Logo of jester cap with thought bubble.

Image source: The Motley Fool.

Arlo Technologies, Inc. (NYSE:ARLO)
Q3 2019 Earnings Call
Nov 07, 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, Akesha. Good afternoon, and welcome to Arlo Technologies' third 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 third 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 the call. A reconciliation of the non-GAAP to GAAP measures can be found in today's press release on our Investor Relations website. And at this time, I would now like to turn the call over to Matt.

Matt McRae -- Chief Executive Officer

Thank you, Erik, and thank you, everyone, for joining us today on Arlo's third-quarter 2019 earnings call. We have a lot to cover today in what was outstanding quarter for the company from an execution perspective. Christine and I will walk you through the major elements, including financial results for the quarter, our definitive agreements with Verisure, launch of Arlo Pro 3, announcement of our first Video Doorbell, implementation of a comprehensive restructuring plan and the closing of a $40 million line of credit. Let's start by talking through some highlights for the quarter.

In Q3, we achieved $106.1 million in revenue, above the high end of our guidance for the quarter. Services revenue was $11.8 million, which represents a year-over-year growth of 20% and a new record for the company. We added about 294,000 registered users to the Arlo platform in Q3 to reach a total of nearly 3.7 million total registered users, up 48% year over year. More importantly, our paid subscriber base continues to grow at a faster pace and reached approximately 211,000 users, up more than 69% from a year ago.

As a reminder, this growth does not include Arlo Ultra and now Arlo Pro 3 customers buying products with our new services business model that includes unlimited free trial of Arlo Smart. We believe, when the trial period for Arlo Smart lapses, many of these customers will subscribe to Arlo Smart and we will see further acceleration in the growth of the paid subscribers in the first half of 2020. Today, I'm excited to announce that we have entered into a truly impactful strategic partnership with Verisure that has multiple benefits to Arlo. Verisure is a leading provider of professionally monitored security solutions with three million customers in 16 countries across Europe and Latin America and going quickly through innovation and excellent service.

The partnership has two main elements. First, Verisure will pay Arlo $50 million for Arlo's European commercial operations, covering marketing and distribution of Arlo products and services, the Arlo brand and Arlo's existing installed base in Europe. From -- the acquisition will create the first multichannel, go-to-market, for-consumer security experience. We understand Verisure plans to invest in sales and marketing to grow these channels significantly over time.

Second, Verisure has committed to purchase a minimum of $500 million of Arlo products over the next five years to be distributed by Verisure. Verisure will also purchase associated cloud services from Arlo, including artificial intelligence, computer vision and other features. This agreement includes prepayment terms and other services that further provide cash for Arlo. In addition to locking in significant growth in Europe, we expect profitability to also improve from where it stands today over the life of the deal.

Arlo will continue to own and operate all channels outside of Europe and will continue to own and drive our innovative product road map, our intelligent cloud services platform and the Arlo app experience on a global basis. The proceeds from this partnership will be used to fund operations and drive additional future growth opportunities across our businesses. The strategic partnership with Verisure is a transformative event for the company. Beyond the cash and future revenue impact, it provides substantial diversification for Arlo on both a regional and channel basis with a partner who is completely aligned to help us aggressively scale the European territory, while affording us lower complexity and operational focus on our other markets.

Perhaps most importantly, Arlo and Verisure have a synergy of vision that will bring millions of customers peace of mind through connected security products to protect what matters most. Moving on to products. In Q3, we launched the Arlo Pro 3, a major update to our best-selling Pro line of indoor/outdoor smart cameras. It leverages many of the breakthrough technologies from Ultra, including an integrated spotlight, color night vision, high dynamic range and our new modular design in a package featuring 2K resolution video and a 160-degree field of view.

The Pro 3 includes a three-month subscription to Arlo Smart, our powerful cloud-based AI and computer vision-based service that enables smart notifications, person detection, vehicle detection, package detection, smoke and carbon monoxide alarm detection, e911 and numerous other features in addition to cloud video storage. This brings a tremendous amount of technology and capabilities to a more aggressive price point for users looking to protect what they care about most. And they have responded by rating the Pro 3 a 4.5 out of five stars at Best Buy, making it one of our highest-rated products at launch. Professional reviews are just rolling in, and the first two both achieved Editors' Choice awards, with CNET commenting "The 2K streaming is stellar." and that "Arlo Pro 3 is the outdoor home security camera to beat." while naming it the "top pick for all home security cameras." And today, we announced that the Arlo Pro 3 won the coveted 2020 CES Innovation Award in the broad smart home category, one of two awards given to Arlo this year.

Pro 3 sets a new benchmark for price and broad market appeal. Arlo also formally announced the Arlo Video Doorbell in the quarter, which is our first video-integrated product in the space and brings significant innovation in the areas of video and audio performance. The product features an industry-leading vertical field of view with a unique 1:1 sensor aspect ratio to see packages on the ground or visitors from head to toe, solving the biggest complaint users have with existing products on the market. Arlo is also using Voice over IP technology to provide a best-in-class audio experience where a doorbell button press results in a phone call on your mobile device, providing a high-quality, low-latency experience.

The audio -- the Arlo Video Doorbell fully integrates with the wider Arlo ecosystem and features a free three-month trial for Arlo Smart, which benefits greatly from the unique image sensor by allowing for superior computer vision detection of people and packages at close range. We believe this powerful combination creates the most sophisticated doorbell on the market and will drive future paid subscribers for Arlo. The Video Doorbell started shipping into the channel last week, will be available in November for Black Friday and is now available for preorder at Best Buy and other authorized Arlo resellers for $149.99. These two major product launches provide us with a phenomenal lineup for the holiday season, but also leading into the full year of 2020.

As discussed previously, we have additional products in our pipeline to announce in the first half of next year, but are now substantially through our post-spin innovation and new product introduction cycle that is refreshing our core products and transitioning to our new business model. As such, we are executing a comprehensive and detailed restructuring plan, with an emphasis on optimizing the business across all functions and materially lowering our operating expenses. The execution of this plan began in the quarter and is focused on accelerating our path to profitability. I'll turn the call over to Christine for her commentary on this restructuring plan, our activities to add cash to the balance sheet, our third-quarter results and our guidance for the fourth quarter and full year.

Christine Gorjanc -- Chief Financial Officer

Thank you, Matt, and thank you, everyone, for joining us for our third quarter of 2019 earnings call. Before I discuss our financials, I would like to provide some detail on our restructuring and line of credit. As Matt mentioned, today, we announced a restructuring plan that has already allowed us to materially lower our operating expenses in Q3 '19 and under which we will continue to see benefits into 2020. Importantly, this will not hinder our ability to deliver market-leading innovation to consumers.

The guidance we gave for the third quarter and full year implied, on an operating expense level, of approximately $40 million per quarter. Our restructuring plan will lower our ongoing non-GAAP operating expenses to an annualized run rate of approximately $33 million to $34 million per quarter, saving approximately $25 million per year compared to our expectation of $160 million. Due to these actions, we will incur charge totaling approximately $1 million to $2 million over the next few quarters. These cost savings will be fully actualized by the second quarter of 2020, but as I mentioned, we already began to see their effect in Q3.

We expect some variability in our quarterly operating expenses mainly due to our allocation of channel marketing expenses between contra revenue and operating expenses as well as other seasonal expenses. These savings include, but are not limited to, reducing outside services, head count, infrastructure and marketing activities. They also include savings that we will realize based on the Verisure deal. Additionally, we have secured a $40 million revolving credit line based on our receivables.

We may use these funds to supplement working capital as needed. As previously disclosed in April 2019, the company's Board of Directors commenced a comprehensive strategic review of the company. On November 7, 2019, the company announced that the strategic review had been formally concluded, but that the company will continue to evaluate a wide range of strategic alternatives available to the company to optimize the value of the company and to improve returns to its stockholders. And now onto the financials.

As Matt highlighted, we achieved $101.1 million of revenue, exceeding the high end of our guidance and up 26.9% sequentially but down 19.1% year over year. During the third quarter, we shipped a total of approximately 1,138,000 devices, of which approximately 1,075,000 are cameras. We added approximately 294,000 registered users to the Arlo platform in Q3. As of the end of the third quarter, we had about 3.7 million registered users, an increase of 47.8% 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 are very pleased with the growth in our subscriber base and believe our new business model for subscriptions, which we introduced with Ultra, have included with Pro 3 and the Video Doorbell 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 Q3 2019 was $11.8 million, which is up 20.2% 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 third quarter of 2019 was $11.4 million, which resulted in a non-GAAP gross margin of 10.7%, just above the midpoint of our guidance. This compares to $30.4 million in the year-ago comparable period and $10.5 million in the prior quarter. Our service gross margin was 41.9% for the third quarter of 2019.

Total non-GAAP operating expenses came in at $36 million, which is up 5.7% year over year but down 4.8% sequentially. Our total non-GAAP R&D expense for the third quarter was $15.1 million and down compared to prior quarter. Our head count at the end of Q3 '19 was 406 employees compared to 402 in the prior quarter. As we mentioned earlier, we began reducing our operating expenses during Q3 and expect to realize $25 million in annualized savings by the end of Q2 '20 compared to our prior expectations of approximately $160 million per year.

That said, we expect Q4 will be up approximately 5% sequentially due to seasonal factors. Our non-GAAP tax expense for the third quarter of 2019 is $332,000. For the third quarter of 2019, we posted a non-GAAP net loss per diluted share of $0.32. We ended the quarter with $153.8 million in cash, cash equivalents and short-term investments, up $15.9 million sequentially.

The increase in cash principally reflects our tight focus on working capital management. We continue to be very focused on managing our cash position and we're very pleased with our inventory management during Q3 and improved DSO of 85 days for Q3. Over the last several months, we have worked to increase our liquidity by adopting a restructuring plan to reduce expenses, securing a credit facility as well as entering into a strategic partnership with Verisure. These actions combined will increase our cash availability by up to an additional $110 million.

Now turning to our outlook. We expect revenue in the fourth quarter to be in the range of $115 million to $125 million. We expect our GAAP gross margin to come in between 9.9% and 12.9% and our non-GAAP gross margin to come in between 10.5% and 13.5% in the fourth quarter of 2019. In Q4, we do not expect to meet all the demand for Pro 2 from our retailers.

An older product, Pro 2 requires chips that are manufactured by a single vendor largely for Arlo. In October, this vendor informed us they would be short approximately 100,000 chips of what we expected for the first half of Q4. We expect this shortfall to cause a revenue headwind of about $15 million in Q4 and adversely impact gross margin. We expect our GAAP net loss per diluted share to come in between $0.39 and $0.45 per share and our non-GAAP loss per diluted share to come in between $0.28 and $0.34 per share.

We expect our GAAP and non-GAAP tax expense to be approximately $400,000 for Q4 '19. And with that, we can open the call to questions.

Questions & Answers:


Operator

[Operator instructions] Your first question comes from the line of Adam Tindle from Raymond James.

Adam Tindle -- Raymond James -- Analyst

OK. Thanks and good evening. Christine, I think I just wanted to start maybe on that last comment and kind of a more near-term question on the product side. Q4 revenue, I know it was a pretty high bar to start, but it's going to come down by over 20%.

So maybe just what is different from your expectation? Heading into this channel inventory, it was supposed to be lean. You thought you had two new products in the quarter, which typically don't get two new products in a single quarter, so that would lead to a big sequential uptick. I know that $15 million chip shortage is going to lead to some of the delta, but not all of it. So I'm just trying to get to the bottom of the -- what on top of the chip shortage is driving the incremental delta from your expectations?

Christine Gorjanc -- Chief Financial Officer

Sure. I think when we look at the full delta, it's really some of the orders are slipping into Q1. Some of it is really we have seen some increased demand, and it's really mixed at that point coming in at the mix and bringing products in. So between the 2, that probably gets close to the delta.

Adam Tindle -- Raymond James -- Analyst

OK. I mean -- and maybe a question for Matt. Is there any any aspect of seeing pushback on the new business model that does not include services leading to lower product sales? Or is that just not happening?

Matt McRae -- Chief Executive Officer

No. We don't see any issue there at all. The product we described that's short is actually an older product. And we're making moves to try and fill as much of that as we can, which is part of the impact on gross margin, but we're not seeing any issue in the shift to the new business model.

Adam Tindle -- Raymond James -- Analyst

OK. Good to hear. I want to touch on Verisure. Traditionally, a monitored security company.

I just want to understand the economic aspects of the deal. I understand it's not fully closed and maybe still negotiable, but any help you can give us. What are the terms? Is the $500 million contingent on anything? Or is it fully committed? What's the gross margin on that $500 million? Just how we can think about the economic expects of it.

Matt McRae -- Chief Executive Officer

Yes. I think what we can share with you from a high level is what we talked about around them purchasing the commercial operations for $50 million and then having a minimum guarantee of the $500 million across various products. Now if you -- what's interesting, if you look at the European market, that market for us is $50 million roughly in revenue today and end markets growing at about 5%. Now with the $500 million guarantee over the next five years, that's suggesting a CAGR locked in at 24%.

So you're seeing a good deal of growth. Now what I'll say from a -- from just a kind of informational perspective is a lot of that growth you will start to see in the second year of the deal, so 2021 going forward because the first year we've got some developments, some integration to do before you start really having the full impact of that, but the $500 million is the minimum guarantee over the five years, suggesting that strong growth of 24% CAGR in that region. Now that compares to kind of a rest of world or if you look at the category in total on a global basis where we're seeing growth roughly in the 5% to 10% range. And of course, as we look forward into 2020, we're targeting to outgrow the market there.

And based on our new products, like a full year on the Doorbell and a couple of products that will be announced next year, we're targeting growth more like 10% to 15% above that category growth market when you compare it to our 2019 full-year guidance.

Adam Tindle -- Raymond James -- Analyst

OK. That's helpful on the timing. And then maybe just on the margin front of it, do you participate in any of the RMR from professional monitoring with it? Or is this just all basically product resale to them? And is it accretive to your current product margin? Is it dilutive? Just any ballpark on how we can think about the gross margins on that $500 million over time?

Matt McRae -- Chief Executive Officer

Yes. Yes. So what I can comment on is the $500 million guarantee over the next five years is really hardware purchases, but the deal also encompasses all of our Arlo Smart services, including computer vision and the like. And in fact, they're going to deploy the product through multiple channels.

And through their direct channel, every customer buying an Arlo product will likely have service attached. So we think this will actually serve as an acceleration of our subscriber and RMR market by this great partnership we have with Verisure, who really understands how to sell services in a professional and innovative way into the market that they're strongest in, which includes obviously the European territory. So we're not commenting on gross margins in detail, but I did say in the script, if you remember, that as we look at this deal going forward, not only is the $50 million business in Europe going to grow based on their investment and based on the $500 million guarantee just on the hardware side, but we see profitability actually growing from that standpoint over the five years as well.

Adam Tindle -- Raymond James -- Analyst

OK. That's helpful. Maybe just one last one on the Arlo Smart trial. It's going to lapse in early 2020 for the first tranche.

Any way that you can help us with how you're thinking about potential for incremental subscribers versus churn? Any help with the potential incremental services TAM from that opportunity would be helpful.

Matt McRae -- Chief Executive Officer

Yes. We -- so when we look at current business model, which, you're right, is still being rolled on the products we're selling today, I think we've commented in the past that people who try the service are attaching it in a healthy, I think we used the term manner, and now our term is actually also healthy. So we're using that to model what we think is going to happen next year. We don't -- there's nothing that we're actually sharing at this point, but based on what we're seeing in the current models, we expect to see an acceleration, especially as we kind of execute one and start to look on the first full quarter of having people on the new business model for several of our products.

And to that point, we've had Arlo Ultra for the last six months or so really on this new business model. And Arlo Pro 3, which we announced today, is on a shorter version of that same business model, only 90 days. And the Video Doorbell that we announced today is also on that 90-day trial. So we're really looking in kind of that Q1 to a kind of Q2 time frame to see what that lift will be.

All indications is that it will be a decent lift and we're looking forward to reporting that.

Adam Tindle -- Raymond James -- Analyst

OK. One final clarification. On the Verisure, you had mentioned on the response to the question that they're going to -- Arlo Smart is going to be lumped into that. Is that also a one-year free trial for those customers? Is that an ongoing -- how does the Arlo Smart piece work with the Verisure relationship?

Matt McRae -- Chief Executive Officer

Yes. So those products sold through the existing retail channels will, at this point, mimic what you see here in the United States. So there will be -- the new business model on the new products and it will flow through in a similar way. For those products sold through the Verisure direct channels, that will be actually encompassed into the Verisure service package.

And so they will be signing up for kind of a contracted service that includes Arlo Smart for those products that are Arlo developed and manufactured and sold to Verisure.

Adam Tindle -- Raymond James -- Analyst

OK. Thank you very much.

Operator

And our next question comes from the line of Hamed Khorsand from BWS Financial.

Hamed Khorsand -- BWS Financial -- Analyst

Hi. So first question I had was what kind of changes are you making this quarter, specifically Q4, to offset those shortages in Pro 2? I guess, is it any marketing, any kind of strategy to push the customer to buy Pro 3 and Ultra?

Matt McRae -- Chief Executive Officer

Yes. So Pro 2, obviously the shortage came in pretty late from a notification perspective. And then what we've been doing is working with our partners from a channel perspective and leveraging other products like Ultra and Pro 3 into some of those promotional opportunities.

Hamed Khorsand -- BWS Financial -- Analyst

OK. Are you going to pull back on some of the doorbusters? I know Best Buy has been advertising your Pro 2 as a doorbuster for Thanksgiving weekend. Is that going to change up now because of the shortfall?

Matt McRae -- Chief Executive Officer

No. I think you will see that continue. It's just the number of units potentially sold because of the shortfall of supply is different than what we obviously expected coming into the quarter.

Hamed Khorsand -- BWS Financial -- Analyst

OK. What I'm having difficulty is -- obviously, you have better margins here if you sold Pro 3 and Ultra, right? So isn't there are more of an emphasis to move them -- the customer higher instead of just putting them...

Christine Gorjanc -- Chief Financial Officer

Yes. I mean we'll probably give them a little bit deeper discount on that, but then we also will get the service revenue for that when it turns around into Q2.

Matt McRae -- Chief Executive Officer

Yes. The other issue that will hit is because we're having to bring in product at the last minute to fulfill some of the retailer demands in freight and some other things that are little bit more expensive.

Hamed Khorsand -- BWS Financial -- Analyst

OK. And then once you -- we've gone to Q1, Q2, do you think you will have enough supply to get gross margins back at a higher level?

Christine Gorjanc -- Chief Financial Officer

Yes, absolutely. We'll be back in stock in the Pro 2 by mid-December, in full stock.

Hamed Khorsand -- BWS Financial -- Analyst

OK. Thank you.

Operator

Your next question comes from the line of Thomas Boyes from Cowen and Company.

Thomas Boyes -- Cowen and Company -- Analyst

Thank you very much. I just had a couple of quick ones. I was wondering what the feedback you've had from the direct-to-customer sales through arlo.com and really how that matured over the past quarter?

Matt McRae -- Chief Executive Officer

Yes, that's been a -- it's been a great start. I mean, obviously, we launched a rather simplistic version of the site, but it did meet all of our internal goals, and it's something that we'll obviously continue to invest in as we go forward and into 2020. What's interesting is not only do we do view that as an incremental revenue opportunity and obviously a potential path for higher gross margins, it's also an area where we can explore new business models, potential bundles and other things in kind of a low-risk manner before rolling that out in scale to some of our channel partners. So it's been a -- we would call it a great success starting from 0, and it's something we're going to continue to build over time.

Thomas Boyes -- Cowen and Company -- Analyst

Great. And how has the competitive environment changed over the last several months? Have you seen any of your other competitors start to offer e911 services or anything like that in the geographies that you compete in?

Matt McRae -- Chief Executive Officer

We haven't seen a lot of news in that area. I think there's been a couple of announcements of some maybe one or two of the features being launched or maybe rolled out next year, but in the -- as we sit here today, Arlo is still is the only company that has that suite of services that we have in Arlo Smart. And of course, we have a road map to add additional services over time over the next couple of quarters and as we get into 2020, so we're not standing still. I would expect, now that we've had Arlo Smart in the market for a year, almost 1.5 years as we get to the end of this year, some of those original features could start appearing on other products.

But like I said, we're going to continue to march forward and have a whole road map on adding additional compelling features to that to drive not only additional subscribers from a number and revenue perspective, but also in the future, look at potential opportunities to increase ARPU through adding more advanced features in the future.

Thomas Boyes -- Cowen and Company -- Analyst

Great. And then I think I understand the revenue component of the guidance well enough with the $15 million delta and then mix obviously explaining the rest of it. Could you just tell me to better understand maybe the margin impacts relative to maybe where I think expectations were heading into the quarter? Is that just a greater degree of promotions that's causing that expectation delta?

Christine Gorjanc -- Chief Financial Officer

Yes. I mean, starting with our most -- we promote more in Q4 than any quarter. But definitely, as we're substituting some other products, for example, Pro 3 for Pro 2, we're promoting that more heavily, so that does affect the margins, which I mentioned in the script. And then also during Q4, we do have the freight, additional freight because we are bringing over Pro 3 and Doorbell and all the MPI products.

The new products are coming over via freight, air freight.

Thomas Boyes -- Cowen and Company -- Analyst

Excellent. And then just one last one, really quick. What would your cash expectations need to be like kind of looking into 2020 post the Board's review, strategic review and understanding what kind of the cost of initiatives that you're already working with are?

Christine Gorjanc -- Chief Financial Officer

I mean, if you think about it, we're ending this quarter with $154 million. We have access to another $110 million. And so I think when we look at that, we would always like to have $100 million. So I think we're pretty pleased with the work that's happened this quarter.

Thomas Boyes -- Cowen and Company -- Analyst

Thank you very much.

Operator

[Operator instructions] And there are no further questions at this time. I will now turn the call over to Matt McRae for closing remarks.

Matt McRae -- Chief Executive Officer

Thank you, everyone, for joining us today on what you can tell is a significant quarter for Arlo. The announcements today represent the culmination of actions and execution taken since our spin from NETGEAR, the strong financial performance, the successful and on-time launch of Pro 3, our announcement of the Video Doorbell, the multifaceted strategic deal with Verisure providing a cash infusion and future revenue, our restructuring plan and the revolving credit facility that put Arlo on a solid ground to execute our business plan. The team here continues to be maniacally focused on operating the company in a focused, efficient and disciplined manner as we diversify the business and capture growth opportunities across markets. Thank you.

Operator

[Operator signoff]

Duration: 33 minutes

Call participants:

Erik Bylin -- Investor Relations

Matt McRae -- Chief Executive Officer

Christine Gorjanc -- Chief Financial Officer

Adam Tindle -- Raymond James -- Analyst

Hamed Khorsand -- BWS Financial -- Analyst

Thomas Boyes -- Cowen and Company -- Analyst

More ARLO analysis

All earnings call transcripts