Arlo Technologies, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-looking Statements This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and the Private Securities Litigation Reform Act of 1995. Such statements are based upon current expectations that involve risks and uncertainties. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. For example, the words “believes,” “anticipates,” “plans,” “expects,” “intends,” “could,” “may,” “will,” and similar expressions are intended to identify forward-looking statements, including statements concerning our business and the expected performance characteristics, specifications, reliability, market acceptance, market growth, specific uses, user feedback, and market position of our products and technology. Our actual results and the timing of certain events may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a discrepancy include, but are not limited to, those discussed in “Part II—Item 1A—Risk Factors” and “Liquidity and Capital Resources” below. All forward-looking statements in this document are based on information available to us as of the date hereof, such information may be limited or incomplete, and we assume no obligation to update any such forward-looking statements. These statements are inherently uncertain and investors are cautioned not to unduly rely upon these statements. The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and the accompanying notes contained in this Quarterly Report on Form 10-Q (the “Quarterly Report”). Unless expressly stated or the context otherwise requires, the terms “we,” “our,” “us,” the “Company,” and “Arlo” refer to Arlo Technologies, Inc. and our subsidiaries. Business and Executive Overview Arlo combines an intelligent cloud infrastructure and mobile app with a variety of smart connected devices that are 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 28.4 million smart connected devices. As of April 2, 2023, the Arlo platform had approximately 7.5 million cumulative registered accounts across more than 100 countries around the world coupled with 2.0 million cumulative paid subscribers and annual recurring revenue of $182.6 million. We conduct business across three geographic regions—(i) the Americas; (ii) Europe, Middle-East and Africa (“EMEA”); and (iii) 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. For the three months ended April 2, 2023 and April 3, 2022, we generated total revenue of $111.0 million and $124.8 million, respectively. Loss from operations was $14.1 million and $8.7 million for the three months ended April 2, 2023 and April 3, 2022, 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 paid account 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 channel partnerships and to continue our global expansion. We expect to increase our investment in research and development going forward as we continue to introduce new and innovative products and services to enhance the Arlo platform and compete for engineering talent. We also expect our sales and marketing expense to increase in the future as we invest in marketing to drive awareness of our brand and demand for our products and services. 22 Table of Contents Key Business Metrics In addition to the measures presented in our unaudited condensed consolidated financial statements, we use the following key metrics to evaluate our business, measure our performance, develop financial forecasts and make strategic decisions. We believe these key business metrics provide useful information by offering the ability to make more meaningful period-to-period comparisons of our on-going operating results and a better understanding of how management plans and measures our underlying business. Our key business metrics may be calculated in a manner different from the same key business metrics used by other companies. We regularly review our processes for calculating these metrics, and from time to time we may discover inaccuracies in our metrics or make adjustments to better reflect our business or to improve their accuracy, including adjustments that may result in the recalculation of our historical metrics. We believe that any such inaccuracies or adjustments are immaterial unless otherwise stated. As of and for the Three Months Ended April 2, 2023 % Change April 3, 2022 (In thousands, except percentage data) Cumulative registered accounts 7,510 17.5 % 6,389 Cumulative paid accounts 2,044 60.7 % 1,272 Annual recurring revenue $ 182,583 80.2 % $ 101,341 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 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 end-users to monitor the devices attached to that household. Cumulative Paid Accounts . Paid accounts are defined as any account worldwide where a subscription to a paid service is being collected (either by us or by our customers or channel partners, including Verisure). Annual Recurring Revenue (“ARR”) . 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 Non-Recurring Engineering (“NRE”) service revenue from strategic partners. 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. Impact of Global Geopolitical, Economic and Business Conditions During the three months ended April 2, 2023, we remained focused on the ongoing conflict in Ukraine, supply chain disruptions, inflation, lower consumer confidence and rising interest rates by preserving our liquidity and managing our cash flow by 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 headcount and non-essential spending, subleasing and not renewing excess office space, and deferring hiring. We continue to monitor the 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 ongoing conflict in Ukraine, supply chain disruptions, the inflationary macro environment, lower consumer confidence and rising interest rates and current financial conditions within the banking industry, including the effects of recent failures of other financial institutions, and liquidity levels. 23 Table of Contents Results of Operations We operate as one operating and reportable segment. The following table sets forth, for the periods presented, the unaudited condensed consolidated statements of comprehensive loss data, which we derived from the accompanying unaudited condensed consolidated financial statements: Three Months Ended April 2, 2023 April 3, 2022 (In thousands, except percentage data) Revenue: Products $ 67,060 60.4 % $ 94,825 76.0 % Services 43,944 39.6 % 29,926 24.0 % Total revenue 111,004 100.0 % 124,751 100.0 % Cost of revenue: Products 64,041 57.7 % 80,777 64.8 % Services 11,746 10.6 % 10,399 8.3 % Total cost of revenue 75,787 68.3 % 91,176 73.1 % Gross profit 35,217 31.7 % 33,575 26.9 % Operating expenses: Research and development 17,750 16.0 % 16,379 13.1 % Sales and marketing 15,353 13.8 % 13,168 10.6 % General and administrative 15,622 14.1 % 12,621 10.1 % Others 632 0.6 % 79 0.1 % Total operating expenses 49,357 44.5 % 42,247 33.9 % Loss from operations (14,140) (12.8) % (8,672) (7.0) % Interest income (expense), net 726 0.7 % (5) — % Other income, net (39) — % 411 0.3 % Loss before income taxes (13,453) (12.1) % (8,266) (6.7) % Provision for income taxes 792 0.7 % 213 0.2 % Net loss $ (14,245) (12.8) % $ (8,479) (6.9) % Revenue Our gross revenue consists primarily of sales of devices, prepaid and paid subscription service revenue and NRE service revenue. We generally recognize revenue from product sales at the time the product is shipped and transfer of control from us to the customer occurs. Upon device shipment, we attribute a portion of the sales price as prepaid service, deferring this revenue at the outset and subsequently recognizing it ratably over the estimated useful economic 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 strategic partners under NRE arrangements. Our revenue consists of gross revenue, less end-user customer rebates and other channel sales incentives, 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. We conduct business across three geographic regions—(i) the Americas; (ii) EMEA; and (iii) APAC—and generally base revenue by geography on the ship-to location of the customer for device sales and device location for service sales. 24 Table of Contents Three Months Ended April 2, 2023 % Change April 3, 2022 (In thousands, except percentage data) Americas $ 56,632 (17.3) % $ 68,466 Percentage of revenue 51.0 % 54.9 % EMEA 48,472 (3.0) % 49,975 Percentage of revenue 43.7 % 40.1 % APAC 5,900 (6.5) % 6,310 Percentage of revenue 5.3 % 5.0 % Total revenue $ 111,004 (11.0) % $ 124,751 Product revenue decreased in all regions by $27.8 million, or 29.3% for the three months ended April 2, 2023 compared to the prior year period, primarily driven by the decrease in product shipments in all regions due to a reduction in the average selling prices (“ASPs”) of our products as we increased promotional activities to stimulate household acquisition and increased subscriber growth coupled with the softening consumer demand as a result of current macro-economic factors. Service revenue increased in all regions by $14.0 million, or 46.8% for the three months ended April 2, 2023 compared to the prior year period, primarily due to increases in paid accounts and rates for our subscription plans. Cost of Revenue Cost of revenue consists of both product costs and service costs. Product costs primarily consist of the cost of finished products from our third-party manufacturers and 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 and excess components, and royalties to third parties. Service costs consist of costs attributable to the provision and maintenance of our cloud-based platform, including personnel, storage, security and computing, IT and facilities overhead as well as NRE service costs incurred under NRE arrangements. 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, 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 costs, and charges for excess or obsolete inventory. 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 service costs and gross margin and allows us to adapt to changing market dynamics and supply chain constraints. The following table presents cost of revenue and gross margin for the periods indicated: Three Months Ended April 2, 2023 % Change April 3, 2022 (In thousands, except percentage data) Cost of revenue: Products $ 64,041 (20.7) % $ 80,777 Services 11,746 13.0 % 10,399 Total cost of revenue $ 75,787 (16.9) % $ 91,176 25 Table of Contents Product cost of revenue decreased 20.7% for the three months ended April 2, 2023 compared to the prior year period, primarily due to a decrease in product shipments coupled with a decrease in freight-in costs due to normalization of the supply chain and utilization of ocean freight. Service cost of revenue increased 13.0% for the three months ended April 2, 2023 compared to the prior year period, as a result of service revenue growth, offset by cost optimizations. Gross Profit The following table presents gross profit for the periods indicated: Three Months Ended April 2, 2023 % Change April 3, 2022 (In thousands, except percentage data) Gross profit: Products $ 3,019 (78.5) % $ 14,048 Services 32,198 64.9 % 19,527 Total gross profit $ 35,217 4.9 % $ 33,575 Gross margin percentage: Products 4.5 % 14.8 % Services 73.3 % 65.3 % Total gross margin 31.7 % 26.9 % Product gross profit decreased for the three months ended April 2, 2023 compared to the prior year period, primarily due to the decrease in product shipments in all regions due to a reduction in the ASPs of our products as we increased promotional activities to stimulate household acquisition and increased subscriber growth coupled with the softening consumer demand as a result of current macro-economic factors. The product gross profit decrease was partially offset by the decrease in freight-in costs due to normalization of the supply chain and utilization of ocean freight. Service gross profit increased for the three months ended April 2, 2023 compared to the prior year period, primarily due to growth in paid service revenue in all regions as a result of increases in paid accounts and rates for our subscription plans as well as cost optimizations. Operating Expenses Research and Development Research and development expense consists primarily of personnel-related expense, safety, security, regulatory services and testing, other research and development consulting fees, and corporate IT and facilities overhead. Generally, we recognize research and development expenses as they are incurred. Research and development expense directly attributable to delivering the Verisure NRE is recognized in cost of service. We have invested in and expanded our research and development organization to enhance our ability to introduce innovative products and services. We expect research and development expense to increase in absolute dollars as we develop new product and service offerings and compete for engineering talent. 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. 26 Table of Contents The following table presents research and development expense for the periods indicated: Three Months Ended April 2, 2023 % Change April 3, 2022 (In thousands, except percentage data) Research and development expense $ 17,750 8.4 % $ 16,379 Research and development expense increased by $1.4 million for the three months ended April 2, 2023 compared to the prior year period, primarily due to an increase of $2.0 million in personnel-related expenses mainly from stock-based compensation and merit increase in base salary, partially offset by a decrease of $0.7 million in corporate IT and facilities overhead. Sales and Marketing Sales and marketing expense consists primarily of personnel expense for sales and marketing staff, technical support expense, advertising, trade shows, media and placement, corporate communications and other marketing expense, product marketing expense, IT and facilities overhead, 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 demand for our products and services. The following table presents sales and marketing expense for the periods indicated: Three Months Ended April 2, 2023 % Change April 3, 2022 (In thousands, except percentage data) Sales and marketing expense $ 15,353 16.6 % $ 13,168 Sales and marketing expense increased $2.2 million for the three months ended April 2, 2023 compared to the prior year period, primarily due to increases of $1.0 million in marketing expenditures, $0.6 million in credit card processing fees and $0.4 million freight-out expenses. General and Administrative General and administrative expense consists primarily of personnel-related expense for certain executives, finance and accounting, investor relations, human resources, legal, information technology, professional fees, corporate IT and facilities overhead, strategic initiative expense, and other general corporate expense. We expect our general and administrative expense to fluctuate as a percentage of our revenue in future periods based on fluctuations in our revenue and the timing of such expense. The following table presents general and administrative expense for the periods indicated: Three Months Ended April 2, 2023 % Change April 3, 2022 (In thousands, except percentage data) General and administrative expense $ 15,622 23.8 % $ 12,621 General and administrative expense increased $3.0 million for the three months ended April 2, 2023 compared to the prior year period, primarily due to an increase of $3.9 million in personnel-related expenses mainly from stock-based compensation and merit increase in base salary, partially offset by decreases of $0.8 million in corporate IT and facilities overhead and other. 27 Table of Contents Others Others include separation expense, which consists primarily of costs of legal and professional services for IPO-related litigation associated with our separation from NETGEAR, and restructuring charges, which consist of severance costs and office exit expense associated with the abandonment of certain lease contracts. Interest Income (Expense) and Other Income (Expense), Net The following table presents interest income (expense) and other income (expense), net for the periods indicated: Three Months Ended April 2, 2023 % Change April 3, 2022 (In thousands, except percentage data) Interest income (expense), net $ 726 ** $ (5) Other income (expense), net $ (39) ** $ 411 **Percentage change not meaningful. Interest income (expense), net increased for the three months ended April 2, 2023 compared to the prior year period, primarily due to the increase in our short-term investments as well as a result of higher interest rates. Other income (expense), net decreased for the three months ended April 2, 2023 compared to the prior year period, primarily due to the foreign currency exchange losses for the three months ended April 2, 2023 compared to the foreign currency exchange gains in the prior year period. Provision for Income Taxes The following table presents provision for income taxes for the periods indicated: Three Months Ended April 2, 2023 % Change April 3, 2022 (In thousands, except percentage data) Provision for income taxes $ 792 271.8 % $ 213 Effective tax rate (5.9) % (2.6) % Provision for income taxes increased for the three months ended April 2, 2023, compared to the prior year period, primarily due to higher U.S. earnings and also the application of Section 174 of the Internal Revenue Code requiring capitalization of research and experimental expenses. Consistent with the prior year, we maintained a valuation allowance against our U.S. federal and state deferred tax assets and did not record a tax benefit on these deferred tax assets since it is more likely than not that these deferred tax assets will not be realized. 28 Table of Contents Liquidity and Capital Resources As of April 2, 2023, our cash and cash equivalent and short-term investments totaled $118.7 million and we had unused borrowing capacity of $8.4 million based on the terms and conditions of our revolving credit facility. We have a history of losses and may continue to incur operating and net losses for the foreseeable future. As of April 2, 2023, our accumulated deficit was $359.7 million. Historically, we have funded our principal business activities through cash flows generated from operations and available cash on hand. Material Cash Requirements We believe that our existing sources of liquidity will be sufficient to meet 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. To the extent that current and anticipated future sources of liquidity are insufficient, we may seek to raise additional funds through public or private equity. We have no commitments to obtain such additional financing and cannot provide assurance 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 may vary from those currently planned and will depend on numerous factors, including the introduction of new products, the growth in our service revenue, the ability to increase our gross margin dollars, as well as cost optimization initiatives and controls over our operating expenditures. As we grow our installed base and related cost structure, there will be a need for additional working capital, hence, we have increased our subscription rates effective February 3, 2023. Leases and Contractual Commitments Our operating lease obligations mostly include offices, equipment, data centers, and distribution centers. Our contractual commitments are primarily inventory-related purchase obligations with suppliers. Contingencies We are involved in disputes, litigation, and other legal actions. We evaluate whether or not a potential loss amount or a potential range of loss is probable and reasonably estimable under the provisions of the authoritative guidance that addresses accounting for contingencies. Significant judgment is required to determine both the probability and the estimated amount of loss. In such cases, we accrue for the amount or, if a range, we accrue the low end of the range, only if there is not a better estimate than any other amount within the range, as a component of legal expense within litigation reserves, net. Refer to Note 8. Commitments and Contingencies in the Notes to Unaudited Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q for further information about our operating leases, purchase obligations, and legal contingencies. 29 Table of Contents Cash Flow The following table presents our cash flows for the periods presented: Three Months Ended April 2, 2023 April 3, 2022 (In thousands) Net cash provided by (used in) operating activities $ 10,329 $ (24,557) Net cash used in investing activities (22,672) (44,938) Net cash used in financing activities (4,691) (5,272) Net cash decrease $ (17,034) $ (74,767) Operating activities Net cash provided by operating activities increased by $34.9 million for the three months ended April 2, 2023 compared to the prior year period, primarily due to changes in working capital as a result of an increase in our service revenue driven by growth in paid accounts and increased subscription rates, higher collection from customers on products sales due to enhanced collection efforts, and lower payments to suppliers primarily as a result of lower inventory purchases. Investing activities Net cash used in investing activities decreased by $22.3 million for the three months ended April 2, 2023 compared to the prior year period, primarily due to lower net purchases of short-term investments. Financing activities Net cash used in financing activities decreased by $0.6 million for the three months ended April 2, 2023 compared to the prior year period, primarily due to the decrease in withholding tax from restricted stock unit releases, partially offset by lower proceeds related to employee benefit plans. Critical Accounting Policies and Estimates For a complete description of what we believe to be the critical accounting policies and estimates used in the preparation of our Unaudited Condensed Consolidated Financial Statements, refer to our Annual Report on Form 10-K for the year ended December 31, 2022. There have been no material changes to our critical accounting policies and estimates during the three months ended April 2, 2023, other than as discussed in Note 2. Significant Accounting Policies and Recent Accounting Pronouncements, in the Notes to Unaudited Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report. 30 Table of Contents Item 3. Quantitative and Qualitative Disclosures About Market Risk During the three months ended April 2, 2023, there were no material changes to our market risk disclosures as set forth in Part II Item 7A "Quantitative and Qualitative Disclosures About Market Risk" in our Annual Report on Form 10-K for the year ended December 31, 2022.