Arlo Technologies, Inc. (ARLO) CEO Matt McRae on Q2 2021 Results - Earnings Call Transcript

Arlo Technologies, Inc. (NYSE:ARLO) Q2 2021 Earnings Conference Call August 4, 2021 5:00 PM ET

Company Participants

Erik Bylin - IR

Matt McRae - CEO

Gordon Mattingly - CFO

Conference Call Participants

Jeffrey Rand - Deutsche Bank

Catherine Huntley - Raymond James

Hamid Khorsand - BWS Financial

Thomas Boyes - Cowen and Company

Operator

Ladies and gentlemen, thank you for standing by. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions]

I would now like to turn the conference over to Erik Bylin. Please go ahead, sir.

Erik Bylin

Thank you, operator. Good afternoon and welcome to Arlo Technologies' Second 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 our potential future business, results of operations, and financial conduction, including descriptions of our revenue, gross margins, operating margins, tax rates, expenses, cash outlook, guidance for the second half and full year 2021, transition to our Services First business model, the commercial launch and momentum of Arlo Secure, and Arlo Secure Plus, strategic objectives and initiatives, market expansion and future growth, our partnership with Verisure, continued new product and service differentiation, supply chain challenges, and the impact of the COVID-19 pandemic on our business, operating results, and financial condition.

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 quarter report on Form 10-Q.

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.

At this time, I would now like to turn the call over to Matt.

Matt McRae

Thank you, Eric and thank you everyone for joining us today on Arlo's second quarter 2021 earnings call. Our team again outperformed our expectations while navigating the considerable supply chain challenges that so many companies are currently facing and with the excellent second quarter performance, we continue to see acceleration across key metrics; product revenue, service revenue, and total revenue for the quarter were all up 48% year-over-year.

Total paid accounts were up 133% year-over-year and non-GAAP gross profit dollars were up an incredible 328% year-over-year.

Our strategic shift towards services, the success of our new business model, and the resulting transformative improvement in our profitability are undeniable. And while we expect these supply chain challenges to continue in the near-term, we see continued strong demand and are reconfirming our expectations for the full year.

And now I will dive a bit deeper into our Q2 results. Revenue came in comfortably above the top end of our guidance at $98.6 million. Q2 marked the eighth consecutive quarter of record service revenue at $25.3 million.

The strength in our services business coupled with double-digit year-over-year revenue growth in Americas and Asia-Pacific and triple-digit year-over-year revenue growth in EMEA drove non-GAAP gross margin of over 18% year-over-year.

This strong performance 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 $0.04. And our cash, cash equivalents, and short-term investments balance increased by $1.6 million during the quarter, landing at a healthy $178.7 million.

We have lowered our non-GAAP operating loss by an impressive 86% year-over-year in the first half of 2021 from a $52.3 million loss in 2022 to a $7.4 million loss in 2021. And with our current cash position, we anticipate reaching profitability without the need to raise additional capital.

Our current performance and these results underline the profound impact of Arlo's successful transition to a services first company. In Q2, we added 146,000 paid accounts, a record high which represents an increase of 28% sequentially and 240% year-over-year,

To put that paid account growth into context, under our legacy business model, it took us more than one and a half years to add the same number of paid accounts we just added in the second quarter alone.

On July 4th, we reach more than 700,000 paid accounts, and believe we are well-positioned to achieve our 1 million paid account goal by our year-end earnings call. And as previously mentioned, service revenue in Q2 was over $25 million, giving us a clear path to hit our projection of $100 million of service revenue for the year.

As we experience this tremendous growth in services, Arlo is also driving innovation to further enhance the value provided to our users. In July, we announced a major update to our service plans which have replaced Arlo Smart.

Arlo Secure features computer vision based object detection, AI-based audio detection, interactive notifications, animated event preview, secure cloud storage of video up to 2k resolution 24/7 premium support and 10% off Arlo.com purchases.

Arlo Secure is $9.99 per month and now supports an unlimited number of devices. Arlo Secure Plus includes all of the features from Arlo Secure, increases the resolution of cloud video stores to 4K and includes our Arlo's new 24/7 Emergency Response, which provides a new level of assistance when every second counts. A single tap allows the user to request specific emergency resources to be immediately dispatched with a choice of fire, police, or medical.

In addition, users can rapidly share critical information saved to their Arlo app with emergency personnel to better prepare first-responders in route information can include addresses, gate access codes, medical conditions of family members, pet details and more.

Live trained Emergency Response agents will assist by providing continuous updates to users and first-responders via the preferred method of communication, whether that be through the Arlo app, SMS messaging, or voice call. Arlo Secure Plus is $14.99 per month, and also supports an unlimited number of devices.

The new Arlo Secure service plans extends further Arlo's technology leadership, while providing significant value to our users. And the industry first emergency response functionality provides a compelling case for users to step up to Arlo Secure Plus.

As a reminder, under our new business model, where we included a free 90 day trial of Arlo smart, we see 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 towards 65%. Going forward, our new business model products will contain a free 90-day trial of Arlo Secure Plus, so users can experience the full breadth of capabilities provided by the Arlo platform.

Our industry leading technology continues to outclass the competition on the hardware side as well. Since our last earnings call in May, Arlo's Pro Four Series won the Editor's Choice Award from Tech hive. The essential spotlight camera won acclaim from T3. Digital Trends awarded our essential indoor cameras are recommended by, the Ultra 2 won Tom's Guide Highly Recommended Award, and numerous Arlo solutions are featured in best of 2021 lists across the industry. The glowing reception our technology continues to garner is a testament to our Lowe's commitment to innovation and bringing peace of mind to our customers.

Finally, I would like to update you on our strategic partnership with Verisure. Today Arlo's those existing suite of products and services are being sold by perisher not only through his retail channel, but also through its direct security channel where it has more than 3.6 million customers across Europe and Latin America.

We're excited to share that the new camera system designed specifically to meet the needs of their security channel was successfully moved in production in Q2, and we expect initial field rollouts in Europe in the second half of this year, and full volume deployments in 2022.

That success led to current quarter revenue in Europe growing 123% year-over-year. And we expect Europe to deliver more than $100 million in 2021 for a growth rate of more than 60%.

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 significant service subscription acceleration.

Our programs and initial rollout remains on track for 2021. And we look forward to realizing the full benefit of the relationship in 2022 and beyond.

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 third quarter.

Gordon Mattingly

Thank you, Matt and thank you everyone for joining us today. We delivered strong Q2 2021 financial results that exceeded our expectations, growing our non-GAAP gross profit dollars by 328% year-over-year, while revenue was above the high end of our guidance, and up more than 47% over Q2 2020.

Our financial performance for the quarter was underpinned by the successful execution of our new business model, leading to record levels and paid account.

The Arlo team navigated continuing tough supply challenges to exceed our expectations on revenue, while significantly improving our profitability. Most notably, we decreased our non-GAAP operating loss by $20.5 million year-over-year.

Now, moving on to the Q2 financial detail. Revenue came in at $98.6 million, up 47.9% year-over-year and 19.4% sequentially and was driven by meaningful growth in both product and service revenue.

Product revenue for Q2 2021 was $73.3 million, which was up 47.8% compared to last year and up 22.7% sequentially. Our year-over-year product revenue growth was driven by strong performance in all our geographical territory.

In Europe, we've benefited from continued strength from our Verisure relationship. In Americas from a return to growth in retail and momentum from our online store Alro.com. In Asia-Pacific some [ph] growth in retail.

Our service revenue for Q2 2021 was a record $25.2 million, up 48.3% over last year and up 10.8% sequentially with our new business model fueling our growth.

Our service revenue also includes $2 million of NRE services we're providing for Verisure, along with associated costs as compared with $1.5 million in the first quarter of 2021. During the second quarter we shipped approximately 808,000 devices of which approximately 805,000 were cameras.

From this point on, 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 second quarter of 2021 was up $21 million year-over-year to $27.5 million, which resulted in a non-GAAP gross margin of 27.9%, down from 32.3% in Q1 2021 and up more than 18 percentage points from 9.6% in Q2 2020. The year-over-year is driven by strong progress on both product and service gross margins over the last year.

The $21 million year-over-year improvement in non-GAAP gross profit included improvements of $13.2 million from product and $7.8 million from services. Non-GAAP product gross margin was 17.2%, slightly down from 22.6% in Q1 2021 due to higher promotional spending in airfreight and up over 18 percentage points from negative 1.3% 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 58.9%, slightly higher than 57.9% in Q1 2021 and significantly higher than 41.5% in Q2 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 $31.8 million, up $2 million, or 6.9% sequentially and up $0.5 million or 1.6% year-over-year.

We believe our non-GAAP operating expenses will be in $34 million to $35 million per quarter in the second half of the year as we invest in R&D and digital advertising and incur [indiscernible] cost.

Our total non-GAAP R&D expense for the second quarter was up slightly sequentially at $12.4 million. Our headcount at the end of Q2 was 349 employees compared to 355 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 Q2. Our non-GAAP tax expense for the second quarter of 2021 was $164,000. In Q2, we posted a non-GAAP net loss per diluted share of $0.04, much better than our guidance and a significant improvement year-over-year.

During the quarter, we concluded an agreement to sublease our entire San Jose office, which start in February 2022 and run to the end of our committed term in 2029. We expect the sublease will save $3 million to $4 million per annum across the business from next year. But due to the nature of the transaction, it did generate a non-cash impairment charge of $9.1 million, which is included within our GAAP operating expenses in Q2.

We ended the quarter with $178.7 million in cash, cash equivalents, and short-term investments, up $1.6 million sequentially and down $26.8 million year-over-year.

We continue to make progress on our working capital management during Q2. Our DSOs came in at 48 days, down significantly from 63 days a year ago and down from 54 days sequentially. Q2 inventory closed at $43.2 million, a decrease of $12.8 million over Q1 2021, with turns at 5.7 compared to 3.4 last quarter and 3.1 a year ago.

Now, turning to our outlook. We expect third quarter revenue to be in the range of $100 million to $110 million. Our team did an excellent job navigating COVID-19 related supply chain challenges in the first half of the year. And while we expect these challenges to impact our revenue and cost to a greater extent in the second half of the year, we believe we can still make incremental topline progress as the first half. Given that, we expect our 2021 full year revenue to come in between $410 million and $420 million.

For the third quarter of 2021, we expect our GAAP net loss per diluted share to come in between $0.30 and $0.23 per share and our non-GAAP net loss per diluted share to come in between $0.19 and $0.12 per share.

In line with 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.

While supply constraints are limiting our topline and impacting our costs, the team Arlo remains extremely focused on getting to breakeven on a non-GAAP basis later in the year.

And now, I'll open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions]

And our first question comes from line of Jeffrey Rand from Deutsche Bank.

Jeffrey Rand

Hi, thanks for taking the question and congrats on a nice quarter. You continue to see nice growth in your subscription business, how do you think about the opportunity of your current install base who could potentially become subscribers? And what is your strategy for converting these users who have already bought the product and not signed up after their free trial?

Matt McRae

That's a great question. We are seeing subscribers come from a couple of areas. So, one is obviously the partnership with Verisure and some of the strong growth we're seeing in Europe. Two is all the new registered users that we're capturing every quarter through our normal channels. But three, to your point, is we are very active in tapping into our legacy, what we call our legacy install base. We do that a couple of ways. One is we're running specific promotions for signup to Arlo Smart, now called Arlo Secure and our new service plans that we announced this quarter,

But also pushing different hardware or new hardware as we launch new products in the market. And what we see is when a household that had legacy hardware adds a new camera to that ecosystem at home, the propensity for them to actually sign up for service to cover all that ecosystem actually goes a lot higher. So, we're having, I would say, quarter-over-quarter more success, every quarter as we learn how to market to them. We AV test all of the promotions to that legacy install base and we're continuing to refine that going forward. But it is an area that we're actively mining, but also getting better at as we go over time.

Jeffrey Rand

Great. Thank you. And as a follow-up, you're forecasting revenue grow modestly sequentially in 3Q, but you're non-GAAP EPS outlook is for a larger loss than 2Q, looks like some of this is from higher operating expenses. But it also looks like you'll see some gross margin pressure sequentially. Can you just talk about what is driving this gross margin pressure?

Gordon Mattingly

Sure. Hi Jeff, its Gordon here. The -- I mean really in Q3, we're balancing revenue against profit. The supply constraints are really the story there to be honest. And what we're doing in Q3 is spending a bit more on air freight in order to get the product to our customers. That's probably the biggest reason for the slight decrease in product gross margins. If not service those margin, for product gross margin, and it is just really a result of the supply challenges we faced. Also a little bit of cost component increases built into that as well.

Jeffrey Rand

Great. Thank you.

Operator

The next question comes from line of Adam Tindle from Raymond James.

Catherine Huntley

Hi, this is Catherine on to Adam. Thanks for taking our question. Can you talk about the early feedback that you've seen from your new subscription plan, Arlo Secure and Arlo Secure Plus? How many people do you plan on having it by this time next year?

Matt McRae

Yes, we're not going to forecast going forward, because I think it was yet to be seen how many people actually moved from Arlo Smart to Arlo Secure Plus, depending on which plan works better for them and that's something we'll learn over the next couple quarters.

Obviously, all new subscriptions that come on will be Arlo Secure, because we no longer sell Arlo Smart. So, giving you a forecast on that would actually give you a forecast going out a little bit farther on subscriptions.

But as far as the reaction -- early on reaction, it's positive. I will tell you that with there's two major changes inside the plan. One is we move to unlimited device support and that's something customers have been asking for and in fact, actually, channel partners have been asking for that because it makes it simpler to educate users on what plan they need, depending on how many devices they have.

Now, it's an extraordinarily simple message. No matter how many devices you have, here's a plan that covers everything. So, we think that'll take some of the friction out of some of the signup process or some of the complexity initial on.

But the other real innovation that we've rolled out is something we call Emergency Response and I touched upon it a little bit in my earlier remarks, but it is the world's first live agent professional monitoring one tap capability for a user to actually tap the exact emergency response that they need through an application, so the user can actually have an icon for fire, police, or medical. And if they tap medical, for instance, medical first-responders are actually dispatched immediately. So, they already know who to send. And at the same time, a live agent actually reaches out to the end user and coordinates that response and sees if there's any other help that needs to be done.

So, again, world first, we think it adds a lot of peace of mind to our customers. But it's the capability nobody else has, we think it can reduce response time. Now, that emergency response functionality is actually in the $14.99 plan. So, one of the things we'll be focused on going forward is pitching that functionality and looking at getting some of our users to step up to the larger plan.

Catherine Huntley

I agree. The simplicity standout, could you describe your ideal inventory position coming out of the pandemic, your turns are up to five, 5.7 times possibly an all-time high? Are you planning on rolling out any promotional activity later this year?

Matt McRae

That's a great point. The inventory level in Q2 -- for Q2, which is actually seasonally, the weaker half of the of the year for -- that number is pretty high. And we did tap into -- you can see the inventory shrunk by about $13 million, our on hand inventory quarter-over-quarter. And that was part of the reason why I think we're able to overdeliver against original expectations for Q2.

We will do what we can to get inventory to a slightly higher level, but it's not a mini-model where we need it to be. And certainly as we look forward to the second half of the year, we've got a lot more visibility into the supply that's coming. We work very closely with our manufacturing partners, with our chipset providers, we've extended our demand outlook, and we've got a good degree of confidence. That's why we reiterated for the year the $400 million to $420 million of revenue.

Catherine Huntley

Thanks for the time.

Gordon Mattingly

Thank you.

Matt McRae

Thank you.

Operator

Your next question comes online of Hamid Khorsand from BWS Finance.

Hamid Khorsand

Hi. First question is, given your annual revenue guidance, it seems -- or it sounds like you're going to be expecting a lot more revenue out of Europe. Does it matter on your end if it's coming from Europe or if it's in North America as far as the revenue is concerned? As far as gross profit dollars? And how likely is it those European consumers would actually adopt Arlo Secure when they're already a Verisure customer?

Gordon Mattingly

Hey Hamid, great question. To answer it does it matter where -- whether it's coming from Europe or the U.S., I think just take a look at our results where Verisure has been quite a large proportion of our mix.

In the current quarter Europe was 25%, in Q1, it was more than that, in Q3 last year, it was pretty high, too. You can see our product gross margins in all those courses have been pretty healthy. So, my answer to that is no, it doesn't matter.

And then the second answer to the question with respect to subscription attached in the Verisure Security channel which we're starting to sell into now, just a reminder, we have a one-to-one attach to services. So, we should see some nice growth in paid accounts from the Verisure Security challenge as that begins to pick up steam latter part of this year, but more so a 2022 play.

Hamid Khorsand

My question was how comfortable are you with the supply chain being able to secure the necessary components to get to Q4 just given that the inventory did decline sequentially?

Gordon Mattingly

Yes, we've focused on that probably every minute of every day right now. And we have been working very, very closely. Supply chain team have done an amazing job. You saw the results for Q2, we were able to eke out supply that we didn't have visibility into when we guided Q2. Supply chain team did a fantastic job. We've elongated our window with our suppliers and we're working very, very closely with our OEM partners, and with our chipset providers. And right now, yes, we have good visibility into supply for the latter part of this year and we've got a good degree of confidence in reiterating the guide for the year of $400 million to $420 million revenue.

Hamid Khorsand

And lastly, could you just clarify when you're talking about breakevens or -- is that for the quarter or for a specific month in the year?

Gordon Mattingly

Yes, with respect to breakeven, just want to clarify the team are -- remain highly focused on getting there. And we'd be talking about a lot more confidently if it wasn't for the supply chain challenges that we're facing. That being said, we believe we have a shot of at it in Q4 and the entire team united him are pulling out all the stops to make sure we get as close to that as we can.

Hamid Khorsand

Okay. Thank you.

Gordon Mattingly

Thank you.

Operator

And your last question comes from one of Tom Boyes with Cowen and Company.

Thomas Boyes

Hi. Thank you for taking the questions. The first one Europe, obviously, it's great to see the Verisure partnership going so well, I'm just wondering how you thought about replicating that in other geographic regions like deploying in Asia-Pacific?

Matt McRae

Yes, we think that the B2B channel or the partnership channel is an important area of growth for us. Obviously, Verisure is a great example of that. We've signed a deal with Calyx, if you remember here in the United States, to do some distribution through them to CSDs, especially rural CSDs across the United States.

We've done other deals like [indiscernible] homes for deploying doorbells into new home builds across the country. So, that is an area where we focused quite a bit. One of the areas you'll see us continue to focus on also is ISPs or service providers. And that's something we'll talk more about as we get through the rest of year.

But that idea of B2B non-consumer channels is something that's foreign too. We're constantly looking for additional partners there and as we sign-up or have more news in some of those other areas, we'll definitely report them. But it is a vector of strong growth for us. And in some of these deals like Calyx, like Verisure, the thing that's important is it's not just the hardware sale that goes into the partnership and the deployment into the consumers' home. It is what Gordon mentioned earlier is a one-to-one attach rate on services. So, it drives that hardware sale, but it's also driving a household that's got a one-to-one attach, which is driving our paid account number.

Thomas Boyes

Nice. Very helpful. And then the other one, obviously, it's very nice to see kind of the evolution of the 911 to emergency services response. And I know something that competitors have had more of a difficult time replicating just on the -- one side. And I was just wondering, is there -- how do you entice someone who is on an older part of Smart platform that has access to the traditional E911 to go with Arlo Secure as a base level or to go to Arlo Smart to get that functionality? Or is that something that is still offered? And there's a fine line of demarcation between what's an Emergency Response level service and what's a traditional E911?

Matt McRae

Yes. No, it's a great question. So, you can see that, E911 was our first foray into very low latency access and the ability to access remotely 911 from wherever you are, and reduce the latency for that Emergency Response. We were the first rolled out, we're still one of the only ones that ever rolled out E911 and we know how important that is to our users, we got a lot of great feedback on how to make that better.

What you're seeing is all of that feedback plus some innovation actually going into Emergency Response, which really takes it out a significant level, not only from a user experience perspective, but also from the accuracy and the speed of which emergency first-responders can be dispatched. Plus having a live agent, almost an emergency concierge, that's working with you to ensure that that your emergency is being dealt with, plus being able to actually send information in many cases right to the laptop or the computer that's inside the cab of the fire truck or in the police car, things like gate access codes, or if you have a family member that has a certain medical conditions.

So, a lot of feedback went into that. We think Emergency Response is the most innovative way to now respond to emergency situation that you see through any kind of smart security system.

As far as enticing people, Arlo, if you can remain as a customer, you can remain on your Arlo Smart plan if you want, we feel Emergency Response is such a big step forward that we'll see people actually kind of transition over to the Arlo Secure plans.

The other benefit obviously, is the unlimited device count, which really simplifies the plans. And the other we made that that choice to do that as we're seeing people continuously adding on additional Arlo devices where they may have had a couple of Pro 2s. They buy a Pro 3, let's say, which is a new business model product. They then sign up for Arlo Smart service. And then they may want to add two or three more devices over time.

This doesn't have any upper limit, you can continue to add devices into that household. Plus, if you step up to the Secure Plus, you get the new Emergency Response. So, two big things there that I think will entice people to move over. And of course, like I mentioned on the earlier remarks, every new registered account and registered user coming on will have the choice between Arlo Secure and Arlo Secure Plus, and Arlo Smart is no longer offered.

Thomas Boyes

I appreciate the insight. Thanks so much.

Matt McRae

You're welcome.

Operator

And there are no more questions. I'd like to turn it back over to Mr. McRae.

A - Matt McRae

Thank you operator. I'd like to take a moment just to thank all of the teams at Arlo for the outstanding work to deliver the world's best the most recognized smart security system that we've talked a lot about today. We've launched more than 10 products under our new business model and continue to see an acceleration of our service revenue and paid accounts.

The new Arlo Secure plans that we've been talking about bringing innovative industry-first features to our users and will further drive our recurring revenue business higher. And as we're seeing the first results of our impactful relationship with Verisure after more than a year of groundbreaking work, we're very excited about where that's headed, especially as we look into the following year.

I could not be more proud of the achievements as we continue to focus on our mission of protecting and connecting what users care about most. Thank you everyone for joining us on the call today.

Operator

This concludes today's conference call. Thank you for participating. You may now disconnect.