ARLO (2019 - Q2)

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 Erik Bylin. Please go ahead, sir. Erik Byl

Thank you, Gabriel. Good afternoon, and welcome to Arlo Technologies Second Quarter 2019 Financial Results Conference Call. Joining us from the Company are Mr. Matthew McRae, CEO; and Ms. Christine Gorjanc, CFO. The format of the call will start with an introduction and commentary on the business provided by Matt followed by a review of the financials for the second quarter along with guidance provided by Christine. We'll then have time for any questions. If you have not received a copy of today's press release, please visit Arlo's Investor Relations website at www.arlo.com. Before we begin the formal remarks, we advise you that today's conference call contains forward-looking statements. Forward-looking statements include statements regarding expected revenue, gross margins, operating margins, tax rates, expenses and future cash outlook, continued new product and service differentiation and future business outlook. Actual results or trends could differ materially from those contemplated by these forward-looking statements. For more information, please refer to the risk factors discussed in Arlo's periodic filings with the SEC, including the most recent annual report on Form 10-K and quarterly report on Form 10-Q. Any forward-looking statements that we make on this call are based on assumptions as of today, and Arlo undertakes no obligation to update these statements as a result of new information or future events. In addition, several non-GAAP financial measures will be mentioned on this call. A reconciliation of the non-GAAP to GAAP measures can be found in today's press release on our Investor Relations website. At this time, I would now like to turn the call over to Matt.

Thank you, Erik. And thank you, everyone, for joining us today on Arlo's Second Quarter 2019 Earnings Call. Strong and focused execution in the second quarter resulted in Arlo achieving our financial objectives and driving our innovation pipeline as we continue our path towards profitability. Revenue was up 44% sequentially. We came in at the high-end of our expectations for gross margin and completed the right sizing of channel inventory while significantly lowering our on-hand inventory. Arlo’s market leadership continued in Q2 as we achieved a market share of nearly 40% reflecting strong demand for Arlo products. Additionally, our paid subscription business continues to accelerate up more than 80% year-over-year. These impressive market results arrive while the team has done an excellent job executing our innovative roadmap, sowing the seeds for future growth from new products, new categories, new service offerings, and higher subscription attach rates. Let's start by talking through some highlights for the quarter. In Q2, we delivered $83.6 million in revenue above our guidance for the quarter. Services revenue was $11.2 million, which represents a year-over-year growth of 23%. We added about 271,000 registered users to the Arlo platform in Q2 to reach a total of 3.4 million total registered users up more than 54% year-over-year. More importantly, our paid subscriber base continues to grow at a faster rate to approximately 187,000 users up more than 80% from a year ago. As a reminder, this growth does not include Arlo Ultra customers buying products with our new services business model included. We believe these latent future subscribers will further accelerate the growth in paid users. Moving on to our products, I'll start with a brief update on Arlo Ultra. As you may recall, Ultra is the state-of-the-art security camera in the market with numerous key technologies and differentiated features including 4K streaming, 4K recording, high dynamic range, integrated spotlight, colored night vision, 180-degree field of view, noise cancellation, beamforming microphones and automatic track and zoom. All enclosed in an advanced and modular design. Ultra continues to win industry praise and was recently awarded Editors' Choice by PC Magazine which said, “If you're looking for the best wireless outdoor security money can buy, the Arlo Ultra is your best bet and our Editors' Choice.” And won an award for Best Security Product from T3, which said Arlo delivered a "perfect picture, and serious smarts in a brilliantly engineered package". Customer reviews for our Arlo Ultra are averaging between four and five stars driving sales mix up during Q2, which is the first quarter of full distribution. Additionally, consumers buying Ultra are receiving one year of Arlo Smart, our powerful AI and computer vision service capable of detecting people, vehicles, packages and animals. And we anticipate that we'll see strong conversion to pay subscriptions from Arlo Ultra customers at the one-year anniversary of those sales. Today, we are also pre-announcing a new core camera product that we expect to launch in the second half of this year in time for the holiday sales period. This camera will leverage many of the breakthrough technologies we pioneered with Ultra in a system capable of 2K resolution at a price point that will achieve a new benchmark for price performance and appeal to a broad market. This new camera will also utilize our new business model and include a three-month Arlo Smart subscription with purchase contributing to the further acceleration of our paid subscribers. I look forward to sharing more details with you in the coming months as we get closer to the channel launch date. In the second half, we also expect to launch our video doorbell, which was previously announced at ISC West. It includes several differentiating features, integrates into the full Arlo ecosystem and with our Arlo Smart platform provides the most advanced front door security solution in the world. The video doorbell will also implement our new business model and include a three month Arlo Smart subscription with purchase driving future subscriptions. More information will be available closer to the channel launch date. In addition to these upcoming products, Arlo is innovating in the areas of Software-as-a-Service and user experience. Numerous updates and new features including geo-fencing improvements, variable notification mute, performance enhancements, smoke and CO2 alarm detection and additional security features are being rolled out. And today we announced that HomeKit Apple's smart home platform is now supported on Arlo Pro and Arlo Pro 2 Security Camera Systems. iOS users can utilize Siri to quickly activate a live stream on their iPhone or iPad or set up an automation to trigger HomeKit enabled lights to turn on when motion is detected by an Arlo camera. By adding Apple HomeKit in Siri to our existing support of Amazon Alexa and Google Assistant, Arlo is in a unique and powerful position to support all voice and smart home platforms providing the best experience for users. Finally, in Q2 we launched direct-to-consumer sales on arlo.com. Our e-commerce store not only represents an important incremental channel of distribution, but also a vital platform of engagement with our customers. Our e-commerce store will give us new insight into customer preferences, allow us to test unique bundles, develop new business models and drive lifetime revenue per customer. It is clear to me that Arlo has reclaimed its innovation routes and we are well on the path to expanding our reach in the smart home security market while laying the foundation for accelerating growth and profitability. Now I'd like to turn the call over to Christine for her commentary on the second quarter, guidance for the third quarter and full year.

Thank you, Matt and thank you everyone for joining us on our second quarter of 2019 earnings call. As Matt highlighted, we delivered $83.6 million of revenue, exceeding the high-end of our guidance and up 44% sequentially, but down 24.7% year-over-year as we had to promote and drive down channel inventory in the quarter. As a reminder, the year ago comparison period references carve-out financials for Q1 and Q2 of 2018, whereas our Q3 2018 financial results going forward are based on standalone financials. You can find further detail regarding Arlo’s carve-out financials contained in our SEC filings, including our previously filed Form S-1 and the related public offering perspective. During the second quarter, we shipped a total of approximately 933,000 devices, of which approximately 839,000 are cameras. We added approximately 271,000 register users to the Arlo platform in Q2. As of the end of the second quarter, we had about 3.4 million registered users, an increase of 54.1% from a year ago. Growing our registered user base is critical to growing our recurring subscription business, which we believe will help improve both our margins and revenue predictability. We factored in an adjustment to our paid subscriber total in Q1, and given that we added 25,000 paid subscribers in Q2 to bring our total paid subscriber count to 187,000, an increase of 83.3% year-over-year. We're very pleased with the growth in our subscriber base and believe our new business model for subscriptions, which we introduced with Ultra and will continue with future product introductions, will be a substantial driver of this subscriber base and recurring revenue growth in the near future. Our services revenue for Q2 2019 was $11.2 million, which is up 23.3% over last year. From this point on, my discussion points will focus on non-GAAP numbers. The reconciliation from GAAP to non-GAAP is detailed in our earnings release distributed earlier today. Our non-GAAP gross profit for the second quarter of 2019 was $10.5 million, which resulted in a non-GAAP gross margin of 12.5% at the high-end of our guidance and solid progress from the first quarter. This compares to $29 million in the year ago comparable period and $2.7 million in the prior quarter. Our service gross margin was 45.2%. Total non-GAAP operating expenses came in at $37.8 million, which is up 25.3% year-over-year, largely due to the effect of carve-out financials, but down 2% sequentially. Our total non-GAAP R&D expense for the second quarter was $16 million, down 5.4% sequentially. Our head count at the end of Q2 2019 was 402 employees compared to 401 in the prior quarter. Our team is extremely focused on managing costs, while still executing the initiatives that will maximize our growth in shareholder value. These numbers reflect the continuous diligence we are practicing around managing expenses. As you have seen in our guidance, our business is scaling in the second half of the year with the introduction and ramp of new products. We expect non-GAAP operating expenses to increase slightly in the second half of the year to facilitate these launches and growth. Our non-GAAP tax expense for the second quarter of 2019 was $207,000 and for the second quarter of 2019 we posted a non-GAAP net loss per diluted share of $0.36. We ended the quarter with $137.9 million in cash, cash equivalents and short-term investments. The decrease in cash primarily reflects our non-GAAP operating loss along with a $15 million working capital outflow driven by increased accounts receivable and a decrease in accrued liabilities. We expect the working capital outflow we experienced in Q2, will more than reverse itself in Q3. We continue to be very focused on managing our cash position and we were very pleased with our inventory management during Q2. In the first six months of this year, we reduced worldwide channel inventory by approximately $70 million including bringing U.S. retail channel inventory to 10.1 weeks of stock at the close of Q2 and we are back to normal levels of inventory in the channel. Additionally, we also lowered our on hand inventory ending in the quarter at $97.2 million, down $34 million or 25.9% sequentially. The significant reduction in both channel and on-hand inventory puts Arlo in an excellent position as we prepare to launch new products in the second half of the year. Now turning to our outlook. We expect revenue in the third quarter to be in the range of $95 million to $105 million. We expect our GAAP gross margin to come in between 8.1% and 11.1% and non-GAAP gross margin to come in between 9% and 12% in the third quarter of 2019. We expect our GAAP net loss per diluted share to come in between $0.53 and $0.47 per share and our non-GAAP loss per diluted share to come in between $0.43 and $0.37 per share. We expect our non-GAAP and GAAP tax expense to be approximately $300,000 for Q3 2019. And we are reaffirming the full year 2019 guidance we gave in our last earnings announcement. With that, I will open the call for questions.

Our first question will come from the line of Adam Tindle from Raymond James. Please go ahead. Your line is open.

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

Sure. So I think the starting point is the channel inventory is right sized and we have two products coming in the back half of the year. And the majority of that revenue and shipment will come in Q4. It's the camera product that we just announced, the refreshed camera and the 2K and then also the video of doorbell, which is a new category for us really. So everything in that sale is incremental. And also, we do expect with the new products less promotion in that as far as the reduction in our marketing spend, which also increases our revenue into Q4. So we do believe that this is an unusual quarter in the fact that we have two new products coming in and they're going to come in slightly towards Q4, reduce channel inventory with some of the older products. And that's really where we're at for the quarter.

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

I think the guide there was really the non-GAAP operating margin $95 million to $105 million, and we do believe where we affirming that we will be within that range.

Okay. And then maybe just a couple bigger picture questions. Matt, I know that the company had a long term target to get 30% of revenue from services. You obviously see – have seen some good growth in paid subscribers. Maybe just talk about the goal of the 30% of revenue from services and kind of the key factors to accelerating that. Are there incremental services within that offering that are on the roadmap that are helping to get you to that level?

Yes. I think, you'll see two things, getting us to that long term operating model. One is from a roadmap perspective, as I mentioned in the script and going forward we have a robust roadmap not just for hardware but also on the service side. So, expect to see additional features launched in the second half of this year and that roadmap to continue innovating and adding services that people want to sign up for. We do a lot of surveys and really understand what people are looking for in that service and are actually prioritizing the service and software roadmap to link up with that. And then two, I think the biggest – the biggest lift or the acceleration that we believe we'll see is when the new business model starts to kick in on ultra, but also both products we announced on the call today or reannounced and then preannounced include the new business model as well. And as a reminder, that's an inclusion of a period of free service or subscription that comes with the purchase and then it flips over to a paid model which will drive obviously a higher attach rate than what we've seen from a legacy perspective. Those are the two largest. So from a roadmap perspective and from a feature and service perspective, we'll be adding what we believe will drive subscriptions. And then obviously the new business model will have probably the biggest impact from a trajectory.

Okay. That's helpful. And maybe just one last one for me. Just was curious on, Matt, your observations on sell through of Ultra. I think you mentioned in the prepared comments a lot of positive reviews. I think you said sales mix was up in the quarter. So I'm just curious to understand the price elasticity dynamics that you're observing in the market with a premium product like that. And given this, maybe just, go through the algorithm for future product revenue growth from the standpoint of units in ASPs. Are you finding that there's that demand at this new level of ASPs that maybe surprising you?

Well. Yes. What I would say is, for my comments that the mix is up in Q2, which is good. And I think it's, where we needed to be as a company going forward. As you know, if you've probably looked at pricing for Ultra, we have not promoted it. And that goes along the lines of a Christine’s point where you're going to see marketing spend go down as we launch new products because we're launching product at the right price point, servicing those different product segments with the right product at the right price, which gives us the ability to reference and actually address different market segments. And I think Ultra is doing a good job as at driving sales in that upper segment. The product we just preannounced today steps down one segment from there and a bit of a broader market but will obviously be priced in the right manner, go after that product as well. So we're seeing, it mix up, quarter-over-quarter and we're seeing success at that price point, and then we'll start to address additional price points as we continue our NPL roadmap or new product launches.

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

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

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

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

Yes. it’s actually – it’s a good question. It’s actually leveraging a lot of the technology from Ultra including the battery, and a lot of other components. So, it’s – from an execution perspective, we have very high confidence given that we had the first issue with Ultra have corrected that and we’re seeing great reviews from both customers and professional reviewers on Ultra and we’re seeing the sales mix up, it’s building off of all of that same technology on both the hardware and software back end perspective, including the battery.

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

Yes. it’s similar to what we’ve seen in the past, where one of our most popular – one of the most popular skews that’s sold is the four-camera bundle, but the average is still roughly above three cameras on a sales perspective.

Okay. Very good. And one more broad, could you just give us a general sense of maybe the pricing landscape and competitive environment that you’re seeing? I mean, I noticed that there’s still some promotional pricing on some retailers for some of the lower-tier cameras, even after rightsizing the inventory. Is that more just to kind of make additional space for the 4K camera as it comes – as it comes through in the end of the year 4Q?

Yes. that’s right. So, you’re seeing us, there’s activity prior as we were correcting the channel inventory, the activity you’re seeing now is to actually clear the shelf and be ready for the 2K camera that we just preannounced today. And so you’ll see that continue as we do that transition. We’re being real smart about that transition to make sure we don’t get power with too much inventory.

Very good. And then just one last one, for kind of the security product line in general, is that something that we should know expect to see in the beginning half of 2020 or is that going to be more part of say that spring refresh back half of the year as those things are brought on line.

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

Excellent. Well, thank you very much.

Thank you.

Our next question will come from the line of Hamed Khorsand of BWS Financial. Please go ahead. Your line is open.

Hey, first off, just a quick question as you’re now reaching normalization in the channel and you’re going into Q3 with less than revenue expectations, why isn’t there greater scale in your margins that you’re providing guidance.

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

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

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

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

So if you, yes, if you look at the market share sequentially, quarter-over-quarter we grew a little bit. So, we ended close to 40% market share. Our typical market share range as you know is typically 35% to 40%. So, we’ve been helding pretty steady quarter-over-quarter on the market share measurement.

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

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

Okay. Thank you.

You’re welcome.

Thanks.

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

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

This concludes today’s conference call. You may now disconnect.