Arlo Technologies, Inc. (ARLO) Earnings Call Transcript & Summary

Good afternoon, and welcome to the Deutsche Bank 2020 Technology Conference. I am Jeff Rand, consumer electronics analyst at Deutsche Bank. We are happy to be joined today by Arlo Technologies' CEO, Matthew McRae; and CFO, Gordon Mattingly. I will start with some questions from management, but please submit any questions that you have through the question box on the left side of your webcast page.

Let's start with the current demand environment. Can you give us some insight into how demand has trended through the pandemic? And where we stand today? Are there certain products or price ranges that have performed better than others during these times?

Thanks, Jeff, for having us. And I just -- as I get started answering questions, I just want to remind everybody that before we begin, we advise everybody on today's conference call that we contain forward-looking statements, and I would refer you to our publicly available investor presentation for more information. Yes, the demand environment, obviously, took a hit in Q2. And you noticed from a POS perspective, we saw year-over-year sales go down. Although how much of that was active raw demand versus just the go-to-market is not for debate. As you know, many retailers shifted operations or closed stores. So some of the POS decline, I think, was more caused by the disruption in the actual go-to-market than it was from the actual demand for the product or the product category. As we said, and we gave guidance in Q3, we see some of that recovering and recovering through the year as we then start to look for maybe a more normal year in 2022 -- 2021. But I would say that demand for the product and demand for the product category is where we expected. Also, as you know, as part of COVID, there's a lot of awareness generated around not only security, but checking in on loved one, and many people have moved, obviously, to buying a lot of product on online and having it delivered to their front door. So we've seen a lot of interest in, obviously, using cameras in our doorbell with our package detection to protect not only packages that are left at the front door, but to be able to provide what we call touchless delivery of food or other things, where you can see that the person who delivers your meal as a family actually drops off the meal and walks away before you open the front door because you don't want to be face-to-face. So in a lot of ways, I think recent events have actually triggered interest and a little bit of a wider awareness in the category as we move forward.

Great. On the supply side, it seems like there were some disruptions during the early days of the pandemic. You mentioned some of the stores closed. But now the supply chain seems to be closer to fully operational, can you give us an update on your supply chain? And any steps you're taking to protect against future disruptions?

Yes. Arlo was fortunate in that we had moved years past to finished goods production outside of China. So a lot of our product is built in other locations, which meant that the impact of the early stages of COVID, that shut down parts of China, impacted us a lot less. Really impacted us at the component level and some of the components are actually sourced from that region and then send to our manufacturing locations that are elsewhere. So our disruption was relatively minimal in that we were mostly outside of China, and recovered very quickly. The team at Arlo did an absolute fabulous job, not only adjusting to the impact of the pandemic in those first couple of weeks is we're understanding what was happening from that disruption perspective, but working with our partners, making sure that we had what was mostly a completely uninterrupted supply chain from there going forward. When we look at what's happening now, what's left over from that supply chain disruption, there are bits here and there that we're managing around it. It could be specific components. It could be a disruption of being able to have people on site at certain locations during product ramp, as an example. So having engineers on site, often engineers have to go into a 14-day quarantine before they can come on site to the factory as an example. So there's a little bit more friction in the system. But if you know ahead of time, you can plan that as part of your product ramp. We have successfully launched 2 products during the pandemic, and those products were launched on time. So we're excited about that. I mean, the team did, again, a fabulous job launching Floodlight and our Arlo Essential product during this pandemic, which shows that we're able to operate outside of that. I would say one of the biggest components that we're tracking, as we go forward and continues to be something that's changing week-by-week, is things like air freight, which, obviously, got very expensive right after the pandemic hit because most of them, not most, a lot of air freight is actually in the belly of passenger aircrafts. Some of that capacity is actually all-in passenger planes. And when COVID hit and we saw passenger planes stopped flying because the demand wasn't there. Actually, it brought capacity down from an air cargo perspective, and so we saw rates spike. Those rates have started to normalize through the quarter, and we're, obviously, planning around those. But as we hit, what will be a very different Q4 and that there's going to be multiple product launches, including Apple iPhone and others that aren't going to be eating up capacity in Q4, not to mention Prime Day landing in Q4 from a holiday perspective, we think there's going to be a lot of demand going into Q4, and that's something we're watching very carefully from a freight perspective.

Great. You exited the second quarter with U.S. channel inventory levels at healthier levels than from first quarter. Are you comfortable with where U.S. channel inventory levels are? And has the pandemic changed behavior at all in the channel?

Gordon, taking this one. So yes, you're absolutely right. We did make good progress at the end of the previous quarter in terms of channel inventory management. And we ended with U.S. retail channel inventory between 6 and 7 weeks, which is pretty low. Norm that you'd expect to see for retail channel inventory would be probably more in the 10 to 14 weeks type of level, so definitely low. But I spoke taking the context, the backlog is relatively normal. I think when we went through the last Great Recession, around about 2008 time frame, we did see a lot of destocking by our channel partners. Is the -- the channel is clearly focused on managing their own cash position, which often manifests itself in terms of destocking. So certainly, the reaction to the macro situation, which is pretty understandable, and that cash management side of things, but also what we saw with some of our retail partners, with a lockdown that was imposed certainly and store closures, we saw a change in the mix between online and in-store. Some of our retailers, we talked about that, this when we did our earnings call. Some of our retailers actually fit from an 80-20 in-store online mix to complete in the height of the lockdown. So 80% online, 20% in-store. And that, obviously, means far less requirements for actual inventory level in its store. I think it moved back to a more normal level now, probably roughly 50-50, which is still different from what it was historically pre-pandemic. And to answer the question in terms of, are we comfortable with the levels and do we expect that to change over time? It kind of depends on how the pandemic plays out and whether further lockdowns happen. Obviously, we're back to more like a 50-50 split, as I said, compared to that 80-20. 6.6 weeks of stock for us is pretty low. I would expect that to tick up. But thirdly, we head into the holiday season. It will be interesting because I think some retailers are, certainly, planning their holiday promotions in different ways, and are probably expecting to do a lot more transaction through online compared to in-store. So it will be interesting to see. But certainly, I would expect it to tick up a little bit, but in light of the current prevailing environment, is kind of anyone's guess as to how that plays out. But certainly, it's been impacted by the pandemic. And hopefully, if we look forward to kind of next year, assuming that situation kind of rectifies itself, I think we should probably get back to more normal levels.

Great. And you guys have started to see impressive traction in your service businesses with attach rates in your new business model around 10x that of your old business model. Do you expect these high attach rates to continue? And how do you think about your business mix of product versus services over the longer term?

Yes. It's been a big transition for Arlo to go from our "old business model", or sometimes we call it a legacy business model to the new business model that we started that transition towards the end of last year. And it is 10x higher than the old from a conversion rate or attach rate on service. And so it is something we've seen. We've now reported on over 2 quarters, and so we do expect that to continue. Any new business model product that offer is just fundamentally different and it's driving that much more value into the consumer market. The other thing I would want to comment on is, as you see subscriptions start to tick up, both in just absolute value, but also in the rate of subscriptions quarter-over-quarter, that's something we're also looking at potentially continuing. And so one of the things we've done is we've actually added a slide in our investor deck that showed old business model products sell-through versus new business model product sell-through in the channel, both going back 2 quarters and then looking forward, 2 quarters, Q3 and Q4 of this year, to help investors understand that as we ramp from old to new, or have a mix shift from old to new on a sell-through basis, that is one of the driving factors why we'll see subscriptions actually tick up over time as well. From a product and service mix perspective, obviously, you're going to see services mix in quite aggressively over the next 2 to 3 years. So if you just look at relative growth rates, from a service and hardware perspective, not only is the service revenue growing faster because of our business model change, but it will also have a higher impact on our gross margin going forward as well.

Great. And your registered accounts have also seen healthy growth, growing 33% year-over-year in the second quarter. While not all these turn into paid accounts, are there benefits to Arlo related to marketing or something else from a registered user that doesn't become a paid subscriber?

Well, there is, and that's because a household captured is a future paid subscriber. It's the way that we look at it. So we have -- we've released that our attach rate on the conversion rate of the service to a hardware sale is now about 50%, which is, obviously, high and much higher than our legacy business model. And then the way we measure that is, basically, we have a 90-day free trial, and then do they actually sign up for service within 30 days or of that trial concluding. But you see people sign up after that 120-day period. So they may not count as a conversion, but they will sign up over time. And so we're constantly going into our overall user base, which includes paid and nonpaid registered users and providing offers to get them into the paid area. So we view that as the top of our funnel. A hardware device sold and a registered user captured is not only a household for future hardware sales, but we believe it is a future paid subscriber if we do our job right, and that's something we're very much focused on.

Great. And let's dig a little deeper into your services business. Arlo Smart is the foundation of this business and offers a lot of intriguing features, including person and packaging detection and enhanced 9-1-1 option. What do you think are the key differentiators for Arlo Smart versus offerings from competitors? And what will allow Arlo to stay ahead of its competitors in its offering?

Yes. There's really 2 things separate Arlo Smart, one is the broad features as part of that service package that we've built up over time. And I would say the second is the performance and the accuracy of the service when compared to a lot of the other services that are out there. So if you look at the features that are part of our Arlo Smart package, it started with person detection, which was, obviously, one of the most important from a computer vision perspective, and quickly expanded to vehicle detection, animal detection, and now package detection, especially at the front door, which has become extraordinarily important. As I mentioned before, we're doing a lot of e-commerce. I want to know when a package has been dropped off at their front door. So we've expanded not only the objects that we detect, but we're actually doing multiple object detection simultaneously and in a very low latency environment. So not only is the detection accuracy very high, but the performance of the notification is also very fast. And that's something we spend a lot of time on. We also, as part of the package offer, e911. And for those who are not familiar with e911, it's similar to 911, except the calls are automatically routed to the location of the emergency event where your cameras are. So if I'm in New York, as an example, and my home is in California, and I see a fire or I see something happening at my home in California, obviously, if I dial 9-1-1 in New York, I'm going to get 9-1-1 dispatch. And it's going to take them a long time to try and figure out the right 9-1-1 center to support my house. When you tap e911 in our app, we automatically route that call directly to the 911 center that services your neighborhood. So that saves a lot of time. There are a lot of other features, including rich notifications, call to action, where you can actually take action in the notification screen without having to launch the app first; and even things like smoke and carbon monoxide detection, where we've microphone in the camera to listen for smoke or carbon monoxide alarms inside your house and actually give you a notification of that. So it is a collection of not only features, but services that really provide that peace of mind for an end user, both from a security perspective, but also from a potential other emergency perspective like fire or smoke or carbon monoxide. And we're the only one with that broad of an offering in that service path. And we'll be adding more over time, and that's part of our road map. But again, the performance of the service, I think, is also something that is very critical. We have a measure that we often look at call time to respond. And that is, if an event is happening, how fast can that user actually respond to that event? And in compute performance in the cloud for when we run the service, the hardware performance with Wi-Fi performance, but also the app design itself and making sure that the user can take action very quickly. And we think we have a best-in-class solution, and that's part of what's actually driving, we think, the higher subscriber counts as we move forward.

Great. And this summer, you announced a partnership with Securitas Security Services USA, which I believe is important in diversifying your customer base. This is also your first substantial SmartCloud SaaS deal in the U.S. Can you talk about what excites you most about this deal? And the opportunity going forward for SmartCloud SaaS deals?

Yes. It is an exciting deal for us. We are -- this does -- you're correct. This does represent a diversification of our customer base and revenue base. And this is something that we've been committed to and talked about on past earnings calls, as something that we're focused on. And in this case, Securitas provides service to businesses, even high net worth individual from a guarding perspective. And are going to use a collection of products, including Pro 3 in some of our normal products, but also Arlo Go, where they can provide temporary security on hind using cellular radio for notifications and video. So if you need to secure a site before a principle comes on site the following day or during that event, they can actually secure and monitor a site ahead of time in that way. So it is, obviously, not a retail channel deal. This is a different channel, but it's also a different end customer in that it's not a consumer. It's actually either small, medium businesses or high net worth individuals or principles that they're supporting. So it's, I think, an exciting deal from a diversification perspective, but I think it also, on your question around what does this be for potential other SaaS deals, what we've discovered as we go and talk to partners and potential partners, is that Arlo is very well placed from a partnership perspective in that we take privacy very seriously. We have a proposing policy. And we are very careful about what we do with data, what data we collect and make sure that we keep everybody's data extraordinarily private and protected. And that's good from a partnership perspective. We also don't collect any data or use it for advertising or try and sell e-commerce through with that advertising. That data is only used to provide the service that the partner is asking for. And we're very widely compatible from an ecosystem perspective. So as you know, we work with Amazon Alexa. We work with Google Home. Our products work with Home Care, even Samsung SmartThings and IFTTT and that broad compatibility actually sets us apart as well. So what we found is that actually, Arlo is well positioned. It's not only a leading company from a platform -- video platform perspective, from a scale and performance perspective, but also the positioning that we've taken from being very broadly compatible with other ecosystems and technologies and having privacy be one of our core differentiators in the space has made us a good partner for those looking for a smart video platform from a SaaS perspective.

Great. Yes, they're definitely very exciting. Sticking to partnerships, your Verisure partnership guaranteed a minimum of $500 million in purchases over a 5-year period. Can you give us an update on how the partnership is going? And touch on how this partnership will support growth in your services business? As I would assume it would be a positive for that business, too.

Yes. Absolutely, you're right. So Verisure is actually our first SaaS deal that we announced at the end of last year, beginning of this year, and is, obviously, a regional differentiation or diversification as much as it is a channel diversification. So Verisure is a traditional security player in Europe. Very aggressive on their growth, very innovative, and we partnered with them, not only in the direct channels for e-comm and retail, but also they'll be taking Arlo products into their direct sales environment. And we're working with them on so custom-designed products to actually drive growth and innovation in that direct business. To your point and question on how does this drive potential to the services business, that direct piece of that business, including Arlo products being sold through that channel and the custom products that we're working on with Verisure to launch in the future, we'll have a 1:1 attach rate on services. So every time it gets deployed, that will be a subscriber attached to that. So yes, it's going to drive hardware sales, the $500 million guarantee over 5 years, it's really just a measure of the hardware purchase guarantee. In addition to that $500 million purchase guarantee on a hardware side, there will be a lot of service and subscription revenue coming from that 1:1 attached to the direct channel.