Arlo Technologies, Inc. Q2 FY2022 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 second quarter 2022 earnings call. Our services-first strategy and excellent execution produced another quarter of record-breaking results in Q2. Total revenue reached $119 million, up 21% year-over-year and well above the top end of our guidance. We are currently seeing healthy demand and resilience in the Arlo customer base, which contributed to the stellar results and our ability to raise guidance for the full year. Our annualized recurring revenue or ARR continued to grow at a rapid pace, exiting Q2 at $117 million, up 67% year-over-year. As a reminder, our ARR is the fastest-growing and highest-margin portion of our service revenue and represents the annualized recurring subscription revenue we derive from our paid accounts. Total paid accounts were up 113% year-over-year with Arlo adding 206,000 paid accounts in Q2, an increase of 41% year-over-year and flat sequentially as our migration to the new business model is complete, and additions take on the normal seasonality of our sell-through with a 90-day lag for the three-month free trial period. In addition, I am delighted to announce that, on July 15th, we achieved another significant landmark in our services business, as we surpassed 1.5 million total paid accounts. As we shared on our Investor Day presentation in March this year, the accounts we capture through our domestic retail channel have an ARPU of $9.35 per month, and when combined with our low world-class churn metrics, translates to an LTV of $550 per user based on Q4 '21 data. With continued strong ARR growth, service revenue reached $32.8 million, up 30% year-over-year and marked a record for the 12th consecutive quarter. Despite the additional complexities and expenses driven by the pandemic supply chain disruptions, we posted our highest ever non-GAAP gross profit of $35.1 million and our third consecutive quarter of non-GAAP operating profit outperforming the high end of our guidance for non-GAAP EPS, which came in at a profit of $0.01 per share. To maximize the opportunities presented by our successful services-first business model, Arlo is executing a long-range plan that focuses on three primary areas of the business to drive revenue growth, margin expansion, and through that shareholder value. First, while our products and services regularly garner best-in-class accolades, the number one reason people don't buy Arlo products is because they have not heard of Arlo. This month, we are excited to commence the rollout of our brand awareness campaign, which we will conduct in a targeted manner that focuses on new household formation to drive incremental subscription revenue. While we are kicking off the targeted marketing in Q3, we expect the bulk of the increase in POS to materialize in 2023. More information, including examples of our campaign creative, can be found at arlo.com/protect. Second, we are expanding our product portfolio to address new segments and new markets. An innovative new app called Arlo Safe will provide personal protection for an individual or entire family by offering one-touch emergency health, family location, and safety features, and auto crash response. Our new innovative security system will bring full sensor-based security functionality to our ecosystem of smart cameras. Both of these provide significant opportunities to drive new subscriptions, and we expect these to be available before the end of the year. And third, Arlo will continue to broaden our routes to market. Our most prominent example of this to date has been our Verisure relationship, which has been very successful, driving outsized growth in Europe and an impressive 46% of our Q2 revenue. We also formed a partnership with Calix last year in which Calix integrated Arlo services into their platform to broadband service providers around the country. Most recently, our launch of Arlo Go 2 with partners like Verizon and T-Mobile is providing cellular-based smart security to numerous market segments, often with unique financing offers or subsidized hardware pricing, lowering the initial acquisition costs for consumers. All of these long-range plans are built to realize our three to five-year targets of 5 million paid accounts, $300 million in ARR, and double-digit operating margins. The outstanding results this quarter show that our focused execution is on track to achieve these ambitious metrics. We are tracking the macroeconomic trends closely, and while they may predict softness in consumer demand and higher execution risks in the second half of this year, our confidence in reaching our long-range plan targets remains unchanged. And with that, I would like to hand the call over to Gordon, who will provide more insight into our financial performance, operational details, and outlook for the third quarter and full year.

Thank you, Matt. And thank you everybody for joining us today. We delivered strong Q2 2022 financial results that exceeded our guidance, growing our revenue by 20.7% year-over-year, while growing non-GAAP gross profits sequentially and year-over-year to a record for the Company of $35.1 million. Our financial performance for the quarter was once again underpinned by a successful shift to a services-first business model, which helped drive our non-GAAP gross profit up by 27.7% year-over-year comfortably over indexing revenue growth. The Arlo team was able to bring channel inventory in line with targets and at the same time navigate supply chain challenges to exceed our expectations on revenue. Even after investing $1.2 million on creating content for our upcoming awareness campaign, we were able to grow our year-over-year non-GAAP operating profit by $5.3 million and post our third consecutive quarter of non-GAAP operating profits. Additionally, I would like to point out that foreign exchange did not have a material impact on our financials in Q2, and we do not expect it to have an impact moving forward. Now, moving on to the Q2 financial details, revenue came in at a second fiscal quarter record of $119 million, up 20.7% year-over-year and down 4.6% sequentially. The strong revenue result clearly demonstrates how our channel diversification and ARR growth are benefiting the business. Our service revenue for Q2 2022 was a record $32.8 million, up 9.6% sequentially and 29.8% year-over-year, driven by our services-first business model and the addition of 206,000 paid accounts in the quarter. While service revenue accounted for 27.6% of our Q2 2022 revenue, it delivered 61.5% of our non-GAAP gross profit. Our service revenue also includes $0.2 million of NRE services we are providing for Verisure, along with associated costs compared with $0.1 million in the first quarter of 2022. Product revenue for Q2 2022 was $86.2 million, which was up 17.6% year-over-year and down 9.1% sequentially. Our year-over-year product revenue growth was driven by continued strength from our Verisure relationship in Europe, while the sequential result reflected destocking in both our America and Asia-Pacific sales channels, where we were pleased to end the quarter at normal channel inventory levels as we head into the seasonally stronger second half. During the second quarter, we shipped 1.1 million devices, all of which 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 second quarter of 2022 was up $7.6 million year-over-year and up $0.6 million sequentially to $35.1 million, which resulted in a non-GAAP gross margin of 29.5%, up from both 27.9% in Q2 2021 and from 27.6% in Q1 2022. The $7.6 million year-over-year improvement in non-GAAP profit included an improvement of $6.7 million from services and $0.9 million from products. The improvement in non-GAAP service gross profit was driven by growth in our ARR, coupled with cost optimizations. The improvement in non-GAAP product gross profit was driven by higher product revenue. Non-GAAP service gross margin came in at a record 65.8%, significantly up from 58.9% in Q2 2021 and an improvement on 65.4% in Q1 2022. Non-GAAP product gross margin was 15.7%, down from 17.2% in Q2 2021, mainly driven by product mix and flat with Q1 2022 at 15.7%. Total non-GAAP operating expenses were $34.1 million, up $0.6 million or 1.9% sequentially and up $2.3 million or 7.2% year-over-year as we invest in R&D ahead of our new products and service introductions and lay the groundwork for our upcoming awareness campaign, in which we invested a total of $1.2 million during the second quarter. Our total non-GAAP R&D expense for the second quarter was down $0.3 million sequentially at $13.8 million. Our headcount at the end of Q2 was 354 employees compared to 358 in the prior quarter. The second quarter was an excellent example of how the team is driving leverage in the business. While revenue was up 21% year-over-year, our gross margin expanded by more, driving a 28% increase in gross profit while our operating expenses only grew 7% after investing more than $1 million in our awareness campaign. This resulted in a year-over-year improvement of more than $5 million in non-GAAP operating income. As a reminder, during the early stages of the Verisure relationship, we agreed to provide them with transition services, which included training with Arlo employees as well as systems costs and some outside service costs. We have included these costs in our normal operating expenses. The reimbursement from Verisure is included in other income and was approximately $0.1 million during Q2. Our non-GAAP tax expense for the second quarter of 2022 was $0.2 million. In Q2, we posted a non-GAAP net profit per diluted share of $0.04, much better than our guidance and a $0.05 improvement year-over-year, driven by a combination of revenue growth and gross margin expansion. We ended the quarter with $135.3 million in cash, cash equivalents, and short-term investments, down $10.2 million sequentially and down $43.4 million year-over-year. The sequential reduction was driven by a reduction in working capital of $7 million, primarily from lower deferred revenue and accrued liability balances coupled with taxes paid. Our inventory closed at $39.2 million, an increase of $2.2 million over Q1 2022 with turns at 7.5 compared to 8.7 last quarter and 5.7 a year ago. Now, DSO came in at 57 days, up from 48 days a year ago with the increase driven by customer mix and down from 58 days sequentially. Now, turning to our outlook. We expect third-quarter revenue to be in the range of $125 million to $135 million. We expect our GAAP net loss per diluted share to come in between $0.28 and $0.21 per share, and our non-GAAP net loss per diluted share to come in between $0.17 and $0.10 per share. Our guidance includes approximately $8.8 million of awareness spending as we kick off our campaign in the third quarter in line with the plan we communicated in our Analyst Day back in March. For the full year, and up from previous guidance, we expect our revenue to be in the range of $500 million to $520 million, while we expect our non-GAAP operating loss to be in the range of $15 million to $25 million equivalent to break-even non-GAAP operating profit for the year minus our planned awareness spending. The team at Arlo continues to work tightly with our retail partners, and while we recognize many retailers may be rethinking their inventory strategy for the coming quarters, we believe we have taken potential adjustments into account in considering our updated full-year revenue guidance. In line with previous guidance, we expect to end the year with $110 million to $120 million in cash, cash equivalents, and short-term investments. 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.

Congrats on the quarter. Maybe just help me understand the inventory levels. So are you guys working through some lower-margin inventory yet or has that kind of been worked through?

Jacob, it's Gordon here. Are you talking about channel inventory?

Yes.

Yes, channel inventory is in reasonably good shape, actually. If you look back to where it was at the end of last quarter, U.S. retail channel inventory was up near 16 weeks. Our goal is for 10 to 14 weeks. We brought that down in Q2 and we ended the quarter within our target range at 11.8 weeks. So, it's right there. The other thing to bear in mind, we are heading into seasonally stronger sales; Prime Day was right at the beginning of Q3. I think the stock position, the channel inventory position in America's retail is pretty nicely balanced, to be honest. Outside of that, we also made some really good progress in Asia-Pacific in Q2. If you look back to Q1, we told you at the end of Q1 that we were looking to take action to bring APAC inventory more in line. It ended near 20 weeks at the end of Q1. We cut that in half in Q2, and we're now back to pretty normal run rate levels of inventory and APAC at 9.8 weeks. So, I think the channel inventory situation that we are looking at is right where we want it to be.

And maybe just Verisure sure contract. Obviously, they're a huge portion of the revenue. But talking about Calix, can you give us an update? Their revenue edge segment was up 129%. Maybe if you could just kind of give us a progress update on how things are going with Calix, that would be helpful.

Yes, I'd be happy to and, in fact, you called out Verisure as well, and you can see what a strong quarter we've had as we continue to roll out with them. On Calix, we're really still in the rollout phase. We’re adding BSPs, or their customers, broadband service providers every quarter and look to continue to ramp that through the end of this year and have it become more material to our strategic accounts as we get into 2023. We started with them in the second half of last year. At that time, we had around 12 or 13 broadband service providers; we're now around 40 broadband service providers. I would look to see that to continue to ramp through this year to where we get to some critical mass as we enter 2023.

And maybe just on 2023 guidance, you're still expecting to double the growth rate from '22?

Yes, that's still where we see it. Obviously, the macro environment has somewhat changed since we gave the guidance earlier this year. But in terms of growth rate year over year, yes, we still believe that that is reasonable. We just literally kicked off the awareness campaign that is obviously pretty central to achieving that growth rate. We're looking forward to seeing how that goes and reporting back on progress when we see more data on that.

Hi, could you just talk about the rate of paid subscribers? If you're doing anything different than what you've talked about to investors given that it’s been rising at a steady increase? I just want to see what's causing that and if it is stable to assume that that will continue?

Yes, it's a great question, Hamed. I think some of the growth in the past has been us phasing in the new business model. If you go back over the last 12 to 18 months, especially if you go back a couple of quarters and look past from there. Some of that quarter-over-quarter growth was being driven by us rolling out old product or legacy product and rolling in through the channels and POS the new business model product. That is basically complete. When you look at our baseline kind of adds for retail direct, it’s going to follow seasonality across our channels in a lot of ways. So, you'll see Q2 paid account ads are going to be related to Q1 POS because we have a 90-day free trial, and so we'll see them typically turn into a paid account 90 days later. There's some exceptions to that. The paid account — sorry, the campaign that we are doing around awareness will obviously drive incremental paid accounts above normal seasonality. We are seeing strength from some of our strategic partners. Again, I mentioned Verisure in the last question. Those are added on top of what we would see as kind of normal seasonality from the retail and direct pay. So that’s kind of what's driving the growth on a quarterly basis. Some of it is going to be driven by retail POS seasonality and some of it is done just through great execution for some partners like Verisure.

And could you just talk about the inventory situation within the channel with retailers in the current environment? Are you looking to sell more directly to the consumer going into Q4? And how comfortable are you that the consumer is not going to retract on their spending habits?

Yes. From an inventory perspective, I think Gordon gave a great overview on where we sit from a channel inventory across our regions. The commentary in the script is really around. We're seeing specific retailers trying to optimize their positions and their balance sheets with regards to inventory. Some of them are looking for less inventory, some of them are looking for a little bit more and we are making those adjustments that were built into the guidance that we provided for Q3 going forward. We have not seen a pullback from a consumer perspective as far as purchases and kind of consumer confidence as it relates to them executing with Arlo across our channels. We just finished Prime Day as an example, and that was actually very strong for us. It exceeded expectations as we just got into this quarter. We are watching very carefully what kind of the back half of Q3 and as we get into Q4 looks like and continue monitoring consumer behavior. We review POS data from our retailers every week, actually twice a week inside of Arlo. We’re going to stay on top of this as we get through the quarter. I would expect to see possibly some additional competitive offers if things do slow down a little in the channel. But what we are currently witnessing through Q2 and even during Prime Days is some resiliency and strength from the consumers that are purchasing Arlo.

Hi, thanks for taking the questions. You guys have already asked me. You confirmed the plans to double growth in fiscal year '23, but I was also wondering if you could hit on operating profit and if that goal of becoming operating profitable is still intact? And if there is a chance would you lean into growth over margins if the opportunity presents itself?

Just to reiterate what we said previously around 2023, we'll still be in investment mode in the first half of the year. So we are still looking at non-GAAP operating loss in the first half, crossing over back into profitability for the second half of '23. For the full year, we're expecting to be at break-even for 2023. That's the outlook. That's the same outlook that we shared earlier this year when we gave you those projections. I'll pass it over to Matt, just to talk about the balance between taking margin versus profit and what his thoughts on that might be. But certainly, I think the awareness campaign that we just embarked on is a pretty good start in us saying that, as we've mentioned, the number one reason people don't buy Arlo is that they haven't heard of Arlo. So, we want to invest and acquire households. That is what we're doing in Q2, Q4 and then in the first half of next year.

Yes. I think the question around balancing growth and profitability is something we talk about quite a bit internally, not only in the short-term but the long term. If you look back at our March presentation, you can see what we're pegging as far as our long-range plan and how to drive that growth. The marketing spend you see in the second half of this year, and to Gordon's commentary next year, where the first half we think we'll continue to spend given our expected results from the campaign is where we are right now on that balance. Over the next 12 months, we will be driving growth, and spending into that growth. But as the results start to pull through, we think we'll return to profitability in the second half of next year. That is where we are in our current balance. Obviously, any macroeconomic headwinds could make us adjust as we get into next year, where we may turn up growth if we see an excellent reaction to the campaign or pull back potentially, or continue to spend at the current level depending on what we see in the second half of this year. That balance is where we spend a lot of time and spent a lot of time in our long-range plan, really focusing on maximizing shareholder value creation over the next three to five years.

All right, thank you for all that. If I could just ask one more regarding the awareness campaign just getting kicked off. If you guys have had any early feedback, and if there are any metrics you guys are tracking to see how it's going? If you have a plan to lean more towards growing direct to consumer versus retail with this campaign, that would be great to hear.

Yes, it's a great question. Regarding the channel, you’ll see us through various media leveraging arlo.com significantly because in a brand awareness campaign, a lot of the traffic flows there naturally; it provides a bit of education, and we think we do that best at arlo.com. You'll see us do some partnerships with some of our channel partners, tagging and driving traffic to them as well. It will be a mix, but I would say overall emphasis, a significant portion would be to arlo.com for both the educational component and potential transactions for products and services. As for efficacy, we are slightly more than a week in, so we have very little data; initial data is usually erroneous, and it typically takes at least 30 to 60 days to get an initial idea of effectiveness. We believe the actual effects of our campaign will be more towards the end of this year into 2023 due to the lag typically associated with branding campaigns transforming to actual POS and consumer spending. We're looking for data as we exit the year and will report the first part of next year. The way we track this is through a well-characterized waterfall and customer journey at Arlo. We track if we sell a number of cameras, how many activate, how many complete the free trial, convert to paid accounts, and churn over what time period. A lot of that was shared on Analyst Day. This campaign is just adding to the top of our funnel, so we will monitor all those metrics and see if they increase or decrease as we execute the campaign and drive incremental households and paid accounts. We're excited to share more as we kind of exit this year and start the new year. Thank you, operator. I would like to take a moment to thank all the teams at Arlo for the hard work to deliver such outstanding results in the face of continuous pandemic and macroeconomic headwinds. The excellent execution confirms our trajectory at this early stage of our long-range plan, and we look forward to continuing from here. Thank you again for joining the call today.

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