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Arlo Technologies Could Be A Surprise Win

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About: Arlo Technologies, Inc. (ARLO)
by: Shareholders Unite
Summary

The company has had a very rough time since splitting off from Netgear with increasing losses and the shares down 70% or so.

While the company is still very far from profitability, there are signs things could improve from here based on new products, cost-cutting and an excellent deal with Verisure.

We first have to go through a difficult Q4 where chip shortages is stunting growth.

Since Arlo Technologies (ARLO), the security camera maker, spun off from Netgear, its fortunes have been rather disappointing:

ChartData by YCharts

Needless to say, this has been a tough year for investors:

Consumer electronics in general is a difficult market, and the home security camera market is no exception. However, there are a number of reasons to assume things will get better after Q4.

Turnaround?

We think there are possibilities for a turnaround, based on the following elements:

  • Market growth
  • Innovative products
  • Services
  • Restructuring plan
  • Deal with Verisure

Security camera market

In a way, the disappointing performance of the company is curious, because there is a considerable degree of market growth. From Security Sales & Integration:

IP Security Camera Market Forecast to Be Worth $20B By 2025

The IP security camera market is projected to grow from its current market value of more than $8 billion to over $20 billion by 2025, according to a study by Global Market Insights

Or, from MarketWatch:

The rise in demand for advanced security technologies in industrial facilities to ensure the safety & security of workers is the key factor driving the growth of Global IP Camera Market. Global IP Camera Market is valued at USD 5.2 Million in 2018 and expected to reach USD 18.6 Million by 2025 with the CAGR of 19.8% over the forecast period.

Although one should keep in mind that the home security market, which is the segment in which Arlo operates, is only a fraction of that. From GlobeNewswire:

Market Research Future (MRFR)’s study projects that the global home security camera market is expected to grow leaps and bounds over the forecast period 2017 to 2023. The report further reveals that the global market is set to scale a valuation of USD 1,306.3 Mn towards the end of 2023. Increasing crime rates in developing nations have been prognosticated to accelerate revenue creation for the market participants.

While the market is growing, the main problem for Arlo is competition, SA contributor Edgar Torres argued:

For example, Amazon's Ring and Blink cameras. Also, Google has a camera that competes directly with ARLO named Nest. These three products can readily replace ARLO's offerings, which should be a huge red flag for investors. Unfortunately, we already see a massive slowdown in ARLO's revenues. I believe that this is a direct consequence of ARLO's increasingly intense competition.

While we recognize these competitive pressures and by no means want to belittle them, we're not quite as pessimistic as Torres. The company has new competitive products out, and its service platform has introduced an interesting new source for higher-margin recurring revenues.

Products

Arlo Technologies offers a number of products:

  • Arlo Security Camera, a battery-operated Wi-Fi security camera.
  • Arlo Q and Arlo Q Plus, an indoor wired solution that allow users to monitor their surroundings.
  • Arlo Pro, a battery-operated weather-resistant Wi-Fi camera.
  • Arlo Go, an LTE-enabled wire-free camera that provides untethered mobile monitoring.
  • Arlo Baby, a baby monitor with air quality and temperature sensors, motion and audio detection, and advanced night vision.
  • Arlo Pro 2, a battery-operated weather-resistant Wi-Fi camera with advancements in sound and motion detection.
  • Arlo Security Light, a wire-free lighting product.
  • Arlo Audio Doorbell, a smart audio doorbell solution to pair with Arlo Security Camera or Arlo Security Light products.
  • Arlo Chime, a product that plugs into standard wall outlet and pairs with the Arlo Audio Doorbell to play various ringtones or act as a siren.

But this quarter, the company has introduced two new products that have gathered promising reviews.

Arlo Pro 3

From the earnings deck:

Management listed some of the outstanding features on the Q3CC:

It leverages many of the breakthrough technologies from ultra including an integrated spotlight, color night vision, high dynamic range, and our new modular design in a package featuring 2K resolution video and 160-degree field of view.

In a hyper-competitive market like the home IP market, advantages don't tend to last long, but at least it gives the company a new opportunity to reignite revenue growth. Then, there is the new Arlo Doorbell. From the Q3CC:

The product features an industry leading vertical field of view with a unique one-by-one sensor aspect ratio to see packages on the ground or visitors from head-to-toe solving the biggest complaint users have with existing products on the market. Arlo is also using voice-over-IP technologies to provide a best-in-class audio experience where a doorbell button press results in a phone call on your mobile device providing a high-quality low latency experience.

But perhaps more importantly, both products come with a 3-month free subscription to Arlo Smart, after which some percentage of customers will sign up for a paid subscription.

Arlo Smart

From the earnings deck:

Arlo Smart is really a smart idea, not only to shake up a hyper-competitive market with additional services, but also because the offered services introduce a new business model which is based on software and features higher margins and recurring revenues.

In the cloud, Arlo can add intelligence to its products, enabling these to become smart and recognize people and objects through computer vision and AI.

The Arlo Smart platform has shown an impressive growth in registered users. From the earnings deck:

Only a fraction of these are paying customers, but growth is even more impressive here. From the earnings deck:

Service revenue for Q3 2019 was $11.8 million, up 20.2% over last year. Services gross margin is 41.9%. According to management, there will be further acceleration in the growth of paid subscribers in the first half of 2020.

Restructuring

ChartData by YCharts

These are GAAP figures. Their non-GAAP equivalents aren't quite as bad, but the picture will be clear - like much of the consumer electronics space, margins are quite miserable.

Arlo Technologies is embarking on a restructuring effort in order to shave off some $25 million of its $160 million annual operating expenses (or 15.6%) and get a quarterly run rate of $33-34 million. This is supposed to be complete by Q2 of next year. From the Q3CC:

These savings include but are not limited to reducing outside services, headcount, infrastructure and marketing activities. They also include savings that we will realize based on the Verisure deal. Additionally, we have secured $40 million revolving credit line based on our receivables.

Verisure

The company engaged in a strategic deal with Verisure, a European security solutions provider with 3M customers. This deal comprises of several elements:

  • Arlo sells its European marketing and distribution business for $50 million.
  • Verisure will purchase a minimum of $500 million of Arlo products in the next five years and associated cloud services (on top of the $500 million).

The latter basically guarantees the company much faster growth in its European sales compared to the existing situation, which is a $50 million market for the company growing at a CAGR of roughly 5% a year.

That $500 million minimum product sale through Verisure implies a much more impressive 24% CAGR. The first year (2020) requires some integration work, so the real growth will start the year after, 2021.

This is also likely to boost the company's subscription rates, as all the sold products come with services attached.

Q3 results

From the 10-Q:

The results were actually a bit better than expected, with revenue coming in $4 million higher than expected, although 19.1% lower than Q3 last year. Sequentially, there was a considerable 26.9% growth. Q3 Non-GAAP EPS (-$0.32) beat by $0.05.

We have to say the $107 million operating loss in the first 9 months of the year is pretty ugly and shows the enormous task ahead.

Guidance

Management expects Q4:

  • Revenue: $115-$125 million (last year $122 million)
  • Non-GAAP gross margin: 10.5-13.5%
  • Non-GAAP EPS between -$0.34 and -$0.28

But there is a mishap. The vendor for the chips of the Arlo Pro 2 is short roughly 100K chips, which is producing a headwind of $15 million in revenues and also some impact on gross margin - not quite what the company needs right now, even if the problem is solved later in the quarter.

Cash

ChartData by YCharts

The cash bleed is actually fairly limited given the huge operational losses. Arlo still has plenty of cash and equivalents ($153.8 million at the end of Q3), and this actually went up $15.9 million due to changes in working capital. But that is, of course, no long-term solution. Here is management on this matter (Q3CC):

Over the last several months, we have worked to increase our liquidity by adopting a restructuring plan to reduce expenses securing a credit facility as well as entering into a strategic partnership with Verisure. These actions combined will increase our cash availability by up to an additional $110 million.

Given the large cash balance, there is little dilution, although the spin-off was only a year ago.

ChartData by YCharts

Valuation

With a market cap of $220 million, sales this year of $368 million and an EV of $66 million, the shares sell for an EV/S of just 0.18. Analyst expect an EPS loss of $1.47 this year, declining to a loss of $0.91 next year despite an encouraging revenue increase to $414.5 million. Apparently, company executives see a bargain here. From FinViz:

Conclusion

While Arlo Technologies has a market-leading share in the US and its products are generally well-received, it has a history of substantial losses that are not likely to disappear anytime soon.

There are encouraging signs - there is market growth, the company is shaving 15%+ of operational cost, it has introduced two new products that are well-received, and it executed a deal with Verisure that will materially increase sales in Europe and probably also boost subscription rates. The latter are growing well, and the profile of that business is much better compared to the product metrics. The company has still plenty of cash and no debt, but investors need to realize that the losses are really substantial.

The best investors can hope for is that the losses will diminish, and we see a good chance of this happening. This might actually lift the shares quite a bit. Despite the encouraging developments, there are no guarantees that Arlo can turn a profit anytime soon, or even at all.

The shares are at support level, and we think they could bounce from here on improvements in 2020, although we first have to go through a tough Q4.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.