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

Covering tech services here for Citi Research. Matt McRae here from Arlo Technologies. Great to have you here, Matt. Welcome to the conference.

This is a name that's a little bit new to me as well. So for investors, I think are new to the story, maybe let's dig into what you believe the market opportunity is today for Arlo and where does Arlo fit in the broader connected home ecosystem?

Yes. So Arlo -- for those that are very unfamiliar with the story, we are a spin about 8 years ago from a company called NETGEAR, who was in the home networking business. And they were looking to develop products that would utilize a lot of the wireless networks at home to try and trigger upgrades for people to buy the latest wireless router standard and hit upon video as a use case that would eat up a lot of bandwidth and drive people to a new router. And decided that there was -- Roku had just started and there were some streaming set-top boxes and figured that wasn't the right area and hit upon the idea of DIY, do-it-yourself security and built the first Arlo camera nearly, I think it's over 11 years ago now, maybe 12 years ago. And it took off like a rocket. So the market since then has really been going through a transition from what we call DIFM or do-it-for-me, meaning installers coming and building home security systems in your home to DIY, which is do-it-yourself. So the technology that Arlo created in the market segment that we actually created was really around simplicity, powerful visual-based security and driven from the idea that you could take 2 or 3 cameras and install them in 20 minutes. So that market that was 100% DIFM 10, 12 years ago is now about 16-plus sometimes as high as 70% DIY, and the rest of the market is now about 1/3 of the market. So that's the shift. Now the other thing I would tell you about the size of the market is independent studies and surveys show that about 20%, it's anywhere from 18% to 22% of broadband households in the United States now have a camera or some kind of visual-based security that they can access through the Internet. And we always -- I've been in the consumer space a long time with -- across multiple companies. And right around the 15% to 20% is when you move from early adopter, maybe tech-forward type customers and market segment into mass market. And so we think we entered that transition about 1.5 years ago. And we're seeing that in many ways. One is we're seeing a new group of customers coming and buying the product. But we're also seeing the transition of -- for instance, we're seeing Walmart be a bigger part of the market than was historical over the last 3 years, and that's usually a signal that's going in mass market. So our view is the next 30 million households in the United States alone will probably come on and become connected with digital-based security in the next 3 to 5 years.

Services make up roughly 60% of the business right now. What are some of the important strategic decisions that enabled that transition? And I guess, how do you think about expanding that base going forward?

Yes, it's a great question. And again, it goes to the history of the company. So when we spun, we were really a hardware company at that time. So we were -- it's all about the hardware margin and just trying to sell as many widgets as you could in any quarter. But it was clear at that moment that home security is really a services business, right? You're providing an ongoing value proposition to that end user. And so after we spun, we set about basically transforming the company from a hardware first to a services first organization. And that was a change in the culture. It was a change in the road map. It was a change in finance and accounting practices and which metrics we're chasing, it changed everything in the company. So I'd say the genesis of that transition happened probably right at our IPO, which was in the middle of 2018, took about 2.5, almost 3 years to actually really transform the company at its DNA into a services company. And if you look, we crossed over not only service revenue being a bigger portion of our revenue than hardware, but from a profitability perspective, probably about 2 years ago, and it's just been a rocket ride ever since. So you're going to see that continue. Certain metrics you look at, we're looking at our service revenue growth year-over-year, approaching -- we want to stay around 20%. So still be one of the fastest-growing companies in the space. We've also seen gross margin, so blended gross margin across the company has gone from 30% to 40% to 50%. And we think we're on our way to 60% is where we want to target over the next couple of years. Operating margin as a company, too, was negative when we were a hardware company, broke through into positivity, and we hit almost 20% in the last quarter. So I would say we're in that 15% to 20% positive operating margin headed towards 25%-plus over the next few years.

Should we think of hardware, and we've seen this other companies that have transitioned into more of a service-based model. Is hardware more of like a customer acquisition tool?

Yes. So the way we look at it, it was a dial we turned slowly as we transition the company to services. But once we hit about 2 million -- 2 million to 3 million paid subscribers, I think it was around 2.5 million, the economics and the profitability of the company transformed to the point where we could really look at hardware as CAC. So as part of our customer acquisition cost, we measure ourselves on hardware unit sales because that brings new households into the funnel. We measure ourselves on blended gross margin. So even if the hardware goes negative margin, what we're always doing is looking at the blended gross margin expanding. So it's a good way to be disciplined around the overall profitability of the company growing. And then we measure ourselves on things like LTV to CAC ratios to make sure that our CAC is still at a very healthy level against the value of the customers that we're actually bringing to the table from a shareholder value perspective. And just to give you a couple of numbers, our LTV is approaching $1,000. I think it was $976, $967 last quarter. And typically, our CAC is anywhere from $200 to $300. So our LTV to CAC ratio at the beginning of the year was about a 4x which is considered world-class, and we'd like to keep it between a 3 and a 5 and it moves up and down depending on promotions in that.

And $300, I'm sorry, $300 CAC.

Yes. $200 to $300 CAC on $1,000 LTV. So you can see every time we lean in and produce additional households, the shareholder return is actually very, very high.

And how do you think about pricing on the services? Is that -- do you have a tailwind there? Is there a sensitivity? Can you just walk through some of those?

Yes. So a couple of things. When we made our transition, one of the things that we tested early on was the pricing elasticity on hardware versus service. And what we quickly found out is that consumers are much more sensitive to the upfront cost of the hardware. So making that initial purchase. So how much value are they getting? How many cameras can they buy for a certain budget? How hard is it to install as well. So do they have to hire somebody to install or not is part of the cost equation. But once they're a subscriber, they're relatively insensitive to price because of the amount of value we're providing. So our ARPU right now on average on our retail and direct is just over $15. A couple of years ago, that was closer to $11. So we've had ARPU increasing substantially over time. But most of our competitors in the broader security space are typically anywhere from $40 to $60 or even $70 a month. So we feel we're nowhere near the kind of the ceiling of where we can go. And our typical road map is, we will produce a lot of new functionality, new services, new features into our service tiers and then look to earn a price increase in that following year. So it's a little bit of a tick-tock type timing. So this year, you'll see us introduce a lot of new features in the coming weeks and something we call Arlo Secure 7, which will be a new version of our subscription services, setting us up for potential ARPU enhancement increases next year.

I definitely want to get into the platform in a bit here. But I guess before we get to that point, I want to position Arlo against maybe some very large brands out there that are very platform-centric, have lots of bells and whistles, DFIM (sic) [ DIFM, ] even DIY. How should we think about Arlo's wedge in the market here? What are some of the differentiating factors that Arlo has?

Yes. So if you look at the competitive landscape, it's really, I would say, in 2 major buckets and one of the buckets has a little sub bucket maybe. So if you look in the retail and direct space, you've heard of names like Ring or Nest, and then there's a lot of smaller competitors in that retail space. We're a solid #2 there. I would say Ring is #1, mostly because they own the channel. So they own Amazon, they spend a ton on marketing. But we're happy being in that #2 and having a more innovative service, a much more profitable business, and we think we're getting the best customers out of that retail space. So it's -- and we even see Google kind of pulling back and some of the other brands are starting to consolidate a bit in the retail channel. And as the services business has become a larger component of the overall business and specifically our P&L, a lot of the entries that come into the market, whether they're overseas, Chinese, Taiwanese coming in and building just hardware and trying to sell that, it's very difficult to stay competitive because we can go negative easily on the hardware because all of our economics come on the service. If you don't have that service component, it's extremely hard to be competitive long term. So that's on the retail side. I would say it's really Ring and Arlo battling it out in the retail space, and we're seeing some consolidation that we think we can take advantage of over time.

Our work in this space has also shown that integration is a major, major factor here. I mean everybody has -- can't use multiple apps to manage their home. They want integrated control center, no other way of saying it. I do want to talk about the platform a little bit, but in particular, the Secure 7 release, which -- there's been a lot of investment ahead of that. Can you just walk us through kind of what that enables, what sits underneath the platform? It seems like it's such a strategic asset.

Yes, it really is. So we've -- especially as became very cash flow positive and started building up cash reserves, it's really moved to a more formal capital allocation plan as a company. And that includes stock buybacks. It includes a small acquisition we made, we may talk about it in a few minutes. But it also deals with our organic investment in the platform, especially over the last 3 to maybe 4 years. One of the things that's happening is the AI level layers in the service is getting more and more sophisticated. And we've always been at the forefront of developing those new technologies and rolling them out. So to give you an idea, we rolled out probably what is one of the world's first consumer subscription AI services in the world. In 2018, we rolled out a subscription service around object detection and computer vision using AI capabilities. And I remember at the time, we called it AI and it actually freaked users out, so we changed the computer vision because AI wasn't even being talked about and people didn't really understand what it is, and it's kind of gone through, I guess, a bell curve where people are getting freaked out about it again.

Coming along.

Yes. That's how long we've been doing this, right? So we created the first object detection. Is it a person? Is it a package? All that almost 8 years ago and have been building on that. The overall road map of where we see AI going in the space is, one, is moving from detection. And now what we do is recognition. So I can see facial recognition, but we also do vehicle recognition. So is that my wife's car in the driveway? Is it an unknown car in the driveway? We started doing custom micro models and all these things in that area. Where it's moving next is interpretation or assessment. So we're -- one of the things you'll see from Arlo Secure 7 is the beginning of what we call threat assessment. And that's not just trying to detect objects in a scene. It's actually looking at the overall event. So do I see a person? What are they holding? What are they wearing? What time of day is it? Are people home? Are people not home? Do I see a person at the front door and the back door at the same time? Are they approaching a window versus the door? So we take all of this information in and the AI interprets a threat level to that event and then can trigger certain responses based on that. Most security systems, actually all security systems today are binary, right? They either do nothing or they call the call center, the police and set off the siren. And so it's either on or off and there's no in between. What threat assessment allows us to do is actually score things on a much more granular level. And so if it's nothing, maybe we don't even give you a notification. Maybe it's something interesting, we give you a normal notification. Maybe it's at night and something looks suspicious and we can give you an escalated notification that punches through any do not disturb. And then if it's really high on the threat level, we can actually dispatch first responders without even contacting you and then letting you know that it's already happening. So it's a much more powerful area. Its interpretation and assessment of what's happening, not just, is there a package at the front door. So I think that's going to open the next maybe 2 to 3 years of innovation in that area. And then you brought up platform, kind of broader platform. The other thesis we're operating under, and you'll see a little bit of this in Arlo Secure 7, but a lot more in Arlo Secure 8, not to get ahead of ourselves. But the smart home and home security is really becoming smart home security. So we see those worlds combining. What's interesting is there's a lot of incremental benefit from the smart home capabilities. For instance, we could develop a lot of those devices and capabilities into our threat assessment. So maybe if somebody does approach your house late at night, it could turn on all the lights or flash the lights or do something to actually deter and it's actually using your smart home to actually become part of your security layer, right? But what's interesting also is almost all of the economics, especially on a recurring revenue model from smart homes are coming from security. So people don't pay for a smart lock on a monthly basis. They don't subscribe to their smart light bulbs. What they do is they subscribe to security. And so the economic comes from the security element of the relationship and the control and the end user. But really, what's happening is it's going to become smart home security combined, and that you'll see start to ratchet up over the next couple of years as well.

The reasoning functionality, that's fascinating. You can think about all of the applications that you could tie to that and personalization involved in that as well. Wow. That's fascinating. And the revenue opportunity here, is it a significant up-step? Or do you think it's just -- it's going to be more of a market share play?

Yes. I think it's both in a way because, again, I think we'll be at the forefront. It will be great for the brand. It will drive people who are interested in the latest capabilities to come to Arlo for that from a marketing perspective. But also, I think you'll see it shift our ARPU higher as we mix people into higher-tiered services, have the opportunity to maybe increase price as that gets into the marketplace. And that will be paired with a new platform launch that we'll do next year from a hardware perspective as well. So a lot of that organic investment, you'll see some of it in Arlo Secure 7 in the next couple of weeks and a big part of it about probably next summer, Q3 of next year, and that's part of our capital allocation plan. I was telling an investor at one of the meetings this morning that we -- it almost felt like we were getting to a plateau of capability in the space when you could pretty much detect any object and be able to recognize people and cars and everything. And I would say over the last 12 months to maybe 18 months, there was a punch through to this more interpretive intelligent reasoning capabilities that have risen to the level that I think we're going to see another 3 to 5 years of intense innovation and ability for us to extract additional value from customers that are getting something real, something beneficial from our subscription services.