Arlo Technologies, Inc. (ARLO) Q3 2020 Earnings Call Transcript

Arlo Technologies, Inc. (ARLO -1.86%)
Q3 2020 Earnings Call
Nov 05, 2020, 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 turn the conference over to Erik Bylin. Please go ahead, sir.

Erik Bylin -- Investor Relations

Thank you. Good afternoon, and welcome to Arlo Technologies third quarter of 2020 financial results conference call. Joining us from the company are Mr. Matthew McRae, 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 expected revenue, gross margins, operating margins, tax rates, expenses, future cash outlook, our partnership with Verisure, continued new product and service differentiation, future business outlook and the impact of the COVID-19 pandemic on the business and operations. 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 today 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 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.

Matt McRae -- Chief Executive Officer

Thank you, Erik, and thank you, everyone, for joining us today on Arlo's third quarter 2020 earnings call. In today's call, Gordon and I will walk you through the major elements including: financial results for the quarter, paid account growth and new product announcements. Arlo's strong third quarter results served as further evidence of the improvement we have made in the business. Accelerating paid service accounts, gross margin expansion across both products and services, a strong contribution from Verisure and our continued operating discipline combined to produce a significant improvement in profitability and further demonstrate the transformational impact of our business model transition.

We delivered $110.2 million in revenue, which is up over 65% sequentially, well above the upper end of our guidance and a return to year-over-year growth. Our non-GAAP gross margin improved by 11 percentage points sequentially as our product gross margin recovered and our service gross margin continued its upward trajectory. Non-GAAP operating expenses came in at $31.2 million, down almost $5 million year-over-year and reflected our sustained focus on operational efficiency. These results demonstrate the leverage we can generate in the business as we shrink our non-GAAP operating loss by more than $16 million year-over-year, and that, in turn, helped us close the quarter with a very healthy cash, cash equivalents and short-term investments balance of more than $193 million.

Arlo once again set a record by adding 58,000 paid accounts in Q3 and ended the quarter with approximately 356,000 paid accounts, an increase of 69% year-over-year. This resulted in our fifth consecutive quarter of record services revenue at $19 million, which is up 61% year-over-year. The driving force behind the success is our new business model, which features a 90-day free trial of Arlo Smart, our best-in-class AI-powered motion identification and security service. Once the free trial of Arlo Smart expires, we have consistently seen a 50% subscription conversion rate to the paid service, which is 10 times higher than the conversion rate of our old business model.

Last quarter, we launched the Essential Spotlight camera, which completed our phase-out of old business model products. So beginning in 2021, virtually all of our retail product sales will be under the new business model. Now, we'd like to walk you through our recent product announcements that substantially expanded our new Essential product family. The first is Essential XL Spotlight, which shares all of the features from our recently announced Essential Spotlight, but lengthens battery life to an incredible 12 months.

The second is Essential, a simplified version of the product, for those who do not need the spotlight or color night vision functionality, and this product will be available exclusively from Walmart this holiday season for $99.99. And finally, we announced the Essential Wire-Free Doorbell, which brings all of the award-winning features from our wired video doorbell to a new battery-operated design that substantially expands our addressable market. The new Wire-Free Doorbell is available for preorder and will ship out across our channels later this year. Arlo also announced upgraded versions of our Pro and Ultra product families in the quarter.

The Ultra 2 and Pro 4 wire-free spotlight cameras carry all of the great features of our award-winning Ultra and Pro 3 with improved performance. The Ultra 2 is available for preorder at Amazon, Arlo.com and Best Buy and is available for purchase now at Costco. The Pro 4 camera has already won the Editor's Choice award from review.com and is available now at arlo.com and Best Buy. All of these newly announced products feature our new business model with a three-month free trial, joining our award-winning lineup including the Pro 3 Floodlight, which continues to garner critical acclaim from industry reviewers.

In Q3, Android Central named our floodlight among the best outdoor security cameras of 2020, and Tech Ares called it the best wireless floodlight camera they've used yet. In summary, Arlo's Q3 results provide a window for where the business is heading as we continue our transition to the new business model. The team continued to execute at a high level as we answered the challenges from the pandemic and drove innovation while still managing costs. This performance has provided a compelling set of data points that speak volumes about the long-term prospects and trajectory of the business.

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 Q4.

Gordon Mattingly -- Chief Financial Officer

Thank you, Matt. I'm pleased to share that the Arlo team delivered outstanding results this quarter, with revenue coming comfortably above expectations and showing year-over-year growth. With strong revenue performance, improving gross margin and tight management of our operating expenses, we drove a dramatic improvement in our bottom line, both sequentially and year over year. We also saw further evidence of the success of our new business model and our paid account growth again accelerated.

Our team's focused execution enabled Arlo to outperform expectations and deliver a result, which shows the significant progress we're making with the business. And now moving on to the financials, as Matt highlighted, we achieved $110.2 million for revenue, up 65.4% sequentially, and importantly, up 3.9% year over year. Product revenue for Q3 2020 was $91.3 million, which is down 3.2% compared to last year and up 84% sequentially, as retail operations improved considerably from the second quarter and we received a solid contribution from Verisure. The third quarter revenue reflects Verisure's stock-in for the holiday season so we expect fourth quarter revenue from Verisure to return to the levels we saw in the first half.

With Europe accounting for 25% of our revenue in Q3, Verisure contributed to the improvements we saw in both revenue and profitability during the quarter, and we continue to execute on plan with them. Our service revenue for Q3 2020 and was $19 million, which is up 60.6% over last year and up 11.4% sequentially. The main driver of our excellent service revenue growth is our paid account growth under our new business model, where for the third consecutive quarter, we have seen very strong conversion to a paid subscription of Arlo Smart after the free trial end. Our service revenue also includes $2.3 million of NRE services we are providing for Verisure, along with the associated costs as compared with $2.3 million in the second quarter of 2020 and zero a year ago.

During the third quarter, we shipped approximately 978,000 devices, of which approximately 967,000 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. While our revenue was up 3.9% year over year, our non-GAAP gross profit for the third quarter of 2020 was up 100% year over year to $22.7 million, which resulted in a non-GAAP gross margin of 20.6%, up from 9.6% in Q2 2020 and 10.7% in Q3 2019.

The improvement in non-GAAP gross margin came from both products and services. Non-GAAP product gross margin, which came in at 14.8%, up from 6.8% a year ago, benefited from scale across the product supply chain, lower promotional spending and progress in the transition to products under our new business model. Non-GAAP service gross margin, which came in at 48.7%, up from 41.5% in the second quarter of 2020 and 41.9% in Q3 2019, was driven by growth in paid accounts as well as the team's continued focus on cost optimization. We are very pleased that we have delivered three consecutive quarters of service margin expansion, a trend of sequential and year-over-year service margin improvement, which we expect to continue.

As previously mentioned, our non-GAAP service gross margin is burdened by the cost of the free Arlo Smart trials under the new business model, as well as the cost of servicing the free basic service under the old business model. Also, as mentioned, our service revenue includes $2.3 million of NRE services we are providing to Verisure. In Q3, operating expenses once again benefited from last year's restructuring, along with our continued expense management. Total non-GAAP operating expenses were $31.2 million, down $4.8 million or 13.4% year over year and down 0.2% sequentially.

As previously mentioned, beginning in the third quarter, we began shifting our marketing efforts to drive online awareness in line with prevailing buying patterns and capitalized on the growing opportunity of our online store, arlo.com. In the seasonally stronger fourth quarter, we expect to increase our spending on these activities. And accordingly, we expect sales and marketing expenses to rise in Q4. While the balance of our opex component should remain relatively flat, we expect that this will result in operating expenses ending up in the original target range of $33 million to $34 million in Q4.

Our total non-GAAP R&D expense for the third quarter was roughly flat sequentially at $12.6 million. Our headcount at the end of Q3 was 358 employees compared to 355 in the prior quarter. As a reminder, during the early stages of Verisure operating the European commercial business, we agreed to provide them with transition services, which includes training time with Arlo employees, system costs, as well as some outside service costs. We have included these costs in our normal operating expenses.

The reimbursement of Verisure is included in other income and was approximately $0.9 million during Q3. Our non-GAAP tax expense for the third quarter of 2020 is $115,000. For the third quarter of 2020, we posted a non-GAAP net loss per diluted share of $0.10, better than the high end of our guidance. We ended the quarter with $193.6 million in cash, cash equivalents and short-term investments, down $11.8 million sequentially and up $39.8 million year-over-year.

We were once again pleased with our working capital management during Q3. Our DSO came in at a record low of 47 days, down from 63 days sequentially and 85 days a year ago, helped by the growth in paid subscriptions and our online store, along with increased revenue mix from customers with more favorable payment terms. Coupled with our disciplined inventory management, which resulted in turns of 4.6 in the quarter, we were able to keep our working capital relatively flat sequentially despite revenue being up 65.4%. Now turning to our outlook, we expect fourth quarter revenue to be in the range of $105 million to $115 million.

Our normal seasonal uptick from Q3 to Q4 will be muted as Verisure returns to revenue levels seen in the first half of the year after stocking in during Q3. Looking ahead to 2021 as we continue to grow our service revenue and progress our relationship with Verisure, seasonality will differ slightly from previous years. Heading into the first quarter of 2021, we expect to see a sequential revenue decline of approximately 30%, an improvement from the 47% sequential decline we saw in Q1 2020, which was also impacted by COVID-19. From there, we believe we can return to sequential growth throughout 2021 and achieve mid-teens growth for the full year.

Moving back to the fourth quarter of 2020, we expect our GAAP net loss per diluted share to come in between $0.36 and $0.26 per share, and our non-GAAP loss per diluted share to come in between $0.26 and $0.16 per share. Regarding our cash position, we continue to believe that considering a range of outcomes for the COVID-19 pandemic and its effect on our supply chain and retail and distribution channels, we will end this year with more than $150 million in cash, cash equivalents and short-term investments without tapping into our credit facility. We will continue to monitor our performance during the remainder of the year and closely manage our operations to preserve our cash. We can now open the call to questions.

Questions & Answers:

Operator

[Operator instructions] And your first question comes from Adam Tindle with Raymond James.

Unknown speaker

OK. This is Madison on for Adam. I appreciate you taking my questions. I wanted to start on the paid subscribers.

So you added nearly 60,000 of them in the quarter. And this is an important milestone to reaching breakeven. How can we think about the sustainability of this level of paid adds? Is there anything that drove the acceleration that you'd expect to moderate? And then lastly, I know you mentioned some contribution from Verisure. Was there any Verisure contribution to the paid adds?

Gordon Mattingly -- Chief Financial Officer

This is Gordon. That's a great question. I mean certainly we're very pleased with the paid subscriber adds. I think a good thing to look at is the deck that we've put online, the investor deck, which gives you an idea of the proportion of our mix of sell-through in Q3 that was associated with the new business model products.

That's definitely something to look at. Obviously, we're very pleased that it was a record quarter of paid subscriber adds, and we do believe that that momentum is going to continue going forward. And in terms of Verisure, predominantly Verisure at the moment is really focused on the retail channel in Europe and obviously Europe is impacted by COVID. So the security channel for Verisure we think will start kicking in more in the latter part of next year.

So that's really the characterization of Verisure. But yes, we're really pleased with it and we do expect the momentum to continue.

Unknown speaker

OK, great. And then just a follow-up, you talked about promotional activity increasing for Q4. Obviously that's normal and sales and marketing spend to increase. But I was hoping you could touch on your expectations from a gross margin standpoint.

Do you think products gross margin can remain positive? And then just any color on what you're expecting from the competitive environment and discounting for this holiday season. Thank you.

Gordon Mattingly -- Chief Financial Officer

Yes. I'll take the first part of the question, and then I'll let Matt take the second half. So just with respect to product gross margins, Q3, we benefited from a couple of things, certainly scale helped. And then secondly, we've largely completed the transition from the legacy products to the new business model products.

That definitely helped product gross margin in Q3. I expect that will continue in Q4. You rightly pointed out, it's an extended promotional period in Q4, particularly this year with Prime Day in Q4. So that will be a slight headwind in Q4.

And then the other thing in Q4 is air freight. We think the air freight rates are going to go up a little bit in Q4. They do naturally anyway with normal peak. Somewhat we're seeing peak on top of peak in Q4 with respect to air freight, so a couple of those things combined.

I still think product gross margin in Q4 will be in the low double digits, but slightly down from what we saw in Q3.

Matt McRae -- Chief Executive Officer

And from a competitive set perspective, as we look at Q4, it's going to be a very unique Q4, partially because of what Gordon just touched on with Prime Day actually landing in October, and some of the more traditional retailers reacting to that and starting their promotional period earlier. What I would say on top of that is because of COVID and the operational requirements to kind of limit the number of people that would be in physical stores, the retailers have also decided to kind of spread the promotions over a longer period of time. What that means is we've gotten a good look at what a lot of these promotions already look like as we sit here, already having a month under our belt. And we haven't seen anything out of the ordinary or anything unexpected from a competitive set perspective.

So we think it's going to be a normal Q4 from at least a pricing and promotions perspective, but how that is being rolled out from an operational perspective is different because of Prime day and because of the operational challenges of physical retail. We think we'll see more, for instance, of online sales and some of these physical retailers having a much more omnichannel quarter.

Unknown speaker

Got it. Congrats on the strong results and guide. Thank you.

Operator

Thank you. And your next question comes from the line of Hamed Khorsand with BWS.

Hamed Khorsand -- BWS Financial -- Analyst

Just wanted to ask you about the Q4 inventory at retailers. The sell-in process, is that fairly complete? Are you expecting refilling that inventory? And how aggressive you think you think you would have to get on promotions? I know you just said it looks normal. But do you think the inventory might be too high, just given how you guys performed in Q3 on Prime Day?

Matt McRae -- Chief Executive Officer

Well from an inventory perspective, we're seeing inventory still relatively low from historical standards. So you'll see it's around 8.4 weeks, which is again, low -- we think not only healthy for the quarter and the new operational footprint, but obviously, historically, very low. So we're watching that, obviously, very carefully as we go through. We want to make sure we're balanced.

But given where we are in the quarter, you're going to see us not only have we shipped in stuff for Q4 holiday, especially with Verisure in Europe, but also some here in the United States. There will be additional shipments for some of the promotions toward the back half of the quarter and a little bit of replenishment, but it will -- I think it will be very similar to a normal quarter from a shipment perspective. It's more how the POS is happening at the retailer that's different with a lot more being done online instead at the physical store.

Hamed Khorsand -- BWS Financial -- Analyst

Does it matter for you that if you end up selling more Essentials than the Pro 3 or Pro 4, or are you just looking just to pick up the incremental paid user?

Matt McRae -- Chief Executive Officer

Well, yes. So there's a couple of things there. One is what we've seen so far with Essential is a couple of data points. One, it's being sold to a different customer.

So we look at Essential as playing in a new price band and allowing us to actually capture a new customer. So that's one. Two, we're seeing relatively consistent subscriber sign-up. So when you when you talk about our long-term business model around subscription, Essential is going to play an important component of that.

So from an Essential perspective, that's where we see it kind of playing across different channels. And it will be not only attaching a new customer to the Arlo ecosystem, but actually driving incremental subscriptions for us down the road.

Hamed Khorsand -- BWS Financial -- Analyst

And my last question was, when do you think you will hit that inflection point as far as the service gross margin starting to tick up again?

Matt McRae -- Chief Executive Officer

Well, to Gordon's point, and he can comment in more detail. I mean, we're seeing service gross margins tick up over the last three quarters, up to a record level this quarter and we expect that to continue, based both on mix, but also just the performance of the business and the leverage that we're getting on the subscription business.

Gordon Mattingly -- Chief Financial Officer

Yes. Just to add some color to that. As Matt said, three consecutive quarters of improvement, up from 34% approximately in Q4 a year ago, up to 48% in Q3. I'm pretty pleased with that.

We do expect the sequential improvement to continue certainly for the next few quarters. And as Matt said, the mix of paid subscriptions is definitely helping that. And the team has done a fantastic job on cost optimization as well, which really helps. So yes, we expect the improvement to continue, Hamed.

Operator

[Operator instructions] And your next question comes from Thomas Boyes with Cowen. Your line is open.

Thomas Boyes -- Cowen and Company -- Analyst

My questions, just a couple of quick ones from me. I just wanted to get a sense if you're seeing any new trends develop following Amazon Prime Day, as well as some of the sales promotions that were going at Best Buy and on Arlo's owned store. Is there a preference among customers for less number of cameras and they're picking up more doorbells or floodlight products? How is that really developing?

Matt McRae -- Chief Executive Officer

Yes. We're not seeing a big change there. We have moved a lot of our products to a base station optional SKU so that they can use the base stations if they want, they get additional capabilities, including local storage and other things, or they can use it now with Wi-Fi. And that's true of Pro 3, our new Pro 4 camera, as an example.

So that's mixing up a little bit of the kitting we're seeing at retail. But so far, we haven't seen a big shift on the number of cameras. For us, we look at doorbell and, for instance, floodlight as an incremental add above and a way to bring customers into the Arlo ecosystem. Where before you had to come in, if you were looking to buy cameras first.

Now you can come in if you're looking for a doorbell and then add Arlo cameras later. So it's a little early for us to tell exactly what's happening, but we haven't seen a big shift in the number of cameras per household. And you can kind of back into some of that by just looking at the number of registered accounts against the cameras, the devices that Gordon kind of reported that we sold in the quarter.

Thomas Boyes -- Cowen and Company -- Analyst

Got it. Now for the refreshes with Arlo Ultra 2 and then the Pro 4 line, is there any cost advantages there from a gross margin perspective, whereas these start to come on, they've just been engineered a little bit better as far as a manufacturing angle and you should see some of that start to appear as those gain in penetration?

Matt McRae -- Chief Executive Officer

Yes. There's a couple of trends inside of hardware. So one is the biggest thing that's contributing to the significant growth in gross margin on the product side, is the transition from the older business model product, some of the older technologies to the new business model product and our newer technology platform. And that's something we've been talking about for several quarters.

And with Essential, we're basically done with the Essential launch and have everything on a more modern architecture. So that's going to contribute to gross margin from the product side as we go forward. That's the biggest jump. I will say, obviously, we look and work extraordinarily hard on every single product from a gross margin side and look for continuing improvement in costs on a quarter-by-quarter basis.

And when we do launch a new product, there's typically some advancements that we've built into that platform. So it's a little bit more efficient or sometimes new feature and functionality or sometimes both. And so it depends on what we're launching. But as you go forward, we're continuously optimizing the platform.

But the biggest jump is coming from being on modern architectures and getting rid of some of the old business model products, which is predominantly done now with the Essential family launch.

Thomas Boyes -- Cowen and Company -- Analyst

Got it. So is Arlo, the original Ultra still being offered with a one-year bundle? Or has that shifted over to the three-month as well?

Matt McRae -- Chief Executive Officer

You'll see that continue to sell-through for a little while, but it will transition to the Ultra 2 with the consistent business model with the rest of our product on a 90-day trial.

Thomas Boyes -- Cowen and Company -- Analyst

Got it. Got it. Another thing is just the e911 service is obviously something that was very differentiated for Arlo. And now that it's been around for a couple of years, I mean, have you started to see any of your competitors add this feature? I'm not aware of any.

But maybe you are. And I was wondering if they haven't, why do you think that is? Is it a technical challenge?

Matt McRae -- Chief Executive Officer

Yes. So it's a good question. I think we're still definitely on the forefront when it comes to cloud-based services for cameras and for security systems. And you're pointing out one great example which is e911, allowing somebody to -- allowing us to intelligently route an emergency call to the right 911 center for where the cameras are located.

I have not seen anybody else do this in a scaled way. It's actually relatively difficult to do. And we've done it as part of one of the original launches of Arlo Smart. In addition, we're also one of the only companies doing multiple simultaneous object detection with computer vision.

That's something that we can do better than anyone else, including person package vehicle, animal, and do that in a very low latency manner and a bunch of other features inside that pack. So we talk a lot about on the call, our innovation on a hardware device level. But you're pointing out a great area where our innovation and our lead from an innovation perspective on the service is still substantial over the competitors in the marketplace. And of course, we're not standing still, and we'll continue to innovate on that service level.

Thomas Boyes -- Cowen and Company -- Analyst

Great. I guess just to get a COVID-19 question in there, I just wanted to just double check, given the resurgence globally, I mean there's been some talk of potential lockdowns in Europe. I just wanted to get a better sense of maybe any exposure to the supply chain or manufacturing capabilities more broadly, just as you look out heading to the end of the year?

Matt McRae -- Chief Executive Officer

Yes. It's -- I mean, it's something we're looking at literally on a daily basis, both on the supply chain side and also talking with our channel. COVID is resurging a bit in Europe. You rightly point that out.

It's resurging a little bit here in the United States as well. I think the major difference is, this isn't a surprise this time. And a lot of operational changes have already been put in place by our partners, both forward and backwards in our supply chain. So I think everybody is in a much better position to deal with different lockdowns or things that are happening.

Consumers are very used to buying products online. A lot of our physical retailers have gotten a lot better at selling online and have been able to kind of start to mix their business a little bit different. So I think there's -- obviously, risk, as Gordon pointed out, in Q4 and kind of as we look into next year and how that's going to go. But I'd say everybody has gotten a lot better about how to deal with this from an operational perspective, and we kind of know what to look for.

So I think the risk is a lot more muted than it was before.

Thomas Boyes -- Cowen and Company -- Analyst

Understood. That was all for me. Thanks for the time and congratulations again on the quarter.

Operator

And there are no further questions at this time. Mr. Matt McRae, I'll turn the call back over to you.

Matt McRae -- Chief Executive Officer

Thank you. So that concludes our call for the Q3. I want to wish everybody a happy and safe holiday, and we'll talk to you soon. Thank you, everyone.

Operator

[Operator signoff]

Duration: 34 minutes

Call participants:

Erik Bylin -- Investor Relations

Matt McRae -- Chief Executive Officer

Gordon Mattingly -- Chief Financial Officer

Unknown speaker

Hamed Khorsand -- BWS Financial -- Analyst

Thomas Boyes -- Cowen and Company -- Analyst

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