Earnings Call Transcript - ARLO Q3 2022

Operator, Operator

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.

Matthew McRae, CEO

Thank you, Erik, and thank you everyone for joining us today on Arlo's 2022 third quarter earnings call. Amid the rapidly shifting economic environment, the team executed well to produce a solid quarter of financial results in Q3. Total revenue was within guidance at $128 million, up 7.7% sequentially and up more than 15% year-over-year, and non-GAAP gross profit reached a record $38 million, up over $13 million from a year ago. This resulted in a non-GAAP gross margin of nearly 30% in the quarter. Our growing consumer SaaS business continues to be a key driver of our results. Total paid accounts were up 91% year-over-year as we added 195,000 paid accounts in Q3. Service revenue reached $35.4 million, which is up 31% year-over-year, and our non-GAAP service gross margin rose to 66.7%. While we were pleased with our execution against a challenging supply picture, near the end of Q3, we started to see a shift in consumer behavior, where broad-based inflationary pressures, coupled with the threat of recession, are dampening consumer demand industry-wide. With a weaker demand outlook, our retail partners are moving to increase promotions and lower inventory. In consideration of this, we took immediate action to adjust our strategy and match our operational footprint to this new outlook for Q4 and 2023. First, we decided to pause our branding campaign. As we discussed, the initial awareness spend was a test implemented to measure via paid account uplift over our baseline subscriber run rate. However, despite creating nearly one billion impressions and a promising list in consideration in the first six weeks, the volatility of the baseline in this market makes it difficult to effectively measure and evaluate the efficacy and ROI of the spend. So this spend is paused indefinitely until we see the market return to a more positive and stable trajectory. Second, we initiated a review of expenditures across the company to identify areas for further optimization of our business. We have well-defined plans to lower the run rate in various areas of OpEx to ensure we are structured to maintain our most important levers of top-line growth and achieve our long-range plan in the most efficient and disciplined manner. As these industry headwinds form, we also expect overall component supply will increase, giving us more leverage over supply chain pricing and allowing us to further utilize sea freight in the coming year to lower cost of goods sold. Our goal is to proactively attack these opportunities to ensure they positively impact our business as soon as possible. We are acting prudently and decisively to preserve capital during these headwinds, and we'll continue to adjust our operations as we deem necessary in the face of shifting data and consumer sentiment. Despite the softening in consumer demand and the pause of our awareness campaign test, Arlo remains on track to achieve the long-range plan targets we shared in March of this year. In fact, the recent shift in the economic environment proves out how important it is for Arlo to continue diversifying our routes to market with enterprise partnerships to reach incremental households as we shared in our long-range plan. Verisure has installed Arlo services in more than 320,000 households through their direct channel in the last 12 months. Calix continues to ramp through their broadband service provider partners. And we continue to see success with Arlo CO2, with partners such as T-Mobile, Verizon, U.S. Cellular, Celcom, and Bell Canada. We will continue to pursue these strategic partnerships as we make progress in diversifying our routes to market and creating predictable revenue streams. Arlo's focus on innovation and new product introduction rounds out the last focus area of our long-range plan. In October, we launched Arlo Safe, our new mobile application and service that provides individuals and families safety and security on the go. This represents a major expansion of our addressable market, as Arlo has moved from protecting a specific location with hardware devices and services to protecting people no matter where they are with a cloud-connected app. Arlo Safe has numerous innovations, including a check-in mode for family members and direct dispatch of first responders to you or your remote family member. Arlo Safe is available for download now in the Apple and Google app stores and a two-button service bundle is available now at Best Buy. Individual subscriptions are $4.99 per month. A family subscription is $9.99 per month and we rolled out a new Safe & Secure plan, which combines the features of our Arlo secure service for home security with the Arlo Safe Family Service for $19.99 per month. In addition to Arlo Safe, I am pleased to announce two major product launches for our core Arlo Secure platform. The first is our Innovative Security System with the world's first multi-sensor and utilizing Sterling, our new two-way encrypted long-range wireless protocol. This brings full sensor-based security and professional monitoring to the Arlo ecosystem. The modular hub includes battery backup, cellular backup, direct dispatch buttons, an integrated motion sensor, a microphone for smoke and carbon monoxide alarm listening, and an NFC reader, and our incredible multi-sensor combines a door sensor, window sensor, tilt sensor, motion sensor, water leak sensor, ambient light sensor, temperature sensor, tamper sensor, and a smoke and carbon monoxide listener into one small form factor. This brings significant advantages throughout our supply chain to our channel partners and to the end-user experience. Coupled with these groundbreaking hardware components, we launched our new $19.99 Safe and Secure plan, as mentioned, which includes 24/7 professional monitoring and cellular backup service. The second product announcement is the new Arlo Pro 5S smart security camera, the Pro 5S marks a major advancement in the industry and integrates with our new security system to provide professional-level features. It is the world's first tri-band camera with dual-band Wi-Fi for maximum performance and Arlo's SecureLink, which provides new power modes for extended battery life, increased robustness in challenging RF environments, and continuous operation during power and Internet outages by leveraging the battery and cellular backup functionality of our security hub. This groundbreaking functionality creates what we believe is the world's most advanced and reliable security system. Both the security system and Pro 5S are available for pre-order and we'll be shipping through channels in early December. Our new channels and new products expand our addressable market and provide significant new avenues to expand our subscriber base and ARPU. I'm delighted to announce that Arlo now has more than 1.7 million total paid accounts, well on our way to our $5 million target, and our annualized recurring revenue or ARR continues to grow at a rapid pace, exiting Q3 at $125 million, up 56% year-over-year, and marching towards our $300 million target. And now I would like to introduce Kurt Binder, who recently took over as Chief Financial Officer for Arlo, and also welcome him to his first call. Kurt will provide more insight into our financial performance, operational details, and outlook for the fourth quarter and full year.

Kurt Binder, CFO

Thank you, Matt, and thank you, everyone, for joining us today. Let me start by saying that I am extremely excited to serve the company in my new role, and I look forward to working with you all in the future. I will start by sharing some financial details on Q3. Revenue for the third quarter came in at $128.2 million, up nearly 8% sequentially and 15% year-over-year. Against an uncertain macroeconomic backdrop and inflationary pressures impacting consumer spending, we experienced softening demand in our customer base in the second half of Q3. However, we are pleased that our channel diversification and ARR growth demonstrated resilience to deliver revenue within our guidance range. Our service revenue for Q3 2022 was another record $35.4 million, up 8% sequentially and 31% year-over-year. This was driven by the addition of 195,000 paid accounts in the quarter and a robust installed base of 1.7 million subscribers. While service revenue accounted for only 28% of our Q3 2022 total revenue, it represented 62% of our total gross profit. Product revenue for Q3 2022 was $92.7 million, which was up 8% sequentially and 10% year-over-year. Our year-over-year product revenue growth was driven by the shipment of 1.3 million cameras worldwide, with 45% of our revenue coming from our international customers. Within our globally diverse customer base, we have experienced continued strength from our strategic relationship with Verisure in the EMEA region, with revenue up 70% year-over-year in that region. Our ability to develop such a strong and collaborative relationship with Verisure has proven to be a great intangible for Arlo. And I am excited to see what similar opportunities we can develop in other regions across the globe. 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 distributed earlier today. Our non-GAAP gross profit for the third quarter of 2022 was up $13 million or 52% year-over-year to $38 million. This resulted in a non-GAAP gross margin of 29.7%, up from 29.5% in Q2 2022, and 22.6% in Q3 of 2021. The $13 million year-over-year increase in non-GAAP gross profit included $8 million from services and $5 million from products. The improvement in non-GAAP service gross profit was driven by growth in our ARR and the monetization of our installed base of paid subscribers coupled with cost optimizations. The improvement of non-GAAP product gross profit was driven by higher product shipments and related revenue over a consistent fixed cost base. Non-GAAP service gross margin came in at 66.7%, significantly up from 59.5% in Q3 2021 and a slight improvement on 65.8% in Q2 2022. Non-GAAP product gross margin was 15.6%, up from 10.8% in Q3 2021 and flat to Q2 2022. Total non-GAAP operating expenses were $42.3 million, up $8 million or 24% sequentially and up $10 million or 30% year-over-year. The increase in total non-GAAP operating expenses was driven by sales and marketing expenses as we executed on the initial phase of our brand awareness campaign, in which we invested a total of $8.8 million during Q3. Although we experienced some immediate benefit from this campaign, as Matt mentioned, we are pausing it until visibility into the current economic environment and our path to resuming profitability is clear. Our total non-GAAP operating expenses, excluding the marketing investment were relatively consistent with the sequential and year-over-year periods. Our headcount at the end of Q3 was 360 employees, which was a slight increase from 354 in the prior quarter. In Q3, we posted a non-GAAP net loss of $4.2 million, which would have been non-GAAP net income of $4.6 million when excluding the brand awareness spend. Our non-GAAP net loss translates to a net loss per diluted share of $0.05, much better than our guidance and a $0.03 improvement year-over-year. The non-GAAP net loss figures were driven by a combination of revenue growth and gross margin expansion, coupled with a disciplined approach to cost management. You can expect us to continue a deliberate and disciplined approach to managing operating expenses. As Matt mentioned earlier, our plan to reduce operating expenses in areas such as headcount, office leases, and outside services is prudent, especially in this uncertain economic climate, but we will remain steadfast in driving revenue growth and profitability through paid subscriber adds and supplemental service opportunities. Regarding our balance sheet and liquidity position, we ended the quarter with $125.3 million in available cash, cash equivalents, and short-term investments, down $10 million sequentially and $41 million year-over-year. The reduction in available cash this quarter is attributable to fluctuations in working capital, principally an increased investment in inventory. Our Q3 inventory balance was $73.2 million, an increase of $34 million over Q2 2022, with inventory turns at 4.3 times as compared to 7.5 times last quarter and 7.6 times a year ago. The increase in inventory is attributable to a number of factors, including the seasonal restocking in anticipation of the holiday consumer purchasing pattern coupled with our internal objective to maintain more appropriate inventory levels to support consumer demand in the fourth quarter and early 2023. Our inventory balance in the past quarters was low due to supply chain constraints experienced by Arlo as well as many other companies. The objective is to maintain a more healthy inventory level, so we are responsive to consumer buying patterns, but in an efficient and cost-effective manner. And finally, our DSOs came in at 59 days, down from 62 days a year ago and up from 57 days sequentially. We will continue to monitor our working capital balances in line with our revenue levels with a focus on maintaining a solid balance sheet and liquidity position in the future. Now turning to our outlook. We expect fourth quarter revenue to be in the range of $105 million to $115 million. We expect our GAAP net loss per diluted share to be between $0.30 and $0.23 per share, and our non-GAAP net loss per diluted share to be between $0.13 and $0.06 per share. Our Q4 guidance takes into account approximately $5 million of residual brand awareness spend committed before we paused the overall campaign. Considering the uncertain economic climate and potential near-term top-line revenue headwinds, Arlo is committed to a disciplined approach to expense management and streamlining operations. As discussed earlier, we plan to reduce our costs beginning in the fourth quarter, which would include reducing our global workforce by about 10% and in order to drive the business to a breakeven non-GAAP operating income target. We are acting quickly and expect that our cost savings initiatives will begin to manifest in Q4 and will be fully actualized in the second half of 2023. Further, we expect to end the year with available cash, cash equivalents, and short-term investments in the range of $90 million to $100 million. While this is lower than previously forecasted, we believe this range represents an acceptable level for cash as the working capital investments materialize in the first half of 2023, and we drive closer to non-GAAP operating income. We will continue to monitor our performance and prudently manage our operations to preserve our cash position. As we evaluate the upcoming 2023 year, we expect to experience volatility in the market for the next few quarters. In general, we believe we are now facing a market that will be flat to down in the upcoming quarters, and we have rapidly pivoted our strategy and operations to address this environment. Although we expect to grow a bit faster than the market, we will manage our spend in 2023 to reflect market conditions, but in a manner that allows us to return to a breakeven non-GAAP operating income target by the back half of 2023. And now, I'll open it up for questions.

Hamed Khorsand, Analyst

Hi. Could you just talk about the actions you're taking? Are you taking it from a headcount perspective? Are you taking out from having already stocked inventory, you don't need to source expensive components right now? Could you just be a little bit more elaborate on that?

Matthew McRae, CEO

Yes. As part of reviewing the operations, I would say it's comprehensive across the organization. So Kurt mentioned an overall reduction in headcount of about 10% across the company and that's an action that's already been taken. We have a full review of outside expenses, so we're going to look to reduce expenses from kind of outside parties and outside services. I would tell you, as part of the analysis we're seeing as well, I think there's a lot of operational savings that are happening as these headwinds form. So we're seeing, obviously, freight expenses come down as part of COGS. We're seeing component supply obviously start to ease off restrictions and the ability to negotiate pricing as we go forward as well. So it's everything from supply chain costs, cost of goods sold to actual operational, both internal and external expenses of the company.

Hamed Khorsand, Analyst

It seems like you were taken by surprise. What do you think led to that? Was it purely driven by consumer behavior, or were retailers generally reducing their inventory?

Matthew McRae, CEO

Yes, I don't believe we were surprised. We were closely monitoring the situation. In our previous commentary, we mentioned that we were tracking demand weekly. We even assessed incoming data from our channel twice a week. The first half to possibly the first two-thirds of the quarter showed strong demand, which is reflected in our Q3 results. However, after Labor Day, we began to notice significant changes in the data and feedback from our retail partners, indicating a shift in demand and customer sentiment. Many retailers adjusted their inventory strategies, reducing their typical holding period from 12 to 15 weeks down to as little as 4 to 6 weeks for the holiday season. Following Labor Day, we observed these abrupt changes and responded promptly. The week after Labor Day was when we started modifying our company operations based on the collected data.

Hamed Khorsand, Analyst

If you're pausing the ad spend and reducing headcount, why do you expect net losses to continue through the first half of 2023, especially since subscriber service revenue is increasing, and you've mentioned that Verisure will contribute to your service revenue through the rollout of their cameras?

Kurt Binder, CFO

Okay. Well, I think in terms of our guidance and direction for 2023, our overall feeling is we want to make sure that we're a bit cautious. We believe that the plan that we've laid out and the actions that we're in the process of taking will get us to a point where we're at breakeven non-GAAP operating target, profit target. But, and our hope is that certain things will start to unfold here in probably Q1 to Q2 to get us a bit to that level earlier, but we thought it was best to be a bit cautious given the uncertainty and the economic climate that we're dealing with right now.

Jacob Stephan, Analyst

Yeah. Hey, guys. Thanks for taking my questions. Can you just confirm the guide for 2023, I think previously it was doubling the growth rate and adjusted income positive. Is that on a quarterly basis, or are you coming in to that for the year?

Matthew McRae, CEO

I think that was based on the assumption that brand spending would continue into next year. As we look at the market for next year, we expect the current environment to persist, and anticipate that both our segment and the overall market for our product line will remain flat or decline. This is supported by the insights we’re gathering from the channels and early data suggesting that trends will continue post-holiday. Kurt noted that we usually aim to perform slightly better than the overall trend, so we are looking to achieve modest year-over-year growth as we move forward. Normal seasonality will also play a role as we transition from this year into the next. Therefore, pausing brand spending and assessing the situation in Q4 while considering that this sentiment may carry into the first half of next year provides some clarity on our expectations for the upcoming year.

Jacob Stephan, Analyst

Okay, that's helpful. Could you discuss the increase in inventories? Where is the weakness in the US? There has been a fourth consecutive quarter of Verisure shipments exceeding $50 million. Can you clarify where you're noticing the weakness in the US? Is it on the retailer side, or are customers visiting arlo.com less frequently?

Matthew McRae, CEO

From a demand perspective, we are definitely noticing that the consumer retail channels are where we are experiencing challenges. This highlights our commentary about having a diverse revenue base, which is beneficial because our substantial services business is our main strategy as a company and serves as a strong foundation. Partners like Verisure are crucial for us. The weakness we're observing is primarily with our retail channel partners on the consumer side. Yes. And just to add to that, we made an investment leading into the fourth quarter, about $34 million of incremental inventory and in the midst of that, as Matt mentioned earlier that there was a bit of this shift in expectation with the retailers on the weeks on hand inventory that they plan to hold, especially in the club channel. We have been adjusting to that. But what that has resulted in is a bit of destocking that occurred in Q3, probably will continue into Q4, and that is impacting some of the revenue targets. So the investment we think in inventory is going to pay off over the next couple of quarters, mainly because we think we'll be at levels where we'll be able to meet consumer demand a bit quicker. And also because we are trying to find ways to reduce the overall COGS associated with logistics and freight and getting inventory here into the DCs and into our retailers.

Jacob Stephan, Analyst

Okay. Maybe just one last one on brand awareness. Can you give us a more specific kind of timeline on when you may have paused that campaign and maybe just talk about the burn rate on the increased ad spend, give us a better hint on sales and marketing expense.

Matthew McRae, CEO

Yes. Toward the end of Q3, we started noticing signals that led us to decide to pause the spending. There is typically a delay because media purchases are made in advance. As we mentioned, the spending has been halted, but you will notice some residual impact in Q4. After that, there will be no further expenditures related to that brand awareness campaign. Initially, we saw great results; the campaign ran for about six or seven weeks and generated over 1 billion impressions, achieving over 80% reach in key demographics. We were beginning to see positive effects. However, considering that the primary goal was to measure lift against a baseline, and since both the baseline and customer sentiment have shifted, we believe it is prudent to pause the campaign until the market stabilizes and improves. We suspended it towards the end of Q3, just weeks after Labor Day. There will be some residual spending due to earlier media purchases, but this will taper off as we move into next year, ultimately returning to zero.

Jacob Stephan, Analyst

All right. Thanks, guys.

Matthew McRae, CEO

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 continuing pandemic and macroeconomic headwinds. While we could not predict the current customer spend environment when we developed our long-range plan, our diversified revenue base, innovation leadership, coupled with our expense reduction plan and disciplined execution means our confidence in achieving those long-range targets is unchanged. Thank you, everyone, for joining us today.

Operator, Operator

And this will conclude today's conference. Thank you for your participation, and you may now disconnect.