2023-10-19 03:11:38 ET
Summary
- With its services-first business model, established global presence, and commitment to product innovation, we are confident that Arlo will deliver strong returns for its shareholders.
- Our analysis affirms the company's successful business transformation, positioning Arlo strategically for sustainable long-term growth and profitability.
- Aligned with Wall Street analyst expectations and our DCF model projecting a substantial upside potential, the stock appears highly attractive.
- Given Arlo's strong market position, innovative strategies, and compelling valuation, we recommend a "Buy" rating for investors.
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Investment Thesis
Arlo Technologies (ARLO) stands as a key player in the rapidly expanding smart home security market. By transforming its business model to prioritize services and subscriptions, Arlo is witnessing substantial growth in its paid subscriber base. The company's strategic positioning, evident through its global presence and commitment to service-oriented solutions, positions it favorably for future expansion and profitability. The Services segment exhibits strong growth, setting the stage for a promising FY24 and beyond.
Arlo's transformation to a service-first business model has started to accelerate revenue and gross margin expansion. The company's innovative product lineup showcases its commitment to meeting evolving consumer needs. Analyst consensus and DCF calculations reveal an undervalued stock, with a fair value of $12, indicating a substantial upside potential for investors.
Company Overview
Arlo Technologies, one of the best brands in the smart home security market, delivers smart home security solutions around the world, using various smart devices and services. Its products include cameras, smart security lights, baby monitors, audio doorbells, and more, and it sells these products through various channels such as retail, wholesale, wireless carriers, as well as its own online store and paid subscription services.
The company's objective is to stay ahead of competition with cutting-edge technology and build trusted, lifelong customer relationships by delivering exceptional user experiences (Source: Arlo).
Business Overview
Market Opportunity
The global Home Security Systems market is highly fragmented, comprising numerous local and global players. According to MarketsandMarkets , the global home security market is anticipated to reach $84 billion by 2027, growing at a CAGR of 8.2%.
WW Home Security Systems Market (MarketsandMarkets)
Arlo Technologies has successfully established a robust presence in key regions worldwide, spanning over tens of countries. This strategic positioning enables the company to leverage the market opportunity and cater to the increasing demand for smart home security systems, particularly in regions like North America, Europe, and Asia Pacific.
Business Model Transformation
As the demand for smart home security systems continues to soar, Arlo Technologies finds itself in a prime position to capitalize on this expanding market. The company has implemented a clear and effective strategy aimed at establishing itself as a dominant player in the smart home security industry. Arlo Technologies' most strategic move was the shift to a service-first business model, designed to propel accelerated growth and enhanced profitability.
ARLO Revenue Mix and GM % Trajectory (Author)
Arlo operates within two primary revenue segments: Products and Services. In 2019 , Services accounted for a mere 10% of the revenue mix, and the company faced challenges with low gross margins. Recognizing the need for transformation, Arlo's leadership made a decisive shift from being solely a hardware products company to becoming a service-oriented business, adopting a subscription revenue model. This strategic pivot yielded remarkable results: gross margins surged to 36% , primarily attributable to a substantial 75% gross margin contribution from Services. Additionally, the number of paid accounts witnessed an impressive 55% year-over-year growth, reaching 2.3 million subscribers.
Currently, Services constitute almost half of Arlo's overall business, poised to achieve an annual revenue milestone of $200 million this year as per Arlo's Q3 guidance . This remarkable transformation underscores Arlo Technologies' ability to adapt and innovate, positioning the company as a key player in the smart home security market.
ARLO Paid Accounts Growth (ARLO Quarterly Earnings)
We firmly believe that this strategy will drive significant growth and profitability for Arlo in the upcoming years.
Innovative Product Roadmap
Arlo Technologies differentiates itself through a strategic focus on product innovation. Utilizing its expertise in design, engineering, and technology, the company consistently develops advanced products that align with changing consumer needs. Arlo's dedication to research and development is evident in its diverse product range. For instance, the Arlo Essential XL series, including the 2nd generation Arlo Essential XL Outdoor Camera , sets a new standard for affordable cameras, meeting the demands of budget-conscious consumers while delivering enhanced battery life.
Arlo Product Portfolio (www.arlo.com)
Arlo's strategic product roadmap not only demonstrates their technical expertise but also underscores their capacity to effectively foresee and address market demands.
Financials
Revenue Acceleration Fueled by Services
In Q2 2023, Arlo Technologies reported a revenue of $115 million , representing a slight decrease of 3% year-over-year. However, it is crucial to note the substantial growth within the Services segment, which is experiencing rapid expansion. Service quarterly revenue surged impressively by 54% year-over-year, reaching a historical high of $50 million .
ARLO Service Revenue Growth and GM Expansion (ARLO Quarterly Earnings)
Arlo's FY23 full year guidance for flat revenue growth might raise concerns, but the robust momentum within the Services sector signals a promising trajectory. Analysts anticipate a significant increase in revenue for FY24, estimating a growth rate of approximately 9% year-over-year , driven by the ongoing momentum in the Services business (see chart below).
ARLO Revenue Estimates (Seeking Alpha)
Improving Gross Margins
Arlo's gross profit margins have displayed a consistent improvement, notably reaching 37% in FY23Q2 (see chart below). This notable increase can be attributed to the robust expansion of the Services business. The strategic focus on enhancing the Services segment not only fuels revenue growth but also contributes significantly to the overall improvement in gross margins.
ARLO Gross Profit Margin and Revenue (Finbox)
While the overall revenue figures might seem subdued, the accelerating Services segment coupled with the consistent improvement in gross margins paints a promising picture for Arlo Technologies.
Valuation
Currently, Wall Street stands firmly behind the stock, rating it as a Strong Buy with an average price target of $14.75 , indicating a substantial upside potential.
Our discounted cash flow [DCF] model also paints an optimistic picture. Using a 10% weighted average cost of capital [WACC] for discounting, we have assumed conservative revenue growth estimates, aligning on the WW home security market's growth rate of 8.2%. Additionally, we have factored in a 5% revenue CAGR as a terminal growth value beyond the 10 years modeled. Our assumptions also include Arlo turning profitable from fiscal year 2025 onwards, maintaining an average 9% free cash flow [FCF] margin.
Based on our DCF calculations, the business's fair value is approximately $1.12 billion. This valuation reveals a substantial upside potential for the stock, indicating a target price of $12.
Risks
The company derives approximately one-third of its sales from the EMEA region. However, during Q2 2023, there was a notable decline in EMEA revenue, experiencing a -19% year-over-year decrease . Management clarified that this decline was primarily due to their largest channel partner adjusting their inventory levels and that it should not be interpreted as a demand-related problem. Nonetheless, it is essential to closely monitor the performance in the EMEA region for any structural changes in market dynamics.
ARLO Revenue by Geography (investor.arlo.com)
Conclusion
With its services-first business model, established global presence, and commitment to product innovation, we are confident that Arlo will continue to increase market share and deliver strong returns for its shareholders. Our analysis indicates that the company is strategically positioned for sustainable long-term growth and profitability in the market.
Considering its current undervaluation, we recommend a "Buy" rating for Arlo with a price target of $12 .
For further details see:
Arlo Technologies: Perfectly Positioned For Sustained Growth