Arlo Technologies, Inc. 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion of our financial condition and results of operations together with the audited consolidated financial statements and notes to the financial statements included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those discussed under “Risk Factors” in Part I, Item 1A above. Business and Executive Overview Arlo combines an intelligent cloud infrastructure and mobile app with a variety of smart connected devices that is transforming the way people experience the connected lifestyle. Arlo’s deep expertise in product design, wireless connectivity, cloud infrastructure and cutting-edge AI capabilities focuses on delivering a seamless, smart home experience for Arlo users that is easy to setup and interact with every day. 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 over 19.2 million smart connected devices, and as of December 31, 2020, our smart platform had approximately 5.0 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 solution providers, Arlo's direct to consumer store and paid subscription services. International revenue was 28.4%, 26.6% and 22.6% of our revenue for the years ended December 31, 2020, 2019 and 2018, respectively. For the years ended December 31, 2020, 2019 and 2018, we generated revenue of $357.2 million, $370.0 million and $464.9 million, respectively. Loss from operations was $104.9 million, $85.2 million, $74.8 million for the years ended December 31, 2020, 2019 and 2018, respectively. Income (loss) from operations for the years ended December 31, 2020, 2019 and 2018 included separation expense of $0.2 million, $1.9 million and $27.3 million, respectively. Income (loss) from operations for the years ended December 31, 2020 and 2019 included gain on sale of business of $0.3 million and $54.9 million, respectively. 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. Key Business Metrics In addition to the measures presented in our 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, 54 Table of Contents 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. Year Ended As of and for the Year Ended December 31, 2020 % Change 2019 % Change 2018 (In thousands, except percentage data) Cumulative registered accounts 5,047 25.7 % 4,015 40.9 % 2,850 Cumulative paid accounts 435 89.1 % 230 59.7 % 144 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 of 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 the Company or by the Company’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 of 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. 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 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 decreases 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 fourth quarter of 2020. As of December 31, 2020, Americas retail channel inventory 55 Table of Contents declined compared to December 31, 2019 due to lower inventory holding by our Retail Channel customers during the pandemic. This has contributed to a 6.8% decline in net revenue in the Americas, compared to the prior year. In addition, international freight capacity has dropped, causing air and ocean freight rates to materially increase. Furthermore, transit times have also increased. For the year ended December 31, 2020, we saw a 56% increase in freight-in expense compared to the prior year, as a result of the higher sea and 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 their 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. For example, increased demand for electronics as a result of the COVID-19 pandemic, effects of the U.S. trade war with China, increased demand for chips in the automotive industry and certain other factors have led to a global shortage of semiconductors. Due to such shortage, starting in the fourth quarter of 2020 we started to experience component shortages, including longer lead times for components, and supply constraints, which we expect to continue into 2021. Such shortages and constraints are affecting our ability to meet scheduled product deliveries and worldwide demand for our products in the first quarter of 2021 and potentially beyond. 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 fiscal year 2021. 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 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. Comparability of Historical Results Through July 1, 2018, the operating results of Arlo had historically been disclosed as a reportable segment within the consolidated financial statements of NETGEAR, enabling the identification of directly attributable transactional information, functional departments, and headcount. Revenue and Cost of revenue, with the exception of channel sales incentives, were derived from transactional information specific to Arlo products and services. Directly attributable operating expenses were derived from activities relating to Arlo functional departments and headcount. Arlo employees also historically participated in NETGEAR’s stock-based incentive plans, in the form of restricted stock units (“RSUs”), stock options, and purchase rights issued pursuant to NETGEAR’s employee stock purchase plan. Stock-based compensation expense has been either directly reported by or allocated to Arlo based on the awards and terms previously granted to NETGEAR’s employees. The consolidated statements of operations of the Company as presented for the year ended 2018 reflect the directly attributable transactional information specific to Arlo and certain additional allocated costs through July 1, 2018. The allocated costs for corporate functions included, but were not limited to, allocations of general corporate expenses 56 Table of Contents from NETGEAR including expenses related to corporate services, such as executive management, information technology, legal, finance and accounting, human resources, tax, treasury, research and development, sales and marketing, shared facilities and other shared services. These costs were allocated based on revenue, headcount, or other measures the Company has determined as reasonable. Following July 1, 2018, the consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The amount of these allocations from NETGEAR reflected within operating expenses in the consolidated statements of operations was $30.6 million from January 1, 2018 to the date of the completion of the IPO, which included $9.4 million for research and development, $10.0 million for sales and marketing, and $11.2 million for general and administrative expense. The management of Arlo believes the assumptions underlying the consolidated financial statements, including the assumptions regarding the allocated expenses, reasonably reflect the utilization of services provided, or the benefit received by Arlo during the periods presented. Nevertheless, the consolidated financial statements may not be indicative of Arlo’s future performance and do not necessarily reflect Arlo’s results of operations, financial position, and cash flows had Arlo been a standalone company during the period presented. Components of Our Operating Results 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 First generation camera products under our old business model come with a prepaid service that provides users with rolling seven-day cloud video storage, the ability to connect up to five cameras and 90 days of customer support. Our second generation camera, doorbell and floodlight products under our new business model come with a prepaid service that includes a one-year free trial period of Arlo Smart bundled with our Arlo Ultra products launched in early 2019, and a three-month free trial period of Arlo Smart bundled with our products launched after September 2019. 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 services also include certain development services provided to Verisure under a NRE arrangement as part of the disposal of our commercial operations in Europe in the fourth quarter of 2019. Refer to Note 4, Disposal of Business, in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for a complete discussion of the NRE arrangement. 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. 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 the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for a complete discussion of the Supply Agreement. 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, IT and facilities overhead, warranty costs associated with returned goods, write-downs for excess and obsolete inventory, royalties to third 57 Table of Contents 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 cloud-based back-end IT infrastructure. We believe this outsourcing strategy allows us to better manage our product and services costs and gross margin. 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 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 fiscal 2021 as we manage our expenses while continuing to develop new product and service offerings to support the connected lifestyle market. 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 direct to consumer store, and the extent to which we invest in marketing to drive awareness of our brand and drive demand for our products. 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, 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. 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 of $0.2 million, $1.9 million and $27.3 million during the years ended December 31, 2020, 2019 and 2018, respectively, to replicate certain services previously provided by NETGEAR. The significant reduction during the years ended December 31, 2020 and 2019 was as a result of the substantial completion of our Separation from NETGEAR on December 31, 2018. 58 Table of Contents Gain on sale of business Gain on sale of business represents the gain on sale of the Company's commercial operations in Europe in the fourth quarter of 2019. Interest Income Interest income represents interest earned on our cash, cash equivalents and short-term investments. 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 Other income (expense), net primarily represents gains and losses on transactions denominated in foreign currencies, foreign currency contract gain (loss), net, and other miscellaneous income and expense. We have also included any reimbursement for the Verisure TSA in Other income. Income Taxes We record our provision for income taxes in our consolidated financial statements using the asset and liability method. Under this method, we recognize income tax liabilities or receivable for the current year. We also recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities, as well as for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using the tax rates that are expected to apply to taxable income for the years in which those tax assets and liabilities are expected to be realized or settled. We record a valuation allowance to reduce our deferred tax assets to the net amount that we believe is more likely than not to be realized. Our assessment considers the recognition of deferred tax assets on a jurisdictional basis. Accordingly, in assessing our future taxable income on a jurisdictional basis, we consider the effect of its transfer pricing policies on that income. We have placed a valuation allowance against U.S. federal and state deferred tax assets and certain foreign tax attribute carryforwards since we do not anticipate to realize the benefits of deferred tax assets. We recognize tax benefits from uncertain tax positions only if we believe that it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. As we expand internationally, we will face increased complexity in determining the appropriate tax jurisdictions for revenue and expense items. Our policy is to adjust these unrecognized tax benefits in the period when facts and circumstances change, such as the closing of a tax audit, the expiration of statute of limitation for a relevant taxing authority to examine a tax position, or when additional information becomes available. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made and could have a material impact on our financial condition and operating results. The provision for income taxes includes the effects of any accruals that we believe are appropriate, as well as the related interest and penalties. The Tax Cut and Jobs Act of 2017 ("Tax Act") introduced the global intangible low-taxed income (“GILTI”) provisions effective in 2018, which generally impose a tax on the net income earned by foreign subsidiaries of U.S company in excess of a deemed return on their tangible assets. We recognize the tax on GILTI as a period cost when the tax is incurred. 59 Table of Contents Results of Operations We operate as one operating and reportable segment. The following table sets forth, for the periods presented, the consolidated statements of operations data, which we derived from the accompanying consolidated financial statements: Year Ended December 31, 2020 2019 2018 (In thousands, except percentage data) Revenue: Products $ 284,868 79.8 % $ 323,242 87.4 % $ 427,113 91.9 % Services 72,286 20.2 % 46,765 12.6 % 37,805 8.1 % Total revenue 357,154 100.0 % 370,007 100.0 % 464,918 100.0 % Cost of revenue: Products 263,905 73.9 % 307,348 83.1 % 354,023 76.1 % Services 37,860 10.6 % 26,855 7.3 % 18,820 4.0 % Total cost of revenue 301,765 84.5 % 334,203 90.3 % 372,843 80.2 % Gross profit 55,389 15.5 % 35,804 9.7 % 92,075 19.8 % Operating expenses: Research and development 60,137 16.8 % 69,384 18.8 % 58,794 12.6 % Sales and marketing 49,064 13.7 % 56,985 15.4 % 52,593 11.3 % General and administrative 51,096 14.3 % 47,624 12.9 % 28,209 6.1 % Separation expense 248 0.1 % 1,913 0.5 % 27,252 5.9 % Gain on sale of business (292) (0.1) % (54,881) (14.8) % — — % Total operating expenses 160,253 44.9 % 121,025 32.7 % 166,848 35.9 % Loss from operations (104,864) (29.4) % (85,221) (23.0) % (74,773) (16.1) % Interest income 802 0.2 % 2,737 0.7 % 1,239 0.3 % Other income (expense), net 3,436 1.1 % 913 0.2 % (1,177) (0.3) % Loss before income taxes (100,626) (28.1) % (81,571) (22.0) % (74,711) (16.1) % Provision for income taxes 625 0.2 % 4,380 1.2 % 772 0.1 % Net loss $ (101,251) (28.3) % $ (85,951) (23.2) % $ (75,483) (16.2) % Revenue 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. Year Ended December 31, 2020 % Change 2019 % Change 2018 (In thousands, except percentage data) Americas $ 269,395 (6.8) % $ 289,160 (23.3) % $ 376,805 Percentage of revenue 75.4 % 78.1 % 81.0 % EMEA $ 61,832 8.0 % $ 57,232 (12.6) % $ 65,462 Percentage of revenue 17.3 % 15.5 % 14.1 % APAC $ 25,927 9.8 % $ 23,615 4.3 % $ 22,651 Percentage of revenue 7.3 % 6.4 % 4.9 % Total revenue $ 357,154 (3.5) % $ 370,007 (20.4) % $ 464,918 60 Table of Contents Revenue decreased 3.5% across all geographic regions for the year ended December 31, 2020 compared to the prior year. 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 and a slowdown in our customer demand for connected cameras, partially offset by an increase in service revenue and less provisions for sales returns, price protection and marketing expenditures that are deemed to be a reduction of revenue. Service revenue increased by $25.5 million, or 54.6%, for the year ended December 31, 2020 compared to the prior year, due to increased paid accounts and recognition of NRE and other incremental service revenue from Verisure in the fiscal year 2020. Revenue decreased 20.4% across all geographic regions for the year ended December 31, 2019 compared to the prior year. The decrease was primarily driven by a slowdown in our customer demand for connected cameras, increased competition, higher marketing expenditures deemed to be a reduction of revenues, increased provisions for price protection that are deemed to be a reduction of revenue, offset by higher service revenue. We launched Arlo Ultra, with 4K video resolution capability, in the first fiscal quarter of 2019, Arlo Pro 3, with 2K video resolution capability, in the third fiscal quarter of 2019 and Arlo Video Doorbell with 180 degree viewing angle, in the fourth quarter of 2019. Service revenue increased by $9.0 million, or 23.7%, for the year ended December 31, 2019 compared to the prior year, as our paid subscribers increased compared to the prior year. Cost of Revenue The following table presents cost of revenue for the periods indicated: Year Ended December 31, 2020 % Change 2019 % Change 2018 (In thousands, except percentage data) Cost of revenue: Products $ 263,905 (14.1) % $ 307,348 (13.2) % $ 354,023 Services 37,860 41.0 % 26,855 42.7 % 18,820 Total cost of revenue $ 301,765 (9.7) % $ 334,203 (10.4) % $ 372,843 Cost of products revenue decreased for the year ended December 31, 2020, primarily due to the decrease in product revenue and overhead costs, partially offset by higher excess and obsolete inventory provision compared to the prior year. The increase in excess and obsolete inventory provision reflects lower expected future demand for certain older product lines for the fiscal year 2020 as we transition to newer technologies. The increase in cost of services revenue 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, offset by cost optimizations implemented during the year. Cost of products revenue decreased for the year ended December 31, 2019, due primarily to a decline in product revenue compared to the prior year. Cost of services revenue increased for the year ended December 31, 2019, 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, offset by cost optimizations implemented during the year. 61 Table of Contents Gross Margin The following table presents gross margin for the periods indicated: Year Ended December 31, 2020 % Change 2019 % Change 2018 (In thousands, except percentage data) Gross profit: Products $ 20,963 31.9 % $ 15,894 (78.3) % $ 73,090 Services 34,426 72.9 % 19,910 4.9 % 18,985 Total gross profit $ 55,389 54.7 % $ 35,804 (61.1) % $ 92,075 Gross profit percentage: Products 7.4 % 4.9 % 17.1 % Services 47.6 % 42.6 % 50.2 % Total gross profit percentage 15.5 % 9.7 % 19.8 % Gross margin increased for the year ended December 31, 2020 compared to the prior year, due to a combination of both product and service margin increases. The product margin increase is primarily due to decreased provisions for price protection and marketing expenditures that are deemed to be reductions of revenue and decreased product overhead, partially offset by higher excess and obsolete inventory provision. Service margin increased for year ended December 31, 2020, compared to the prior year, primarily due to an increase in paid service revenue and cost optimizations implemented. Gross margin decreased for the year ended December 31, 2019 compared to the prior year, due to a combination of both product and service margin declines. The product margin decline is primarily due to increased marketing expenditures deemed to be a reduction of revenues, increased provisions for price protection that are deemed to be reductions of revenue, increased warranty costs, product overhead and freight-related costs, offset by less charges for excess or obsolete inventory. Service margin decreased for the year ended December 31, 2019 compared to the prior year, primarily due to higher service cost growth which included the cost of the free 3-month and 12-month trials of Arlo Smart included in our new product offerings in fiscal 2019. Operating Expenses The first and second quarters of 2018, are based on carve-out financials and reflect the transactions which are directly attributable to Arlo and certain allocated costs, whereas third quarter and fourth quarter of 2018 and full years of 2019 and 2020 are based on our actual results for the periods as a standalone public company. Research and Development The following table presents research and development expense for the periods indicated: Year Ended December 31, 2020 % Change 2019 % Change 2018 (In thousands, except percentage data) Research and development expense $ 60,137 (13.3) % $ 69,384 18.0 % $ 58,794 Research and development expense decreased for the year ended December 31, 2020 compared to the prior year, due to decreases of $2.6 million in personnel-related expenses primarily as a result of the reduction in force implemented in the last quarter of 2019, and $4.1 million in IT and facility overhead, partially offset by an increase of $2.0 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 $4.1 million were attributed to the Verisure NRE arrangement, and are classified as cost of service revenue in fiscal year 2020. 62 Table of Contents Research and development expense increased for the year ended December 31, 2019 compared to the prior year due to increases of $2.5 million in personnel-related expenses and $8.3 million in IT and facilities overhead. The increased expenditures on personnel-related expense and engineering projects were due to continuous investment in strategic focus areas, principally the expansion of our Arlo product and service offerings and the growth of our cloud platform capabilities. The increase in IT and facilities overhead is due to the fact that starting in late 2018 Arlo moved to separate facilities globally and for the full year of 2019 Arlo maintained its own facilities and IT infrastructures and systems globally as a standalone public company. Sales and Marketing The following table presents sales and marketing expense for the periods indicated: Year Ended December 31, 2020 % Change 2019 % Change 2018 (In thousands, except percentage data) Sales and marketing expense $ 49,064 (13.9) % $ 56,985 8.4 % $ 52,593 Sales and marketing expense decreased for the year ended December 31, 2020 compared to the prior year, primarily due to decreases in personnel-related expenses of $5.5 million, outside professional services of $2.1 million, and IT and facility overhead of $2.1 million, partially offset by an increase in credit card processing fees of $1.0 million driven by the growth in sales from Arlo's direct to consumer store and paid accounts service revenue. The decreases are as a result of a general reduction of headcount within sales and marketing as well as the transfer of our European sales and marketing team to Verisure on December 30, 2019, coupled with a reduction in travel related expense as a result of COVID-19 restrictions. Sales and marketing expense increased for the year ended December 31, 2019 compared to the prior year, primarily due to an increase in outside professional services of $2.0 million, IT and facilities overhead of $2.7 million, and personnel-related expenses of $1.2 million. The increases were partially offset by a decrease of $1.5 million in expenses related to NETGEAR Transition Service Agreement ("TSA"). The increase in IT and facilities overhead is due to the fact that starting in late 2018 Arlo moved to separate facilities globally and for the whole of 2019 Arlo maintained its own facilities and IT infrastructures and systems globally as a standalone public company. General and Administrative The following table presents general and administrative expense for the periods indicated: Year Ended December 31, 2020 % Change 2019 % Change 2018 (In thousands, except percentage data) General and administrative expense $ 51,096 7.3 % $ 47,624 68.8 % $ 28,209 General and administrative expense increased for the year ended December 31, 2020 compared to the prior year, primarily due to higher personnel-related expenditures of $7.8 million, partially offset by decreases of $2.2 million in legal and professional services and $1.1 million of transaction costs related to the disposal of our commercial operations in Europe in the fourth quarter of 2019. The increase in personnel-related expenditures were mainly driven by the $7.4 million stock-based compensation expense recognized for the voluntary forfeiture of certain options by our Chief Executive Officer in January 2020, partially offset by the reversal of the previously recognized stock-based compensation expense amounting to $1.2 million of unvested options and restricted stock units upon the separation of our former Chief Financial Officer in June 2020. 63 Table of Contents General and administrative expense increased for the year ended December 31, 2019 compared to the prior year, primarily due to higher IT and facilities overhead of $9.7 million, higher personnel-related expenditures of $6.0 million, higher legal and professional services of $5.3 million, and transaction costs of $1.9 million related to the disposal of our commercial operations in Europe, partially offset by $4.2 million decrease in NETGEAR TSA related expenses. The increase in general and administrative expense was driven by the increase in related IT and facilities overhead due to the fact that starting in late 2018 Arlo moved to separate facilities globally and for the whole of 2019 Arlo maintained its own facilities and IT infrastructures and systems globally, increased customary public company costs, including outside legal and audit fees, insurance and other costs as our company became a standalone public company since August 2018. Separation Expense The following table presents separation expense for the periods indicated: Year Ended December 31, 2020 % Change 2019 % Change 2018 (In thousands, except percentage data) Separation expense $ 248 (87.0) % $ 1,913 ** $ 27,252 **Percentage change not meaningful. Separation expense consists primarily of charges for third-party advisory, consulting, legal and professional services, IT-related expenses, and other items that are incremental and one-time in nature related to our separation from NETGEAR. To operate as a standalone company, we have incurred separation costs. The significant reduction for fiscal years of 2020 and 2019 was as a result of the substantial completion of our Separation from NETGEAR effective December 31, 2018. Gain on sale of business Year Ended December 31, 2020 % Change 2019 % Change 2018 (In thousands, except percentage data) Gain on sale of business $ (292) ** $ (54,881) ** $ — **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 of $54.9 million. In the first quarter of 2020, we recognized an additional gain of $0.3 million as a result of the final working capital adjustment. There was no gain on sale of business for the year ended December 31, 2018. Refer to Note 4, Disposal of Business , in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K 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: Year Ended December 31, 2020 % Change 2019 % Change 2018 (In thousands, except percentage data) Interest income 802 ** 2,737 ** 1,239 Other income (expense), net 3,436 ** 913 ** (1,177) **Percentage change not meaningful. 64 Table of Contents During the year ended December 31, 2020, we earned interest income of $0.8 million from our cash equivalents and short-term investments. The reduction, compared to the prior year, is primarily due to the decrease in our short-term investments and cash and cash equivalents as we funded our operations and the decline in interest rates. Other income (expense), net increased for the year ended December 31, 2020 compared to the prior year, primarily due to Verisure TSA related income of $4.0 million recognized in fiscal year 2020. During the year ended December 31, 2019, we earned interest income of $2.7 million from our cash equivalents and short-term investments. Other income (expense), net increased for the year ended December 31, 2019 compared to the prior year, primarily due to Verisure TSA related income of $0.8 million and higher foreign currency transaction gains, mainly as a result of the U.S. dollar strengthening against transaction currencies. Provision for Income Taxes Provision for income taxes and effective tax rate consisted of the following: Year Ended December 31, 2020 % Change 2019 % Change 2018 (In thousands, except percentage data) Provision for income taxes $ 625 (85.7) % $ 4,380 (31.6) % $ 772 Effective tax rate (0.6) % (5.4) % (1.0) % The decrease in provision for income taxes for the year ended December 31, 2020 compared to the prior year was primarily due to lower foreign earnings in 2020, resulting from the sale of our commercial operations in Europe during the fourth quarter of 2019. Furthermore, 2019 included the gain on sale of certain assets related to the Company's commercial operations in Europe during the fourth quarter of 2019. Losses incurred predominantly in the U.S continue to be subject to a full valuation allowance. The increase in provision for income taxes for the year ended December 31, 2019 compared to the prior year was primarily due to higher foreign earnings in 2019 and gain on sale of certain assets related to the Company's commercial operations in Europe during the fourth quarter of 2019. Losses incurred predominantly in the U.S continue to be subject to a full valuation allowance. 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 December 31, 2020, our accumulated deficit was $232.8 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 December 31, 2020, we had cash, cash equivalents and short-term investments totaling $206.1 million. As of December 31, 2020, 23.3% of our cash and cash equivalents were held outside of the U.S. Starting in 2018, as a result of the Tax Act, the tax impact on the repatriation of foreign earnings is generally immaterial. 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 of up to $40.0 million and as of December 31, 2020, we have not borrowed against this credit facility. Refer to Note 10. Debt in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K 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 65 Table of Contents 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. 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, the growth in our service revenue, as well as the ability to increase our gross margin dollars and continue to maintain controls over our operating expenditures. Cash Flow The following table presents our cash flows for the periods presented. Year Ended December 31, 2020 2019 2018 (In thousands) Net cash provided by (used in) operating activities $ (46,530) $ 9,171 $ (17,686) Net cash provided by (used in) investing activities (3,975) 76,262 (71,285) Net cash provided by (used in) financing activities (23) (38) 244,287 Net increase (decrease) in cash and cash equivalents and restricted cash $ (50,528) $ 85,395 $ 155,316 Operating activities Net cash used in operating activities increased by $55.7 million for the year ended December 31, 2020 compared to the prior year. This increase comprised a $55.8 million reduction in adjusted net loss for cash flows, offset by an increase in working capital used in operations of $111.5 million, mainly due to a reduction in accounts payable in 2020, compared to an increase in accounts payable in 2019 and an initiative to right-size inventory in 2019 which was not repeated in 2020. Net cash provided by operating activities increased by $26.9 million for the year ended December 31, 2019 compared to the prior year, due primarily to improved working capital management, offset by a $55.0 million year over year decrease in the adjusted net loss from operations. Our cash inflow from changes in assets and liabilities increased by $81.9 million year over year as a result of increased accounts receivable collections, prepayments from Verisure product purchases and NRE services under the Supply Agreement and lower inventory balance. Our days sales outstanding (“DSO”) decreased to 64 days as of December 31, 2020 as compared to 97 days as of December 31, 2019, primarily as a result of customer mix, an increase in service revenue and growth in sales from Arlo's direct to consumer store, 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 decreased to $64.7 million as of December 31, 2020 from $68.6 million as of December 31, 2019, primarily due to lower inventory purchases. Our ending inventory turns were 5.0x in the three months ended December 31, 2020 down from 5.9x turns in the three months ended December 31, 2019, primarily as a result of a reduction in product shipments which was not offset by a corresponding reduction in inventory. Our accounts payable decreased to $62.2 million as of December 31, 2020 from $111.7 million as of December 31, 2019, primarily as a result of lower inventory purchases and earlier payments to suppliers for purchases made. Investing activities 66 Table of Contents Net cash used in investing activities increased by $80.2 million for the year ended December 31, 2020 compared to the prior year, primarily due to a reduction in proceeds from maturity of short-term investments of $30.3 million and a reduction in proceeds from sale of our commercial operations in Europe in 2019 of $52.7 million, partially offset by less purchases of property and equipment of $2.8 million due to the completion of leasehold improvements in 2019 at our San Jose headquarters. Net cash provided by investing activities increased by $147.5 million for the year ended December 31, 2019 compared to the prior year, primarily due to the more maturity of short-term investments in the amount of $55.0 million, less purchases of short-term investments of $24.9 million, less purchases of property equipment of $15.0 million, and proceeds from sale of our commercial operations in Europe in the amount of $52.7 million. Financing activities Net cash used in financing activities was $23 thousand for the year ended December 31, 2020 and comprised withholding tax from restricted stock unit releases of $4.78 million, offset by proceeds from Employee Stock Purchase Plan contributions and exercises of stock options of $4.76 million. Net cash used in financing activities was $38 thousand in the year ended December 31, 2019 and comprised proceeds from Employee Stock Purchase Plan contributions of $1.8 million, offset by $1.9 million in tax withholdings from restricted stock unit releases. Backlog Our backlog consists of products for which customer purchase orders have been received and that are scheduled or in the process of being scheduled for shipment. As of December 31, 2020, we had a backlog of $5.7 million, compared to $5.4 million as of December 31, 2019 and $18.9 million as of December 31, 2018. As we typically fulfill orders received within a relatively short period after receipt, our revenue in any fiscal year depends primarily upon orders booked and the availability of supply of our products in that year. In addition, most of our backlog is subject to rescheduling or cancellation with minimal penalties. As a result, our backlog as of any particular date may not be an indicator of revenue for any succeeding period. Similarly, there is a lack of meaningful correlation between year-over-year changes in backlog as compared with year-over-year changes in revenue. Accordingly, we do not believe that backlog information is material to an understanding of our overall business, and backlog as of any particular date should not be considered a reliable indicator of our ability to achieve any particular level of revenue or financial performance. Contractual Obligations The following table summarizes our non-cancelable operating lease commitments and purchase obligations as of December 31, 2020: Payments due by period Less Than 1-3 3-5 More Than Total 1 Year Years Years 5 Years (In thousands) Operating leases $ 35,821 $ 5,931 $ 10,747 $ 7,645 $ 11,498 Purchase obligations 19,532 19,532 — — — $ 55,353 $ 25,463 $ 10,747 $ 7,645 $ 11,498 67 Table of Contents Operating leases We entered into several office lease agreements under non-cancelable operating leases with various expiration dates through June 2029. The terms of certain of our facility leases provide for rental payments on a graduated scale. We recognize rent expense on a straight-line basis over the lease period and have accrued for rent expense incurred but not paid. The amounts presented are consistent with contractual terms and are not expected to differ significantly, unless a substantial change in our headcount requires us to exit an office facility early or expand our occupied space. For the years ended December 31, 2020 and 2019, rent expense was $7.0 million and $7.0 million, respectively. For the six months ended July 1, 2018, rent expense reflected allocations from NETGEAR and may not be indicative of our results. Rent expense was $1.4 million after the Separation through December 31, 2018. Letters of Credit In connection with the lease agreement for the headquarters located in San Jose, California, we executed a letter of credit with the landlord as the beneficiary. As of December 31, 2020, we had approximately $3.6 million of unused letters of credit outstanding, of which $3.1 million pertains to the lease arrangement. Purchase obligations We enter into various inventory-related purchase agreements with suppliers. Generally, under these agreements, 50% of the orders are cancelable by giving notice of 46 to 60 days prior to the expected shipment date and 25% of orders are cancelable by giving notice 31 to 45 days prior to the expected shipment date. Orders are not cancelable within 30 days prior to the expected shipment date. As of December 31, 2020, we had $19.5 million in non-cancelable purchase commitments with suppliers. We expect to sell all products for which we have committed purchases from suppliers. Uncertain tax position As of December 31, 2020, the total gross unrecognized tax benefits and related interest and penalties was $1.4 million. The timing of any payments that could result from these unrecognized tax benefits will depend upon a number of factors. The unrecognized tax benefits have been excluded from the contractual obligations table because reasonable estimates cannot be made of whether, or when, any cash payments for such items might occur. We do not expect to reduce our liabilities for uncertain tax positions in any jurisdiction, where the impact would affect the statement of operations, in the next 12 months. Off-Balance Sheet Arrangements As of December 31, 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 Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and pursuant to the regulations of the SEC. The preparation of the consolidated financial statements requires management to make assumptions, judgments and estimates that can have a significant impact on the reported amounts of assets, liabilities, revenue and expenses. We base our estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. Actual results could differ significantly from these estimates. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. On a regular basis, we evaluate our assumptions, judgments and estimates and make changes accordingly. We also discuss our critical accounting estimates with the Audit Committee of the Board of Directors. Note 2, Summary of Significant Accounting Policies , in Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K describes the significant accounting policies used in the preparation of the 68 Table of Contents consolidated financial statements. We have listed below our critical accounting policies that we believe to have the greatest potential impact on our consolidated financial statements. Revenue Recognition Revenue from contracts with customers is recognized when control of the promised goods or services is transferred to the customers in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. The majority of revenue comes from sales of hardware products to customers (retailers, distributors, and service providers). Revenue is recognized at a point in time when control of the goods is transferred to the customer, generally occurring upon shipment or delivery dependent upon the terms of the underlying contract. The amount recognized reflects the consideration we expect to be entitled to in exchange for the transferred goods. We sell paid subscription services to our end user customers where we provide customers access to our cloud services. Revenue for subscription sales is generally recognized on a ratable basis over the contract term, beginning on the date that the service is made available to the customers at the time of registration. The subscription contracts are generally 30 days or 12 months in length, billed in advance. All such service or support sales are typically recognized using an output measure of progress by looking at the time elapsed as the contracts generally provide the customer equal benefit throughout the contract period. In addition to selling paid subscriptions, we also sell services bundled with hardware products and accounts for these sales in line with the multiple performance obligations guidance. Revenue from all sales types is recognized at transaction price, the amount we expect to be entitled to in exchange for transferring goods or providing services. Transaction price is calculated as selling price net of variable consideration which may include estimates for future returns, sales incentives, and price protection related to current period product revenue. Our standard obligation to our direct customers generally provides for a full refund in the event that such product is not merchantable or is found to be damaged or defective. In determining estimates for future returns, management analyzes historical sales and returns data, channel inventory levels, current economic trends, and changes in customer demand for our products. Sales incentives and price protection are determined based on a combination of the actual amounts committed and estimated future expenditure based upon historical customary business practice. Typically variable consideration does not need to be constrained as estimates are based on predictive historical data or future commitments that we plan and control. However, we continue to assess variable consideration estimates such that it is probable that a significant reversal of revenue will not occur. Contracts with Multiple Performance Obligations Some of our contracts with customers contain multiple promised goods or services. Such contracts include hardware products with bundled services, various subscription services, and support. For these contracts, we account for the promises separately as individual performance obligations if they are distinct. Performance obligations are determined to be considered distinct if they are both capable of being distinct and distinct within the context of the contract. In determining whether performance obligations meet the criteria for being distinct, we consider a number of factors, such as the degree of interrelation and interdependence between obligations, and whether or not the good or service significantly modifies or transforms another good or service in the contract. The embedded software in most of the hardware products is not considered distinct and therefore the combined hardware and incidental software are treated as one performance obligation and recognized at the point in time when control of product transfers to the customer. Services that are included with certain hardware products are considered distinct and therefore the hardware and service are treated as separate performance obligations. After identifying the separate performance obligations, the transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. Standalone selling prices are generally determined based on the prices charged to customers or using an adjusted market assessment. Standalone selling price of the hardware 69 Table of Contents is directly observable from add-on camera and base station sales. Standalone selling price of the premium services are directly observable from direct sales to end users, while the service is estimated using an adjusted market approach. Revenue is then recognized for each distinct performance obligation as control is transferred to the customer. Revenue attributable to hardware is recognized at the time control of the product transfers to the customer. The transaction price allocated to the service is recognized over the specified service period or over the estimated useful life of the hardware, beginning when the customer is expected to activate their account. Useful life of the hardware is determined by industry norms, technical and financial relevance, frequency of new model releases, and user history. Long-term Supply Arrangement - Verisure We have entered into a Supply Agreement as part of the disposal of our commercial operations in Europe where Verisure prepays future product purchases with a minimum product purchase commitment also required. The Supply Agreement includes product purchases, paid subscription services, basic services, and an option for Verisure to acquire development services by submitting a statement of work (“SOW”). Products sold come with a standard twelve month warranty. Verisure assumes responsibilities for all warranty claims, returns of products and certain technical support provided to end users. We provide technical support for paid subscription services where Verisure cannot resolve the issue. Verisure is responsible for any marketing and promotion of our products and services sold in Europe. Products are priced at a cost plus markup based on markups specified in the agreement and that price varies based on the cost of the product. The paid subscription service and basic service pricing is based on the number of users monthly and is priced at a cost plus markup specified in the Supply Agreement, which varies based on the user and service type. T he transaction price for products and paid subscription services is entirely variable because the consideration is dependent on the actual costs. We allocate variable consideration specified for products entirely to products, and variable consideration specified for the paid subscription services entirely to the paid subscription services. For development services, no contract exists until an SOW is submitted and approved by both parties. For products, since quantity and product types are not specified in the agreement, contracts are not deemed to exist until we receive and accept the customer purchase order ("PO"). Each product with a valid PO is a single performance obligation. We recognize variable consideration for products upon delivery and for services when the monthly service is rendered for paid subscription services and basic services. The non-refundable product prepayments does not relate to future goods or services, as such no further assessment of material rights is required. Further, as the transfer of products is at the discretion of the customer (i.e. when Verisure issues a PO), a significant financing component does not exist as it relates to the product prepayments. We also expect that the product prepayments will be fully utilized by Verisure within 12 to 18 months, hence, no additional accounting consideration is necessary for breakage. We also concluded that we are acting as the principal in the Supply Agreement and determined that revenue should be presented gross. Non-recurring Engineering Arrangement - Verisure The Supply Agreement also provides for certain development services under an SOW to Verisure ("NRE arrangement") as part of the disposal of our commercial operations in Europe. In the NRE arrangement, Verisure pays non-refundable installments upon the commencement of agreed-upon milestones. There is a single performance obligation as the distinct goods and services promised under the SOW are highly interdependent or interrelated inputs that produce a single combined output given the nature of such arrangement. The output (or work-in-progress of such output) typically has no alternative use to us given the customized nature of the arrangement and we have enforceable rights given that the non-refundable milestone payments are prepayments in nature; control for NRE development services therefore transfers over time. We determined that the most appropriate measure of progress for revenue recognition is the input method based on cost because we can reasonably estimate the total costs for the NRE, and the costs incurred reasonably reflects our efforts to satisfy the performance obligation. The NRE costs include labor, material, overhead as well as the use of outside services. The total estimated NRE costs are based on a combination of historical costs together with quotes from vendors 70 Table of Contents for supplying parts or services towards the completion. Adjustments to cost and profit estimates are made periodically due to changes in scope of work, hours to complete and estimated profitability, including those arising from final contract settlements. These changes may result in revisions to revenue and costs and are recognized in the period in which the revisions are determined. Any losses expected to be incurred on contracts in progress are charged to operations in the period such losses are determined. If total NRE costs calculated upon completion in the current period are more than the estimated total costs at completion used to calculate revenue in a prior period, then the profits in the current period will be lower than if the estimated costs used in the prior period calculation were equal to the actual total costs upon completion. Allowances for Warranty Obligations and Returns due to Stock Rotation Our standard warranty obligation to our direct customers generally provides for a right of return of any product for a full refund in the event that such product is not merchantable or is found to be damaged or defective. At the time we recognize revenue, we record an estimate of future warranty returns to reduce revenue in the amount of the expected credit or refund to be provided to our direct customers. At the time we record the reduction to revenue related to warranty returns, we include within cost of revenue a write-down to reduce the carrying value of such products to net realizable value. Our standard warranty obligation to end-users provides for replacement of a defective product for one or more years. Factors that affect the warranty obligation include product failure rates, material usage and service delivery costs incurred in correcting product failures. We record the estimated cost associated with fulfilling the warranty obligation to end-users in cost of revenue. Because our products are manufactured by third-party manufacturers, in certain cases we have recourse to the third-party manufacturer for replacement or credit for the defective products. We give consideration to amounts recoverable from our third-party manufacturers in determining our warranty liability. Our estimated allowances for product warranties can vary from actual results, and we may have to record additional revenue reductions or charges to cost of revenue, which could materially impact our financial position and results of operations. In addition to warranty-related returns, certain distributors and retailers generally have the right to return products for stock rotation purposes. Upon shipment of the product, we reduce revenue by an estimate of potential future stock rotation returns related to the current period product revenue. We analyze historical returns, channel inventory levels, current economic trends and changes in customer demand for our products when evaluating the adequacy of the allowance for stock rotation returns. Our estimated allowances for returns due to stock rotation can vary from actual results, and we may have to record additional revenue reductions, which could materially impact our financial position and results of operations. Sales Incentives We accrue for sales incentives offered to customers as a marketing expense if we receive an identifiable benefit in exchange and can reasonably estimate the fair value of the identifiable benefit received; otherwise, it is recorded as a reduction to revenue. As a consequence, we record a substantial portion of our channel marketing costs as a reduction of revenue. We record estimated reductions to revenue for sales incentives when the related revenue is recognized or ahead of customer or end customer commitment if customary business practice creates an implied expectation that such activities will occur in the future. Valuation of Inventory We value our inventory at the lower of cost or net realizable value, cost being determined using the first-in, first-out method. We continually assess the value of our inventory and will periodically write down its value to account for estimated excess and obsolete inventory based upon assumptions about future demand and market conditions. On a quarterly basis, we review inventory quantities on hand and on order under non-cancelable purchase commitments and compare those quantities to our estimated forecast of product demand for the next nine months to determine what inventory, if any, is not saleable. We base our analysis on the product demand forecast but take into account market conditions, product development plans, product life expectancy and other factors. Based on this analysis, we write down the carrying value of the affected inventory to account for estimated excess and obsolete amounts. At the point of loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do 71 Table of Contents not result in the restoration or increase in that newly established cost basis. As demonstrated during prior years, demand for our products can fluctuate significantly. If actual demand is lower than our forecasted demand and we fail to reduce our manufacturing accordingly, we could be required to write down the value of additional inventory, which would have a negative effect on our gross profit. Goodwill Goodwill pertains to the acquisitions of Avaak, Inc. (“Avaak”) and Placemeter, Inc. (“Placemeter”). Goodwill represents the purchase price exceeds the estimated fair value of net assets of businesses acquired in a business combination. We perform an annual impairment assessment of goodwill at the reporting unit level on the first day of the fourth fiscal quarter. The analysis may include both qualitative and quantitative factors to assess the likelihood of an impairment. Should certain events or indicators of impairment occur between annual impairment tests, we will perform the impairment test as those events or indicators occur. Examples of such events or circumstances include: a significant decline in our expected future cash flows, a sustained, significant decline in our stock price and market capitalization, a significant adverse change in the business climate and slower growth rates. We test goodwill for impairment at the reporting unit level by first performing a qualitative assessment to determine whether it is more likely than not (that is, a likelihood of more than 50%) that the fair value of the reporting unit is less than its carrying amount. The qualitative assessment considers: macroeconomic conditions, industry and market considerations, cost factors, overall company financial performance, events affecting the reporting units and changes in our stock price. If the reporting unit does not pass the qualitative assessment, we estimate its fair value and compare the fair value with the carrying amount of the reporting unit, including goodwill. If the fair value is greater than the carrying amount of the reporting unit, we do not record an impairment. We also test goodwill for impairment by performing a quantitative assessment, which is used to identify both the existence of impairment and the amount of impairment loss. The quantitative assessment compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value is less than the carrying amount, an impairment loss shall be recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. We would record any impairment charge within earnings in the consolidated statements of operations. Stock-based compensation Our employees have historically participated in NETGEAR’s stock-based compensation plans. Stock-based compensation expense has been allocated to us based on the awards and terms previously granted to our employees as well as an allocation of NETGEAR’s corporate and shared functional employee expenses. We measure stock-based compensation at the grant date based on the fair value of the award. The fair value of stock options and the shares offered under the employee stock purchase plan is estimated using the Black-Scholes option pricing model. Estimated compensation cost relating to restricted stock units ("RSUs") is based on the closing fair market value of NETGEAR’s common stock on the date of grant. Equity awards granted by the Company under its own stock-based compensation plans on or after the completion of the IPO are comprised of performance-based stock options (the “PSOs”), stock options, RSUs, performance RSUs ("PSUs"), and market-based performance RSUs ("MPSUs"). The Company uses the fair value method of accounting for its equity awards granted to employees and measures the cost of employee services received in exchange for the stock-based awards. The Company recognizes this compensation expense generally on a straight-line basis over the requisite service period of the award. The fair value of stock options and PSOs is estimated on the grant or offering date using the Black-Scholes option pricing model and the forfeitures are recorded as they occur. The fair value of RSUs and PSUs is measured on the grant date based on the closing fair market value of the Company’s common stock. The Company utilizes a Monte Carlo pricing model customized to the specific provisions of the 2018 Plan to value the MPSUs awards on the grant date. The fair value determined using the Monte Carlo simulation model varies based on the assumptions used for the expected stock price volatility, the correlation coefficient between the Company and Russell 2000 Index, risk-free interest rates, and dividend yield. 72 Table of Contents The stock-based compensation cost is recognized ratably over the period during which an employee is required to provide service in exchange for the awards, usually the vesting period, which is generally four years for stock options and three to four years for RSUs. For PSOs and PSUs, stock-based compensation expense associated with individual performance milestones is recognized over the expected performance achievement period when the achievement becomes probable. For MPSUs, stock-based compensation expense is recognized ratably over the performance period subject to achievement of market conditions. Our 2018 Employee Stock Purchase Plan (“ESPP”) is intended to provide employees with the opportunity to purchase our common stock through accumulated payroll deductions at the end of specified purchase period. Eligible employees may contribute up to 15% of compensation, subject to certain income limits, to purchase shares of our common stock. The terms of the plan include a look-back feature that enables employees to purchase stock semi-annually at a price equal to 85% of the lesser of the fair market value at the beginning of the offering period or the purchase date. The duration of each purchasing period is generally six months. We determine the fair value using the Black-Scholes Model using various inputs, including our estimate of expected volatility, term, dividend yield and risk-free interest rate. We recognize compensation costs for the ESPP on a straight-line basis over the requisite service period of the award. Income Taxes We record our provision for income taxes in our consolidated financial statements using the asset and liability method. Under this method, we recognize income tax liabilities or receivable for the current year. We also recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities, as well as for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using the tax rates that are expected to apply to taxable income for the years in which those tax assets and liabilities are expected to be realized or settled. We record a valuation allowance to reduce our deferred tax assets to the net amount that we believe is more likely than not to be realized. Our assessment considers the recognition of deferred tax assets on a jurisdictional basis. Accordingly, in assessing our future taxable income on a jurisdictional basis, we consider the effect of its transfer pricing policies on that income. We have placed a valuation allowance against U.S. federal and state deferred tax assets and certain foreign tax attribute carryforwards since we do not anticipate to realize the benefits of deferred tax assets. We recognize tax benefits from uncertain tax positions only if we believe that it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. As we expand internationally, we will face increased complexity in determining the appropriate tax jurisdictions for revenue and expense items. Our policy is to adjust these unrecognized tax benefits in the period when facts and circumstances change, such as the closing of a tax audit, the expiration of statute of limitation for a relevant taxing authority to examine a tax position, or when additional information becomes available. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made and could have a material impact on our financial condition and operating results. The provision for income taxes includes the effects of any accruals that we believe are appropriate, as well as the related interest and penalties. The Tax Act introduced the GILTI provisions effective in 2018, which generally impose a tax on the net income earned by foreign subsidiaries of U.S company in excess of a deemed return on their tangible assets. We recognize the tax on GILTI as a period cost when the tax is incurred. 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 , in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K. 73 Table of Contents Emerging Growth Company Status As an emerging growth company (“EGC”), under the Jumpstart Our Business Startups Act (“JOBS Act”), we are allowed to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are made applicable to private companies, unless we otherwise irrevocably elect not to avail ourselves of this exemption. While we have not made such an irrevocable election, we have not delayed the adoption of any applicable accounting standards. 74 Table of Contents