Arlo Technologies (NYSE:ARLO) has proven to be nothing but a disappointment for investors ever since the company has been spun-off from former parent company Netgear (NTGR). In August, I wondered if Arlo offered security solutions at a safe price, as I concluded to remain cautious despite cheap sales multiples in relation to its growth, on the back of real concerns about margins.
The main reason why I was interested in Arlo at the time was the potential arbitrage opportunity which presented itself between Arlo and Netgear, as that spread never became compelling enough to initiate a position in the spread. I am glad that I have passed on this "opportunity" as recent quarterly results, and notably the 2019 outlook are nothing short of a real disaster. The lack of insight and realistic guidance by management so "early" following the spin-off, and a very competitive and difficult marketplace make this a rather easy avoid for me. This comes despite the rock-bottom valuation and relatively large net cash balances, as the extent of the problems is simply very large.
Arlo - The Business
Arlo is a hardware producer which combines cloud infrastructure with its mobile app in order to create connected devices for consumers and businesses. These clients use Arlo's devices and solutions to protect people and property which they care about. Typical applications include cameras, security cameras, monitors and security lights, among other other applications.
After being launched in 2014, Arlo has rapidly shipped millions of devices and in fact millions of users have registered themselves across the globe. With costs of Wi-Fi systems and RF connectivity being cheap and constantly available, the solutions of Arlo come at low costs, as compatibility makes it an easy solution for consumers as well.
The Old Thesis
The spin-off of Arlo took place through an IPO in which 10.2 million shares were sold at $16 per share, quite a bit below the preliminary pricing range of $18-$20 per share. These shares were issued by Arlo which thus raised $163 million in gross proceeds, as Netgear held 62.5 million shares in Arlo at the time, for exactly a billion-dollar market value at the offer price. Of the money raised in the offering, former parent Netgear contributed $70 million to Arlo as well, creating a comfortable cash balance.
Despite the soft pricing in the offering, Arlo's shares rose from $16 to $20 per share, as the equity valuation of Arlo rose to $1.45 billion. Accounting for $220 million in net cash, operating assets were valued at $1.2 billion at the time.
So what was this valuation based on? Part of Netgear, Arlo has doubled sales in 2017 to $370 million, yet despite the spectacular growth, the company was just marginally profitable with an operating profit of $6 million. Nonetheless, this modest profit looked compelling compared to an operating loss of $13 million reported in 2016.
At the time of the IPO, growth still looked solid, but was slowing down. First quarter sales for 2018 rose by 63% to $100 million, as second quarter sales were seen at $107-$112 million, implying sales growth of 38%. Worrisome is that the company guided for second quarter losses due to the separation from Netgear, as real costs will be incurred in setting up the own business infrastructure. Nonetheless, sales multiples looked compelling given my estimate of 35% sales growth in 2018, as I believed that sales could hit the half a billion mark, for a relatively modest 2.4 times sales multiple.
The combination of a modest sales multiple and rapid growth made that I was interested in the company, although margins are very low due to competition from many high-profile companies, including Foxconn (OTCPK:FXCOF) and Samsung (OTCPK:SSNLF), among many others, with arguably a lot of advantages over Arlo.
About The Results, Ever Since The IPO
After the IPO, the company released third quarter results at the end of October. Revenue growth slowed down to 25% to $131 million as the company reported a $13.4 million operating loss. Even after adjusting for a $5.8 million separation expense, the company was losing quite a bit of money, as investors were not happy with the results as well, with shares falling towards $12 at the time.
For the fourth quarter, the company guided for sales of $140-$155 million on which the company was expected to report operating losses between 15% and 18% of sales. The real bombshell came early February as the company announced that fourth quarter sales did increase by just 3% to $129.3 million as Arlo reported an operating loss of $32.5 million, including a modest $3.6 million separation expense.
If that was not enough, the results were accompanied by a terrible outlook. First quarter sales are seen at just $48-$52 million, as the company sees GAAP losses of $0.61 per share, plus or minus two cents. With a share count of 74 million shares that suggests net losses of $45 million, almost equal to the sales rate.
For the year, the company sees sales at $380-$420 million, an 11-20% decline on an annual basis. GAAP losses are seen at $119-$129 million, a huge loss by all means. Having plunged to $3.70 per share, with 74 million shares outstanding, the market value of the business has plunged to $274 million. This stands in sharp contrast, as the business was awarded a $1.4 billion valuation at the time of the spin-off/IPO.
The current market valuation should furthermore be seen in relation to a cash position of $201 million, or a net cash position of $181 million after accounting for some lease obligations. This makes that operating assets are valued at less than hundred million, down from $1.2 billion at the time of the IPO! The reason for that is simple and that it's the utterly disappointing financial performance both in terms of sales, but certainly in relation to losses, and a terrible outlook.
What Went Wrong?
The company attributes the slowdown in growth and margin pressure on a general market slowdown by the end of 2018 which caused a real channel inventory buildup to take place and thus required a "reset," as seen in the first quarter guidance.
While the very soft Q1 results suggest that sales growth in the remainder of the year might be flattish or perhaps show modest growth again, the real concern is that of course management has no credibility at all given the fact that it has seen two devastating quarters coming out of the spin-off process.
Reality is that I see no triggers, despite the very low valuation of the shares and operating assets at this point in time, as revenue and margin trends remain dismal. Thus, I continue to watch the trends unfold with great interest throughout 2019, but I am not inclined to pick up any shares at this point in time.
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