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Arlo Technologies, Inc. (NYSE:ARLO)
Q1 2019 Earnings Call
April 30, 2019 5:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen, thank you for standing by. [Operator instructions] I would now like to turn the conference over to Erik Bylin. Please go ahead, sir.

Erik Bylin -- Investor Relations

Thank you. Good afternoon, and welcome to Arlo Technologies first-quarter 2019 financial results conference call. Joining us from the company are Mr. Matthew McRae, CEO; and Ms.

Christine Gorjanc, CFO. The format of the call will start with an introduction and commentary on the business provided by Matt followed by the financials for the first quarter along with guidance provided by Christine. We'll then have time for questions. If you have not received a copy of today's release, please visit Arlo's Investor Relations website at www.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 expected revenue, gross margins, operating margins, tax rates, expenses and future business outlook. Actual results or trends could differ materially from those contemplated by these forward-looking statements. For more information, please refer to the risk factors discussed in Arlo's periodic filings with the SEC, including the most recent annual report on Form 10-K and Form 10-Q.

Any forward-looking statements that we make on this call are based on assumptions as of today, and Arlo undertakes no obligation to update these statements as a result of new information or future events. In addition, several non-GAAP financial measures will be mentioned in this call. A reconciliation of the non-GAAP to GAAP financial measures can be found in today's press release on our investor relations website. At this time, I would like to turn the call over to Matt.

Matthew McRae -- Chief Executive Officer

Thank you, Erik. And thank you, everyone, for joining us today on Arlo's first-quarter 2019 earnings call. Arlo's first quarter was one of solid progress across our financial and operational objectives. We exceeded our expectations for revenue, gross margin and net loss per diluted share and are on track to make continual financial progress through the year.

Market share remains strong while paid subscriptions accelerated. The Ultra product family is now in worldwide distribution. We preannounced our video integrated doorbell, and we announced a partnership to enter the large, professionally installed market for security. Let's start by talking through some results of the quarter.

In Q1 we delivered $57.9 million in revenue, down from a year ago but above our guidance. Services revenue was $11.3 million, which represents a year-over-year growth of 37%. During Q1 we added about 276,000 registered users to the Arlo platform to reach a total of 3.1 million total registered users, up more than 62.1% year over year. More importantly, our paid subscriber base grew to approximately 174,000 users, which is up 89.1% year over year.

We are thrilled to see such strong results in paid users, which we believe validates our strategy to drive recurring revenue growth. As a reminder, the paid subscriber number does not yet include Ultra users under our new business model who receive bundled services as part of their purchase, which we believe will drive significant incremental paid subscriber growth in the future. As you may remember from our last call, we talked about the slowdown in the U.S. consumer connected camera market, which impacted sales and caused channel inventory to build up during the fourth quarter of 2018.

Arlo reacted quickly, took immediate actions and adjusted operations, demasking indications that the slowdown may continue into 2019. We were able to reduce channel inventory substantially in the quarter while maintaining our market leadership position at 37% -- 36% on a point-of-sale basis in Q1, despite higher than normal promotions in the market. Moving on to our products. Arlo completed the worldwide launch of Ultra product family, our latest flagship wirefree security camera and smart hub.

Ultra features true 4K image quality with HDR, colored night vision, integrated spotlight, 180-degree field of view, advanced noise cancellation and a new modular design. Last week we also launched an exclusive black version of Arlo Ultra in collaboration with our partner Best Buy. With Ultra, Arlo has rolled out a new business model where we bundled in a one-year subscription to Arlo Smart, our powerful AI and computer vision service capable of detecting people, vehicles, packages and animals among other features. We believe this model will accelerate paid subscriber conversion when Ultra owners pass their 1-year purchase anniversary.

Customer reviews are positive since our wider roll out, with most recent consumer review at a four or five star, and professional reviews are just starting to roll in after extensive testing. TechHive says the Arlo Ultra "delivers super sharp 4K video and is another winner for Arlo". Digital Trends commented on Ultra's "beautifully crafted hardware design, painless set up and top-notch clarity". AppleInsider called Ultra "the ultimate security camera" and commented that they would recommend it "in a heartbeat".

Ultra has clearly set a new bar in the market segment for performance and features. At the ISC West show, we showcased the full breadth of our smart home security products and previewed our upcoming video-integrated doorbell that includes 1080p video, a wide field of view, crystal clear two-way audio and full integration into the Arlo ecosystem with Arlo Smart. We're excited about our entry into this fast-growing market and we'll provide further updates in the later part of 2019. Additionally, at ISC West, we announced a partnership with I-View Now, a provider of cloud-based video alarm verification platform.

Arlo's collaboration with I-View Now enables security dealers to offer verified alarm monitoring services across Arlo's security camera systems and in conjunction with Arlo's existing AI capabilities, as well as cloud infrastructure to reduce false alarms, deliver faster response times and ensure an added level of peace of mind for homes and businesses. For Arlo, this represents an expansion of our channel later this year into the large, professionally installed security market and a catalyst for additional growth. Now I'd like to turn the call over to Christine for her commentary on the first-quarter, guidance for the second quarter and full year.

Christine Gorjanc -- Chief Financial Officer

Thank you, Matt. And thank you, everyone, for joining us on first quarter of 2019 earnings call. As Matt highlighted, we delivered $59.7 million of revenue, exceeding the high end of our guidance, but down 42.5% year over year. As a reminder, the year-ago comparison period references carve-out financials for Q1 and Q2 2018 whereas our Q3 and Q4 2018 and Q1 2019 results are based on stand-alone financials.

You can find further detail regarding Arlo's carve-out financials contained in our SEC filings, including our previously filed Form S-1 and the related public offering prospectus. During the quarter we shipped a total of approximately 650,000 devices, of which approximately 621,000 are cameras. We added approximately 276,000 registered users to the Arlo platform in Q1. As of the end of the first quarter, we had about 3.13 million registered users, which is an increase of 62.1% from a year ago.

Growing our registered user base is critical to growing our recurring subscription business, which we believe will help both improve our margins and revenue predictability. We added 30,000 paid subscribers in Q1, bringing our total paid subscriber count to 174,000, up 89.1% year over year. We are very pleased with the growth in our subscriber base and believe our new business model for Ultra will be a substantial driver of this subscriber base and recurring revenue growth in the future. Our services revenue for Q1 2019 was $11.3 million, which is up 37.3% over last year.

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 first quarter of 2019 was $2.7 million, which resulted in a non-GAAP gross margin of 4.7%, above the high end of our guidance. This compares to $29.8 million in the year-ago comparable period and $5.6 million in the prior quarter.

Our service gross margin was 49.9%. Total non-GAAP operating expenses came in at $38.6 million, which is up 50% year over year due largely to the effect of carve-out financials and up 2.3% sequentially. We anticipate operating expenses to increase slightly during Q2 as we record an additional depreciation and backfill open key requisitions. Our total non-GAAP R&D expense for the first quarter was $16.9 million, up 5.6% sequentially.

R&D is critical to the innovation that creates our product and service differentiation, and we continue to invest in R&D as we execute our product and service roadmaps. Our headcount at the end of Q1 '19 was 401 employees. Our non-GAAP tax expense for the first quarter of 2019 is $220,000. For the first quarter of 2019, we posted a non-GAAP loss per diluted share of $0.47.

We ended the fourth quarter with $180.4 million in cash, cash equivalents and short-term investments. We were pleased with our progress in lowering channel inventory during Q1 and more specifically in our larger retail channel. While our U.S. retail channel reported 14.5 weeks of stock at the close of Q1, that number does not reflect the progress we made during the quarter.

We compute waste of stock on a 6 weeks of prior sell-through data, which is much lower at the end of Q1 than it is at the end of Q4, given the strong holiday season and then the seasonally slow Q1. That said, we expect to be back to normal levels of inventory in the channel by the end of the second quarter. Now turning to our outlook. While we will continue to work with our channel partners to return to normal inventory levels, we expect to see a strong sequential increase from the first quarter to the second.

We expect revenue in the second quarter to be in the range of $75 million to $80 million. We expect our GAAP gross margin to come in between 9% and 12%, and our non-GAAP gross margins come in between 10% and 13% in the second quarter of 2019. We expect our GAAP loss per diluted share to come in between $0.55 and $0.51, and our non-GAAP loss per diluted share to come in between $0.44 and $0.40 per share. We expect our GAAP and non-GAAP tax expense to be approximately $300,000 for Q2 '19, and we are reaffirming the full-year 2019 guidance we gave in the last earnings announcement.

With that, I will turn the call back over to Matt for some comments before we go to the Q&A.

Matthew McRae -- Chief Executive Officer

Thank you, Christine. I am proud of the team's execution, excited about our announcements and looking forward to our strong new product launches for the holiday season. However, the last couple of quarters have also made it clear that we must be vigilant and efficient in our execution. The management team is maniacally focused on the task at hand in optimizing our strategy and investment across the organization.

We have and will continue to focus on taking decisive actions to tightly manage opex, reduce costs for both hardware and services and execute new product introductions to improve our path to profitability. While we remain confident in our competitiveness, market leadership and strategy, Arlo has today announced that the board of directors is reviewing all strategic options for the company in an effort to ensure we are maximizing shareholder value and positioning Arlo for the greatest impact in the market. More information can be found in our press release, and we do not plan to comment further at this time. And with that, we can open the line for questions. 

Questions and Answers:

Operator

Certainly. [Operator instructions] Your first question comes from Adam Tindle from Raymond James. Your line is open. Please go ahead.

Madison Suhr -- Raymond James -- Analyst

Good afternoon. This is Madison on for Adam. I wanted to start on the cadence for the quarter. I know Q4 had some volatility month-by-month, but how did the March quarter progress? Was there still meaningful volatility in the product category or have things returned to a more normalized growth rates?

Christine Gorjanc -- Chief Financial Officer

Well, I think in Q1 what we had said is, because we had inventory in the channel, we will be very focused on helping our channel partners clear that out, meaning our ship in to the channel was quite a bit less. So our -- what I would tell you is, our ship in probably increased as we went through the channel, given the amount of inventory that was already there and especially as Ultra was released in the third month of the quarter.

Madison Suhr -- Raymond James -- Analyst

OK. And then I also wanted to touch on the Q2 margin guide. So it seems like ex the $4 million tariff benefit related to exiting China manufacturing that gross margins are still trending in kind of the mid-single digit range. Can you talk about much of the gross margin pressure is related to clearing out that excess channel inventory versus other factors, maybe a more competitive pricing environment or other things? Thanks.

Christine Gorjanc -- Chief Financial Officer

Yes. I think what we had said in February and is also true today is it was going to take us the first half of 2019 to clear that channel inventory, so we do expect to continue to spend some marketing dollars as we clear through that inventory. Now we don't really have any -- there's no tariff issues really going on in Q2, we are completely moved out of China at this point. But what we will see is the gross margin will see the biggest improvement as our subscription revenue continues to grow and new products hit the market where we expect to have to do far less in the promotional category.

Madison Suhr -- Raymond James -- Analyst

OK. That's helpful. And if I could sneak one more in because I know services was obviously a bright spot and nice to see an acceleration here. Can you help us understand what's driving the adoption of services on kind of more of an accelerated level? Is it more targeted marketing efforts? Product innovation? Just any additional commentary there would be helpful.

Matthew McRae -- Chief Executive Officer

Yes, this is Matt. I think there's -- some of it is targeted marketing that we're doing both to the installed based and to new users that are registered for the first time into the Arlo ecosystem. There have been a lot of optimization in the service, as well as we learned kind of week-by-week and use our marketing analytics to understand where people are dropping off. So the sign of experience, especially for new users, has been streamlined.

We've gotten better at marketing and positioning things. I think the general awareness is also up. So we're seeing it across the board. I'll tell you there is some lift obviously from the holiday period and people signing up from -- in December buying the product and then signing up after the 30-day free trial into January.

But it didn't necessarily slow down through the quarter. I think overall awareness, the performance of the platform and us getting better at streamlining the funnel from that free trial dropping all the way in through to an actual converted paid subscriber.

Madison Suhr -- Raymond James -- Analyst

OK. That's very helpful. Thank you very much.

Operator

Your next question comes from the line of Jeff Osborne from Cowen and Company. Please go ahead. Your line is open.

Jeff Osborne -- Cowen and Company -- Analyst

Good afternoon, guys. Just a couple on my end. Can you just talk about the Best Buy experience and percentage of stores that are trained? I think there was one of the initiatives you had from the last call is getting more personal touch in the store and getting everybody up to speed, is this something that's rolled out nationwide or still work to be done?

Matthew McRae -- Chief Executive Officer

There's still work to be done. So with Best Buy, we've got a very strong partnership with them and there's a series of activities. One was the wider rollout of Ultra in March. As I mentioned in the script last week, we actually launch an exclusive SKU with them, a black version of Ultra, which is interesting.

They're actually hosting an event called Achievers right now, and we're doing training across the footprint and people who come to that event. So you'll see us continue to engage both on the educational side but also the awareness side of Best Buy as we get through Q2. And then there's a normal cadence of that that we'll do as we get closer to the holiday season. But I would say, especially for Ultra, we're in the beginning stages, if not early middle stages of continuing to educate and ramp the Best Buy resources we have.

Jeff Osborne -- Cowen and Company -- Analyst

Got it. That's good to hear. And you highlighted the promotion environment was intensified in Q1. What in your perspective is the environment that we're in now? What your anticipation is for the summer months?

Matthew McRae -- Chief Executive Officer

Yes. Some of this is typical after holiday and we experienced this last year where you see a promotional period in Q4 and then having that carry over into Q1 a bit as people are clearing inventory and getting ready for the spring reset. It was definitely a competitive market, so we're happy that we're able to hold our share at 36%. I think you'll see continued progress as we go through the year and then obviously the normal seasonality where you'll see additional promotions as you get into Q -- kind of Q4, beginning of the holiday period.

So we're expecting a more normal seasonality for the rest of the year.

Jeff Osborne -- Cowen and Company -- Analyst

Got it. And then, Christine, a few for you. You mentioned 14.5 weeks of inventory and we talked about with the prior caller's questions, but can you just remind us of what the target is, your normalized channel and inventory levels?

Christine Gorjanc -- Chief Financial Officer

Typically, on a retail, it's 10 to 12 and it would probably depend which quarter of the year that that was in, so it would be 10 to 12. But again, we do, do that on a backward looking basis on POS for the prior six weeks. So that's why you see the difference. But we were really actually quite pleased to how much inventory came down in the channel, and we believe we will have them at normal inventory levels by the end of Q2.

Jeff Osborne -- Cowen and Company -- Analyst

Got it. And then just one last one on the modeling. Obviously, a lot of things in your business that you can't control. As you look out to the second half, I know you're not giving guidance there, but one of the items that you can't control is just the opex.

So you highlighted that there's some requisites in R&D, in particular in 2Q. Should be continue to model sort of a 2% to 3% increase in expenses in the third and fourth quarter or do you anticipate a bit of a pause?

Christine Gorjanc -- Chief Financial Officer

No. I would say, as we get from this quarter going forward, it's going to be relatively flat. There'll be a few ups and downs, small numbers, it might be noncash-like depreciation and that. But relatively flat after we exit Q2, where is our planning process.

We've gone through a lot of looking at all the different expenses and where we can cut and where we can just stay flat or actually come down. And so we have quite a bit of that baked into the annual guidance that we did. So relatively flat as we come out of Q2.

Jeff Osborne -- Cowen and Company -- Analyst

Thank you. Helpful. Appreciate it.

Operator

[Operator signoff]

Duration: 22 minutes

Call Participants:

Erik Bylin -- Investor Relations

Matthew McRae -- Chief Executive Officer

Christine Gorjanc -- Chief Financial Officer

Madison Suhr -- Raymond James -- Analyst

Jeff Osborne -- Cowen and Company -- Analyst

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