Up front, I got Arlo Technologies (ARLO) completely wrong. The business was part of my bull case for former parent NETGEAR (NTGR) back in 2017, and I still own ARLO shares received in the spin-off executed at the end of 2018. I liked the story here, and what I thought was the undercovered (and undervalued) story of Arlo was both part of the bull case for NTGR pre-spin and the reason I held on as shares started sinking steadily soon after the company's August IPO.
Even ahead of the IPO, I made the classic investment mistake (human mistake?) of making the facts fit the narrative, and not the other way around. In my update in early August 2018, heading into the Arlo IPO, I identified key concerns about the margin impacts of higher-than-expected duplicative costs, and potentially decelerating growth at Arlo - yet essentially ignored those concerns. More warning signs followed: disappointing pricing for the IPO, margin concerns coming out of the Q3 report in October, a Q4 guidance cut in December. The market caught on, as ARLO kept falling into this week's Q4 release:
Self-flagellation aside, the point is that there were plenty of reasons to be cautious of (or short) ARLO heading into this week. Even in that context, however, Tuesday's Q4 report was stunning. And it raises questions not just about the ARLO share price - but about the viability of the business itself. The near-term worst-case scenario has played out - and played out quickly. And it makes the ultimate worst-case scenario - a bankruptcy - a very real possibility.
The Numbers Become Terrifying
Results for the fourth quarter itself were pretty much in line with updated guidance. It's the outlook for Q1 that led to the 49% decline in trading Wednesday - and with good reason, as the guidance is disastrous. Most notably, first quarter revenue is expected to come in at $48 to $52 million - against the pre-release consensus of $126.5 million. That's roughly 60% miss (sixty percent!).
I've seen a few commenters here argue that the analysts bear some responsibility for the divergence as well, and that may be true. But whatever the consensus numbers 'should' have been, the shortfall relative to any reasonable expectations (including those of management) is staggering. Expectations aside, look at the trajectory of Arlo's year-over-year growth, using revenue figures from the Q4 earnings presentation:
Source: author from ARLO data; Q1 at the midpoint of guidance
It's a stunning reversal. And, again, it threatens Arlo's very viability. The collapsing sales have a huge impact on margins. Per the Q4 release, non-GAAP EBIT margins in 2017 were positive 4.3%. Arlo was breakeven on that line (again, on an adjusted basis), through the first nine months of 2018, due in part to higher spending on opex and promotions. But as revenue growth stalled out, margins collapsed: non-GAAP operating margin in Q4 was -19.4%, and the midpoint of full-year 2019 guidance suggests a -25% print next year.
The plunge on Wednesday is not a case of the market overreacting or scrambling to price in some sort of out-year risk. The numbers at this point already are terrifying. Arlo closed the year with $201 million in cash and investments on the balance sheet and no debt. But CFO Christine Gorjanc estimated on the Q4 call that cash burn next year would be non-GAAP operating loss plus $4 million or so (the difference between estimated capex and D&A).
Based on guidance, Arlo expects to burn $99-$109 million next year - in the range of half its year-end cash. And while Q1 guidance, in particular, is being hit by overbuilt inventory at retailers following disappointing holiday sales (more on this later), it's not as if top-line weakness is a one-time problem. The midpoint of guidance for Q1 and the full year suggest sales in the last three quarters in total will decline as well - by about 5.7%.
Fundamentally, then, the concerns are valid - and actually rather obvious. This is a business with margins of -20% and declining sales that is going to burn ~half its cash pile this year if it meets guidance. Any investor (myself included) even considering buying or owning this stock needs to understand that uncomfortable truth.
The GoPro/Fitbit Problem
Exactly a year ago, Fortune contributor Aaron Pressman cast doubt on the planned spin of Arlo, comparing the company unfavorably to hardware plays Fitbit (FIT) and GoPro (GPRO). Heading into 2019, ARLO looks like an accelerated version of those stocks, with heady growth followed by quick reversals to declining revenue:
That's obviously not a good thing for ARLO. And even below $4, those comparisons are problematic for two key reasons. First, both Fitbit and GoPro - like Arlo management on its Q4 call - argued that their initial revenue declines around the holiday season were driven at least in part by inventory build at retailers that eventually would be worked through. And both companies were at least to some degree overly optimistic.
Indeed, it's remarkable how similar Arlo's Q4 2018 is to GoPro's Q4 2015. Both companies cut Q4 guidance ahead of the release. GoPro then guided for Q1 2016 revenue of $160-$180 million against a $298 million consensus, a miss similar in scale (though not quite as stark) to Arlo's Q1 outlook. On the GPRO Q4 2015 call, CFO Jack Lazar said that Q1 would require an "adjustment" in channel inventory, but that GoPro would "see increased sell-through as the year progresses on". That's not how it played out: full-year 2016 revenue would come in at $1.19 billion, well below initial guidance of $1.35-$1.55 billion. GPRO stock hasn't really stopped falling since, touching an all-time low in December.
Fitbit saw the same problem a year later - and said roughly the same thing. Higher-than-expected inventory at retailers led to weak first-half 2017 guidance, per the Q4 2016 call. That company, too, though it would work through the issues. CEO James Park said on that call that "by the time we get through the first half, we've got everything rebalanced and that is behind us," which led the company to forecast stronger results in Q3 and Q4. Fitbit actually did meet its initial guidance for 2017 in terms of revenue and adjusted gross margin, and 2H numbers were better on a relative basis. But it took until Q3 2018 for the company to again post year-over-year revenue growth. FIT, too, touched an all-time low late last year.
That history colors the argument that Arlo simply had a blip in Q1 which can be worked through, after which growth naturally will resume. GPRO and FIT bulls no doubt made the same case. And that leads to the second problem: Arlo really can't afford to take the same trajectory. Fitbit, after all, still has a mountain of cash (over $600 million at the end of Q3, a figure which likely will rise by year-end). GPRO actually is in sight of a point where cash could become a concern, with post-Q3 cash of $148 million and trailing TTM FCF of -$45 million or so (and convertible debt on the balance sheet). But near-term solvency isn't an issue there, either.
For Arlo, however, a path similar to that of GoPro and Fitbit probably isn't good enough. The company is aiming to end 2019 with ~$100 million in cash. Something close to stabilization in 2020 in terms of revenue, even assuming some level of opex cuts and gross margin improvement (in part due to the comparison against Q1 2019 GM of just 0-3%) means the company easily could use up another half of that remaining balance next year, at which point investors can legitimately wonder about the ability to build inventory for the ensuing holiday season. There is very little room for error over the next 24 months.
But external options look limited. Raising debt after Q4 seems unlikely. Arlo maybe could secure a revolver backed by inventory ($125 million at year end), but that's far from guaranteed given that a restructuring (and the possibly associated inability to service the 'cloud' portion of the product) would significantly undercut the value of the collateral. Equity sales would be difficult at this point and might require a rights offering (along with dilution and likely further pressure on ARLO shares). Gorjanc demurred on the Q4 call when asked about the tax implications of a sale of the company, but it seems highly likely that Arlo needs to stay independent for two years to maintain the tax-free status of the spinoff. That means Arlo can't sell itself before the end of 2020 - at which point the cash crunch might be obvious.
The fundamental problem here is that Arlo needs to jumpstart growth relatively quickly - basically no later than Q1 2020. The qualitative problem is that the recent history of similar single-product hardware companies suggests that feat will be difficult to accomplish. That's a dicey combination, to say the least.
The Path Out and Valuation
Meanwhile, even ignoring peers, the path to growth for Arlo looks potentially troublesome. It was the delayed launch of the Arlo Ultra that was supposedly responsible for the Q4 revenue guidance cut; reports came on Thursday that the product was being pulled from shelves amid myriad issues.
Subscription growth is supposed to boost revenue and profits - but so far, it's still a small piece of the overall business. Per figures from the Q4 call, just 5% of registered users are subscribers. Service revenue for the year, based on numbers from the 10-Q and the call, totaled just $38 million - and some of that revenue is booked in conjunction with product sales.
Arlo is launching a security system in the second half, which could drive growth. Gorjanc projected a "meaningful contribution from our new product introductions" in Q3 and Q4. But she also guided for "modest" y/y growth in those quarters - which suggests that Arlo already believes that legacy product revenue will continue to decline in the back half of the year. And the issues with the Ultra potentially undercut one of the drivers for that growth - and perhaps represent an early roadblock toward meeting 2019 guidance.
From a high level, there's still an intriguing case here. Enterprise value is under $200 million, putting EV/revenue at 0.5x. That's a discount to both GPRO and FIT, and well below commercial valuations of 2x+ for Avigilon (acquired by Motorola Solutions (MSI) last year) and Axis Communications AB (before that stock was delisted). Per figures cited on the call, Arlo still has a category-leading market share at 41% and the market, on the whole, grew 16% in 2018. And while competition is intense, we do know at least that Logitech (LOGI), whose Smart Home revenue fell 49% y/y in its fiscal Q3 (December quarter), has fallen away.
Still, this story here looks an awful lot like that of GPRO and FIT - and that's concerning, if not downright terrifying. And, again, unlike those hardware plays, Arlo doesn't have the same amount of time for a turnaround, nor does it have the potential for a sale (or for rumors to spike the stock). The issues with Ultra add another negative layer to the story, and the launch of the security system into a crowded space is going to require capital behind it that Arlo may not be able to afford.
This is a company in serious trouble at the moment. And I'm not sure what the answer is. Arlo needs to jumpstart growth - or else it very likely goes bankrupt. It's pretty much impossible to cut enough costs to turn a -20% EBIT margin positive. But the growth in the category is decelerating, Arlo already has a decent share, and there's not much reason for near-term optimism toward the newer efforts and/or the growth in subscription revenue.
Again, I got this story wrong - and it's certainly possible I'm doing so again. But the outlook for 2019 suggests a company already backed into a corner. It's going to take a lot of work, and a lot of time, for Arlo to make its way out. It may not be able to do so before it's too late.
Disclosure: I am/we are long ARLO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I will likely exit my position on Friday or next week.