Arlo Technologies - Q3 2023

Transcript

Kurt Binder (CFO)

was 353, which represents a slight change from 345 team members at the end of Q2, and 360 team members in the same prior year period. In Q3, we posted non-GAAP net income of $9.6 million. Our non-GAAP net income translates to earnings per dilutive share of $0.09, a record for Arlo, and at the high end of our guidance range. Regarding our balance sheet and liquidity position, we ended the quarter with $126 million in available cash, cash equivalents, and short-term investments. This balance was up over $2 million sequentially and demonstrates the solid capital position that Arlo is in right now.

We are pleased to report that we generated approximately $7 million in free cash flow in Q3, which represents free cash flow margin of 5%, an improvement driven by our increased profitability and solid working capital management. Additionally, our year-to-date free cash flow was a remarkable $28 million throughout the first three quarters of 2023, or an almost $64 million improvement over the same period last year. Our Q3 inventory balance ended at $53 million, up $14 million from Q2 2023, as a result of the launch of our Essential 2 camera portfolio and in line with our expectations. Inventory turns in Q3 were at 5.5 times, down from 6.1 times in the last quarter. Our new product launch will enable us to remain highly aggressive with our product pricing strategy, particularly through the holiday season and into 2024.

We remain focused on maintaining appropriate inventory levels to effectuate a smooth product transition with our retailers and partners. These factors have impacted our inventory balance and thereby our ability to generate similar levels of free cash flow. And finally, our accounts receivable balance was $70 million at the quarter end, with Q3 DSOs at 49 days, down from 59 days from the same period last year. We will continue to monitor our working capital balances in line with our revenue and forecasted consumer demand levels, with a focus on maintaining a solid balance sheet and liquidity position in the future. Now, turning to our outlook.

We expect fourth quarter revenue for 2023 to be in the range of $129 million-$139 million, or $485 million-$495 million for the full year, thereby increasing the midpoint of our full year guidance. We expect our GAAP net loss per diluted share to be between a loss of $0.05 to income of $0.01 per share, and our non-GAAP net income per diluted share to be between $0.06 and $0.12 per share for Q4 2023. Service revenue is still forecasted to grow at approximately 45% over last year, thereby becoming a much larger portion of our overall revenue and profitability mix, and we expect non-GAAP services gross margin to be in the range of 75% for 2023.

Now I'll open it up for questions.

Operator (participant)

At this time, if you would like to ask a question, please press star followed by the number one on your telephone keypad. We'll pause for just a moment to compile the questions. Your first question comes from the line of Scott Searle with Roth MKM. Your line is open. Scott Searle with MKM, your line is open.

Scott Searle (Managing Director and Senior Research Analyst)

Hey, good afternoon. Thanks for taking my questions. Nice job on the quarter, guys. Hey, Kurt, I apologize, bouncing between calls, but I was wondering if you could talk a little bit about the ARPU mix in the quarter between strategics, and otherwise. It looked like it was a little bit down sequentially. I'm wondering if there's anything to read into that in terms of pricing, rebates or otherwise, and how we should expect that to trend over the next couple of quarters.

Kurt Binder (CFO)

Yeah. Hey, Scott, welcome to the team. Thanks again for your support, and glad to have you on the call today. Great question. You know, we're still very pleased with the way that our ARPU is trending. We've communicated in the past that when you look at our retail channel, our ARPU trends in the range of $11.50, which is up year-over-year, driven much because of our pricing strategy that we employed earlier this year. So that's been trending very well. The ARPU on the strategic account side is heavily driven around the actual revenue model.

As we've mentioned in the past, it's more of a cost consumption, SaaS-based pricing type model, so that tends to be lower than our retail channel ARPU, but it's right in line with our expectations. What we are seeing, though, is that in terms of the overall subscriber mix, subscriber mix has been mixing up slightly higher on the strategic account side, so that might have a trend of impacting our overall blended ARPU, but it's still in line with expectations, and it's still trending in a favorable way.

Scott Searle (Managing Director and Senior Research Analyst)

Gotcha. And just as a follow-up, I'm wondering if you could talk a little bit about attach rates in terms of paid accounts, if we're seeing any sort of divergence on that front, or things are consistent, you know, progressing in line with expectations. And I guess as part of that now, the more advanced 24/7 security monitoring opportunity for you, I'm wondering, you know, how you see that fitting into the picture, what the broad-based expectations are for that? Thanks.

Matthew McRae (CEO)

Yeah. Yeah, this is Matt. I'm happy to welcome you as well to the call, Scott. From a security perspective, the security system, I mean, we're very excited about that. You know, I'll just kind of reference the announcement we made this morning around the Total Security subscription package, which is really exciting. It combines the service and the hardware together in one low monthly payment. You know, we're doing that with our partner, Affirm, and that's us positioning the security system, which comes with higher ARPU over time in that relationship, in a way that consumers are kind of used to buying that already, especially from a direct customer. So yeah, we're very excited about that.

I'm trying to remember, what was the first part of your question?

Scott Searle (Managing Director and Senior Research Analyst)

Oh, Matt, just in terms of attach rates,

Matthew McRae (CEO)

Oh, Attach Rates.

Scott Searle (Managing Director and Senior Research Analyst)

Yeah.

Matthew McRae (CEO)

Yes, sorry.

Scott Searle (Managing Director and Senior Research Analyst)

Yep.

Matthew McRae (CEO)

Yes, so we haven't seen any big changes in attach rates or conversion rates. And just to remind everybody, we actually track both. So attach rates for us is a measure 30 days after the initial trial is done. We take a quick snap and look at the attach rates, and that's roughly 50%, and then we continue to follow those cohorts all the way up till six months or later, and that's what we call our conversion rate. Both of those metrics, and I will even add churn to this bucket, are still extremely consistent, quarter-over-quarter, so we're not seeing any big swings there at all.

Scott Searle (Managing Director and Senior Research Analyst)

Great. Thanks so much.

Matthew McRae (CEO)

Yeah, you're welcome.

Operator (participant)

Your next question comes from the line of Jacob Stephan with Lake Street. Your line is open.

Jacob Stephan (Senior Research Analyst)

Hey, guys. Congrats on the quarter. I guess the first question would kind of be focusing on the service gross margins here. You know, when I look at service gross margin decline sequentially, you know, is there anything specific you can really point to, as, as the reasoning? And maybe just kind of reiterate, you know, why you think you can hit that 75%, full year target.

Kurt Binder (CFO)

Yeah. Hey, Jacob. Hey, glad to have you on the call. Yeah, so as you pointed out, overall services gross margin quarter-over-quarter did drop slightly. We were at 75% on a Non-GAAP basis. Last quarter, we were at 74%, 74.1% this quarter. A lot of that was driven by the services revenue mix in the quarter. As we've talked about in the past, we do have quarters where NRE is a bigger portion of our overall revenue, and our NRE service revenue tends to be at a lower margin profile. So that will happen quarter to quarter. You may see some fluctuations. But I will say, and I, you know, emphasize that we're still very extremely excited about how we're executing on the services business.

As we mentioned previous quarter, we reiterate again this quarter, that we expect that services business to be up 45% year-over-year, and we still are targeting for a full year to be in that range of 75%. So that's our target for the year.

Jacob Stephan (Senior Research Analyst)

Okay. So if I recall correctly, the guidance for service revenue growth year-over-year was raised slightly last quarter, and I think it equated to something around 48%. So is this kind of just a resetting of expectations, or I guess just a little like downtick or-

Kurt Binder (CFO)

No, no.

Jacob Stephan (Senior Research Analyst)

[crosstalk] You know, understand that?

Kurt Binder (CFO)

Last quarter... Yeah, we definitely guided to a, in that $200 million range for sure. I don't know if we actually cited the actual percentage growth, but what we see from when you look at last year's full year service revenue versus this year's full year service revenue, to be exact, we'll be up probably 45%. That's what we're targeting.

Jacob Stephan (Senior Research Analyst)

Okay. And just one more on the kind of overall competitive environment. I mean, ADT reported recently, you know, they're kind of refocusing on the core business, you know, launching some newer, you know, kind of lower ASP products. You know, do you see any new kind of competitors or any new competition from ADT or any of the other guys in the market?

Matthew McRae (CEO)

Yeah

Jacob Stephan (Senior Research Analyst)

-today?

Matthew McRae (CEO)

It's a great question. We are actually seeing some more consolidation, and actually some brands come out of our major channels, which I think provides some opportunity on the upside. So if I step back and just provide a little bit of commentary on what we're seeing, you know, across both Arlo.com, but more specifically, our retail and direct paid channels, like the big retailers. You know, we positioned ourselves, I think, extraordinarily well based on our pricing strategy and some of the things we talked about in our prepared remarks, and we're expecting, you know, a great holiday season. I mentioned in the prepared remarks that we had an above forecast or strong Amazon Big Deal Day, which was in the October timeframe.

I'm happy to report today, too, that Walmart launched its AE event, which is its annual event, which is kind of its biggest promotion in Q4 for its holiday period yesterday. Arlo is the flagship product for that in this market segment, and we've got about, you know, a day and a half of data under our belt, and it's actually stronger than expectation as well. So we're seeing, like I mentioned before, you know, a consistent, resilient demand based on how we're executing in the channels, and we're starting to see in certain channels some of our competitors actually be pulled off the shelf as the retailers are concentrating on those brands that are actually investing in the channel and actually driving growth for them.

So yes, there's some noise about certain products being launched here and there, but I would say the overall trends we're seeing in our channels are actually around us gaining share, us gaining mind share with the channel partners, and seeing some of our competitors actually come off the shelf.

Jacob Stephan (Senior Research Analyst)

Okay. Yeah, no, that's, that's very helpful. Thanks for all the, the color. Good luck going forward here, guys.

Matthew McRae (CEO)

Thank you.

Adam Tindle (Managing Director)

Definitely. Thank you.

Operator (participant)

Your next question comes from the line of Adam Tindle with Raymond James. Your line is open.

Adam Tindle (Managing Director)

Okay, thanks. Good afternoon, and congrats on the $200 million of ARR, a really nice milestone to hit there. I wanted to start, Matt, on net new paid subscribers. I think it was just under 200,000, 197,000 for the quarter. And if we compare that to net new registered users, it looks like the attach rate that we could see is a little bit lower than it's been in a couple of quarters, and I wonder if there's maybe some rationale behind that. And then secondly, that 197 number is also a little bit lower sequentially. I think it's above your typical targets, but. And you had some one-timers in there. Just what looks like the implied deceleration sequentially.

Any comments on that and the implied attach rate on, you know, why it might look a little bit like a deceleration quarter-over-quarter?

Matthew McRae (CEO)

Yeah. Yeah, exactly. Yeah, yeah. Great question, Adam. And actually, the two questions you have are actually related. So I'll remind you, in the previous, I guess two quarters, we commented that Verisure, one of our top partners, is actually doing a bit of a catch-up on the paid account numbers right now. From a revenue and all perspective, we're charging them correctly, but they had a firmware issue in one of their regions where it wasn't incrementing the actual paid account level. So if last quarter, which was closer to 240,000 and change, from a net ad perspective, if you backed out that, it was right in the 170-190 range per quarter.

So, you know, call it the 180, 185, roughly, if you back that out. This quarter, same thing, they added fewer of a catch-up, so we were closer to 200,000, but the catch-up was probably closer to 10,000-15,000, again, putting us right in that 170-190 range. So, removing that noise from just the catch-up, actually, you're seeing consistent growth in paid subscribers as we're going forward. I will say that I think we'll see this continue, so they are not done cleaning up and doing firmware upgrades in that region to get the, the number to kinda increment correctly. And it's just an aberration on that single number, but it does affect certain calculations if you're dividing paid accounts for ARPU and some of those things.

So it can shift things around a little bit. In reality, we're gonna see, I think, still stick with that 170-190 range as we go forward. You may see a bigger catch-up number next quarter, maybe it's smaller. I think we probably have about 2 to maybe 3 more quarters of catch-up at most, before we can get back to just kind of the normal run rate of business. But again, if you back out that kind of fluctuating catch-up from that one region in Europe, the paid account growth is actually perfectly consistent quarter-over-quarter and exactly within the range we've been talking about.

Adam Tindle (Managing Director)

Super helpful. Super helpful. Okay, thank you. And then just as a follow-up, the pro monitoring release, obviously excited to see that. It's been a long time coming. Just, you know, curious if you could comment on... You know, you've had a long time to think about this, how you're looking to differentiate with that platform. There's a number of these offerings out there, how you differentiate. And then, Kurt, if you could, talk about the financial impact. I know it's, you know, probably fairly small right now, but if that grows to a bigger part of the business, what would it do to the financial profile? Thanks.

Matthew McRae (CEO)

Yeah. So the total subscription, what we call Total Security subscriptions, is a relatively unique offer, especially in the DIY space, right? We are basically underneath financing the hardware and the service together over 36 months, but it's being presented to the end user as a subscription because we'll roll them into a subscription on the 37th month. So it is seen as, you know, from an offering perspective, as a single low monthly payment, no upfront cost, and you're getting both the hardware and the professional monitoring for that. If you click through the website, you'll see there's actually three tiers, which is also interesting.

So we have a starter pack that starts as low as $9.99 per month with professional monitoring, and then it goes all the way up to a more, advanced pack that actually includes the full system, plus cameras, multiple sensors, and everything else. So it's got a wide offering range, and it's starting at a very aggressive price point. And the offer, at least in the DIY space, is very unique. One of the reasons we're excited about it is it presents the solution very much in a similar fashion and a very competitive fashion against some of the more traditional security, vendors that are out there. And there's roughly 20-25 million households that have old, traditional security at much higher monthly payments. And here's a solution that says we can not only lower your monthly payment, but there's no outlay for hardware.

So the transition over is actually very easy for the end user. So that's the thought behind it. And it's, you know, it's great. We've already got people signing up, which is great, even though we just launched a couple of hours ago. And so we're excited by that. We'll see how it goes, and then we're hoping to lean in even further next year into that type of offering in the market.

Kurt Binder (CFO)

... Yeah, and then Adam, in terms of its the overall operating model and the financial profile, it's actually very attractive for us. I mean, Matt, I think talked about it last quarter, that we're offering a 24/7 monitoring-type service, but it gives us the ability in our overall portfolio of service plans to uplift our subscribers into a higher plan. And typically, that higher plan is almost 60% greater than our overall blended average. So we see it as an operating model that is very healthy, that allows us to expand ARPU and expand ARPU over time. The great thing is right now, the total security solution we're providing is through our direct-to-consumer channel, and therefore, our profitability is much higher.

Now, we might experiment in getting into other channels with a similar type offering, but right now it's a very healthy, profitable channel for us, and we look to allow that to help us drive ARPU expansion over time, while we're selling it through our direct-to-consumer channel.

Adam Tindle (Managing Director)

Okay, perfect. Just a quick clarification, Kurt. I just hear a lot of the financing component behind this. Could you just double-click on how you went about looking to protect Arlo? Is there recourse to you-

Kurt Binder (CFO)

Yeah

Adam Tindle (Managing Director)

... for, you know?

Kurt Binder (CFO)

Great question. Great question. And the answer is no. That's what was so important about building this partnership with the firm. When we started working on this several months ago, we wanted to make sure that first, the model would resonate with consumers and be over a nice 36-month period. But the great thing about this type of arrangement is we, Arlo, get paid up front for the total package, and then they service and take the risk associated with the credit over that 36 months. So in our case, we, we have very little to no recourse around credit, liability, and we get cash up front, so it improves our overall free cash flow.

What we wanna focus on, though, is as we get to the 36-month term, is what can we do to not only extend that contract with the customer, but also potentially get more services, more hardware bundled for the next phase of that relationship? So all good in terms of, you know, balance sheet and, and credit risk standpoint.

Adam Tindle (Managing Director)

Sounds great. Thank you, guys.

Matthew McRae (CEO)

Sure. Thank you, Adam.

Operator (participant)

Your next question comes from the line of Hamed Khorsand with BWS Financial. Your line is open.

Hamed Khorsand (Principal and Director of Research)

Hi, could you elaborate on your holiday sales plans? Are you specifically about inventory, are you over expressing on the Essential side, where it's gonna be low price point items, or is it a, you know, a balanced mix?

Matthew McRae (CEO)

Yeah. So the, you know, it'll lean into definitely the new product launch, which is, which is our new Essential 2 product. And I think that's a match of what we see just happening in the macroeconomic environment, so we're meeting the consumer where they are. From a unit perspective, it'll be probably our largest quarter as a company from, from, from a holiday perspective, so we're excited by it. The plan is multi-channel. I already mentioned, you know, the activity we had at Amazon earlier in the quarter. The Walmart deal is live as of yesterday, and you'll see some more unfold, obviously through November and the beginning of December. It's probably the most robust holiday plan we've ever had.

And it'll be leaning, as it usually does, leans into the most, you know, the most recent or the newest product at launch, which this year is Essential 2.

Kurt Binder (CFO)

And then from an inventory perspective, I mean, as we head into fourth quarter right now, as we communicated, we're sitting in the $53 million-$54 million range, which frankly, is a very comfortable level for us. Now, we will be stocking up a bit in the early part of Q4 with the ability to replenish over time as these promotion campaigns execute with our retailers. So I think we're well, we're well-situated on our side from an inventory level, and we feel like the retail channel themselves, is those retailers are, are in good standing as well. So I don't expect any concerns of meeting the demand. The demand seems to be evident and present.

We'll have sufficient supply, and we'll monitor it throughout the fourth quarter, make sure that we set ourselves up for success heading into Q1 of next year.

Hamed Khorsand (Principal and Director of Research)

When looking into Q1 of next year, with the 50% conversion rate, how much of a significant move do you expect in the retail ARPU?

Matthew McRae (CEO)

The retail hardware or retail service?

Hamed Khorsand (Principal and Director of Research)

Yeah, the service ARPU, right? Because you're giving away 90 days.

Matthew McRae (CEO)

Actually, our new trial is actually 30 days, so it, it, somewhere it used to be relatively easy to take the entire volume, shipped volume or POS volume in Q4 and say, "That will be service revenue in Q1," because it's a 90-day free trial. As we've migrated to a 30-day trial, it's a little blurrier. So some of the sales, hardware sales in Q4 might see some increased accounts activity in Q4. Some will actually be in Q4 and spill over into Q1. Holiday quarter, Q4, always brings in some other timing variances. A lot of people buy products, and even if they buy in October, they stick it under the tree and don't open it until the end of December or potentially early Q1, and so there's some shifting there.

So from an ARPU perspective, we're not expecting big shifts in ARPU. What I would say we're looking forward to is service revenue lift from potentially having more new households formed over a robust holiday period. But that's some of the normal seasonality I think we've always had in our business. It's just, it's a little blurrier as we move to a shorter free trial period.

Hamed Khorsand (Principal and Director of Research)

Great. Thank you.

Matthew McRae (CEO)

You're welcome.

Operator (participant)

There are no further questions at this time. This does conclude today's conference call. Thank you for joining. You may now disconnect.