Arlo - Earnings Call - Q4 2021

Transcript

Speaker 0

Good afternoon and welcome to Arlo Technologies 2021 Earnings and Investor Briefing. Joining us from the company are Mr. Matthew McCray, CEO and Mr. Gordon Mattingly, CFO.

The format of the meeting today will start with a review of the business and financials for the fourth quarter and full year 2021. We will then share new insights to give investors an enhanced view into the Arlo business, followed by an overview of our long range plan growth drivers. Finally, we will provide Q1 guidance, full year 2022 guidance and a set of new long range targets for the company. There will be time for questions at the end. 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, results of operations and financial condition, including descriptions of our expected future revenue, gross margins, operating margins, tax rates, expenses, cash outlook, guidance for the first quarter and full year 2022, long range guidance and targets, the value of our business overall and individual segments, expected returns for our investors, the effect of our awareness campaign on future growth, our 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, our partnership with Verisure, continued new product and service differentiation, supply chain challenges and the impact of the COVID-nineteen 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 periodic filings with the SEC, including the most recent quarterly 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 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 meeting over to Matt.

Speaker 1

Thank you, Eric, and thank you, everyone, for joining us today on Arlo's fourth quarter twenty twenty one earnings call and investor briefing. When Arlo became a stand alone public company over three years ago, we knew there was enormous potential in a transformation to a services focused strategy. And while that journey was not easy, our unwavering commitment to that outcome and focused execution as a team has built a powerful consumer SaaS business. The goals we set last year to measure our progress on this road of transformation were ambitious and cut across the organization from top line growth to the focus on our services business and the impact it would have on our financials. Arlo beat these goals across the board, achieving $435,000,000 in total revenue and a growth rate of 22%, reaching 1,000,000 paid accounts on December, three months early, achieving $103,500,000 in service revenue, raising our services gross margin to over 60%, achieving $3,500,000 of non GAAP operating profit in Q4 and ending with a healthy cash and cash equivalents balance of $176,000,000 significantly above target.

These results are all the more impressive given the pandemic related supply chain challenges that were present for the entire year, and I could not be prouder of the stellar management and execution by the Arlo team. This is the team that will now turn our focus to achieving Arlo's new long range targets that we will roll out later today. Diving into the fourth quarter results. Arlo achieved record revenue of $142,900,000 up 29 sequentially and 24% year over year, plus a record non GAAP gross profit of $32,700,000 up 30% sequentially and 27% year over year. Our total paid accounts at the 2021 stood at 1,067,000, up 145% year over year.

We added 190,000 paid accounts in the quarter, a record high, which represents an increase of 141% year over year. Our annualized recurring revenue, or ARR, was $90,000,000 in Q4, growing 94% year over year. Driven by our new business model, our ARR is the fastest growing and highest margin portion of our total services revenue and represents the annualized recurring service revenue we derive from our paid accounts. ARR excludes prepaid service revenue, such as legacy carve in revenue from our old business model and NRE service revenue from strategic partners. The strength of our ARR helped grow non GAAP service gross margin to 63.2%, up from 59.5% in Q3 twenty twenty one and '58 point 9% a year ago, another record for Arlo.

The momentum we are seeing across the business culminated in a record non GAAP operating profit of $3,500,000 up $10,800,000 sequentially and $10,000,000 year over year, and most significantly, our first quarter of profitability as a public company. To achieve this, we overcame an additional $4,600,000 of airfreight expense as a result of the global supply chain situation, a true testament to how the team is executing. Our new Arlo Secure service plans are at the core of this incredible performance. Arlo Secure features computer vision based object detection, AI based audio detection, interactive notifications, animated event preview, secure cloud storage of video and 20 fourseven premium support. Arlo Secure Plus includes all of the features from Arlo Secure, increases the resolution of cloud video storage up to four k, and includes Arlo's new 20 emergency response, which provides the ability to directly request fire, police, or medical first responders and speak with a security expert in the event of emergency.

As a reminder, under our new business model, where we include a free 90 trial of Arlo Secure, we have consistently seen a 50% subscription conversion rate upon expiration of the initial trial period. And as we follow cohorts over a six month period, we have seen the attach rate to our subscription services grow to nearly 65%. Our industry leading technology continues to outclass the competition and receive critical acclaim from expert publications. Since our last earnings call in November, our products have been recognized with two Editors' Choice Awards, multiple design awards and featured in Best of twenty twenty one lists across the industry. Innovation has been a hallmark of Arlo from the very beginning, and this will continue to be an area of focus as we endeavor to create the best products and services for our customers.

And now I would like to hand the meeting over to Gordon, who will provide more insight into our financial performance and operational details.

Speaker 2

Thank you, Matt, and thank you, everyone, for joining us today. As Matt mentioned, we delivered our strongest ever financial results in Q4. Revenue was a record for the company, above the high end of our guidance and up 24.4% over Q4 twenty twenty, while our non GAAP gross profit was also a record and over indexed our revenue growth, growing 27% year over year. Our financial performance for the quarter was again underpinned by the successful execution of our new business model, leading to record levels of paid accounts and record non GAAP service gross margin as a public company of 63.2%. Despite the significant airfreight headwinds outlined on our last call, we were able to exceed expectations on non GAAP gross profit, which, coupled with our disciplined management of operating expenses, meant we delivered our highest ever non GAAP operating result as a public company, crossing over to a non GAAP operating profit of $3,500,000 Our non GAAP operating result was up an impressive $10,000,000 over Q4 twenty twenty, performance which underlines the transformation in our business.

And now moving on to the Q4 financial detail. Revenue came in at $142,900,000 up 24.4% year over year and 28.5% sequentially. Our service revenue for Q4 twenty twenty one was a record 28,500,000 up 5.4% sequentially and up 32% over last year, with our new business model fueling our growth. While service revenue accounted for 19.9% of our Q4 twenty twenty one revenue, it delivered 55% of our non GAAP gross profit. Our service revenue also includes $1,100,000 of NRE services we are providing for Verisure, along with associated costs as compared with $1,300,000 in the 2021.

Product revenue for Q4 twenty twenty one was 114,400,000 which was up 35.9% sequentially and up 22.6% compared to last year. Our year over year product revenue growth was driven by continued strength from our Verisure relationship in Europe, while Europe and Asia Pacific both contributed to the sequential increase. Despite the fantastic job our supply chain team did to secure supply to help us exceed expectations in Q4, year over year and sequential product revenue growth were both impacted by supply chain challenges, which were most pronounced in supply for The Americas. During the fourth quarter, we shipped approximately 1,303,000 devices, all of which 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 2021 was up $7,000,000 year over year to $32,700,000 which resulted in a non GAAP gross margin of 22.9%, up from 22.6% in Q3 twenty twenty one and up from 22.4% in Q4 twenty twenty. The £7,000,000 year over year improvement in non GAAP gross profit included improvements of £5,300,000 from services and £1,700,000 from products. Product gross margin was impacted by COVID-nineteen related supply chain challenges, which drove a significant $4,600,000 increase in air freight expense year over year. Non GAAP service gross margin came in at 63.2%, higher than both the 59.5% in Q3 twenty twenty one and 58.9% in Q4 twenty twenty.

The year over year and sequential growth was driven by substantial paid account growth under our new business model, coupled with continued cost management progress. Non GAAP product gross margin was 12.9%, up from 10.8 in Q3 twenty twenty one, mainly due to scale benefits and lower sales returns offsetting the incremental air freight expense and down from 14% a year ago, again mainly impacted by the incremental $4,600,000 in air freight expense, offset by scale benefits and lower sales returns. While short term product gross margin will continue to be adversely impacted by incremental air freight expense due to the current COVID-nineteen related supply chain challenges, the incremental long term customer lifetime value we derive from the associated paid accounts is compelling, and we believe more than justifies the investment. Matt and I will discuss this further in the next segment of today's meeting. Total non GAAP operating expenses were $29,200,000 down $3,300,000 or 10.1% sequentially and down $3,000,000 or 9.5% year over year as we started to benefit from the sublease of our former San Jose office and lower professional fees.

Our total non GAAP R and D expense for the fourth quarter was down sequentially at $11,300,000 Our headcount at the end of Q4 was three fifty three employees compared to three forty six 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 have included these costs in our normal operating expenses. The reimbursement from Verisure is included in other income and was approximately $500,000 during Q4. Our non GAAP tax expense for the 2021 was $200,000 In Q4, we posted a non GAAP net profit per diluted share of $04 much better than our guidance and a £0.12 improvement year over year.

We ended the quarter with $175,700,000 in cash, cash equivalents and short term investments, up $9,700,000 sequentially and down $30,400,000 year over year. Q4 inventory closed at $38,400,000 a decrease of $1,400,000 over Q3 twenty twenty one, with turns at 10.5 as compared to 7.6 last quarter and five a year ago, reflecting the supply chain challenges. Our DSO came in at fifty days, down from sixty four days a year ago and from sixty two days sequentially, with the decrease being driven by the timing of shipments in the quarter, customer mix and strong performance by our collections team. And now I'll hand it back to Matt, who's going to kick off the Business Insights segment of today's meeting.

Speaker 1

Thank you, Gordon. As you can see from our strong performance in the fourth quarter, Arlo is now a fast growing services business. Our transformation away from a pure hardware company affected every aspect of the company, from our road map and operations to the culture that guides Arlo's direction. We are focused on creating and sustaining meaningful recurring relationships with our users by providing innovative solutions for the security of their home and loved ones. Everyone deserves to feel safe, and this broader vision is fueling our continued growth.

And that growth is evidenced by the scale of our platform, which is one of the most intelligent and scaled SaaS cloud implementations in the world with real time audio and video AI capabilities, low latency emergency event responses, and fully integrated smart home device control. Arlo's platform captures over two thirty million videos per day while processing more than fifteen hundred hours of video per minute, providing a constant security presence for our users and partners. Arlo's transition to the new services first business model triggered an inflection point in our business and is driving the utilization of our SaaS platform. We crossed 500,000 paid accounts on 03/01/2021 and then doubled that number to 1,000,000 paid accounts on 12/01/2021. Our year over year paid account growth was 145% in Q4 twenty twenty one, which drove our record breaking results.

As you can see, our growth has been very consistent. And as a result, we feel this area of our business could benefit from additional investment. In an effort to provide more visibility into Arlo's Services business, we recently began reporting our annual recurring revenue, which reached $90,000,000 in the fourth quarter, growing at nearly 100% year over year. And we expect to reach $100,000,000 in ARR in the first quarter of twenty twenty two, which is another large milestone for the company and puts a spotlight on the immense value created since our business model changed. As we look forward at Arlo and consider how to invest our capital to further accelerate shareholder value creation, we thought it would be helpful to provide some additional onetime snapshot metrics on our Services business.

If we look at quarterly churn to provide more context and to compare with some of the top consumer services companies in the world, you will see that best in class businesses trend roughly between two point five percent and five percent, with Netflix being the lowest at 2.4%. Looking specifically at the churn rate of Arlo's new business model, which does not include the older legacy accounts and is therefore representative of our current and future business, you will see Arlo's churn rate is 2.8%. While we are extremely proud of this number, it is an area of continuous focus for us as we optimize and improve our services business and consumer experience. If we dive a little deeper and focus specifically on the retail and direct paid accounts, which constitute more than 95% of our ARR, in the 2021, these accounts had a monthly average revenue per user, or ARPU, of $9.35 ARPU is a new focus area for Arlo after achieving our near 65% attach rates on service. We have seen a very consistent and predictable performance through the quarters.

And as you would expect, extremely focused performance on the next stage of our journey, driving both subscriber acceleration and ARPU expansion. Our recent launch of Emergency Response is our first small step at growing ARPU, and I'm happy to report that we saw a $0.27 lift in ARPU on new subscribers after the launch when comparing to before Emergency Response was available. The gross margin for our Retail and Direct paid accounts was more than 80% in Q4, showing the profitability of Arlo Secure and Arlo Secure Plus. And finally, our Retail and Direct monthly churn rate was a healthy 1.2%, demonstrating the value our service has to users and the resulting stickiness of our services and our ability to retain subscribers. What these metrics show is a Services business generating more than $90,000,000 in ARR, growing at nearly 100% year over year, with the largest portion of that business, Retail and Direct Paid accounts, generating more than $9 ARPU with gross margins in excess of 80% and a monthly churn rate of 1.2%.

These are world class consumer SaaS metrics and illustrate the health and performance of our services business. And while the full value of this business is not yet reflected in the present, this deeper dive provides the perfect context for Arlo's path forward and where we plan to focus our efforts to drive additional shareholder value over the next three to five years. Gordon and I will now walk you through three main strategic and execution pillars that formed out of our extensive long range planning process over the last six months. Our lens throughout this process was driving growth and maximizing shareholder value. The first is brand awareness.

As you know, Arlo prides itself on the innovation and quality across our products and services. We win the bulk of reviews, head to head comparisons, Editor's Choice Awards, and Best of Awards with reviewers calling out our leading user experience, rich service features, ease of installation, interoperability, and high quality devices. The question I often get is why anyone would buy anything other than Arlo. This is a question we often look at through direct surveys and potential customer outreach. The number one reason people don't purchase Arlo is that they have never heard of Arlo.

Not everyone reads the expert reviews or sees the awards. And as this market segment moves into the mainstream, awareness will be linked to accelerating future growth. And now that our transformation is complete, we can move our attention to that acceleration.

Speaker 2

As a services first business, we believe it is appropriate to appraise our investment decisions based on metrics that are commonly applied to subscription and SaaS companies, namely the cost to acquire customers or CAC and lifetime value or LTV. Addressing CAC first, you can see that the non GAAP gross profit generated by our product sales fully funds our non GAAP sales and marketing expenses, including the three month free trial of Arlo Secure, which we carve out from revenue and deduct from product gross profit at the time of sale. With non GAAP product gross profit fully covering the entire company's non GAAP sales and marketing costs, this means our paid account net CAC is zero. Now using churn, ARPU and gross margin for our overall recurring paid services business, we calculate the lifetime value of a paid account as $550 per account. Said another way, with our current level of investment to acquire new valuable paid accounts fully funded by the profit we earn on our product sales and in the context of what Match has told us, the fact that the number one reason people do not buy Arlo is because they have not heard of us, we believe this presents a truly compelling investment opportunity.

Putting all this together and summarizing it, our technology is consistently rated the best in the market. The number one reason customers choose competing brands over Arlo is they have not heard of Arlo. With a net CAC of zero, we have room to invest to generate awareness of Arlo and acquire new paid accounts. And finally, our LTV is on a par with best in class consumer SaaS companies in the world. For these reasons, we believe now is the opportune moment to turn up the volume, drive awareness of our incredible brand and harvest what we expect will be significant incremental LTV and return for investors.

Of course, we will do this in a measured way, and we'll apply the same diligence, rigor and discipline to this investment that we demonstrated as we transformed our business and took Arlo to non GAAP profitability. Our new awareness campaign will start in the second quarter of this year and begin with an initial $21,000,000 total investment for the year, dollars 1,000,000 in Q2 and $10,000,000 in Q3 and Q4. While this year's spend may provide some nominal lift in 2022, the natural lag before it takes effect means the most likely impact will be felt in the following year. And if measured effective, we expect to maintain our incremental awareness spending at a run rate of about $10,000,000 per quarter in 2023. This initial awareness investment is directly focused on household formation and driving incremental retail paid accounts.

I will provide more color on what this will look like in our guidance section as we position Arlo to capitalize on what we believe is a significant untapped opportunity for our business.

Speaker 1

The second area of focus to driving additional annual recurring revenue for Arlo will be expansion of our product and services portfolio. During the transformation of our business, Arlo expanded into new product categories such as doorbells and floodlights. Entering these high growth product categories diversified our revenue and drove incremental paid accounts over the years, but both were close to the core smart security camera space we helped invent years ago. Our intention going forward is to launch three new product service offerings in the next three years that will be focused on driving additional high margin recurring revenue, and I'll be touching on two of these launches today. The first is a new announcement for a service called Arlo Safe.

While Arlo's current products and services provide security and safety for a physical location and those residing there, Arlo Safe provides safety for a person or family no matter where they are located. The service allows a single tap to request emergency help from our twenty four seven safety experts. It could be a safety emergency, a medical emergency, or a fire, and Arlo Safe will priority dispatch the needed first responders to the user's location. This feature can also alert personal safety contacts such as friends or family that can provide additional assistance. And it includes walk with me, which allows the user to hold a button until they are clear of a dangerous situation.

The service also includes a broader family safety and communications platform. Family members can see each other's location either through real time tracking or through opt in check ins, and help can be sent to a family member's location in the event of emergency. And the service includes crash response, which can automatically sense an automobile crash and summon help if the user is unable to do so on their own. The alert would also be sent to your family or safety contacts with exact location information. We are very excited to extend Arlo's value proposition beyond physical building locations to provide our users peace of mind on the go and for their entire family.

Arlo Safe will be launching this summer. The second major product expansion was announced at CES, the Arlo Security System. This moves Arlo beyond video monitoring into the full security space, increasing our total available market. The system is anchored by an innovative modular hub, which includes a keypad, battery backup, cellular backup, and NFC, which allows arming and disarming from a mobile phone or smartwatch. The hub is paired with an innovative multi sensor, which includes eight functions, motion detection, door sensing, window sensing, tilt sensing, temperature sensing, water leak sensing, smoke alarm detection, carbon monoxide alarm detection and ambient light sensing in a small form factor the size of your thumb.

Arlo's MultiSensor enables unprecedented flexibility for the DIY end user and a significantly simpler supply chain execution for our partners. The Arlo Security System has already won numerous awards, including the CES Innovation Honoree, CES Editor's Choice, Top Pick and two Best of CES Awards. Arlo also announced support for Matter, the smart home device interoperability specification, also supported by Apple, Amazon and Google. This not only underscores our continued commitment to be the most compatible security solution on the market, but it also signals Arlo's move into the broader smart home control space with future user experiences to be announced later this year. These product launches will be supported by an expanded service offering.

You are familiar with our current smart security camera plans, Arlo Secure and Arlo Secure Plus with emergency response. Arlo Safe will have two plans, an individual plan for $4.99 per month and a full family plan with added features for $9.99 per month. And later this year, we anticipate rolling out a compelling bundle called Safe and Secure Pro that combines the features of Secure Plus with the features of Safe Family and adds full professional monitoring, cellular backup, and battery backup for our security system at $19.99 per month. This represents the most significant expansion of our service offering since our company's inception and provides Arlo opportunities to capture new households and continue to focus on ARPU expansion over time. The third major area of focus for Arlo to drive growth and shareholder value is continued investment across our channels.

When Arlo spun from Netgear, one of our goals was to launch new channels and diversify our sources of revenue. We began to focus on b to b partnerships and launched arlo.com as a direct channel. As you can see, this has been an area of great success, and the traditional retail and ecommerce channel is now less than 50% of our sales, which has reduced execution risk. And there is significant opportunity for growth across these new channels. Arlo is available from all major retailer and e commerce sites across our major regions.

The pandemic has blurred some of the once bright lines in this channel, with physical retailers selling online and leveraging their footprint for distribution or in store pickup, while online retailers are exploring store locations to serve customers better. There are opportunities to invest and grow this channel by leveraging cross platform tools, insights and the convergence of these best practices we have developed over the last two years. We are also excited to work with our partners on our new product launches that expand the category beyond location based security. Our decision to invest in arlo.com has delivered impressive results as well, far exceeding our expectations. It created a direct relationship with our users, providing additional insights into buying behavior.

And since we launched in July 2019, arlo.com has rapidly grown and now generates more profit than any other channel in North America. Additionally, with immediate payment terms, it is also the channel with by far the shortest cash conversion cycle. With our planned investment in awareness and the resulting traffic, we expect arlo.com to continue to grow and become an increasingly important channel for us and our customers in the next few years. Two years ago, we launched Arlo Smart Cloud, which leveraged our incredible SaaS platform to meet the needs of B2B partners on a global basis. These strategic accounts quickly became our fastest growing channel and often feature 100% attach rate on service, which drives our paid accounts.

Arlo has built a meaningful business dedicated to driving the success of our partners, many of which you see listed here. I would like to take a moment to update you on several initiatives in this area. Our partnership with Calix launched last year and created a compelling channel for Arlo to reach rural and remote users that may be underserved by traditional retail stores. Calix has integrated Arlo services into platform to broadband service providers around the country. Through this relationship, Arlo Secure has a one:one attach rate on hardware deployments.

13 BSPs are signed up, and we look forward to this partnership continuing to ramp throughout the year. Today, we are announcing that our partnership with Calix will be expanded to include the new Arlo security system. Soon, broadband service providers will be able to provide Arlo's full home security services through Calix's platform. The teams are working on integration now, and a launch date will be provided later this year. Last year, we launched Arlo Go two exclusively with Verizon.

Arlo Go two is a major update to our cellular capable camera and includes WiFi failover, onboard GPS and higher quality video, making it the ideal solution for construction sites, remote locations and numerous other verticals. Verizon sells ARLOGO II in store and online with the option to finance the hardware purchase on the user's monthly bill. I'm excited to announce that the distribution of Arlo Go two will expand dramatically in the 2022 with AT and T, Bell Mobility, Cellcom, U. S. Cellular and T Mobile all already launched or launching soon, and we expect more carriers to be announced later this year.

And finally, Verisure, our deep strategic partner in Europe. Arlo's suite of products and services are being sold by Verisure not only through its retail channel, but also through its direct security channel where it has more than 4,000,000 customers across Europe and Latin America. Last year, we finished the integration of our systems and started production on the first custom hardware device for Verisure, a specific indoor motion detector and camera. The custom camera was successfully moved into production in Q2 for initial field rollouts in Europe in the 2021 and full volume deployments in 2022. As you recall, we have a five year initial term with Verisure.

We have a $500,000,000 minimum purchase guarantee on Arlo hardware alone. Strength from shipments of the customized camera helped lift revenue in Europe to $53,600,000 or 37.5% of our revenue in the 2021, up 250% year over year. For the full year 2021, Europe grew to $134,200,000 up 117% year over year and accounting for 31% of our revenue. As the partnership entered 2022, we were 40% through the contract term, while Verisure had purchased 32% of their $500,000,000 commitment, which shows the minimum growth we expect to see over the next three years of our initial term. I am pleased to announce that based on the success of that first custom product, we are now developing a second custom product for Verisure that should further drive growth upon its expected deployment in 2023.

In summary, Arlo's long range plan is focused on these three primary areas to drive growth. We are confident that investing in awareness to fill our well characterized funnel, expansion into new product categories focused on subscription services and investing into our diversified routes to market will maximize shareholder value creation. And now I will hand it back to Gordon, who will cover 2022 guidance and our new long term targets based on this plan.

Speaker 2

Thank you, Matt. For the 2022, we expect revenue to be in the range of $110,000,000 to $120,000,000 up just under 40% year over year at the midpoint. Our team continues to do an incredible job navigating unprecedented COVID-nineteen related supply chain challenges, helping us deliver to demand. We expect our GAAP net loss per diluted share to come in between 19¢ and 13¢ per share, and our non GAAP net loss per diluted share to come in between a loss of 6¢ and 0¢ per share. Our guidance includes air freight expense of approximately 5¢ per diluted share compared to 8¢ per diluted share in q four twenty one and less than 1¢ per diluted share in Q1 twenty twenty one.

This additional freight expenditure is a direct result of the current COVID-nineteen related supply chain challenges. We expect airfreight expense will normalize when the global supply chain situation stabilizes. Moving on to 2022 as a whole, we expect revenue to be in the range of $490,000,000 to $510,000,000 up 15% year over year at the midpoint of our guidance range. In terms of seasonality, we expect approximately 44% of our 2022 revenue will be in the first half. Service revenue is estimated to grow about 30% year over year.

As a reminder, service revenue comprises three streams, NRE service revenue and prepaid service revenue, both of which we expect to shrink year over year will be complete our current custom camera projects with Verisure and move further away from our legacy business model and recurring paid service revenue, which we expect to grow 55% to 60% year over year. We estimate non GAAP product gross margin will land in the low to mid teens range as it will continue to be heavily impacted by airfreight. We expect non GAAP service gross margin to be in the 60% to 65% range. We expect non GAAP operating expenses will come in at approximately $160,000,000 for the year, starting at $33,000,000 to $34,000,000 in the first half and then increasing in line with the $20,000,000 awareness investment in the second half. For the full year, we expect our non GAAP operating loss will be in the range of $15,000,000 to $25,000,000 in line with the amount that we will invest in Awareness.

As we move into 2023, we expect to see the investments in awareness first drive product sales, which will then drive subscription acceleration. Given that, we expect our top line percentage growth rate to roughly double year over year into the 30s in 2023. We expect the awareness investment to drive increased product revenue growth through the year, with a resulting increase in service revenue growth to follow. As a reminder, with the three month trial of Arlo Secure, which we offer on all new business model products, there is a little more than a one quarter lag from product sell through to paid account sign up. We expect the leverage provided by this growth will return Arlo to full year non GAAP operating profitability in 2023 and will drive non GAAP operating margin expansion in the following years.

With this accelerated growth trajectory, we would like to share the new long term targets, which we expect to reach in the next three plus years. We believe our strategy will produce more than 5,000,000 paid accounts and result in a greater than $1,000,000,000 business. We expect our ARR will more than triple in that time to over $300,000,000. With the greater top line leverage and contribution from the highly profitable recurring revenue stream, we expect to achieve double digit non GAAP operating margins. We at Arlo are extremely excited about this transition and the new trajectory it puts us on.

It is clearly based on the hard work and exemplary execution of our team over the past three years. We appreciate you joining us today and look forward to sharing more with you on our progress in the coming quarters. And with that, I'll open it up for questions.

Speaker 3

The coming quarters. And with that, I'll open it up for questions.

Speaker 4

Thank you. And we will go first to Adam Tindle of Raymond James.

Speaker 5

Okay. Thank you very much. A lot of information there. And I thought maybe I'd just start with a high level question, Matt. First of all, congrats on the very strong finish to the year and reaching that breakeven plus.

You basically self funded to 1,000,000 subscribers, and it was helpful for you to outline that in the CAC presentation. I just wanted to ask, why not just keep running that engine? Wondering what other operational models that you evaluated, like staying the course and the risk versus benefit of the increased spending here in the interim? If you could maybe just kind of give us a high level view of the different strategies that you talked about in the planning session, that would be helpful. Thanks.

Speaker 6

Yes, great question, Adam. We did go through a very extensive process. We've talked about it on past calls, the long range planning process and looked at the trajectory of the company over the next three to five years on an organic growth path, meaning using continuing to do the self funding and what trajectory that would actually produce for the company versus a smaller, modest, very well disciplined investment in the brand and where that would bring us. And the reason to give you some of those extra business insights like the net CAC and LTV shows you how much room we really have to invest and actually accelerate the shareholder value creation over time. So we did ran multiple scenarios and came out at the level that you see, obviously blended with where we are in the supply chain, how much inventory we can get over the next twelve months and blending all that together into the plan you see here today.

And this actually optimized for shareholder value creation, like I said, between the three to five year. But almost every type of trajectory of spend was actually looked at and this is the optimal one for the company.

Speaker 5

Okay. That's helpful. And it's obviously nothing overly dramatic, particularly given the cash on the balance sheet at the moment. But maybe, Gordon, if you could double click on the composition of the incremental spending. Is there a way that we could think about, you know, what portion is more fixed versus variable?

How quickly you can flex the business model because this is a market that changes rapidly? Maybe just give us a little bit more color on the investments and where they're going, how much fixed versus variable?

Speaker 3

Yes, great question. I'll take part of it and ask Matt to take the other part. So the spending is pretty much entirely discretionary. I mean, we can turn that spending on or off and adjust it as we see the results coming in. So it's not a fixed level of spending.

It is discretionary, driven by us. And we certainly plan to tailor it based on the results that we see. As to the actual composition of what that spending is addressing, I will ask Matt to speak to that with a bit more color.

Speaker 6

Yes. It's very much focused on the higher up portion of the funnel. So Adam, as you know, we've been organically kind of running the business as we went through this business transformation from a hardware first company to now a services first company. And that meant the bulk of any spend we had anywhere in the marketing area was really very low in the funnel, in the channel, working closely with our partners, little bit in arlo.com, very close to where the decision making process was for a purchase. And that served us pretty well into here on a certain growth path.

That spend will continue. So we'll continue to execute in channel kind of close to that decision making process. What you'll see here is that modest level of kind of increased spend on the higher portions of the funnel. So brand awareness, solution product awareness and education, bringing people to the brand, bringing people to the top of the funnel. Because everything else from the top of the funnel down, we have very well characterized, right?

Part of our transformation and part of the last eight quarters as a company is we've gotten a very good handle on product sale, dropping to activation, dropping to trial, dropping to conversion, dropping to our attach rates and churn. And so a lot of that we want to share today so you could really see the health of that business. And so the primary goal of the spend is to actually bring more households, more users into the top of the funnel to run that through our very well characterized model. That's why we're so comfortable with the ROI.

Speaker 5

Yes, makes sense. Very helpful. Maybe just one last one. I've got 10 more, but I'll keep it to one last one. You gave a stat on secure, talking about how 50% subscribe after expiration and then up to 65% subscribe within six months.

And I just wanted you to maybe double click on the strategy to chase down and increase that subscriber conversion late. It's pretty unusual to be able to do that in consumer, and you're kind of proving an upsell engine arguably. I'm wondering if you could double click on that strategy and then wondering what you can apply that to new services that you think about as you think about those meaningful recurring relationships with customers? Thanks.

Speaker 6

Yes. That's a great question. We a lot of that is just a very disciplined execution of promotional journeys that we take our customers through. So we now have a very good idea of when a customer activates, what's the journey, how many percent actually become a customer in the first ninety days, how many between 9,120, what messages at 120 and beyond gets them to actually reengage and become a customer. Why are they churning?

How do we bring them back? So it's a tremendous it's basically based on two years of a tremendous amount of detail around AB testing, the journeys that we take them through. And I think we have a good leadership inside of the company, but also a very good engine at eking out little portions of percentages here and there and optimizing it over time. We mentioned you brought up a new product. We announced Arlo Safe today, which we're really excited about.

It will launch this summer. And that's a new service for us that doesn't even require hardware. It actually shortens the funnel. And so a lot of the expertise and a lot of the learnings that we've got on Arlo Secure, you'll see us bring over to Arlo Safe as we rapidly learn post launch on how to optimize the conversion and the attach rate and reduction of churn over time.

Speaker 5

Great. It seems like a lot of levers at your disposal. Congrats again. I'll hop back in the queue. Thanks.

Speaker 6

Thanks, Adam. Thank you.

Speaker 4

And we'll go next to Jeffrey Rand of Deutsche Bank.

Speaker 5

Hi. Congrats on another great quarter and thanks for taking the question. As you focus more on ARPU, what gives you the confidence that consumers will further increase their monthly spending with you considering the growing number of monthly subscriptions that consumers are adding are facing throughout their lives?

Speaker 6

Yes. It's really focused on how what role security has in consumer's life. So based on our experience and my past experience, there's a couple of buckets that consumers really feel comfortable spending on a monthly basis. And I won't go through all of them, but obviously content is one of them. You think of movies and music, Netflix and Spotify and things like that.

Well, one of the other major areas is security. And this is a segment of the market where many consumers, still upwards of 20,000,000 to 25,000,000 consumers here in The United States, are paying $40.50 dollars or more, dollars per month. And so our focus is really to provide an outstanding value at the price levels that we showed you in presentation today. So we've already had tremendous success at the roughly $9.99 price point, right? We actually shared for the first time our ARPU on our retail and direct accounts at $9.35 So a $10 price segment looks good.

We gave a little bit of visibility into the ARPU increase that we've seen since we've launched emergency response on new subscribers, a $0.27 increase so far as we've started to create more value. So and then you'll see, as we mentioned, with Arlo Safe and Arlo Safe and Secure plan reaching that $19.99 dollars plan, providing significantly more value at $20 than most traditional security providers provide at $50 per month. So it's an area where consumers are comfortable spending. It's something that matters to them. We're helping them protect an asset, whether it's their home, but also their family.

And so if there's an emotional connection to it, it's an area that they do spend money. And traditionally, they've spent significantly more. And for us, the way we want to capture those customers is provide a lot more value at every price segment that we have.

Speaker 5

Great. Thank you. And as my follow-up, how do you think about free cash flow and cash on your balance sheet after factoring in the incremental awareness spending in 2022 and 2023?

Speaker 3

Yes. If I were to look at cash going through this year, I think we will end the year probably in the range of 110,000,000 to $120,000,000 of cash. That really reflects the guidance we just gave for the operating results for the year, which is breakeven pretty much minus the awareness investment of $21,000,000 It reflects that plus if you look at our inventory at the 2021, our inventory I mean, we'd love to have turns over 10 every quarter, but that's not realistic. So our inventory level is definitely lower than we would ideally like. If you look at the cash flow statement for 2021, you can see that was quite a source of cash generation in the year.

We shrunk our inventory by roughly $25,000,000 in 2021. So the other piece aside from the operating result is really looking to build that inventory back up again. We've talked about it in recent calls that we are missing out on end user demand in some cases just because we don't have the supply when we need it. We definitely want to get our inventory back up to a more healthy level. So that's the guidance for this year.

And then we don't think the cash balance will bottom out much below $100,000,000 as we transition back into non GAAP operating profitability in 2023. That's the outlook on cash.

Speaker 5

Great. Thank you.

Speaker 4

And we'll go to our next question from Hamed Khorsat of BWS Financial.

Speaker 7

Hi, so the first question I had was could you just explain what your strategy is, if it's any different as far as the marketing that you're going to take Calm later this year?

Speaker 6

Well, the strategy is the same, but the marketing we'll be doing is wholly incremental to what we've done historically. So again, historically, it's been mostly lower in the funnel, messaging around obviously the benefits of RLO and the rest. What you'll see us is taking that up higher in the funnel to generate awareness early in the purchase journey of these customers. So it's not a, I would say, a great departure from what we've done in the past. What we're doing is we're turning up the volume higher in the funnel to make sure that we're capturing as many households as we can.

Speaker 7

So is this going to be mainly digital targeted advertising?

Speaker 6

I think you'll see a mix of kind of top funnel strategies. So some traditional media, definitely a lot of digital. One of the things we want to make sure we're doing is really characterizing the performance of the spend that we do through arlo.com, through product purchases, through conversion to paid accounts. And digital will be a big portion of it because we can actually directly tie that performance back and continue to optimize the campaign as we go forward.

Speaker 7

And then the other question I had was just the cadence from the revenue guidance standpoint. It seems like Q1 is even though it's supposed to be seasonally the weakest, it seems like it's still pretty high. Is that impact from Verisure? And how does that play a role as you go on into the rest of the year?

Speaker 3

Yes. I think what we'd say about Q1 is we are benefiting from being already eight weeks into the quarter. So we've got great visibility into Q1. We've got great visibility into supply. And I would say, as you extend the forecast horizon through the latter part of the year, we just don't have quite as good visibility right now.

So the visibility we have in Q1 is really good. That's part of it. Yes, the strength that we saw in Q4 from Berishore, we're expecting continue in Q1. As well as that, look at the weaker stock in retail in Americas. You could see at the end of Q4 that was pretty low.

It was in the seven to eight week range. Typically, you would look for ten to fourteen weeks of inventory in the channel. So part of it is really looking to get that inventory in the Americas retail channel back up to a normal level. So that's all playing to the Q1 guidance and hopefully that gives you a little bit more color on what our thinking is there.

Speaker 7

It does. And then my last question was, as you rolled out Arlo Secure and Secure Plus, could you give any kind of insight as to what the composition of new subscribers is between the two? Are people rolling off from the free trial and staying on with Secure Plus? Or are they opting for the lower Secure?

Speaker 6

Yes. We don't break it out numerically. The best guidance I can give you what we said in our prepared remarks, where we're seeing a $0.27 when you look at ARPU from that blended sign ups on new subscribers versus before emergency response. We're seeing a mix up of $0.27 on a blended basis, meaning there is a bit more people signing up for Arlo Secure Plus than before we had launched Arlo Secure with emergency response.

Speaker 8

Okay. Thank you.

Speaker 6

You're welcome. Thank you.

Speaker 4

And moving on, we'll go to a question from Thomas Bliss of Cowen and Company.

Speaker 8

Great. I appreciate you taking the question. I wanted to specifically see if you could address maybe the transition or conversion of those legacy Arlo Smart customers. Is there specific incentive being offered for them? Or is the plan just being sunset and moved on?

How is that happening?

Speaker 6

Yes. Right now, it's sunset. So, they can keep that plan, although we do see people starting to migrate over because of, emergency response in some cases. But those plans still exist or grandfathered in if you're an existing subscriber.

Speaker 8

Got it. And then as my follow-up, obviously great to see kind of the long term potential of arlo.com taking shape. And I was just wondering today, how are customers engaging with the platform? Is the customer going to say to Best Buy or something like that buying the initial cameras and then as they need more cameras or something going to arlo dot com to get additional services. Is that is that how that's happening?

Speaker 6

Yeah. I I would say there's three, ways that people tend to engage with arlo.com. One is it's just engaging with arlo.com through maybe some of the low funnel tactics that we have. We've driven them to our website for the initial purchase. Two, like you mentioned, maybe they bought cameras in a traditional channel and they're coming to sign up for service And we find them and they obviously sign up for service directly through us on arlo.com.

And then there's some cross channel things that happen. So we know, for instance, when a user buys a set of cameras that it's usually around the thirty second or thirty third day after activation that they start to look for accessories. And so we'll time our direct promotions in a way to try and hit some of those points that we've discovered through just user behavior research and drive them into arlo.com to actually complete that purchase. So there's a couple of different ways that they come into the platform, and we're looking to continue to optimize that.

Speaker 8

Excellent. I appreciate the insight. I'll hop back in queue.

Speaker 4

And we'll go to our next question from Jacob Sevin of Lake Street Capital.

Speaker 9

Hey, guys. Thanks for taking my questions. Congrats on the solid quarter and guidance. When looking at non GAAP service gross margins, they look modestly higher in the quarter. Maybe you just give us some color on how we should think about that moving forward?

Speaker 3

Yes. We're really pleased with the progress we're making on the services margin. Incredibly, a couple of years ago in 2019, our non GAAP services gross margin was down in the 34% range. And we're really pleased to have brought that all the way up most recently to about 63%. And for the full year, last year at 60%, really clean result.

Very happy with the progress we're making there. The guidance for this year for non GAAP service gross margin is 60 to 65%. That's the range that we're giving this year. And obviously, the team has done a fantastic job of cost optimizations as well as the mix benefits from paid account growth has really helped the services gross margin. And as we talked about before, we do invest opportunistically to retain and engage our customers.

We've offered new features. Matt has spoken about the change in service plans to all those secure and secure plus Those are innovations that we do from time to time to retain and engage our customers. So it's a balance between how much of that we do versus just letting it drop to the bottom line. But 60% to 65% is the range that we envisage for this year.

Speaker 9

Okay, great. That's helpful. Maybe is there any difference in the conversion rate to a paid subscription among your different channels? If somebody goes to Best Buy and picks up a camera, is that any different than if they were to go and buy it off your website?

Speaker 6

Yes. It's remarkably consistent, what I would tell you. So when we look at we slice internally by channel, we slice it by price segmentation, which means we also price it slice it by product types, so ultra versus essential and the rest. And I would tell you the numbers that we report, it's remarkably consistent across all the different products, all the different go to market channels. With the exception of some of our B2B, Arlo Smart Cloud engagements, for instance, Verisure's direct channel, the work we're doing with Calix, those are 100% attach rate.

So because of the way those are sold as part of the managed service and the hardware goes for the service. So putting those aside, when you look at just the normal retail kind of more organic attach of service, it doesn't change a lot across channels or products.

Speaker 9

Okay. And then just one last one here. Do you

Speaker 6

guys have any plans on rolling out the SAFE package immediately to Verisure, making that available to your channel partners or your the B2B? Yes. So we're looking at rolling both of the products we announced today or talked about today through partners. Obviously, Calix is already committed to rolling the security system. Arlo Smart, we're talking to partners.

So everything we do as a company, we'll look to bring to market under the Arlo brand, but we have a suite of partners that are looking to continue to add services to their customers through partnerships. So you'll see us continue those discussions. But the one we can talk about today is obviously Calix expanding their Arlo offering to include our full security system.

Speaker 9

Okay, great. Thanks and congrats again on a great quarter.

Speaker 6

Thank you. Appreciate it.

Speaker 4

And with no other questions in the queue, I would like to turn the call over to Matt McCray for any closing comments.

Speaker 3

Thank you,

Speaker 6

operator. Argo has completed a journey of transformation from a pure hardware company to a services first business. That strong foundation now serves as the platform on which we build our future. Today, we shared deeper insights into that performance, the performance of our services business and detailed three areas of focus that will fuel our future growth. I can tell you everyone at Arlo is focused on our new long term targets and continuing the operational excellence that has brought us thus far.

We look forward to reporting our progress as we execute our plan. And I'll thank you one last time for joining us today.

Speaker 4

And so this concludes today's call. Thank you for your participation. You may now disconnect.