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Arlo Technologies, Inc. (NYSE:ARLO)
Q2 2019 Earnings Call
Aug 06, 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, Gabriel. Good afternoon, and welcome to the Arlo Technologies second quarter of 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 a review of the financials for the second quarter, along with guidance provided by Christine. 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 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, future cash outlook, continued new product and service differentiation 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 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 mentioned on this call. A reconciliation of the non-GAAP to 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.

Matthew McRae -- Chief Executive Officer

Thank you, Erik, and thank you, everyone, for joining us today on Arlo's second-quarter 2019 earnings call. Strong and focused execution in the second quarter resulted Arlo achieving our financial objectives and driving our innovation pipeline as we continue our path toward profitability. Revenue was up 44% sequentially. We came in at the high end of our expectations for gross margin and completed the rightsizing of channel inventory while significantly lowering our on-hand inventory.

Arlo's market leadership continued in Q2 as we achieved a market share of nearly 40%, reflecting strong demand for Arlo products. Additionally, our paid subscription business continues to accelerate, up more than 80% year over year. These impressive market results arrive while the team has done an excellent job executing our innovative road map, sowing the seeds for future growth from new products, new categories, new service offerings and higher subscription attach rates. Let's start by talking through some highlights for the quarter.

In Q2, we delivered $83.6 million in revenue, above our guidance for the quarter. Services revenue was $11.2 million, which represents a year-over-year growth of 23%. We added about 271,000 registered users to the Arlo platform in Q2 to reach a total of 3.4 million total registered users, up more than 54% year over year. More importantly, our paid subscriber base continues to grow at a faster rate to approximately 187,000 users, up more than 80% from a year ago.

As a reminder, this growth does not include Arlo Ultra customers buying products with our new services business model included. We believe these latent future subscribers will further accelerate the growth in paid users. Moving on to our product. I'll start with a brief update on Arlo Ultra.

As you may recall, Ultra is the state-of-the-art security camera in the market with numerous key technologies and differentiated features, including 4K streaming, 4K recording, high-dynamic range, integrated spotlight, colored night vision, 180-degree field of view, noise cancellation, beamforming microphones and automatic tracking zoom, all enclosed in an advanced modular design. Ultra continues to win industry praise and was recently awarded Editor's Choice by PC Magazine, which said, "If you're looking for the best wireless outdoor security money can buy, the Arlo Ultra is your best bet in our Editor's Choice."; and won an award from best -- for best security product from T3, which said Arlo delivered a, "perfect picture and serious smarts in a brilliantly engineered package." Customer reviews for Arlo Ultra are averaging between four and five stars, driving sales mix up during Q2, which is the first quarter of full distribution. Additionally, consumers buying Ultra are receiving one year of Arlo Smart, our powerful AI and computer vision service capable of detecting people, vehicles, packages and animals. And we anticipate that we'll see strong conversion to paid subscriptions from Arlo Ultra customers at the one-year anniversary of those sales.

Today, we are also preannouncing a new core camera product that we expect to launch in the second half of this year, in time for the holiday sales period. This camera will leverage many of the breakthrough technologies we pioneered with Ultra in a system capable of 2K resolution at a price point that will achieve a new benchmark for price performance and appeal to a broad market. This new camera will also utilize our new business model and include a three-month Arlo Smart subscription with purchase contributing to the further acceleration of our paid subscribers. I look forward to sharing more details with you in the coming months as we get closer to the channel launch date.

In the second half, we also expect to launch our video doorbell, which was previously announced at ISC West. It includes several differentiating features, integrates into the full Arlo ecosystem and with our Arlo Smart platform, provides the most advanced front-door security solution in the world. The video doorbell will also implement our new business model and include a three-month Arlo Smart subscription with purchase, driving future subscriptions. More information will be available closer to the channel launch date.

In addition to these upcoming products, Arlo is innovating in the areas of Software-as-a-Service and user experience. Numerous updates and new features, including geofencing improvements, variable notification mute, performance enhancements, smoke and feel to alarm detection and additional security features are being rolled out. And today, we announced that HomeKit, Apple's smart home platform, is now supported on Arlo Pro and Pro 2 security camera systems. iOS users can utilize Siri to quickly activate a live stream on their iPhone or iPad or set up an automation to trigger HomeKit-enabled lights to turn on when motion is detected by an Arlo camera.

By adding Apple HomeKit and Siri to our existing support of Amazon Alexa and Google Assistant, Arlo is in a unique and powerful position to support all voice and smart home platforms, providing the best experience for users. Finally, in Q2, we launched direct-to-consumer sales on arlo.com. Our e-commerce store not only represents an important incremental channel of distribution but also a vital platform of engagement with our customers. Our e-commerce store will give us new insight into customer preferences, allow us to test unique bundles, develop new business models and drive lifetime revenue per customer.

It is clear to me that Arlo has reclaimed its innovation routes, and we are well on the path to expanding our reach in the smart home security market while laying the foundation for accelerating growth and profitability. Now I'd like to turn the call over to Christine for her commentary on the second quarter, guidance for the third quarter and full year.

Christine Gorjanc -- Chief Financial Officer

Thank you, Matt, and thank you, everyone, for joining us on our second quarter of 2019 earnings call. As Matt highlighted, we delivered $83.6 million of revenue, exceeding the high end of our guidance and up 44% sequentially but down 24.7% year over year as we had to promote and drive down channel inventory in the quarter. As a reminder, the year-ago comparison period references carve-out-out financials for Q1 and Q2 of 2018 whereas our Q3 2018 financial results going forward are based on stand-alone financials. You can find further detail regarding Arlo's carve-out-out financials contained in our SEC filings, including our previously filed Form S-1 and the related public offering prospectus.

During the second quarter, we shipped a total of approximately 933,000 devices, of which approximately 839,000 are cameras. We added approximately 271,000 registered users to the Arlo platform in Q2. As of the end of the second quarter, we had about 3.4 million registered users, an increase of 54.1% from a year ago. Growing our registered user base is critical to growing our recurring subscription business, which we believe will help improve both our margins and revenue predictability.

We factored in an adjustment to our paid subscriber total in Q1, and given that, we added 25,000 paid subscribers in Q2 to bring our total paid subscriber count to 187,000, an increase of 83.3% year over year. We're very pleased with the growth in our subscriber base and believe our new business model for subscriptions, which we introduced with Ultra and will continue with future product introductions, will be a substantial driver of the subscriber base and recurring revenue growth in the near future. Our services revenue for Q2 2019 was $11.2 million, which is up 23.3% over last year. From this point on, my discussion points will focus on non-GAAP numbers.

A reconciliation from GAAP to non-GAAP is detailed in our earnings release distributed earlier today. Our non-GAAP gross profit for the second quarter of 2019 was $10.5 million, which resulted in a non-GAAP gross margin of 12.5%, at the high end of our guidance and solid progress from the first quarter. This compares to $29 million in the year-ago comparable period and $2.7 million in the prior quarter. Our service gross margin was 45.2%.

Total non-GAAP operating expenses came in at $37.8 million, which is up 25.3% year over year, largely due to the effect of carve-out financials but down 2% sequentially. Our total non-GAAP R&D expense for the second quarter was $16 million, down 5.4% sequentially. Our head count at the end of Q2 '19 was 402 employees, compared to 401 in the prior quarter. Our team is extremely focused on managing costs while still executing the initiatives that will maximize our growth and shareholder value.

These numbers reflect the continuous diligence we are practicing around managing expenses. As you have seen in our guidance, our business is scaling in the second half of the year with the introduction and ramp of new products. We expect non-GAAP operating expenses to increase slightly in the second half of the year to facilitate these launches and growth. Our non-GAAP tax expense for the second quarter of 2019 is $207,000.

And for the second quarter of 2019, we posted a non-GAAP net loss per diluted share of $0.36. We ended the quarter with $137.9 million in cash, cash equivalents and short-term investments. The decrease in cash primarily reflects our non-GAAP operating loss, along with a $15 million working capital outflow, driven by increased accounts receivable and a decrease in accrued liabilities. We expect the working capital outflow we experienced in Q2 will more than reverse itself in Q3.

We continue to be very focused on managing our cash position, and we were very pleased with our inventory management during Q2. In the first six months of this year, we reduced worldwide channel inventory by approximately $70 million, including bringing U.S. retail channel inventory to 10.1 weeks of stock at the close of Q2, and we are back to normal levels of inventory in the channel. Additionally, we also lowered our on-hand inventory ending in the quarter at $97.2 million, down $34 million or 25.9% sequentially.

The significant reduction in both channel and on-hand inventory puts Arlo in an excellent position as we prepare to launch new products in the second half of the year. Now turning to our outlook. We expect revenue in the third quarter to be in the range of $95 million to $105 million. We expect our GAAP gross margin to come in between 8.1% and 11.1% and non-GAAP gross margin to come in between 9% and 12% in the third quarter of 2019.

We expect our GAAP net loss per diluted share to come in between $0.53 and $0.47 per share and our non-GAAP loss per diluted share to come in between $0.43 and $0.37 per share. We expect our non-GAAP and GAAP tax expense to be approximately $300,000 for Q3 2019, and we are reaffirming the full-year 2019 guidance we gave in our last earnings announcement. With that, I will open the call for questions.

Questions & Answers:


Operator

[Operator instructions] Your first question will come from the line of Adam Tindle from Raymond James. Please go ahead.

Adam Tindle -- Raymond James -- Analyst

Christine, I just wanted to maybe start with that very last thing that you said on reaffirming guidance for 2019. I understand, obviously, channel inventory in a much better position, but I think the implied Q4 revenue number at the midpoint there would need to be up like 60% sequentially or something like that in order to get to $400 million for the year. So maybe just help us understand, kind of on that last comment, what led you to reaffirm guidance the climb that it implies in Q4 from a revenue standpoint.

Christine Gorjanc -- Chief Financial Officer

Sure. So I think the starting point is the channel inventory is rightsized, and we have two products coming in the back half of the year and the majority of that revenue and shipment will come in Q4. It's the camera product that we just announced, the refreshed camera and the 2K and then also the video doorbell, which is a new category for us, really. So everything in that sale is incremental.

And also, we do expect with the new products less promotion, and that as far as the reduction in our marketing spend, which also increases our revenue into Q4. So we do believe that this is an unusual quarter and the fact that we have two new products coming in, and they're going to come in slightly toward Q4, reduce channel inventory with some of the older products, and that's really where we're at for the quarter.

Adam Tindle -- Raymond James -- Analyst

OK. And then maybe just to be clear. I think previously, you had thought that annual gross margin would be in the mid-teens, the non-GAAP operating loss around $100 million at the midpoint. Are you reaffirming those levels as well? Or are there new numbers that we can think about for that?

Christine Gorjanc -- Chief Financial Officer

I think the guide there was really the non-GAAP operating margin, $95 million to $105 million, and we do believe we're reaffirming that we will be in that range.

Adam Tindle -- Raymond James -- Analyst

OK. And then maybe just a couple bigger-picture questions. Matt, I know that the company had a long-term target to get 30% of revenue from services. You obviously have seen some good growth in paid subscribers.

Maybe just talk about the goal of the 30% of revenue from services and kind of the key factors to accelerating that. Are there incremental services within that offering that are on the road map that are helping to get you to that level?

Matthew McRae -- Chief Executive Officer

Yes. I think you'll see two things getting us to that long-term operating model. One is from a road map perspective, as I mentioned in the script and going forward, we have a robust road map, not just for hardware but also on the service side. So expect to see additional features launched in the second half of this year and that road map to continue innovating and adding services that people want to sign up for.

We do a lot of surveys and really understand what people are looking for in that service and are actually prioritizing the services offer road map to link up with that. And then, two, I think the biggest lift or the acceleration that we believe we'll see is when the business model starts to kick in on Ultra. But also, both products we announced on the call today or reannounced and then preannounced include the new business model as well. And as a reminder, that's an inclusion of a period of free service or a subscription that comes with a purchase, and then it flips over to a paid model, which will drive, obviously, a higher attach rate than what we've seen from a legacy perspective.

Those are the two largest, so from a road map perspective and from a feature and service perspective, we'll be adding what we believe will drive subscriptions. And then obviously, the new business model will have probably the biggest impact from that trajectory.

Adam Tindle -- Raymond James -- Analyst

OK. That's helpful. And maybe just one last one for me. Just was curious on, Matt, your observations on sell-through of Ultra.

And I think you mentioned in the prepared comments a lot of positive reviews. I think you said sales mix was up in the quarter. So I'm just curious to understand the price elasticity dynamics that you're observing in the market with a premium product like that. And given this, maybe just go through the algorithm for future product revenue growth from the standpoint of units and ASPs.

Are you finding that there's demand at this new level of ASPs that maybe is surprising you?

Matthew McRae -- Chief Executive Officer

Well, yes. What I would say is, per my comments, the mix is up in Q2, which is good. And I think it's where we needed to be as a company going forward. As you know, if you probably looked at pricing for Ultra, we have not promoted it.

And that goes along the lines of Christine's point where you're going to see marketing spend go down as we launch new product because we're launching product at the right price point, servicing those different product segments with the right product at the right price, which gives us ability to reference and actually address different market segments. And I think Ultra is doing a good job at driving sales in that upper segment. The product we just preannounced today steps down one segment from there and a bit of a broader market but will obviously be priced in the right manner to go after that product as well. So we're seeing it makes up quarter over quarter, and we're seeing success at that price point.

And then we'll start to address additional price points as we continue our NPI road map, our new product launches.

Operator

[Operator instructions] Your next question will come from the line of Thomas Boyes of Cowen and Company. Please go ahead. Your line is open.

Thomas Boyes -- Cowen and Company -- Analyst

Great. Thanks for taking my questions. Just a couple of quick ones. Is there any opex savings from the direct-to-customer sales platform that you now have versus, obviously, selling through, say, Best Buy or something?

Christine Gorjanc -- Chief Financial Officer

Yes. I mean that's probably what you'd look at in the gross margin is potentially, we can make some of that money that the channel would make over time. Although I do believe right now it's just getting started for this year.

Thomas Boyes -- Cowen and Company -- Analyst

Got it. And then the new 2K camera, is that using the same battery packs that was kind of perfected with Arlo Ultra? Because the, obviously, initiative was rectified, and then it kind of seems like smooth sailing going forward. It's not a new format or anything like that, it's using the same battery?

Matthew McRae -- Chief Executive Officer

Yes. It's actually -- it's a good question. It's actually leveraging a lot of the technology from Ultra, including the battery and a lot of other components. So it's -- from an execution perspective, we have very high confidence given that we have the first issue with Ultra, have corrected that, and we're seeing great reviews from both customers and professional reviewers on Ultra.

And we're seeing the sales mix up. It's building off of all of that same technology on both the hardwares and software back in perspective, including the battery.

Thomas Boyes -- Cowen and Company -- Analyst

Great to hear. And then actually the follow-on with the sell-through for Ultra. Are you seeing any disposition toward four-camera systems versus two-camera bundles initially?

Matthew McRae -- Chief Executive Officer

Yes. It's similar to what we've seen in the past where one of our most popular -- one of the most popular SKUs that's sold is the four-camera bundle. But the average is still roughly about three cameras on a sale perspective.

Thomas Boyes -- Cowen and Company -- Analyst

OK. Very good. And one more broad. Could you just give us a general sense of maybe the pricing landscape and competitive environment that you're seeing? I mean I noticed that there's still some promotional pricing with -- on some retailers for some of the lower-tier cameras, even after rightsizing the inventory.

Is that more just to kind of make additional space for the 4K camera as it comes through in the end of the year, 4Q?

Matthew McRae -- Chief Executive Officer

Yes, that's right. So you're seeing us -- there's activity prior as we were tracking the channel inventory. The activity you're seeing now is to actually clear the shelf and be ready for the 2K camera that we just preannounced today. And so you'll see that continue as we do that transition.

We're being real smart about the transition to make sure we don't get pow with too much inventory.

Thomas Boyes -- Cowen and Company -- Analyst

Very good. And then just one last one. For kind of the security product line in general. Is that something that we should now expect to see in the beginning half of 2020? Or is that going to be more part of, say, that spring refresh back half of the year as these things are brought online?

Matthew McRae -- Chief Executive Officer

Yes. I think for the security, as part of our kind of continuous look in the business review of what we do and try to maximize the impact, we've accelerated a couple of products, the ones we talked about today. The security product, you'll look at maybe the second part of the first half, maybe Q2 or Q3 timing for that product, as we launched probably with some additional services that would go with it.

Operator

Our next question will come from the line of Hamed Khorsand of BWS Financial.

Hamed Khorsand -- BWS Financial Inc. -- Analyst

First off, just a quick question. If you're now reaching normalization in the channel and you're going into Q3 with lifted revenue expectations, why isn't there greater scale in your margins that you're providing in guidance?

Christine Gorjanc -- Chief Financial Officer

Well, in Q3 -- first of all, it is a little more promotional than Q2, starts out with prime day. Secondly, as we just mentioned with the last question, there is still inventory being cleared out of the channel right now as we get ready for the new product camera coming in. And again, the new camera and the doorbell are coming in late Q3 and into Q4. So that's why you see a much larger Q4, and you will see the uptick in the gross margin there.

Hamed Khorsand -- BWS Financial Inc. -- Analyst

OK. And then, as far as the marketing is concerned, are you marketing the new products this quarter in preparation for them ending in the store? Or are you still marketing the older products?

Christine Gorjanc -- Chief Financial Officer

Well, right now, it's really -- when I guess, I'm saying channel marketing, I mean the marketing that is spent as those products sell through the channel. So since the new ones aren't out yet, this is really more the old one right now. And then also, as Matt mentioned, on Ultra, we haven't really discounted that. So as the new products come into market, we will not be discounting them, whereas today, approaching the market for three or four years, it's more heavily discounted.

Hamed Khorsand -- BWS Financial Inc. -- Analyst

OK. And then I missed the first portion of the call, so I apologize if you answered this. But from a competitive landscape, if you're not discounting Ultra at all, are you retaining market share? Are you growing market share just given the competitive landscape?

Matthew McRae -- Chief Executive Officer

So if you -- yes. If you look at market share sequentially quarter over quarter, we grew a little bit. So we ended close to 40% market share. Our typical market share range, as you know, is typically 35% to 40%.

So we've been holding pretty steady quarter over quarter on the market share measurement.

Hamed Khorsand -- BWS Financial Inc. -- Analyst

And do you think this was driven because of Ultra or your older products?

Matthew McRae -- Chief Executive Officer

It's a mix. I mean obviously, as we are moving through channel inventory that's generating POS and driving market share, and we're seeing Ultra start to mix in, so when you're talking about revenue market share, which is a measure we use, Ultra, obviously, has an outsized impact on that because it's a higher-ASP product, but I would say a lot of that market share is also from us moving POS and moving channel inventory out, get ready for the new product.

Hamed Khorsand -- BWS Financial Inc. -- Analyst

OK. Thank you.

Matthew McRae -- Chief Executive Officer

Welcome.

Operator

There are no further questions at this time. I will now turn the call over to Matt McRae for closing comments.

Matthew McRae -- Chief Executive Officer

Thank you, everyone, for joining us for our earnings call today.

Operator

[Operator signoff]

Duration: 28 minutes

Call participants:

Erik Bylin -- Investor Relations

Matthew McRae -- Chief Executive Officer

Christine Gorjanc -- Chief Financial Officer

Adam Tindle -- Raymond James -- Analyst

Thomas Boyes -- Cowen and Company -- Analyst

Hamed Khorsand -- BWS Financial Inc. -- Analyst

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