Arlo: Security Solution At A Secure Price?
- Arlo Technologies is a spin-off coming out of Netgear.
- The company reports strong growth, although growth is coming down rapidly.
- I like the modest sales multiple, yet worry about the very modest margins especially if corporate cost allocation is not yet accounted for.
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Arlo Technologies (NYSE:ARLO) went public as a spin-off from Netgear (NTGR), creating a pure play in a rapidly growing segment, although growth is coming down. Concerns of mine include the rapid slowdown in growth, the fact that the company has hardly been profitable despite strong growth, and the fact that the stand-alone business will incur additional costs.
Hence this remains a ¨show me first¨ story, yet I am placing the company on my watchlist, certainly in combination with the relative arbitrage opportunity provided between Arlo and its former mother company.
Arlo combines cloud infrastructure with a mobile app to create connected devices. The solution is about creating seamless connections to help consumers and businesses to protect both people and property they care about the most. Typical applications to think about include (security) cameras, baby monitors and security lights, among others.
Since the launch late in 2014, the company has shipped 7.5 million devices, as the platform now has 1.9 million registered users in over a hundred countries. With Wi-Fi systems and RF connectivity being cheap and constantly being available, solutions provided come at a very low cost. The smart design of cameras and compatibility make it an easy solution for consumers as well.
Note that the company is not a new business; it has been an operating business within Netgear, which is now spinning Arlo out (in part). This brings with it some uncertainties as the fact that the company will become a stand-alone business involves setting up company infrastructure. This makes that the company will incur a non-specified amount of costs as well.
The Offering And Valuation Discussions
Arlo Technologies sold 10.2 million shares at $16 each indicating that demand for this offering was quite disappointing, with the preliminary pricing range being set at $18-$20 per share. Despite the softer pricing, Arlo generated $163 million in gross proceeds in connection to the offering.
Netgear holds another 62.5 million shares in Arlo following the offering, which values equity of the company at $1.16 billion at $16 per share. This implies that the stake of Netgear is worth exactly $1 billion at the offer price; a significant amount given that its business is valued at roughly $2.0 billion (market valuation of the equity). As shares of Arlo quickly jumped to $20 per share, the valuation of Netgear's stake has rapidly risen to $1.25 billion!
Note that Netgear will however make a $70 million contribution to the business as well. That suggests that Arlo is operating with roughly $220 million in net cash following the IPO, making that operating assets are valued at around $940 million at the offer price, or at levels just above the $1.2 billion valuation at around $20 per share.
The company has reported rapid growth being part of Netgear. Revenues doubled in 2017 to $370 million as the company turned an operating loss of $13 million into a near $6 million operating profit, despite incurring more than a million in separation expenses.
Growth continued in the first quarter of 2018. First quarter sales were up by 63% to little over $100 million. If not for $6.5 million in separation expenses, the company reported operating earnings of about a million, comparing to a break-even result in the first quarter of last year.
The company believes that second quarter sales will come in at $107-$112 million, indicating that year-over-year growth has slowed down to roughly 38%. The company is specifically warning that it expects to report losses in Q2 due to the separation, and further losses in the second half of the year given that it has to set up an own business infrastructure. Hence we should not look forward to profits in 2018 or perhaps 2019. Assuming 35% year-over-year growth for all of 2018, revenues come in at roughly $500 million this year. This suggests that operating assets are valued at about 2.5 times sales at $20 per share.
Reasons for the modest sales multiple is that of low margins and stiff competition. Competitors are both more resourceful and plentiful including the big technology names (or their subsidiaries) as well as more traditional names such as Foxconn (OTCPK:FXCOF) and Samsung (OTCPK:SSNLF), among others.
Secure Solutions, But Not So Secure Investment?
I have some scepticism regarding this offering. The unleveraged business trades at roughly 2.5 times sales seen this year, which seems very low given that sales doubled in 2017. Note however that the pace of growth is slowing down rapidly, as the company is essentially close to breaking-even. Small current profits will however turn into losses following the incorporation of the own infrastructure.
Problematic is that the company will incur quite some costs related to becoming an independent company, following the separation from Netgear. Unfortunately it seems that we only really learn more about the real extent of these additional costs, and the pace of current growth following the release of the results in the quarters to come. While lack of earnings during these boom times might be concerning, revenue multiples seem relatively modest given the (past) growth rates reported by the business.
Hence I will certainly keep the company on my radar, as well as "mother" company Netgear. After all, the fact that the former subsidiary is now publicly valued just like Netgear, makes that relative arbitrage in terms of holding a long position in Netgear following a successful IPO of Arlo looks appealing.
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