Arlo Technologies (ARLO) Q1 2022 Earnings Call Transcript

Arlo Technologies (ARLO -3.18%)
Q1 2022 Earnings Call
May 10, 2022, 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, operator. Good afternoon, and welcome to Arlo Technologies first quarter of 2022 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 first quarter along with guidance for the second quarter provided by Gordon. We'll then have time for any questions. If you have not received a copy of today's press release, please visit Arlo's investor relations website at investor.arlo.com.

Before we begin the formal remarks, we advise you that today's conference call contains forward-looking statements. Forward-looking statements include statements regarding our potential future business, operating results and financial conditions, including descriptions of our revenue, gross margins, operating margins, earnings per share, tax rates, expenses, cash outlook, guidance for the second quarter of 2022. Transition to a services-first business model, the commercial launch and momentum of new products and services, strategic objectives and initiatives, market expansion and future growth, the effect of our anticipated awareness campaign on future growth. Partnerships with Verisure and Calix, continued new product and service differentiation, supply chain challenges, transportation costs and the impact of the COVID-19 pandemic on our business, operating results and financial conditions.

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 discussed on this call.

A reconciliation of the GAAP to non-GAAP measures can be found in today's press release on our Investor Relations website. At this time, I would now like to turn the call over to Matt.

Matt McRae -- Chief Executive Officer

Thank you, Erik, and thank you, everyone, for joining us today on Arlo's first quarter 2022 earnings call. My comments will be focused on our record-breaking results in Q1 and a summary of our growth drivers going forward. For more detail on our plans, please refer to Arlo's recent investor day presentation. Our transformation continues to produce results that outperformed Q1 expectations across all metrics.

Total revenue reached $124.8 million, up 51% year over year and well above the top end of our guidance. Service revenue reached $29.9 million, up 31% year over year and marked a record for the 11th consecutive quarter. Total paid accounts were up 132% year over year with Arlo adding 205,000 paid accounts in the quarter, which represents an increase of 8% sequentially and 80% year over year. Our annualized recurring revenue, or ARR, achieved a significant landmark by breaking through $100 million, exiting Q1 at $101 million and growing 74% year over year.

As a reminder, our ARR is the fastest growing and highest margin portion of our service revenue and represents the annualized recurring service revenue we derive from our paid accounts. Despite the additional costs driven by the pandemic supply chain disruptions, we posted our highest ever non-GAAP gross profit of $34.5 million and our second consecutive quarter of non-GAAP operating profit, outperforming the high end of our guidance for non-GAAP EPS, which came in at a profit of $0.01 per share. These exceptional Q1 results flow from the incredible transformation at Arlo and our focus on a services-first strategy, where roughly two-thirds of our hardware buyers become subscribers. As we shared last quarter, the accounts we capture through domestic retail have an ARPU of $9.35 per month, and when combined with our low world-class churn metrics translates to an LTV of $550 per user based on Q421 data.

Looking ahead, Arlo is executing a new long-range plan as described at our most recent Investor Day that focuses on three primary areas of the business to drive revenue growth, margin expansion and through that shareholder value. First, while our best-in-class products and services generate significant accolades, the No. 1 reason people don't buy Arlo products is because they have not heard of Arlo. We will begin to invest in brand awareness in a targeted manner, focused on new household formation and driving incremental subscriptions.

Second, we are expanding our product portfolio to address new segments and new markets. We expect Arlo Safe will launch in Q3 and provide personal protection for an individual or entire family. And in Q4, we plan to launch our new innovative Security System that brings full sensor-based security functionality to our ecosystem of smart cameras. Both of these new segments provide significant opportunities to drive new subscriptions and grow our ARPU.

And third, we will continue to broaden our routes to market. Our most prominent example of this to date has been our Verisure relationship, which has been very successful, driving outsized growth in Europe and only looks more promising going forward. We also formed a partnership with Calix last year, in which Calix integrated Arlo services into their platform to broadband service providers around the country. Today, 29 broadband service providers are signed up, and we are excited to ramp this in the coming year.

As we execute these growth strategies and work to realize our new three- to five-year targets of 5 million paid accounts, $300 million in ARR and double-digit operating margin, Arlo will exhibit the same discipline that we demonstrated as we transformed our business. And with that, I would like to hand the call over to Gordon, who will provide more insight into our financial performance, operational details and outlook for the second quarter.

Gordon Mattingly -- Chief Financial Officer

Thank you, Matt, and thank you, everyone, for joining us today. We delivered strong Q1 2022 financial results that exceeded our expectations, growing our revenue by 51.1% year over year and above the high end of our guidance, while growing non-GAAP gross profit sequentially and year over year to a record for the company of $34.5 million. Our financial performance for the quarter was again underpinned by the successful execution of our services first business model, leading to record levels of paid accounts. The Arlo team navigated continuing tough supply conditions to exceed our expectations on revenue, while improving our year-over-year non-GAAP operating profitability by $4.1 million and posting our second consecutive quarter of non-GAAP operating profit.

And now moving on to the Q1 financial detail. Revenue came in at a first fiscal quarter record of $124.8 million, up 51.1% year over year and down only 12.7% sequentially. The strong sequential revenue result clearly demonstrates how our channel diversification and ARR growth are benefiting the business. Our service revenue for Q1 2022 was a record $29.9 million, up 5.1% sequentially and 31.3% year over year with our services first business model, fueling our growth.

While service revenue accounted for 24% of our Q1 2022 revenue, it delivered 56.8% of our non-GAAP gross profit. Our service revenue also includes $0.1 million of NRE services we are providing for Verisure, along with associated costs, as compared with $1.1 million in the fourth quarter of 2021. Product revenue for Q1 2022 was $94.8 million, which was up 58.7% year over year and down 17.1% sequentially. Our year-over-year product revenue growth was driven by continued strength from our Verisure relationship in Europe, coupled with growth in retail in Americas, where we were pleased to bring retail channel inventory back up to more normal levels.

During the first quarter, we shipped approximately 1 million devices, all of which were cameras. 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 first quarter of 2022 was up $7.8 million year over year and up $1.8 million sequentially to $34.5 million, which resulted in a non-GAAP gross margin of 27.6%, down from 32.3% in Q1 2021 and up 4.7 percentage points from 22.9% in Q4 2021.

The $7.8 million year-over-year improvement in non-GAAP gross profit included an improvement of $6.4 million from services and $1.4 million from products. The improvement in non-GAAP service gross profit was driven by growth in our ARR, coupled with cost optimization. The improvement in non-GAAP product gross profit was driven by higher revenue, more than offsetting an incremental $3.3 million of air freight expense due to COVID-19-related supply chain challenges. Non-GAAP service gross margin came in at a record 65.4%, significantly up from 57.9% in Q1 2021 and an improvement on 63.2% in Q4 2021.

Non-GAAP product gross margin was 15.7%, down from 22.6% in Q1 2021, mainly due to a year-over-year increase of $3.3 million in air freight expense and up from 12.9% sequentially, helped by a $3.1 million reduction in air freight expense. Total non-GAAP operating expenses were $33.4 million, up $4.3 million or 14.7% sequentially and up $3.7 million or 12.4% year over year as we invest in R&D ahead of our new product and service introductions and lay the groundwork for our upcoming awareness campaign. Our total non-GAAP R&D expense for the third quarter was up $2.8 million sequentially at $14.1 million. Our headcount at the end of Q1 with 358 employees compared to 353 in the prior quarter.

As a reminder, during the early stages of the Verisure relationship, we agreed to provide them with transition services, which include training with Arlo employees, as well as systems costs and some outside service costs. We have included these costs in our normal operating expenses. The reimbursement from Verisure is included in other income and was approximately $0.4 million during Q1. Our non-GAAP tax expense for the first quarter of 2022 was $0.2 million.

In Q1, we posted a non-GAAP net profit per diluted share of $0.01, and much better than our guidance and a $0.04 improvement year over year. We ended the quarter with $145.5 million in cash, cash equivalents and short-term investments, down $30.2 million sequentially and down $31.6 million year over year. The sequential reduction was driven by reductions in accounts payable in line with sequentially lower product purchases and deferred revenue, in line with Verisure's prepaid product purchases. Q1 inventory flows at $37 million, a decrease of $1.4 million over Q4 2021, returns at 8.7% as compared to 10.5% last quarter and 3.4% a year ago.

Our DSO came in at 58 days, up from 54 days a year ago and up from 50 days sequentially, with the increase driven by customer mix. Now turning to our outlook. We expect second quarter revenue to be in the range of $105 million to $115 million. We expect our GAAP net loss per diluted share to come in between $0.19 and $0.14 per share.

Now our non-GAAP net loss of diluted shares come in between $0.08 and $0.03 per share. Our guidance includes approximately $1.2 million of awareness spending as we develop content and messaging ahead of starting our campaign in earnest in the third quarter, in line with what we communicated in our analyst day in March. In line with previous guidance, we expect to end the year with $110 million to $120 million in cash, cash equivalents and short-term investments. And we will continue to monitor our performance and prudently manage our operations to preserve our cash position.

And now I'll open it up for questions.

Questions & Answers:

Operator

[Operator instructions] Your first question comes from the line of Catherine Huntley with Raymond James. Your line is open.

Catherine Huntley -- Raymond James -- Analyst

Hey guys, congratulations on a great quarter. This is Catherine on for Adam.

Matt McRae -- Chief Executive Officer

Great. Thank you. Good to talk to you.

Catherine Huntley -- Raymond James -- Analyst

Can you talk about the weeks of channel inventory and how they're elevated globally? And could you maybe speak to why we're seeing channel inventory increase while supply is still very tight? And how can we think about the financial impact of this normalizing?

Gordon Mattingly -- Chief Financial Officer

Yeah, sure. Looking at the channel inventory, typically, let's break it out into the relevant parts. So looking at Americas retail ended at just over 15 weeks, we would typically target 10 to 14 weeks of stock in the channel to be a normal level for retail. So we're just a little bit above the target range, but not by much.

And quite frankly, we're actually happy for it to be there. We did get stopped toward the end of the quarter, and the denominator in that calculation is the last six weeks of sell-through. So you're looking at a situation where inventory was filled toward the end of the quarter and the sell-through before that was slightly depressed due to shortage of inventory. So I think that's the context you need for the Americas retail inventory.

We think it's actually a pretty normal level. And quite frankly, we're quite pleased to have it at that level compared to where it has been. Then if we look at APAC, APAC distribution is a little bit on the high side, but you need to appreciate APAC distribution is a very relatively immaterial part of our business. So from a dollar perspective, it's not very meaningful.

We're making a small destock in APAC in Q2, and that's already reflected in the guide, but it's certainly not material. So overall, I think we're pretty well-positioned from a channel inventory perspective, I don't see anything concerning there at all.

Catherine Huntley -- Raymond James -- Analyst

Perfect. Thanks so much for that color. And you've previously laid out your discretionary plan for brand awareness and what you'll be spending about $10 million per quarter. And you spoke about this on the tail end of the call.

What are the learnings so far that you've had as you approach this investment given that it's coming up? And how can we think about the timing and magnitude? What has changed since the last call?

Matt McRae -- Chief Executive Officer

Yeah. Great question. Yes. So we're still committed to doing the spend that we talked about at the Analyst Day.

And just as a reminder, it's a relatively small defined spend from an amount perspective, but also from a time perspective. So the last six months of the year, we're doing that $20 million spend like you architected -- articulated just in your question. And then look at those results at the end of the year going into next year to determine where we want to adjust that going forward. The ultimate metric from the spend will be incremental paid accounts, right, that are driving the LTV and the shareholder value in the company.

So we're committed to this well-defined and kind of disciplined spend in the second half. As we've been planning it, there hasn't been a lot of changes. We are looking for changes in the media landscape. We are looking for some of that as we'll get into -- closer to the spend, which is going to be in Q3, as Gordon articulated.

But right now, there hasn't been any changes since the Analyst Day, and we're looking forward to not only executing that spend, but sharing the results of that at the end of the year.

Catherine Huntley -- Raymond James -- Analyst

Great. It's always a pleasure and keep up the great work.

Matt McRae -- Chief Executive Officer

Thank you very much.

Gordon Mattingly -- Chief Financial Officer

Thank you.

Operator

Your next question comes from the line of Hamed Khorsand with BWS Financial. Your line is open.

Hamed Khorsand -- BWS Financial -- Analyst

Hi. I just want to know about the paid users. The amount -- the growth that you saw this quarter, does that include anything from your partners, Verisure or the 29 broadband service providers?

Matt McRae -- Chief Executive Officer

Yeah. So it is across, but a lot of those gains are obviously from the retail holiday season, right? You know we have a 90-day free trial. And so a lot of the paid or POS that we see that comes from the holiday period, those accounts tend to become paid accounts in the Q1. So you're seeing some of that, obviously, growth is coming from retail, coming on the 90-day post trial after purchases in the holiday period.

And we've seen a growth in Verisure. We've mentioned that the custom camera is starting to ramp and you're seeing that in some of the results from a revenue mix perspective. And as you know, some of the direct business that we do with Verisure is a one to one on paid accounts. I would say those are the two primary areas of growth and paid accounts.

We are starting to see Calix ramp, but I think that will take longer before it's really material in the paid accounts. We did share on the call that we now have 29 BSPs or broadband service providers that are now active at least from an onboarding perspective through Calix. We expect that number to continue to ramp. So I think the contribution from Calix will be later in the year going into the following year as a lot of these strategic accounts kind of take a while to ramp.

Hamed Khorsand -- BWS Financial -- Analyst

And is the contribution from Verisure something like a step-up every quarter? Or is it going to be lumpy?

Matt McRae -- Chief Executive Officer

It's a little bit more steady is what we see from Verisure because while the retail paid accounts will, at some point, follow some seasonality like we were talking about, right? A lot of hardware sold in Q4 will drive paid accounts in Q1, and you'll see some seasonality in at least the growth on paid accounts from a normal retail business. Verisure's direct business, which is beginning to ramp especially with the custom camera we launched last year, will be a little bit more steady quarter over quarter because it doesn't really adhere to the normal promotional periods you would see in a traditional consumer channel. I don't think we've seen a huge impact of that yet, but that's an effect, I think we'll see as we continue to ramp the direct business with Verisure over time.

Hamed Khorsand -- BWS Financial -- Analyst

OK. And I didn't hear you say this in the script, but are you still at a 50% conversion rate for hardware?

Matt McRae -- Chief Executive Officer

Yeah. So those numbers really haven't changed. So the -- we have two metrics that I think we've shared in the past. One is that initial conversion rate, which is what you're talking about, which is right about 50%, and that's really a measure of how many people have signed up in the free trial and the 30 days post of that free trial expiring.

So that first 120 days from the hardware activation, that's 50%. And then we've shared what we call the six-month cohort and we count that as an attach rate. So what we've done is we follow the different populations across our different products and channels and everything, and those are all consistent as well, roughly around what we shared in the script, roughly that 65%, almost two-thirds of hardware purchasers six months later in a cohort analysis are attached to service at that time. So we do still have -- it rises from 50% to that 65% over some additional time as some people are signing up after that initial conversion period.

Hamed Khorsand -- BWS Financial -- Analyst

OK. Great. Thank you.

Matt McRae -- Chief Executive Officer

You're welcome.

Operator

Your next question comes from the line of Jeff Osborne with Cowen and Co. Your line is open.

Jeff Osborne -- Cowen and Company -- Analyst

Yeah, good afternoon, guys. A couple of questions. I was wondering if you could sort of post mortem diagnose where the upside came from in the quarter relative to your initial expectations. I heard two rationale on the call.

One was the supply chain management and then also U.S. retail channel. I wasn't sure if both of those were the source of upside or one versus the other.

Gordon Mattingly -- Chief Financial Officer

Yeah, it's a combination. I think you nailed it pretty well there. We were able to get a little bit more supply than what we're expecting at the time of the guide. That definitely helped.

And as we talked about earlier, we were able to get some additional inventory, very welcome inventory into the U.S. retail channel in particular, which was also not something that we had visibility into at the time we guided. So it's really those two things, but largely just tied to supply availability.

Jeff Osborne -- Cowen and Company -- Analyst

Got it. And then Gordon, how does -- has anything changed in the last four to five weeks with the lockdown in China and some of the components that go back and forth in China to Southeast Asia to be made in packages? I'm just curious what the COVID shutdown in China does to the ever aging battle of supply chain management for you folks in the industry more broadly.

Gordon Mattingly -- Chief Financial Officer

Yeah. Well, it certainly doesn't make it easier, for sure. We obviously manufacture, as you know, in Vietnam and Batam and we do have components obviously being manufactured -- limited components manufactured in Shanghai. I would say we've seen a little bit of impact there.

Not a large amount. The impact we've seen has been reflected in the guide, anyway. One interesting one that we do see is congestion actually crossing the border from China into Vietnam. That's definitely stepped up in light of lockdowns as an additional that we face and we're just looking at alternative routes to get those components into Vietnam.

But other than that, we haven't seen much of a downside so far. I say so far. But on the bright side we are seeing some nice reductions in air freight rates, we're seeing some nice reductions in sea freight rates. We're actually seeing low transit times from Vietnam for example to the U.S.

Those have come down from kind of pandemic heights of 70-day transit times down to something more like 50 days, which is welcome news. So that part of it, heading in the right direction and yes, you rightly said the lockdowns in China are having a slightly negative effect.

Jeff Osborne -- Cowen and Company -- Analyst

Got it. And the last question I had was the helpful chart showing the DIY market share growth over the past three years in the deck. I was wondering within the DIY camera market and security market, what you felt your share has been over the past three years. If you could sort of give some helpful metrics there.

Matt McRae -- Chief Executive Officer

Yeah, it's changed and it's hard to do an apples-to-apples comparison because some of the key market studies that actually present that from a third-party perception, like NPD actually changed the way that they calculated them. And they started bringing in FirstParty.com and some other things that are reported by some, but not by others goes up and down based on promotional timing, both our promotional timing but also the promotional timing of our competitors. I haven't seen a lot of real big movements recently. We did see a decline in market share back in that time period.

And that was expected and kind of built in. We decided to focus on the customers' market segments, price segments and channels that we're going to deliver who are really just selling hardware and it was not a high propensity to subscribe to service after the hardware purchase. So we saw that initial decline and then had kind of laid into a relatively consistent share over the last couple of time periods. So I haven't seen any real big movement.

We haven't seen a lot of movements in the market in general from competitive behavior or anything else.

Jeff Osborne -- Cowen and Company -- Analyst

Thanks. Appreciate the thoughts. That's all I had.

Operator

Your next question comes from the line of Mark Argento with Lake Street Capital. Your line is open.

Mark Argento -- Lake Street Capital Markets -- Analyst

Hey, good afternoon, guys. Just a couple of quick ones. First, on gross margins, beat our numbers nicely or estimates. And do you anticipate just kind of given the current environment, you're going to be able to maintain kind of that 26%, 27% level going forward? Any thoughts around kind of the trend there?

Gordon Mattingly -- Chief Financial Officer

Hey Mark, it's Gordon here. I would look at it separately breaking it out between service revenue and product revenue. And I think the guidance we've already given on both those stays in place. On service revenue, we've guided 60% to 65%.

We still stick to that. It was nice to come in slightly above that in Q1. We did benefit in Q1 a little bit from mix benefit just with the Verisure NRE being a slightly lower proportion of the mix but we stick to the guidance we've given 60% to 65% on the service gross margin. And on the product side of things, low to mid-teens is where we see it probably down -- ticking down a little bit from where we were at in Q1 and Q2.

But I think the low to mid-teens on the product side of things is where we see it panning out. So not vastly different to what the actual results you saw in Q1, that's the guidance we've given for the year.

Mark Argento -- Lake Street Capital Markets -- Analyst

Great. That's helpful. And then, Matt, you had mentioned the 29 ESPs by the Calix relationship. As you launch additional products, in particular, the full security suite, are those going to go through the channel as well? How do you think about products and then channel distribution?

Matt McRae -- Chief Executive Officer

Yeah. It's a great question. I mean like the Calix relationship, it's a very positive one. And I think we've mentioned in the past that we feel it's helping us reach households that are probably underserved from some of our channels.

These are -- tend to be more rural or smaller areas of the country that may not have a Best Buy or Costco nearby just as an example. And so what I can say is Calix and Arlo, we've done a pretty deep integration on the back. It's one of the reasons why the ramp takes a little while. There's a lot of technical integration on the back.

And so we look at the products and additional services as a layer on top of that and a great way to kind of leverage the work that's been done on the initial integration. So the cameras, as you know, are rolling out, and that's what we're kind of talking about different DSPs that are signing up. And last quarter, I think we mentioned it at the Investor Day, we did announce that Calix is also committed to rolling our security system. And so that will be longer because there is an additional integration that needs to happen.

So we didn't release a date yet. But they are committed, and we are committed with them to deploy the security system in addition to our cameras over time. And that's what's great about some of these partnerships is they're typically not focused on a single product. They're focused on a longer-term relationship that cuts across products, especially after you've done the kind of deeper platform integration work.

And so they've kind of paid dividends over time. And we're going to see that with Calix over the next year or so.

Mark Argento -- Lake Street Capital Markets -- Analyst

Great. And then just one final one. In terms of supply chain, and I know component availability is still an issue broadly. But any concern that you're not going to be able to get the security products out by the second half of this year? Or you got some confidence that you can source what you need?

Matt McRae -- Chief Executive Officer

Yeah. So just on a general level, I think Gordon did a great job kind of breaking down where we see freight because that's part of this as well. So from a freight perspective, we are seeing improvements. And we're seeing that, as Gordon mentioned, both in cost and in time for delivery, right? Actual transit time of coming into us.

So that's actually helping us because when the transit time is shorter that means component purchasing can happen later, which actually helps on the component side when things are short. And that's why I bring that up. Components, you're correct. Absolutely.

Components are still relatively tight. It's not across the board. It's kind of hit and miss in different areas. We've been forecasting the security system from a component level perspective for quite a while.

I think we've mentioned on the Investor Day and one of the questions where we tend to take our forecasting at a component level almost out 50 weeks to give our component suppliers a lot of visibility. And we have done that on the security system as well. So at this time, we're confident that we've got the supply that we need to launch the product in Q4 and have already forecasted Q1 and Q2 into the system as well.

Mark Argento -- Lake Street Capital Markets -- Analyst

Great. Thanks, guys.

Matt McRae -- Chief Executive Officer

Hey, you're welcome.

Gordon Mattingly -- Chief Financial Officer

Thank you.

Operator

There are no further questions. I'll turn the call back to Matthew McRae for closing remarks.

Matt McRae -- Chief Executive Officer

Thank you, operator. I'd like to just take a moment to thank all of the teams at Arlo. I know a lot of them listen in for the hard work to deliver such an amazing result for Q1. We're at the beginning of our new long-range plan that we described last quarter and Q1 was an absolutely outstanding start.

So thank you to the team, and thank you for everyone joining the call today.

Operator

[Operator signoff]

Duration: 34 minutes

Call participants:

Erik Bylin -- Investor Relations

Matt McRae -- Chief Executive Officer

Gordon Mattingly -- Chief Financial Officer

Catherine Huntley -- Raymond James -- Analyst

Hamed Khorsand -- BWS Financial -- Analyst

Jeff Osborne -- Cowen and Company -- Analyst

Mark Argento -- Lake Street Capital Markets -- Analyst

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