Arlo Technologies, Inc. Q2 FY2023 Earnings Call

Thank you for your patience. All participants are currently in listen-only mode. I will now hand the conference over to Erik Bylin. Please proceed, 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 a record non-GAAP earnings per share of $0.06. Arlo achieved a record company gross margin of 37% and record operating margin of 5%. With great working capital management, Arlo produced a 10% free cash flow margin. Comparing the first half of 2023 with the first half of 2022, Arlo improved its cash from operating activities by $52 million. For the first time in company history, our non-GAAP gross profit from services alone exceeded our non-GAAP operating expenses. This is a huge crossover point for Arlo and highlights the exciting trajectory we are on. Our strategy and execution are driving these results and generating significant shareholder value. Despite the macroeconomic conditions, we are seeing strong demand, as evidenced by our key metrics and our inventory levels. Most recently, we saw that demand carried through to a successful Prime Day, which gives us a glimpse into the current consumer mindset ahead of the second half. This upcoming holiday season, Arlo will lean further into our successful pricing strategy by launching a totally new low-cost security camera platform, and we have secured substantial placement in promotional vehicles across our major channels. Customer acquisition drives paid accounts, which drives the expansion of Arlo's profitability. With this backdrop, we expect full-year service revenue to grow nearly 50% year-over-year and now exceed our $200 million target. Our non-GAAP service gross margin for the full year will be roughly 75% and should propel us to our target of 5% non-GAAP operating margin for the full year, a more than 6 percentage point improvement compared to 2022. It is an exciting time at Arlo as we witness the years of hard work begin to materialize in a meaningful way across the business. Congratulations and thank you to the whole Arlo team for the milestones we passed and the ones we are focused on next. And with that, I'll turn it over to Kurt.

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 underreported by a partner in previous quarters. Our normal net paid account run rate remains in the 170,000 to 190,000 range. However, we expect this catch-up to continue over the next couple of quarters as our partner 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 revenue accounted for 44% of our Q2 2023 revenue and importantly, represented 88% of our total gross profit. Additionally, our quarter end ARR was $194 million, up more than 66% year-over-year and providing another proof point of the tremendous growth of our services business. Product revenue for Q2 was $64.7 million, which was down about 3% sequentially and 25% year-over-year. During the quarter, we shipped a total of 954,000 cameras worldwide compared to 1.1 million in the prior year period. Product revenue was impacted by a slight decline in shipment volume but more so due to declines in average selling prices driven by a deliberate shift in our pricing strategy and mix in global product assortment. In the quarter, approximately 32% of our revenue originated from our international customers. Our EMEA results were impacted in Q2 as our largest partner continues to constrain inventory levels, a cycle other channel partners went through in previous quarters. We are confident this is not an end market demand issue and expect this near-term response to macro conditions in the region to moderate over time. From this point on, my discussion points will focus on non-GAAP numbers. The reconciliation from GAAP to non-GAAP figures is detailed in our earnings release distributed earlier today. Our non-GAAP gross profit for the second quarter was $43 million, up 23% year-over-year. This resulted in a non-GAAP gross margin of 37%, up 470 basis points from 33% in Q1 of 2023. The year-over-year increase in non-GAAP gross profit in Q2 was attributable to the growth in our services business. The improvement in non-GAAP service gross profit was driven by growth in our subscriptions and planned pricing coupled with cost optimizations. Non-GAAP service gross margin for the quarter was 75%, slightly up from 74% in Q1 of 2023 and significantly up from 66% in Q2 of 2022. Non-GAAP product gross margin for the quarter was 8% and consistent with our guidance provided in March of this year. Furthermore, we are very pleased that our services non-GAAP gross profit exceeded our non-GAAP operating expenses in the quarter. This was an important achievement for the Arlo team, thereby validating our ability to transform into a sustainable operating model around our services business now and well into the foreseeable future. Total non-GAAP operating expenses for the second quarter were $37.5 million, up sequentially and year-over-year by less than $3.5 million. The year-over-year increase is attributable to continued investment in sales and marketing expenses to help drive household acquisition and paid account growth. The non-GAAP operating expenses for the first half of 2023 were slightly better than our expectations and reflect the cost savings initiatives implemented in Q4 of last year. Our headcount at the end of Q2 was 345, which represents a slight change from 334 team members at the end of Q1 and 354 team members in the same period last year. In Q2, we posted non-GAAP net income of $6.1 million. Our non-GAAP net income translates to earnings per diluted share of $0.06 at the top end of our guidance range provided last quarter. The marked improvement in non-GAAP operating margin was driven by a combination of service revenue growth and gross margin expansion coupled with a disciplined approach to cost management. Regarding our balance sheet and liquidity position, we ended the quarter with $123.7 million in available cash, cash equivalents, and short-term investments. This balance was up $5 million sequentially and is trending in line with our expectations. We are pleased to report that we generated approximately $11.5 million in free cash flow in Q2, which represents free cash flow margin of 10% and improvement driven by our increased profitability and solid working capital management. Additionally, our Q2 inventory balance ended at $39.4 million, representing a slight decrease from Q1 of 2023 with inventory turns at 6.1x and relatively consistent with last quarter. As Matt mentioned, we are launching a broad assortment of new products in the second half of 2023, which will enable us to remain highly aggressive with our product pricing strategy, particularly through the seasonally strong holiday season and into 2024. We remain focused on maintaining appropriate inventory levels to effectuate a smooth product transition with retailers and partners while being able to meet any potential upside in consumer demand that may be experienced. These factors may impact our inventory balance and thereby our ability to generate similar levels of free cash flow as working capital may fluctuate. Finally, our accounts receivable balance was $57.3 million as of July 2, with Q2 DSOs at 45 days, down from 57 days from the same period last year. We will continue to monitor our working capital balances in line with our revenue and forecasted consumer demand levels with a focus on maintaining a solid balance sheet and liquidity position in the future. Now turning to our outlook. While we remain cautious about our product revenue outlook for the year, we expect the third quarter revenue for 2023 to be in the range of $122 million to $132 million. We expect our GAAP net loss per diluted share to be between $0.07 and $0.01, and our non-GAAP net income per diluted share to be between $0.04 and $0.10 per share. We reiterate our 2023 full-year revenue guidance range to be between $470 million and $500 million and that our service revenue is forecasted to grow at roughly 48% year-over-year to approximately $200 million. We estimate non-GAAP product gross margin will be in the mid-single digits as we pursue promotional activities and sales models that prioritize the acquisition of new paid accounts. However, we expect non-GAAP service gross margin to be at or above 75% in 2023. And now I'll open it up for questions.

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 cautious? And then also, if you could also provide a little bit more understanding as to what this catch-up is and why it is 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. For example, at the end of last year, they were really managing their inventory to a target number and Verisure seems to be doing that this year. The exact amount, we don't know, but we can see them managing their inventory down. We have visibility into a much longer forecast with them, as we have a great long-term partnership with them. So we can see that recovering after they hit whatever target they're trying to hit internally. I think it’s very similar to what we saw the retailers do at the end of last year, and now they are 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 at the location at the household, means we do a cost-plus model, so the cost in our cloud is accurate. We mark that up. We charge them as 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. Thus, we can see some of the catch-up this quarter. We think they will 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 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. We have also seen similar load-ins for a couple of other key retailers like, for instance, Costco. 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 mentioned it in the script. Prime Day was strong, and that is a continuation of what we've described as 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 and our value proposition across multiple channels. Prime Day was a great example of that. 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 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? 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 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, while a lot of it may load in Q3. 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. That is around both, I would say, in general, despite some concern about consumers, they are seeing relatively good foot traffic and we are seeing relatively good sales. Specifically around Arlo, the success we've had in the first half of this year and our pricing strategy generating additional sales for them in the segment. It is clear that Arlo is capturing share in the market. There is relative 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. However, there is 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 on a promotional level in the second half.

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

Yes. No, I wouldn't read into that too much, Jacob. From what we're hearing and we're working with Verisure on a week-to-week basis, they have a clear inventory target that they will hit by the end of this year. That's been factored into the PO placement that you're currently seeing. To give you an overview of what we're seeing, we currently 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. We also see that the end market demand in the EMEA region is still pretty resilient. Although they are 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. We don’t feel there are any major concerns around the end market demand.

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 a 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. We have been focused on driving the overall percentage 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. That was a big milestone, one I think we had communicated before, but it was positioned to be more of a Q3 or Q4 event. We were super pleased we managed to do that this quarter. Looking forward, we think, for the full year, we will be at or above that 40% target. Going into 2024, we will move 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 to aim for ending this year at above 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? Any guardrails around how low retail and e-commerce you're willing to go?

Yes. It's more a question of the relative growth between the two. To give you a little history, when we spun from Netgear, roughly 83% of our revenue was coming from traditional retail. Now it's closer to maybe 40% or 45%. A lot of that was a strategic initiative to diversify our revenue base, and we saw some significant opportunity in what we call strategic accounts or B2B partners, Verisure being the largest of those partners. Both will grow; we are seeing growth in the retail channel now. We believe we’re capturing share in some of those traditional retail channels, and our pricing strategy is working. We’re seeing growth across new strategic accounts and existing ones. As far as the balance will be, it’s a question around relative growth between the two. I’d say there are significant opportunities on the strategic account basis, which might drive higher growth as we look out over the next 12 to 24 months. But on the retail side, the market is actually flat to down right now, and we're growing. We always try to grow our retail and direct account markets faster than the market, and we’re being very successful at that. I don’t have a hard number for you, but there’s additional upside on the strategic accounts, just because there are so many 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 clarify on the subscriber add with the Verisure catch-up. Are you still expecting 185,000 paid subscriber adds per quarter for next quarter and for Q4? How does that look going forward?

Yes. Our normal runway stays the same regarding paid accounts, which is between 170,000 and 190,000 each quarter. I think that's still true. Although in this quarter, I believe we were probably on the high end of that range. We had a successful quarter regarding paid accounts. Then you add on additional catch-up. This quarter, we were closer to 240,000, 245,000 paid accounts. I think we'll see similar catch-up moving forward as well, it can be plus or minus depending on how many firmware upgrades are done. But those will not add to financial metrics like service revenue; they just catch up on the absolute count of accounts because of under-accounting those paid accounts. So when you're modeling it from a financial perspective and service revenue, that 170,000 to 190,000 range is the right way to look at it, noting that there's some catch-up happening on the paid account number, which doesn’t affect 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.