Arlo Technologies, Inc. Q3 FY2025 Earnings Call

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

Thank you, operator. Good afternoon, and welcome to Arlo Technologies Third Quarter 2025 Financial Results Conference Call. Joining us from the company are Mr. Matthew McRae, CEO; and Mr. Kurt Binder, COO and CFO. If you have 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. ARR, Rule of 40 and other KPIs, guidance for the fourth quarter of 2025, the long-range plan targets, the rate and timing of paid subscriber growth, the commercial launch and momentum of new products and services, the timing and impact of tariffs, strategic objectives and initiatives, market expansion and 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 conditions. 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 our annual report on Form 10-K and our most recent quarterly report on Form 10-Q filed earlier today. 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 the 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, Tahmin, and thank you, everyone, for joining us today on Arlo's Third Quarter 2025 Earnings Call. Q3 was another record-breaking quarter for Arlo across numerous performance and financial metrics. I'll start by highlighting our outstanding SaaS business, which continues to grow and propel Arlo to new heights. We added 281,000 paid accounts during the quarter, well above our target range of 190,000 to 230,000, which drove our total paid accounts to 5.4 million. This performance was driven by net additions in our retail and direct channel, coupled with stronger performance from our partner, Verisure. I'd like to take a moment to congratulate Verisure on their recent acquisition of ADT Mexico and their successful initial public offering last month. Their success is so well-deserved, and we look forward to continuing to be a part of their growth and outstanding execution across their expanding footprint. Arlo Secure 6, our latest AI-based security platform, is also driving our performance with users finding substantial value in the features and capabilities. In our retail and direct channel, average revenue per user was over $15 per month, and the lifetime value of each user grew to over $870, a new record for Arlo. These metrics helped propel Arlo's annual recurring revenue to $323 million, up 34% year-over-year and another record for the company, while service gross margin expanded 770 basis points to more than 85%. In addition to this impressive service performance, Arlo also executed the largest product launch in company history during the quarter, comprised of new platforms and products across our Essential, Pro and Ultra product tiers. These platforms not only bring a 20% to 35% reduction in BOM costs and new form factors such as pan, tilt, zoom, they also contributed to a nearly 30% year-over-year unit sales growth in Q3. These new products are receiving high ratings from both professional and user reviews, which call out the ease of setup, high performance and new capabilities across the lineup. The execution of this product launch and transition was nearly flawless. Arlo launched over 100 SKUs simultaneously across channels on time despite several shipping and weather disruptions, all while managing the ramp-up of inventory for a smooth transition. This is extraordinarily difficult to achieve, and a huge congratulations and thank you to the Arlo cross-functional teams on this exceptional outcome. There are very few companies in the world that have successfully developed world-class capabilities in both the Software Service segment and the hardware device segment. This quarter is a great illustration that Arlo is one of those rare companies that can not only excel in both areas, but also bring these segments together to create compelling user experiences and drive real shareholder value. And that could not be more obvious based on our full Q3 results and profitability. Adjusted EBITDA was up 50% year-over-year and reached $17 million. GAAP earnings per share was $0.07 in the quarter, a new record for Arlo. And year-to-date, we reported a massive $0.35 improvement compared to the first 9 months over last year. And looking at our services business in a Rule of 40 context, Arlo achieved a result of 46, which underscores the elite performance against all peers in the SaaS space. Looking ahead to Q4, Arlo is exceptionally well positioned in a competitive market with our new product launch, and we expect to see 20% to 30% unit growth year-over-year, which sets us up well for service revenue growth heading into 2026. And we continue to see great progress across our strategic accounts, including Verisure driving growth via their IPO, Allstate deploying kits to home insurance customers, and ADT testing units in the field ahead of next year's market launch. Expect more announcements in this area over the coming quarters. Given this performance, it is clear that Arlo is making excellent progress against our long-range plan targets of 10 million paid accounts, $700 million in ARR, and an operating income of over 25%. Now I'll turn it over to Kurt for a more detailed review of our Q3 results and our outlook ahead.

Thank you, Matt, and thank you, everyone, for joining us today. During the quarter, we again delivered outstanding financial results driven by our commitment to our services-first strategy. Every decision that we make as an organization is centered around delivering an innovative and value-added smart home security experience that drives annual recurring revenue, and these efforts are yielding strong results. As Matt mentioned, the lifetime value generated by our paid accounts is at an all-time high and ensuring that we continue to fill the acquisition funnel and drive our subscriptions and services revenue is paramount to delivering best-in-class SaaS metrics and achieving our long-term financial goals. Now on to the results for the quarter. Subscriptions and services revenue was $79.9 million, up 29% year-over-year, driven by a significant increase in ARPU and a great pace of paid account adds over that same period. This strong performance is largely due to the introduction of our new AI-driven Arlo Secure 6 rate plan offerings. Additionally, our intense focus on enhancing customer journeys and delivering a differentiated value proposition drove new paid accounts to select our premium rate plans and existing customers to upgrade to higher rate plans. Paid accounts continued their strong growth trajectory as we generated 281,000 paid subscribers in Q3. We exited the quarter with a base of 5.4 million paid accounts, an increase of 27% year-over-year. Improving ARPU trends and the growth in our retail paid account base reflects our ability to guide customers to our higher-value AI-enhanced service levels and in turn, drove our annual recurring revenue to $323 million, up 34% over the same period last year. Total revenue for the third quarter came in at $139.5 million, up slightly from the prior year period, with our subscriptions and services revenue comprising 57% of total revenue, up from 45% in the same period last year. This level of predictable and recurring service revenue is the key driver of our substantial improvement in profitability and our ability to deliver best-in-class SaaS metrics, including ARR growth. Product revenue for the period was $59.6 million, down $16.2 million or 21% when compared to the prior year and as a result of the industry-wide decline in ASPs as well as the frequency and depth of promotional campaigns, especially in Q3 as we promoted our end-of-life products to make way for the sell-in of our broader next-generation product portfolio. We continue to drive new household formation by optimally pricing our products to increase point of sale volume and utilize the devices as a subscriber acquisition vehicle. The refresh of our product portfolio offers a considerable reduction in BOM costs, enhancing our competitiveness across various price tiers while also helping to offset some of the tariff impact. And with the upcoming holiday season, we are leveraging this portfolio to help accelerate the growth trajectory of our subscriptions and services revenue. Given the outstanding subscriptions and services gross margin and expanding profitability with each new paid account, our decision to sacrifice product gross margin for durable, highly profitable subscriptions and services revenue is an easy one. We view a modest decline in product gross margin as part of our cost of customer acquisition. And even after considering the incremental investment, we are still delivering a best-in-class lifetime value to customer acquisition cost ratio in the range of 3x. Our goal to drive solid point of sale volume and gain access to additional households in Q3 occurred as planned, and we expect a similar outcome in the fourth quarter. We believe the strategy insulates us from certain external market factors and drives shareholder value, and we will continue to lean into this approach during this Q4 holiday selling season. In Q3, international customers generated $58 million or 42% of our total revenue, down from $66 million or 48% in the prior year period related to the increased level of subscription and service revenue from our U.S. retail business and the successful launch of our new products. Verisure continues to be an important partner for us in Europe, and we thank them for their continued collaboration and expect them to remain a solid growth driver in the future. From this point on, my discussion will focus on non-GAAP numbers. The reconciliation from GAAP to non-GAAP figures is detailed in our earnings release, which was distributed earlier today. Our non-GAAP subscriptions and services gross margin was 85%, again, a new record and up 770 basis points year-over-year. The significant growth in services gross margins is attributable to enhanced ARPU, coupled with a reduction in the cost to serve our customers, including lower storage and compute costs. Product gross margins were negative, representing a modest decline when compared to the same period last year. The decline in product gross margin is related to the full quarter impact of tariffs approximating $5 million, coupled with industry-wide ASP declines and planned promotional spend on end-of-life products to optimize inventory levels ahead of our recent product launch. Even withstanding these items, we reported consolidated non-GAAP gross margin of 41%, up 540 basis points year-over-year. Our continued improvement in profitability in a period where the full impact of tariffs was experienced underscores the significant ancillary benefits that the shift to our services enterprise provides us. Total non-GAAP operating expenses for the third quarter were $41.1 million, up 6% from $38.7 million in the same period last year. The year-over-year increase is primarily driven by app store fees and an increase in personnel to support R&D investment as we launch our new innovative product offerings and Arlo Secure 6 this year. Our leveraged go-to-market approach has enabled us to maintain our operating expenses at roughly $40 million per quarter or less since 2022, while growing ARR at a 37% CAGR during that period, which is truly remarkable. For the third quarter, adjusted EBITDA was $17.1 million or an adjusted EBITDA margin of 12.2%. The growth in adjusted EBITDA represents a 50% increase year-over-year and a powerful testament to the operating leverage created by scaling our subscriptions and services business. Further, we generated non-GAAP net income of $18.1 million for the third quarter and $53.3 million for the 9-month period ended September 30, which was up an impressive 68% when compared to the same period last year. Regarding our balance sheet and liquidity position, we ended the quarter with $165.5 million in cash, cash equivalents and short-term investments. This balance is up about $19 million since September of 2024, even withstanding certain strategic investments and our ongoing share repurchase program. We generated record free cash flow of $49 million during the first 9 months of the year, representing a free cash flow margin of almost 13%. Our Q3 accounts receivable balance was $76.7 million at quarter end, with DSOs at 50 days, up from 45 days in the same period last year. Our Q3 inventory balance was $44.4 million, down from the $52 million level in September of last year and a testament to the amazing job that our supply chain team has done with optimizing inventory levels ahead of our portfolio refresh. Inventory turns were 6.4x, up from 5.8x last year as we sold in inventory for one of our largest product launches in history. Now turning to our outlook. Even with the full impact of tariffs during the period, our business generated outstanding financial results driven by the resilience of our subscriptions and services business. The recent launch of our innovative product portfolio gives us dry powder to remain competitive given the solid reduction in BOM cost. We will leverage our new products and competitive ASPs to drive strong point of sale volume and accelerate paid subscription growth. As a result, we expect our Q4 consolidated revenue outlook to be in the range of $131 million to $141 million. Additionally, we expect non-GAAP net income per diluted share for Q4 to be in the range of $0.13 to $0.19. And now I'll open it up for questions.

The first question comes from Adam Tindle with Raymond James.

I wanted to begin by discussing margins. It's clear that our overall gross and operating margins are quite strong. However, when we examine the details, we see that despite the significant 20% to 30% reduction in BOM costs associated with our largest launch, product gross margin continues to be under pressure. I realize there are several factors influencing this. Could you remind us of the inventory accounting method, and whether this BOM cost reduction is fully reflected in our Q3 results? Additionally, you mentioned an inventory clear out. Kurt, could you help us quantify its impact in the quarter and indicate whether it will affect future quarters?

Yes, Adam, I want to emphasize that we are highly focused on our consolidated gross margins. We are very pleased to report that our third quarter consolidated gross margins improved by about 540 basis points compared to last year. On a year-to-date basis, we’ve seen an increase of around 640 basis points. As we've noted previously, we are committed to growing our consolidated gross margin, and we will keep working towards that in the future. Regarding the product gross margin you mentioned, on a non-GAAP basis, it was approximately negative 17.3%. This figure is influenced by several factors. Notably, we experienced our first full quarter of tariffs. If we exclude tariffs from the calculation, the margin would be around negative 8%, which represents a significant improvement from the 17% range and moves us closer to high single digits. Furthermore, we had considerable end-of-life investment to ensure that our inventory levels were appropriate, allowing us to transition to our newly launched generation of products. We invested upfront to drive promotional activity and clear that inventory. Now that this inventory has been processed, we feel confident about our position going into the fourth quarter. Overall, we are very pleased with the performance across all of our operating metrics, particularly regarding our profitability targets such as adjusted EBITDA, non-GAAP operating income, and gross margins, all of which are showing positive movement. We are satisfied with the team's overall performance in this area.

Yes, it definitely offers a foundation for potential margin growth when some of these temporary factors recover. This makes logical sense. Perhaps a follow-up, Matt. There are several future growth drivers for the business. I know you highlighted some partnerships in your prepared remarks. I would like to inquire about two of these. First, regarding Verisure, you mentioned the ADT Mexico component. Do you see this as a wider opportunity for Arlo to expand in Latin America more broadly? Would that require a separate RFP process for success, or do you have insight into this opportunity? What is its potential size? Secondly, about ADT, you mentioned they are testing units prior to the market launch. I realize you might have limited information to share, but can you provide any guidance as we approach this regarding investor expectations on the scale of that partnership?

Yes, that's a great question. When discussing growth drivers, you're absolutely right that we're concentrating on specific areas. One key area is the growth in our traditional retail channels, which is performing very well. We noted during the call that units have increased year-over-year by nearly 30% from a point-of-sale perspective, and we anticipate growth ranging between 20% and 30% in that segment. Another important area is what we refer to as strategic accounts or our B2B initiatives. You mentioned some of these, including the ADT Mexico acquisition by Verisure, which I believe officially closed yesterday in European time. We've been collaborating with them for months, preparing and certifying our products for Mexico. Currently, we are the exclusive provider of some backend services for them, and we are also developing camera solutions for them, both with Arlo products for those regions and custom products we've tailored for their needs. We expect that the ADT Mexico acquisition will represent an initial focus for them, with potential for broader expansion across Latin America, which we believe could drive significant growth for both companies. We are very excited about that opportunity. Regarding ADT, while I can't disclose much beyond what I've mentioned, I can say that from an Arlo execution perspective, we have met all necessary timelines, and products are already deployed in the field, delivering a stellar user experience. We look forward to providing more information as it becomes available. Additionally, there are several other partnerships we are currently discussing, and I expect that by the end of Q1 or possibly moving into Q2, we will announce a few more significant partnership accounts that could materially affect our business going forward. If I take a step back and consider how we aim to achieve our long-term targets—10 million subscribers, $700 million in annual recurring revenue, and increasing our operating income by over 25%—Kurt and I previously noted that we expect approximately 60% of our incremental growth to originate from strategic accounts. Based on recent developments and upcoming opportunities, I'm confident that this will hold true. This is noteworthy because we believe that traditional channels, both retail and direct, are also growing nicely and have significant growth potential. I hope this provides you with more clarity on those specific accounts and our expectations for this segment of our business in the coming quarters.

The following comes from Jacob Stephan with Lake Street Capital Markets.

Great quarter. I wanted to ask about your previous comments regarding gross shipments in Q3 being higher than initially expected. You also mentioned a unit growth of 20% to 30% for the second half of the year, particularly in Q4. Can you help us understand the situation better? We noticed an increase in negative margin within the products segment, although product revenue exceeded our expectations. I know tariffs are influencing this, but could you contrast this with your expectations? It seems like you might have slightly outperformed your plan in Q3. I'm curious if there's been any pull-forward into Q3 that would affect what's anticipated for Q4.

Yes, there wasn't any pull-in. It was a very strong quarter. To break it down further, the strong growth in shipments is due to the ramp-up and load-in of all our new products. We tend to build in a bit of conservatism when forecasting for the quarter because various supply chain logistics issues can arise. For instance, there was a fire on a container ship in Korea, containers were lost in the ocean in Long Beach, and we faced two typhoons. There are always challenges. However, the team executed exceptionally well despite these issues, ensuring that all the products arrived on time. We found that the buffer we usually set aside for potential supply chain problems wasn't necessary, resulting in a strong quarter for gross shipments. The growth of 20% to 30% or the 29% year-over-year increase in units sold reflects our forecast based on actual point of sale data. We are pleased with the 29% growth in Q3 and the anticipated 20% to 30% in Q4, as increased shipments correlate with household formation and subsequently service revenue. This dynamic drives the company's impressive performance and profitability growth over time. Q3 typically shows strong gross shipments due to seasonal trends, but this quarter was particularly strong because of the team's execution and the introduction of many new products. The 29% growth in Q3 and the projected 20% to 30% growth are indicators of future service revenue potential stemming from point of sale activity.

Yes. Understood. I know you guys run a tight ship on the logistics team. But maybe kind of help me think through some of the more important partners then as we enter kind of the back half of the year here. Obviously, you guys have bigger shelf share at Best Buy. You're kind of growing into a longer-term partnership with Walmart. Help me think through some of these strategic kind of retail partners?

Yes, absolutely. I mean I think just commenting on Q4 in general, we know it was going to be a very competitive quarter. We're seeing great demand in the channel, so that's a good sign as we roll forward on Q4, but we knew it was going to be a competitive quarter, and you can see us preparing the entire company to actually be really successful inside of a competitive environment. So the product launch with 20% to 35% COGS declines is an example of that. A lot of the promotional activity we've got lined up with our biggest partners. Some of those are obviously Amazon, which is a big part of the market. We're actually gaining some share there week by week, and so we're happy about that. You mentioned Walmart. I mean, Walmart is part of our thesis around this product segment going more mass market. And we're seeing a wider population actually enter the space as the awareness over the product category and people feeling less safe in general is starting to drive. And we've been proven right over the last couple of holiday seasons. So we're expecting a strong holiday season with Walmart as well. And that's the channel as we've launched in our new product line, we've gone from 4 SKUs or 5 SKUs to closer to 9 SKUs at Walmart, so almost a doubling of shelf share there. And that's partially what's driving some of the unit velocity year-over-year from a quarter basis and why we feel like we're going to be exceptionally positioned with this product line going throughout 2026. So from a partnership perspective or where we think some of the growth is coming, it's across the board. I think we'll see strength in our strategic accounts. And then a lot of our big retail partners were set up, I think, very well for what will be a competitive quarter, but something we completely anticipated with our product launch and our promotional activity. And for us, as you know, it's really about driving that household formation to see that service revenue grow through the end of the year and actually tip over into a strong service quarter in Q1.

Got it. And maybe just kind of continuing on the service revenue growth question and comments. When we look at paid subscribers adding 281,000, maybe you could kind of help us piece out the timing of those subs in the quarter, obviously keeping in mind your $310 million service revenue guidance for the full year.

Yes. I think it was pretty much through the quarter. There are some that kind of came a little bit later as we promoted the older product through the channel that Kurt was talking about, some of the end-of-life product towards the end of the quarter as the new product came in. So it might be a little bit more backloaded than you would expect over maybe a traditional just very linear trajectory through the quarter. But that 281,000 was really driven by 2 things. One, Verisure performed very well, and I think that was part and parcel of their IPO and going to market there and just really leaning into sales and executing extraordinarily well in Europe. But we're seeing strength in our retail and direct channels as well, which is great. And so you see a more balanced revenue line when Kurt was talking about the split between Europe and the United States. So you're seeing some strength across our traditional channels. Another indicator of that is what I was saying before around seeing nearly 30% unit growth in the quarter. Now if you remember, when we guided the year on service revenue, we guided close to $300 million in service revenue. And on our last call, already seeing what was happening in Q3, we took that up to closer to $310 million. And so that's the confidence we're seeing. We are already seeing some of that sell-through happen in Q3 on the previous call and why we were willing to kind of bring up that guidance to demonstrate how strong not only the lift and the growth in the market of unit sales going through to the end user, but that it is resulting in higher than originally expected service revenue, which obviously leads to greater profitability.

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