Arlo Technologies, Inc.
Q4 2020 Earnings Call Transcript

Published: 23 Feb 2021

[Operator:]

Ladies and gentlemen, thank you for standing by. At this time all participants are in a listen only mode. Later we will conduct a question-and-answer session. I would now like to turn the conference over to Erik Bylin. Please go ahead, sir.

[Erik Bylin:]

Thank you, operator. Good afternoon, and welcome to Arlo Technologies Fourth Quarter and Full Year 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 fourth quarter and full year, along with guidance provided by Gordon will then have some closing remarks from that before we enter Q&A. At that time, we will have time for any questions. If you've not received a copy of today's press release, please visit Arlo's Investor Relations website at www.arlo.com.

[Matthew McRae:]

Thank you, Erik. And thank you, everyone, for joining us today on Arlo's fourth quarter 2020 earnings call. On today's call, Gordon and I will walk you through Arlo’s results for the quarter, which include an overview, commentary on paid account growth, new product announcements, and update on partnerships and financial results. We will also provide some expanded commentary on our outlook going forward based on the foundation we built in 2020. During a very tumultuous 2020, Arlo said about implementing a business model transition that cut across our entire organization, we refresh most of our product portfolio, we launched new service plans, we won more awards than any other time in our company history. We diversified our revenue through key partnerships, and we optimized business operations. All while we fought through the pandemic induced disruptions that swept through our industry, our markets, and indeed our world. With a dramatically stronger financial foundation, Arlo’s is not different company it was a year ago. We are stronger and on a new upward path. And I could not be prouder of the entire Arlo team for what we accomplished in 2020. And now on to our Q4 results, I'm pleased to share that we delivered $114.8 million in revenue at the top end of our guidance. Our non-GAAP gross margin grew by more than 10 percentage point’s year-on-year, while our service gross margin improved by more than 10 percentage points sequentially. In addition to our substantial gross margin expansion, our unrelenting focus on operational efficiency and excellence delivered nearly $4 million of non-GAAP operating expense reduction year-on-year. That combined performance created significant leverage in our business, improving our non-GAAP net loss by $14 million when compared with last year, and sending us well past the high end of our guidance for non-GAAP net loss per share, which came in at a loss of $0.08.

[Gordon Mattingly:]

Thank you, Matt. While the lockdown and supply chain disruption induced by the pandemic hampered our growth in 2020. We made excellent progress running the business, improving our P&L during the year. Even with the financial burden, the business model transition and pandemic induced challenges in the first half. We produce meaningful margin expansion for the full year across both product and service, which resulted in a 610 basis point increase in non-GAAP gross margin. We outperformed the target we laid out in our 2019 restructuring plan and lowered our non-GAAP operating expenses by more than $20 million in 2020. Importantly our results have shown incremental improvements as we progress through the year as we transition to the new business model, and began to realize its benefits. In total, we reduced our non-GAAP operating loss by more than $14 million for the year but much of this improvement coming in the back half. A trend of sequential improvement culminated in strong results for the fourth quarter of 2020. With revenue at the high end of our guided range, considerable margin expansion and EPS well above guidance. We ended the year with more than $206 million in cash, cash equivalents and short term investments, an excellent outcome given the complexity and transformation we navigated through during 2020. And now, moving on to the Q4 financial detail. Revenue came in at $114.8 million from 4.2% currently to down 6.2% year-on-year. Product revenue for Q4 2020 with $93.3 million, which was down 15.1% compared to last year and up 2.2% sequentially. Our year-on-year revenue decline was largely due to Verisure's stocking in the third quarter for the European market. That's internal pattern that was much different from what we had seen in the past.

[Matthew McRae:]

Thank you, Gordon. Beyond our guidance for Q1, and our reaffirmation of our past commentary on 2021 revenue, I want to share a bit more on the trajectory of our business as we look ahead. As I mentioned at the beginning of the call, Arlo is a different company than it was a year ago. We start this year on a solid foundation, and with a clear focus on what will drive our future success. The transition to our new business model was a watershed moment that redefined our path, and will continue to accelerate. While we added 200,000 paid accounts in 2020, we expect to add nearly three times that number in 2021 to reach 1 million paid accounts by our fourth quarter call this time next year. And while we have shared with you that we see a 50% conversion rate after the initial 90 day service period ends under our new business model, as we follow cohorts over a six month period, we see that number of clients a 65% catch rate to our subscription services. These factors should translate to approximately $100 million in service revenue in 2021. At a gross margin of more than 50%. Arlo is now a services first company from our culture through to our roadmap. And I have never been more confident in our team, our company and our path as we continue to unlock substantial value from our assets, and then the business model. And with that, we can open up the call for questions.

[Operator:]

The first question comes from the line of Jeffrey Rand with Deutsche Bank. Your line is open.

[Jeffrey Rand:]

Hi, thanks for taking my question. And congrats on a good quarter. Your weeks of inventory went up in both the retail and distribution channel. And it's about three weeks higher than at the end of 2019. Can you talk a little bit about the dynamics around the pandemic or holiday season that are changing your inventory or how are you thinking about your inventory levels right now?

[Gordon Mattingly:]

Hi, Jeff. This is Gordon, thanks for the question. So in terms of the actual weeks of stock, just to remind you that the denomination of that calculation is the last six weeks of PLA. Actually, in terms of actual dollars of inventory. We've seen the dollars come down year-on-year. So and in Q4 and certainly if you look at the distribution weeks of stock that's just really timing as shipping in and shipping out. So any 11.7 feet, I think that will come down as we head into Q1. Looking ahead to 2021, I think it's fair to say that we don't expect to see much of a tailwind from channel inventory sale. I think to your point, you're absolutely right. In the inventory levels, both retail and distribution are a lot more normalized, a lot closer than normal levels, compared to what we saw for example, at the end of Q2. So we don't expect too much of a tailwind in 2021 from channel.

[Jeffrey Rand:]

Great. Thank you. And are you still seeing any increased logistical costs due to the pandemic? And is there any visibility on when these should decrease?

[Gordon Mattingly:]

Yes, that that's what we are seeing for sure. And we've spoken about this quite a lot and certainly Arlo’s, no different from the rest of the market. Certainly air freight rates, we've seen elevated rates there all the way back from you know the back end of Q1 last year, and that's showing no signs of abating. And that will you know, turn back around perhaps towards the back end of this year, perhaps, but it's all reliant on the pandemic and how that plays out. I would want to get how that's going to pan out. But certainly air freight rates still elevated. We also seen a more recent phenomenon of sea freight rates also being elevated. And due to the additional pressure on the freight, we're also seeing actual elongated shipping times as well. And some degree of congestion at ports as well. So that side of things still continues. We haven't really seen any change, it's probably as we've gone through the pandemic have last six months, probably gotten a little bit worse and due to the pressure on sea freight. And right now, we don't see any signs of that abating. But everything depends on how the pandemic plays out.

[Jeffrey Rand:]

Great. And then just one more for me, your product gross margin grew meaningfully year-on-year in 4Q, are you seeing less need for promotional activity? Or are there other factors involved?

[Gordon Mattingly:]

I think it's a combination of things. But the first and foremost, we did go through the business model transformation. And certainly the gross margin profile you saw in the first half of 2020 is very much a story of . And as we went through that business model transition, you know, we certainly saw an uptick in product gross margin. And that's a reflection, you know, of the new technology that we bought out into the market that naturally means you don't have to promote quite as much. So that that's really first and foremost, obviously, with all over seasonality in our business, 35% to 40% of business in first half, 60-ish percent in the second half. So the rescale benefits as well, the benefit product growth margin in Q3 and Q4. Certainly looking ahead to Q1, I would say we expect product gross margins to be in the low double digits. And that's really a reflection of that change in the scale between the second half of last year and the first half of this year. But yes, I think it's fair to say the new technology is definitely helping us and we don't have to promote quite as much either.

[Jeffrey Rand:]

Thank you.

[Operator:]

Your next question comes from the lines of Adam Kindle with Raymond James. Your lines open.

[Adam Kindle:]

Okay, thanks. Good afternoon, Matt. I just wanted to start on the subscriber metrics and intend to roughly triple paid subscribers in 2021 reach a million subscribers. Those are, you know, big numbers, I would just be curious on the color on visibility into that level to go out, you know, that that far this early is a significant step function from already healthy growth rates. So just wondering, do you have some perhaps contractual visibility with bearish or and Calix? Is there an underlying growth assumption just how you're building up to those impressive goals?

[Matthew McRae:]

Yes, it's a great, great question, Adam. And I know, obviously, we decided to add that additional commentary in the call today, because we do have high confidence in what we're seeing in the subscription side of our business. So I would say it's multi fold. One, as you've seen quarter-over-quarter-over-quarter, we've been able to grow our subscriber base at a very predictable way and we really understand what that trend is. We also have great visibility into the subscriber business, right? When we sell product and get certain trials in one quarter that gives us a very good idea of what's going to happen in the following quarter. So that has provided a lot of confidence not only in the business itself, but where the business is going. You're also correct in that we have several partnerships that will start to bring in additional upside to subscriber numbers. Verisure is a good example of that, where today most of the execution was Verisure is around the retail and e-com business in Europe, which follows a similar paid service rate as consumers that buy here from retail in the United States may attach, or they convert at 50%. We shared you know, the actual attach rate six months out is closer to 65%. That's another new metric we wanted to share today. But the very short direct business, which has a one to one attach rate on service will start to happen later in 2021, later this year, and we've been sharing that, we're progressing on those custom products and some of the work in integration with Verisure. And that's been happening, on time every quarter as we get close to it. So you're absolutely right. It's a mix of having a lot of history now a year of history under our belt at what's happening with a new business model. We feel very comfortable with our metrics and seeing where that's headed, and the visibility we have towards that and seeing some partnership layer in as we get towards the end of 2021.

[Adam Kindle:]

Okay and do you have a sense for size of the direct versus indirect with Verisure yet, are still theoretical?

[Matthew McRae:]

I think it's too early to call. I think both will be sizable, but it's going to depend on execution and the rollout across multiple regions and so, I would say even the direct business won't be fully operational until we get deeper into 2022. Because they have so many different regions that they plan on deploying the product. But both will be substantial. And we're starting to build some of those forecasts, because we have long lead components now. So the visibility there is good. But you know, we're not sharing how that breaks up. But I think it's too early to really place a bet on which side will be bigger in 2021. But we expect that direct business to continue to scale as we get into 2022.

[Adam Kindle:]

Okay, and I know, it's still somewhat early for the services and subscriber business, but I’d be just curious what you're learning about the characteristics of your subspace, specifically, you know, perhaps lifetime value of a subscriber, gross churn or retention rate that you're experiencing? So basically, how valuable is the subscriber and how sticky are they?

[Matthew McRae:]

Yes, so we have not released some of the metrics that you're touching upon there. I can kind of reiterate some of the ones we did release today and give you a more qualitative, look at it as we've shared. The new business model is dramatically different than the old. So number one, as we mentioned in the call, 10 times increase in conversion rate, we incrementally shared on the call today to provide some more visibility, that when looking at cohorts, over six months after that purchase of hardware, that hatch rate on service actually climbs to 65%. That's what's given us our confidence in some of the longer term outlook on the subscription business so that people can kind of understand where we think Arlo is going. What's interesting is, it's so early to your point. And actually, the churn is so much lower than our old business model, that I'm not sure we have a handle on, things like long term value of some of the customers because we're not seeing a lot of cancellations off the back, we have a good churn rate. So we're still looking at it. It's early in that transition, but we're seeing it accelerated, you've seen it quarter over quarter. And we couldn't be more excited about what's actually happening from a metric perspective on the subscriber side. We tried to share a lot more visibility on the subscription business on the call today. And we'll look forward, maybe on an annual basis to try and provide additional look, as we crossed some of these big thresholds like crossing a million subscribers 12 months from today.

[Adam Kindle:]

Yep, that would be helpful. Thanks for the details and congrats on the momentum.

[Operator:]

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

[Unidentified Analyst:]

Thank you for taking the question. This is Wahid for Hamed. Just to follow up on that last change. In terms of subscribers, could you kind of shed some light on which subscription level they're opting for is at the high end, the low end? Is it a good mix?

[Matthew McRae:]

Yes, so we've shared this in the past a bit, again, not on a full breakout basis on a quantitative basis. But on a qualitative basis, we have a single can plan, we have our $10, kind of middle plan. And then we have our high end plan at $15. And we've shared most people are signing up for the middle plan. And if you back in kind of our service revenue against subscriber, as you'll see, what the ARPU is, and it's a little bit lower than, than the midpoint there because of certain promotions and the free trial and things like that layering in. But I would say most of our subscribers are in that middle tier, which is great for us. One of the things we talked about on a previous call, as we've rebooted the entire product portfolio and got everything over into a new business model. And most of our sales now in 2021, will be products on the new business model, we're doing a couple things. One is we're looking at how to continue to fine tune the metrics on the subscription business, bring up the conversion rate a little bit more, we reduce churn a little bit more, we've hired in the leadership that's helping us really optimize that services business. But one of the things looking out farther will now be, considering opportunities to actually increase ARPU over time that has not been a focus in the last 12 to 18 months, we've really just been focused on driving that conversion rate, we really understanding how to drive the transition in our business. That complete again, still optimizations to do but work through that transition period in 2021 is going to be a year of really optimizing that model. We will start to look at our roadmaps over time now thinking about ARPU expansion, but hopefully that gives you an idea of where kind of the tip of the bell curve is on a distribution and where we think things will head over time.

[Unidentified Analyst:]

And just one more question. In terms of you were talking about the supply chain in the chip shortages? Do you anticipate that is going to have a pricing promotions impact on new products or legacy products?

[Matthew McRae:]

Well, it's more of a supply chain, slow flow down from a supply perspective. And what I mean by that is, , every quarter, we've got certain upsides we can chase. And I think it's a little bit more difficult to chase some of these upsides, most of our old product, we stopped building a quarter or so ago, and those shipments happened a while back. And if you look in our investor deck, you'll see the old business model versus new business model mix per quarter. And you'll see we're exiting the year where most dramatically, almost all of our product is now on the new business model. So looking forward, from a supply chain perspective, I think it's really just us making sure we can service the needs of our retailers. It may attenuate some of the upside, but we're also extending our forecasting deeper into BR to try and make sure that through very diligent operations, we're going to be able to reach the numbers we talked about on the call. It does, you know, when there is shortages, sometimes I mean, you don't have to promote as much to reach some of that upside, and will always be as you've seen in the last couple quarters, really diligent about the spend versus opportunity and make sure we're driving gross margin where we can.

[Unidentified Analyst:]

Thank you very much.

[Operator:]

Next question comes from the line of Jeff Osborne with Cowan and Company. Your line is open.

[Jeff Osborne:]

Good afternoon, guys. A couple of questions on my end on the semiconductor issue. What's your working assumption as to when that resolves itself as it relates to hitting the $400 million target for the year? Is that something you think is just a Q1 issue or lingers throughout the spring and into the summer?

[Matthew McRae:]

Yes, I think it's distributed. And what I mean by that is, there's some ships that are clearly out longer than that. And there's some that I think will clear up within a quarter or so from here. So when you look at any given product, it's a little bit different. So we're seeing shortages across normal products, normal chipsets that we can find in other channels, sometimes you can go and buy it on the broker, or you can negotiate with an ODM to pull it from other sources. And then there are some subsets that are longer. We have great visibility right now into where that fits. And this is something that we're tracking on a week by week basis. And we're extending our forecasting into those suppliers to make sure that we can deliver the revenue that we're commenting on the quarter today. But so in some areas, yes, I think we're looking at another quarter or so. In other areas, it's longer and the way we're operating and providing visibility into our supply chain is attempting to match that so that we can deliver what we need to.

[Jeff Osborne:]

Got it. That's helpful, Matt, and then the guidance for revenue for Q1, would that have been higher if ports weren't as congested in the shortage, wasn't there? Or is that a good number of the true indicative demand that's out there that you're seeing?

[Gordon Mattingly:]

It’s Gordon, that's a great question. I think the reason we were calling out supply constraints. And you know, the guide that we gave $70 million to $80 million in Q1, otherwise would be a little bit higher, lots of supply constraints that we're already seeing in Q1. And comments, we think the supply constraints will certainly impact first half the year. And I think the seasonality that we thought we would see this year is probably going to be a little bit more pronounced than we had previously thought just because of that.

[Jeff Osborne:]

Make sense and my last question. I'm not sure if you can touch on this. But can you just give us a conceptual framework of how to think about 2020 and what your strategies are for 2021 as it relates to the potential mix shift of sales through the Arlo store versus through say, Best Buy and Amazon? Was there any noticeable shifts in 2020 and then any initiatives for ‘21 to accelerate traffic through your own site?

[Matthew McRae:]

Yes, that's a great question. So what you know, if I go back to 2019, a little bit for the window of your question, we had launched Arlo.com, kind of close to the end of the year. I think it was in Q3, going into Q4 before we had all of our products up on our website. That was great timing, as it turns out, as the COVID pandemic started to impact Q1, late Q1 going into Q2, what we've seen in 2020, to answer your question is definitely initially in the first half of massive shift online. And I think we shared with you some metrics from one of our retail partners, that's anonymous, but where they had 70% in store and 30% online, and within 60 days that had completely converted whereas 70% online, 30% actually in store or through in store pickup. So we saw that that also helped us grow Arlo.com because so many of the consumers that moved to online channels. Throughout the year, we saw the channel start to normalize a little bit where some of our customers started to get a little bit more balanced on 50-50 days. But we continue to grow Arlo.com through the year. And of course, there are a lot of benefits to Arlo.com including a faster cash conversion, higher gross margin, and our ability to drive potentially new business models or new offerings to consumers directly. So that's big. When I look at 2021, again, we're still seeing a little bit more of a normalized what I would call omni-channel approach for most retailers in that they learned a lot from that shift to online. And I think for many retailers, that bigger online component is going to be part of their strategy going forward. At the same time, we are continuing to invest in Arlo.com, we actually had a brand new website launch yesterday, which includes massive upgrades to the e-commerce functions to the shopping cart functions and lays down the foundation for us to do some other interesting things from an e-commerce perspective. So we will continue to invest in Arlo.com, both from a marketing perspective, but also from an infrastructure perspective. And I think we're going to see the channel, broader channel be a little bit more omni in basis meaning a little bit more balanced between their online efforts and their actual physical store efforts. Now, that's different by retailer, someone, a retailer that sells grocery will still have a higher percentage in store than online a little bit, and one that's mostly selling technology, for instance, is going to see a bigger mix of online than they had on a historical basis.

[Jeff Osborne:]

My only thought to that, Matt, and I'll let you go, is there an implication of that shift then to promotion spend for 2021, relative to say, a normal year for you pre-COVID?

[Matthew McRae:]

I don't think it changes a lot, the seasonality to spend is the same obviously, we're spending a little bit more on Arlo.com. And so that that flows through a little bit differently. The biggest changes we saw last year was the timing of promotion. So you know, Prime Day landing in Q4 was disruptive and created a different seasonality than we've seen before, our expectation is we'll see a more normalized calendar from a promotional perspective. And so we're going to attack at the same way, focused on a balanced approach of driving awareness, driving sales of our key products, but also delivering the gross margin that we need to wall in turn, obviously, driving subscribers. So, I don't see a big change, the tools underneath have changed quite a bit. So, we've started utilizing certain tools that allow us to get better visibility inside of retailer websites that drives promotional volumes of traffic to certain areas. And so we've gotten a lot smarter, not only how we approach promotion, but also the tools that we use underneath because a lot of more now digital and are integrated directly into retailer.com sites. But the overall spend in the calendar I think will be basically what you would expect from a normalized retail deployment.

[Jeff Osborne:]

That's all I had. Thank you.

[Operator:]

There are no further questions at this time. Matt McRae, I turn the call back over to you.

[Matthew McRae:]

Great, thank you, operator. I want to thank everybody for joining the call. And that concludes our commentary for today. Thank you.

[Operator:]

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