2023-08-29 01:24:07 ET
Summary
- ARLO stock suffered a significant drop in 2022, but it is now coming back, and I believe it has the potential to double in the next 12 to 24 months.
- Arlo Technologies is a pioneer in DIY (do it yourself) smart security cameras and doorbells and generates revenue through subscription-based cloud services.
- The company has successfully transformed into a service business, with strong growth in paid accounts and annual recurring revenue, while keeping expenses under control.
In December 2021 I wrote my last article in Seeking Alpha and it was about Arlo Technologies, Inc. (ARLO), which I prognosticated would double in price in 2022, oh boy! The reality could not have been more brutal as the stock price got chopped by more than 60% in the following 12 months. 2022 was a terrible market for small caps without GAAP profitability regardless of the performance of the actual business. ARLO, the company, continued to perform, but the stock was in a complete different ballgame. I suffered the carnage and decided to exit the stock and take tax loss credits but I was determined to buy back once again when the shelling was over. I did that in December last year with the stock languishing at just $3 and I bought a sizable amount of shares for my finances. Now with the stock at around $10 I am happy with my decision which confirms my belief that many times the stock market doesn't accurately reflects the real value of a business and that there are always investment opportunities for those willing to take the time to research thoroughly for these hidden gems and have the patience.
I decided to write once again in SA and decided to do it once again with ARLO, which I think still represents a very compelling investment proposition.
In ARLO you can find a down to earth business model of a company that sells smart security cameras and doorbells and makes their money by selling cloud based services on a subscription basis to the buyers of these cameras. These are high tech cameras with 4K Video, Artificial Intelligence, they are interactive and Cloud based. Arlo pioneered DIY Smart Security which consumers now prefer over professionally installed solutions. According to the company, they operate in an industry that has a large TAM opportunity as the Global Home Security Market is estimated at $53 Billion (growing to $78 Billion by 2025).
ARLO products seamlessly integrates with many smart home platforms, including Apple Homekit, Amazon Alexa, Google Assistant, and more. They offer full control from one app in your phone and allow to get notifications on your smart device that show whether a person, package, animal, or vehicle has been detected. They also offer other sophisticated services for an additional fee, like Arlo Safe and Secure plans , with interactive notifications and Emergency Response, and Professional Monitoring, you'll get 24/7 Live Security Experts monitoring your home.
The Business Model
Until 2021 they were making money on sales of the cameras and services was a small but growing part of their business, but since 2022 the company decided to go all in with services and now uses hardware sales as a mean to generate service revenue as more than 65% of the clients end up signing for a monthly recurring service within the first 6 months of purchasing the equipment. Nowadays, margins on their hardware business (they sell an average of one million cameras per quarter) are very low, at around 5% gross margins, but their service business is growing tremendously and has a monstrous 75% gross margin contribution.
This from their latest earnings call:
Arlo has completed the transformation to a service business, as evidenced by the underlying drivers of our outstanding financial performance. Paid accounts grew 55% year-over-year to 2.3 million subscribers. Service revenue grew 54% year-over-year, reaching a record $50 million and our annual recurring revenue grew 66% year-over-year to $194 million. We also achieved a record service gross margin of 75%."
They are adding between 170K to 190K net paid subs per quarter that contribute a monthly $11.50 Retail ARPU (clients they make on their own, not via an strategic partner) and have a very low churn rate of 1.1%. These subs command a 75% Gross Margin and they are growing with excellent cost controls. For instance, headcount in Q2 2023 was 345 vs Q1 2023 334 and below Q2 2022 of 354 employees. The bump in SG&A at the end of 2022 seen in the graph is mostly explained by an ill-timed, and in my opinion unnecessary, marketing campaign that costed $ 30MM that has been terminated.
Seeking Alpha
The company is looking to accelerate its new found winning strategy by trying to gain market share with a new line up of lower cost security cameras that will be launching soon. This from their latest Conference Call:
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"
ARLO commercializes its hardware through different venues. Currently, approximately 30% is done via Bix Box retailers like Target, Walmart, Amazon and Best Buy. An increasing percentage of sales are coming from the direct to consumer efforts at ARLO.COM, these sales are the most profitable and generate a higher engagement with the client. Most importantly, strategic alliances make the highest percentage of sales, of these alliances the one stablished with VERISURE in EMEA is of utmost importance to the company.
Verisure
On November 7th, 2019, ARLO got into a partnership with Verisure. Verisure is big, it is by far the most important security company in Europe and Latin America and the contract stablishes a one to one subscription contract with all the clients that Verisure installs ARLO cameras.
This is the key of this agreement:
Multi-channel supply partnership: In connection with Verisure's addition of Arlo's retail and e-commerce go-to-market channels, Arlo will become a key supplier to Verisure for smart security cameras. Verisure has a guaranteed minimum purchase commitment of $500 million cumulatively over the next five years. Verisure will also purchase associated cloud services from Arlo, including artificial intelligence, computer vision and other advanced technologies. "
From this contract, already $400 million have been delivered and the company expects to exceed the $500 million by the second quarter of next year. Nothing has been said in the latest conference call regarding how this business relationship will continue past this 500 million mark. My feeling is that both companies benefit from this partnership as Verisure has access to ARLO leading technology which allows them to lower customer costs. There is a possibility that Verisure chooses another vendor but I am inclined to think that they might offer to acquire ARLO. This is certainly a risk going forward, there is a bigger discussion regarding this strategic relationship in my previous article.
Balance Sheet & Valuation:
The company has been able to navigate the challenging 2022 market and has made it to the other side. They are finally making a profit on a non GAAP basis and I estimate that soon they will be turning a GAAP Profit as well. In the meantime, they have no debts and $123.7 million in available cash, cash equivalents and short-term investments. The company generated approximately $11.5 million in free cash flow in Q2, which represents a free cash flow margin of 10%.
There are 92 Million shares outstanding which gives the company a market cap of $990 MM and Enterprise Value (EV) of $765 M. I believe this valuation is cheap considering the recurring nature of their business, low churn, high growth and proven business model.
These are some financial projections that I have done myself based on actual data and guidance from the company regarding this year and how they see their business evolving in the future. As you can see in these projections, I assume the company keeps adding 180K subs per quarter and that their sales of equipment increases slowly, but this could accelerate if their new lower cost product line is successful. I am keeping gross margins stable but increasing them slightly in service as they gain economies of scale. ARLO has recently increased their service price and that had an irrelevant effect on churn, so an additional price increase can't be discarded in the future that will bump up service GM. Shares outstanding continue to increase as they pay part of salaries in stock but this is something I hope can be addressed and paid in cash or the company buy back shares in the market to compensate the dilution, they will have enough FCF to do it.
Hope this time my prediction comes true, but I would venture again that this stock has the potential to double in the next 24 months. The risks to this outlook, besides a market crash like 2022, is a slowdown in the rate of subs acquisition and that something unexpected happens with their business partner Verisure.
For further details see:
Arlo Technologies: Buy This AI And Cloud Gem That Is Set To Double