What changed in this filing

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Item 7. Management’s Discussion and Analysis

2022-03-02 compared with 2021-02-26 · 172 added, 324 removed, 251 unchanged (66% of the section changed)

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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.

We have elected to omit discussion on the earliest of the three years covered by the consolidated financial statements presented.

Refer to Item 7.

Management's Discussion and Analysis of Financial Condition and Results of Operations located in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020, filed on February 26, 2021, for reference to discussion of the fiscal year ended December 31, 2019, the earliest of the three fiscal years presented.

Business and Executive Overview

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International revenue was 38.9% and 27.5% of our revenue for the years ended December 31, 2021 and 2020, 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.

For the years ended December 31, 2021 and 2020, we generated revenue of $435.1 million and $357.2 million, respectively.

Loss from operations was $60.1 million and $104.9 million for the years ended December 31, 2021 and 2020, respectively.

Loss from operations for the years ended December 31, 2021 and 2020 included separation expense of $1.6 million and $0.2 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.

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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,

including adjustments that may result in the recalculation of our historical metrics.

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.

Year Ended As of and for the Year Ended December 31,

2020 % Change 2019 % Change 2018

2021 % Change 2020

(In thousands, except percentage data)

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Cumulative paid accounts 1,067 145.3 % 435

Annual recurring revenue $ 90,100 93.5 % $ 46,552

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.

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, and includes accounts owned by Verisure.

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.

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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;

• 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

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.

Annual Recurring Revenue .

Effective as of the third quarter of 2021, we adopted Annual Recurring Revenue ("ARR") as one of the key indicators of our business performance.

We believe ARR enables measurement of our business initiatives, and serves as an indicator of our future growth.

ARR represents the amount of paid service revenue that we expect to recur annually and is calculated by taking our recurring paid service revenue for the last calendar month in the fiscal quarter, multiplied by 12 months.

Recurring paid service revenue represents the revenue we recognize from our paid accounts and excludes prepaid service revenue and NRE service revenue from strategic partners.

The ARR for the comparative period presented was derived following the same methodology.

ARR is a performance metric and should be viewed independently of revenue and deferred revenue, and is not intended to be a substitute for, or combined with, any of these items.

COVID-19 Effect on Financial Results

We continue to closely monitor developments and are taking steps to mitigate the potential risks related to the COVID-19 pandemic to us, our employees and our customers.

The extent of the impact of the COVID-19 pandemic on our business operations will depend on future developments, including the duration of the pandemic, the broader implications of the macro-economic recovery and the impact on overall customer demand, all of which are uncertain and cannot be predicted.

Our priorities and actions during the COVID-19 pandemic continue to be focused on protecting the health and safety of all those we serve, our employees, our customers, our suppliers and our communities, including implementing continuous updates to our health and safety policies and processes and progress made through vaccinations.

We continue to instruct all but a limited number of our global workforce to work remotely as a precautionary measure intended to minimize the risk of the virus to them and the communities in which we operate, while we continue to focus 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 presented by the COVID-19 pandemic.

We also continue to work with our suppliers to address any supply chain disruptions, which might include larger component backlogs, component cost increases, 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.

trade war with China, increased demand for chips in the automotive

industry and certain other factors have led to a global shortage of semiconductors.

As a result, we have experienced component shortages, including longer lead times for components and supply constraints, that have affected both our ability to meet scheduled product deliveries and worldwide demand for our products.

Also, as a result of the COVID-19 pandemic, our supply chain partners are limited by production capacity, constrained by material availability, labor shortages, factory uptime and freight capacity, each of which constrains our ability to capitalize fully on end market demand.

The increased lead time in production due to component shortages and supply chain disruption brought our inventory down to a record low level at $38.4 million as of December 31, 2021.

In addition, as of December 31, 2021, international freight capacity has dropped, causing air and ocean freight rates to materially increase.

Furthermore, transit times have also increased, causing us to rely more on air freight in order to meet our customers' demands.

For the year ended December 31, 2021, we saw a 138% increase in freight-in expense compared to the prior year, as a result of the higher sea and air freight rates and component shortages which necessitated use of air freight to meet customer requested delivery dates.

We expect supply chain constraints to persist in 2022.

While we have been broadly successful in navigating COVID-19 related challenges to date, any further disruptions brought about by the COVID-19 pandemic to our supply chain and operations could have a significant negative impact on our net revenue, gross and operating margin performance.

In addition, as a result of the COVID-19 pandemic, 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 our hedging instruments, among others.

During the second quarter of 2021, we evaluated our existing real estate lease portfolio in light the COVID-19 pandemic and its impact on the changing nature of office space use by our workforce.

This evaluation resulted in the decision to sublease our office space in San Jose, California.

As a result, we recorded an impairment charge of $9.1 million, which includes $6.8 million associated with the right-of-use assets and $2.3 million associated with other lease related property and equipment.

Refer to Note 5, Balance Sheet Components in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for further information about the impairment of the right-of-use asset and long-lived assets.

Throughout 2021, we remained focused on navigating these on-going challenges presented by the COVID-19 pandemic through preserving our liquidity and managing our cash flow through taking preemptive action to enhance our ability to meet our short-term liquidity needs.

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

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

Our gross revenue consists primarily of sales of devices, prepaid and paid subscription service revenue and NRE service revenue from Verisure.

Our gross revenue consists primarily of sales of devices, prepaid and paid 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.

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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.

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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

overhead costs, including personnel expense for operation staff, 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 parties;

and amortization expense of certain acquired intangibles.

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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.

product and service 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.

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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.

We expect research and development expense to stay relatively flat in absolute dollars as we manage our expenses while continuing to develop new product and service offerings.

Research and development expense directly attributable to delivering the Verisure NRE is recognized in cost of service.

Sales and Marketing

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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.

outbound freight costs;

and credit card processing fees.

We expect our sales and marketing expense to increase in the future as we invest in marketing to drive awareness of our brand and drive demand for our products and services.

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.

We 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.

Impairment Charges

During the second quarter of 2021, we reviewed certain of our right-of-use assets and other lease-related assets for impairment in conjunction with our decision to sublease our office space in San Jose, California.

As a result, we recorded an impairment charge for the right-of-use asset and other lease-related assets included in the San Jose office asset group.

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.

Separation expense consists primarily of costs of legal and professional services for IPO-related litigation associated with our separation from NETGEAR.

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.

Gain on sale of business represents the gain on the sale of our 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.

We expect our interest income in absolute dollars to stay relatively flat as we deploy our short-term investments and cash and cash equivalents to fund our operations, while interest rates are expected to increase.

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.

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.

We have also included any reimbursement for the Verisure TSA and the Employee Retention Credit ("ERC") under the Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act") for qualified wages in Other income.

Results of Operations

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Year Ended December 31,

2020 2019 2018

(In thousands, except percentage data)

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General and administrative 49,489 11.4 % 51,096 14.3 %

Impairment charges 9,116 2.1 % — — %

Separation expense 1,596 0.4 % 248 0.1 %

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Year Ended December 31,

2020 % Change 2019 % Change 2018

2021 % Change 2020

(In thousands, except percentage data)

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Total revenue $ 435,137 21.8 % $ 357,154

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.

Revenue increased 21.8% across all geographic regions for the year ended December 31, 2021 compared to the prior year.

Product revenue increased by $46.8 million, or 16.4% for the year ended December 31, 2021 compared to the prior year, primarily driven by a 117.1% increase in product sales to Verisure.

The increase is also driven by customer mix and the associated contractual terms and the decreases in provisions for sales returns, price protection and marketing expenditures deemed to be a reduction of product revenue.

Service revenue increased by $31.2 million, or 43.2%, for the year ended December 31, 2021 compared to the prior year, primarily due to increased paid accounts.

Cost of Revenue

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Year Ended December 31,

2020 % Change 2019 % Change 2018

2021 % Change 2020

(In thousands, except percentage data)

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Total cost of revenue $ 327,102 8.4 % $ 301,765

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.

Cost of revenue increased 8.4% for the year ended December 31, 2021 compared to the prior year driven by increases in both product revenue and service revenue.

Cost of product revenue increased $21.4 million, or 8.1% for the year ended December 31, 2021 compared to the prior year, primarily due to increases in shipped product costs and freight-in expense as a result of COVID-19 related supply chain disruption, partially offset by lower warranty cost and excess and obsolete inventory provision compared to the prior year.

The decrease in warranty cost is a result of a lower scrap rate driven by increased and more profitable refurbished product sales, lower returns and fewer product transitions.

The decrease in excess and obsolete inventory provision is due to fewer product transitions and more effective inventory management.

Cost of service revenue increased $3.9 million, or 10.3% for the year ended December 31, 2021 compared to the prior year, driven by service revenue growth, offset by cost optimizations implemented.

The following table presents gross margin for the periods indicated:

Year Ended December 31,

2020 % Change 2019 % Change 2018

2021 % Change 2020

(In thousands, except percentage data)

Gross profit:

Gross margin:

Products $ 46,286 120.8 % $ 20,963

Services 61,749 79.4 % 34,426

Total gross profit $ 55,389 54.7 % $ 35,804 (61.1) % $ 92,075

Gross profit percentage:

Total gross margin $ 108,035 95.0 % $ 55,389

Gross margin percentage:

Products 14.0 % 7.4 %

Services 59.7 % 47.6 %

Total gross profit percentage 15.5 % 9.7 % 19.8 %

Total gross margin percentage 24.8 % 15.5 %

Gross margin increased for the year ended December 31, 2021 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.

The product margin increase is primarily due to customer mix driving a decreased provision for price protection and lower marketing expenditures that are deemed to be reductions of revenue, decreased warranty costs and a lower excess and obsolete inventory provision, partially offset by higher freight-in costs as a result of COVID-19 related supply chain disruption.

Service margin increased for year ended December 31, 2021, compared to the prior year, primarily due to an increase in paid service revenue coupled with various cost optimizations implemented.

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

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Year Ended December 31,

2020 % Change 2019 % Change 2018

2021 % Change 2020

(In thousands, except percentage data)

Research and development expense $ 59,063 (1.8) % $ 60,137

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.

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.

Research and development expense decreased for the year ended December 31, 2021 compared to the prior year, due to a decrease of $2.8 million in IT and facility overhead, partially offset by an increase of $0.9 million in personnel-related expenses and a decrease of $1.0 million in various research and development expenses that were attributed to the Verisure NRE arrangement.

For the year ended December 31, 2021, research and development expenses amounting to $2.8 million were attributed to the Verisure NRE arrangement and classified as cost of service revenue.

Sales and Marketing

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Year Ended December 31,

2020 % Change 2019 % Change 2018

2021 % Change 2020

(In thousands, except percentage data)

Sales and marketing expense $ 48,909 (0.3) % $ 49,064

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.

Sales and marketing expense decreased for the year ended December 31, 2021 compared to the prior year, primarily due to a decrease of $1.8 million in outside professional services and a decrease of $1.7 million in marketing expenditures, partially offset by an increase of $2.1 million in personnel-related expenses, and an increase of $1.4 million in credit card processing fees driven by the growth in sales from Arlo's direct to consumer store and paid accounts service revenue.

General and Administrative

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Year Ended December 31,

2020 % Change 2019 % Change 2018

2021 % Change 2020

(In thousands, except percentage data)

General and administrative expense $ 49,489 (3.1) % $ 51,096

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.

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.

General and administrative expense decreased for the year ended December 31, 2021 compared to the prior year, primarily due to a decrease of $4.0 million in personnel-related expenditures partially brought about by the one-time charge for stock-based compensation expense recognized in the first quarter of 2020 upon the voluntary forfeiture of our CEO's stock options in January 2020, a decrease of $1.9 million in legal and professional services and a decrease of $0.8 million in Verisure transaction costs which was recognized in the first half of 2020, partially offset by an increase of $1.6 million in IT and facility overhead.

Impairment Charges

The following table presents impairment charges for the periods indicated:

Year Ended December 31,

2021 % Change 2020

(In thousands, except percentage data)

Impairment charges $ 9,116 ** $ —

**Percentage change not meaningful.

As a result, we recorded an impairment charge of $9.1 million, which included $6.8 million associated with the right-of-use assets and $2.3 million associated with the leasehold improvements and furniture, fixtures and equipment included in the San Jose office asset group.

Separation Expense

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Year Ended December 31,

2020 % Change 2019 % Change 2018

2021 % Change 2020

(In thousands, except percentage data)

Separation expense $ 1,596 543.5 % $ 248

**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.

Separation expense consists primarily of the costs of legal and professional services for IPO-related litigation associated with our Separation from NETGEAR.

Gain on sale of business

Year Ended December 31,

2020 % Change 2019 % Change 2018

2021 % Change 2020

(In thousands, except percentage data)

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**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 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 $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.

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Year Ended December 31,

2020 % Change 2019 % Change 2018

2021 % Change 2020

(In thousands, except percentage data)

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Other income (expense), net $ 4,775 39.0 % $ 3,436

**Percentage change not meaningful.

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.

Interest income decreased for the year ended December 31, 2021, compared to the prior year, primarily due to the decrease in our short-term investments and cash and cash equivalents as we funded our operations and a decline in interest rates.

Other income (expense), net increased for the year ended December 31, 2021 compared to the prior year, primarily due to the ERC under the CARES Act for qualified wages amounting to $1.8 million, which was recognized as Other income in the second quarter of 2021, partially offset by decreases in Verisure TSA related income.

The CARES Act was signed into law on March 27, 2020 in response to the COVID-19 pandemic.

The ERC, as one of the provisions that provide economic relief for individuals and businesses under the CARES Act, is a refundable payroll tax credit that encouraged businesses to keep employees on the payroll during the COVID-19 pandemic.

Provision for Income Taxes

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Year Ended December 31,

2020 % Change 2019 % Change 2018

2021 % Change 2020

(In thousands, except percentage data)

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Effective tax rate (1.2) % (0.6) %

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.

Our effective tax rate for 2021 was lower than the U.S.

federal income tax rate of 21% primarily due to a lower effective tax rate on foreign earnings and valuation allowance on our net U.S.

deferred tax assets and certain foreign tax attributes as it is more likely than not that some or all of our deferred tax assets will not be realized.

The increase in provision for income taxes for the year ended December 31, 2021 compared to the prior year was primarily due to higher foreign earnings in 2021.

Refer to Note 9, Income taxes in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for additional discussion.

Liquidity and Capital Resources

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As of December 31, 2021, 7.4% 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

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.

Starting in 2018, the Tax Cuts and Jobs Act of 2017 (the “Tax Act”) 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 October 2021, we entered into the Credit Agreement with Bank of America, N.A., providing for a credit facility of up to $40.0 million.

In addition, the Credit

Agreement includes an uncommitted accordion feature that allows us to request the lender increase the loan commitments by up to an additional $25.0 million, subject to the satisfaction of certain conditions.

As of December 31, 2021, 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 the Credit Agreement.

Based on our current plans, the Credit Agreement with Bank of America, N.A., 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.

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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 used in operating activities $ (23,197) $ (46,530)

Net cash provided by (used in) investing activities 17,732 (3,975)

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

Net cash used in financing activities (4,970) (23)

Net decrease in cash and cash equivalents and restricted cash $ (10,435) $ (50,528)

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.

Net cash used in operating activities decreased by $23.3 million for the year ended December 31, 2021 compared to the prior year.

This decrease comprised a $48.7 million reduction in adjusted net loss for cash flows, offset by an increase in working capital used in operations of $25.4 million, mainly driven by an increase in accounts receivable and a decrease in deferred revenue, partially offset by increased accounts payable and lower inventory balance.

Our days sales outstanding (“DSO”) decreased to 50 days as of December 31, 2021 as compared to 64 days as of December 31, 2020, primarily due to more front-loaded shipments in the fourth quarter and slightly improved quarter end aging.

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.

Inventory decreased to $38.4 million as of December 31, 2021 from $64.7 million as of December 31, 2020, driven by longer production lead times, component shortages and supply chain disruptions, which necessitated extensive use of air freight, all of which were brought about by COVID-19-related issues, coupled with lower returns.

Our ending inventory turns were 10.5x in the three months ended December 31, 2021 up from 5.0x turns in the three months ended December 31, 2020, primarily as a result of the lower inventory balance and extensive use of air freight, as previously discussed.

Our accounts payable increased to $84.1 million as of December 31, 2021 from $62.2 million as of December 31, 2020, primarily as a result of higher inventory purchases in the fourth quarter of 2021.

Investing activities

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.

Net cash used in investing activities decreased by $21.7 million for the year ended December 31, 2021 compared to the prior year, primarily due to maturity of our of short-term investments.

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.

Net cash used in financing activities was $5.0 million for the year ended December 31, 2021 and comprised withholding tax from restricted stock unit releases of $13.2 million, offset by proceeds from our 2018 Employee Stock Purchase Plan contributions and exercises of stock options of $8.23 million.

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 of December 31, 2021, we had a backlog of $4.4 million, compared to $5.7 million as of December 31, 2020.

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.

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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

Purchase obligations 19,532 19,532 — — —

$ 55,353 $ 25,463 $ 10,747 $ 7,645 $ 11,498

Operating leases

We entered into several office lease agreements under non-cancelable operating leases with various expiration dates through June 2029.

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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.

For the years ended December 31, 2021 and 2020, gross rent expense was $7.0 million in both years.

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.

In connection with the lease agreement for office space located in San Jose, California, we executed a letter of credit with the landlord as the beneficiary.

As of December 31, 2021, we had approximately $3.6 million of unused letters of credit outstanding, of which $3.1 million pertains to the lease agreement.

Purchase Obligations

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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

Critical Accounting 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.

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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

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.

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 describes the significant accounting policies used in the preparation of the consolidated financial statements.

We have listed below our critical accounting estimates which require management to make difficult, subjective and complex judgements often as a result of the need to make estimate on matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or assumptions.

Actual results could differ from those estimates.

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.

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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

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

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.

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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.

As of December 31, 2021 and 2020, accrued warranty-related returns amounted to $18.0 million and $24.9 million, respectively.

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.

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

As of December 31, 2021 and 2020, accrued stock rotation amounted to $1.8 million and $4.2 million, respectively

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;

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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.

As of December 31, 2021 and 2020, accrued sales and marketing amounted to $31.4 million and $38.6 million, respectively.

Valuation of Inventory

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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

not result in the restoration or increase in that newly established cost basis.

At the point of loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do 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 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.

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.

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 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.

As we expand internationally, we will face increased complexity in determining the appropriate tax jurisdictions for revenue and expense items.

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.

At December 31, 2021 and 2020, excess and obsolescence reserve amounted to $2.7 million and $6.3 million, respectively.

Long-lived Assets and Right-of-use Assets Impairment

During the second quarter of 2021, we evaluated our real estate lease portfolio in light of the COVID-19 pandemic and the changing nature of office space use by our workforce.

This evaluation included a decision to sublease our office space in San Jose, California.

This change in the use of our San Jose office space led management to test the recoverability of the carrying amount of the asset group related to the sublease.

On May 25, 2021, the carrying amount of the asset group exceeded the anticipated undiscounted value of the sublease income over the sublease term.

Accordingly, we reviewed certain of our right-of-use assets and other lease related assets including leasehold improvements, furniture, fixtures and equipment under the sublease asset group for impairment.

As a result of the evaluation, we recorded an impairment charge of $9.1 million, which included $6.8 million associated with the right-of-use assets and $2.3 million associated with other lease related property and equipment, in the second quarter of 2021.

The assets found to be impaired were written down to their fair value calculated using a discounted cash flow method (income approach).

The fair value of the asset group was determined by utilizing projected cash flows from the sublease, discounted by a risk-adjusted discount rate that reflects the level of risk associated with receiving future cash flows.

The inputs utilized in the analyses were classified as Level 3 inputs within the fair value hierarchy.

Refer to Note 6, Fair Value Measurements and Note 11, Commitments and Contingencies in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K, for additional information about the fair value measured on a non-recurring basis and for further information about the sublease, respectively.

Goodwill Impairment

On the first day of the fourth quarter of 2021, we performed an annual assessment of goodwill at the reporting unit level.

We operate as one operating and reportable segment.

We performed a qualitative assessment in consideration of macroeconomic conditions, industry and market conditions, cost factors, overall company financial performance, and c hanges in our stock price.

We believed that it was more-likely-than-not that the fair value of the reporting unit was greater than our respective carrying value and therefore performing the next step of impairment test for the reporting unit was unnecessary.

No goodwill impairment was recognized in the years ended December 31, 2021, and 2020.

If there are events occurred or circumstances changed (i.e.

a decline in our stock price based on market conditions and deterioration of our business) that would more likely than not reduce our fair value below the carrying amount, we may have to record a charge to our earnings for the associated goodwill impairment of up to $11.0 million .

Uncertain Tax Position

We are subject to income taxes in the U.S.

and numerous foreign jurisdictions.

We apply significant judgement in determining our uncertain tax positions.

Although we believe that our reserves of uncertain tax position are reasonably adequate, no assurance can be given that the final outcome of these matters will not be different from our reserves.

When facts and circumstances change, our reserves are adjusted, 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 reserves 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.

Recent Accounting Pronouncements

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Item 7. Management’s Discussion and Analysis