2023-10-05 05:33:09 ET
Summary
- Arlo, a small-cap tech company, has seen its stock skyrocket by over 150% this year due to increased services revenue and improved gross margins.
- Arlo's shift towards selling subscriptions has led to incredible profitability and long-term growth potential.
- The company has a highly rated product and brand, a large addressable market, partnerships with major retailers, and a growing subscription base.
With interest rate fears hitting a fever pitch, it's generally not a great time to buy into the stocks of small-cap tech companies that have already more than doubled year to date. Where the rise has been accompanied by a massive fundamental improvement, however, we can make exceptions on a case by case basis.
Enter Arlo ( ARLO ), the security camera vendor. This small-cap stock has seen its stock skyrocket by more than 150% year to date, buoyed by a massive boost in services revenue and an accompanying lift in gross margins. And as a result of this shift toward selling subscriptions, the company has entered into a phase of incredible profitability.
As a reminder for investors who are newer to Arlo, the company's big move this year was to reduce hardware pricing in order to stimulate household adoption and services growth. And while hardware revenue did decline y/y (potentially suggesting that demand is relatively inelastic, as price drops outweighed volume gains), services revenue is soaring - which is the key to the long term future for Arlo. I commented on this favorable shift in my earlier article on Arlo, and despite continued strength in the stock, I also continue to be bullish on this name as it achieves outsized services growth and notches impressive scaling on its margin profile.
Hardware replacement cycles are difficult to predict. This is especially true of devices like security cameras - objects that we don't typically interact with on a day to day basis. It's better for Arlo to use the device to capture an install base, and generate lifetime revenue from its storage offerings.
Here is my full long-term bull case on Arlo:
- Highly rated product and brand. Arlo has been highly reviewed by major tech publications like CNET and PCMag and is considered one of the top home smart cameras. In addition to this, Arlo is one of the most prominent security companies to promote DIY installation, vs. other cameras that required expensive technicians for installation.
- Large addressable market. Arlo estimates the market for home security to currently stand at $53 billion, and it also expects this opportunity to grow to $78 billion by 2025 . With less than ~$500 million in annual revenue, Arlo has plenty of room to expand and innovate in this space. Given as well that there is no clear leader in the home security camera market, Arlo has a chance to take the crown.
- Partnerships with some of the largest retailers in the country. Arlo products are sold through resellers like Best Buy ( BBY ), Costco ( COST ), Amazon ( AMZN ), and others. Arlo's visibility to consumers is unmatched, and the company is well-positioned for retail sales growth ahead of the holiday season.
- Building a subscription base. Arlo is moving away from being a pure hardware products company. Paid subscriber accounts, now above 2 million customers, are growing at a >50% y/y clip. Arlo also notes that ~65% of new hardware customers sign up for Arlo Secure within six months.
- Profitability. Unlike many small-caps of its size, Arlo has hit pro forma operating profitability, or hovered very close to it, for several quarters in a row.
Stay long here: there's plenty of upside left to go.
Q2 download
Let's now go through Arlo's latest quarterly results in greater detail. The Q2 earnings summary is shown below:
Arlo's revenue declined -3% y/y to $115.1 million, ahead of Street expectations of $110.9 million (-7% y/y). Again as previously mentioned, the biggest drivers of revenue were the price cuts to hardware that resulted in greater adoption of services. Product revenue fell -25% y/y to $64.9 million (underlying units fell -11% y/y, while price cuts made up the balance of the difference), while services revenue jumped 53% y/y to $50.3 million.
Needless to say, the cheaper hardware entry prices drove substantial account adoption. Paid accounts grew 55% y/y to 2.29 million, adding 245k net-new accounts in the quarter: stronger than 182k net adds in Q1. ARR, meanwhile, jumped 66% y/y to $193.6 million. This serves to underline the point that the new accounts that Arlo is bringing on this quarter will carry benefits across many quarters and years. Management also noted that ARPU per subscriber is increasing as well, as households trend toward selecting higher-priced plans.
It's also worth noting that churn rates for Arlo remain incredibly low. The chart below shows that Arlo's ~1% churn compares very favorably against some of the most notable subscription brands:
Management noted that demand has remained strong in spite of a tough macro environment, with performance carrying throughout Prime Day. Per CEO Matthew McRae's prepared remarks on the Q2 earnings call :
Our strategy and execution are driving these results and generating significant shareholder value. Despite the macroeconomic conditions, we are seeing strong demand as is evidenced by our key metrics and our inventory levels. Most recently, we saw that demand carried through to a successful Prime Day, which gives us a glimpse into the current consumer mindset ahead of the second half.
This upcoming holiday season, Arlo will lean further into our successful pricing strategy by launching a totally new low-cost security camera platform, and we have secured substantial placement in promotional vehicles across our major channels. Customer acquisition drives paid accounts, which drives the expansion of Arlo's profitability. With this backdrop, we expect full year service revenue to grow nearly 50% year-over-year and now exceed our $200 million target."
From a margin perspective: not only are company gross margins improving due to the favorable mix shift toward services (36.4% in Q2, up 470bps y/y), but the underlying services margin is also hitting an all-time high driven by economies of scale. Services gross margins scaled to 75.2%, up 170bps sequentially and up roughly ten points y/y.
Pro forma operating margins, meanwhile, hit 4.7% in the quarter - up 390bps y/y . On top of gross margin gains, headcount fell slightly y/y - down to 345 total employees, versus 354 at the same time last year.
Key takeaways
With a rapid buildup in paid subscription accounts, rising subscription ARPUs, gross margin improvements and bottom-line expansion, there's a lot to like about Arlo despite the sharp YTD rise. Keep riding the upward trend here.
For further details see:
Arlo: Executing On Its Subscription Strategy