2023-04-16 05:52:20 ET
Summary
- Shares of Arlo have nearly doubled this year owing to the company's continued progress on building out its subscription business.
- The company recently passed 2 million paid subscribers.
- Arlo is expecting to hit pro forma operating margins of 5% in FY23, compared to -1% in FY22, driven by continued mix shift into services revenue.
- Still trading at just ~1x forward revenue, Arlo remains quite cheaply valued.
In this volatile stock market environment, it's often the most under-the-radar stocks that have the most potential to outperform the broader markets. Don't neglect small-cap plays even as most investors back away from risk-taking.
One of my most fortunate calls this year was on Arlo ( ARLO ), a smart camera maker that has quickly become one of the most dominant brands in home security. Earlier this year when Arlo was trading under $4, I recommended a buy on the stock owing to its persistent undervaluation. Now, the stock is up ~75% year to date, as investors have gotten behind the company's growing services story.
In spite of the sharp recent momentum, I remain bullish on Arlo and believe there is still plenty of upside left to go. There are two keys to this story. The first is Arlo's services business. The company invested heavily in its early years in low/no-margin hardware in order to build up its brand name and its customer base, but that's only now starting to play out, as gross margins and operating margins creep upward. Recently, Arlo announced that it crossed 2 million paid subscribers , and in its most recent quarter the company added new customers at a nearly ~200k/qtr pace.
The second key is valuation. Arlo remains quite cheap in spite of its strengths: at current share prices near $6, Arlo trades at a market cap of just $574.3 million. After we net off the $113.7 million of cash on the company's most recent balance sheet, Arlo's resulting enterprise value is $440.6 million.
For FY23, meanwhile, Wall Street analysts are expecting Arlo to generate revenue of $474.5 million, representing a -3% y/y decline. This puts Arlo's valuation at just 0.9x EV/FY23 revenue. The drag to revenue is hardware-based; the company noted that channel partners are shrinking their inventory in the face of expected sales slowdowns. However, underneath the hood, Arlo's services revenue (and services revenue mix) is expanding.
Even if we assign zero value to hardware revenue and assume a ~35% revenue mix to services in FY23 (versus 28% in FY22), services revenue in FY23 would be $166.1 million (+22% y/y; versus a Q4 exiting growth rate of 34% y/y); Arlo's valuation against its services revenue only would be just 2.6x EV/FY23 services revenue. Note as well that Arlo's CEO anecdotally noted in the fourth-quarter earnings call that he expects the next twelve months of services revenue to be "nearly $200 million", so even this estimate skews conservative.
Beyond its cheap valuation, here is my full long-term bull case for Arlo:
- Best-in-class category leader. 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.
- Huge TAM. 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 nearly a 2x 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.
The bottom line here: Arlo's rebound rally is just getting started. Stay long here and keep riding the upward momentum.
Q4 download
Let's now cover Arlo's latest Q4 results in greater detail. The Q4 earnings summary is shown below:
Arlo's revenue declined -17% y/y to $118.5 million, but beat Wall Street's expectations of $107.4 million (-25% y/y) by a fairly hefty margin. Underneath the hood, product/hardware revenue fell -30% y/y, while services revenue grew 34% y/y. As a percentage of revenue, services mix of 32% improved dramatically versus 20% in the year-ago Q4.
The hardware revenue decline is driven by channel partners' bearishness. Per CFO Kurt Binder's remarks on the Q4 earnings call:
As mentioned last quarter and consistent with commentary heard across the broader consumer retail market, we experienced softening demand in the second half of Q3, which continued into the fourth quarter. This trend coupled with certain retailers tightening their inventory level can be attributed to the revenue decline we experienced in Q4 and we expect these pressures to continue into early 2023."
The optimistic view of this is that demand will be pushed-out rather than lost. And if and when consumer sell-through improves, retailers will have to play catch-up on inventory, which is a tailwind to Arlo's future revenue growth.
It's the services story, however, that we should be zooming in on. Q4 period-end subscribers grew 75% y/y to 1.86 million, and Arlo provided an intra-quarter update in Q1 that subscribers surpassed 2 million.
The improved services revenue mix helped tilt pro forma gross margins up five points to 28%, though pro forma operating margins in the fourth quarter fell to -3%, two points worse than -1% in the year-ago Q4 driven by higher discretionary marketing spend. Management does expect pro forma operating margins to hit positive 5% in FY23, however, driven by continued growth in services amid hardware pressures.
Key takeaways
Despite its recent run-up, Arlo remains quite conservatively valued at <3x forward services revenue and <1x total revenue. Services are the key to the company's growth, and the company has continued to aggressively expand its subscriber base while holding onto an industry-low ~1% churn rate. Stay long here.
For further details see:
Arlo: Strong Momentum For The First Time In Years