial of Arlo Secure Plus, we see a consistent 50% subscription conversion rate at the end of the initial trial period. Over a six-month period, we observe the attach rate to our subscription services increasing to 65%. Our industry-leading technology continues to excel and receive acclaim from experts. Since our last earnings call in August, our products have earned three Editor's Choice awards, multiple design accolades, and features in various Best of 2021 lists. CNET noted about the Arlo Pro 4 that "in a point-by-point comparison on resolution, performance, battery life and so on, it just consistently outshines the competition." This positive reception reflects our commitment to innovation, which continues with our latest product launch. We have introduced the new Arlo Go 2 Smart Security Camera exclusively with Verizon. The Arlo Go 2 is a LTE, WiFi, and GPS-enabled device that utilizes our expertise in RF and low-power design to provide uninterrupted security in areas without power or internet, such as construction sites, vacation homes, RVs, vehicle fleets, and large properties. The Arlo Go 2 is now available nationwide through Verizon, with more carrier partnerships on the horizon for next year. Now, I will hand the call over to Gordon, who will share more insights into our financial performance, operational details, and outlook for the fourth quarter.

Thank you, Matt. Thank you, everyone, for joining us today. We delivered strong Q3 2021 financial results that exceeded our expectations, growing our non-GAAP gross profit by 10.7% year-over-year, while revenue was above the high end of guidance and up 0.8% over Q3 2020. Our financial performance for the quarter was again underpinned by the successful execution of our new business model, leading to record levels of paid accounts. The Arlo team navigated continuing tough supply conditions to exceed our expectations on revenue while again improving our year-over-year profitability, decreasing our non-GAAP operating loss by $1.2 million year-over-year. Moving onto the Q3 financial detail, revenue came in at $111.1 million, up 0.8% year-over-year and 12.8% sequentially. Our service revenue for Q3 2021 was a record $27 million, up 6.9% sequentially and up 42.4% compared to last year, with our new business model fueling our growth. While service revenue accounted for 24.3% of our Q3 2021 revenue, it delivered 63.9% of our non-GAAP gross profit. Our service revenue also includes $1.3 million of NRE services we are providing, along with associated costs, as compared with $2 million in the second quarter of 2021. Product revenue for Q3 2021 was $84.2 million, which was up 14.8% sequentially and down 7.8% compared to last year. Our sequential product revenue growth was driven by continued strength from our Verisure relationship in Europe, coupled with growth in retail in America as we head into the seasonally stronger fourth quarter. Year-over-year and sequential product revenue growth were both impacted by supply chain challenges, which were most pronounced in the early stages of the quarter. While our sell-through was dampened by shortages, our supply chain team did a fantastic job securing additional supply in the latter part of the quarter and replenishing channel inventory ahead of the seasonal uptick we expect in the fourth quarter. During the third quarter, we shipped approximately 1,012,000 devices, all of which were cameras. From mid-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 third quarter of 2021 was up $2.4 million year-over-year to $25.1 million, which resulted in a non-GAAP gross margin of 22.6%, down from 27.9% in Q2 2021 and up more than 2 percentage points from 20.6% in Q3 2020. The year-over-year improvement was driven by strong progress on service gross margins while product gross margin was impacted by COVID-19 related supply chain challenges, which drove a significant increase in airfreight expense year-over-year. The $2.4 million year-over-year improvement in non-GAAP gross profits includes an improvement of $6.8 million from services, offset by a reduction of $4.4 million from products. Non-GAAP service gross margin came in at 59.5%, slightly higher than 58.9% in Q2 2021, and significantly higher than 48.8% in Q3 2020. The year-over-year growth was driven by substantial paid account growth under our new business model, coupled with cost management over the last year. Non-GAAP product gross margin was 10.8%, down from 17.2% in Q2 2021, mainly due to a sequential increase of $2.7 million in air freight expense and down from 14.8% a year ago, again mainly impacted by an incremental $3.6 million in air freight expense, while short-term product gross margin will continue to be adversely impacted by incremental air freight expense due to the current COVID-19 related supply chain challenges. The incremental long-term customer lifetime value we derive from the associated paid account is compelling and more than justifies the investments. Total non-GAAP operating expenses were $32.5 million, up $0.7 million or 2.1% sequentially and up $1.2 million or 4% year-over-year. Our total non-GAAP R&D expense for the third quarter was down slightly sequentially at $12.3 million. Our headcount at the end of Q3 was 346 employees compared to 349 in the prior quarter. As a reminder, during the early stages of the Verisure relationship, we agreed to provide them with transition services, which include training with Arlo employees as well as systems costs and some outside service costs. We've included these costs in our normal operating expenses. The reimbursement from Verisure is included in other income and was approximately $0.5 million during Q3. Our non-GAAP tax expense for the third quarter of 2021 was $0.2 million. In Q3, we posted a non-GAAP net loss per diluted share of $0.08, much better than our guidance and the $0.02 improvement year-over-year. We ended the quarter with $166.1 million in cash, cash equivalents, and short-term investments, down $12.6 million sequentially and down $27.6 million year-over-year. Q3 inventory closed at $39.8 million, a decrease of $3.4 million over Q2 2021, with turns at 7.6 as compared to 5.7 last quarter and 4.6 a year ago. Our DSO came in at 62 days, up from 47 days a year ago and up from 48 days sequentially, with the increase driven by the timing of shipments in the latter part of the quarter. Now turning to our outlook, we expect fourth quarter revenue to be in the range of $130 million to $140 million and accordingly, our full-year revenue to come in at between $422 million and $432 million, up $12 million on previous guidance at the midpoint of the current range. Our team has done an incredible job navigating unprecedented COVID-19 related supply chain challenges in 2021, enabling us to exceed the top line guidance provided back in February. For the fourth quarter of 2021, we expect our GAAP net loss per diluted share to come in between $0.16 and $0.09 per share, and our non-GAAP net loss per diluted share to come in between $0.07 and $0.00 per share. Our guidance includes airfreight expense of approximately $0.08 per diluted share compared to $0.03 per diluted share in Q4 2020. This additional freight expenditure is a direct result of the current COVID-19 related supply chain challenges. We expect airfreight expense to normalize when the global supply chain situation stabilizes. Up from previous guidance, we expect to end the year with more than $140 million in cash, cash equivalents, and short-term investments and we'll continue to monitor our performance and prudently manage our operations to preserve our cash position. And now, I'll open it up for questions.

Hi, this is Alex on for Adam. So I was just curious looking into this year's holiday season and kind of also looking into next year, given the current inventory levels in the supply chain setup, how do you think about promotional activity in sort of how will that play out?

Yes, it's a great question. We're making those decisions almost in real-time. As you've heard on the call, we had both in Q3 and we're expecting even in Q4 more demand than we have from a supply perspective. So in those areas where we think we might be a little bit light on supply, we are pulling back on some of those promotions because there is no reason to do that. As we get into next year, that will depend as the supply chain disruptions start to unwind as we expect it to do throughout the year, and we'll continue to make those decisions based on the balance of what's happening in the channel, what supply we have coming in, and what we need to do for the quarter. The good news is the demand is absolutely there for the product, and in several areas, we have stocked out and we're making sure we're reacting on that to maximize profitability.

Perfect. And then you ran things, we're seeing a nice mix shift towards devices other than IP cameras. I'm just curious, do these devices typically carry different subscription attach rates? And are there any significant gross margin discounts to speak of as we move towards doorbells and flood lights?

Yes, it's a great comment. We are seeing that diversification and we think it's important. It's one of our long-term goals we set out as we spun was to not only diversify on the go-to-market side, but also in the area that you're calling out - diversifying across different product categories. When we look at those products both from subscription attach rate and from a gross margin, they are very consistent with what we see on the cameras. There are a couple of percentage points either way on a given quarter, but I would look at them as totally consistent with what we're seeing from IP cameras.

Congrats on a good quarter and your continued progress with your services business. My first question, I wanted to dig deeper into the annual recurring revenue number that you gave. Based on how you describe it, excluding your legacy business and NREs, eventually would you expect all your services revenue to be included in your ARR number? How much of your services revenue in Q3 is currently included in ARR?

Yes. At the moment, we didn't break that out, but you can do some pretty simple math to work out answering the second part of your question. We disclosed the ARR as $80 million, now the ARR is using the last calendar month in the quarter multiplied by 12. So it's a little bit apples and oranges. You take the $27 million of service revenue in Q4 multiplied by 4, that gives you $108 million annualized. So you can get an idea, comparing the 80s to 108, you get a rough idea of how much of the total service revenue that recurring paid ARR bit accounts for. That's answering the second part of your question. And the first one, do we expect to shift mainly to ARR in the future? I think the mix will continue to shift more in favor of that recurring paid services piece. We don't think the NRE is going to disappear. We're certainly going to be working to get additional opportunities, strategic accounts to continue the NRE service revenue. The legacy piece, yes, that will go away. But remember, we do still offer a free trial with all our new business model products, and that piece is part of the prepaid service revenue that is excluded from the ARR.

Great. As a follow-up, I wanted to learn more about the supply chain. What are the main issues you're encountering? Are you primarily managing increased costs for your components and airfreight, or is there significant unmet demand?

There is meaningful unmet demand, and it depends on the product. Some products, we're in good stock, and some products we have stocked out multiple times during the quarter. In Gordon's script, we talked about some shipments coming later in the quarter, and that's why we missed a little bit of demand in Q3. Also, I think we'll see that continue into Q4. So we're seeing healthy demand for the product. As far as the causes of it, we are seeing some component shortages. We are seeing some component cost increase in some areas, but I wouldn't say that's the primary factor. As components are starting to go short, the first thing that happens is the lead times on those components go out. As we've described on previous calls, we then took our forecasting out farther than those lead times. Yes, it slows down some of those components in certain areas, but as you can tell from our good results in the quarter and our guide up in Q4, we feel we're executing on top of some of the shortages that we're seeing from a component side. I would say the biggest impact is really around freight and that has to do with the costs, not only the cost of airfreight that Gordon shared on the call, but also the cost of sea freight are anywhere from 3x to 10x normal, but the lead times on the sea freight are what's really disruptive - something that would take 6 to 8 weeks to come over is now taking multiple weeks and may be sitting 6 to 8 weeks outside of the port. What we've done in response to that is actually shipped a lot more of our product to airfreight, which is why you're seeing the cost go up. For example, take a year ago, in Q4 as we look forward or even Q3, 20%, maybe the max would be about 20% of our product coming in would be on airfreight. We're anticipating in Q4, 80% of our product coming in will be on airfreight. That's how we're actually getting around some of the sea freight congestion, some of those problems as we're using more airfreight, and that's why you're seeing that, we called out in the script as those costs will go up. Again, we do believe it's transitory, it's temporary. As we get into next year, we should see some of that unwind, but we think the right call in Q4 is to continue the airfreight coming in, so we can meet as much of the demand as possible in Q4 which obviously generates future subscribers.

So first question I had was on Europe. Obviously, the revenue there increased. Is that all associated with Verisure, and how much of the Q4 guidance involves Verisure and the ramp-up ahead of the exclusive product release from Verisure?

Yes. In Q3, definitely some of that is obviously from Verisure. We are basically tracking exactly on time with the release of the custom product we announced on the previous call, so that's great. They are deploying it region by region. We're seeing a bit of that in Q3. To your question, we'll see a bit more of that in Q4. The full effect of that product being rolled out won't be really felt until next year. I would expect it to step up a bit in Q4 and then continue to step up as we get into next year. We'll see Verisure continue to grow going forward as that starts to roll out, and we're seeing - we're expecting to see some additional growth obviously on the retail side in Europe as well as they continue to invest in the brand at some of the go-to-market.

Yes, we're not anticipating any negative contribution. In Q3, we maintained low double-digit gross margins on the hardware side, and we believe that our guidance for Q4 suggests a continuation of that trend. We do not expect to enter negative territory for hardware margins and anticipate that we will continue to see positive gross margins. Additionally, the services gross margin for Q3 was 59.5%, marking an improvement from the previous quarter and a record for us as an independent company. We are also seeing slow but steady improvement in the services gross margin.

Jeff, are you there?

So first question I had was on Europe. Obviously, the revenue there increased. Is that all associated with Verisure, and how much of the Q4 guidance involves Verisure and the ramp-up ahead of the exclusive product release from Verisure?

Yes. In Q3, definitely some of that is obviously from Verisure. We are basically tracking exactly on time with the release of the custom product we announced on the previous call, so that's great. They are deploying it region by region. We're seeing a bit of that in Q3. To your question, we'll see a bit more of that in Q4. The full effect of that product being rolled out won't be really felt until next year. I would expect it to step up a bit in Q4 and then continue to step up as we get into next year. So we'll see Verisure continue to grow going forward as that starts to roll out, and we're seeing - we're expecting to see some additional growth obviously on the retail side in Europe as well as they continue to invest in the brand at some of the go-to-market. Thank you, operator. As we close, I would like to thank all the teams at Arlo for the hard work to deliver not only the outstanding Q4 but also the confidence in Q4 as we continue to face the global pandemic-related disruptions. The entire company is absolutely laser-focused on finishing the year strong, and I'm looking forward to our year-end earnings call. Thank you everyone for joining us today.

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