Arlo Technologies, Inc.

Ladies and gentlemen, thank you for standing by. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. At that time, if you have a question, you will need to press star 1 on your push-button phone. I would now like to turn the conference over to Eric Bilen. Please go ahead, sir.

Thank you, operator. Good afternoon, and welcome to Arlo Technologies' third quarter of 2021 financial results conference call. Joining us for the company are Mr. Matthew McCrae, CEO, and Mr. Gordon Mattingly, 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 third quarter, along with guidance provided by Gordon. We'll then have time for any questions. If you have not received a copy of today's press release, please visit Arlo's investor relations website at investor.arlo.com. Before we begin the formal remarks, we advise you that today's conference call contains forward-looking statements. Forward-looking statements include statements regarding our potential future business, results of operations and financial condition, including descriptions of our revenue, gross margins, operating margins, tax rates, expenses, cash outlook, guidance for the fourth quarter and full year 2021, 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 COVID-19 pandemic on our business, operating results, and financial condition. Actual results or trends could differ materially from those contemplated by these forward-looking statements. For more information, please refer to the risk factors discussed in Arlo's periodic filings with the SEC. including the most recent 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 call over to Matt.

Thank you, Eric. And thank you, everyone, for joining us today on Arlo's third quarter 2021 earnings call. Once again, the Arlo team outperformed expectations across all metrics as we continue to navigate the unprecedented supply chain challenges so many companies are facing around the world. Total revenue was up 1% year over year. Service revenue was up 42% year over year. and total paid accounts were up 146% year-over-year. And despite the additional costs driven by the pandemic supply chain disruptions, non-GAAP gross profit dollars were up over 10% year-over-year, comfortably over-indexing top line growth more than tenfold. Digging a little deeper into our services business to provide some additional clarity, we reported our annualized recurring revenue, or ARR, as $80 million in Q3, growing 103% 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 carbon revenue from our old business model, and NRE service revenue from strategic partners. Looking ahead to Q4, I see our team's great execution continuing in the face of what may be the peak of supply chain headwinds. Arlo is raising guidance for Q4, raising guidance for full year, and raising guidance for our year-end cash balance. In addition, our annualized recurring revenue is expected to grow by more than 100% again in Q4, and we plan to provide a more fulsome report on this topic on our fourth quarter earnings call. Returning to Q3 results, revenue came in above the top end of our guidance at $111.1 million, and Q3 marked the ninth consecutive quarter of record service revenue at $27 million. We added 182,000 paid accounts a record high, which represents an increase of 25% sequentially and 214% year over year. To put that account growth into context, under our legacy business model, it took us more than two years to add the same number of paid accounts we just added in the third quarter alone. This continued acceleration of our services business, which accounted for 64% of our non-GAAP gross profit dollars in the quarter, helped more than offset over $3 million of incremental air freight expenditure compared to a year ago, pushing total non-GAAP gross profit up by $2.4 million and up more than 10% year over year. Arlo outperformed the high end of our guidance for non-GAAP net loss per share, which came in at a loss of 8 cents, And we have lowered our non-GAAP operating loss by an impressive 76% year over year in the first three quarters, down to $14.7 million in 2021. Our cash, cash equivalents, and short-term investments landed at a healthy balance of $166.1 million. And with our current cash position and financial trajectory, we anticipate reaching profitability without the need to raise additional capital. Our transformation to a services company powered these impressive Q3 results, but is also propelling us towards our long range targets. On October 18th, we reached more than 900,000 paid accounts and believe we are positioned to achieve our one million paid account goal significantly ahead of our year end earnings call. And as previously mentioned, service revenue in Q3 was $27 million giving us a clear path to exceed our projection of $100 million of service revenue for the year. 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 up to 2K resolution, and 24-7 premium support. Arlo Secure Plus includes all of the features from Arlo Secure, increases the resolution of cloud video storage to 4K, and includes Arlo's new 24-7 emergency response, which provides the ability to directly request a fire, police, or medical responder and speak with a security expert in the event of an emergency. Arlo Secure Plus is $14.99 per month and further extends Arlo's technological leadership while providing significant value to our users. As a reminder, under our new business model, where we include a free 90-day trial of Arlo Secure+, we see a consistent 50% subscription conversion rate upon expiration of the initial trial period. As we follow cohorts over a six-month period, we see the attach rate to our subscription services grow towards 65%. Our industry-leading technology continues to outclass the competition and garner critical acclaim from expert publications. Since our last earnings call in August, our products have been recognized with three Editor's Choice Awards, multiple Design Awards, and features in Best of 2021 lists across the industry. CNET commented on Arlo Pro 4, quote-unquote, in a point-to-point comparison, resolution, performance, battery life, and so on. It just consistently outshines the competition. This glowing reception is a testament to our commitment to innovation, which continues with the most recent product announcement. We just launched the new Arlo Go 2 smart security camera exclusively with Verizon. Arlo Go 2 is a LTE Wi-Fi and GPS-enabled device that leverages our deep intellectual property in RF, and low-power design to deliver a camera that provides uninterrupted security in environments with no power or internet connectivity, such as construction sites, vacation homes, boats, RVs, vehicle fleets, or large properties. Arlo Go 2 is now available nationwide through Verizon, with additional carrier partners coming next year. And now, I would like to hand the call over to Gordon, who will provide more insight into our financial performance operational details, and outlook for the fourth quarter.

Thank you, Matt. And thank you, everyone, for joining us today. We delivered strong Q3 2021 financial results that exceeded our expectations, growing our non-GAAP gross profit by 10.7% year over year, while revenue was above the high end of guidance and up 0.8% over Q3 2020. 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. The Arlo team navigated continuing tough supply conditions to exceed our expectations on revenue while again improving our year-over-year profitability, decreasing our non-GAAP operating loss by $1.2 million year-over-year. And now, moving on to the Q3 financial detail. Revenue came in at $111.1 million, up 0.8% year-over-year and 12.8% sequentially. Our service revenue for Q3 2021 was a record $27 million, up 6.9% sequentially and up 42.4% over last year. with our new business model fueling our growth. While service revenue accounted for 24.3% of our Q3 2021 revenue, it delivered 63.9% of our non-GAAP gross profit. Our service revenue also includes $1.3 million of NRE services we are providing for Bereshaw, along with associated costs as compared with $2 million in the second quarter of 2021. Product revenue for Q3 2021 was $84.2 million, which was up 14.8% sequentially and down 7.8% compared to last year. Our sequential product revenue growth was driven by continued strength from our Verisure relationship in Europe, coupled with growth in retail in America as we head into the seasonally stronger fourth quarter. Year-over-year and sequential product revenue growth were both impacted by supply chain challenges, which were most pronounced in the early stages of the quarter. While our sell-through was dampened by these shortages, our supply chain team did a fantastic job securing additional supply in the latter part of the quarter. and replenishing channel inventory ahead of the seasonal uptick we expect in the fourth quarter. During the third quarter, we shipped approximately 1,012,000 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 growth profit for the third quarter of 2021 was up $2.4 million year-over-year to $25.1 million, which resulted in a non-GAAP growth margin of 22.6%, down from 27.9% in Q2 2021, and up more than two percentage points from 20.6% in Q3 2020. The year-over-year improvement was driven by strong progress on service growth margins, while product growth margin was impacted by COVID-19-related supply chain challenges, which drove a significant increase in air freight expense year over year. The $2.4 million year-over-year improvements in non-GAAP growth profits included an improvement of $6.8 million from services offset by a reduction of $4.4 million from products. Non-GAAP service growth margin came in at 59.5%, slightly higher than 58.9% in Q2 2021, and significantly higher than 48.8% in Q3 2020. The year-over-year growth was driven by substantial paid account growth under our new business model. coupled with cost management over the last year. Non-GAAP product growth margin was 10.8%, down from 17.2% in Q2 2021, mainly due to a sequential increase of $2.7 million in air freight expense, and down from 14.8% a year ago, again, mainly impacted by an incremental $3.6 million in air freight expense. While short-term product growth margin will continue to be adversely impacted by incremental air freight expense due to the current COVID-19 related supply chain challenges, the incremental long-term customer lifetime value we derive from the associated paid accounts is compelling and more than justifies the investment Total non-GAAP operating expenses were $32.5 million, up $0.7 million, or 2.1% sequentially, and up $1.2 million, or 4% year over year. Our total non-GAAP R&D expense for the third quarter was down slightly sequentially at $12.3 million. Our headcount at the end of Q3 was 346 employees compared to 349 in the prior quarter. As a reminder, during the early stages of the Verishaw 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 Verishaw is included in other income and was approximately $0.5 million during Q3. Our non-GAAP tax expense for the third quarter of 2021 was $0.2 million. In Q3, we posted a non-GAAP net loss per diluted share of $0.08, much better than our guidance, and a $0.02 improvement year over year. We ended the quarter with $166.1 million in cash, cash equivalent, and short-term investments, down $12.6 million sequentially, and down $27.6 million year-over-year. Q3 inventory closed at $39.8 million, a decrease of $3.4 million over Q2 2021, with turns at 7.6 as compared to 5.7 last quarter and 4.6 a year ago. Our DSO came in at 62 days, up from 47 days a year ago and up from 48 days sequentially, with the increase driven by the timing of shipments in the latter part of the quarter. Now, turning to our outlook. We expect fourth quarter revenue to be in the range of $130 to $140 million, and accordingly, our four-year revenue to come in at between $422 and $432 million, up $12 million on previous guidance at the midpoint of the current range. Our team has done an incredible job navigating unprecedented COVID-19-related supply chain challenges in 2021, enabling us to exceed the top nine guidance we provided back in February. For the fourth quarter of 2021, we expect our GAAP net loss for diluted share to come in between 16 cents and 9 cents per share, and our non-GAAP net loss for diluted share to come in between 7 cents and 0 cents per share. Our guidance includes air freight expense of approximately 8 cents per diluted share, compared to $0.03 per diluted share in Q4 2020. This additional freight expenditure is a direct result of the current COVID-19 related supply chain challenges. We expect air freight expense will normalize when the global supply chain situation stabilizes. Up from previous guidance, We expect to end the year with more than $140 million in cash, cash equivalents, and short-term investments. And we'll continue to monitor our performance and frequently manage our operations to preserve our cash position. And now, I'll open it up for questions.

At this time, I would like to remind everyone, in order to ask a question, press star, then the number one on your telephone keypad. Your first question comes from the line of Adam Tindall with Raymond James. Your line is now open.

Hi, this is Alex on for Adam. Thanks for taking our questions. So I'm just curious, looking into this year's holiday season and also looking into next year, given current inventory levels in the supply chain setup, how do you think about promotional activity and sort of how will that play out?

Yeah, it's a great question. We're making those decisions. almost in real time. As you've heard on the call, we had both in Q3 and we're expecting even in Q4 more demand than we have from a supply perspective. So in those areas where we think we might be a little bit light on supply, we are pulling back on some of those promotions because there's no reason to do that. As we get into next year, that'll depend as the supply chain disruptions start to unwind, as we expect it to do throughout the year. And we'll continue to make those make those decisions based on the balance of what's happening in the channel, what supply we have coming in, and what we need to do for the quarter. But that gives you an idea of what happened in Q3. What we see probably continuing in Q4, the good news is the demand is absolutely there for the product. And in several areas, we have stocked out, and we're making sure we're reacting on that to maximize profitability.

Perfect. Thanks. And then one of the other things, we're seeing a nice mix shift towards devices other than IP cameras. I'm just curious, do these devices typically carry a different subscription attach rate, and are there any significant gross margin discounts to speak of as we move towards smart doorbells and floodlights?

Yeah, it's a great comment. We are seeing that diversification, and we think it's important. It's one of the long-term goals we set out as we spun was to not only diversify on the go-to-market side, but also in the area that you're calling out, diversifying across different product categories. When we look at those products, both from subscription attach rate and from a gross margin, they're very consistent with what we see on the cameras. So there's a couple percentage points either way on a given quarter, but I would look at them as totally consistent with what we're seeing from IP cameras.

Fantastic. Thank you.

Your next question comes from the line of Jeffrey Rand with Deutsche Bank. Your line is now open.

Hi, thanks for taking my question. Congrats on a good quarter and your continued progress with your services business. My first question, I wanted to dig deeper into this annual recurring revenue number that you gave. Based on how you describe it, excluding your legacy business and NREs, eventually, would you expect all your services revenue to be included in your ARR number? And how much of your services revenue in 3Q is currently included in ARR?

Thanks for the question. Yeah, at the moment we didn't break that out, but you can do some pretty simple math to work out answering the second part of your question. We disclose the ARR as 80 million. Now the ARR is using the last calendar month in a quarter, multiplied by 12. So it's a little bit apples and oranges. You take the 27 million of service revenue in Q4, multiply it by four, that gives you $108 million annualized. So you can get an idea, comparing the 80 to the 108, you get a rough idea of how much of the total service revenue that recurring paid ARR bit accounts for. That's answering the second part of your question. And the first one, do we expect it to shift mainly to ARR in future? I think the mix will continue to shift more in favor of that recurring paid services piece. We don't think the NRE is going to disappear. We're certainly going to be working to get additional opportunities with strategic accounts to continue the NRE service revenue. And the legacy piece, yes, that will go away. But remember, we do still offer a free trial with all our new business model products, and that piece is part of the prepaid service revenue. that is excluded from that ARR.

Great, thank you. And as I follow up, I wanted to dig deeper into the supply chain. What are the main problems you're seeing? Are you able to mostly meet demand? It costs you more for your components and for air freight, or is there meaningful unmet demand?

There's meaningful unmet demand, and it depends on the product. So some products we're in, I would say, good stock, and some products we have stocked out multiple times during the quarter. You know, in Gordon's script, you know, we talked about some shipments coming later in the quarter, and that's why we missed a little bit of demand in Q3. Like I said, also, I think we'll see that continue into Q4. So, we're seeing healthy demand for the product. As far as the causes of it, you know, we are seeing some component shortages. We are seeing some component cost ups in some areas, but I wouldn't say that's the primary factor. You know, as components starting to go short, the first thing that happened is the lead times on those components go out. And as we've described on previous calls, we then took our forecasting out farther than those lead times. So yes, it slows down some of those components in certain areas. But as you can tell from our good results in the quarter and our guide up in Q4, we feel we're executing on top of some of the shortages that we're seeing from a component side. I would say the biggest impact is really around freight. And that has to do with obviously the cost not only the cost of air freight that Gordon shared on the call, also the cost of sea freight are anywhere up from 3 to 10x normal. But the lead times on the sea freight is what's really disruptive, right? Something that would take six to eight weeks to come over is now taking multiple weeks and maybe sitting six to eight weeks outside of the port. What we've done in response to that is actually shift a lot more of our product to air freight, which is why you're seeing the cost go up. So as an example, take a year ago, Q4 as we look forward or even Q3, 20%, maybe the max would be about 20% of our product coming in would be on air freight. We're anticipating in Q4, 80% of our product coming in will be on air freight. And that's how we're, you know, actually getting around some of the sea freight congestion, some of those problems as we're using more air freight. And that's why you're seeing that, you know, be called out in the script as those costs will go up. Again, we do believe it's transitory, it's temporary. As we get into next year, we should see some of that unwind. But we think the right call in Q4 is to continue the air freight coming in so we can meet as much of the demand as we can in Q4, which obviously generates future subscribers.

Great. Thank you.

Your next question comes from the line of Jeff Osborne with Cowan & Company. Your line is unmuted.

Jeff, are you there?

We will move on to the next question from Hamid Khorsand with BWS. Your line is now open.

Hi, so first question I had was on Europe. Obviously, the revenue there increased. Is that all associated with VeriSHORE? And how much of the Q4 guidance involves VeriSHORE and the ramp up ahead of the exclusive product release from VeriSHORE?

Yeah, in Q3, definitely some of that is obviously from VeriSHORE. We are basically tracking exactly on time with the release of the custom product we announced on the previous call. So that's great. You know, they are deploying it region by region. We're seeing a bit of that in Q3. And to your question, we'll see a bit more of that in Q4. The full effect of that product being rolled down won't be really felt until next year. So I would expect it to step up a bit in Q4 and then continue to step up as we get into next year. So we'll see Verisure continue to grow going forward as that starts to roll out. And we're expecting to see some additional growth, obviously, on the retail side in Europe as well as they continue to invest in the brand and some of the go-to-market.

Okay, is it too early as far as being able to see what kind of conversion you have on the paid subscriber side going from the old Arlo Smart to the Arlo Secure product?

Yeah, we haven't really released any different numbers, and part of that is it seems to be very consistent going forward as far as a very early read. I will tell you that in our next earnings call, we think we'll have enough data to maybe characterize more around not only the services business as a whole, but anything that we're seeing from a difference from Arlo Smart to Arlo Secure. But right now, I think it's safe to assume that it's at least as good as what we've been seeing for Arlo Smart historically.

And can you maintain a pace on the services side where you're actually able to offset any kind of – negative contribution from the hardware side beyond just Q4?

Yeah, we're not anticipating negative contribution, Hamed. We're still, obviously, Q3, we were still double digit, low double digit gross margin on the hardware side. I think the guide for Q4 implicitly is suggesting something similar. So we're not looking to move into negative territory at all on the hardware. We expect to continue to see positive gross margins on the hardware. And obviously, the services gross margin itself, you saw for Q3, 59.5%. That itself was an improvement on the prior quarter and a record for us as a standalone company. So we're continuing to see slow but steady improvement in the services gross margin as well.

Okay. Thank you. You're welcome.

Your next question comes from the line of Jeff Osborne with Cowan & Company. Your line is now open.

Hey, sorry about that. I guess my phone's not as easy to use as Arlo products. No problem. Good to hear from you. Yeah, absolutely. A couple questions on my end. I was wondering if we could just touch on the channel mix in terms of online versus in-store. Did you see any noticeable trends on that front? And then also, if you could give us an update on how the Arlo store going direct is working out for you.

Yeah, I would tell you there's no big changes we've seen from a mix. Now, I say that, but also know that sometimes when we get reporting from our retailers, it's in a single bucket. And it's hard to differentiate what is actually sold through the retail.com versus the retail brick and mortar. Also, what we've seen is we've seen some increased omni-channel activity. And what I mean by that is somebody may buy a product online and actually drive to the store and pick it up. And that is often counted as an online order, even though they're physically going into the store and picking up and maybe buying additional things. So it's a little tough to give you a great read on that. But from what we've seen on a quarter-over-quarter sequential perspective, haven't seen any massive shift in the retail side. From an Arlo.com perspective, we haven't released any details, obviously, from that perspective. But it is a fast-growing channel, and it is one of our most important channels, not only from a financial and profitability perspective, but it's also a direct relationship with our end user. And so we're able to really glean a lot of data on what they're buying. It is a key market for us to sell accessories. We know that certain customers are apt to buy accessories roughly 30 days after they buy the main camera. We can make sure that we're modeling that. And of course, Arlo.com is the primary way people actually subscribe to our services. So across the board, that is mixing up across not only from a revenue perspective, but it is contributing to our increased profitability.

Got it. That's helpful. And maybe my last question is just can you touch on, you know, the world of semiconductor supplies, seeing sort of an evolution from everything from the foundry to microcontrollers and now more the back end from Vietnam and Malaysia having more challenges. Can you be more precise as to, you know, where your challenges were as it related to supply chains?

issues in q3 uh just so we can sort of uh keep that in mind as we monitor the situation of the semiconductor shortage heading into 2022. yeah it was it's you know on a component level i i'll tell you it's typically relatively low uh value ics so think of like power ics or things like that um that we've got to kind of chase and make sure we get enough supply In Q3, it moved our direction, which is why we were able to ship more towards the end of the quarter. So that's good. The team, from an operations perspective, has done an absolute fabulous job on the procurement operations, getting our fair share, if not more, of some of these ICs. And so we were able to secure the supply that we needed to deliver the results that you saw. And not only that, but deliver the confidence in the guide for Q4. So that's That's from an IC perspective or from a component level perspective, really what's going on there. And we're chasing that not only weekly, but actually daily. And then the rest of it is really the freight and just dealing with finding the air freight capacity, figuring out how much to actually stick on a boat. And, you know, we're starting to see a little bit of congestion even on the air freight side. That's all this product actually landing at airports instead of ports. And a lot of the airports don't have rails. you know, most of those go into ports. So we're seeing some congestion there, nowhere near what we're seeing in the actual shipping ports. So we're keeping an eye on that and making sure that our lead times as products actually land are being, you know, accurately calculated on our side to make sure we give a proper guidance.

Makes sense. I appreciate the insight.

Thank you. Yes, you're welcome.

There are no further questions at this time. Mr. Matt McCray, I turn the call back over to you.

Thank you, Operator. As we close, I would like to thank all the teams at Arlo for the hard work to deliver not only the outstanding Q4, but also the confidence in Q4 as we continue to face the global pandemic-related disruptions. The entire company is absolutely laser-focused on finishing the year strong, and I'm looking forward to our year-end earnings call. Thank you, everyone, for joining us today.

This concludes today's conference call. You may now disconnect.