Description

Introduction

ARLO sells home security cameras, video doorbells, and related service plans. They can be thought of as similar to and competitive with the more familiar AMZN-owned Ring brand. ARLO stock has appreciated by about 50% in the last 6 months, and is up by ~10% after their recent Q4 report earlier this month, as investors have become enthralled with the recurring subscription revenue growth story. ARLO has certainly reported some impressive metrics, such as the staggering +145% growth in paid subscribers in their most recent quarter. However, I believe the recent growth to be of much lower quality than is well-understood, the company is in a competitively disadvantaged position in a crowded market, and there are serious doubts as to whether the company can ever achieve material profitability. As such, I view the current valuation as being quite generous with the potential for substantial downside. Short interest is relatively low, at 5% of the float.

Company Background

ARLO became public as a standalone company when it was spun out of NTGR in 2018. They make various types of wireless connected home security cameras (doorbell cameras, standalone cameras of various resolutions, floodlight cameras, etc). As you can see from their website, they don’t offer much beyond cameras:

https://www.arlo.com/en-us/

ARLO competes most directly against Ring (AMZN) and Nest (GOOG). In general, ARLO cameras are reasonably well-reviewed when compared to Ring & Nest with the key advantages typically noted as offering higher resolution/better video and interoperability across all smart home platforms, relative to peers. 

ARLO sells their products through traditional retail channels (Amazon, Walmart, Best Buy, etc), through their own site, arlo.com, and also through various partners. For example, their European sales are entirely through their partner Verisure, a European security company; Verisure is their largest single partner, though they have a number of others.  

ARLO tries to attach monthly service plans whenever they sell a device, with the primary function of the service plans being uploading and saving video in the cloud. The plans they currently offer range in price from $3/mo to $15/mo. They’ve announced intentions to offer a broader range of monthly plans to be available later this year, but below are their currently available offerings:

In CY21, the company did $435M in revenue (+22% y/y) with a revenue mix of 76% product sales & 24% Services. Services includes some mix of NRE work for partners & pre-paid subscriptions sold under their legacy model (legacy vs current model explanation can be found below). I estimate that about 70% of the $103M in CY21 Services Revenue to be true recurring plan revenue where they’re collecting cash on an ongoing basis, although they do not break this out specifically.

Q421 Report (March 1)

ARLO’s stock has rallied after their Q421 report earlier this month, as the company reported a surprise profit in the quarter (non-GAAP EPS +$0.04 vs -$0.04 expected), along with strong paid account growth and CY22 Revenue guidance above consensus. Key items from the Q4 print:

• Paid subscribers surpassed 1MM, ending the Q4 at 1.067MM, +145% y/y

• Guided total CY22 Revenue to $500M ($490M-$510M range), +15% y/y, vs consensus of $473M

• Posted Non-GAAP EPS of +$0.04 in a surprise first ever quarterly profit vs ($0.04) consensus

• It should be noted that anomalously low quarterly operating expenses that were down 10% sequentially and at the lowest absolute dollar level in several years was responsible for at least half the bottom line beat. The sequential decline in OpEx alone (in their highest seasonal revenue quarter) explains the entire positive 2.5% non-GAAP operating margin reported in the period. While they explained the low Q4 OpEx as being driven by “sublease of our former San Jose office and lower professional fees,” factors which would seem to be somewhat sustainable, they guided Q1 OpEx back up by +15% sequentially in Q122 on a lower revenue level than Q421 and CY22 OpEx much higher (+30% y/y vs +15% guided CY22 revenue growth) showing Q4 OpEx was indeed an anomaly. 

• Big increase in brand marketing spending starting in CY22

Overall, street estimates out of the quarter changed as follows. More detailed discussion of detailed quarterly metrics is in the section below. 

Despite the positives in the quarter, the approximate $50M per year reduction in non-GAAP EBIT estimates for each of CY22 and CY23 is quite notable, to the say the least, but has seemingly been shrugged off by investors for now.  

Low quality metrics, increased investments & long-term profitability questions

While subscriber growth has been impressive, ARPU declines have been dramatic as well, indicating the new subscriber growth is coming in at incrementally lower pricing, and meaningfully so.

For context, the ‘Legacy business model’ (labeling from their chart above) did not emphasize selling/attaching service plans, though they were available and sometimes sold as a prepaid bundle with the camera. The New Business Model means that they now give a 90-day free trial to their service plans with every product sold, and have had good success getting customers to keep the plans after the trial period. They have successfully increased paid service plan attach rates from under 10% to 60%+. That’s the good news.

The company discloses several key metrics each quarter around their recurring service business, namely ARR (annualized recurring service revenue in the last month of the quarter) and quarter end paid accounts (shown above). With these two numbers, we can calculate ARPU:

Couple items here: 

• The table starts in Q320, which is the earliest period for which they disclosed ARR. 

• They actual didn’t start disclosing any ARR numbers until their Q321 report in November 2021, which they did with a one year look-back to Q320, thus the availability of the data above

• This very obvious and ugly downtrend in ARPU has not been discussed on either of the two earnings calls held since this trend was calculable; no analyst has asked what’s going on

Related to the ugly declines in ARPU, it gets worse. Management decided to disclose some new metrics on the just held Q421 call. Here’s the slide:

Note the ARPU of $9.35 that’s over 30% higher than what can be readily calculated as an overall consolidated ARPU. The company does note that they’re excluding some recurring customers on this slide; they said the following on the call:

“If we dive a little deeper and focus specifically on the retail and direct paid accounts, which constitute more than 95% of our ARR, in the fourth quarter of 2021, these accounts had a monthly average revenue per user, or ARPU, of $9.35.”

Note that elsewhere the company discloses their overall paid subscriber churn at 2.8%:

So putting this together, this implies:

The numbers in bold above are calculated. The obvious implication here is that nearly 1/3 of ARLO’s paid subscribers are at around a $1 per month ARPU! Reminder that their lowest disclosed retail pricing plan is $3 per month. But they do also have partner relationships where subscriber metrics and overall details are vague to non-existent. Service GMs overall are in the low 60%s (63.2% Non-GAAP Service GMs in Q421) so it’s hard to see how the implied 300K+ subs around $1/mo ARPU (along with high 7% monthly implied churn) are not negative GM to the company. In summary, the subscriber growth chart is a thing of beauty, but in examining how the sausage is made (strongly declining ARPU & implied math showing a large cohort of paid accounts at only around $1/mo), it seems obvious that the impressive growth in paid accounts the company reports is of highly questionable quality. 

Lifetime Value (LTV)

I won’t spend too much time on this, but I think the company has started putting out a cherry-picked/unrealistic LTV metric (a new disclosure this past quarter):

Note the language at the bottom that does not indicate that they are excluding any subset of their recurring ARR, or paid subscriber base. When I attempt to replicate their LTV calculation, I get the following. Note that in the table below, I use both their actual reported non-GAAP services GM from Q421 of 63.2% and the clearly selective 81% “retail” GM they claim, which they explicitly call out as representing only a subset of their paid subscribers (seen in pasted slide above):

There’s clearly a massive delta between the selectively calculated $550 LTV the company is now pitching to investors and the overall reality of the business. 

Long Term Targets

Further continuing on the ARPU contraction theme from above, the company just gave out “Long Term Targets” as follows for the first time with their Q421 report:

The company stated that these represent 3-5 year out targets. The numbers seem impressive (1.1M paid accounts now going to 5M+, for example). What’s also implied by the above targets is a further nearly 30% ARPU decline to $5/mo from the current $7/mo! They gave no explanation for this but at two recent investor conferences, management emphasized that ARPU expansion is a primary goal! Now, I don’t know whether this is just extreme sloppiness as they attempt to rush out new metrics and long term targets to impress investors, or whether there’s extreme ongoing ARPU compression that the company is simply not discussing with the street…but neither explanation is good. 

One last point on these “Long Term Targets”: they’re targeting 10%+ Non-GAAP EBIT margins, which sounds ok considering a majority of their revenue is low margin (10%-20% GM) product sales. One problem with this is their level of stock-based comp:

So under their years-away Long Term Targets they envision making a slightly greater than 0% GAAP EBIT margin! So if they execute to plan and hit their Long Term Targets, this is barely a real business & certainly not one that earns its cost of capital. How exciting. 

Massive Spending Increase

The company has shown incredible restraint in OpEx spending over the last several years, culminating in the ultra-low OpEx (and first profitable) Q421 quarter. This will now start heading in the other direction. OpEx history:

The above paints a picture of a business that was being starved of investment over the last several years, culminating in Q421 where record low non-GAAP OpEx at just 20% of revenue allowed for one quarter of low-single digit (2.5%) non-GAAP EBIT profitability. 

The trend of steadily declining OpEx is now ending. While it does not explain the entire guided increase in OpEx, the company specifically announced plans for a new incremental $21M (CY22 spend) brand marketing campaign. This is a massive increase in marketing spend: ARLO’s entire non-GAAP S&M spend in CY21 was $43.5M, so this new brand marketing campaign by itself would alone grow the company’s S&M spend by nearly 50%. 

I’d quickly note here that the company has noted being very short on inventory, and as part of their annual guidance, did guide Q2 to be very sub-seasonal (presumably due to inventory shortage):

This is roughly the quarterly revenue cadence they guided to, which arrives at the $500M annual revenue guidance midpoint (guided 44% of CY22 revenue in 1H along with specific Q1 revenue guidance):

In CY20, Q2 revenue was +2% sequentially, and in CY21 Q2 was +19% sequentially. So this Q222 revenue is anomalously bad; I’m willing to give them the benefit of the doubt and say it’s because of their current inventory shortage and not a sudden weakening of demand. Inventory does look very low:

Two obvious questions come to mind though:

1. If they’re that short on inventory right now, why is now the right time to significantly increase marketing spending to drive demand that they may very well can’t meet?

2. Paid subscribers reportedly just grew 145% y/y in Q421 – is this really such a slow growth rate that it needs to be juiced by a massive increase in marketing spend? Perhaps the paid subscriber growth hasn’t actually been of the highest quality (as suggested by ARPU analysis above) and management knows this? Maybe this explains why, despite growing paid subscribers 145% in the MRQ, management is implementing a huge new brand marketing campaign that alone will increase S&M spend by nearly 50% y/y in CY22, and drive the company back into substantial losses?

Overall, it seems the company is acknowledging that the period of under-investing is over and that the company will be returning to its historical pattern of consistent operating losses given more normalized operating expenses. Guidance this year is for ($30M)+ of non-GAAP EBIT losses versus prior street expectations for a modest profit in CY22. 

Competitive Position

I won’t belabor the point that two of its primary competitors, Ring (AMZN), and Nest (GOOG) are both very well capitalized to keep up with any product advances, and would also likely be less margin sensitive on hardware due to their networked home security products driving synergies with their respective advertising & e-commerce businesses. 

I’d note that product reviews (some links at the bottom of this write-up) generally are most favorable towards ARLO in two regards: 1) video quality, 2) interoperability. With multiple competitors offering very similar camera products (including much better capitalized competitors), I highly question the durability of any technical product advantages such as video quality. And I further think that the products available across providers all look very similar to the average consumer, with the notable exception that ARLO’s range of hardware offerings is much more limited than its peers. Regarding interoperability as a supposed advantage, I believe any consumer who is already locked into a particular smart home system, will simply choose the compatible hardware from AMZN, GOOG, AAPL, etc. And if they’re not committed, I don’t think the future flexibility offered by ARLO’s interoperability is all that significant a factor, particularly in light of a key shortcoming of ARLO’s offering. 

ARLO has a key competitive disadvantage that they never discuss, but it’s a big deal

From my analysis, I see that there are four primary players in the mass market low-end/DIY home security system market: Ring, Nest, ARLO, and SimpliSafe. ARLO has a key shortcoming relative to the other 3: it lacks certification under any of its plans as a true home security service. By way of background, homeowners insurance companies will typically either require a monitored home security service or offer discounts on homeowners insurance premiums for having this type of service, or both. For a homeowner looking for a qualifying plan, Ring, Nest (via Brinks), and Simplisafe can all provide a certification that looks like this: 

This briefly describes the qualified professional monitoring offerings from Ring and Simplisafe, while I’d note the Nest/Brinks offering is pricier than Ring/Simplisafe, but not as high as the fuller priced offerings such as ADT that start at $46/month and go up in price from from there. 

Source

Having personally spoken with 3 separate sales reps at ARLO recently, each has confirmed to me that ARLO does not have any plans that would allow them to provide this certification for insurance companies, nor are they aware of any plans for ARLO to offer this. The key missing piece that does not allow them to be a certified provider is that they do not offer 24/7 live human monitoring. This major shortcoming effectively takes ARLO away as a serious competitor for a large swath of homeowners who need a certified offering. This could be why ARLO seems to be relegated to a low & declining ARPU customer base. While pricing varies across these mass market systems, they’re all cheaper on a monthly basis than the full-service ADTs of the world. Simplisafe, for example, has a $15/month plan that is qualified. Recall that ARLO’s high end plan also costs $15/month, but the difference is State Farm et al won’t recognize the ARLO plan! I’m convinced this plays a large role in ARLO’s low ARPU (ARPU on an incremental paid customer in Q421 was just $4.25!) It makes sense that no one’s buying the high end $15/month plan from ARLO given it’s clearly inferior to similar priced options in this key regard.

In terms of market share and where ARLO sits, I have a few relevant data points, each of which point to ARLO being quite a minor player in the space:

2020 Video Doorbell Unit Sales Market Share (ARLO would be somewhere within ‘All Others’):

Versus ARLO’s current 1MM+ paid subscribers at YE21, in April 2019, Simplisafe had 3MM paid subscribers: “SimpliSafe sells a set of sensors, security cameras, and a keypad, then charges $15 per month for its monitoring service. The company now has more than 3 million paid subscribers, up from 2 million in early 2018.”

Valuation & expected cash burn

ARLO currently sports a FD market cap of $865M, and with $176M in cash ($1.94/share, no debt), an EV of $689M. While the balance sheet looks reasonably strong, it should be noted that the company is guiding to cash burn of about $60M in CY22, taking cash down to ~$115M at YE22 and that the CFO recently talked about cash bottoming somewhere below $100M, so they do expect to burn through much of their current cash balance before, perhaps, reaching FCF positive. Assuming normal share count dilution, which has been running at about 6%, and the guided cash burn, YE22 EV at the current share price will be around $800M, so meaningfully higher than what it shows as currently. 

These valuations compare to a current level of 63% GM ARR of $90M. So this recurring revenue story is currently valued at 8x ARR and 12x recurring non-GAAP gross profit. I’d argue this is a very expensive valuation, particularly relative to lower recurring revenue multiples broadly in the market today, and with significant questions around ARLO’s achieving future profitability as a minor player in a highly competitive/commoditized market. 

Given the relatively low service GMs, and serious questions around long-term profitability, I don’t think a 2x-4x ARR multiple would be unwarranted here, which would represent a $4-$6 price target. 

Alternatively, if I give the company credit for their $1B in total revenue (3-5 year long term target) and 5% GAAP operating margins (several hundred bps higher than their LT target), and applied a 20x multiple on taxed GAAP net income, discounted back 3 years at 10%, I’d get to about $6. 

The current stock price approaching $10 is roughly double what I’d deem to be fair value. 

Risks

• If the company can maintain/accelerate paid subscriber growth, while steadying the decline or increasing ARPU (and commensurate service GM benefits), I would re-evaluate

• This is not at all what’s reflected in the company’s long term targets for significant further ARPU deterioration, I’d note

• Recurring revenue/SaaS models/stocks become en vogue again, re-inflating recurring revenue multiples out of their current malaise, and lifting all boats, including the lower quality names such as ARLO

• I’d note here that ARLO is up ~50% in the last 6 months during this period of extreme de-rating of recurring revenue comps so it hasn’t exactly traded inline with these comps during this time, and there’s no reason to believe it deserve a further re-rating higher should others see a valuation rebound

References

Product Reviews:

https://www.digitaltrends.com/home/arlo-vs-ring-camera/

https://spacehop.com/arlo-vs-nest/

Recent ARLO Company Presentation (contains all company slides pasted above):

https://s22.q4cdn.com/363130056/files/doc_presentations/2022/03/Arlo_2022-JMP-Technology-Conference-Presentation.pdf

Catalyst

- Subscriber growth disappoints despite massively increased spending

- ARPU keeps declining, as LT guidance suggests