Arlo: A Growth Stock Underappreciated By The Investment Community

Summary

• Arlo’s new business model is transforming the company into a SaaS business with 50%+ service gross margins expected in 2021.
• Based on management guidance of 1M+ paying subscriber accounts by the Q4 2021 earnings call, Arlo is on track for break-even (sustained profitability) in the Q4 2022–Q2 2023 range.
• The stock may be underappreciated as comparative analysis to sector and industry average TTM P/Es implies a potential 94% to 272% return by end of 2025.

​Introduction

Arlo Technologies (ARLO) is a compelling DIY security spin-off and growth investment opportunity in an expanding and modernizing safety and security industry. The company reported Q4 2020 earnings on 23-Feb-2021 with GAAP EPS of -$0.19 beating by $0.10 and revenue of $114.8M (-6.2% YoY) beating by $3.23M.

The most significant development was management substantiation of the success of the new business model, as evidenced by 3 quarters of results and accelerating total paid accounts reaching 435,000, representing 89% YoY growth. Arlo’s CEO and CFO confidently guided for 1M paying subscriber accounts by the Q4 2021 earnings call. The implications of this milestone, if achieved, are profound for both the company and the investment community.

Source: Arlo’s Q4 2020 Earnings Call Presentation

New Business Model

Arlo’s shift to and focus on paid subscriber accounts yields much appreciated visibility to recurring software revenues. On the Q4 2020 earnings call, Arlo’s management guided for $400M in revenue for fiscal year 2021, with $300M in product sales with mid-teen digit product gross margins and $100M in software revenue with 50%+ services gross margins. In order to reach the 1M paying subscriber accounts milestone by the Q4 2021 earnings call, the company would need to see an addition of 565K accounts throughout 2021, with most of the accounts likely being gained in Q3 & Q4 2021 due to seasonality.

Prudently, Arlo already has 5.05M registered accounts (only 425K are currently paid subscriber accounts), and as such the quarterly rate of 141K added paying accounts appears sustainable beyond 2021. Per the earnings call, there is a 50% conversion rate after the initial 90 day free trial expires, and for cohorts followed over a 6-month period, this conversion rate reaches 65%. This provides the company with plenty of opportunities to capture subscribers from both new purchasers of Arlo’s cameras or from existing non-paying registered users that may be seduced by improving software platform functionality and the Arlo ecosystem.

Source: Arlo’s Q4 2020 Earnings Call Presentation

Extrapolating Arlo’s paid subscriber account growth until end of 2025 demonstrates the underlying strength and impressive growth profile for the company. By the end of 2025, Arlo may reach 3.26M paid subscriber accounts, registering $577M in software revenue.

Source: Author’s Calculations

Source: Author’s Calculations

More importantly, Arlo’s software gross margin expansion over the coming years to a projected 59%+ will continue driving total gross margins upward to the range of 37% by end of 2025. This is assuming a flat margin for products at 11%, which may likely prove to be a conservative projection.

Source: Author’s Calculations

Break-Even and Sustained Profitability

The implication of continued strong paid subscriber growth is that the company may likely reach break-even in the Q4 2022 to Q2 2023 range. By the end of 2023, product and software revenues may nearly match, and by the end of 2024 software revenue may outpace product revenue at ~54% of total revenue. The reliability of the recurring software sales and the continued growth in the paid subscriber base may allow for profitability to become sustainable in 2023 and onward.

For the purposes of the below model, product revenue was assumed to grow at 10% annually (2021 revenues match management guidance). Total Operating Expenses were scaled based on a 17% ratio of total revenues, with R&D expenses estimated to reach $75M by end of 2025. While management did not provide guidance or color on future OPEX reductions, they did achieve a 10.5% year over year non-GAAP OPEX reduction as of Q4 2020 and SGA cost efficiency will likely remain a closely watched metric for further improvements.

Source: Author's Calculations

Industry and Sector Comparisons to Derive 2025 Share Price Projection

Projected revenues of $1.02B by end of 2025 with a total gross margin of ~37% and operating margin of 12.54% would yield $108.3M and EPS of $1.35, assuming 80M shares outstanding. At the current share price of $6.96, this would imply a projected P/E of 5.14 by end of 2025.

Per Fidelity, Arlo is classified under the Information Technology Sector (P/E of 31.75 for this year’s estimate) and under the Electronic Equipment, Instruments & Components Industry (P/E of 19.12 for this year’s estimate). Per Yahoo Finance, Logi has a TTM P/E of 19.37. While ADT and REZI do not display a P/E, Alarm stock has a TTM P/E of 57.44. FLIR has a TTM P/E of 50.86.

Source: Yahoo Finance

A conservative P/E of 10 would imply a share price of $13.53 by end of 2025, or a 94% return from the current level. Using an industry P/E of 19.12 would imply a potential projected share price of $25.88 by end of 2025, or a 272% return from the current level. Arlo is a product leader in the DYI camera niche and may be able to command such a P/E, especially if it continues to win CES and other product awards in the coming years. You may refer to my previous article, which touches on Arlo’s product leadership, product awards and competitive advantages: Arlo: Insiders Are Buying (NYSE:ARLO).

Conclusion

Arlo’s Q4 2020 earnings call results may be underappreciated by the investment community as the small-cap company is still flying under the radar. Stellar accelerating 89% YoY paid subscriber accounts growth is driving both services revenue and services gross margins upward, and is providing a more reliable way to calculate and to evaluate the company’s growth prospects. With $400M in revenue and 1M paid subscriber accounts to be reached by end of 2021, Arlo will continue its transformation to a SaaS business.

The continued growth in software revenue and margins may allow the company to reach break-even and sustained profitability in Q4 2022 to Q2 2023. If the services revenue growth continues with 141K paid accounts added quarterly, total revenues may reach $1.02B by end of 2025. Arlo’s growth profile appears to not have been fully factored into the share price, and the ongoing market correction provides an incredibly attractive entry-point to interested investors. Industry and sector P/E comparisons would indicate a potential projected share price for Arlo of $13.53 to $25.88 by end of 2025, or 94% to 272% share price appreciation from current levels.

Furthermore, management’s insider ownership continues exhibiting a healthy trend. The CEO now owns 1.55M shares ($10.8M), the CFO owns 772K shares ($5.4M), and the General Counsel owns 417K shares ($2.9M). Sizable insider ownership of company stock is an excellent indicator for a spin-off and a small-cap company and demonstrates management’s commitment to the future success of the business.

Investors, as always, are strongly encouraged to conduct their own research into Arlo before initiating a position. Feedback, questions, and commentary on this article are highly encouraged as Seeking Alpha discussions drive useful insight and cross-learning opportunities across the investment community and may reveal both positive and negative fundamental factors to be taken into account for the stock. Thank you for reading.

Analyst’s 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.