Earnings Call Transcript - ARLO Q2 2020

Operator, Operator

Ladies and gentlemen, thank you for waiting. I would now like to hand the conference over to Erik Bylin, please proceed.

Matthew McRae, CEO

Thank you, Erik, and thank you, everyone, for joining us today on Arlo's Second Quarter 2020 earnings call. In today's call, Gordon and I will walk you through the major elements, including financial results for the quarter, paid account growth, new products and a partner announcement. For the second quarter, we reported $66.6 million in revenue; well above the upper end of our guidance. Our non-GAAP operating expenses came in at $31.3 million, down $900,000 sequentially and down more than $6.6 million year-over-year. This is substantially better than our goal of $33 million to $34 million in operating expenses that we set when we restructured last year. Importantly, through diligent spend and working capital management, we maintained our substantial cash, cash equivalents and short-term investments balance above $200 million. Arlo again set records this quarter for both registered accounts and paid account growth. Arlo ended the quarter with approximately 298,000 paid accounts, which is up more than 59% year-over-year. The in-quarter growth of 43,000 new paid accounts was also a record and up an impressive 72% sequentially. This performance resulted in our fourth consecutive quarter of record services revenue at $17 million, which was up 53% year-over-year. At the heart of this success is the transition to our new business model, which features a 90-day trial of Arlo Smart, our industry-leading Cloud storage and AI-powered computer vision service. Once the free trial of Arlo Smart expires, we are seeing a 50% subscription attach rate, which is 10x higher than the attach rate of our old business model. This transition to our new business model has clearly created an inflection point for Arlo. We expect further subscription momentum as our legacy products phase out of the channel and retail sales shift to the new business model lineup between now and the end of the year. In our final step to phase out products with our old business model, Arlo recently launched the Essential Spotlight security camera, which completes our lineup of new products and addresses the fast-growing $100 price segment. This latest addition to our award-winning smart home security ecosystem offers a wide array of features, including high definition video, two-way audio, integrated spotlight, color night vision and six months of battery life. Essential can also connect directly to a Wi-Fi network without the optional smart hub, providing users greater flexibility. The Essential Spotlight camera is now available for sale on Arlo.com and at our major retail partners with very positive early user and press reviews. Last quarter, we announced the full channel availability of the Arlo Pro 3 floodlight camera, the first wire-free, battery-operated integrated floodlight camera in the market. With the floodlight camera comprising up to 20% of the overall connected camera category, this product represents a significant opportunity for Arlo to capture share in a rapidly growing market. Garnering a 4.8 rating at Best Buy, the Pro 3 floodlight has been very well received with many positive reviews, including three Editors' Choice Awards from Digital Trends, PC Magazine and CNET, which called it the best floodlight they have ever tested. Now turning to our business-to-business channel and Software as a Service, Arlo SmartCloud offering. Our partnership with Verisure is proceeding as planned, with all in-quarter milestones achieved. And as mentioned last quarter, we are targeting wide rollout and accelerating growth in 2021. In July, we announced an agreement with Securitas Security Services USA, our first U.S. SmartCloud SaaS customer. Securitas will integrate Arlo SmartCloud and our award-winning cameras into their platform for centralized remote monitoring of their commercial assets. In addition, our SmartCloud AI-enabled security cameras, including the Arlo Pro 3 and Arlo Go, will be used to make Securitas' remote guarding services even more efficient for their commercial clients. At a time when numerous buildings and assets are being left unmonitored due to COVID-19, SmartCloud enables Securitas to monitor and take action on any potential incidents. We are excited to continue expanding our routes to market and to assist Securitas in delivering peace of mind to their customers. In summary, Arlo delivered strong results in Q2, launched a competitively priced camera into the fastest-growing price segment, announced a new SaaS partner and achieved the inflection point in our subscription business that will continue to accelerate through the balance of the year. These results were achieved despite the pandemic, creating challenges on both the supply chain side and go-to-market side of the business. Our employees showed an exemplary commitment to Arlo that helped us overcome these challenges and outperform our expectations for the quarter. I am extraordinarily proud of our execution, the results for the quarter and the foundation that our team has built for future success. And now I would like to introduce Gordon Mattingly, who recently took over as Chief Financial Officer for Arlo, and also welcome him to his first call.

Gordon Mattingly, CFO

Thank you, Matt. Let me start by saying that I'm extremely excited to serve the company in my new role, and I look forward to working with you all in the future. I'm pleased to share that the Arlo team delivered an excellent quarter, with revenue coming in $6.6 million above the high end of guidance, while significantly reducing America's retail channel inventory from 14.5 weeks at the end of Q1 to seven weeks at the end of Q2. We're also very pleased with the acceleration in our paid account growth and what that can do for the business over time. In addition, our restructuring activities and expense management continue to deliver results. We came in well below our previously communicated target of $33 million to $34 million in non-GAAP operating expenses in Q2. These achievements demonstrate our team's continued strength of execution across our business. And now on to the financials. As Matt highlighted, we achieved $66.6 million of revenue, above the upper end of our guidance, up 1.8% sequentially and down 20.3% year-over-year. Product revenue for Q2 2020 was $49.6 million, which is down 31.5% compared to last year and down 2.2% sequentially. The year-over-year performance was mainly driven by COVID-19 effects on our sales channel operations. The sequential performance reflected an uptick in sell-through, which was offset by destocking in our major retail channels. Our service revenue for Q2 2020 was $17 million, which is up 52.7% over last year and up 15.6% sequentially. The main driver of our excellent service revenue growth is our paid account growth under our new business model, where we continue to see very strong conversion to a paid subscription of Arlo Smart after the free trial ends. Our service revenue also includes $2.3 million of NRE services we are providing for Verisure, along with associated costs as compared with $0.9 million in the first quarter of 2020 and zero a year ago. During the second quarter, we shipped approximately 516,000 devices, of which approximately 511,000 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, which was distributed earlier today. Our non-GAAP gross profit for the second quarter of 2020 was $6.4 million, which resulted in a non-GAAP gross margin of 9.6%, an improvement of 2.2 percentage points sequentially. This compares to $10.5 million in the year-ago comparable period and $4.8 million in the prior quarter. Product gross margin has been challenged in the first half of the year due to incremental costs incurred in our transition from products under the legacy business model to products under the new business model. As we increasingly move to shipping products under the new business model, we expect product gross margin for the remainder of 2020 to return to roughly what they averaged in 2019. Our service gross margin was 41.5%, up from 36.8% in the first quarter of 2020. As previously mentioned, our service gross margin is burdened by the cost of the free Arlo Smart trials under the new business model as well as the cost of servicing the free basic service under the old business model. As we have seen in the past two quarters, continued improvement in the paid subscription attach rate will expand service gross margin. Also, as mentioned, our service revenue includes $2.3 million of NRE services we are providing to Verisure. In Q2, operating expenses benefited from our restructuring late last year and our continued expense management efforts. Total non-GAAP operating expenses were $31.3 million, down 17.3% year-over-year and down 2.9% sequentially. In the third quarter, we expect to shift our marketing efforts to drive online awareness, bringing them more in line with the prevailing buying patterns and reflecting the growth we are seeing in our online store, Arlo.com. Given that, we expect sales and marketing expenses to rise in Q3. While the balance of our opex components should remain flat, we expect that this will result in operating expenses ending up in the original target range in Q3. Our total non-GAAP R&D expense for the second quarter was $12.5 million, down $1.1 million compared to the prior quarter. The sequential reduction in R&D expense came both from lower spending and an increase in the time spent by our R&D team on the Verisure NRE, which is classified on the cost of service. Our headcount at the end of Q2 was 355 employees compared to 356 in the prior quarter. As a reminder, during the early stages of Verisure, operating the European commercial business, we agreed to provide them with transition services that include training time with Arlo employees, systems costs as well as 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 $1 million during Q2. Our non-GAAP tax expense for the second quarter of 2020 is $181,000. For the second quarter of 2020, we posted a non-GAAP net loss per diluted share of $0.31; better than the high end of our guidance. We ended the quarter with $205.5 million in cash, cash equivalents and short-term investments, down $1.1 million sequentially; with working capital improvements more or less offsetting the operating loss. We were pleased with the results of our working capital management during Q2, which was helped by the growth in paid subscriptions in our online store. In particular, we significantly improved our DSO, which came in at 63 days, down from 83 days sequentially. We expect DSO to increase in subsequent quarters in 2020 based on business and customer mix, while continuing to show year-on-year improvements. Now turning to our outlook. As previously mentioned, given the uncertainty presented by COVID-19, we have withdrawn our guidance for the full year, but we will provide guidance for the third quarter based on what we know today. Our Q3 guidance takes into consideration what we know about end-user demand, our retail channels and our supply chain as well as the inherent uncertainties presented by COVID-19. We expect third quarter revenue to be in the range of $85 million to $95 million. We expect our GAAP net loss for diluted share to come in between $0.32 and $0.41 per share and our non-GAAP loss and diluted share to come in between $0.24 and $0.33 per share. We'd also like to update our commentary on our cash position. We believe that considering a range of outcomes for the COVID-19 pandemic and its effect on our supply chain and retail distribution channels, we will still end this year with between $125 million and $150 million in cash, cash equivalents and short-term investments without tapping into our credit facility, but will more likely land at the upper end of this range. We will continue to monitor our performance during 2020 and closely manage our operations to preserve our cash. And we can now open the call to questions.

Jeffrey Rand, Analyst

Can you talk a little bit about the traction so far, the Arlo Essential Camera and do you think these customers will eventually have a lower attach, subscription attach rate, as they may be more cost-sensitive than someone buying a more expensive camera?

Matthew McRae, CEO

Yes. So the Essential camera, as you know, has just entered the market. We've got a few weeks of sales under our belt. And I think we're very happy with what we're seeing so far. It's early to comment on what the subscription attach rate may be on this product versus others. But I can tell you, we have not seen any significant variability on the attach rate by price point on all of the products we've had in the market today, including when we promote them down to lower price points. So that's the data we have going in. But so far, I think we're happy with how Essential has actually executed in the channel.

Jeffrey Rand, Analyst

And can you talk a little more about the Securitas opportunity and how this can support growth in both your product and services business going forward?

Matthew McRae, CEO

Yes, we are very excited about the Securitas deal for several reasons. First, it marks our first significant SmartCloud SaaS deal in the United States, which is great for diversifying our channels. Second, the product and service will complement each other with Securitas, similar to our partnership with Verisure. We anticipate a strong attach rate of the service with this deal as they roll it out, labeled Remote Guarding Go, targeting clients such as industrial users, homeowners associations, and small to medium enterprises. Their customer base also presents additional channel diversification opportunities for Arlo Go and Arlo Smart. Moreover, this SaaS deal will include not only our traditional Wi-Fi products but also our Arlo Go product, which operates on cellular connectivity, allowing placement in areas without power or broadband. We'll be implementing our full range of products along with the service into a diverse mix of channels, and we are eager to see the long-term impact of this collaboration.

Adam Tindle, Analyst

Matt, I just wanted to maybe start on an update on the state of the industry and competitive environment. We had noticed that ASPs for the category were trending up. Do you think that's a function of pricing getting more rational? Is it consumers moving up to more premium product versus commodity after maybe experimenting with it and getting more serious about the purchase? Just what you're seeing in that and how that should correlate to product gross margin.

Matthew McRae, CEO

Yes. So we have seen definitely, especially if you look historically, as you know, ASPs were coming down quite aggressively. If you look back, especially a couple of years. That has definitely stabilized. And I think a part of that is we've hit some natural price points; both as an industry but also Arlo and the essential launch is an example of designing a product for a price point, which will help gross margin over time. One of the things that's dragged down our gross margin, and we've discussed it on previous calls, was having to promote old product. So now that we've designed products and completed the refresh of our core product lines at those trigger price points, we expect, as Gordon mentioned in the commentary, to see that go up over time. But I think also, as people are looking at this product category, it is a product category of peace of mind of safety and people generally want quality; not only as the hardware itself, but a trustworthy service that's actually backing up that hardware to provide the peace of mind that people are asking for. So I think those are all coming into play of why we're not seeing the ASP declines we had seen historically over the last couple of quarters.

Adam Tindle, Analyst

Got it. That's helpful. And then secondly, just on subscriptions. You talk about a 50% attach rate when expiring. As we think moving forward, is there a way for us to perhaps quantify that opportunity as the year progresses? I think you're guiding to some pretty healthy overall total revenue sequential growth. I mean, how should we judge this inflection point? You're now adding over 40,000 subs a quarter? And does it just kind of stabilize at that level? Does it hit another step function increase? Just any way to coral our expectations on that?

Matthew McRae, CEO

Yes. I think the best guidance is some of the information we included in the investor deck. And the reason I say that is we're at this very complex moment in this transition where we have legacy business model, products in the field selling through, we have new business model products selling through. We have the original ultra that had a 12-month trial. We've got products with 90-day trials. So the transition that we think will be substantially through as we exit this year is going to be relatively complex for the next couple of quarters. I think one of the biggest drivers of that from a modeling perspective will be the sales, meaning the point of sale, POS sales through at the channel; mix of legacy to new products, right? And we've included a chart in our investor deck that shows the forecast, the actuals for Q1 and Q2 and the forecast for Q3 and Q4 going forward. And that should help provide some guidance. We wanted to provide additional information, especially in this kind of complex state that we're in. And then obviously, as we get into next year, you would see us predominantly, almost completely on the new business model, obviously, and the modeling will get a lot easier as you look at POS and how that trickles down 90 days later to sign-ups and conversion.

Hamed Khorsand, Analyst

I wanted to ask you about the competitive landscape. We're aware that Securitas is active in the U.S., and one of your competitors had a win this week. Will it put you at a disadvantage if your competitors have significantly more cash and are leveraging that to gain market share?

Matthew McRae, CEO

Well, I think what's happening is that the whole space is heating up and being validated, I think, by some of the activity you're seeing on the deal side, right? One of the trends we're seeing is security is definitely becoming smart security or smart home security. And of course, Arlo is the leader in the space, especially from a technology perspective, is obviously working on several deals. The Verisure deal was obviously our flagship deal that we expect to start contributing more to our results next year as these take a while to actually get integrated. But I think you're going to see the whole area continue to grow, and you'll see additional partnerships. But at the base level, what most of these potential partners, and the partners we've already signed, are looking for is adding video and smart video, meaning computer vision services into their mix and moving from security to actual smart security, which solves a couple of things; one, it creates a much better user experience for the end user but it also provides what's called video verification for events to reduce false alarms and make sure that emergency responders can respond faster; especially when it's verified. So I think that trend is going to continue as we go forward. And I think you're just seeing a lot of activity in the space over the next 12 to 18 months.

Hamed Khorsand, Analyst

So where does that put Arlo as far as being able to get more market share with the service providers?

Matthew McRae, CEO

Yes. I think we're in a great position for that, frankly, because we do have, obviously, the best-in-class hardware. And we also have the widest portfolio of hardware from both a battery operated, like our floodlight, which is the first world-first battery-operated integrated floodlight. Now that we've launched our video doorbell, we've got that full ecosystem of product. And obviously, on the back end, we've got the best computer vision service in the marketplace. But I'll tell you, from a positioning perspective, I think there's a couple of other things that are important. One is our position on privacy, we have taken a very strong stance with our privacy pledge that we don't collect data for surprising purposes to the end user. We don't sell data. So we've taken a very strict view on how we protect that data and what we do and do not collect. And that's great from a partnership perspective. That makes us look very different than some of the other big players in the space. And then, two, we're agnostic from an ecosystem perspective. So if you sign up with some of these other partners out there, you may be stuck with one voice solution or one interoperability capability. Arlo provides obviously compatibility with Apple Siri and HomeKit, Google Voice, Amazon Alexa, Samsung SmartThings, even IFTTT. And so we have the broadest capabilities, so you're not locking your customers into a single solution. And what we found, and we find this through our survey data but also talking to our customers, most homes are a multi-voice household, meaning they may have a Google home device in the kitchen, and they have an iPhone in their pocket and they expect all of that to work in a seamless way, and Arlo is one of the only providers in the world to do that; that makes us a better partner in the space. So I think we're well positioned. And we'll have more information as we go forward.

Hamed Khorsand, Analyst

What are you doing to improve your webpage traffic and convert that into sales? Will this impact any of your retail partners?

Matthew McRae, CEO

Yes. Arlo.com, as you know, we launched in roughly – really launched in Q3 of last year, and we are seeing – we were already seeing nice growth quarter-over-quarter, but obviously, the pandemic accelerated that even further. We have seen those – all of that sales has been completely incremental to channel. So it's a different customer. We're addressing a different customer. I think it opens up the possibility for us to do different kinds of bundles and potential business models direct to the consumer. So it's a very exciting growth path for us and it's been wholly incremental. You'll see us continue to invest in that. It's one of the – on Gordon's commentary. We believe some of our marketing dollars will drop below the line and you'll see that in opex in future quarters and part of that is us investing in our direct channel a little bit more to continue to drive success on Arlo.com.

Jeffrey Osborne, Analyst

Most of the questions were answered, but I just wanted to understand with Prime Day being in the fourth quarter now instead of the third quarter traditionally, what the ramifications are of that?

Matthew McRae, CEO

Yes. I don't know exactly, to be honest. So we're looking at the modeling of Q4 from a POS perspective. What's interesting is shipments are more predictable than PLS at that point, right, because we know we'll ship in Q3 still for Prime Day. But on the POS side, when you look at the normal seasonality year-over-year, it's obviously going to be different. We've been working really closely with the retailers, which includes, obviously, Amazon, but also the other retailers that have significant promotional activity, including Black Friday and Cyber Monday in that quarter and their reactions to where Prime Day is falling and everything else. So I think we have a good handle on what the planning is. A lot of it will obviously depend on what the operational footprint is going to look like for the individual partners depending on how the pandemic progresses. But I think from a shipment perspective, seasonality will look a little bit more normal than maybe the seasonality on POS because of the difference.

Jeffrey Osborne, Analyst

Because of the early October date, you mean, as opposed to being later?

Matthew McRae, CEO

Having Prime Day occur in Q4 instead of Q3 will affect the timing of point-of-sale activity compared to shipments. If it takes place in early Q4, many of those shipments will still occur in Q3.

Gordon Mattingly, CFO

Yes Jeff, it's Gordon here. I think it's fair to say that, obviously, the degree of uncertainty that we are facing when we went out and actually chose the guide for Q2 was pretty significant. In terms of the beat, I would say it was just mainly sell-through driven beat. So it was just driven by end-user demand being more than what we expected, but take into account the degree of conservatism and caution that we had in our guidance, just based on the level of uncertainty. Obviously, the situation, as you know, is still pretty uncertain. And we've certainly referenced that with the guide for Q3. Obviously, we're not guiding Q4 at this stage, and we continue to monitor the situation pretty closely. But the beat in Q2 was just really driven by end-user demand exceeding our expectations.

Jeffrey Osborne, Analyst

What I was trying to get at, Gordon, is that across all channels, there wasn't one particular outlet performing better than the others.

Gordon Mattingly, CFO

It was generally across all channels. We've generated for all channels.

Jeffrey Osborne, Analyst

Got it. My last two questions are as follows: could you remind us what normal weeks of inventory are? You mentioned a 7% improvement from 14.5%. Where would you like that to be? Additionally, you referenced achieving milestones for Verisure; could you highlight one or two of the key milestones that were reached, so we can better understand what was accomplished in the quarter?

Gordon Mattingly, CFO

Yes, I'll address the first question, and Matt can cover the second one. Regarding the typical weeks for inventory, the situation is quite unique at the moment as there really isn't a standard. Our retail partners are focusing on managing their cash and inventory closely, which is appropriate. Additionally, we have observed a significant change in their business mix. Before COVID-19, the in-store and online sales ratio was about 80/20, but in recent weeks, it almost flipped. Currently, it seems to be around a 50/50 split. However, I don't anticipate a return to the previous normal inventory levels of about 12 weeks anytime soon. For our channel inventory entering Q3, while essential channel fill will provide a slight advantage, we do not expect inventory weeks to revert to the previous 12 to 14 weeks for retail.

Matthew McRae, CEO

To address your question about Verisure, the second part focuses on our milestones this quarter as we integrate and prepare for more execution next year. These milestones primarily involve software integration, hardware development timelines, and actions taken to ready both companies for a more cohesive market offering. We track specific milestones each quarter to ensure we're progressing appropriately, which also helps us account for the non-recurring engineering costs and close those out quarterly. Overall, everything is progressing well. Our previous discussions regarding the deal and its anticipated contributions to Arlo, particularly in years two through five, are still on track. We are pleased with our ongoing collaboration with Verisure.

Operator, Operator

And there are no further questions at this time. I will now turn the call over to Matt McRae for closing comments.

Matthew McRae, CEO

Yes. Thank you, operator. That concludes today's call. I want to thank everybody for joining Arlo on our Q2 2020 earnings call.

Operator, Operator

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