Cricut, Inc. Q1 FY2021 Earnings Call

Good day and thank you for standing by. Welcome to the Cricut Q1 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker’s presentation, there will be a question-and-answer session. I would now like to hand the conference over to your speaker today, Jessica Barker, Investor Relations at Blueshirt Group. Ms. Jessica, please go ahead.

Thank you, operator, and good afternoon everyone. Thank you for joining us on Cricut’s first quarter 2021 earnings call. Please note that today’s call is being webcast on the Investor Relations section of the company’s website. A replay of the webcast will also be available following today’s call. For your reference, prepared remarks and accompanying slides used on today’s call have also been posted to the investor relations section of the company’s website, investor.cricut.com. Joining me today on the call are Ashish Arora, Chief Executive Officer, and Marty Petersen, Chief Financial Officer. Before we begin, we would like to remind everyone that our prepared remarks contain forward-looking statements, and management may make additional forward-looking statements in response to your questions. These statements do not guarantee future performance, and therefore, undue reliance should not be placed upon them. These statements are based on current expectations of the company's management and involve inherent risks and uncertainties, including those identified in the Risk Factors section of Cricut's most-recently filed Form 10-Q and S-1 Registration Statement. Actual events or results could differ materially. All non-GAAP numbers referenced in today's call are reconciled in the press release or the slide presentation on our investor relations website. This call also contains time-sensitive information that is accurate only as of the date of this broadcast, May 13, 2021. Cricut assumes no obligation to update any forward-looking projections that may be made in today's release or call. I will now turn the call over to Ashish to begin.

Thank you, Jessie. Welcome to our first earnings call as a public company. I want to start off by thanking all those that have supported us over the years, our passionate community of users around the world, my special thanks to the Perot family and their investment organization, Petrus Asset Management, for their early investment and continued support, and most importantly our entire Cricut team for their hard work and continued dedication to our mission and our culture. In March, we completed our IPO, and I want to welcome our new shareholders. We look forward to sharing our journey with you as we continue to grow and fulfill our mission to help people lead creative lives. While the IPO will help support growth across multiple strategic initiatives, we will continue to be very disciplined in our investment approach. We have had a long history of delivering solid growth. In 2020, in addition to COVID, we saw growth because of international expansion, the introduction of the Cricut Joy product family. Cricut Joy helped us expand our retail footprint, acquire more beginner users, and broaden our penetration. I’d like to start by sharing a few highlights from the quarter, and then I am going to spend a few minutes talking about the power of our platform and business model, our passionate community, as well as our growth drivers going forward. Q1 was a continuation of growth in 2020 as we acquired new users efficiently and drove engagement. Revenue in the first quarter was $324 million, or 125% growth over Q1 of last year putting us at a trailing 12-month run rate in excess of $1 billion. EBITDA was $68.6 million in the first quarter, a 232% increase over the first quarter of last year. We experienced a significant increase in user growth in the first quarter, growing 76% year-over-year, bringing our total users to just under 5 million, all this while we faced connected machine shortages. For the large influx of users that we acquired in 2020, we benefitted from monetizing those users with accessories, materials, and subscriptions. User acquisition is just the start of our users’ journey with Cricut. Keeping them engaged and creating is one of the important ways we fuel the user acquisition and monetization flywheel. The more users are engaged, the more they are talking about Cricut and sharing projects with friends and family. As of the end of Q1 2021, 62% of our users created with their Cricut machines over the trailing 90-day period, up from 60% in Q1 2020. As our users create with their connected machines, we have an opportunity to drive revenues across our accessories and materials as well as subscriptions that are recurring in nature. Ending paid subscribers grew 118% year-over-year. Let me talk about the platform. We have built a platform of software and products that accompany a user from inspiration to a finished project. We define our platform to include our highly versatile connected machines, design apps to discover and create projects, as well as hundreds of different types of accessories and materials that are designed to seamlessly work across our connected machines. For those new to the Cricut story, let me reinforce some of the key trends that shape our business and a typical user journey. We are benefitting from major long-term secular trends that include personalization, digitization of tools, technology enabling a new generation of entrepreneurs, and proliferation of social media. Our user journey typically starts with the purchase of one of our connected machines. From the time the user opens the box, registers on our platform, and makes their first project, design plays a key role in that journey. Our goal is to wow our users at every touchpoint. Every user gets free design apps on PC, Mac, iOS, and Android, and because we are cloud-based, a user can start a project on one device and pick it up on another. Users can access a selection of images, fonts, and ready-to-make projects, some free and some for purchase, as well as upload their own images. We have two subscription offerings; Cricut Access and Cricut Access Premium. Through these subscriptions, users get access to our content library of over 140,000 images as well as discounts on Cricut.com and priority Member Care. As of the end of Q1 2021, nearly 33% of our users were subscribed to Cricut Access. Our platform offers several community features which allow users to follow each other in the Cricut community, share projects, and create projects that other users have shared. The data from our users’ contributions on the platform gives us valuable insights into their preferences and behaviors. Many of our users share a love of our brand, products, and our mission. Our users are passionate about sharing Cricut tips, tricks, personal stories, and more. All of this helps foster a loyal community of users who are deeply engaged with Cricut. Our community creates a reinforcing network effect. As the number of our users grow, so does the number of projects made and shared physically or digitally. This generates even more shared projects and word-of-mouth that in turn helps to grow our community. This community network effect has allowed us to efficiently acquire new users and drive sales by word-of-mouth referrals, complemented by our targeted sales and marketing efforts. We have over 5 million followers across relevant social media platforms. I encourage you all to visit our social media pages where we regularly showcase the creativity of our users. We also have over 2 billion views on hashtag Cricut on TikTok, which are almost entirely organic. We also have a deep focus on creating a diverse community of users and improving the breadth and depth of content we offer. We are constantly offering new styles, genres, seasonal content, and content that supports causes, all with the goal of inspiring creative needs. For example, in February, during Black History Month, we celebrated creators within our community and shared some of our favorite projects. We also plan to further expand the content in Design Space to reflect the interests of our diverse community. Finally, 29% of our users use their machines to create projects to sell, and many have created their own businesses. We believe we have a huge opportunity to continue to scale our user base. We measure our opportunity in terms of a serviceable addressable market, or SAM. Our SAM includes active creatives who have created at least one project in the last 12 months in categories that we already address with our existing product portfolio. We estimate that our SAM in the U.S. and Canada is roughly 85 million individuals. Combined with our international opportunity in our four top international markets alone, Australia, France, Germany, and the UK, our total SAM is about 130 million individuals. With a user base of approximately five million, we have penetrated less than 4% of our SAM. As we continue to grow and become more mainstream, the opportunity to expand beyond our SAM is significant. Fundamentally, we believe that everyone is innately creative and anyone can be a part of the Cricut community. As we make new products and expand our reach, we believe there is even greater opportunity for creatives and potential creatives anywhere to join the Cricut platform. We also believe there is a significant opportunity for Cricut to grow internationally. We began our international expansion by launching in Australia, Canada, France, Germany, and the United Kingdom. We have also localized our design apps in several languages such as French, German, Portuguese, and Spanish. We will continue to pursue a disciplined international expansion by targeting countries with large populations of active creatives where we believe the Cricut value proposition will resonate. International revenue grew 253% in the first quarter. We believe that the trends that helped drive user acquisition and growth in North America are truly global in nature. In addition, we are seeing similar network effects and a passionate community of users in each of the markets we have launched. In the future, we expect to expand into new emerging markets strategically to continue to drive growth. Our cloud-based software enables us to update the functionality and features of existing physical and digital products and to release new products that seamlessly integrate with our platform. Our platform is extensible, allowing for innovation and growth from new products, tools, and accessories, increased content, and greater functionality available through our software and apps. For example, in Q1, we launched the Cricut Mug Press, a machine accessory that allows our users to easily create professional-looking, personalized mugs for personal use, for gifting, and for selling. Users can now get peel-proof, dishwasher-safe results with our Infusible Ink materials. As part of this launch, we added new designs in our library for mugs and coupled that with new software capabilities, infusible ink transfer sheets, and infusible ink compatible mug blanks. These mugs are designed with a special coating that makes it possible for the infusible ink transfers. They can also use our infusible ink pens to make customized mugs that have handwritten notes and drawings on these mugs. The Mug Press launch is a great example of the extensibility of our platform. Our users are being inspired with new mugs and gift ideas every time they use our apps and cloud-based software. It has been amazing to see our users’ creativity not only in the mugs they are making but also in the occasions and friends they are making gifts for. We have been pleased with sales so far. We spend a lot of time listening to our users, adding greater functionality to our software, and improving the user experience. We added some great educational tutorials and step-by-step 'how-tos' built right inside Design Space to increase ease of use and help drive engagement. We also enhanced our search functionality, added project collections to help users organize their creative work, and launched the highly requested Offset feature which allows users to add decorative outlines and shadowing to shapes, text, or groups of images to make their designs pop. Software is core to our platform and you will see us continue to invest in this area going forward. We have a proven ability to drive profitable growth which we believe positions us well to keep innovating and delivering great experiences for our users over the long term. I’m extremely humbled by what our teams have been able to accomplish and how we’ve been able to enrich the lives of so many community users over the years. With continued strong demand, we enter the second quarter with positive momentum. Although we are taking a judicious approach to the medium-term, we are very long-term focused on executing well and continuing to build our platform and enriching our community. I’ll now turn the call over to Marty for more details on the financials.

Thank you, Ashish, and good afternoon, everyone. It’s good to be here today on our first public earnings call. Before we move into the detailed financial results, I want to touch on the strength of our business model which has been the engine of our rapid growth. Cricut has a proven track record of strong revenue growth and demonstrated profitability stretching back to 2014. Our sales are diversified across categories and give us revenue streams that are largely predictable. As Ashish discussed, the user journey generally starts with the purchase of a Connected Machine. The gross profit from that purchase mostly covers our customer acquisition cost. The purchase then triggers a flywheel of engagement which in turn drives ongoing revenue from subscriptions and accessories and materials. Revenue in the quarter was $324 million, an increase of 125% over Q1 last year, and was the primary driver in delivering significant growth in Net Income and EBITDA. Revenue from Connected Machines grew 148% over Q1 last year. Strong machine sales and new-user acquisition throughout 2020 and Q1 of this year helped drive 141% revenue growth in Subscriptions in the quarter and 102% growth in Accessories and Materials. In terms of geographic breakdown, international revenue growth outpaced growth in North America, increasing 253% in the first quarter over the same quarter in 2020. As a percentage of total revenue, International represented 10.3% in the first quarter, significantly up from 7.4% in all of 2020 and 3.6% in 2019. We anticipate the investments we made in 2020, and ongoing future investments, will continue to expand consumer reach and brand awareness internationally. The Cricut community of users drives healthy engagement on our platform and is one of the keys to building our long-term business with sustainable growth and compelling margins. The way we measure engagement is to look at what percentage of our entire user base is using their machines to create something in a given 90-day period. In the first quarter, engagement remained strong at 62% of our entire user base, up from 60% in Q1 of 2020. Sequentially, it was lower than Q4, which is to be expected, as Q4 is typically our seasonal high quarter in a given year. As we emerge from the COVID environment, we expect that overall engagement will generally be in line with historical levels, though the ways in which our users engage with us may change. For instance, as users begin spending more time outside the home, we may see them doing fewer home improvement projects and turning back to other types of projects like weddings, parties, back-to-school, and t-shirts for family vacations. We also saw higher year-over-year growth in both total users and paid subscribers. We ended the quarter with just under 5 million total users, which represents 76% year-over-year growth. Ending paid subscribers also grew in Q1 to 1.6 million, up 118% over the first quarter of 2020. As engagement remains healthy on our platform, we’re able to monetize that engagement through subscriptions and accessories and materials. We measure that monetization through ARPU in each of those segments. We calculate average revenue per user for subscriptions by dividing total subscription revenue by our entire user base, not just subscribers within that period. ARPU for subscriptions in the first quarter was $9.96, compared to $7.20 in Q1 2020. The increase was driven by an increase in the attached rate of Paid Subscribers to total Users. We calculate ARPU from accessories and materials by dividing that portion of revenue by our average user base for the period. ARPU from accessories and materials in Q1 was $29.45, compared to $25.40 in Q1 2020. This increase was driven by our typical monetization flywheel, and also by the launch of our Mug Press product line in Q1. Accessories and Materials ARPU experiences seasonality patterns similar to our overall business where Q4 is typically our strongest quarter of the year. All three of our product segments experienced increases in gross margin this quarter. Our total gross margin was 37%, up from 31% in the first quarter of 2020. We benefited from lower tariffs associated with moving the bulk of our Connected Machine production from China to Malaysia. As a result, Connected Machine margins returned to levels closer to what we saw in early 2018 prior to the increase in tariffs. Strategically, primary production will remain in Malaysia, with the ability to flex manufacturing capacity in China as needed. In 2020 and in 2021, this strategy proved successful as we were able to increase production in an effort to help meet unusually high demands. Going forward, we expect to continue to incur some tariffs as we leverage production capacity in China to help address continued demand for Connected Machines. In addition, depending upon how the post-COVID environment plays out, we may choose to be more promotional in the second half of the year as demand and supply normalize, which could put pressure on margins. Profitability and a disciplined approach to spending have always been a priority for us. Our cost structure is characterized by three things: efficient Sales and Marketing spend, driven by our strong word-of-mouth adoption and network effects, investing in R&D for growth, and leverage in our fixed costs. Total operating expenses in the first quarter were $55.6 million, an increase over Q1 2020 of $28.2 million. $8.2 million of this increase was a one-time charge related to the corporate reorganization associated with the IPO. As we move into 2021, we will continue to invest carefully in marketing initiatives, including those that support our international business, new products, our platform, our global community, and content, all to support future revenue growth to drive new users and increased engagement. We have always focused on building a long-term, durable business model that allows us to grow the top line, invest for our future, and just as importantly continue to deliver solid profitability. We are pleased to report a ninth consecutive quarter of positive net income. Q1 net income was $49.4 million, up 279% from the same period last year, and diluted earnings per share was $0.24. Note that Cricut did not have a comparable EPS history prior to the reorganization at the time of the IPO. Turning to EBITDA, which includes stock-based compensation expense, we delivered EBITDA of $68.6 million or 21.2% margin in the first quarter, compared to $20.7 million or 14.4% margin in the first quarter 2020. Q1 total stock-based compensation expense was $11.7 million, including $3.5 million in recurring stock-based compensation expense and an $8.2 million one-time charge related to the IPO corporate reorganization. Going forward, we expect stock-based compensation expense to be approximately $11 million per quarter over the next three quarters. Turning now to the balance sheet and liquidity. We ended the quarter with $337 million in cash, cash equivalents, and marketable securities which includes $243 million in proceeds from the IPO. Subsequent to quarter-end, the underwriters exercised a portion of the overallotment option, bringing the approximate total proceeds to $261 million. We also have an untapped credit line of $137 million as of the end of Q1. Cash used in operations for the first quarter was $22 million, reflecting payments for higher levels of inventory as we continue to work to keep up with demand, especially on Connected Machines. As we discussed during our IPO process, we are not providing quantitative guidance at this time. That said, I want to provide some color as we look to the rest of the year. Typically, Q2 is our seasonally low quarter and declined slightly from Q1 in a normal year. While we are only midway through the second quarter, current trends suggest that Q2 revenues will be in a range similar to Q1. As we look to the second half of the year, we maintain a careful view as we navigate several different dynamics related to the pandemic and possible inventory supply challenges that might occur. However, we currently expect to add at least as many new users in the full year 2021 as we did in the full year 2020. Please note that user growth in Q1 typically benefits from the increased number of machines sold in the last few weeks of the preceding Q4 holiday season. And due to typical seasonality, sequentially lower user growth would be expected in Q2, with new user growth picking back up later in the calendar year. It’s also important to remember that we have aggressively and consistently grown the business for many years prior to the pandemic. We have built a durable business model and a passionate and viral community of users that drive our new-user acquisition. We believe the fundamentals, the macro trends, and the behaviors that drove our growth then remain intact. We have made significant progress over the years to reach our long-term targets and we are proud of what we’ve achieved so far. Longer-term, we will continue to invest for growth, drive new user acquisition and engagement, and bring the Cricut ecosystem to millions more around the globe. Our long-term model includes gross margins in the 37% to 38% range and EBITDA margins in the 17% to 20% range. We are committed and focused on the long term, and it is our job to continue to execute the way we always have. With that, we’ll turn it back to the operator for questions.

Thank you. Your first question comes from Rod Hall with Goldman Sachs. Your line is open.

Hey, can I ask a follow-up? The numbers look good, and things are improving into Q2 as well. I wanted to confirm your user growth expectations and your comments on the timing throughout the year. I assume that user growth is stronger than usual at the start of this year due to the lockdown conditions, but I also think it may not be as robust later in the year as you typically anticipate. I'm just unclear about your expectations for user growth in the latter part of the year. That's my first question, and I have another follow-up.

Yes, I want to emphasize something we discussed in my prepared remarks regarding the typical seasonal variation in new user acquisition. We see a significant increase in new users in the first quarter compared to the second quarter, and as the year progresses, new user growth typically accelerates later in the year. We have always anticipated some normalization as we move past the pandemic, and we are pleased that this hasn't occurred so far. I want to reiterate my earlier comments, assuring that we are confident we will at least match last year's new user numbers this year. Last year was exceptional for us, so we expect to see growth beyond that strong performance.

Okay. Thanks.

I just want to add, thanks for the question, really apt. I just wanted to add a bit more color to what Marty said because it kind of gives you the overall flavor of the business. So first, I wanted to remind everyone that while 2020 was a strong year, we've grown at a CAGR of 45% for several years prior to COVID, right. And Marty mentioned that currently we expect to add at least as many new users in 2021 as we did in 2020. What that means is that as we go into the second half of the year, we have a significantly larger number of users than we did going into the second half of 2020, right. And then, so from that we benefit from those users being engaged from ARPU, from subscriptions, accessories, and materials. And, I know we mentioned in our prepared remarks, we talked about some engagement behaviors changing, but many of these behaviors will still remain intact, right. So people still have back to school. In fact, they will be bigger this year. People still crowd for Halloween, Thanksgiving Holidays, people still want to use our products for emotional wellness, right. So in some way I just want to reinforce a few things that we tried to highlight in our prepared remarks. We have a durable business model, so the passion in the vital community of users and our fundamentals and trends remain strong and intact.

I want to add that, as Ashish mentioned, we've seen a significant influx of new users in 2020 and the first quarter of 2021 who are contributing to our average revenue per user. Specifically, we gained one million new users in the latter half of 2020 and another 600,000 in the first quarter of 2021. If we consider additional numbers for the second quarter, we can anticipate that these users, based on our historical data, will continue to generate revenue not just through the latter part of 2021 but for many years to come. This is in addition to the existing user base, contributing to a favorable trend for both the short-term and long-term outlook.

Yeah. Hey, could I ask a follow-up or you guys mind if I…

Sure.

The progression of subscription ARPU has been excellent. Ashish, I know it was one of your strategic goals to continue enhancing that. I recognize that you made some efforts to address this around the IPO. I'm curious about your current plan for the remainder of the year to further increase the value of that subscription. Could you elaborate on that?

Yes, Rod, as you mentioned, subscriptions play a crucial role in our portfolio. We aim to enhance both engagement and the value of our subscriptions. Currently, the value of the subscription is based on content, which is why we've focused on significantly increasing the diversity and breadth of our offerings. Additionally, we have launched several software services exclusively for subscribers. Moving forward, you will see us continue to enrich the overall value of subscriptions by enhancing content, software, and other services. I am genuinely excited about the work our team is doing, and I believe you will see more developments in the future.

Great, okay, thanks a lot guys. Appreciate it.

Thanks, Rod.

And your next question comes from the line of Katy Huberty with Morgan Stanley.

Thank you, good afternoon. It was impressive to see the acceleration in year-on-year growth, even as we start thinking about lapping COVID at the tail end of the March quarter. When I think about the acceleration from 114% growth in December to 125% growth in March, that's about $17 million of incremental revenue. Any color, just generally speaking on what drove that incremental revenue base, was it largely related to the Mug Press launch, are you starting to see retailers build more channel inventory as they prepare for increased traffic in their stores, are there other factors that we should think about that help drive the growth acceleration? And then I have a follow-up.

Yes, Katy, you identified two key points. One is the restocking of machines. We are improving our inventory and supply issues with machines. What you are seeing specifically in machines is the replenishment of channel inventories and strong demand from Q1 that has continued from 2020. Additionally, our Mug Press and the entire Easy Press line are performing well, with growth outpacing that segment overall. Subscriptions are also a factor; our average revenue per user has risen due to a higher rate of subscribers among users. Therefore, all three of our segments have played a role in the growth.

And Marty, just a follow-up on that. How many more quarters do you think it would take you to get to the appropriate channel inventory levels and catch up with some of the backlog in the business? I mean, I appreciate that it depends on what happens with supply, but is it multiple quarters in a normal supply environment to get to normal channel inventory levels, or is it quicker than that?

Yes, that's a difficult question to answer because there are several aspects to consider. One is demand and where that may go in the second half of the year and beyond. More importantly, it's about the supply chain, which is affected by various factors. There are logistical challenges including constraints on shipping, containers, commodities, and other components. Therefore, it is challenging to predict when we will be in a comfortable position with our machine inventory. Many of these supply chain constraints are likely to persist in some form through the end of the year. We have taken several steps to mitigate these challenges as much as possible. We should monitor the situation at least through year-end to see some improvement. On the materials and accessories side, we have returned to a relatively comfortable position, but the machine segment is where we currently face more supply constraints.

Okay. Helpful...

Katy, I'll just add a comment, I think, very consistent as Marty said. We're definitely better in the Q2 and the rest of the year timeframe than we were in Q4 and Q1 last year. But I think the challenges that Marty has highlighted continue to exist, but I think we're definitely in a better position today and for the next few months and quarters than we were three or six months ago.

Okay. And then, Ashish, if I can just ask you a follow-up. You're not providing quantitative guidance because it's hard to know how the world normalizes post the pandemic, and that is a big investor debate across all consumer stocks that saw a boost in their business as consumer behavior changed last year. Can you just talk at a high level, what metrics are you as CEO and the management team tracking to understand how your business might evolve and what are some of the leading indicators that we should think about that helps us understand early what the normal run rate of this business overall and the consumer behavior will be within your user base?

I want to begin by emphasizing our focus on estimating market size accurately. We continuously analyze how to penetrate our serviceable addressable market and total addressable market further. We identify macro-level trends as leading indicators, including seasonality and whether these trends are becoming mainstream. For instance, trends like personalization, social media, and the rise of prosumers serve as key indicators for us to ensure our business assumptions remain valid. In terms of specific metrics, net new user growth is significant, as is user engagement. User engagement is a critical driver of our growth, enhancing both average revenue per user and generating positive word of mouth. As users create more projects, they are likely to share their experiences, both online and offline. Maintaining high engagement is essential for us, and we believe that if we can achieve that, we will remain in a solid position.

Thank you, congrats on the strong quarter.

Thank you, Katy.

Your next question comes from the line of James Suva with Citigroup.

Thank you. And congratulations on your results and the qualitative outlook that you gave about subscribers. Following up on some of the earlier questions about as the year progresses, I've been trying to buy some of the product online for my wife and stuff like that, and it continues to be sold out, which is a good situation of demand exceeding supply. It sounds like you've mentioned equilibrium and supply, did you say by the end of this calendar year, and does that account for semiconductor shortages, not for your supplies but for your equipment, and does that include also restocking the channel?

To clarify, my comment about the end of the year was meant to indicate that the situation will likely persist at least through then. I'm not suggesting that we'll have stock restored or return to normal levels by year-end since it's difficult to make that prediction. Many challenges in the supply chain are expected to continue until the year's close. Regarding components, we are experiencing shortages; however, we have taken significant steps to address these issues by securing long-term agreements with manufacturers that will support us through at least the end of the year. Despite shortages observed in other sectors, we still achieved a 148% increase in machine growth in Q1, demonstrating our ability to manufacture machines, although we cannot meet current demand fully.

Great. And then as my follow-up, my wife won't let me take apart her machine to see what's all inside of it, but I do note there's metal and plastic. And in the world, there's been some changes of both metal and plastic costs. Is that going to hurt your margins, or is it just in aggregate, they don't add up to be meaningful enough? But any thoughts about raw materials, not semiconductors, but plastics and metals, cutting knives, tools, all these things that my wife uses? Thank you.

Yes, we are currently observing increases in commodity prices, including sheet metal, resin, glue, and polymers, among others. This trend is mainly due to supply and demand dynamics, and we believe it is temporary. While it may affect our margins in the short term, we expect the supply and demand balance to stabilize in the medium term.

And Jim, I want to add to what Marty said. As you pointed out, there is an increase in commodity costs. I’m proud of our team for broadening our supply chain and bringing in additional contract manufacturers. This will help us mitigate some of those costs through increased competition among our suppliers. We are taking proactive steps to offset these cost increases when they occur.

Thank you so much for the details and clarifications. It's greatly appreciated.

Thank you Jim.

Your next question comes from the line of Adrienne Yih with Barclays.

Good afternoon. I will add my congratulations. It was very nicely done, great start to the year. Ashish, I want to stay on the inventory issue and I guess my question is, what are the forward order books like in the wholesale channel? Are you able to meet that demand, or do you have to kind of push it off a little bit based on the uncertainty? That's my first question. And then my second question for you is what is your go-to-market strategy in a new geography? Do you have customized software, and how much do you prep the market with advertising in a new market? And then I have one for Marty, thank you.

During Q1, we faced inventory constraints, which led us to adjust our promotional strategy since maintaining our usual promotional schedule didn't make sense under the circumstances. As the quarter progressed, our position improved, and looking ahead to Q3 and Q4, we anticipate a balanced supply and demand scenario rather than an oversupply. On the international side, I'm genuinely excited because creativity knows no borders. The factors driving our growth in the U.S. and certain other markets are applicable globally, although some local nuances exist. In certain countries, the retail channels might not be as developed, but there's still a demand we can meet. We've successfully collaborated with mass retailers, electronics stores, and office supply chains to deliver solutions to customers. While our international marketing and sales expenses might increase somewhat, they won’t rise significantly. However, our go-to-market approach remains consistent, focusing on driving user engagement, promoting our products, leveraging digital and social platforms effectively, and building enthusiastic customer interactions. This grassroots strategy not only boosts awareness but also enhances the customer experience, fostering engagement that leads to network effects and word-of-mouth promotion. Thus, both our channel strategy and consumer marketing efforts will continue to adhere to this core framework.

Very helpful. And for Marty, this is a little bit of a loaded question because it's got so many components to it. So far, what I'm hearing on the cost side is that raw materials are going up, but you have new unit breakpoints, which are sort of economies of scale, you're shifting countries of manufacturing. And so I guess my question is, let's just take the 600 basis points of gross margin expansion in the quarter. If you take out the country mix, so how would we think about the IMU or the initial margin on the manufacturing of the product versus perhaps mix shift of higher-margin subscriptions and accessories and materials, and that's why I say the loaded question because there's so much going on in there, so any help there would be super helpful? And maybe one of the easiest ways to start that is when did you shift to Malaysia from China as a full quarter and maybe that will help me give myself a baseline? Thank you.

I will address your last question first regarding our machine production shift. We started this transition in 2019, coinciding with an increase in tariffs on machines in mid-2019. Earlier in 2019, the 10% tariff wasn’t as impactful, but it became more noticeable in the second half of the year. By early 2020, we had largely moved all manufacturing to Malaysia. However, the pandemic caused manufacturing closures in Malaysia and other countries, leading us to shift some production back to China. As a result, we haven't experienced a full quarter without the impact of tariffs because we have been continuing to produce some machines in China to meet strong demand. Therefore, we still haven't had a full quarter outside of China. What was your other question?

Yes, regarding the 600 basis points, let's use that as an example for gross margin year-on-year improvement. How much of that can be attributed to manufacturing costs compared to a shift in the mix towards other categories, such as subscriptions, accessories, and materials?

Yes, most of that was due to tariffs. In Q1 2020, our machines had a gross margin of 9%, and this quarter it's 15%, primarily driven by tariffs. However, subscriptions also contributed, with a full percentage point increase, as they carry a gross margin of around 90%. Overall, the majority of the improvement is tariff-related, along with some reductions in manufacturing costs as we have negotiated better terms with new manufacturers while expanding our supplier base.

I want to add that promotions likely played a role as well. We were more active with promotions in Q4. Generally, there has been an increase in promotional activity. However, in Q1, we were limited, so we reduced our promotions.

Yes, makes sense. Well, best of luck, and I'm glad to hear Q2 is off to a strong start as well.

Thank you, Adrienne.

And your last question comes from the line of Mark Altschwager with Baird.

Good afternoon. Thank you for addressing my question, and congratulations on the quarter and your first call as a public company. To begin, I would like to inquire about engagement. It's great to see that it has increased year-over-year. Can you share any insights on how engagement has evolved during the March, April, and May timeframe? I understand that the metric you report is a 90-day metric, so I am looking for a qualitative understanding of user behavior lately, especially as vaccine distributions have progressed and there is a rise in demand for out-of-home activities. Additionally, what key learnings can you share as we move past lockdowns that will shape your outlook for the rest of the year?

Sure. We are really excited about our engagement, which has remained consistent and even improved compared to last year at this time. This is particularly significant as most of our new users are first-timers, and it usually takes them some time to get familiar with the platform. The fact that engagement has remained strong is very encouraging. We haven't seen much change in engagement types recently, even in the past few weeks and months. Engagement was robust throughout Q1, and we've seen similar patterns as we approached Mother's Day. Looking ahead to the second half of the year and summer, while there's a possibility that some engagement patterns might shift—perhaps with fewer home DIY projects—our platform's versatility means that new events like weddings and trips will generate demand for matching t-shirts. Back-to-school season is also expected to drive significant engagement. We are closely monitoring these patterns and aligning our content programs accordingly. I want to stress that while certain engagement patterns may evolve, many will remain consistent, with festivals, holidays, and gifting still being prominent. We continue to track these trends and adapt our engagement strategies. Additionally, we have made significant investments in our dedicated engagement team, which I believe will help us better understand changes in user behavior and proactively maintain healthy engagement.

Mark, and just one quick comment on a general comment on engagement. Engagement does have some seasonality in it, lots of engagement, particularly in Q4 when people are making things for the holidays, both Thanksgiving and Christmas. And so you do see some seasonality patterns in engagement.

And one final point, Mark, is that because we have a platform and are connected, we can see this engagement in real-time. We not only have programs that are forward planning, but we can also react on a daily or weekly basis. If we notice a downturn, we can analyze what's causing it and implement programs to offset some of that. This is a significant advantage of having a cloud-based platform that allows us to observe this behavior in real-time.

Thank you for the insight. I wanted to follow up on international growth, which has been impressive. Is the 10% of sales level something you anticipate maintaining throughout the year? Additionally, could you provide more details on the factors contributing to this growth, such as new retail relationships compared to sales with existing partners? Are there any significant differences in accessory materials, average revenue per user, and subscription penetration when compared to your domestic markets? Thank you.

Thanks, Mark. Those are good questions. Right now, we are not commenting on the future state of the business or our targets, but we are genuinely excited and learning a lot as we enter these markets. As you saw, 10% of our total revenues in Q1 came from international sources. We are very focused on expanding into more countries. We have launched in the four markets previously mentioned and have now moved into several European countries, including the Nordics, Spain, and Italy, as well as the Middle East and South Africa. We're also building a team in Singapore, Malaysia, and other Asian countries. In some of these markets, we recognize that specialty retail is important, which we consider central to our concentric go-to-market strategy. However, in many countries, we have not had that advantage. Consequently, we have successfully partnered with other retailers, like consumer electronics, office, and mass retailers, to deliver our solutions. Our go-to-market strategy remains unchanged. One difference I would point out is the emergence of prosumers in some international markets. Initially, in North America, we concentrated on the hobby market, but we discovered that 29% of our users were also upselling products intended for our offerings. In several of these new countries, we will approach the market with more focus on small businesses and prosumers and then gradually expand into the hobby market. Overall, we are still in the early stages, have a strong team in place, and this is just the beginning.

Great, thank you. And best of luck.

Hey, thank you Mark.

Excuse me speakers, I'm showing no further questions at this time. You may continue.

I think that's it then. We want to thank everybody for joining us today and we look forward to many more of these calls. Thank you.

Thanks everyone.

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