Arlo Technologies - Q1 2023

Transcript

Moderator (participant)

Thank you, operator. Good afternoon. Welcome to Arlo Technologies' first quarter 2023 financial results conference call. Joining us from the company are Mr. Matthew McRae, CEO, and Mr. Kurt Binder, CFO. The format of the call will start with an introduction and commentary on the business provided by Matt, followed by a review of the financials for the first quarter, along with guidance for the second quarter and full year provided by Kurt. We'll have time for any questions. If you've not received a copy of today's 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, operating results, and financial condition, including descriptions of our revenue, gross margins, operating margins, earnings per share, expenses, cash outlook, free cash flow and free cash flow margin, guidance for the second quarter and full year of 2023, the rate and timing of subscriber growth, the transition to a services first business model, the commercial launch and momentum of new products and services, strategic objectives and initiatives, market expansion and future growth, the effect of our brand awareness campaign on future growth, partnerships with various market leaders and strategic collaborators, continued new product and service differentiation, and the impact of general macroeconomic conditions 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 annual report on Form 10-K and quarterly report on Form 10-Q. Any forward-looking statements that we make on this call are based on assumptions as of today, 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 discussed on this call. A reconciliation of the GAAP to non-GAAP measures can be found in 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 (CEO)

Thank you, Eric. Thank you everyone for joining us today on Arlo's first quarter 2023 earnings call. As I mentioned on our last call, Arlo had crossed an inflection point, and our results in Q1 provide a glimpse of the bright future ahead. While we remain cautious with regards to the overall macroeconomic outlook, the decisive operational actions we took at the end of Q3, combined with our recent product launches and new pricing strategy, drove outstanding results and has positioned Arlo to outperform the market. We reached non-GAAP profitability ahead of expectation in Q1. We are guiding to a substantial increase in non-GAAP profitability for Q2. We are raising full year guidance for 2023, and we expect our profitability and cash position to improve throughout the rest of the year. This underlines the continuing valuation dislocation for Arlo.

We are redoubling our efforts to generate awareness with investors as we execute the business and strategy that is creating our successful trajectory. Looking at Q1 in more detail, revenue came in at $111 million, which was above the high end of our guidance, and we saw strong demand throughout the quarter, thereby driving our inventory lower. Arlo added 182,000 paid accounts and crossed the 2 million paid account subscriber milestone in Q1. Earlier this year, we adjusted the pricing on our hardware and subscriptions to optimize our ability to drive shareholder value, lowering hardware prices to sell more units while increasing subscription pricing to accelerate service revenue. The price increases have had an immaterial impact on churn to date, and we have seen an upward mix shift across our subscription plans.

These factors drove service revenue up 47% year-over-year to $44 million for the quarter, and non-GAAP service gross margin grew 380 basis points sequentially to reach a record 74%. Exiting the quarter, Arlo's annual recurring revenue grew an incredible 80% year-over-year and reached $183 million. The observed price elasticity and successful upselling is a testament to the value proposition Arlo's services bring to our users, as well as to the lifetime value of each subscriber. Arlo remains on track to continue our strong pace of subscriber additions and achieve $200 million of service revenue in 2023 at close to 75% non-GAAP gross margin and growing nearly 50% year-over-year.

The performance of our services business not only delivered non-GAAP profitability, it drove $9 million of free cash flow in Q1. We expect Arlo to generate free cash flow and non-GAAP profitability throughout the year, leading to our target of 5% non-GAAP operating margin for full year 2023. Underpinning this achievement is what continues to be heralded by many reviewers as the best cameras and doorbells available on the market. Our innovative, technologically advanced portfolio of products propelled Arlo to the top of numerous best of 2023 lists in the quarter and awards from publications including The Verge, Consumer Reports, Engadget, Wirecutter, Android Police, Digital Camera World, New York Post, In The Know, Pocketnow, SlashGear, Good Design, Digital Trends, Popular Mechanics, and Tech Junkie.

We have also expanded our product portfolio to include a full security system with an advanced multi-sensor at its core that provides numerous advantages over the competition. Arlo's extensive award-winning product ecosystem is a powerful subscriber acquisition lever that continues to drive new paid accounts. Arlo Safe, our new personal and family safety service, opens new doors for users to enter our ecosystem. A simple download from the Apple or Google App Store begins a user's engagement with Arlo. I am pleased to share that today we announced a partnership with Ping ID, a company known for world-class authentication and corporate security solutions. Ping ID will be providing Arlo Safe as an employee benefit across their company. This reflects an exciting new channel for Arlo to drive paid accounts.

All of these services run on Arlo's SmartCloud platform that provides an unparalleled level of security and performance for our users and partners. The SmartCloud architecture is flexible and scalable, allowing us to quickly bring new features, services, and solutions to market as we look to expand our capabilities and offerings over the next 24 months of our long-range plan. With that, I'll turn it over to Kurt.

Kurt Binder (CFO)

Thank you, Matt, and thank you everyone for joining us today. I will start by sharing some financial details and an overview of the business for Q1 2023. Revenue for the first quarter came in above the high end of our guidance at $111 million, down 6% sequentially and 11% year-over-year. The decline in revenue was attributed to lower product revenue, a trend which commenced in the second half of 2022 in the face of a softening consumer demand environment. This trend was partially offset by our approach to reducing product prices as a catalyst to household acquisition and subscriber growth. To date, this approach has been effective and has enabled us to maintain strong subscriber additions and deliver strong growth of our highly profitable service revenue.

We are extremely pleased with our services revenue and ARR growth, which helped deliver revenue above our guidance range and strongly contributed to Arlo delivering non-GAAP net operating profit in Q1. Our service revenue for Q1 was another record at $44 million, an increase of $14 million or 47% year-over-year, and an increase of $5.6 million or 15% quarter-over-quarter. The increase, driven by the addition of 182,000 paid accounts in the quarter, coupled with certain in-app enhanced functionality and features, enabled us to increase our subscription plan prices in the quarter. Our installed base reached a major milestone of 2 million paid account subscribers during Q1, which represents an inflection point in our operating model. Service revenue accounted for 40% of our Q1 2023 revenue, and importantly represented 91% of our total gross profit.

Additionally, our quarter end ARR was $183 million, up 80% year-over-year, thereby providing greater predictability and visibility into our ability to deliver on near-term revenue and profitability targets. Product revenue for Q1 was $67 million, down 16% sequentially and 29% year-over-year. During the quarter, we shipped a total 964,000 cameras worldwide, with 50% of our revenue coming from our international customers. In fact, we again experienced consistent results in the quarter with our strategic partner, Verisure, in EMEA, with product revenue up 27% sequentially, slightly down 8% year-over-year. Our strong and collaborative relationship with Verisure continues to be a very important one for us and a great intangible as we explore future growth opportunities together. From this point on, my discussion points will focus on non-GAAP numbers.

The reconciliation from GAAP to non-GAAP figures is detailed in our earnings release distributed earlier today. Our non-GAAP gross profit in the first quarter was $36 million, up 5% year-over-year. This resulted in a non-GAAP gross margin of 33%, up 500 basis points from 28% in Q4 of 2022. The year-over-year increase in non-GAAP gross profit in Q1 was attributable to growth in our service business as we had brought down product gross margins as part of our overall pricing strategy. The improvement in non-GAAP service gross profit was driven by growth in our ARR or subscription plan pricing and the monetization of our install base of paid subscribers coupled with cost optimization.

Non-GAAP service gross margin for the quarter was 74%, significantly up from 70% in Q4 of 2022 and 65% in Q1 of 2022. Non-GAAP product gross margin for the quarter was 6% and consistent with our guidance provided in March of this year. Total non-GAAP operating expenses for the first quarter were $35 million, down sequentially and up $2 million or 5% year-over-year. The year-over-year increase is attributable to continued investment in sales and marketing expenses to help drive household acquisition and subscriber growth. The non-GAAP operating expenses for the first quarter were slightly better than our expectations and reflect the cost savings initiatives implemented in Q4.

Our head count at the end of Q1 was 334 employees, which represents a decrease from 343 team members at the end of Q4 and 358 team members in the same period last year. In Q1, we posted non-GAAP net income of $1.1 million. Our non-GAAP net income translates to earnings per dilutive share of $0.01, much better than our guidance provided last quarter. The significant improvement in non-GAAP operating margin was driven by a combination of service revenue growth and gross margin expansion, coupled with a disciplined approach to cost management. You can expect us to be deliberate and disciplined in managing operating expenses in line with revenue growth and our customer-centric operating model.

In Q4, we execute on various initiatives to reduce operating expenses, all of which have proven to be prudent considering the uncertain economic climate, but more so in aligning our organizational structure with the services first strategy. Regarding our balance sheet and liquidity position, we ended the quarter with $118.7 million in available cash equivalents and short-term investments. This balance was up nearly $5 million sequentially and is well above the high end of our guidance range provided last quarter. We are pleased to report that we generated approximately $9.4 million in Free cash flow in Q1, which represents free cash flow margin of 8.5%, driven by our increased profitability and working capital management.

Additionally, our Q1 inventory balance ended at $39.9 million, representing a decrease of $6.6 million or 14% from Q4 of 2022, with inventory turns at 6.4 times and consistent with last quarter. Finally, our accounts receivable balance was $52.8 million as of April 2, with Q1 DSO at 44 days, down from 50 days sequentially and 58 days from the same period last year. We will continue to monitor our working capital balances in line with our revenue levels, with a focus on maintaining a solid balance sheet and liquidity position in the future. Now turning to our outlook. Considering that Arlo surpassed the 2 million paid account subscriber milestone this past quarter, let me emphasize that the company is upon an inflection point in 2023.

The forecasted revenue growth in our service business will drive Arlo to be materially profitable in 2023. Given the current consumer environment, we still remain cautious about our product revenue outlook for the year. With that said, we expect the second quarter revenue for 2023 to be in the range of $105 million-$115 million. We expect our GAAP net loss per dilutive share to be between $0.15 and $0.09, and our non-GAAP net income per dilutive share to be between $0.01 and $0.07 per share for Q2 of 2023. For the full year, we reiterate that service revenue is forecasted to grow at roughly 45% year-over-year to approximately $200 million, thereby becoming a much larger portion of our overall revenue and profitability mix.

We estimate non-GAAP product gross margin will be in the mid-single digits as we pursue promotional activities and sales models that prioritize the acquisition of new households and subscribers. However, we expect non-GAAP service gross margin to be at or above 75% in 2023. Additionally, we are adjusting upwards our 2023 full year revenue range to be between $470 million-$500 million. Now I'll open it up for questions.

Operator (participant)

Thank you. Ladies and gentlemen, if you have a question today, please press star 1 on your telephone keypad. We'll pause for just a moment to give everyone an opportunity to signal. We'll go first to Jacob Stephan, Lake Street.

Jacob Stephan (Senior Research Analyst)

Hey, guys. Congrats on the solid quarter. Certainly nice to see the free cash flow positive. Maybe just starting off, could we talk about, kind of the 20% sequential monthly ARPU increase? I just want to see if you could provide any more color on how we can kinda think about, how much of the additional increase is related to price, subscriptions increase, and, you know, how we can kinda look at that moving forward?

Kurt Binder (CFO)

Sure, Jacob, great to talk to you today. Just a couple thoughts about the ARPU expansion. Obviously, you know that ARPU expansion is driven by a whole host of factors. Obviously the increase in subscribers has played a big part in that, the mix of those subscribers. More recently, the price increase that we put in place in the quarter. We were really pleased to see that, given the in-app functionality that we've added over the last several quarters, we were able to enact about a 20%-30% increase in the actual pricing within our subscription plan. With that, we saw very little impact on churn, and as a result, it read through to a growth in our overall services revenue and the profitability that we experienced in the quarter.

Pretty excited about the results for Q1, and we'll expect that the profitability of the services revenue to be in that gross margin range of about 75% for the remainder of the year.

Jacob Stephan (Senior Research Analyst)

Okay. Got it. Have you guys kind of talked about how we can think about, you know, the percentage of paid subs who pay monthly versus annually? I know there's a slight price difference on, those two?

Matt McRae (CEO)

Yeah. We haven't broken that out yet. You know, that change or the addition of the annual plan happened mid-quarter, so it's a little bit early. It's something that we could probably provide later in the year as we see things settle out. A couple comments on it though. One, as we made the price increase on the monthly plans, as we talked about, obviously that had an impact on the quarter even though it happened in mid-quarter, so we expect the first quarter of the full impact of that price release, price increases to happen in Q2.

What's interesting is on the annual plan, even though they're at the, you know, the discounted price, which is equals the old price from the monthly plans, those are also more profitable for us because we only do one transaction from a billing, credit card, and clearance perspective instead of 12 throughout the year. Both the annual plan and obviously the new pricing on the monthly plans, are both accretive to profitability for us. We haven't broken that out yet, and something we'll probably do later in later commentary as it settles out and we get a full quarter under our belt.

Jacob Stephan (Senior Research Analyst)

Okay. Got it. maybe just talk about the Ping ID announcement. Is that bundled in terms of subscription revenue or you know is each person who's getting the Safe button, are they paying the $25 a month and it's reimbursed by the company? Tell me how that kind of contract works.

Matt McRae (CEO)

Yeah. Yeah. It's an exciting announcement.

Jacob Stephan (Senior Research Analyst)

Maybe just looking at the pipeline.

Matt McRae (CEO)

Yeah. Yeah. No, I'm glad you brought it up. It's exciting for us because it, you know, it's a, it's a first of its kind B2B deal for us. What I mean by that is it's actually being provided as an employee benefit. Ping Identity as a company is purchasing the subscriptions for their employees and delivering them to their employee base as an added benefit of being an employee of Ping Identity. All of the features including, you know, personal safety, family safety, crash protection, everything that Arlo Safe provides, will be part of the benefits of working at Ping Identity.

It's exciting for us, number one, because PingID is such a, you know, a household name, you know, in the business community at least around safety and security, and it's a, it's a huge, I think, you know, vote around Arlo Safe being something that provides tremendous value to an individual and their family. But it's also exciting for us because this is us seeing a new opportunity, a new potential go-to-market specifically for Arlo Safe, but potentially Arlo Secure as well over time, and that is, you know, some of our services being seen as an employee benefit, which obviously could have, you know, future growth on paid accounts. It's being bought by the company and being distributed for free to the employee as a benefit of being an employee at PingID.

Jacob Stephan (Senior Research Analyst)

Okay. Great. Maybe just one last one here. You guys reported you had $98 million in backlog to Verisure. I believe that was a new metric at the time. You shipped north of $40 million in product in Q1 here, so that should leave roughly $50 million in shipments kind of remaining in that backlog obligation. You know, how can we think about the Verisure contract moving forward? It seems like you guys have been progressing certainly nicely on that, on that contract, maybe what does that look like going forward?

Kurt Binder (CFO)

I'll just reiterate some of the commentary we've provided in the past. The relationship with Verisure is a good one for us, one that's very healthy and collaborative, so we're excited about its potential. As we've indicated, we're in the, I would say, the last third of a 5-year contract, whereby they had purchase commitments in the range of $500 million. What we've done in the past is we've given backlog insight into the upcoming year. That backlog actually gets adjusted periodically throughout the year as demand fluctuates and as we service that demand through supply. In terms of the exact number, I don't know that we actually posted that in our quarter. I would say that we're proceeding well against that $500 million commitment.

We expect that by the end of that five years, we'll have exceeded that target. It remains to be seen, ultimately what the backlog will be for this year. I don't have that information available to share with you right now.

Jacob Stephan (Senior Research Analyst)

Okay. Got it. That's helpful. Great quarter, guys. Best of luck going forward here.

Matt McRae (CEO)

Thank you.

Operator (participant)

Up next, we'll hear from Adam Tindle, Raymond James.

Adam Tindle (Managing Director)

Okay, thanks. Good afternoon. Matt, maybe want to start with you. We've heard kind of a variety of different results from consumer companies, whether it's in, you know, the Wi-Fi arena, the home speaker arena, and a lot of them have been disappointing. There's been some citations of, you know, channel inventory issues, particularly in e-commerce or even retail, where they're willing to hold less inventory. I guess, when you look around the consumer electronics space, relative to your results, you know, what do you think are the things that are maybe insulating you from the trends that are being experienced by others? Or do you think this is something that may ultimately impact Arlo at some point, just on a lagged effect?

Matt McRae (CEO)

Yeah, great question, Adam Tindle. A couple things I would say. One, I think we're operating in a market segment that is just more naturally resilient to some of the headwinds that you would see in a macroeconomic slowdown. What I mean by that is, you know, being in the segment of safety and security, often is a lot stickier, and the demand is more resilient because it's around, you know, being safe, keeping your family safe, keeping your assets like a home, or a small business safe. It's not one of the first things that consumers cut back when they're spending. When there's a need for a safety or security solution, there's a need for a safety and security solution, you know, at that time.

I think from a general market perspective and market segmentation perspective, safety and security, is an area that's going to be more resilient as we go through, this macroeconomic chaos that we're having a little bit of as we go forward. Two, I would say, we identified, the turnaround in the market, I think earlier than most. In Q3, you know, we took actions across many areas, including cutting costs, really working with our supply chain to bring down product costs, changing our pricing, so we're bringing down that upfront cost, even though we're increasing the monthly cost. Consumers are much more sensitive to the out-of-box experience and the cost of getting into a solution.

I think our pricing strategy has changed in a way to react to the market as the market was becoming a little softer. That has worked. We said on the last call that we expect this year to behave a lot like Q4 did as far as how consumers are looking for deals, they're looking for a lower upfront cost. Once they're into a solution and they're subscribed as a subscriber, it's a very sticky service. Those are the two I would say. I think we're in a unique market segment compared to things that are a lot more discretionary. Then two, I think we have done an excellent job at reading where the market is going, adjusting our strategy across our operations, our supply chain, and our pricing to match where the consumer is.

We're seeing that resilience continue even outside of Q, Q1 as we're starting to go into Q2. That's one of the reasons why you see us upping not only our future profitability, but actually upping the full year guidance on revenue, is that we expect this to continue and our success to continue throughout the rest of the year.

Adam Tindle (Managing Director)

Yep. Certainly very prescient moves. Makes sense to me. I guess maybe as a follow-up, the Secure product is such an interesting potential growth driver moving forward. I'm curious, you know, kind of what you're learning as you venture down that journey, and in particular, you know, the potential partnerships that it might ultimately open up or go to markets. I mention that because there's just been a number of moves, you know, whether it's insurance providers like a State Farm investing heavily in ADT, or technology companies like Google and ADT, right, that are interested in those that have this sort of technology. Sort of these outside partnerships that might end up being open up to you from the Secure piece of the business.

Just wondering if you could talk about early observations and the opportunities for those, sorts of partnerships moving forward and any timeline or visibility into that would be helpful. Thanks.

Matt McRae (CEO)

Another great question. I'll tell you, I'm very bullish on what we call strategic accounts or partnerships going forward. I think there's a overall recognition about the market segment that we're in, and we just discussed together, the value it provides an end user, the revenue it can provide on a recurring basis. You know, there's only a certain number of segments that consumers will pay on a monthly or recurring basis for value that's provided through a subscription. When you look at the smart home, it's really around security. I think there's many avenues, of which you've touched on, whether it's service providers or insurance, and other insurance companies or other B2B partners where Arlo is potentially a great fit as a partner.

We talked about our long range plan, last year and last March when we rolled it out, one of our key pillars was continuing to invest in and expanding our B2B strategic account base. It's a focus for us. We don't have anything to announce at the moment, I will tell you, I do believe there's some very strong potential, and I'm bullish over the, call it the 12 to 18-month time horizon, that it'll continue to drive results for Arlo, continue to drive paid accounts, and become an even a bigger portion of our business as we head forward.

Adam Tindle (Managing Director)

Great. Looking forward to it. Thanks and congrats.

Matt McRae (CEO)

Thank you very much, Adam.

Operator (participant)

Next up, we'll hear from Hamed Khorsand, BWS Financial.

Hamed Khorsand (Principal)

Hi. Could you first address, you know, the price changes you undertook in the quarter, and how much of your subscriber base saw that price increase in Q1, and how many will see it in Q2?

Matt McRae (CEO)

The price changes happened over the course of February. The reason it didn't happen on a single day is it depends on when the natural renew date happens. If you were on the 5th of a month, it renewed on the 5th of February. If you were on the 14th of the month, it would be the 14th of February. Throughout the month of February, 100% of our subscriber base rolled into the new pricing. It basically happened throughout February. On an average, you would say half the quarter was benefiting from that price increase. Of course, next quarter will be 100%. As we exited February, meaning going into March, 100% of the subscriber base was moved over to the new pricing.

Hamed Khorsand (Principal)

Okay. In your pre-made remarks, you had said something about mix shift in service plans. Are you seeing more, you know, movement towards the higher end or the lower end of your service plans now with the higher price points?

Matt McRae (CEO)

Yeah, a great question. We are seeing an increase, meaning an upward shift. As I think the security system is starting to roll out, as Arlo Safe has rolled out in a bundle, we have our Arlo Safe and Secure bundle, and some of the feature changes that we made, putting more value or more capabilities into our Arlo Secure Plus, we are seeing a mix-up where people are signing up for more higher priced plans compared to historical. I think Kurt kind of alluded to that in his answer to a question around both price increases and the mix shift upwards in price selection or plan selection has impacted ARPU.

Hamed Khorsand (Principal)

Okay. My last question was just given the seasonality of first quarter, how do you feel about the point of sale, transactions now with your, you know, focus being on price, do you feel like you're winning market share?

Matt McRae (CEO)

Yeah, I do think we're winning market share. It's been, you know, obviously a strong quarter. As I mentioned, we're seeing that resilience in the consumer continue as we go forward. We think we're absolutely on the right strategy. We think it's gonna drive not only some market share gain, but obviously paid accounts as we get through the year. We're really happy with where we're sitting. We think the pricing strategy was exactly the right move, especially as, you know, we are a services business at the forefront, and the hardware sale is really how we instantiate that relationship with the end user. This is really leaning into that, and it's providing great results for the company.

Hamed Khorsand (Principal)

Okay. Thank you.

Matt McRae (CEO)

Thank you, Hamed.

Operator (participant)

That does conclude the question and answer session and also concludes today's conference. We would like to thank you all for your participation. You may now disconnect.