Arlo Technologies, Inc. (NYSE:ARLO) Q1 2021 Earnings Conference Call May 5, 2021 5:00 PM ET
Erik Bylin - Investor Relations
Matt McRae - Chief Executive Officer
Gordon Mattingly - Chief Financial Officer
Conference Call Participants
Catherine Huntley - Raymond James
Jeffrey Rand - Deutsche Bank
Thomas Boyes - Cowen and Company
Ladies and gentlemen, thank you for standing by. [Operator Instructions] I would now like to turn the conference over to Erik Bylin. Please go ahead, sir.
Thank you, operator. Good afternoon and welcome to Arlo Technologies' first quarter of 2021 financial results conference call. Joining us from the company are Mr. Matthew McRae, CEO; and Mr. Gordon Mattingly, CFO. The format of the call will start with an introduction and commentary in the business provided by Matt, followed by a review of the financials for the first quarter, along with guidance, provided by Gordon. We'll then have time for any questions. If you have not received a copy of today's press release, please visit Arlo's investor relations website at investor.arlo.com.
Before we begin the formal remarks, we advise you that today's conference call contains forward-looking statements. Forward-looking statements include statements regarding expected revenue, gross margins, operating margins, tax rates, expenses, future cash outlook, our partnership with Verisure, continued new product and service differentiation, future business outlook, and the impact of COVID-19 pandemic on our business and operations. Actual results or trends could differ materially from those contemplated by these forward-looking statements. For more information, please refer to the risk factors discussed in Arlo's periodic filings with the SEC, including the most recent annual report on Form 10-K.
Any forward-looking statements that we make on this call are based on assumptions as of today, and Arlo undertakes no obligation to update these statements as a result of new information or future events. In addition, several non-GAAP financial measures will be mentioned on this call. A reconciliation of the GAAP to non-GAAP measures can be found on today's press release on our investor relations website.
And at this time, I would now like to turn the call over to Matt.
Thank you, Eric, and thank you, everyone, for joining us today on Arlo's first-quarter 2021 earnings call. In my past commentary, I mentioned that Arlo is not the same company it was a year ago. And clearly, our Q1 results put an explanation point on that statement. Revenue is up 26% year over year.
Service revenue is up 55% year over year. Paid accounts are up 115% year over year, and non-GAAP gross margin is up an incredible 336% year over year, reaching an all-time high for Arlo. Diving a bit deeper into our Q1 results, revenue came in above the top end of our guidance at $82.6 million, and our strong operational discipline lowered non-GAAP operating expenses by nearly $2.5 million year over year. Q1 marked the seventh consecutive quarter of record services revenue at $22.8 million.
This drove non-GAAP gross margin of nearly 10% sequentially, again, to reach an all-time record for the company. This performance, coupled with our commitment to maintaining leverage, led to a soundly outperforming the high end of our guidance for non-GAAP net loss per share, which came in at a loss of just $0.03. And our cash, cash equivalents, and short-term investments balance remained solidly healthy at $177.1 million. Our strategic shift toward services, the success of our new business model, and the resulting momentum are undeniable as we look forward to reaching $100 million in service revenue this year and 1 million paid subscribers by our year-end earnings call after just passing through 500,000 subscribers on March 1.
We anticipate our trajectory will have us reach breakeven on a non-GAAP basis in the second half of this year. And with this, will not need to raise additional capital. Our current performance and these near-term milestones demonstrate the profound impact of Arlo's successful transition to a service-first company. In Q1, we had 114,000 paid account additions, which represents an increase of 44% sequentially and 356% year over year.
As a reminder, last year, Arlo carried out a refresh of our product portfolio, phasing out legacy offerings under the old business model in favor of an entirely new suite of products that feature a free 90-day trial of Arlo Smart, our unique and unmatched AI-powered motion identification and security service. Through features like advanced computer vision-based object identification, audio analytics, customizable notification, activity zones, and cloud video storage, we are honored to provide home and business owners with total peace of mind. Arlo Smart is truly a value-add for our customers, leading us to maintain a consistent 50% subscription conversion rate upon expiration of the initial trial period. And as we follow cohorts over a six-month period, we see the attach rate to our subscription services grow toward 65%.
Arlo's newest product, the essential indoor camera, which includes an automatic privacy shutter, represents the final product transition to our new business model and is available now at a suggested retail price of $99.99. It has already been named a winner of the TechRadar Pro, TWICE, and Residential Systems Picks award, honoring the best and most influential customer technology at CES. Over the last quarter, Arlo's engine of innovation also turned to our user experience. We launched version 3.0 of our application for Apple IOS and Google Android devices with a wide collection of new features and improvements.
App and live stream performance are increased up to two times, deep linking from notifications allows faster access to past events. Smarter and richer notifications are now available through Google Home, Amazon Alexa, Samsung SmartThings, and IFTTT ecosystems and video events can be viewed directly on Google Nest Hub. In addition, Arlo 3.0 enables an industry-first animated clip inside of the notification window on iOS and Android, providing a clear indication to the user, what kind of motion-triggered the event in a much better context to determine the threat level. This is the beginning of an innovation cycle from Arlo that will span across our experiences, services, and new segments.
Our current solutions continue to win acclaim across the industry. U.S. News & World Report awarded the Pro series of Best Security Camera of 2021 in multiple categories. Pocket-lint recognized the essential indoor camera as the best indoor security camera.
Our Pro 4 Series won Editor's Choice awards from both PC Magazine and Digital Trends. The Essential Wirefree Doorbell won acclaim from Android Central, the AMBIENT, and beat Google's Nest Doorbell in a head-to-head review posted by review.com. And finally, Arlo was recognized for excellence in design by winning three coveted red.design awards for our Pro 3 Floodlight, Essential Spotlight Camera, and the Essential Wire-free Video Doorbell. I would like to take a moment to thank all of the teams at Arlo for their outstanding work to deliver the world's best and most recognized smart security ecosystem.
We have launched more than 10 products under our new business model, and our innovation has clearly spread across our hardware, as well as our services, all designed to continue to enhance the entire Arlo experience. And our teams have successfully completed a major program with our partner, Verisure, a new camera designed specifically to their needs that will move into production in Q2 for initial rollouts this year and full-volume deployments in 2022. This is a significant milestone in our relationship and will drive future growth in product and service revenue. As a reminder, our strategic engagement with Verisure includes a guaranteed minimum of $500 million of product purchases alone over the five-year term from the start of 2020 and service acceleration through the direct sales channel.
You can see in our quarter results, the traction we are seeing in Europe as Verisure invests across the channels and continues their rollout of the Arlo solution. Our programs and rollouts remain on track in 2021, and we look forward to the full benefit of the relationship in 2022. And now I would like to hand the call over to Gordon, who will provide more insight into our financial performance, operational details, and outlook for the second quarter and full year.
Thank you, Matt, and thank you, everyone, for joining us today. We delivered strong Q1 2021 financial results that exceeded our expectations, recording an all-time high for non-GAAP gross margin, our revenue was above the high end of guidance and up more than 20% over Q1 2020. Our financial performance for the quarter was driven primarily by the successful execution of our new business model, leading to record levels with paid account. The Arlo team navigated supply challenges to exceed our expectations on revenue, while significantly improving our profitability through prudent spend management.
Most notably, we decreased our non-GAAP operating loss by $24.3 million year over year and $3.4 million sequentially despite the normal seasonal product revenue downtick. And now moving on to the Q1 financial detail. Revenue came in at $82.6 million, up 26.1% year over year and down 28.1%, sequentially, due to normal product revenue seasonality. Product revenue for Q1 2021 was $59.8 million, which was up 17.8% compared to last year and down 35.9% sequentially.
Our year-over-year product revenue growth was primarily driven by strength in Europe from our Verisure relationship. Our service revenue for Q1 2021 was a record $22.8 million, up 54.8% over last year and up 5.7%, sequentially, with our new business model fueling our growth. Our service revenue also includes $1.5 million of NRE services we are providing for Verisure, along with associated costs as compared with $2.4 million in the fourth quarter of 2020. During the first quarter, we shipped approximately 597,000 devices, of which approximately 595,000 were cameras.
From this point in time, my discussion points will focus on non-GAAP numbers. The reconciliation from GAAP to non-GAAP is detailed in our earnings release distributed earlier today. Our non-GAAP gross profit for the third quarter of 2021 was up $21.8 million year over year to $26.7 million, which resulted in a non-GAAP gross margin of 32.3%, up from 22.4% in Q4 2020 and up more than 20 percentage points from 7.4% in Q1 2020. This represents a record gross margin and was driven by strong progress on both product and service gross margins over the last year.
The $21.8 million year-over-year improvement in non-GAAP gross profit included improvements of $14.1 million from product and $7.8 million from services. Non-GAAP product gross margin was 22.6%, significantly higher than 14% in Q4 2020 due to lower promotional spending in airfreight and up over 23 percentage points from negative 1.2% a year ago. As you recall, in the first half of last year, gross margins were adversely affected by the transition from legacy products, coupled with demand uncertainty due to COVID-19. Non-GAAP service gross margin came in at 57.9%, slightly lower than 58.9% in Q4 2020 and significantly higher than 36.8% in Q1 2020.
The year-over-year growth was driven by substantial paid account growth under our new business model, coupled with cost management over the last year. Total non-GAAP operating expenses were $29.8 million, down $2.5 million, or 7.7%, both year over year and sequentially. This was the result of continued prudent cost management and lower marketing expenses quarter over quarter. We believe our non-GAAP operating expenses will be approximately $33 million in the second quarter and in the $33 million to $34 million range per quarter in the second half of the year.
Our total non-GAAP R&D expense for the first quarter was slightly down sequentially at $12.2 million. Our headcount at the end of Q1 was 355 employees compared to 359 in the prior quarter. As a reminder, during the early stages of the Verisure relationship, we agreed to provide them with transition services, which include training with Arlo employees, as well as systems costs and some outside service costs. We've included these costs in our normal operating expenses.
The reimbursement from Verisure is included in other income and was approximately $0.9 million during Q1. Our non-GAAP tax expense for the first quarter of 2021 was $180,000. In Q1, we posted a non-GAAP net loss per diluted share of $0.03, much better than our guidance and our best result as a public company. We ended the quarter with $177.1 million in cash, cash equivalents, and short-term investments, down $29 million sequentially and down $29.5 million year over year.
We continue to make progress on our working capital management during Q1. Our DSO came in at 54 days, down significantly from 83 days a year ago and down from 64 days sequentially. Q1 inventory closed at $56 million, a decrease of $8.7 million over Q4 2020, with turns at 3.4 compared to 5 last quarter and 3.4 a year ago. Now turning to our outlook.
We expect second-quarter revenue to be in the range of $18 million to $90 million. Our team did an excellent job navigating supply chain challenges in the third quarter from component shortages to sea freight lead times. And while we expect similar headwinds in the second quarter, we believe we can make incremental progress over the first quarter. For the second quarter of 2021, we expect our GAAP net loss per diluted share to come in between $0.33 and $0.26 per share and our non-GAAP net loss per diluted share to come in between $0.20 and $0.13 per share.
Slightly up from previous guidance, we expect to end the year with approximately $130 million in cash, cash equivalents, and short-term investments, and we'll continue to monitor our performance and prudently manage our operations to preserve our cash position. And now I'll open it up for questions.
[Operator Instructions] Your first question is from the line of Adam Tindle with Raymond James.
Hi. This is Catherine Huntley on for Adam. We were wondering what you're learning about characteristics from your subscriber base, specifically a lifetime value of sub-vectors? And on the same token, how do you believe that your partnerships will drive upside in the future? And when you spoke about Verisure, you have previously mentioned that there's a 1-1 attach rate. And how do you believe that this will impact the services? I know you gave a little bit of color on product already. Thank you.
Yeah. Thank you for the question. Talking about service and service growth as we're going forward. So as you can see, we're still accelerating as far as net adds on a quarter basis.
And we've mentioned before that the churn rate on the new business model is also lower. So there's actually a double benefit of not only accelerating. It's seen a higher attach rate that approaches 65% over a six-month cohort, but the business model also is showing a lower churn rate. So we are learning a lot about the customers, the different segments, nothing we can share publicly, but we use those to drive not only our visibility into the customer base but driving some of the promotional activities that we're seeing actually have a better effect each quarter as we're going forward.
We're getting smarter about how to address customers from a subscription perspective. Verisure, in particular, is and will be adding subscriptions really in three buckets. So the first bucket is our partnership in deploying Arlo branded product in the retail channel, retail, and e-commerce channel there. And we're seeing strong performance there, much like we're seeing here in the United States.
Verisure is investing heavily in the Arlo brand throughout the channels. And as far as personnel and full-up marketing dollars, even running television ads in Europe to drive demand for Arlo through those traditional channels. So we're seeing strong growth in subscribers, just like we're seeing here in the United States. Also, the second bucket is Arlo branded product through their direct channels.
And that's them upselling Arlo branded cameras and security cameras to traditional install, traditional channel that they sell security systems through. And we're starting to see that get added into the mix, and those are, to your point, a 1-1 attach. So we're seeing 100% attach rate on services to those cameras that are being deployed through their direct channel. And then finally, the third ramp of subscribers that we'll see on top of the product is what we mentioned in the call that we've reached a milestone in our development of a custom product for Verisure that will be deployed in high-volume next year, and we'll see that start to phase in, in the second half of this year and full-volume deployments like I said, next year, and those will also be a 1-1 attach on service.
So, Verisure is actually -- there's three buckets that are contributing to the service mix, and we expect that to accelerate and help us hit our 1 million subscribers by our year-end call next year.
Great. Thank you so much for the color. And also, can you talk about the shift to services, to your point, and what you were mentioning in the previous answer? And how you believe that's going to impact margins? What do you plan on seeing as your business shift is complete and also especially since you plan on breaking even so soon?
Thanks. That's a great question. I think you can actually see already some of the benefits that services business is having on our gross margin even in Q1. Services in Q1 were actually a record percentage of our total mix, just under 28%.
And obviously, you can see we were pretty pleased with the service gross margin itself, which we kept just under 58% in Q1. But the benefit of that great gross margin and the high mix that we saw in Q1, you can see in the gross margin result, 32% on a long-debt basis, a record for us as a company, and we're very pleased with that. So certainly, as a service revenue continues to grow, we would expect it to account for an increasingly large proportion of our mix, and we would expect that to reflect itself in the gross margin. But keep in mind the seasonality in our business.
Q1, from a product revenue perspective, is the lowest seasonal point for us. And obviously, Q4 is the strongest point. So you'll see some mix variation. But I think Q1 results exemplify the benefits of that services business and what it does for our margins.
Thank you. And congrats on the quarter.
Your next question is from the line of Jeffrey Rand with Deutsche Bank.
Hi. Congrats on a great quarter. Can you talk about your supply chain if you're seeing any areas of tightness? And do you have any -- do you have good visibility into securing enough components to meet your full-year revenue outlook? And how much upside in demand could your supply support?
Yeah. It's a great question. So we are, obviously, still in a world where COVID is having some impacts on the business, and I'll lay out a couple of components of that. So one, we still see elevated freight costs for both sea freight and airfreight.
And sea freight, we're seeing a little bit of congestion. So a little bit longer lead time just from a freight perspective. I think we're managing very well. You can see in the quarter, we're managing very well those expenses.
Those could go up again, you know, as we go through the year a bit, but we're managing it through the [indiscernible] team and everything else. I think the area that has a little bit more of an impact will be component and component shortages. We have been forecasting out quite much further than we would normally forecast out to make sure that we're securing the supply we need. And at this point, we feel comfortable with our year guidance of, you know, having those components.
Although, again, we may see that pressure intensify as we get into the second half. The biggest impact the component shortages are having out there is our ability to actually respond to upside. So, you know, we just published, you know, a great Q1, and I can tell you there was more demand in Q1 than we could actually service. And again, not because there's a big shortage in components, but because the lead times are higher.
Our reaction time actually bringing in upside-finished goods is a little bit slower than normal. So I think we'll see that where potential upsides are being attenuated, but we're seeing strong demand at the same time that we're seeing some of the component shortage. But we are managing that out. We are taking our forecast out a lot farther.
We're managing this, I think, very well with our -- with not only our suppliers but our manufacturers. And so while we're relatively comfortable now, I think what we're trying to adjust for is how do we address potential upsides through the year as they come up and how much of that can we actually execute.
Great. And as my follow-up, maybe a little more high-level question, but the pandemic has changed a lot about how people work, go to school, and interact with people. And some of these change behaviors are likely to continue after a pandemic. Can you talk about how you think changing behavior during the pandemic will impact longer-term demand for your products?
Yeah. It's generated a tremendous amount of awareness. And I think there's been several, what I would call, vertical areas of awareness and uses for the product that I think will be, you know, still with us for quite a bit. Some of it will be a permanent change.
The most obvious is the amount of deliveries and interactions that happen at the front door. And some of that is the shift to e-commerce, just in general, where people are buying things and they're being delivered. But even meals being delivered instead of going out to restaurants, and some of that has caused a lot higher traffic at your front door. And one of the things we noticed is people, not only do they want to know when something's left at the front door, they also want to make sure that it's not being taken and lifted from a test perspective.
But even in a meal delivery scenario, people want to see the meal delivered and then actually see the delivery person leave, so they don't come face to face during the pandemic and can pick the food up after people have left. So I think the entire activity and the traffic and the awareness around the front door is something that's going to persist. There are other trends as well, you know, being able to check in on loved ones remotely and make sure they're moving around because you don't get there as often. So I think some of these trends are long term.
And then, in fact, we think we'll see some increased demand as actually, people get to leave the house, and they want to make sure now that they're not in the home all the time, that it's secure when they're remote. So we think some of these trends will continue. And then some of them may accelerate as actually people start to travel again and want to launch their premise as they start to leave their home again.
Great. Thank you.
Your next question is from the line of Thomas Boyes with Cowen.
Excellent. So really nice quarter. The product gross margins were up significantly, and it looks like there was a lot of some healthy destocking into the channel. I was just wondering if you could remind us how many inventory you're typically targeting.
And then maybe provide us some insight into maybe the steady-state margins for the product business, you know, for the balance of the year.
Yeah. Great questions. Really, in Q1, the product gross margin benefited from a couple of main things. We were able to control airfreight in Q1 pretty nicely.
So that was the first thing. And then the second thing, it was a relatively quiet quarter for the promotional activity. Not a lot of events going on in Q1 from a promotional perspective, and that certainly helped gross margin as well from a product perspective. Addressing your question on the channel inventory, we actually did destock the channel in Q1.
I just need to remind you that the denominator in that calculation is the final six weeks of sell-through. Now, if you look at it, Q1 is our seasonally weakest quarter from a sell-through perspective. And you're comparing that to Q4. The last six weeks of Q4 actually included the holiday period.
So the denominator in that calculation in Q1 is a lot lower than what it was in Q4. So I know it looks like we've stopped in the channel, we actually destocked it. And I think looking at the channel inventory level now where it's at for North America retail, 12.5 weeks. I think that it's pretty reasonable stop.
I think for the rest of the year, we'll see the normal seasonal pattern of stocking, destocking that we would see. I don't think there's going to be any tailwinds or headwinds from our COVID perspective on channel inventory. So I think we're relatively normalized. But just to clarify, we did actually destock from a dollar perspective in Q1 in Americas.
I'm sorry, what was the final question you had?
It was just on the steady-state margin for the product business.
Steady-state margin from a product perspective, we would expect mid-teens is a reasonable guideline for steady-state product gross margins.
Got it. And then just as my follow-up, you know, the entire product line has now had a, you know, complete refresh. Everyone's offering smart bundles, and you're making adapting on the software side. I was wondering what potential hardware refreshes you could do down the line? Is it something simply is just you're going to go from 4K to 8K? Or are there other, you know, hardware technology gaps that you see down the line?
Yeah. I think there are several areas, and we don't want to, you know, get too much into roadmap at this time. But I would tell you that there's still significant opportunity to innovate on the core camera lineup from a technology perspective and in ways that consumers would care about, and we're working on several of those aspects right now. I would tell you the monthly service, our subscription, which includes all those AI components, I do believe it's still at its early stages of providing value to customers, and we're already at a very healthy conversion rate and an even more healthy attach rate.
And I think there's a lot we can do over time to actually add value there. The last thing I would say is, you know, our mission and vision here at Arlo is to really protect and connect people and provide that peace of mind. And I think there's some adjacent categories that we'll be looking at over time. So without announcing anything, in particular, we are moving some of our innovation engine, like I said on the call, not only are we going to continue to drive and the company that's delivering the best products, physical products with the highest technology in the industry first and delivering the best service from a feature set and functionality perspective.
But we will be starting to look at opportunities to scale beyond what we've just refreshed, which is our core kind of smart monitoring camera lineup.
[Operator Instructions] There are no further questions at this time. I'd like to turn it back over to management for closing remarks.
Yeah. Thank you, operator, and thank you, everybody, for joining us on what was another great quarter for Arlo. We look forward to speaking to you again next quarter.
This does conclude today’s conference. Thank you for participating. You may now disconnect.