Arlo Technologies, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-looking Statements This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, (the “Securities Act”) Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and the Private Securities Litigation Reform Act of 1995. Such statements are based upon current expectations that involve risks and uncertainties. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. For example, the words “believes,” “anticipates,” “plans,” “expects,” “intends,” “could,” “may,” “will,” and similar expressions are intended to identify forward-looking statements, including statements concerning our business and the expected performance characteristics, specifications, reliability, market acceptance, market growth, specific uses, user feedback, market position of our products and technology and the potential adverse impact of the COVID-19 pandemic on our business and operations. Our actual results and the timing of certain events may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a discrepancy include, but are not limited to, those discussed in “Part II—Item 1A—Risk Factors” and “Liquidity and Capital Resources” below. All forward-looking statements in this document are based on information available to us as of the date hereof and we assume no obligation to update any such forward-looking statements. The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and the accompanying notes contained in this quarterly report and the audited financial statements and notes thereto as of and for the year ended December 31, 2019 and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in our Annual Report on Form 10-K, as amended, filed by us with the SEC. Unless expressly stated or the context otherwise requires, the terms “we,” “our,” “us,” “the Company,” and “Arlo” refer to Arlo Technologies, Inc. and our subsidiaries. Business and Executive Overview Arlo combines an intelligent cloud infrastructure and mobile app with a variety of smart connected devices that transform the way people experience the connected lifestyle. Our cloud-based platform provides users with visibility, insight and a powerful means to help protect and connect in real-time with the people and things that matter most, from any location with a Wi-Fi or a cellular connection. Since the launch of our first product in December 2014, we have shipped approximately 18.0 million smart connected devices, and, as of September 27, 2020, our smart platform had approximately 4.8 million cumulative registered accounts across more than 100 countries around the world. We conduct business across three geographic regions-the Americas; Europe, Middle-East and Africa (“EMEA”); and Asia Pacific (“APAC”) and we primarily generate revenue by selling devices through retail, wholesale distribution, wireless carrier channels, security channels, Arlo online store and paid subscription services. International revenue was 33.0% and 23.3% of our revenue for the three months ended September 27, 2020 and September 29, 2019, respectively, and 31.4% and 25.4% of our revenue for the nine months ended September 27, 2020 and September 29, 2019, respectively. For the three months ended September 27, 2020 and September 29, 2019, we generated revenue of $110.2 million and $106.1 million, respectively, representing a year-over-year increase of 3.9%. Loss from operations was $18.0 million for the three months ended September 27, 2020 and $31.1 million for the three months ended September 29, 2019. For the nine months ended September 27, 2020 and September 29, 2019, we generated revenue of $242.3 million and $247.6 million, respectively, representing a year-over-year decline of 2.1%. Loss from operations was $89.2 million for the nine months ended September 27, 2020 and $107.0 million for the nine months ended September 29, 2019. Our goal is to continue to develop innovative, world-class connected lifestyle solutions to expand and further monetize our current and future user and subscriber bases. We believe that the growth of our business is dependent on many factors, including our ability to innovate and launch successful new products on a timely basis and grow our installed base, to increase subscription-based recurring revenue, to invest in brand awareness and channel partnerships and to continue our global expansion. We expect to maintain our investment in research and development going forward as we continue to introduce new and innovative products and services to enhance the Arlo platform. 38 Table of Contents Key Business Metrics In addition to the measures presented in our unaudited condensed consolidated financial statements, we use the following key metrics to evaluate our business, measure our performance, develop financial forecasts and make strategic decisions. In 2019, management’s incentive compensation was partially determined using certain of these key business metrics. We believe these key business metrics provide useful information by offering the ability to make more meaningful period-to-period comparisons of our on-going operating results and a better understanding of how management plans and measures our underlying business. Our key business metrics may be calculated in a manner different from the same key business metrics used by other companies. We regularly review our processes for calculating these metrics, and from time to time we may discover inaccuracies in our metrics or make adjustments to better reflect our business or to improve their accuracy, including adjustments that may result in the recalculation of our historical metrics. We believe that any such inaccuracies or adjustments are immaterial unless otherwise stated. Three Months Ended Nine Months Ended September 27, 2020 % Change September 29, 2019 September 27, 2020 % Change September 29, 2019 (In thousands, except percentage data) Cumulative registered accounts 4,774 29.3 % 3,691 4,774 29.3 % 3,691 Cumulative paid accounts 356 68.7 % 211 356 68.7 % 211 Devices shipped for the period 978 (14.1) % 1,138 2,136 (21.4) % 2,718 Cumulative Registered Accounts . We believe that our ability to increase our user base is an indicator of our market penetration and growth of our business as we continue to expand and innovate our Arlo platform. We define our registered accounts at the end of a particular period as the number of unique registered accounts on the Arlo platform as of the end of such particular period. The number of registered accounts does not necessarily reflect the number of end-users on the Arlo platform, as one registered account may be used by multiple people. We changed our definition from registered users to registered accounts starting in the fourth quarter ended December 31, 2019 due to the Verisure transaction. Verisure will own the registered accounts but we will continue to provide services to these European customers under the Verisure Agreements. Cumulative Paid Accounts. Paid accounts worldwide measured as any account where a subscription to a paid service is being collected (either by Arlo or by Arlo's customers or channel partners), plus paid service plans of a duration of more than 3 months bundled with products (such bundles being counted as a paid account after 90 days have elapsed from the date of registration). In the fourth quarter ended December 31, 2019, we redefined paid subscribers as paid accounts to include customers that were transferred to Verisure as part of the disposal of our commercial operations in Europe, because we will continue to provide services to these European customers and receive payments associated with them, under the Verisure Agreements. Devices Shipped . Devices shipped represents the number of Arlo cameras, lights, and doorbells that are shipped to our customers during a period. Devices shipped does not include shipments of Arlo accessories and Arlo base stations, nor does it take into account returns of Arlo cameras, lights, and doorbells. The growth rate of our revenue is not necessarily correlated with our growth rate of devices shipped, as our revenue is affected by a number of other variables, including but not limited to returns from customers, end-user customer rebates and other channel sales incentives deemed to be a reduction of revenue per the authoritative guidance for revenue recognition, sales of accessories, and premium services, the types of Arlo products sold during the relevant period and the introduction of new product offerings that have different U.S. manufacturer’s suggested retail prices. Impact of COVID-19 On March 11, 2020, the World Health Organization announced that COVID-19, a respiratory illness, caused by a novel coronavirus, is a pandemic. COVID-19 has spread to many of the countries in which we, our customers, our suppliers and our other business partners conduct business. Governments in affected regions have implemented, and may continue to implement, safety precautions which include quarantines, travel restrictions, business closures, cancellations of 39 Table of Contents public gatherings and other measures as they deem necessary. Many organizations and individuals, including the Company and its employees are taking additional steps to avoid or reduce infection, including limiting travel and staying home from work. These measures are disrupting normal business operations both in and outside of affected areas and have had significant negative impacts on businesses and financial markets worldwide. We anticipate that our financial results could be adversely impacted due to: • temporary closure or decrease in foot traffic to our major customers' retail stores and shift of focus to essential goods distribution; • disruption to our supply chain caused by delayed delivery of components from our third-party manufacturers and other suppliers located in regions affected by COVID-19; • deferment of customer spending due to economic uncertainty; • decreased productivity due to travel bans, work-from-home policies or shelter in place orders; and • a slow-down in the global economy or a credit crisis. The onset of the COVID-19 pandemic started to affect our product shipments in the second quarter of 2020 due to our major customers' retail stores facing temporary closures and decrease in foot traffic, certain of our customers shifting focus to essential goods distribution, and other uncertainties caused by the pandemic. The decline in product shipments continued throughout the third quarter of 2020. As of September 27, 2020, our Americas retail channel inventory declined to 8.5 weeks compared to 13.5 weeks as of September 29, 2019 due to disruption to our sales channel. This has contributed to a decline in net revenue in Americas by 11.3% and 9.0%, compared to the three and nine months ended September 29, 2019, respectively. At the same time, we saw a significant increase in freight-in expense of 41.2% and 84.9%, compared to the three and nine months ended September 29, 2019, respectively, as a result of higher airfreight rates. While this is expected to be temporary, the current circumstances are dynamic and the future impacts of COVID-19 on our business operations, including the duration and impact on overall customer demand, cannot be reasonably estimated at this time. Our priorities and actions during the COVID-19 pandemic are focused on protecting the health and safety of all those we serve, our employees, our customers, our suppliers and our communities, including implementing early and continuous updates to our health and safety policies and processes. We have successfully migrated all but a limited number of our global workforce to work remotely while local and state governments have imposed shelter-in-place orders in the United States and around the world. We are focused on providing our team with the resources that they need to meet the needs of our customers and deliver new innovations to the markets we serve, despite challenges introduced by the COVID-19 pandemic. We continue to work with our suppliers to address any supply chain disruptions, which might include larger component backlogs, travel restrictions and logistics changes that can impact our operations. As a result, we could experience material charges from potential adjustments of the carrying value of our inventories and trade receivables, impairment charges on our long-lived assets, intangible assets and goodwill, and changes in the effectiveness of the Company’s hedging instruments, among others. We also anticipate that COVID-19 could continue to reduce our revenues and increase product and service costs and operating expenses for the remainder of fiscal 2020. We are focused on navigating these recent challenges presented by COVID-19 through preserving our liquidity and managing our cash flow through taking preemptive action to enhance our ability to meet our short-term liquidity needs. These actions include, but are not limited to, proactively managing working capital by closely monitoring customers' credit and collections, renegotiating payment terms with third-party manufacturers and key suppliers, closely monitoring inventory levels and purchases against forecasted demand, reducing or eliminating non-essential spending, and deferment of salary increases and hiring. We continue to monitor this rapidly developing situation and may, as necessary, reduce expenditures further, borrow under our revolving credit facility, or pursue other sources of capital that may include other forms of external financing in order to maintain our cash position and preserve financial flexibility in response to the uncertainty in the United States and global markets resulting from the COVID-19 pandemic. 40 Table of Contents Results of Operations We operate as one operating and reportable segment. The following table sets forth, for the periods presented, the unaudited condensed consolidated statements of operations data, which we derived from the accompanying unaudited condensed consolidated financial statements: Three Months Ended Nine Months Ended September 27, 2020 September 29, 2019 September 27, 2020 September 29, 2019 (In thousands, except percentage data) Revenue: Products $ 91,271 82.8 % $ 94,306 88.9 % $ 191,597 79.1 % $ 213,359 86.2 % Services 18,965 17.2 % 11,810 11.1 % 50,721 20.9 % 34,235 13.8 % Total revenue 110,236 100.0 % 106,116 100.0 % 242,318 100.0 % 247,594 100.0 % Cost of revenue: Products 79,107 71.9 % 88,755 83.6 % 182,481 75.3 % 206,878 83.6 % Services 9,720 8.8 % 6,858 6.5 % 28,986 12.0 % 18,618 7.5 % Total cost of revenue 88,827 80.6 % 95,613 90.1 % 211,467 87.3 % 225,496 91.1 % Gross profit 21,409 19.4 % 10,503 9.9 % 30,851 12.7 % 22,098 8.9 % Operating expenses: Research and development 15,436 14.0 % 16,701 15.7 % 44,871 18.5 % 52,456 21.2 % Sales and marketing 12,720 11.5 % 13,657 12.9 % 35,471 14.6 % 42,389 17.1 % General and administrative 11,137 10.1 % 11,062 10.4 % 39,758 16.4 % 32,512 13.1 % Separation expense 77 0.1 % 137 0.1 % 238 0.1 % 1,760 0.7 % Gain on sale of business — — — — (292) — % — — Total operating expenses 39,370 35.7 % 41,557 39.2 % 120,046 49.5 % 129,117 52.1 % Loss from operations (17,961) (16.3) % (31,054) (29.3) % (89,195) (36.8) % (107,019) (43.2) % Interest income 74 0.1 % 596 0.6 % 760 0.3 % 2,170 0.9 % Other income (expense), net 543 0.5 % 154 0.1 % 2,837 1.3 % 138 0.1 % Loss before income taxes (17,344) (15.7) % (30,304) (28.6) % (85,598) (35.3) % (104,711) (42.3) % Provision for income taxes 115 0.1 % 286 0.3 % 443 0.2 % 855 0.2 % Net loss $ (17,459) (15.8) % $ (30,590) (28.8) % $ (86,041) (35.5) % $ (105,566) (42.6) % Revenue Our gross revenue consists primarily of sales of devices, prepaid and paid subscription service revenue and NRE service revenue from Verisure. We generally recognize revenue from product sales at the time the product is shipped and transfer of control from us to the customer occurs. Our prepaid services primarily pertain to devices which are sold with our Arlo prepaid services offering, providing users with the ability to store and access data for up to five cameras for a rolling seven-day period. Prepaid services also include one year of Arlo Smart bundled with our Arlo Ultra products launched in early 2019, and three-month free subscription for Arlo Smart services for our Arlo Pro 3 products launched in late September 2019, Arlo Video Doorbell launched in late November 2019, Arlo Floodlight camera launched in May 2020, Arlo Essential Spotlight camera launched in late June 2020, and the latest version of Arlo Ultra which started shipping in June 2020. Upon device shipment, we attribute a portion of the sales price to the prepaid service, deferring this revenue at the outset and subsequently recognizing it ratably over the estimated useful life of the device or free trial period, as applicable. Our paid subscription services relate to sales of subscription plans to our registered accounts. Our NRE service revenue relates to the development services under the NRE arrangement with Verisure discussed in Note 4. Our revenue consists of gross revenue, less end-user customer rebates and other channel sales incentives deemed to be a reduction of revenue per the authoritative guidance for revenue recognition, allowances for estimated sales returns, price protection, and net changes in deferred revenue. A significant portion of our marketing expenditure is with customers and is deemed to be a reduction of revenue under authoritative guidance for revenue recognition. 41 Table of Contents Under the Supply Agreement, Verisure became the exclusive distributor of our products in Europe for all channels, and will non-exclusively distribute our products through its direct channels globally. We expect that our revenue and profitability in Europe will improve over the lifetime of the Supply Agreement. Refer to Note 4, Disposal of business , in Notes to Unaudited Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q for a complete discussion of the Supply Agreement. We conduct business across three geographic regions: Americas, EMEA, and APAC. We generally base revenue by geography on the ship-to location of the customer for device sales and device location for service sales. Three Months Ended Nine Months Ended September 27, 2020 % Change September 29, 2019 September 27, 2020 % Change September 29, 2019 (In thousands, except percentage data) Americas $ 75,861 (11.3) % $ 85,562 $ 176,990 (9.0) % $ 194,492 Percentage of revenue 68.8 % 80.6 % 73.0 % 78.6 % EMEA 28,010 115.4 % 13,002 46,846 25.4 % 37,370 Percentage of revenue 25.4 % 12.3 % 19.3 % 15.1 % APAC 6,365 (15.7) % 7,552 18,482 17.5 % 15,732 Percentage of revenue 5.8 % 7.1 % 7.6 % 6.4 % Total revenue $ 110,236 3.9 % $ 106,116 $ 242,318 (2.1) % $ 247,594 Revenue for the three months ended September 27, 2020 increased 3.9%, compared to the prior year period. The increase was primarily driven by higher service revenue and less provisions for sales returns and marketing expenditures that are deemed to be a reduction of revenue, partially offset by a decrease in product shipments as a result of disruption to our sales channels due to the COVID-19 pandemic. Revenue for the nine months ended September 27, 2020 decreased 2.1%, compared to the prior year period. The decrease was primarily driven by a decrease in product shipments as a result of disruption to our sales channels due to the COVID-19 pandemic, partially offset by an increase in service revenue and less provisions for sales returns and marketing expenditures that are deemed to be a reduction of revenue. Service revenue increased by $7.2 million, or 60.6%, and $16.5 million, or 48.2%, for the three and nine months ended September 27, 2020 compared to the prior year periods, respectively, due to increased paid accounts compared to the prior year periods and recognition of NRE and other incremental service revenue of $3.2 million and $8.1 million from Verisure in three and nine months ended September 27, 2020, respectively. Cost of Revenue Cost of revenue consists of both product costs and costs of service. Product costs primarily consist of: the cost of finished products from our third-party manufacturers; overhead costs, including purchasing, product planning, inventory control, warehousing and distribution logistics, third-party software licensing fees, inbound freight, warranty costs associated with returned goods, write-downs for excess and obsolete inventory, royalties to third parties; and amortization expense of certain acquired intangibles. Cost of service consists of costs attributable to the provision and maintenance of our cloud-based platform, including personnel, storage, security and computing, as well as NRE service costs incurred under the Verisure NRE arrangement. Our cost of revenue as a percentage of revenue can vary based upon a number of factors, including those that may affect our revenue set forth above and factors that may affect our cost of revenue, including, without limitation: product mix, sales channel mix, registered accounts' acceptance of paid subscription service offerings, fluctuation in foreign exchange rates and changes in our cost of goods sold due to fluctuations in prices paid for components, net of vendor rebates, cloud platform costs, warranty and overhead costs, inbound freight and duty product conversion costs, charges for excess or obsolete inventory, and amortization of acquired intangibles. We outsource our manufacturing, warehousing, and distribution logistics. We also outsource certain components of the required infrastructure to support our 42 Table of Contents cloud-based back-end IT infrastructure. We believe this outsourcing strategy allows us to better manage our product and services costs and gross margin. The following table presents cost of revenue and gross margin for the periods indicated: Three Months Ended Nine Months Ended September 27, 2020 % Change September 29, 2019 September 27, 2020 % Change September 29, 2019 (In thousands, except percentage data) Cost of revenue: Products $ 79,107 (10.9) % $ 88,755 $ 182,481 (11.8) % $ 206,878 Services 9,720 41.7 % 6,858 28,986 55.7 % 18,618 Total cost of revenue $ 88,827 (7.1) % $ 95,613 $ 211,467 (6.2) % $ 225,496 Cost of revenue decreased for the three and nine months ended September 27, 2020, primarily due to the decrease in product revenue and overhead costs, partially offset by higher service costs and excess and obsolete inventory provision compared to the prior year periods. The increase in service costs is in line with the service revenue growth and due to our continued investment in our cloud service offerings to improve our customer experience and to enhance our security profile, as well as Verisure NRE service costs. The increase in excess and obsolete inventory provision reflects lower expected future demand for certain older product lines for the nine months ended September 27, 2020 as we transition to newer technologies. 43 Table of Contents Gross Margin The following table presents gross margin for the periods indicated: Three Months Ended Nine Months Ended September 27, 2020 September 29, 2019 September 27, 2020 September 29, 2019 (In thousands, except percentage data) Gross profit: Products $ 12,164 $ 5,551 $ 9,116 $ 6,481 Services 9,245 4,952 21,735 15,617 Total gross profit $ 21,409 $ 10,503 $ 30,851 $ 22,098 Gross profit percentage: Products 13.3 % 5.9 % 4.8 % 3.0 % Services 48.7 % 41.9 % 42.9 % 45.6 % Total gross profit percentage 19.4 % 9.9 % 12.7 % 8.9 % Product margin increased for the three and nine months ended September 27, 2020, compared to the prior year periods, primarily due to a decrease in provisions for sales returns and marketing expenditures that are deemed to be a reduction of revenue, partially offset by higher excess and obsolete inventory provision. Service margin increased for the three months ended September 27, 2020, compared to the prior year period, primarily due to an increase in paid service revenue and cost optimizations implemented. Service margin decreased for the nine months ended September 27, 2020, compared to the prior year period, primarily due to higher investment in our cloud service offerings and lower gross margin on the NRE service revenue associated with the Verisure NRE arrangement. Operating Expenses Research and Development Research and development expense consists primarily of personnel-related expense, safety, security, regulatory services and testing, other research and development consulting fees, and corporate IT and facilities overhead. We recognize research and development expense as it is incurred. We have invested in and expanded our research and development organization to enhance our ability to introduce innovative products and services. We believe that innovation and technological leadership are critical to our future success, and we are committed to continuing a significant level of research and development to develop new technologies, products, and services, including our hardware devices, cloud-based software, AI-based algorithms, and machine learning capabilities. We expect research and development expense to stay relatively flat in absolute dollars for the remainder of fiscal 2020 as we manage our expenses while continuing to develop new product and service offerings to support the connected lifestyle market. The following table presents research and development expense for the periods indicated: Three Months Ended Nine Months Ended September 27, 2020 % Change September 29, 2019 September 27, 2020 % Change September 29, 2019 (In thousands, except percentage data) Research and development expense $ 15,436 (7.6) % $ 16,701 $ 44,871 (14.5) % $ 52,456 Research and development expense decreased for the three months ended September 27, 2020, compared to the prior year period, due to decreases of $1.2 million in corporate IT and facility overhead, partially offset by increases of $0.6 million in personnel-related expenditures and $0.6 million in expenses related to outside professional services. Also, certain research and development expenses amounting to $1.2 million were attributed to the Verisure NRE arrangement in fiscal 2020, and are classified as cost of service revenue. Research and development expense decreased for the nine months ended September 27, 2020, compared to the prior year period, due to decreases of $2.4 million in personnel-related expenses primarily due to the reduction in force implemented in the last quarter of 2019, and $3.2 million in corporate IT 44 Table of Contents and facility overhead, partially offset by increase of $1.3 million in expenses related to outside professional services. Also, contributing to the reduction in Research and development expense, various research and development expenses amounting to $3.1 million were attributed to the Verisure NRE arrangement, and are classified as cost of service revenue in fiscal 2020. Sales and Marketing Sales and marketing expense consists primarily of personnel expense for sales and marketing staff; technical support expense; advertising; trade shows; corporate communications and other marketing expense; product marketing expense; IT and facilities overhead; and outbound freight costs. We expect our sales and marketing expense to fluctuate for the foreseeable future based on the seasonality of our business, the growth of our online store, and the extent to which we invest in marketing to drive awareness of our brand and drive demand for our products. The following table presents sales and marketing expense for the periods indicated: Three Months Ended Nine Months Ended September 27, 2020 % Change September 29, 2019 September 27, 2020 % Change September 29, 2019 (In thousands, except percentage data) Sales and marketing expense $ 12,720 (6.9) % $ 13,657 $ 35,471 (16.3) % $ 42,389 Sales and marketing expense decreased for the three months ended September 27, 2020, compared to the prior year period, primarily due to decreases in personnel-related expenses of $1.1 million as a result of a general reduction of headcount within sales and marketing as well as the transfer of our European sales and marketing on December 30, 2019 to Verisure coupled with a reduction in travel related expenses as a result of COVID-19 restrictions. Sales and marketing expense decreased for the nine months ended September 27, 2020, compared to the prior year period, primarily due to decreases in personnel-related expenses of $4.3 million, marketing expenditures of $1.4 million and corporate IT and facility overhead of $1.2 million as a result of a general reduction of headcount within sales and marketing as well as the transfer of our European sales and marketing on December 30, 2019 to Verisure coupled with a reduction in travel related expense as a result of COVID-19 restrictions. General and Administrative General and administrative expense consists primarily of personnel-related expense for certain executives, finance and accounting, investor relations, human resources, legal, information technology, professional fees, corporate IT and facilities overhead, strategic initiative expense, and other general corporate expense. We expect our general and administrative expense to stay relatively flat in absolute dollars. However, we also expect our general and administrative expense to fluctuate as a percentage of our revenue in future periods based on fluctuations in our revenue and the timing of such expense. The following table presents general and administrative expense for the periods indicated: Three Months Ended Nine Months Ended September 27, 2020 % Change September 29, 2019 September 27, 2020 % Change September 29, 2019 (In thousands, except percentage data) General and administrative expense $ 11,137 0.7 % $ 11,062 $ 39,758 22.3 % $ 32,512 General and administrative expense increased for the three months ended September 27, 2020, compared to the prior year period, primarily due to higher personnel-related expenditures of $1.3 million, partially offset by lower costs of $0.9 million in legal and professional services. General and administrative expense increased for the nine months ended September 27, 2020, compared to the prior year period, primarily due to higher personnel-related expenditures of $7.5 million, as a result of the $7.4 million stock-based compensation expense recognized for the voluntary forfeiture of our CEO's IPO Options in January 2020, partially offset by the reversal of the previously recognized stock-based compensation expense amounting to $1.2 million of unvested IPO Options and RSU upon separation of Ms. Gorjanc in June 2020, and 45 Table of Contents $0.8 million of Verisure transaction costs recognized in 2020, partially offset by lower costs of $0.8 million in legal and professional services. Separation Expense Separation expense consists primarily of costs associated with our separation from NETGEAR, including third-party advisory, consulting, legal and professional services for separation matters including IPO-related litigation, IT-related expenses directly related to our separation from NETGEAR, and other items that are incremental and one-time in nature. To operate as a standalone company, we have incurred separation costs. The significant reduction during the three and nine months ended September 27, 2020 was as a result of the substantial completion of our Separation from NETGEAR effective December 31, 2018. The following table presents separation expense for the periods indicated: Three Months Ended Nine Months Ended September 27, 2020 % Change September 29, 2019 September 27, 2020 % Change September 29, 2019 (In thousands, except percentage data) Separation expense $ 77 (43.8) % $ 137 $ 238 (86.5) % $ 1,760 Gain on sale of business The following table presents gain on sale of business for the periods indicated: Three Months Ended Nine Months Ended September 27, 2020 % Change September 29, 2019 September 27, 2020 % Change September 29, 2019 (In thousands, except percentage data) Gain on sale of business $ — ** $ — $ (292) ** $ — **Percentage change not meaningful In the fourth quarter of 2019, we sold our commercial operations in Europe which resulted in a gain on sale of business. In the first quarter of 2020, we recognized an additional gain of $292 thousand as a result of the final working capital adjustment. There was no gain or loss for the three months ended September 27, 2020 and the three and nine months ended September 29, 2019. Refer to Note 4, Disposal of business , in Notes to Unaudited Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q for a complete discussion of this disposal. Interest Income and Other Income (Expense), Net The following table presents other income (expense), net for the periods indicated: Three Months Ended Nine Months Ended September 27, 2020 % Change September 29, 2019 September 27, 2020 % Change September 29, 2019 (In thousands, except percentage data) Interest income $ 74 ** $ 596 $ 760 ** $ 2,170 Other income (expense), net $ 543 ** $ 154 $ 2,837 ** $ 138 **Percentage change not meaningful. Our interest income was primarily earned from our short-term investments and cash and cash equivalents. We expect our interest income in absolute dollars to decrease as we use up our short-term investments and cash and cash equivalents to fund our operations, while interest rates have also declined. Other income (expense), net, increased for the three months ended September 27, 2020, compared to the prior year period primarily due to Verisure TSA income of $0.9 million recognized in 2020, partially offset by a decrease of $0.4 million in fair value remeasurement of liability-classified awards for employees transferred to Verisure in December 2019 and a decrease of $0.2 million due to losses in foreign currency hedging contracts. Other income (expense), net, increased 46 Table of Contents for the nine months ended September 27, 2020, compared to the prior year period primarily due to Verisure TSA income of $3.0 million recognized in 2020. Provision for Income Taxes Three Months Ended Nine Months Ended September 27, 2020 % Change September 29, 2019 September 27, 2020 % Change September 29, 2019 (In thousands, except percentage data) Provision for income taxes $ 115 (59.8) % $ 286 $ 443 (48.2) % $ 855 Effective tax rate (0.7) % (0.9) % (0.5) % (0.8) % The Company’s provision for income taxes was primarily attributable to income taxes on foreign earnings. The decrease in provision for income taxes for the three and nine months ended September 27, 2020, compared to the prior year periods was primarily due to lower foreign earnings in 2020. Losses incurred predominantly in the U.S. continue to be subject to a full valuation allowance. On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act was enacted by the United States. The CARES Act did not have a material impact on the Company's provision for income taxes for the three and nine months ended September 27, 2020. Liquidity and Capital Resources We have a history of losses and may continue to incur operating and net losses for the foreseeable future. As of September 27, 2020, our accumulated deficit was $217.6 million. Our principal sources of liquidity are cash, cash equivalents and short-term investments. Short-term investments are marketable government securities with an original maturity or a remaining maturity at the time of purchase of greater than three months and no more than 12 months. The marketable securities are held in our company’s name with a high quality financial institution, which acts as our custodian and investment manager. As of September 27, 2020, we had cash, cash equivalents and short-term investments totaling $193.6 million. 6.3% of our cash and cash equivalents were held outside of the U.S. Starting in 2018, as a result of legislation enacted in 2017, informally titled the Tax Cuts and Jobs Act (the “Tax Act”), due to the one-time transition tax on un-repatriated earnings, the tax impact would generally be immaterial should we repatriate our cash from foreign earnings. The cash and cash equivalents balance outside of the U.S. is subject to fluctuation based on the settlement of intercompany balances. In November 2019, we entered into a business financing agreement with Western Alliance Bank providing for a credit facility to up to $40.0 million and as of September 27, 2020, we have not borrowed against this credit facility. Refer to Note 9. Debt in the Notes to Unaudited Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q for further details on such business financing agreement. Based on our current plans, the business financing agreement with Western Alliance Bank, and market conditions, we believe that such sources of liquidity will be sufficient to satisfy our anticipated cash requirements for at least the next 12 months. However, in the future we may require or desire additional funds to support our operating expenses and capital requirements or for other purposes, such as acquisitions, and may seek to raise such additional funds through public or private equity or debt financings or collaborative agreements or from other sources. However, the COVID-19 pandemic continues to rapidly evolve and has already resulted in a significant disruption of global financial markets. If the disruption persists and deepens, we could experience an inability to access additional capital, which could in the future negatively affect our capacity to support our operating expenses and capital requirements or to make investments for other purposes, such as acquisitions. In addition, to preserve the tax-free treatment of our separation from NETGEAR, we have agreed in the tax matters agreement with NETGEAR to certain restrictions on our business, which generally will be effective during the two-year period following the special stock dividend (the “Distribution”) by NETGEAR to NETGEAR stockholders of the 62,500,000 shares of Arlo common stock owned by NETGEAR that occurred on December 31, 2018, that could limit our ability to pursue certain transactions including equity issuances. 47 Table of Contents We have no commitments to obtain such additional financing and cannot assure you that additional financing will be available at all or, if available, that such financing would be obtainable on terms favorable to us and would not be dilutive. Our future liquidity and cash requirements will depend on numerous factors, including the introduction of new products, potential acquisitions of related businesses or technology. The following table presents our cash flows for the periods presented: Nine Months Ended September 27, 2020 September 29, 2019 (In thousands) Net cash used in operating activities $ (59,317) $ (42,715) Net cash used in investing activities (2,155) 5,209 Net cash used in financing activities (1,581) 82 Net cash decrease $ (63,053) $ (37,424) Operating activities Net cash used in operating activities increased by $16.6 million for the nine months ended September 27, 2020 compared to the prior year period. This increase comprised $35.8 million improvement in net cash used in operating activities excluding changes in working capital, primarily due to a reduction in net loss, offset by an increase in cash used in working capital of $52.4 million, mainly as a result of a reduction in inventory in 2019 which has not been repeated in 2020. Our days sales outstanding (“DSO”) decreased to 47 days as of September 27, 2020 compared to 97 days as of December 31, 2019, primarily as a result of customer mix, an increase in service revenue and growth in Arlo online store sales, all of which have shorter payment terms. Typically, our DSO in the fourth quarter is higher due to seasonal payment terms provided to our larger customers, while service revenue is typically a lower percentage of our revenue in the fourth quarter. Inventory increased marginally to $69.0 million as of September 27, 2020 from $68.6 million as of December 31, 2019, primarily due to higher inventory purchases, partially offset by lower on-hand inventory balance. Our ending inventory turns were 4.6x in the three months ended September 27, 2020 down from 5.9x turns in the three months ended December 31, 2019, primarily as a result of the normal seasonal reduction in our business, accentuated by the impact of COVID-19. Our accounts payable decreased to $74.7 million as of September 27, 2020 from $111.7 million as of December 31, 2019, primarily as a result of payments to suppliers for the purchases made in the fourth quarter of 2019 and the normal seasonality of our business. Investing activities Net cash used in investing activities increased by $7.4 million for the nine months ended September 27, 2020 compared to the prior year period, primarily due to higher short-term investments of $10.3 million, partially offset by less purchases of property and equipment of $3.0 million due to the completion of leasehold improvements in 2019 at our San Jose headquarters. Financing activities Net cash used in financing activities of $1.6 million and $0.1 million in the nine months ended September 27, 2020 and September 29, 2019, respectively, represented withholding tax from restricted stock unit releases, offset by proceeds from ESPP contributions. Contractual Obligations Our principal commitments consist of obligations under operating leases for office space, equipment, data center facilities and distribution center facilities, as well as non-cancellable purchase commitments. Refer to Note 10. 48 Table of Contents Commitments and Contingencies, in Notes to Unaudited Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q for a complete discussion of our contractual obligations. Off-Balance Sheet Arrangements As of September 27, 2020, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC Regulation S-K. Critical Accounting Policies and Estimates For a complete description of what we believe to be the critical accounting policies and estimates used in the preparation of our Unaudited Condensed Consolidated Financial Statements, refer to our Annual Report on Form 10-K for the year ended December 31, 2019. There have been no material changes to our critical accounting policies and estimates during the nine months ended September 27, 2020, other than as discussed in Note 2. Significant Accounting Policies and Recent Accounting Pronouncements, in the Notes to Unaudited Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q, Recent Accounting Pronouncements For a complete description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on financial condition and results of operations, refer to Note 2, Summary of Significant Accounting Policies and Recent Accounting Pronouncements , in Notes to Unaudited Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q. 49 Table of Contents Item 3. Quantitative and Qualitative Disclosures About Market Risk During the nine months ended September 27, 2020, there were no material changes to our market risk disclosures as set forth in Part II Item 7A "Quantitative and Qualitative Disclosures About Market Risk" in our Annual Report on Form 10-K for the year ended December 31, 2019.