Arlo Technologies, Inc. (NYSE:ARLO) Q3 2023 Earnings Call Transcript

Arlo Technologies, Inc. (NYSE:ARLO) Q3 2023 Earnings Call Transcript November 9, 2023

Operator: Ladies and gentlemen, thank you for standing by. At this time, all participants are in a listen-only mode. [Operator Instructions]. I would now like to turn the conference over to Tahmin Clarke. Please go ahead, sir.

Tahmin Clarke: Good afternoon, and welcome to Arlo Technologies third quarter 2023 financial results conference call. Joining us from the company are Mr. Matthew McRae, CEO; and Mr. Kurt Binder, 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 for the fourth quarter provided by Kurt. We will then take your questions. If you’ve not received a copy of today’s 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 condition, including descriptions of our revenue, gross margins, operating margins, earnings per share, expenses, cash outlook, free cash flow and free cash flow margin; guidance for the fourth quarter of 2023; the rate and timing of paid subscriber growth; the 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 brand awareness campaign on future growth; partnerships with various market leaders and strategic collaborators; continued new product and service differentiation; and the impact of general macroeconomic conditions on our business, operating results and financial condition.

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 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.

Matthew McRae: Thank you, Tahmin, and thank you, everyone, for joining us today on Arlo’s third quarter 2023 earnings call. Arlo delivered an outstanding performance in Q3 across both financial and operational measures. The decisions that we made 12 months ago in anticipation of the shifting market landscape, and consumer sentiment were on target and have positioned Arlo for success, despite the challenging macro environment. Our first decision focused on lowering the barrier of entry into the Arlo ecosystem. This led to us rebalancing our pricing across hardware and services by lowering upfront hardware costs and increasing recurring service prices. Implementing this change allowed us to maintain our robust product sales, which in turn drove our highly profitable and predictable services business, despite a weakening consumer environment.

The outcome of this decision is clearly illustrated in our outstanding results. After crossing over 2 million subscribers earlier this year, Arlo now has 2.5 million subscribers and is growing paid accounts at roughly 50% year-over-year. Additionally, annual recurring revenue, or ARR, grew 60% year-over-year to $200 million. This robust paid account growth comes along with increased ARPU and an LTV that is now $700 per subscriber. And as a reminder, our customer acquisition cost is roughly $100, which means our LTV to CAC ratio is a stellar seven. This morning, to further bring down the barrier of entry, Arlo launched our new total security subscription offerings in partnership with a firm, which combines hardware and service solutions into a single, low monthly payment.

Pricing for this package starts at just $9.99 per month, including professional monitoring and dramatically lowers the cost of entry for consumers in the need of a Security Solution. This new offering represents an outstanding value proposition and compelling opportunity for those customers looking for their first security system or upgrading from a traditional security system where they are paying too much for antiquated technology and poor service. The second decision that we made a year ago, to counter the initial macroeconomic indicators was to change our normal roadmap cadence and prioritize developing a new low-cost Essential Platform. The team works tirelessly over the last 12 months to develop our new Essential 2 platform, which includes significant user experience enhancements, video quality upgrades, battery life improvement and new features all at a substantially lower price.

In fact, a significant portion of the innovation cycle came from the close hardware integration and resulting cost reductions with our supply partners that enabled Arlo to target lower-priced segments with a superior product and user experience. The launch of Essential 2, also demonstrates our operational excellence across our supply chain capabilities. This is the largest product launch in Arlo’s history. We ramped, our production to 800,000 units across more than 40 SKUs in less than eight weeks in order to support a robust holiday sales plan in collaboration with our channel partners. This strong execution contributed to our Q3 revenue of $130 million, which is at the high-end of our guidance range. Additionally, we generated record non-GAAP earnings per share of $0.09, which represents an operating margin of 6.5%, another record for the company.

Stepping back and comparing the first nine months of this year to last year, free cash flow is up about $65 million. This strong financial performance puts us well ahead of the long-range plan we communicated to investors at the beginning of last year. As I look across our channels and even recent promotional events like Amazon’s big deal days, Arlo is seeing continued resilience in consumer demand that defines the broader economic trends being reported. Rising safety awareness, concern about crime and our pricing strategy have continued to successfully counter any macroeconomic headwinds. Throughout the year, we have gained share and coupled with the Essential 2 launch, Arlo could not be positioned any better to deliver a successful holiday season.

The result of those decisions, speak for themselves. As a result of strong operational trends, we are raising our guidance for Q4 and the full year. Our results and expectations for continued operational and financial success highlight the inherent strength and resilience of a true SaaS recurring revenue business. And while it may sound counterintuitive given the volatile times in which we currently operate, Arlo is better positioned than it’s ever been and boasts the future that is only getting brighter with each quarter, as we continue to execute our plan with a dogged determination and focus. We know the important role we play in our users’ lives and there is a clarity of purpose, coupled with a consistent cadence of execution towards our key goals of paid account growth, expansion of profitability and ultimately, the creation of additional shareholder value.

And with that, I’ll turn it over to Kurt.

Kurt Binder: Thank you, Matt, and thank you, everyone, for joining us today. I will start by sharing some financial details and an overview of the business for Q3 2023. Revenue for the third quarter came in near the high-end of our guidance range at $130 million, up $15 million sequentially and slightly higher on a year-over-year basis. While revenue was relatively consistent year-over-year, the composition of that revenue continues to change dramatically. In the quarter, service revenue was almost 40% of total revenue, while last year, it accounted for 28% of total revenue. This shift is reflective of our services first approach, as well as the impact of our new pricing strategy. I want to highlight the strength of our services revenue and ARR growth, which helped deliver solid revenue performance and contributed to Arlo generating a record non-GAAP operating profit in Q3 of $8 million or 6.5% operating margin.

Our service revenue for Q3 was another record at $51 million, an increase of $15.6 million or 44% year-over-year. This growth was driven by our subscription price increases and the addition of almost 625,000 paid accounts over the past three quarters. This number does include some catch-up of bear shore accounts that were underreported as discussed on our last call. Again, we continue to expect the normal growth in paid accounts to remain in the 170,000 to 190,000 range per quarter. Our installed base continued its strong growth trajectory and reached 2.5 million subscribers in Q3. As mentioned earlier, services accounted for nearly 40% of our Q3 total revenue and importantly, represented 86% of our total non-GAAP gross profit as our pricing strategy is clearly designed to maximize product sales, but with an intent to drive growth in our highly predictable and profitable services business.

Our record operating profit, up $12.6 million from last year stands as another proof point that the strategy is working. Additionally, we’re excited to have reached ARR of $200 million in Q3, up about 60% year-over-year, providing another solid proof point of the tremendous power of the recurring revenue in our services business. Product revenue for Q3 was $79 million, which was up over 20% sequentially and down 15% year-over-year. During the quarter, we shipped a total of 1.3 million cameras worldwide, compared to $1.2 million in the prior year period. Product revenue was impacted by a slight increase in shipment volume, but more so due to declines in average selling prices driven by a deliberate shift in our pricing strategy and mix in global product assortment.

In the quarter, approximately $50 million or 38% of our revenue originated from our international customers. Our EMEA results were impacted in the past few quarters as our largest partner continued to constrain inventory levels, a cycle other channel partners went through in previous quarters. We remain confident this is not an end market demand issue and expect this near-term response to macro conditions in the region to moderate over time. From this point on, my discussion will focus on non-GAAP numbers. The reconciliation from GAAP to non-GAAP figures is detailed in our earnings release distributed earlier today. Our non-GAAP gross profit for the third quarter was $44 million, up 16% year-over-year. This resulted in a non-GAAP gross margin of 34% up 400 basis points from 30% in Q3 of 2022.

The year-over-year increase in non-GAAP gross profit was attributable to the growth in our services business. The improvement in non-GAAP service gross profit was driven by growth in our subscriptions and planned pricing, coupled with cost optimization. Non-GAAP service gross margin for the quarter was 74%, slightly down from 75% in Q2 2023, and significantly up from 67% in Q3 of 2022. Non-GAAP product gross margin for the quarter was 8% and consistent with the previous quarter as well as our guidance provided in March of this year. Furthermore, we are very pleased that once again, our services non-GAAP gross profit exceeded our non-GAAP operating expenses in the quarter, a critical financial achievement we expect to continue to build upon in the future.

Total non-GAAP operating expenses for the third quarter were $36 million, slightly down sequentially, but significantly down year-over-year. The year-over-year decrease is primarily attributable to the suspension of our brand awareness campaign just after Q3 of last year. The non-GAAP operating expenses for the first three quarters of 2023 were markedly better than our expectations and reflect the cost savings initiatives implemented last year as well as a disciplined approach to discretionary spending throughout 2023. Our headcount at the end of Q3 was 353, which represents a slight change from 345 team members at the end of and 360 team members in the same prior year period. In Q3, we posted non-GAAP net income of $9.6 million. Our non-GAAP net income translates to earnings per diluted share of $0.09, a record for Arlo and at the high end of our guidance range.

Regarding our balance sheet and liquidity position, we ended the quarter with $126 million in available cash, cash equivalents and short-term investments. This balance was up over $2 million sequentially and demonstrates the solid capital position that Arlo is in right now. We are pleased to report that we generated approximately $7 million in free cash flow in Q3 which represents free cash flow margin of 5%, an improvement driven by our increased profitability and solid working capital management. Additionally, our year-to-date free cash flow was a remarkable $28 million throughout the first three quarters of 2023 or an almost $64 million improvement over the same period last year. Our Q3 inventory balance ended at $53 million, up $14 million from Q2 2023 as a result of the launch of our Essential 2 camera portfolio and in line with our expectations.

Inventory turns in Q3 were at 5.5 times and down from 6.1 times in the last quarter. Our new product launch will enable us to remain highly aggressive with our product pricing strategy, particularly through the holiday season and into 2024. We remain focused on maintaining appropriate inventory levels to effectuate a smooth product transition with our retailers and partners. These factors have impacted our inventory balance and thereby, our ability to generate similar levels of free cash flow. And finally, our accounts receivable balance was $70 million at the quarter end with Q3 DSOs at 49 days. down from 59 days from the same period last year. We will continue to monitor our working capital balances in line with our revenue and forecasted consumer demand levels with a focus on maintaining a solid balance sheet and liquidity position in the future.

Now, turning to our outlook. We expect the fourth quarter revenue for 2023 to be in the range of $129 million to $139 million or $485 million to $495 million for the full year, thereby increasing the midpoint of our full year guidance. We expect our GAAP net income loss per dilutive share to be between a loss of $0.05 to income of $0.01 per share and our non-GAAP net income per diluted share to be between $0.06 and $0.12 per share for Q4 2023. Service revenue is still forecasted to grow at approximately 45% over last year thereby becoming a much larger portion of our overall revenue and profitability mix, and we expect non-GAAP services gross margin to be in the range of 75% for 2023. And now I’ll open it up for questions.

Operator: [Operator Instructions] Your first question comes from the line of Scott Searle with Roth MKM. Your line is open. Scott Searle with MKM. Your line is open.

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Q&A Session

Scott Searle: Good afternoon. Thanks for taking my questions. Nice job on the quarter, guys. Kurt, I apologize bouncing between calls, but I was wondering if you could talk a little bit about the ARPU mix in the quarter between strategic’ and otherwise, it looked like it was a little bit down sequentially. I’m wondering if there’s anything to read into that in terms of pricing rebates or otherwise? And how we should expect that to trend over the next couple of quarters?

Kurt Binder : Yeah. Hey, Scott, and welcome to the team. Thanks again for your support. I’m glad to have you on the call today. Great question. We’re still very pleased with the way that our ARPU is trending. We’ve communicated in the past that when you look at our retail channel, our ARPU trends in the range of $11.50, which is up year-over-year, driven much because of our pricing strategy that we employed earlier this year. So that’s been trending very well. The ARPU on the strategic account side is heavily driven around the actual revenue model. As we’ve mentioned in the past, it’s more of a cost consumption SaaS-based pricing type model. So that tends to be lower than our retail channel ARPU, but it’s right in line with our expectations.

What we are seeing though is that in terms of the overall subscriber mix, subscriber mix has been mixing up slightly higher on the strategic account side. So that might have a trend of impact in our overall blended ARPU, but it’s still in line with expectations, and it’s still trending in a favorable way.

Scott Searle: Got you. And just as a follow-up, I’m wondering if you could talk a little bit about attach rates in terms of paid accounts, if we’re seeing any sort of divergence on that front or things are consisting — progressing in line with expectations. I guess as part of that now, the more advanced 24/7 security monitoring opportunity for you. I’m wondering how you see that fitting into the picture, what the broad-based expectations are for that. Thanks.

Matthew McRae: Yes. Yes, this is Matt. I’m happy to welcome you as well to the call, Scott. From a security perspective, the security system, I mean, we’re very excited about that. I’ll just kind of reference the announcement we made this morning around the total security subscription package, which is really exciting. It combines the service and the hardware together in one low monthly payment. We’re doing that with our partner firm. And that’s us positioning the security system, which comes with higher ARPU over time in that relationship in a way that consumers are kind of used to buying that already, especially from a direct customer. So yes, we’re very excited about that. I’m trying to remember what was the first part of your question?

Scott Searle: Matt, just in terms of attach rates.

Matthew McRae: Attach rates. Yes, sorry. Yes. So we haven’t seen any big changes in attach rates or conversion rates. And just to remind everybody, we actually track both. So attach rates for us, is a measure — 30 days after the initial trial is done. We take a quick snap and look at the attach rates, and that’s roughly 50%. And then we continue to follow those cohorts all the way up to six months at later and that’s what we call our conversion rate. Both of those metrics, and I will even add churn to this bucket, are still extremely consistent quarter-over-quarter. So we’re not seeing any big swings there at all.

Scott Searle: Great. Thanks so much.

Matthew McRae: Yes, you’re welcome.

Operator: Your next question comes from the line of Jacob Stephan with Lake Street. Your line is open.

Jacob Stephan: Hey, guys. Congrats on the quarter. I guess the first question would kind of be focusing on the service gross margins here. When I look at service gross margins declined sequentially. Is there anything specific you can really point to as the reasoning? And maybe just kind of reiterate why you think you could hit that 75% full year target?