Arlo Technologies, Inc. - Annual Report: 2021 (Form 10-K)
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_______________
FORM 10-K
☑ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the fiscal year ended December 31, 2021
☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the transition period from to
Commission file number: 001-38618
_______________
ARLO TECHNOLOGIES, INC.
(Exact name of registrant as specified in its charter)
| Delaware | 38-4061754 | |||||||
| (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification Number) | |||||||
| 2200 Faraday Ave., | Suite #150 | |||||||
| Carlsbad, | California | 92008 | ||||||
| (Address of principal executive offices) | (Zip Code) | |||||||
Registrant’s telephone number including area code
(408) 890-3900
Securities registered pursuant to Section 12(b) of the Act: | ||||||||||||||
| Title of each class | Trading Symbol(s) | Name of each exchange on which registered | ||||||||||||
| Common Stock, par value $0.001 per share | ARLO | New York Stock Exchange | ||||||||||||
Securities registered pursuant to 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐ No ☑
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☑
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☑ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☑ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
| Large accelerated filer | ☐ | Accelerated filer | ☑ | |||||||||||||||||
| Non-accelerated filer | ☐ | Smaller reporting company | ☑ | |||||||||||||||||
| Emerging growth company | ☑ | |||||||||||||||||||
| If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. | ☐ | |||||||||||||||||||
Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.) Yes ☐ No ☑
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant as of June 27, 2021 was $581.4 million. Such aggregate market value was computed by reference to the closing price of the common stock as reported on the New York Stock Exchange on June 25, 2021 (the last business day of the Registrant's most recently completed fiscal second quarter). Shares of the registrant's common stock held by each executive officer and director and certain entities that own 15% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. The determination of affiliate status is not necessarily a conclusive determination for other purposes.
The number of outstanding shares of the registrant’s Common Stock, $0.001 par value, was 84,795,549 shares as of February 25, 2022.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive proxy statement for its 2022 annual meeting of stockholders, which will be filed within 120 days of the registrant’s fiscal year end, are incorporated by reference into Part III of this Annual Report on Form 10-K.
1
TABLE OF CONTENTS
| Item | PART I | Page | ||||||
| Item 1. | ||||||||
| Item 1A. | ||||||||
| Item 1B. | ||||||||
| Item 2. | ||||||||
| Item 3. | ||||||||
| Item 4. | ||||||||
| PART II | ||||||||
| Item 5. | ||||||||
| Item 6. | ||||||||
| Item 7. | ||||||||
| Item 7A. | ||||||||
| Item 8. | ||||||||
| Item 9. | ||||||||
| Item 9A. | ||||||||
| Item 9B. | ||||||||
| Item 9C. | ||||||||
| PART III | ||||||||
| Item 10. | ||||||||
| Item 11. | ||||||||
| Item 12. | ||||||||
| Item 13. | ||||||||
| Item 14. | ||||||||
| PART IV | ||||||||
| Item 15. | ||||||||
| Item 16. | ||||||||
2
PART I
Forward-Looking Statements
This Annual Report on Form 10-K (“Form 10-K”), including Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 below, includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements other than statements of historical facts contained in this Form 10-K, including statements regarding our future financial position, business strategy and plans and objectives of management for future operations, are forward-looking statements. The words “believe,” “may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “expect” and similar expressions, as they relate to us, are intended to identify forward-looking statements. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions described in “Risk Factors” in Part I, Item 1A below, and elsewhere in this Annual Report on Form 10-K, including, among other things: health epidemics, including the COVID-19 pandemic and its variants, and other outbreaks could significantly disrupt our operations; future demand for our products may be lower than anticipated; consumers may choose not to adopt our new product offerings or adopt competing products; the actual price, performance and ease of use of our products may not meet the price, performance and ease of use requirements of consumers; our dependence on certain significant customers; our reliance on a limited number of third-party suppliers and manufacturers; new cyber threats may challenge the effectiveness or threaten the security of our products; the collaboration with Verisure may not be successful; we may overestimate our ability to maintain, protect, and enhance our intellectual property; our efforts to retain key personnel and to attract, retain and motivate qualified personnel with technical expertise may not be successful; and the impact and timing of the restructuring plan and our business strategies and development plans may not be successful. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Annual Report on Form 10-K may not occur and actual results could differ materially from those anticipated or implied in the forward-looking statements. All forward-looking statements in this Annual Report on Form 10-K are based on information available to us as of the date hereof, such information may be limited or incomplete, and we assume no obligation to update any such forward-looking statements. These statements are inherently uncertain and investors are cautioned not to unduly rely upon these statements. The following discussion should be read in conjunction with our consolidated financial statements and the accompanying notes contained in this Annual Report on Form 10-K.
Summary of Risk Factors
Below is a summary of the principal factors that make an investment in our common stock speculative or risky. This summary does not address all of the risks that we face. Additional discussion of the risks summarized in this risk factor summary, and other risks that we face, can be found below under the heading “Item 1A — Risk Factors” in Part I of this Form 10-K and should be carefully considered, together with other information in this Form 10-K and our other filings with the SEC, before making an investment decision regarding our common stock.
•The effects of health epidemics, including the COVID-19 pandemic and its variants, could have an adverse impact on our business, operations and the markets and communities in which we, our partners and customers operate.
•We obtain several key components from limited or sole sources, and if these sources fail to satisfy our supply requirements or we are unable to properly manage our supply requirements with our third-party manufacturers, we may lose sales and experience increased component costs.
•We depend on a limited number of third-party manufacturers for substantially all of our manufacturing needs. If these third-party manufacturers experience any delay, disruption, or quality control problems in their operations, including due to the COVID-19 pandemic, we could lose market share and our brand may suffer.
•If disruptions in our transportation network occur or our shipping costs substantially increase, including due to the COVID-19 pandemic, we may be unable to sell or timely deliver our products, and our operating expenses could increase.
3
•If we lose the services of key personnel, we may not be able to execute our business strategy effectively.
•We expect our results of operations to fluctuate on a quarterly and annual basis, which could cause our stock price to fluctuate or decline.
•If we fail to continue to introduce or acquire new products or services that achieve broad market acceptance on a timely basis, or if our products or services are not adopted as expected, we will not be able to compete effectively and we will be unable to increase or maintain revenue and gross margin.
•We may need additional financing to meet our future long-term capital requirements and may be unable to raise sufficient capital on favorable terms or at all.
•Some of our competitors have substantially greater resources than we do, and to be competitive we may be required to lower our prices or increase our sales and marketing expenses, which could result in reduced margins and loss of market share.
•We entered into an asset purchase agreement (the “Asset Purchase Agreement”) and supply agreement (the “Supply Agreement”) with Verisure Sàrl (“Verisure”) that gives Verisure exclusive marketing and distribution rights for our products in Europe as well as the ability to sell our products through their direct channel globally. We cannot provide assurance that the arrangement with Verisure will continue to be a successful collaboration.
•We are dependent on information technology systems, infrastructure and data. System security risks, breaches of data protection, cyber-attacks, and erroneous or non-malicious actions or failures to act by our employees or others with authorized access to our networks could disrupt our products, services, internal operations, or information technology systems, and could lead to theft of our intellectual property, and any such disruption could reduce our expected revenue, increase our expenses, damage our reputation, and cause our stock price to decline significantly.
•Our future success depends on our ability to increase sales of our paid subscription services.
•Interruptions with the cloud-based systems that we use in our operations provided by an affiliate of Amazon.com, Inc. ("Amazon"), which is also one of our primary competitors, may materially adversely affect our business, results of operations, and financial condition.
•Our current and future products may experience quality problems, including defects or errors, from time to time that can result in adverse publicity, product recalls, litigation, regulatory proceedings, and warranty claims resulting in significant direct or indirect costs, decreased revenue, and operating margin, and harm to our brand.
•We rely on a limited number of traditional and online retailers and wholesale distributors for a substantial portion of our sales, and our revenue could decline if they refuse to pay our requested prices or reduce their level of purchases or if there is significant consolidation in our sales channels, which results in fewer sales channels for our products.
Item 1. Business
Overview
Arlo Technologies, Inc. (“we”, “Arlo” or the “Company”) combines an intelligent cloud infrastructure and mobile app with a variety of smart connected devices that is transforming the way people experience the connected lifestyle. Arlo’s deep expertise in product design, wireless connectivity, cloud infrastructure and cutting-edge AI capabilities focuses on delivering a seamless, smart home experience for Arlo users that is easy to setup and interact with
4
every day. Our cloud-based platform provides users with visibility, insight and a powerful means to help protect and connect in real-time with the people and things that matter most, from any location with a Wi-Fi or a cellular connection. To date, we have launched several categories of award-winning smart connected devices, including wired and wire-free smart Wi-Fi and LTE-enabled cameras, audio and video doorbells, and floodlight cameras. In addition, Arlo’s broad compatibility allows the platform to seamlessly integrate with third-party internet-of-things (“IoT”) products and protocols, such as Amazon Alexa, Apple HomeKit, Apple TV, Google Assistant, IFTTT, Stringify and Samsung SmartThings. Since the launch of our first product in December 2014, we have shipped over 22.9 million smart connected devices, and, as of December 31, 2021, our smart platform had approximately 6.1 million cumulative registered accounts across more than 100 countries around the world. We plan to continue to introduce new smart connected devices to the Arlo platform both in cameras and new categories, increase the number of registered accounts on our platform, keep them highly engaged through our mobile app and generate incremental recurring revenue by offering them paid subscription services.
Market
Our total addressable market consists of individuals and business owners who use connected devices to enhance their lives. Outside of the home, we have seen adoption of our cellular-enabled products in a variety of use cases, such as neighborhood watch, construction site monitoring, wildlife and outdoor trail surveillance and event monitoring. We believe the small business, government and direct home monitoring channels provide growth areas for us in addition to our retail and e-commerce presence. In early 2020, we launched Arlo SmartCloud ("Arlo Smart") a Software as a Service (“SaaS”) solution to deliver scalable security cloud services for business. With Arlo SmartCloud, we are extending our platform to partners to help innovate and deploy new opportunities beyond our own camera ecosystem. In the third quarter of 2021, we introduced Arlo Secure, our new service plan with coverage for unlimited cameras and an enhanced Emergency Response solution. Arlo Secure replaced Arlo Smart, our previous service plan. Existing Arlo Smart customers are entitled to either retain their existing plans or upgrade to the new Arlo Secure plans of their choosing. We believe we are well-positioned to extend our current reach to the broader connected lifestyle market both within and beyond the home as we continue to launch new products and services within our connected lifestyle platform.
Products
Smart Connected Devices
Released in 2021
Arlo Essential Indoor Camera, released in the first quarter of 2021, features 1080p HD video with enhanced night vision that allows users to capture important details day or night, a 130-degree diagonal field-of-view, motion and audio protection and full duplex audio for two-way conversations. The Arlo Essential Indoor Camera’s unique automated privacy shield is a reassuring feature designed to ease privacy concerns around having a security camera indoors. When the privacy shield is in the disarm mode, recording, motion and audio detection is disabled and won’t be enabled until the shield is opened by the user via the Arlo app. Users can also signal the privacy shield to open automatically and begin recording by starting a live stream or changing the camera to arm mode. This gives users the power to decide when their camera is monitoring a room and recording video/audio, and when it is not. Arlo Essential Indoor Camera also has built-in siren and works compatibly with Amazon Alexa, Google Assistant and IFTTT for easy interaction, automation and control.
Arlo Go 2 LTE/Wi-Fi Security Camera, released in the fourth quarter of 2021, delivers smarter security for remote or hard-to-access locations and enables LTE and Wi-Fi connectivity for monitoring vacation homes, construction sites, commercial properties, trails and more. Arlo Go 2 LTE/Wi-Fi Security Camera works with 4G cellular data plan to provide continuous connectivity and uninterrupted security and provides users with 100% wire-free setup, weather-resistant design, a swappable, rechargeable battery and the ability to connect to Wi-Fi when in range. Users can view and record 1080p full HD video day and night, as well as capture important details with color night vision thanks to an integrated spotlight. The two-way, full-duplex audio ensures clear communication with visitors, while a built-in siren can be triggered remotely or automatically to ward off intruders. Arlo Go 2 is also equipped with GPS positioning to track the camera’s whereabouts, allowing users to locate multiple devices across an expansive area, or in the event of theft.
5
Released in Prior Years
Arlo Q and Arlo Q Plus, released in the fourth quarter of 2015, bring Arlo’s performance and design to an indoor wired solution that allows users to easily monitor their surroundings with 1080p HD video quality. With two-way audio communication, users cannot only watch but also interact with their children, pets or other guests in their home or business. Arlo Q and Arlo Q Plus also feature optional 24/7 recording on a subscription basis. Arlo Q Plus includes the additional functionality of being powered-over-ethernet, which is common for business environments.
Arlo Go, released in the first quarter of 2017, is the world’s first commercially available LTE-enabled wire-free camera and provides untethered mobile security with support by major networks in key markets around the world, including AT&T and Verizon in the United States. Its IP65-rated weather-resistant design, 720p HD video quality, two-way audio and battery-powered operation allow small business owners, construction sites, outdoor enthusiasts and anyone in need of a truly mobile solution to virtually be at any location, anytime, and maintain monitoring capabilities.
Arlo Baby, released in the second quarter of 2017, combines performance and convenience with smart features that give added peace of mind for parents and caregivers. With 1080p HD video quality, air quality and temperature sensors, motion and audio detection, and advanced night vision, parents can be alerted to movement and changes in their child’s environment, and they can also remotely engage with their child using Arlo’s two-way audio feature, play music or custom recordings or even turn on Arlo Baby’s multi-colored night light to soothe their child to sleep. Parents can also easily move Arlo Baby, powered by its rechargeable batteries or by an electrical outlet, to different rooms.
Arlo Chime, released in the third quarter of 2018 and designed to plug into any standard wall outlet and pairs with the Arlo Video Doorbell to play a variety of ringtones or act as a siren, and even contains a silent mode for those times when users don’t want to be bothered. The Arlo Chime runs on two standard AA batteries which can last up to an entire year based on normal usage and features a weather-resistant exterior finish. For added ease and versatility, users also have the option to connect with their existing door chimes without needing to install any additional hardware or wiring.
Arlo Ultra, released in the first quarter of 2019 and designed with advanced 4K high dynamic range ("HDR") video quality with color night vision, wire-free setup, a 180-degree diagonal field-of-view, an integrated spotlight and crystal-clear two-way audio with advanced noise cancellations, Arlo Ultra delivers ultimate peace of mind for anyone looking to monitor their home or business. Users will experience enhanced detail and clarity and are able to zoom in on video clips to uncover details such as license plate and clothing. Arlo Ultra delivers one of the widest viewing angles in the wire-free security camera industry. Ultra is paired with a new Arlo SmartHub that functions as the nucleus of the smart home and engineered with Arlo RF, a proprietary two-way audio frequency technology.
Arlo Pro 3, released in the third quarter of 2019 and designed to provide home and small business owners with a high-performance, simple, wire-free security solution, Arlo Pro 3 features 2K resolution with HDR, an integrated spotlight with color night vision and a super-wide 160-degree field of view. Engineered to work indoors or outdoors, Arlo Pro 3 offers advanced image quality for DIY security that anyone can easily install in minutes and monitor from anywhere using the Arlo app. Arlo Pro 3 also includes a new Arlo SmartHub that securely manages network traffic to the camera in addition to enhancing power and Wi-Fi performance for better range and battery life.
Arlo Video Doorbell, released in the fourth quarter of 2019 and designed to capture what traditional video doorbells can’t, the new smart entry solution boasts an industry-leading vertical field-of-view, allowing users to get a bigger, more precise picture of their front porch. The Arlo Video Doorbell captures footage in a square aspect ratio to allow users to fully view packages on the ground, or visitors from head to toe. It also offers features such as HD resolution image quality along with clear, two-way audio for users to simultaneously see and speak to visitors. Unlike conventional doorbell cameras, the Arlo Video Doorbell delivers direct-to-mobile video calls and personalized alerts when packages, people, vehicles, or animals are detected, allowing for users to quickly reply or take action provided they are an Arlo Smart subscriber or in a trial period. The Arlo Video Doorbell connects to an existing mechanical or digital chime for simple installation and continuous power.
6
Arlo Floodlight Camera, released in the first quarter of 2020 and is the first wire-free floodlight camera on the market. The floodlight camera brings powerful LEDs, an integrated 2K HDR camera, 160-degree field of view, two-way audio, custom lighting configurations and a built-in siren to any home or small business. The floodlight camera can automatically measure the amount of surrounding light to allow for true customization for when the floodlight automatically turns on. The floodlight camera also offers three different light patterns – constant, flashing, and pulsating – which users can control manually on-demand or via automation rules.
Arlo Essential Spotlight, released in the second quarter of 2020 and designed with an industry-leading, 180-degree viewing angle with a square, 1:1 aspect ratio that ensures users can see packages on the ground or visitors from head-to-toe on their mobile devices. Arlo Essential Spotlight features HD video resolution combined with direct-to-mobile video calls, clear, two-way audio, an integrated spotlight with color night vision, built in siren and personalized alerts that allow users to quickly reply to guests or take action. Able to connect directly to Wi-Fi, the latest solution can be powered by its rechargeable battery or be hardwired for continuous charging.
Arlo Ultra 2, released in the second quarter of 2020 and designed to deliver an enhanced user experience with improved range, building on advanced features such as 4K video with HDR, an ultra-wide, 180-degree field of view, auto zoom and tracking on moving object with clarity and detail, color night vision allowing you to see video in color rather than traditional black and white, built-in siren that automatically triggered by motion or audio, or manually triggered via the Arlo App and more. Arlo Ultra 2 works with Amazon Alexa, Google Assistant, Apple Homekit, and IFTTT for easy interaction, automation and control.
Arlo Essential XL Spotlight, released in the third quarter of 2020 and which features an integrated, wire-free, extended-life battery that works for up to one year on one charge, an integrated spotlight with color night vision, HD video, two-way audio, motion detection alerts and a built-in siren. A direct to a Wi-Fi connection enables the Arlo Essential XL Spotlight camera to function as a stand-alone home security solution without the need for a separate Arlo SmartHub or Base Station.
Arlo Essential Wire-Free Video Doorbell, released in the third quarter of 2020, features an easy-to-install, wire-free, battery-powered design. Arlo’s latest front-entry solution – which joins a robust ecosystem of home security products and services – captures what conventional video doorbells can’t. An industry-leading, 180-degree viewing angle with a square, 1:1 aspect ratio ensures users can see packages on the ground or visitors from head-to-toe on their mobile devices. HD video resolution combined with direct-to-mobile video calls, clear, two-way audio and personalized alerts, allow users to quickly reply to guests or take action. Able to connect directly to Wi-Fi, the latest solution can be powered by its rechargeable battery or be hardwired for continuous charging.
Arlo Pro 4 Wire-Free Spotlight, released in the fourth quarter of 2020 and designed with weather resistance, wide 160-degree field of view, 2K video resolution with HDR, and six-month battery life. Pro 4 also includes two-way audio, built-in siren, and integrated spotlight. The updated Pro 4 has the ability to connect directly to home Wi-Fi networks without the need for a dedicated Arlo SmartHub or Base Station, which allows the camera to work as a standalone system for easier installation and setup.
Arlo Accessories
Arlo Charging Accessories are designed to offer additional convenient ways to keep Arlo wire-free cameras up and running even longer. With the Arlo Charging Station, users can charge up to two Arlo Pro, Arlo Pro 2 or Arlo Go batteries with fast-charging technology so there is always a battery ready to go. For those looking to eliminate battery swaps entirely, the mountable and weather-resistant Arlo Solar Panel connects to various Arlo cameras to keep batteries charged with just a few hours of direct sunlight.
Arlo Mounts feature innovative designs that allow users to mount their cameras outdoors or indoors, on ceilings or countertops. The Arlo Quadpod is a flexible mount featuring four legs crafted from flexible stainless steel and silicone that allows users to mount their camera even in challenging spots such as tree branches or metal poles.
7
Arlo Skins allow Arlo owners to customize their Arlo cameras to blend into their environments or add a pop of personality. Popular with outdoor enthusiasts, Arlo Camouflage and Ghillie skins are ultraviolet and water-resistant and made of durable silicone material for easy slip-on, slip-off convenience.
The Arlo App
The Arlo app, available for iOS and Android devices, is designed to provide our users with an easy-to-use, flexible, mobile-first experience that connects our users to the people and things that matter most to them. Our proprietary AI-based capabilities generate relevant and actionable real-time notifications, which enable users to live stream video or contact emergency services through the app notifications when Arlo devices detect motion or sound. The Arlo app also enables users to view their library of video clips and share them via text, email or social networks, and varies depending on the types of service plans that the user has. The app has four main screens: devices, library, mode, and setting:
•The Devices screen provides a quick at-a-glance dashboard of the user’s devices linked to their account, with valuable status icons like device battery life, and actionable buttons to live stream from their Arlo camera, call e911, activate a siren, or access the device’s settings.
•The Library screen delivers a timeline view of recorded video clips in the user’s Arlo Smart account, with additional tagging of clips that contain subject matter identified by Arlo Smart’s AI- and CV-based object detection, such as person, package, vehicle or even animal.
•The Mode screen enables users to quickly Arm or Disarm their Arlo system.
•The Settings screen provides access to additional device or account level information and features, including customization of Arlo Smart notifications and detection capabilities.
Services
In the third quarter of 2021, we introduced Arlo Secure, our new service plan with coverage for unlimited cameras and an enhanced Emergency Response solution. Arlo Secure replaced Arlo Smart, our previous service plan. Existing Arlo Smart customers are entitled to either retain their existing plans or upgrade to the new Arlo Secure plan of their choosing. The premium services boast support for unlimited household security devices, along with advanced AI object detection, and smarter, more interactive notifications. Additionally, the new 24/7, one-touch Emergency Response is available with the Secure Plus plan, enabling Arlo users to directly dispatch first responders during an emergency for quicker action. A three-month free trial period of Arlo Secure is provided with various Arlo camera and doorbell products. The features of the Arlo Secure subscriptions include:
•Emergency Response (Arlo Secure Plus) – With one touch, dispatch fire, police, or medical responders to the camera’s location. If directed by the user, Arlo’s Emergency Response team can also provide critical location information to responders en route to better prepare them, such as gate codes, medical conditions of family members, and pet details.
•2K (Arlo Secure) and 4K (Arlo Secure Plus) Cloud-based Video Recording – View 30 days of recordings securely stored on Arlo’s SmartCloud platform, for ultimate peace of mind and protection even if the device is damaged or stolen in a break-in, storm or other physical incident.
•Unlimited Cameras – Users can enjoy Arlo Secure service for all cameras in their home with one all-encompassing plan. Add new Arlo cameras for no additional charge.
•Advanced Object Detection – Arlo processes and filters 50 million events each day through advanced object detection backed by visual artificial intelligence, allowing for better recognition of people, packages, vehicles, and animals to add key context to notifications and reduce unwanted alerts.
8
•Smart Interactive Notifications – Users can take quicker action by responding to rich notifications or viewing an animated preview of a notification video through the lock screen on their smartphone.
•Smoke and CO Alarm Detection – Get notified when the camera hears a smoke or CO alarm triggered.
•Cloud-based Activity Zones – Users can reduce unwanted notifications by highlighting specific areas on their property where they want motion to be detected.
•Call a Friend – Customers can instantly call a friend through the Arlo App from their notification screen with one tap.
•24/7 Priority Support – Subscribers get priority technical support through the in-app Help Center with omni-channel access to phone, chat, Community or self-help articles.
Our paid services subscriber base has grown from over 230,000 paid accounts as of December 31, 2019 to about 1,067,000 as of December 31, 2021. In addition, some of our older camera products come with a prepaid service that provides users with rolling seven-day cloud video storage, the ability to connect up to five cameras and 90 days of customer support.
In January 2020, we launched Arlo SmartCloud, a SaaS solution to deliver scalable security cloud services for business. Its comprehensive offering includes computer vision, multi-object detection, audio analysis, security services, scaled storage and numerous ecosystem integrations. Arlo SmartCloud is a fully managed robust global platform of capabilities built for security, scalability, and reliability that can be deployed as part of advanced subscription services for hardware companies, automotive companies, service providers, insurance companies, home builders, smart communities, smart cities, traditional security companies, and other related verticals.
Our services also include certain development services provided to Verisure under a Non-recurring Engineering arrangement as part of the disposal of our commercial operations in Europe in the fourth quarter of 2019. Refer to the "Agreements with Verisure" section below for details.
Sales Channels
We sell our products through multiple sales channels worldwide, including traditional and online retailers, wholesale distributors, broadcast channels, wireless carriers, security solution providers as well as directly to consumers through our own online store.
Retailers. We sell to traditional and online retailers, either directly or through wholesale distributors. We work directly with our retail channels on market development activities, such as co-advertising, including digital and traditional media, online promotions and video demonstrations, instant rebate programs, event sponsorship and sales associate training. Our largest retailer is Best Buy and its affiliates. For the year ended December 31, 2021, we derived 13.0% of our revenue from Best Buy and its affiliates, which is the only retailer that accounted for 10% or greater of our revenue in 2021.
Wholesale Distributors. Our distribution channel supplies our products to retailers, e-commerce resellers, wireless carriers and broadcast channels. We sell directly to our distributors, including Ingram Micro, Inc., D&H Distributing Company, and Synnex Corporation.
Broadcast Channels. We also sell our products through TV shopping networks such as HSN.
9
Wireless Carriers. We supply our products to major wireless carriers around the world, including AT&T, Verizon, Telstra and Vodafone. This sales channel is and will continue to be the key route-to-market for our current portable LTE-enabled camera and any future cellular-enabled connected lifestyle devices.
Security Solution Providers. We sell our products and services to security solution providers, including Verisure, from which we derived 30.8% of our revenue, and Securitas Security Services USA, Inc.
Arlo.com. In the third quarter of 2019, we launched our online direct to consumer store to sell our products directly to our customers. We also sell most of our services, such as Arlo Smart and Arlo Secure, directly to consumers.
Agreements with Verisure
On November 4, 2019, we concurrently entered into an Asset Purchase Agreement (the “Purchase Agreement”) and Supply Agreement (the “Supply Agreement” and together with the Purchase Agreement, the “Verisure Agreements”) with Verisure. Verisure is a leading European provider of professionally monitored security systems with 24/7 response services to both residential and small business customers. The Verisure Agreements created a strategic partnership that leverages both the Company and Verisure’s capabilities to create incremental scale to address the ever-growing demand for residential and commercial security. The strategic partnership will combine our innovative connected cameras and cloud services platform with Verisure’s professionally monitored security solutions to provide a new level of smart security for European customers.
The Purchase Agreement provided that, upon the terms and subject to the conditions set forth in the Purchase Agreement, we transferred, sold and assigned to Verisure certain assets (the "Assets") related to our commercial operations in Europe (the "Business") to Verisure for $50.0 million in cash plus additional cash for certain inventory. The Purchase Agreement contains customary representations and warranties regarding Verisure, the Business and the Assets, indemnification provisions, termination rights and other customary provisions. Further, we agreed not to engage in any business that competes with the Business for a period of three years.
Pursuant to the terms and subject to the conditions set forth in the Supply Agreement, Verisure is the exclusive distributor of our products in Europe for all channels, and will non-exclusively distribute our products through its direct channels globally in connection with Verisure’s security business. During the five-year period commencing January 1, 2020, Verisure has an aggregate purchase commitment of $500.0 million. As of December 31, 2021, $160.1 million of the purchase commitment has been fulfilled. On December 30, 2019, Verisure prepaid $20.0 million for product purchases in fiscal 2020 and on December 21, 2020, Verisure prepaid $40.0 million for product purchases in fiscal 2021 and fiscal 2022.
The Supply Agreement also provides for certain development services to Verisure under the Non-recurring Engineering ("NRE") arrangement, including development of certain custom products specified by Verisure, in exchange for an aggregate of $10.0 million, payable in installments upon meeting certain development milestones. In the second fiscal quarter of 2020, an additional $3.5 million was added to the contract price as a result of a modification to Verisure's specification for an Outdoor Custom Camera being developed.
As part of the Purchase Agreement, we also entered into a Transition Services Agreement with Verisure ("Verisure TSA") to assist Verisure with the transition of the Company’s European commercial operations. These transition services primarily include IT support and other services, including sales and marketing, operations and supply chain, finance, legal, and human resources. As compensation for these transition services, we will be reimbursed by Verisure based on actual direct costs plus allocation of overhead.
10
Competition
We believe we are well-positioned to compete within the broader connected lifestyle market, both within and beyond the home as we continue to launch new product lines and services within our smart platform. However, our market is highly competitive and evolving, and we expect competition to increase in the future. We believe the principal competitive factors impacting the market for our products include price, service offerings, functionality, brand, technology, design, distribution channels and customer service.
We believe that we compete favorably in these areas on the basis of our market leadership position in the U.S. consumer network connected camera systems market, best-in-class technology, direct relationship with users and user engagement, trusted Arlo platform, strong Arlo brand and channel partners and deep strategic partnerships with key suppliers, such as Cypress Semiconductor Co., OmniVision Technologies Inc. and Qualcomm Incorporated. Moreover, our focus on building a connected lifestyle platform, combined with our leadership in innovation in the consumer network connected camera systems market, has led to the strength of our Arlo brand worldwide. We believe this focus allows us to compete favorably with companies that have introduced or have announced plans to introduce devices with connected lifestyle functionalities. Nevertheless, the connected lifestyle market remains highly competitive, and has a multitude of participants, including: large global technology companies, such as Amazon (Ring and Blink) and Google (Nest); security service vendors, such as ADT; telecom service providers, such as AT&T and Comcast; and smaller point product companies.
Many of our existing and potential competitors have longer operating histories, greater name recognition and substantially greater financial, technical, sales, marketing and other resources than we do. We anticipate that current and potential competitors will also intensify their efforts to penetrate our target markets. For additional information, see “Risk Factors-Risks Related to Our Business-Some of our competitors have substantially greater resources than we do, and to be competitive we may be required to lower our prices or increase our sales and marketing expenses, which could result in reduced margins and loss of market share.”
Research and Development
We are passionate about developing new and innovative products and services that enable the connected lifestyle. Our research and development team collaborates with our product team to design and build differentiated new products and improve upon our existing products and services. Our goal is to create unique user experiences within the connected lifestyle. For example, our original Arlo camera was the world’s first commercially available 100% battery-operated Wi-Fi security camera with 720p HD video, IP65-rated weather resistance and night vision. The groundbreaking nature of the product, first launched in December 2014, gathered critical acclaim and market success. Our research and development team has taken this same approach to all of our subsequent product releases, constantly innovating to stay ahead of the competition.
As of December 31, 2021, our research and development staff consisted of 131 employees, located in our offices worldwide, and was comprised of front-end and back-end software engineers, radio frequency engineers, electrical engineers, mechanical engineers, system test engineers, computer vision scientists and data analysis engineers, UX and industrial design engineers and mobile app developers. We intend to continue to invest in research and development to expand our platform and capabilities in the future.
Manufacturing
While all of our products are primarily designed in North America, we currently outsource manufacturing to Foxconn Cloud Network Technology Singapore Pte. Ltd., Pegatron Corporation, and Wistron NeWeb Corporation, which are all headquartered in Asia. Although we do not have any long-term purchase contracts, we have executed master product supply agreements with these manufacturers, which typically provide indemnification for intellectual property infringement, epidemic failure clauses, agreed-upon price concessions, division of each party’s intellectual property and product quality requirements. As we expand our product portfolio, we continue to explore new potential manufacturing
11
partners that may provide us with competitive advantages on technology and cost. Since we outsource our manufacturing, we have the flexibility and ability to adapt to market changes, product supply and component pricing while keeping our costs low. In addition to their responsibility for the manufacturing of our products, our manufacturers typically purchase all necessary parts and materials to produce finished goods. To maintain quality standards for our suppliers, we have established our own product quality organization based in Vietnam, Hong Kong, Taiwan, Indonesia, and mainland China, which is responsible for auditing and inspecting process and product quality on the premises of our manufacturers. Our strategic relationships with our manufacturers are an important component of our ability to introduce new products and grow our business.
We focus on driving alignment of our product roadmaps with our manufacturers and determining what we can do collectively to reduce costs across the supply chain. Our operations teams based in the United States, Hong Kong, Taiwan, Vietnam, Indonesia and mainland China coordinate with our manufacturers’ engineering, manufacturing and quality control personnel to develop the requisite manufacturing processes, quality checks and testing and general oversight of the manufacturing activities. We believe this model has enabled us to quickly and efficiently deliver high-quality and innovative products, while enabling us to minimize costs and manage inventory.
Our products are manufactured and packaged for retail sale by our manufacturers mostly in Vietnam and Indonesia, with minimal manufacturers in China, and shipped to our logistics hubs located in the United States, Hong Kong and Australia. Our operations team coordinates with our manufacturers to ensure that the shipment of our products from the manufacturers to these logistics hubs meets customer demand.
Marketing
Our marketing programs are focused on building global brand awareness, increasing product adoption and driving sales. Our marketing efforts target individuals interested in a connected lifestyle. We also increase brand awareness by augmenting word-of-mouth recommendations from Arlo customers and key influencers, interact digitally with current and prospective customers and maintain and develop our strong channel partnerships and strong shelf presence. We collaborate with our retail partners on market development activities to drive in-store and online engagement with the brand and drive purchases.
Customer Care
We provide customer care to Arlo users globally through a variety of communication channels, including phone, chat, email, social media and our Arlo Community, as well as self-guided resources such as knowledge-base articles, how-to videos and technical documentation on our website. We believe that providing timely, responsive customer support and educational content to our users helps foster an ongoing engagement that builds loyalty to our brand and also enables Arlo to understand user needs as they evolve. The online Arlo Community in particular serves as an efficient and engaging platform through which we can deliver customer care and receive feedback from users. We gather and analyze user feedback from all platforms to help inform our design and engineering teams about future enhancements to our products and services.
In order to best serve our users globally, we manage and continually adjust our resources worldwide through a mixture of permanent employees and subcontracted, outsourced resources. As our installed base continues to grow in new geographies, new categories and technologies, we will continue to focus on building a scalable support infrastructure that enables our users to engage with us through the channel that is most convenient and efficient for their needs.
Arlo Cloud Engineering Operations
We currently serve our users from third-party data center hosting facilities. Our cloud platform runs in data centers in the United States and a data center in Ireland to serve our European Union users. We also utilize data centers in Singapore and Australia. We have designed our cloud environments to be highly resilient with built-in redundancy and provide failover to other data centers in our network.
12
Fiscal periods
Our fiscal year begins on January 1 of the year stated and ends on December 31 of the same year. We report our results on a fiscal quarter basis rather than on a calendar quarter basis. Under the fiscal quarter basis, each of the first three fiscal quarters ends on the Sunday closest to the calendar quarter end, with the fourth quarter ending on December 31.
Seasonality
Historically, we have generated higher product revenue in the third and fourth quarters of each year compared to the first and second quarters due to seasonal demand from consumer markets, primarily relating to the beginning of the school year and the holiday season. For example, for the years ended December 31, 2021, 2020 and 2019, our third and fourth quarters collectively represented 58.4%, 63.0% and 61.8%, respectively, of our revenue for such years. Therefore, timely and effective product introductions are critical to our results of operations.
Backlog
Our backlog consists of products for which customer purchase orders have been received and that are scheduled or in the process of being scheduled for shipment. As of December 31, 2021, we had a backlog of $4.4 million, compared to $5.7 million as of December 31, 2020 and $5.4 million as of December 31, 2019. As we typically fulfill orders received within a relatively short period after receipt, our revenue in any fiscal year depends primarily upon orders booked and the availability of supply of our products in that year. In addition, most of our backlog is subject to rescheduling or cancellation with minimal penalties. As a result, our backlog as of any particular date may not be an indicator of revenue for any succeeding period. Similarly, there is a lack of meaningful correlation between year-over-year changes in backlog as compared with year-over-year changes in revenue. Accordingly, we do not believe that backlog information is material to an understanding of our overall business, and backlog as of any particular date should not be considered a reliable indicator of our ability to achieve any particular level of revenue or financial performance.
Intellectual Property
Our ability to protect our intellectual property will be an important factor in the success and continued growth of our business. We rely upon a combination of patent, copyright, trade secret, and trademark laws and contractual restrictions, such as confidentiality agreements and licenses, to establish and protect our proprietary rights. Some of our technology relies upon third-party licensed intellectual property.
We currently hold 95 issued United States patents, 45 pending United States patent applications, 23 international patents, including patents issued by China and the EU, 22 pending patent applications outside of the United States. All the patents and patent applications generally relate to certain aspects of our hardware devices, accessories, software and services. We continually review our development efforts to assess the existence and patentability of new intellectual property.
We also pursue the registration of our domain names and trademarks and service marks in the United States and in certain locations outside the United States. We currently have seven registered trademarks and three pending trademark applications in the United States, as well as 49 registered trademarks and 22 pending trademark applications outside of the United States. We currently hold trademark registrations for “ARLO” in ten countries: the United States, Australia, Brazil, Canada, Chile, China, Japan, Mexico, Peru, and Trinidad and Tobago, as well as the World Intellectual Property Organization. For more information, see “Risk Factors-Risks Related to Our Business-If we are unable to secure and protect our intellectual property rights, our ability to compete could be harmed.”
13
Environmental Laws
Our products and manufacturing processes are subject to numerous governmental regulations, which cover both the use of various materials and environmental concerns. Environmental issues such as pollution and climate change have had significant legislative and regulatory efforts on a global basis, and there are expected to be additional changes to the regulations in these areas. These changes could directly increase the cost of energy, which may have an impact on the way we manufacture products. In addition, any new regulations or laws in the environmental area might increase the cost of the raw materials we use in our products and the cost of compliance. Other regulations in the environmental area may require us to continue to monitor and ensure proper disposal or recycling of our products. To the best of our knowledge, we maintain compliance with all current government regulations concerning our production processes for all locations in which we operate. Since we operate on a global basis, this is also a complex process that requires continual monitoring of regulations and an ongoing compliance process to ensure that we and our suppliers are in compliance with all existing regulations.
Culture and Human Capital Resources
Our culture, mission and values are a critical part of our success. In fact, core to our vision of bringing peace of mind by connecting and protecting what people care about the most is creating the right environment for our people. We strive to ensure that our employees are continually connected to our vision and mission through appropriate communication, throughout our talent proposition and as we serve our customers.
Our culture focuses on connecting our people in an inclusive and flexible workforce, connecting our employees with the right development opportunities, and linking our group success with individual performance. It is founded on an employee value proposition that puts people and teams at the center of our business. Through radical collaboration, trust, and conscious leadership, our diverse teams continue to create innovative solutions for our customers.
We protect our culture through leadership excellence and developing the right leadership behaviors that are both conscious and strategic in their impact on our performance. We value creativity, agility, hard work, transparency, and integrity, as we focus on continually innovating and improving our technology, solutions, brand, and partnerships.
Human capital measures and objectives used to manage our business focus on employee safety and wellness, talent acquisition and retention, employee engagement, development and training, diversity and inclusion, and compensation and pay equity. We strive to attract and retain exceptionally talented, diverse, and ethical employees, and we are proud of the culture we have built. Our talented employees, located throughout the United States, Canada, Asia, Australia, and Europe communicate, connect and work together to deliver a world-class end-to-end connected lifestyle solution. We believe that we maintain a good working relationship with our employees, and we have not experienced any labor disputes. As of December 31, 2021, we had a total of 353 full-time employees, of which approximately 69% were based in the United States, and approximately 31% were based in other global regions.
Diversity and Inclusion
Arlo is proud to be an equal opportunity workplace and an affirmative action employer. We always strive to treat all employees and job applicants based on merit, qualifications, personality, and talent, and to draw from a diverse candidate pool as we recruit new talent across all levels. We deeply connect people from all backgrounds and beliefs and strive for a truly inclusive and collaborative working environment.
We have taken action alongside a group of more than 1,200 businesses in a collective commitment to make progress towards advancing diversity and inclusion in our workplace, communities, and country. We value diversity and integrate it into our business by striving to ensure that our company is representative of the customers we serve and that inclusion is at the core of our workplace culture. In 2020, our Chief Executive Officer signed the CEO Action for Diversity & Inclusion pledge, the largest CEO-driven business commitment to advance diversity and inclusion within the workplace
14
to underscore our commitment. By making the pledge, we go beyond accepting diversity and committed to the following actions:
•Continue to cultivate our workplace to support open dialogue on complex, and sometimes difficult conversations about diversity and inclusion.
•Make unconscious bias education available to everyone.
•Share best known—and unsuccessful—actions.
•Create and share strategic inclusion and diversity plans with our board of directors as a way to prioritize diversity and inclusion and to drive accountability in our organization.
For the second year running, we are partnering with the GEM Consortium ("GEM"). GEM connects highly qualified students from underrepresented groups to STEM graduate programs with much-needed financial support that is often the deciding factor in pursuing graduate education. We have welcomed a number of GEM interns at Arlo.
We host a number of events and days of observance with guest and internal speakers at Arlo. Each Spring, for example, we hold a "Week of Understanding" with speakers on key diversity and inclusion topics. These events provide a platform for dialogue and an opportunity for every employee to learn, discuss, and appreciate differences between colleagues as we grow to drive greater inclusion at Arlo and truly reflect the customers we serve.
COVID-19 and Employee Safety
During the COVID-19 pandemic, our primary focus has been on the safety and well-being of our employees and their families. Our global pandemic efforts include implementing early and continuous updates to our health and safety policies and processes, migrating all but a limited number of our global workforce to work remotely while local and state governments have imposed shelter-in-place orders in the United States and around the world. We are focused on providing our team with the resources that they need to meet the needs of our customers and deliver new innovations to the markets we serve, despite challenges introduced by the COVID-19 pandemic. As the pandemic continues, the health and well-being of our workforce remains our top priority while we ensure productivity while working from home.
Company Information
We were incorporated in Delaware in January 2018 in connection with the separation of our business (the “Separation”) from NETGEAR, Inc. (“NETGEAR”). Our principal executive offices are located at 2200 Faraday Ave., Suite #150, Carlsbad, California 92008, and our telephone number is (408) 890-3900. Our website is http://www.arlo.com. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) are available free of charge on our website as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities Exchange Commission (the “SEC”). The contents of our website are not incorporated into this Annual Report. Further, our references to the URLs for these websites are intended to be inactive textual reference only.
Available Information
Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Exchange Act are filed with the SEC. We are subject to the informational requirements of the Exchange Act and file or furnish reports, proxy statements, and other information with the SEC. Our filings are also available to the public over the Internet at the SEC’s website at http://www.sec.gov.
15
Our website provides a link to our SEC filings, which are available free of charge on the same day such filings are made. The specific location on the website where these reports can be found is http://investor.arlo.com. Our website also provides a link to Section 16 filings which are available free of charge on the same day as such filings are made. Information contained on these websites is not a part of this Annual Report on Form 10-K.
16
Item 1A. Risk Factors
Investing in our common stock involves substantial risk. You should consider carefully the risks and uncertainties described below, together with all of the other information in this Annual Report on Form 10-K, including our financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” when evaluating our business and before deciding whether to invest in shares of our common stock. We describe below what we believe are currently the material risks and uncertainties we face, but they are not the only risks and uncertainties we face. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, may also become important factors that adversely affect our business. If any of the following risks actually occur, our business, financial condition, results of operations, and future prospects could be materially and adversely affected. In that event, the market price of our common stock could decline and you could lose part or all of your investment.
Risks Related to Our Business
The effects of health epidemics, including the COVID-19 pandemic and its variants, could have an adverse impact on our business, operations and the markets and communities in which we, our partners and customers operate.
Our business and operations could be adversely affected by health epidemics, including the recent COVID-19 pandemic, impacting the markets and communities in which we, our partners and our customers operate. On March 11, 2020, the World Health Organization announced that COVID-19, a respiratory illness, caused by a novel coronavirus is a pandemic. In response to the COVID-19 pandemic, many state, local and foreign governments have put in place, and others in the future may put in place, quarantines, executive orders, shelter-in-place orders and similar government orders and restrictions in order to control the spread of the disease. Such orders or restrictions, or the perception that such orders or restrictions could occur, have resulted in business closures, work stoppages, slowdowns and delays, work-from-home policies, travel restrictions and cancellation of events, among other effects that could negatively impact productivity and disrupt our operations and those of our partners and our customers. For example, we have implemented a work-from-home policy for the vast majority of employees, and we may take further actions that alter our operations as may be required by federal, state or local authorities, or which we determine are in the best interests of our employees, customers, partners and stockholders.
In addition, while the potential impact and duration of the COVID-19 pandemic on the global economy and our business in particular may be difficult to assess or predict, the pandemic has resulted in, and may continue to result in significant disruption of global financial markets, reducing our ability to access capital, which could in the future negatively affect our liquidity. The COVID-19 pandemic also could reduce demand for our products and services as our largest channel partners focus on selling essential goods, temporarily close stores or experience decreases in foot traffic. In addition, a recession or market correction resulting from the spread of COVID-19 could further decrease technology spending, adversely affecting demand for our products and services, our business and the value of our common stock.
The COVID-19 pandemic may adversely affect the ability of our third-party manufacturers and other suppliers to fulfill their obligations to us. We rely on these manufacturers to procure components and, in some cases, subcontract engineering work. We cannot guarantee that our third-party manufacturers or other suppliers will be able to meet our near-term or long-term manufacturing requirements. If we experience supply constraints from our third-party manufacturers, we may be required to allocate the affected products amongst our customers, which could have a material adverse effect on our relationships with these customers and on our financial condition. In addition, if we are unable to meet customer demand due to fluctuating or late supply from our third-party manufacturers and other suppliers, it could result in lost sales and have a material adverse effect on our business. We also rely on other suppliers such as cloud infrastructure services providers, distribution centers and logistics and transportation services providers. If our manufacturers and other suppliers are unable to fulfill their obligations to us, we could face products shortages, delay in new product introductions, services to our customers could be interrupted, and our products distribution could be delayed and thus adversely affecting our revenue. For example, increased demand for electronics as a result of the COVID-19 pandemic, effects of the U.S. trade war with China, increased demand for chips in the automotive industry and certain other factors have led to a global
17
shortage of semiconductors. As a result, we have experienced component shortages, including longer lead times for components and supply constraints, that have affected both our ability to meet scheduled product deliveries and worldwide demand for our products. Also, as a result of the COVID-19 pandemic, our supply chain partners are limited by production capacity, constrained by material availability, labor shortages, factory uptime and freight capacity, each of which constrains our ability to capitalize fully on end market demand. As of December 31, 2021, international freight capacity has dropped, causing air and ocean freight rates to materially increase. Furthermore, transit times have also increased, causing us to rely more on air freight in order to meet our customers' demands. For the year ended December 31, 2021, we saw a 138% increase in freight-in expense compared to the prior year, as a result of the higher sea and air freight rates and component shortages which necessitated use of air freight to meet customer requested delivery dates. We expect supply chain constraints to continue in 2022. While we have been successful in navigating COVID-19 related challenges to date, any further disruptions brought about by the COVID-19 pandemic to our supply chain and operations could have a significant negative impact on our net revenue, gross and operating margin performance.
The global pandemic of COVID-19 continues to rapidly evolve, and we will continue to monitor the COVID-19 situation closely. The ultimate impact of the COVID-19 pandemic or a similar health epidemic is highly uncertain and subject to change. We do not yet know the full extent of potential delays or impacts on our business, operations or the global economy as a whole.
We obtain several key components from limited or sole sources, and if these sources fail to satisfy our supply requirements or we are unable to properly manage our supply requirements with our third-party manufacturers, we may lose sales and experience increased component costs.
Any shortage or delay in the supply of key product components would harm our ability to meet scheduled product deliveries. Many of the components used in our products are specifically designed for use in our products, some of which are obtained from sole source suppliers. These components include lens, lens-sensors, and passive infrared (“PIR”) sensors that have been customized for the Arlo application, as well as custom-made batteries that provide power conservation and safety features. In addition, the components used in our end products have been optimized to extend battery life. Our third-party manufacturers generally purchase these components on our behalf, and we do not have any contractual commitments or guaranteed supply arrangements with our suppliers. If demand for a specific component increases, we may not be able to obtain an adequate number of that component in a timely manner. In addition, if worldwide demand for the components increases significantly, the availability of these components could be limited. For example, increased demand for electronics as a result of the COVID-19 pandemic, effects of the U.S. trade war with China, increased demand for chips in the automotive industry and certain other factors have led to a global shortage of semiconductors. Due to such shortage, starting in the fourth quarter of 2020 and throughout 2021 we experienced component shortages, including longer lead times for components, and supply constraints, which we expect to continue in 2022. Such shortages and constraints affected our ability to meet scheduled product deliveries and worldwide demand for our products in 2021, and may affect our ability in 2022. Further, our suppliers may experience financial or other difficulties as a result of uncertain and weak worldwide economic conditions. Other factors that may affect our suppliers’ ability or willingness to supply components to us include internal management or reorganizational issues, such as roll-out of new equipment which may delay or disrupt supply of previously forecasted components, or industry consolidation and divestitures, which may result in changed business and product priorities among certain suppliers. It could be difficult, costly, and time consuming to obtain alternative sources for these components, or to change product designs to make use of alternative components. In addition, difficulties in transitioning from an existing supplier to a new supplier could create delays in component availability that would have a significant impact on our ability to fulfill orders for our products.
We provide our third-party manufacturers with a rolling forecast of demand, which they use to determine our material and component requirements. Lead times for ordering materials and components vary significantly and depend on various factors, such as the specific supplier, contract terms, and demand and supply for a component at a given time. Some of our components have long lead times, such as wireless local area network chipsets, physical layer transceivers, connector jacks, and metal and plastic enclosures. If our forecasts are not timely provided or are less than our actual requirements, our third-party manufacturers may be unable to manufacture products in a timely manner. If our forecasts are too high, our third-party manufacturers will be unable to use the components they have purchased on our behalf. The cost
18
of the components used in our products tends to drop rapidly as volumes increase and the technologies mature. Therefore, if our third-party manufacturers are unable to promptly use components purchased on our behalf, our cost of producing products may be higher than our competitors due to an oversupply of higher-priced components. Moreover, if they are unable to use components ordered at our direction, we will need to reimburse them for any losses they incur.
If we are unable to obtain a sufficient supply of components, or if we experience any interruption in the supply of components, our product shipments could be reduced or delayed or our cost of obtaining these components may increase. For example, in December 2018 we announced a delay in the expected timing of shipment of our Ultra product due to a battery-related issue from one of our suppliers. Component shortages and delays affect our ability to meet scheduled product deliveries, damage our brand and reputation in the market, and cause us to lose sales and market share. For example, component shortages and disruptions in supply in the past have limited our ability to supply all the worldwide demand for our products, and our revenue was affected. At times, we have elected to use more expensive transportation methods, such as air freight, to make up for manufacturing delays caused by component shortages, which reduces our margins. In addition, at times sole suppliers of highly specialized components have provided components that were either defective or did not meet the criteria required by our retailers, distributors, or other channel partners, resulting in delays, lost revenue opportunities, and potentially substantial write-offs.
We depend on a limited number of third-party manufacturers for substantially all of our manufacturing needs. If these third-party manufacturers experience any delay, disruption, or quality control problems in their operations, including due to the COVID-19 pandemic, we could lose market share and our brand may suffer.
All of our products are manufactured, assembled, tested and generally packaged by a limited number of third-party original design manufacturers (“ODMs”). In most cases, we rely on these manufacturers to procure components and, in some cases, subcontract engineering work. We currently outsource manufacturing to Foxconn Cloud Network Technology Singapore Pte. Ltd., Pegatron Corporation, and Wistron NeWeb Corporation. We do not have any long-term contracts with any of these third-party manufacturers, although we have executed product supply agreements with these manufacturers, which typically provide indemnification for intellectual property infringement, epidemic failure clauses, agreed-upon price concessions, and certain product quality requirements. Some of these third-party manufacturers produce products for our competitors. In addition, one of our principal manufacturers, Foxconn closed its acquisition of Belkin International in September 2018, which includes the WeMo brand of home automation products, which may compete directly with us. Due to changing economic conditions, including due to the COVID-19 pandemic, the viability of some of these third-party manufacturers may be at risk. The loss of the services of any of our primary third-party manufacturers could cause a significant disruption in operations and delays in product shipments. Qualifying a new manufacturer and commencing volume production is expensive and time consuming. Ensuring that a contract manufacturer is qualified to manufacture our products to our standards is time consuming. In addition, there is no assurance that a contract manufacturer can scale its production of our products at the volumes and in the quality that we require. If a contract manufacturer is unable to do these things, we may have to move production for the products to a new or existing third-party manufacturer, which would take significant effort and our business, results of operations, and financial condition could be materially adversely affected. In addition, as we contemplate moving manufacturing into different jurisdictions, we may be subject to additional significant challenges in ensuring that quality, processes, and costs, among other issues, are consistent with our expectations. For example, while we expect our manufacturers to be responsible for penalties assessed on us because of excessive failures of the products, there is no assurance that we will be able to collect such reimbursements from these manufacturers, which causes us to take on additional risk for potential failures of our products.
Our reliance on third-party manufacturers also exposes us to the following risks over which we have limited control:
•unexpected increases in manufacturing and repair costs;
•inability to control the quality and reliability of finished products;
•inability to control delivery schedules;
19
•potential liability for expenses incurred by third-party manufacturers in reliance on our forecasts that later prove to be inaccurate;
•potential lack of adequate capacity to manufacture all or a part of the products we require; and
•potential labor unrest affecting the ability of the third-party manufacturers to produce our products.
All of our products must satisfy safety and regulatory standards and some of our products must also receive government certifications. Our third-party manufacturers are primarily responsible for conducting the tests that support our applications for most regulatory approvals for our products. If our third-party manufacturers fail to timely and accurately conduct these tests, we would be unable to obtain the necessary domestic or foreign regulatory approvals or certificates to sell our products in certain jurisdictions. As a result, we would be unable to sell our products and our sales and profitability could be reduced, our relationships with our sales channel could be harmed, and our reputation and brand would suffer.
Specifically, substantially all of our manufacturing and assembly occurs in the Asia Pacific region, primarily in Vietnam, and any disruptions due to natural disasters, health epidemics, and political, social, and economic instability in the region would affect the ability of our third-party manufacturers to manufacture our products. In particular, in the event the labor market in Vietnam becomes saturated, our third-party manufacturers in Vietnam may increase our costs of production. If these costs increase, it may affect our margins and ability to lower prices for our products to stay competitive. Labor unrest may also affect our third-party manufacturers, as workers may strike and cause production delays. If our third-party manufacturers fail to maintain good relations with their employees or contractors, and production and manufacturing of our products are affected, then we may be subject to shortages of products and the quality of products delivered may be affected. Further, if our manufacturers or warehousing facilities are disrupted or destroyed, we could have no other readily available alternatives for manufacturing and assembling our products, and our business, results of operations, and financial condition could be materially adversely affected.
In the future, we may work with more third-party manufacturers on a contract manufacturing basis, which could result in our exposure to additional risks not inherent in a typical ODM arrangement. Such risks may include our inability to properly source and qualify components for the products, lack of software expertise resulting in increased software defects, and lack of resources to properly monitor the manufacturing process. In our typical ODM arrangement, our ODMs are generally responsible for sourcing the components of the products and warranting that the products will work according to a product’s specification, including any software specifications. In a contract manufacturing arrangement, we would take on much more, if not all, of the responsibility around these areas. If we are unable to properly manage these risks, our products may be more susceptible to defects, and our business, results of operations, and financial condition could be materially adversely affected.
If disruptions in our transportation network occur or our shipping costs substantially increase, including due to the COVID-19 pandemic, we may be unable to sell or timely deliver our products, and our operating expenses could increase.
We are highly dependent upon the transportation systems we use to ship our products, including surface, ocean and air freight. Our attempts to closely match our inventory levels to our product demand intensify the need for our transportation systems to function effectively and without delay. On a quarterly basis, our shipping volume also tends to steadily increase as the quarter progresses, which means that any disruption in our transportation network in the latter half of a quarter will likely have a more material effect on our business than a disruption at the beginning of a quarter.
The transportation network is subject to disruption or congestion from a variety of causes, including labor disputes or port strikes, international conflicts, such as the potential escalating conflict between Russia and Ukraine, acts of war or terrorism, natural disasters, and congestion resulting from higher shipping volumes. Labor disputes among freight carriers and at ports of entry are common, particularly in Europe, and we expect labor unrest and its effects on shipping our products to be a continuing challenge for us. A port worker strike, work slow-down, or other transportation disruption in
20
Long Beach, California, where we import our products to fulfill our American orders, could significantly disrupt our business. Our international freight is regularly subject to inspection by governmental entities. As a result of the COVID-19 pandemic, international freight capacity has dropped, causing air and ocean freight rates to materially increase. Transit times have also increased. If our delivery times increase unexpectedly for these or any other reasons, our ability to deliver products on time would be materially adversely affected and result in delayed or lost revenue as well as customer imposed penalties. In addition, if increases in fuel prices occur, our transportation costs would likely increase. Moreover, the cost of shipping our products by air freight is greater than by other methods. From time to time in the past and increasingly more common during the COVID-19 pandemic, we have shipped products using extensive air freight to meet unexpected spikes in demand and shifts in demand between product categories, to bring new product introductions to market quickly and to timely ship products previously ordered. If we continue to rely more heavily upon air freight to deliver our products, our overall shipping costs will increase. A prolonged transportation disruption or a significant increase in the cost of freight could materially adversely affect our business, results of operations, and financial condition.
If we lose the services of key personnel, we may not be able to execute our business strategy effectively.
Our future success depends in large part upon the continued services of our key technical, engineering, sales, marketing, finance, and senior management personnel. The competition for qualified personnel with significant experience in the design, development, manufacturing, marketing, and sales in the markets in which we operate is intense, both where our U.S. operations are based, including Silicon Valley, and in global markets in which we operate. Our inability to attract qualified personnel, including hardware and software engineers and sales and marketing personnel, could delay the development and introduction of, and harm our ability to sell, our products and services. Decreases in our stock price may negatively affect our efforts to attract and retain qualified personnel. Changes to U.S. immigration policies that restrict our ability to attract and retain technical personnel may negatively affect our research and development efforts. We will continue to replace key personnel, from within or looking outside, wherever we find the best candidates.
We do not maintain any key person life insurance policies. Our business model requires extremely skilled and experienced senior management who are able to withstand the rigorous requirements and expectations of our business. Our success depends on senior management being able to execute at a very high level. The loss of any of our senior management or other key engineering, research, development, sales, or marketing personnel, particularly if lost to competitors, could harm our ability to implement our business strategy and respond to the rapidly changing needs of our business. If we suffer the loss of services of any key executive or key personnel, our business, results of operations, and financial condition could be materially adversely affected. In addition, we may not be able to have the proper personnel in place to effectively execute our long-term business strategy if key personnel retire, resign or are otherwise terminated.
We expect our results of operations to fluctuate on a quarterly and annual basis, which could cause our stock price to fluctuate or decline.
Our results of operations are difficult to predict and may fluctuate substantially from quarter-to-quarter or year-to-year for a variety of reasons, many of which are beyond our control. If our actual results were to fall below our estimates or the expectations of public market analysts or investors, our quarterly and annual results would be negatively impacted and the price of our stock could decline. Other factors that could affect our quarterly and annual operating results include, but are not limited to:
•changes in the pricing policies of, or the introduction of new products by, us or our competitors;
•delays in the introduction of new products by us or market acceptance of these products;
•health epidemics and other outbreaks, including the COVID-19 pandemic, which could significantly disrupt our operations;
•introductions of new technologies and changes in consumer preferences that result in either unanticipated or unexpectedly rapid product category shifts;
21
•competition with greater resources may cause us to lower prices and in turn could result in reduced margins and loss of market share;
•epidemic or widespread product failure, or unanticipated safety issues, in one or more of our products;
•slow or negative growth in the connected lifestyle, home electronics, and related technology markets;
•seasonal shifts in end-market demand for our products;
•unanticipated decreases or delays in purchases of our products by our significant retailers, distributors, and other channel partners;
•component supply constraints from our vendors;
•unanticipated increases in costs, including air freight, associated with shipping and delivery of our products;
•the inability to maintain stable operations by our suppliers and other parties with whom we have commercial relationships;
•discovery of security vulnerabilities in our products, services or systems, leading to negative publicity, decreased demand, or potential liability;
•foreign currency exchange rate fluctuations in the jurisdictions where we transact sales and expenditures in local currency;
•excess levels of inventory and low turns;
•changes in or consolidation of our sales channels and wholesale distributor relationships or failure to manage our sales channel inventory and warehousing requirements;
•delay or failure to fulfill orders for our products on a timely basis;
•delay or failure of our retailers, distributors, and other channel partners to purchase at their historic volumes or at the volumes that they or we forecast;
•changes in tax rates or adverse changes in tax laws that expose us to additional income tax liabilities;
•changes in U.S. and international tax policy, including changes that adversely affect customs, tax or duty rates such as tariffs on product imports, as well as income tax legislation and regulations that affect the countries where we conduct business;
•operational disruptions, such as transportation delays or failure of our order processing system, particularly if they occur at the end of a fiscal quarter;
•disruptions or delays related to our financial and enterprise resource planning systems;
•our inability to accurately forecast product demand, resulting in increased inventory exposure;
22
•allowance for credit losses exposure with our existing retailers, distributors and other channel partners and new retailers, distributors and other channel partners, particularly as we expand into new international markets;
•geopolitical disruption, including sudden changes in immigration policies, leading to disruption in our workforce or delay or even stoppage of our operations in manufacturing, transportation, technical support, and research and development;
•terms of our contracts with channel partners or suppliers that cause us to incur additional expenses or assume additional liabilities;
•an increase in price protection claims, redemptions of marketing rebates, product warranty and stock rotation returns or allowance for credit losses;
•litigation involving alleged patent infringement;
•failure to effectively manage our third-party customer support partners, which may result in customer complaints and/or harm to the Arlo brand;
•our inability to monitor and ensure compliance with our code of ethics, our anti-corruption compliance program, and domestic and international anti-corruption laws and regulations, whether in relation to our employees or with our suppliers or retailers, distributors, or other channel partners;
•labor unrest at facilities managed by our third-party manufacturers;
•workplace or human rights violations in certain countries in which our third-party manufacturers or suppliers operate, which may affect the Arlo brand and negatively affect our products’ acceptance by consumers;
•unanticipated shifts or declines in profit by geographical region that would adversely impact our tax rate;
•failure to implement and maintain the appropriate internal controls over financial reporting, which may result in restatements of our financial statements; and
•any changes in accounting rules.
As a result, period-to-period comparisons of our results of operations may not be meaningful, and you should not rely on them as an indication of our future performance.
If we fail to continue to introduce or acquire new products or services that achieve broad market acceptance on a timely basis, or if our products or services are not adopted as expected, we will not be able to compete effectively and we will be unable to increase or maintain revenue and gross margin.
We operate in a highly competitive, quickly changing environment, and our future success depends on our ability to develop or acquire and introduce new products and services that achieve broad market acceptance. Our future success will depend in large part upon our ability to identify demand trends in the connected lifestyle market and quickly develop or acquire, and design, manufacture and sell, products and services that satisfy these demands in a cost-effective manner.
In order to differentiate our products and services from our competitors’ products, we must continue to increase our focus and capital investment in research and development, including software development. We have committed a substantial amount of resources to the manufacture, development and sale of our Arlo Secure services and our wire-free smart Wi-Fi cameras, advanced baby monitors, and smart lights, and to introducing additional and improved models in
23
these lines. In addition, we plan to continue to introduce new categories of smart connected devices to the Arlo platform in the near future. If our existing products and services do not continue, or if our new products or services fail, to achieve widespread market acceptance, if existing customers do not subscribe to our paid subscription services such as Arlo Secure, if those services do not achieve widespread market acceptance, or if we are unsuccessful in capitalizing on opportunities in the connected lifestyle market, as well as in the related market in the small business segment, our future growth may be slowed and our business, results of operations, and financial condition could be materially adversely affected. Successfully predicting demand trends is difficult, and it is very difficult to predict the effect that introducing a new product or service will have on existing product or service sales. It is possible that Arlo may not be as successful with its new products and services, and as a result our future growth may be slowed and our business, results of operations and financial condition could be materially adversely affected. Also, we may not be able to respond effectively to new product or service announcements by our competitors by quickly introducing competitive products and services.
In addition, we may acquire companies and technologies in the future and, consistent with our vision for Arlo, introduce new product and service lines in the connected lifestyle market. In these circumstances, we may not be able to successfully manage integration of the new product and service lines with our existing suite of products and services. If we are unable to effectively and successfully further develop these new product and service lines, we may not be able to increase or maintain our sales, and our gross margin may be adversely affected.
We may experience delays and quality issues in releasing new products and services, which may result in lower quarterly revenue than expected. In addition, we may in the future experience product or service introductions that fall short of our projected rates of market adoption. Currently, reviews of our products and services are a significant factor in the success of our new product and service launches. If we are unable to generate a high number of positive reviews or quickly respond to negative reviews, including end-user reviews posted on various prominent online retailers, our ability to sell our products and services will be harmed. Any future delays in product and service development and introduction, or product and service introductions that do not meet broad market acceptance, or unsuccessful launches of new product and service lines could result in:
•loss of or delay in revenue and loss of market share;
•negative publicity and damage to our reputation and brand;
•a decline in the average selling price of our products and services;
•adverse reactions in our sales channels, such as reduced shelf space, reduced online product visibility, or loss of sales channels; and
•increased levels of product returns.
Throughout the past few years, Arlo has significantly increased the rate of new product and service introductions, with the introduction of new lines of Arlo cameras, smart lights, and doorbell products, as well as the introduction of our Arlo Secure services. If we cannot sustain that pace of product and service introductions, either through rapid innovation or acquisition of new products and services or product and service lines, we may not be able to maintain or increase the market share of our products and services or expand further into the connected lifestyle market in accordance with our current plans. In addition, if we are unable to successfully introduce or acquire new products and services with higher gross margin, our revenue and overall gross margin would likely decline.
We may need additional financing to meet our future long-term capital requirements and may be unable to raise sufficient capital on favorable terms or at all.
We have recorded a net loss of $56.0 million for the year ended December 31, 2021, and we have a history of losses and may continue to incur operating and net losses for the foreseeable future. As of December 31, 2021, our accumulated deficit was $288.8 million.
24
As of December 31, 2021, our cash and cash equivalents and short-term investments totaled $175.7 million. In October 2021, we entered into a Loan and Security Agreement with Bank of America, N.A. (the "Credit Agreement"), providing for a credit facility of up to $40.0 million and as of December 31, 2021, we have not borrowed against this credit facility. Refer to Note 10, Debt in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for further details on the Credit Agreement. While based on our current plans, the Credit Agreement with Bank of America, N.A., and market conditions, we believe that such sources of liquidity will be sufficient to satisfy our anticipated cash requirements for at least the next 12 months, we may require additional funds, either through equity or debt financings or collaborative agreements or from other sources. We have no commitments to obtain such additional financing, and we may not be able to obtain any such additional financing on terms favorable to us, or at all. If adequate financing is not available, we may further delay, postpone or terminate product and service expansion and curtail certain selling, general and administrative operations. The inability to raise additional financing may have a material adverse effect on our future performance. In addition, the COVID-19 pandemic has already resulted in a significant disruption of global financial markets. If the disruption persists and deepens, we could experience an inability to access additional capital.
Some of our competitors have substantially greater resources than we do, and to be competitive we may be required to lower our prices or increase our sales and marketing expenses, which could result in reduced margins and loss of market share.
We compete in a rapidly evolving and fiercely competitive market, and we expect competition to continue to be intense, including price competition. Our principal competitors include Amazon (Blink and Ring), Google (Nest), Swann, Night Owl, Wyze, Foxconn Corporation (Belkin), Samsung, D-Link, Canary and Eufy. Other competitors include numerous local vendors such as Netatmo, Logitech, Bosch, Instar, and Uniden. In addition, these local vendors may target markets outside of their local regions and may increasingly compete with us in other regions worldwide. Many of our existing and potential competitors have longer operating histories, greater brand recognition, and substantially greater financial, technical, sales, marketing, and other resources. These competitors may, among other things, undertake more extensive marketing campaigns, adopt more aggressive pricing policies, obtain more favorable pricing from suppliers and manufacturers, and exert more influence on sales channels than we can. In addition, certain competitors may have different business models, such as integrated manufacturing capabilities, that may allow them to achieve cost savings and to compete on the basis of price. Other competitors may have fewer resources, but may be more nimble in developing new or disruptive technology or in entering new markets.
We anticipate that current and potential competitors will also intensify their efforts to penetrate our target markets. For example, price competition is intense in our industry in certain geographical regions and product categories. Many of our competitors price their products significantly below our product costs. Average sales prices have declined in the past and may again decline in the future. These competitors may have more advanced technology, more extensive distribution channels, stronger brand names, greater access to shelf space in retail locations, bigger promotional budgets, and larger retailers, distributors, and other channel partners, and end-user bases than we do.
In addition, many of these competitors leverage a broader product portfolio and offer lower pricing as part of a more comprehensive end-to-end solution. These companies could devote more capital resources to develop, manufacture, and market competing products than we could.
Amazon is both a competitor and a distribution channel for our products as well as a provider of services to support our cloud-based storage. If Amazon decided to end our distribution channel relationship or ceased providing cloud storage services to us, our sales and product performance could be harmed, which could seriously harm our business, financial condition, results of operations, and cash flows.
Our competitors may also acquire other companies in the market and leverage combined resources to gain market share. If any of these companies are successful in competing against us, our sales could decline, our margins could be negatively impacted, and we could lose market share, any of which could seriously harm our business, financial condition, and results of operations.
25
We entered into an asset purchase agreement (the “Asset Purchase Agreement”) and supply agreement (the “Supply Agreement”) with Verisure Sàrl (“Verisure”) that gives Verisure exclusive marketing and distribution rights for our products in Europe as well as the ability to sell our products through their direct channel globally. We cannot provide assurance that the arrangement with Verisure will continue to be a successful collaboration.
Verisure has the exclusive right to market and distribute our products in Europe. Our results of operations may be negatively impacted if Verisure is not successful in continuing to sell our products in Europe. Even though the Supply Agreement provides for minimum purchase commitments, if Verisure fails to pay on a timely basis, or at all, including because of effects from COVID-19, or otherwise does not perform under the Supply Agreement, our cash flow would be reduced. We are also exposed to increased credit risk if Verisure fails or becomes insolvent. We also cannot provide any assurance that we will successfully develop custom products as specified by Verisure under the Supply Agreement.
The Purchase Agreement and Supply Agreement with Verisure contain customary representations and warranties regarding, the Business and the Assets, indemnification provisions, termination rights, certain financial covenants and other customary provisions. Additionally, we have agreed not to engage in any business that competes with the Business for a period of three years. Our failure to comply with these provisions may have a material adverse effect on our future performance.
We are dependent on information technology systems, infrastructure and data. System security risks, breaches of data protection, cyber-attacks, and erroneous or non-malicious actions or failures to act by our employees or others with authorized access to our networks could disrupt our products, services, internal operations, or information technology systems, and could lead to theft of our intellectual property, and any such disruption could reduce our expected revenue, increase our expenses, damage our reputation, and cause our stock price to decline significantly.
Information security risks have significantly increased in recent years in part due to the proliferation of new technologies and the increased sophistication and activities of organized crime, hackers, terrorists and other external parties, including foreign private parties and state actors. Our products and services may contain unknown security vulnerabilities. For example, the firmware, software, and open source software that we or our manufacturing partners have installed on our products may be susceptible to hacking, unauthorized manipulation, or misuse. In addition, we offer a comprehensive online cloud management service, Arlo Secure, paired with our end products, including our cameras, baby monitors, and smart lights and we recently launched our direct to consumer store to sell our products directly to our customers. If malicious actors compromise this cloud service or our direct to consumer store, or if customer confidential information is accessed without authorization, our business will be harmed. Operating an online cloud service and direct to consumer store are a relatively new businesses for us, and we may not have the expertise to properly manage risks related to data security and systems security. We rely on third-party providers for a number of critical aspects of our cloud services and customer support, including web hosting services, billing, and payment processing, and consequently we do not maintain direct control over the security or stability of the associated systems. If we or our third-party providers are unable to properly secure our system or successfully prevent breaches of security relating to our products, services, or user private information, including user videos and user personal identification information, or if these third-party systems fail for other reasons, our management could need to spend increasing amounts of time and effort in this area. As a result, we could incur substantial expenses, our brand and reputation could suffer and our business, results of operations, and financial condition could be materially adversely affected.
Maintaining the security of our computer information systems and communication systems is a critical issue for us and our customers and we devote considerable internal and external resources to network security, data encryption, and other security measures to protect our systems, customers, and users, but these security measures cannot provide absolute security. The multitude and complexity of our computer systems may make them vulnerable to service interruption or destruction, breaches of security, disruption of data integrity, inadvertent errors that expose our data or systems, malicious intrusion, or random attacks. Likewise, data privacy or security incidents or intentional or non-malicious breaches by employees or others may pose a risk that sensitive data, including our intellectual property, trade secrets or personal information of our employees, customers or users, or other business partners may be exposed to unauthorized persons or to
26
the public, or that risk of loss or misuse of this information could occur, resulting in litigation and potential liability for us, damage our brand and reputation, or otherwise materially adversely affect our business, results of operations, and financial condition. Malicious actors may develop and deploy malware that is designed to manipulate our systems, including our internal network, or those of our vendors or customers. Additionally, outside parties may attempt to fraudulently induce our employees to disclose sensitive information in order to gain access to our information technology systems, our data or our customers’ data. We have established a crisis management plan and business continuity program. While we regularly test the plan and the program, there can be no assurance that the plan and program can withstand an actual disruption in our business, including a cyber-attack, hacking, fraud, social engineering, or other forms of deception. While we have established service-level and geographic redundancy for our critical systems, our ability to utilize these redundant systems must be tested regularly, failing over to such systems always carries risk and we cannot be assured that such systems are fully functional. For example, much of our order fulfillment process is automated and the order information is stored on our servers. A significant business interruption could result in losses or damages and harm our business. If our computer systems and servers become unavailable at the end of a fiscal quarter, for example, our ability to recognize revenue may be delayed until we are able to utilize back-up systems and continue to process and ship our orders. This could cause our stock price to decline significantly. Changes in how our employees work and access our systems during the current COVID-19 pandemic also could lead to additional opportunities for bad actors to launch cyberattacks or for employees to cause inadvertent security risks or incidents.
The effects of a security breach or privacy violation could be further amplified during the current COVID-19 pandemic. In addition, the cost and operational consequences of implementing further data protection measures could be significant and theft of our intellectual property or proprietary business information could require substantial expenditures to remedy. Further, we cannot be certain that (a) our liability insurance will be sufficient in type or amount to cover us against claims related to security breaches, cyberattacks and other related breaches; (b) such coverage will cover any indemnification claims against us relating to any incident, will continue to be available to us on economically reasonable terms, or at all; or (c) any insurer will not deny coverage as to any future claim. The successful assertion of one or more large claims against us that exceed available insurance coverage, or the occurrence of changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could adversely affect our reputation, business, financial condition and results of operations.
Our future success depends on our ability to increase sales of our paid subscription services.
Our future success is largely dependent on increasing sales of our paid subscription services. Even if we are successful in selling our smart connected devices and accessories, if we are unable to maintain or increase sales of Arlo Secure services, our revenue and overall gross margin would likely decline.
Interruptions with the cloud-based systems that we use in our operations provided by an affiliate of Amazon.com, Inc. ("Amazon"), which is also one of our primary competitors, may materially adversely affect our business, results of operations, and financial condition.
We host our platform using Amazon Web Services (“AWS”) data centers, a provider of cloud infrastructure services, and may in the future use other third-party cloud-based systems in our operations. All of our solutions currently reside on systems leased and operated by us in these locations. Accordingly, our operations depend on protecting the virtual cloud infrastructure hosted in AWS by maintaining its configuration, architecture, features, and interconnection specifications, as well as the information stored in these virtual data centers and which third-party internet service providers transmit. Although we have disaster recovery plans that utilize multiple AWS locations, any incident affecting their infrastructure that may be caused by human error, fire, flood, severe storm, earthquake, or other natural disasters, cyber-attacks, terrorist or other attacks, and other similar events beyond our control could negatively affect our platform. A prolonged AWS service disruption affecting our platform for any of the foregoing reasons would negatively impact our ability to serve our end-users and could damage our reputation with current and potential end-users, expose us to liability, cause us to lose customers, or otherwise harm our business. We may also incur significant costs for using alternative equipment or taking other actions in preparation for, or in reaction to, events that damage the AWS services we use.
27
Further, if we were to make updates to our platforms that were not compatible with the configuration, architecture, features, and interconnection specifications of the third-party platform, our service could be disrupted.
Amazon produces the Amazon Cloud Cam, which competes with our security camera products, and acquired two of our competitors, Blink and Ring, in 2017 and 2018, respectively. Amazon may choose to hamper our competitive efforts, using provision of AWS services as leverage. In the event that there is a lapse of service, elimination of AWS services or features that we use, interruption of internet service provider connectivity, or damage to such facilities, we could experience interruptions in access to our platform as well as significant delays and additional expense in arranging or creating new facilities and services and/or re-architecting our solutions for deployment on a different cloud infrastructure service provider, which could materially adversely affect our business, results of operations, and financial condition.
Our current and future products may experience quality problems, including defects or errors, from time to time that can result in adverse publicity, product recalls, litigation, regulatory proceedings, and warranty claims resulting in significant direct or indirect costs, decreased revenue, and operating margin, and harm to our brand.
We sell complex products that could contain design and manufacturing defects in their materials, hardware, and firmware. These defects could include defective materials or components that can unexpectedly interfere with the products’ intended operations or cause injuries to users or property damage. Although we extensively and rigorously test new and enhanced products and services before their release, we cannot assure we will be able to detect, prevent, or fix all defects. Failure to detect, prevent, or fix defects, or an increase in defects, could result in a variety of consequences, including a greater number of product returns than expected from users and retailers, increases in warranty costs, regulatory proceedings, product recalls, and litigation, each of which could materially adversely affect our business, results of operations, and financial condition. We generally provide a one-year hardware warranty on all of our products. The occurrence of real or perceived quality problems or material defects in our current and future products could expose us to warranty claims in excess of our current reserves. If we experience greater returns from retailers or users, or greater warranty claims, in excess of our reserves, our business, financial condition, and results of operations could be harmed. In addition, any negative publicity or lawsuits filed against us related to the perceived quality and safety of our products could also adversely affect our brand, decrease demand for our products and services, and materially adversely affect our business, results of operations, and financial condition.
In addition, epidemic failure clauses are found in certain of our customer contracts. If invoked, these clauses may entitle the customer to return for replacement or obtain credits for products and inventory, as well as assess liquidated damage penalties and terminate an existing contract and cancel future or then-current purchase orders. In such instances, we may also be obligated to cover significant costs incurred by the customer associated with the consequences of such epidemic failure, including freight and transportation required for product replacement and out-of-pocket costs for truck rolls to end-user sites to collect the defective products. Costs or payments we make in connection with an epidemic failure could materially adversely affect our business, results of operations, and financial condition.
If our products contain defects or errors, or are found to be noncompliant with industry standards, we could experience decreased sales and increased product returns, loss of customers and market share, and increased service, warranty, and insurance costs. In addition, defects in, or misuse of, certain of our products could cause safety concerns, including the risk of property damage or personal injury. If any of these events occurred, our reputation and brand could be damaged, and we could face product liability or other claims regarding our products, resulting in unexpected expenses and adversely impacting our operating results. For instance, if a third party were able to successfully overcome the security measures in our products, such a person or entity could misappropriate end-user data, third-party data stored by our users, and other information, including intellectual property. If that happens, affected end-users or others may file actions against us alleging product liability, tort, or breach of warranty claims.
We rely on a limited number of traditional and online retailers and wholesale distributors for a substantial portion of our sales, and our revenue could decline if they refuse to pay our requested prices or reduce their level of purchases or if there is significant consolidation in our sales channels, which results in fewer sales channels for our products.
28
We sell a substantial portion of our products through traditional and online retailers, including Amazon, Best Buy Co., Inc. ("Best Buy"), and Costco Wholesale Corporation (“Costco”) and Verisure and their respective affiliates. For the year ended December 31, 2021, we derived 13.0% of our revenue from Best Buy and its affiliates and 30.8% of our revenue from Verisure and its affiliates, respectively. In addition, we sell to wholesale distributors, including Ingram Micro, Inc., D&H Distributing Company, and Synnex Corporation. We expect that a significant portion of our revenue will continue to come from sales to a small number of such retailers, distributors, and other channel partners. In addition, because our accounts receivable are often concentrated within a small group of retailers, distributors, and other channel partners, the failure of any of them to pay on a timely basis, or at all, would reduce our cash flow. If Best Buy or other retailers closes any of its retail stores due to COVID-19 pandemic, our revenue could be adversely impacted. We are also exposed to increased credit risk if any one of these limited numbers of retailer and distributor channel partners fails or becomes insolvent. Verisure has an aggregate purchase commitment of $500.0 million during a five-year period commencing January 1, 2020. Other than with Verisure, we generally have no minimum purchase commitments or long-term contracts with our retailers, distributors and other channel partners. These purchasers could decide at any time to discontinue, decrease, or delay their purchases of our products. If our retailers, distributors, and other channel partners increase the size of their product orders without sufficient lead-time for us to process the order, our ability to fulfill product orders would be compromised. These channel partners have a variety of suppliers to choose from and therefore can make substantial demands on us, including demands on product pricing and on contractual terms, which often results in the allocation of risk to us as the supplier. Accordingly, the prices that they pay for our products are subject to negotiation and could change at any time. We have historically benefited from NETGEAR’s strong relationships with these retailers, distributors, and other channel partners, and we may not be able to maintain these relationships following our separation from NETGEAR. Our ability to maintain strong relationships with these channel partners is essential to our future performance. If any of our major channel partners reduce their level of purchases or refuse to pay the prices that we set for our products, our revenue and results of operations could be harmed. The traditional retailers that purchase from us have faced increased and significant competition from online retailers. If our key traditional retailers continue to reduce their level of purchases from us, our business, results of operations, and financial condition could be harmed.
Additionally, concentration and consolidation among our channel partner base may allow certain retailers and distributors to command increased leverage in negotiating prices and other terms of sale, which could adversely affect our profitability. In addition, if, as a result of increased leverage, channel partner pressures require us to reduce our pricing such that our gross margin is diminished, we could decide not to sell our products to a particular channel partner, which could result in a decrease in our revenue. Consolidation among our channel partner base may also lead to reduced demand for our products, elimination of sales opportunities, replacement of our products with those of our competitors, and cancellations of orders, each of which could materially adversely affect our business, results of operations, and financial condition. If consolidation among the retailers, distributors, or other channel partners who purchase our products becomes more prevalent, our business, results of operations, and financial condition could be materially adversely affected.
In particular, the retail and connected home markets in some countries, including the United States, are dominated by a few large retailers with many stores. These retailers have in the past increased their market share and may continue to do so in the future by expanding through acquisitions and construction of additional stores. These situations concentrate our credit risk with a relatively small number of retailers, and, if any of these retailers were to experience a shortage of liquidity, it could increase the risk that their outstanding payables to us may not be paid. In addition, increasing market share concentration among one or a few retailers in a particular country or region increases the risk that if any one of them substantially reduces its purchases of our devices, we may be unable to find a sufficient number of other retail outlets for our products to sustain the same level of sales. Any reduction in sales by our retailers could materially adversely affect our business, results of operations, and financial condition.
We depend on large, recurring purchases from certain significant retailers, distributors, and other channel partners, and a loss, cancellation, or delay in purchases by these channel partners could negatively affect our revenue.
The loss of recurring orders from any of our more significant retailers, distributors, and other channel partners could cause our revenue and profitability to suffer. Our ability to attract new retailers, distributors, and other channel
29
partners will depend on a variety of factors, including the cost-effectiveness, reliability, scalability, breadth, and depth of our products. In addition, a change in the mix of our retailers, distributors, and other channel partners, or a change in the mix of direct and indirect sales, could adversely affect our revenue and gross margin.
Although our financial performance may depend on large, recurring orders from certain retailers, distributors, and other channel partners, we do not generally have binding commitments from them. For example:
•our channel partner agreements generally do not require minimum purchases;
•our retailers, distributors, and other channel partners can stop purchasing and stop marketing our products at any time; and
•our channel partner agreements generally are not exclusive.
Further, our revenue may be impacted by significant one-time purchases that are not intended to be repeatable. While such purchases are reflected in our financial statements, we do not rely on and do not forecast for continued significant one-time purchases. As a result, lack of repeatable one-time purchases will adversely affect our revenue. Additionally, we may from time to time grant our retailers, distributors, and other channel partners the exceptional right to return certain products, based on the best interests of our mutual businesses, and such returns, if material, could adversely affect our revenue and gross margin.
Because our expenses are based on our revenue forecasts, a substantial reduction or delay in sales of our products to, or unexpected returns from, channel partners, or the loss of any significant channel partners, could materially adversely affect our business, results of operations, and financial condition. Although our largest channel partners may vary from period to period, we anticipate that our results of operations for any given period will continue to depend on large orders from a small number of channel partners.
The average selling prices of our products typically decrease rapidly over the sales cycle of the product, which may negatively affect our revenue and gross margin.
Our products typically experience price erosion, a fairly rapid reduction in the average unit selling prices over their sales cycles. In order to sell products that have a falling average unit selling price and maintain margins at the same time, we need to continually reduce product and manufacturing costs. To manage manufacturing costs, we must partner with our third-party manufacturers to engineer the most cost-effective design for our products. In addition, we must carefully manage the price paid for components used in our products, and we must also successfully manage our freight and inventory costs to reduce overall product costs. We also need to continually introduce new products with higher sales prices and gross margin in order to maintain our overall gross margin. If we are unable to manage the cost of older products or successfully introduce new products with higher gross margin, our revenue and overall gross margin would likely decline.
We have spent, and expect to continue to spend, significant amounts on advertising and other marketing campaigns, which may not be successful or cost effective.
We have spent, and expect to continue to spend, significant amounts on advertising and other marketing campaigns, such as television, print advertising, and social media, as well as increased promotional activities, to acquire new customers, and we expect our marketing expenses to increase in the future as we continue to spend significant amounts to increase awareness of our smart connected devices and services. For the years ended December 31, 2021 and 2020, sales and marketing expenses were $48.9 million and $49.1 million, respectively, representing approximately 11% and 14% of our revenue, respectively. While we seek to structure our advertising campaigns in the manner that we believe is most likely to encourage people to purchase our products and services, we may fail to identify advertising opportunities that satisfy our anticipated return on advertising spend as we scale our investments in marketing or to fully understand or estimate the conditions and behaviors that drive customer behavior. If any of our advertising campaigns prove less
30
successful than anticipated in attracting customers, we may not be able to recover our advertising spend, and our revenue may fail to meet market expectations, either of which could have an adverse effect on our business. There can be no assurance that our advertising and other marketing efforts will result in increased sales of our products or services.
Introducing new products and services may be difficult and expensive. If we are unable to do so successfully, our brand may be adversely affected and we may not be able to maintain or grow our current revenue and profit levels.
To successfully evolve our product offerings of smart connected devices to appeal to our consumers, we will be required to predict, understand, and react to the rapidly changing tastes of consumers and provide appealing products in a timely manner. New product models that we introduce may not be successful with consumers or our brand may fall out of favor with consumers. If we are unable to anticipate, identify, or react appropriately to changes in consumer preferences, our revenues may decrease, our brand image may suffer, our operating performance may decline, and we may not be able to execute our growth plans.
We have increased the rate of new product and service introductions, including new lines of Arlo cameras, smart lights, and doorbell products, and we may encounter difficulties that we did not anticipate during the product development stage. If we are not able to efficiently manufacture new products in quantities sufficient to support wholesale, retail, and e-commerce distribution, especially in light of the ongoing COVID-19 pandemic and its variants, we may not be able to recover our investment in the development of new product and service iterations and product lines, and we would continue to be subject to the risks inherent to having a limited product line. Even if we develop and manufacture new products and services that consumers find appealing, the ultimate success of any new products or services may depend on our pricing. We may not provide the appropriate level of marketing in order to educate the market and potential consumers about our new products and services. Achieving market acceptance will require us to exert substantial product development and marketing efforts, which could result in a material increase in our research and development and sales and marketing expenses. There can be no assurance that we will have the resources necessary to undertake such efforts effectively or that such efforts will be successful or that we will dedicate our limited marketing resources to the right product lines and services. Failure to gain market acceptance for new products and services could impede our ability to maintain or grow current revenue levels, reduce profits, adversely affect the image of our brand, erode our competitive position, and result in long-term harm to our business and financial results.
If we fail to enhance our brand, our ability to expand our customer base will be impaired and our operating results may suffer.
We believe that developing and maintaining awareness of the Arlo brand is critical to achieving widespread acceptance of our existing and future products and is an important element in attracting new customers. Furthermore, we expect the importance of global brand recognition to increase as competition increases. If customers do not perceive our products to be of high quality, our brand and reputation could be harmed, which could adversely impact our financial results. In addition, brand promotion efforts may not yield significant revenue or increased revenue sufficient to offset the additional expenses incurred in building our brand. Maintaining, protecting, and enhancing our brand may require us to make substantial investments, and these investments may not be successful. If we fail to successfully maintain, promote, and position our brand and protect our reputation, or if we incur significant expenses in this effort, our business, financial condition and operating results may be adversely affected.
The reputation of our services may be damaged, and we may face significant direct or indirect costs, decreased revenue, and operating margins if our services contain significant defects or fail to perform as intended.
Our services, including our intelligent cloud and App platform and our Arlo Secure services, are complex, and may not always perform as intended due to outages of our systems or defects affecting our services. Systems outages could be disruptive to our business and damage the reputation of our services and result in potential loss of revenue.
Significant defects affecting our services may be found following the introduction of new software or enhancements to existing software or in software implementations in varied information technology environments. Internal
31
quality assurance testing and end-user testing may reveal service performance issues or desirable feature enhancements that could lead us to reallocate service development resources or postpone the release of new versions of our software. The reallocation of resources or any postponement could cause delays in the development and release of future enhancements to our currently available software, damage the reputation of our services in the marketplace, and result in potential loss of revenue. Although we attempt to resolve all errors that we believe would be considered serious by our partners and customers, the software powering our services is not error-free. Undetected errors or performance problems may be discovered in the future, and known errors that we consider minor may be considered serious by our channel partners and end-users.
System disruptions and defects in our services could result in lost revenue, delays in customer deployment, or legal claims and could be detrimental to our reputation.
Because we store, process, and use data, some of which contain personal information, we are subject to complex and evolving federal, state, and foreign laws and regulations regarding privacy, data protection, and other related matters, which are subject to change.
We are subject to a variety of laws and regulations in the United States and other countries that involve matters central to our business, including with respect to user privacy, rights of publicity, data protection, content, protection of minors, and consumer protection. These laws can be particularly restrictive in countries outside the United States. Both in the United States and abroad, these laws and regulations are constantly evolving and remain subject to significant change. In addition, the application and interpretation of these laws and regulations are often unpredictable and uncertain, particularly in the new and rapidly evolving industry in which we operate. Because we store, process, and use data, some of which contain personal information, we are subject to complex and evolving federal, state, and foreign laws and regulations regarding privacy, data protection, and other matters. Alleged violations of any of these laws and regulations could result in investigations, claims, changes to our business practices, increased cost of operations, and declines in user growth, retention, or engagement, any of which could materially adversely affect our business, results of operations, and financial condition.
In the EU/EEA, the General Data Protection Regulation (2016/679) (“GDPR”) went into effect in 2018 and replaced Directive 95/46/EC (the EU Privacy Directive), becoming directly applicable in all European Union member states. The GDPR establishes new requirements applicable to the processing of personal data (i.e., data which identifies an individual or from which an individual is identifiable), affords new data protection rights to individuals (e.g., the right to erasure of personal data) and imposes penalties for serious data breaches. Individuals also have a right to compensation under GDPR for financial or non-financial losses. Additionally, Brexit took effect in January 2020, which will lead to further legislative and regulatory changes. While the Data Protection Act of 2018, that “implements” and complements the GDPR achieved Royal Assent on May 23, 2018 and is now effective in the United Kingdom, it is still unclear whether transfer of data from the EEA to the United Kingdom will remain lawful in the long term under GDPR. With the expiry of the transition period on December 31, 2020, companies will have to comply with the GDPR and the GDPR as incorporated into United Kingdom national law, which has the ability to separately fine up to the greater of £17.5 million or 4% of global turnover. On June 28, 2021, the European Commission announced a decision of “adequacy” concluding that the UK ensures an equivalent level of data protection to the GDPR, which provides some relief regarding the legality of continued personal data flows from the EEA to the UK. Some uncertainty remains, however, as this adequacy determination must be renewed after four years and may be modified or revoked in the interim. We cannot fully predict how the Data Protection Act, the UK GDPR, and other UK data protection laws or regulations may develop in the medium to longer term nor the effects of divergent laws and guidance regarding how data transfers to and from the UK will be regulated.
California also recently enacted legislation that has been dubbed the first “GDPR-like” law in the U.S. Known as the California Consumer Privacy Act (“CCPA”), it creates new individual privacy rights for consumers (as that word is broadly defined in the law) and places increased privacy and security obligations on entities handling personal data of consumers or households. The CCPA, which went into effect on January 1, 2020, requires covered companies to provide new disclosures to California consumers, and provides such consumers new ways to opt-out of certain sales of personal
32
information. The CCPA provides for civil penalties for violations, as well as a private right of action for data breaches that is expected to increase data breach litigation. The CCPA may increase our compliance costs and potential liability.
Further, California voters approved a new privacy law, the California Privacy Rights Act (“CPRA”) in the November 3, 2020 election. Effective starting on January 1, 2023, the CPRA will significantly modify the CCPA, including by expanding consumers’ rights with respect to certain sensitive personal information. The CPRA also creates a new state agency that will be vested with authority to implement and enforce the CCPA and the CPRA. New legislation proposed or enacted in various other states will continue to shape the data privacy environment nationally. For example, on March 2, 2021, Virginia enacted the Virginia Consumer Data Protection Act ("CDPA") which becomes effective on January 1, 2023, and on June 8, 2021, Colorado enacted the Colorado Privacy Act ("CPA") which takes effect on July 1, 2023. The CPA and CDPA are similar to the CCPA and CPRA but aspects of these state privacy statutes remain unclear, resulting in further legal uncertainty and potentially requiring us to modify our data practices and policies and to incur substantial additional costs and expenses in an effort to comply. Complying with the GDPR, CCPA, CPRA, CDPA, CPA, or other laws, regulations, amendments to or re-interpretations of existing laws and regulations, and contractual or other obligations relating to privacy, data protection, data transfers, data localization, or information security may require us to make changes to our services to enable us or our customers to meet new legal requirements, incur substantial operational costs, modify our data practices and policies, and restrict our business operations. Any actual or perceived failure by us to comply with these laws, regulations, or other obligations may lead to significant fines, penalties, regulatory investigations, lawsuits, significant costs for remediation, damage to our reputation, or other liabilities.
Some observers have noted that the CCPA, CPRA, CDPA, and CPA could mark the beginning of a trend toward more stringent privacy legislation in the U.S., which could increase our potential liability and adversely affect our business. GDPR and CCPA will impose additional responsibility and liability in relation to our processing of personal data. GDPR, CCPA, and CPRA may require us to change our policies and procedures and, if we are not compliant, could materially adversely affect our business, results of operations, and financial condition.
We are subject to financial and operating covenants in the Credit Agreement with Bank of America, N.A. and any failure to comply with such covenants, or obtain waivers in the event of non-compliance, could limit our borrowing availability under the Credit Agreement, resulting in our being unable to borrow under the Credit Agreement and materially adversely impact our liquidity. In addition, our operations may not provide sufficient cash to meet the repayment obligations of debt incurred under the Credit Agreement.
The Credit Agreement contains provisions that limit our future borrowing availability to the lesser of (x) $40.0 million and (y) an amount equal to the sum of (i) 90% of investment grade eligible receivables and (ii) 85% of non-investment grade eligible accounts, less applicable reserves established by the lender. The Credit Agreement also includes a $5.0 million sublimit for the issuance by the lender of letters of credit. In addition, the Credit Agreement includes an uncommitted accordion feature that allows us to from time to time request that the lender increase the aggregate revolving loan commitments by up to an additional $25.0 million in the aggregate, subject to the satisfaction of certain conditions. The Credit Agreement contains other customary covenants, including certain restrictions on maintaining a minimum cash balance, achieving certain fixed charge coverage ratio for two consecutive quarters, our ability to incur additional indebtedness, consolidate or merge, enter into acquisitions, pay any dividend or distribution on our capital stock, redeem, retire or purchase shares of our capital stock, make investments or pledge or transfer assets, in each case subject to limited exceptions.
There can be no assurance that we will be able to comply with the financial and other covenants in the Credit Agreement, and the effects of the COVID-19 pandemic may increase the risk of our inability to comply with such covenants. Our failure to comply with these covenants could cause us to be unable to borrow under the Credit Agreement and may constitute an event of default which, if not cured or waived, could result in the acceleration of the maturity of any indebtedness then outstanding under the Credit Agreement, which would require us to pay all amounts then outstanding. If we are unable to repay those amounts, the Lender could proceed against the collateral granted to them to secure that debt, which would seriously harm our business. Such an event could materially adversely affect our financial condition and liquidity. Additionally, such events of non-compliance could impact the terms of any additional borrowings and/or any
33
credit renewal terms. Any failure to comply with such covenants may be a disclosable event and may be perceived negatively. Such perception could adversely affect the market price for our common stock and our ability to obtain financing in the future.
Instability in geographies where we have operations and personnel or where we derive amounts of revenue could have a material adverse effect on our business, customers, operations and financial results.
Economic, civil, military and political uncertainty exists and may increase regions where we operate and derive our revenue. Various countries in which we operate are experiencing and may continue to experience military action and civil and political unrest. We have operations in the emerging market economies of Eastern Europe, including operations in Belarus utilizing employees and contractors who perform services relating to new product releases. In late February 2022, Russian military forces launched significant military action against Ukraine. Sustained conflict and disruption in the region is likely. The impact to Belarus and Ukraine, as well as actions taken by other countries, including new and stricter sanctions by Canada, the United Kingdom, the European Union, the U.S. and other countries and organizations against officials, individuals, regions, and industries in Russia, Belarus and Ukraine, and each country’s potential response to such sanctions, tensions and military actions, could have a material adverse effect on our product development timelines. Any such material adverse effect from the conflict and enhanced sanctions activity may disrupt our receipt of software development services and cause us to shift all or portions of our work occurring in the region to other countries. We are actively monitoring the security of our employees and contractors in Belarus and the stability of our infrastructure, including communications and internet availability. To date we have not experienced any material interruptions in our operations there and we are in the process of transitioning our operations out of Belarus to other locations. If we are unable to effectively transition those services or replicate their capabilities in another country, our ability to timely introduce new products and financial results may be harmed.
Global geopolitical, economic and business conditions could materially adversely affect our revenue and results of operations.
Our business has been and may continue to be affected by a number of factors that are beyond our control, such as general geopolitical, economic, and business conditions, conditions in the financial markets, and changes in the overall demand for connected lifestyle products. Our products and services may be considered discretionary items for our consumer and small business end-users. A severe and/or prolonged economic downturn, including as a result of the COVID-19 pandemic, could adversely affect our customers’ financial condition and the levels of business activity of our customers. Weakness in, and uncertainty about, global economic conditions may cause businesses to postpone spending in response to tighter credit, negative financial news and/or declines in income or asset values, which could have a material negative effect on the demand for our products.
In the recent past, various regions worldwide have experienced slow economic growth. In addition, current economic challenges in China, including any global economic ramifications of these challenges, may continue to put negative pressure on global economic conditions. If conditions in the global economy, including Europe, China, Australia and the United States, or other key vertical or geographic markets deteriorate, such conditions could materially adversely affect our business, results of operations, and financial condition. If we are unable to successfully anticipate changing economic and political conditions, we may be unable to effectively plan for and respond to those changes, which could materially adversely affect our business, results of operations, and financial condition. In addition, the economic problems affecting the financial markets and the uncertainty in global economic conditions resulted in a number of adverse effects, including a low level of liquidity in many financial markets, extreme volatility in credit, equity, currency, and fixed income markets, instability in the stock market, and high unemployment.
For example, the challenges faced by the European Union to stabilize some of its member economies, such as Greece, Portugal, Spain, Hungary, and Italy, have had international implications, affecting the stability of global financial markets and hindering economies worldwide. Many member nations in the European Union have been addressing the issues with controversial austerity measures. In addition, the potential consequences of the “Brexit” process in the United Kingdom have led to significant uncertainty in the region. Should the European Union monetary policy measures be
34
insufficient to restore confidence and stability to the financial markets, or should the United Kingdom’s “Brexit” decision lead to additional economic or political instability, the global economy, including the U.S. and European Union economies where we have a significant presence, could be hindered, which could have a material adverse effect on us. There could also be a number of other follow-on effects from these economic developments on our business, including the inability of customers to obtain credit to finance purchases of our products, customer insolvencies, decreased customer confidence to make purchasing decisions, decreased customer demand, and decreased customer ability to pay their trade obligations.
In addition, availability of our products from third-party manufacturers and our ability to distribute our products into non-U.S. jurisdictions may be impacted by factors such as an increase in duties, tariffs, or other restrictions on trade; raw material shortages, work stoppages, strikes and political unrest; economic crises and international disputes or conflicts; changes in leadership and the political climate in countries from which we import products. Further, the imposition of and changes in the U.S.' and other governments' duties, trade regulations, trade wars, tariffs, other restrictions or other geopolitical events, including the evolving relations between U.S. and China and evolving relations with Russia due to the current hostilities between Russia and Ukraine, create uncertainty regarding our ability to market and distribute our products into non-U.S. jurisdictions and any failure to effectively anticipate or respond to such events could materially adversely affect our business, results of operations, and financial condition.
A portion of our global and U.S. sales are comprised of goods assembled and manufactured in our facilities in Taiwan and the People’s Republic of China, and components for a number of our goods are sourced from suppliers in the People’s Republic of China. When tariffs, duties, or other restrictions are placed on goods imported into the United States from China or any related counter-measures are taken by China, our revenue and results of operations may be materially harmed.
In recent years, the U.S. Government has imposed increases to the ad valorem duties applicable to certain products imported from China, including increases of up to 25% for some items. We are actively addressing the risks related to these additional duties, which have affected, or have the potential to affect, at least some of our imports from China. Although we have already taken some steps to mitigate these risks, including by moving a significant portion of our manufacturing and assembly to Vietnam and other areas in the Asia Pacific region outside of China, if these duties are imposed, the cost of our products may increase. These duties may also make our products more expensive for consumers, which may reduce consumer demand. We may need to offset the financial impact by, among other things, moving even more of our product manufacturing to other locations, modifying other business practices or raising prices. If we are not successful in offsetting the impact of any such duties, our revenue, gross margins, and operating results may be materially adversely affected.
Our stock price may be volatile and your investment in our common stock could suffer a decline in value.
There has been significant volatility in the market price and trading volume of securities of technology and other companies, including recently in connection with the ongoing COVID-19 pandemic, which may be unrelated to the financial performance of these companies. These broad market fluctuations may negatively affect the market price of our common stock.
Some specific factors that may have a significant effect on the market price of our common stock include:
•actual or anticipated fluctuations in our results of operations or our competitors’ operating results;
•actual or anticipated changes in the growth rate of the connected lifestyle market, our growth rate or our competitors’ growth rates;
•delays in the introduction of new products by us or market acceptance of these products;
•conditions in the financial markets in general or changes in general economic conditions, including due to the COVID-19 pandemic;
35
•changes in governmental regulation, including taxation and tariff policies;
•interest rate or currency exchange rate fluctuations;
•our ability to forecast or report accurate financial results; and
•changes in stock market analyst recommendations regarding our common stock, other comparable companies, or our industry generally.
We depend substantially on our sales channels, and our failure to maintain and expand our sales channels would result in lower sales and reduced revenue.
To maintain and grow our market share, revenue, and brand, we must maintain and expand our sales channels. Our sales channels consist primarily of traditional retailers, online retailers, and wholesale distributors, but also include service providers such as wireless carriers and telecommunications providers. We generally have no minimum purchase commitments or long-term contracts with any of these third parties.
Traditional retailers have limited shelf space and promotional budgets, and competition is intense for these resources. A competitor with more extensive product lines and stronger brand identity may have greater bargaining power with these retailers. Any reduction in available shelf space or increased competition for such shelf space would require us to increase our marketing expenditures simply to maintain current levels of retail shelf space, which would harm our operating margin. Our traditional retail customers have faced increased and significant competition from online retailers. If we cannot effectively manage our business amongst our online customers and traditional retail customers, our business would be harmed. The recent trend in the consolidation of online retailers has resulted in intensified competition for preferred product placement, such as product placement on an online retailer’s internet home page. In addition, our efforts to realign or consolidate our sales channels may cause temporary disruptions in our product sales and revenue, and these efforts may not result in the expected longer-term benefits that prompted them.
In addition, to the extent our retail and distributor channel partners supply products that compete with our own, it is possible that these channel partners may choose not to offer our products to end-users or to offer our products to end-users on less favorable terms, including with respect to product placement. If this were to occur, we may not be able to increase or maintain our sales, and our business, results of operations, and financial condition could be materially adversely affected. For example, Amazon, one of our primary retailers, produces the Amazon Cloud Cam, which competes with our security camera products, and also acquired two of our competitors, Blink and Ring. For the year ended December 31, 2021, we derived 7.6% of our revenue from Amazon and its affiliates.
We must also continuously monitor and evaluate emerging sales channels. If we fail to establish a presence in an important developing sales channel, our business, results of operations, and financial condition could be materially adversely affected.
If we do not effectively manage our sales channel inventory and product mix, we may incur costs associated with excess inventory, or lose sales from having too few products.
If we are unable to properly monitor, control, and manage our sales channel inventory and maintain an appropriate level and mix of products with our distributors and within our sales channels, we may incur increased and unexpected costs associated with this inventory. We generally allow distributors and traditional retailers to return a limited amount of our products in exchange for other products. Under our price protection policy, if we reduce the list price of a product, we are often required to issue a credit in an amount equal to the reduction for each of the products held in inventory by our wholesale distributors and retailers. If our wholesale distributors and retailers are unable to sell their inventory in a timely manner, we might lower the price of the products, or these parties may exchange the products for newer products. Also, during the transition from an existing product to a new replacement product, we must accurately predict the demand for the existing and the new product.
36
We determine production levels based on our forecasts of demand for our products. Actual demand for our products depends on many factors, which makes it difficult to forecast. We have experienced differences between our actual and our forecasted demand in the past and expect differences to arise in the future. If we improperly forecast demand for our products, we could end up with too many products and be unable to sell the excess inventory in a timely manner, if at all, or, alternatively, we could end up with too few products and not be able to satisfy demand. This problem is exacerbated because we attempt to closely match inventory levels with product demand, leaving limited margin for error. If these events occur, we could incur increased expenses associated with writing off excessive or obsolete inventory, lose sales, incur penalties for late delivery, or have to ship products by air freight to meet immediate demand, thereby incurring incremental freight costs above the sea freight costs, a preferred method, and suffering a corresponding decline in gross margin.
If we are unable to secure and protect our intellectual property rights, our ability to compete could be harmed.
We rely on a combination of copyright, trademark, patent, and trade secret laws, nondisclosure agreements with employees, consultants, and suppliers, and other contractual provisions to establish, maintain, and protect our intellectual property and technology. Despite efforts to protect our intellectual property, unauthorized third parties may attempt to design around, copy aspects of our product design or obtain and use technology or other intellectual property associated with our products. Furthermore, our competitors may independently develop similar technology or design around our intellectual property. Our inability to secure and protect our intellectual property rights could materially adversely affect our brand and business, results of operations, and financial condition.
We rely upon third parties for technology that is critical to our products, and if we are unable to continue to use this technology and future technology, our ability to develop, sell, maintain, and support technologically innovative products would be limited.
We rely on third parties to obtain non-exclusive patented hardware and software license rights in technologies that are incorporated into and necessary for the operation and functionality of most of our products. In these cases, because the intellectual property we license is available from third parties, barriers to entry into certain markets may be lower for potential or existing competitors than if we owned exclusive rights to the technology that we license and use. Moreover, if a competitor or potential competitor enters into an exclusive arrangement with any of our key third-party technology providers, or if any of these providers unilaterally decides not to do business with us for any reason, our ability to develop and sell products containing that technology would be severely limited. In addition, certain of Arlo’s firmware and the AI-based algorithms that we use in our Arlo Secure services incorporate open source software, the licenses for which may include customary requirements for, and restrictions on, use of the open source software.
If we are offering products or services that contain third-party technology that we subsequently lose the right to license, then we will not be able to continue to offer or support those products or services. In addition, these licenses may require royalty payments or other consideration to the third-party licensor. Our success will depend, in part, on our continued ability to access these technologies, and we do not know whether these third-party technologies will continue to be licensed to us on commercially acceptable terms, if at all. In addition, if these third-party licensors fail or experience instability, then we may be unable to continue to sell products and services that incorporate the licensed technologies, in addition to being unable to continue to maintain and support these products and services. We do require escrow arrangements with respect to certain third-party software which entitle us to certain limited rights to the source code, in the event of certain failures by the third party, in order to maintain and support such software. However, there is no guarantee that we would be able to fully understand and use the source code, as we may not have the expertise to do so. We are increasingly exposed to these risks as we continue to develop and market more products containing third-party technology and software. If we are unable to license the necessary technology, we may be forced to acquire or develop alternative technology, which could be of lower quality or performance standards. The acquisition or development of alternative technology may limit and delay our ability to offer new or competitive products and services and increase our costs of production. As a result, our business, results of operations, and financial condition could be materially adversely affected.
37
We also utilize third-party software development companies and contractors to develop, customize, maintain, and support software that is incorporated into our products and services. If these companies and contractors fail to timely deliver or continuously maintain and support the software, as we require of them, we may experience delays in releasing new products and services or difficulties with supporting existing products, services, and our users.
Our sales and operations in international markets expose us to operational, financial and regulatory risks.
International sales comprise a significant amount of our overall revenue. International sales were 38.9% and 27.5% of overall revenue for the years ended December 31, 2021 and 2020, respectively. We continue to be committed to growing our international sales, and while we have committed resources to expanding our international operations and sales channels, these efforts may not be successful and could be impacted by COVID-19 pandemic. International operations are subject to a number of risks, including but not limited to:
•exchange rate fluctuations;
•political and economic instability, international terrorism, and anti-American sentiment, particularly in emerging markets;
•potential for violations of anti-corruption laws and regulations, such as those related to bribery and fraud;
•preference for locally branded products, and laws and business practices favoring local competition;
•potential consequences of, and uncertainty related to, the “Brexit” process in the United Kingdom, which could lead to additional expense and complexity in doing business there;
•increased difficulty in managing inventory;
•delayed revenue recognition;
•less effective protection of intellectual property;
•stringent consumer protection and product compliance regulations, including but not limited to General Data Protection Regulation in the European Union, European competition law, the Restriction of Hazardous Substances directive, the Waste Electrical and Electronic Equipment directive and the European Ecodesign directive, that are costly to comply with and may vary from country to country;
•difficulties and costs of staffing and managing foreign operations;
•business difficulties, including potential bankruptcy or liquidation, of any of our worldwide third-party logistics providers; and
•changes in local tax and customs duty laws or changes in the enforcement, application, or interpretation of such laws.
We are also required to comply with local environmental legislation, and those who sell our products rely on this compliance in order to sell our products. If those who sell our products do not agree with our interpretations and requirements of new legislation, they may cease to order our products and our business, results of operations, and financial condition could be materially adversely affected.
Governmental regulations of imports or exports affecting internet security could affect our revenue.
Any additional governmental regulation of imports or exports or failure to obtain required export approval of our
38
encryption technologies could adversely affect our international and domestic sales. The United States and various foreign governments have imposed controls, export license requirements, and restrictions on the import or export of some technologies, particularly encryption technology. In addition, from time to time, governmental agencies have proposed additional regulation of encryption technology, such as requiring the escrow and governmental recovery of private encryption keys. In response to terrorist activity, governments could enact additional regulation or restriction on the use, import, or export of encryption technology. This additional regulation of encryption technology could delay or prevent the acceptance and use of encryption products and public networks for secure communications, resulting in decreased demand for our products and services. In addition, some foreign competitors are subject to less stringent controls on exporting their encryption technologies. As a result, they may be able to compete more effectively than we can in the United States and the international internet security market.
We are involved in litigation matters in the ordinary course and may in the future become involved in additional litigation, including litigation regarding intellectual property rights, which could be costly and subject us to significant liability.
Our industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding infringement of patents, trade secrets, and other intellectual property rights. From time to time, third parties have asserted, and may continue to assert, exclusive patent, copyright, trademark, and other intellectual property rights against us, demanding license or royalty payments or seeking payment for damages, injunctive relief, and other available legal remedies through litigation. These also include third-party non-practicing entities who claim to own patents or other intellectual property that they believe cover our products. If we are unable to resolve these matters or obtain licenses on acceptable or commercially reasonable terms, we could be sued or we may be forced to initiate litigation to protect our rights. The cost of any necessary licenses and litigation related to alleged infringement could materially adversely affect our business, results of operations, and financial condition.
In the event successful claims of infringement are brought by third parties, and we are unable to obtain licenses or independently develop alternative technology on a timely basis, we may be subject to indemnification obligations, be unable to offer competitive products, or be subject to increased expenses. If we do not resolve these claims on a favorable basis, our business, results of operations, and financial condition could be materially adversely affected.
As part of growing our business, we may make acquisitions. If we fail to successfully select, execute, or integrate our acquisitions, then our business, results of operations, and financial condition could be materially adversely affected and our stock price could decline.
From time to time, we may undertake acquisitions to add new product and service lines and technologies, acquire talent, gain new sales channels, or enter into new sales territories. Acquisitions involve numerous risks and challenges, including relating to the successful integration of the acquired business, entering into new territories or markets with which we have limited or no prior experience, establishing or maintaining business relationships with new retailers, distributors, or other channel partners, vendors, and suppliers, and potential post-closing disputes.
We cannot ensure that we will be successful in selecting, executing, and integrating acquisitions. Failure to manage and successfully integrate acquisitions could materially harm our business, financial condition, and results of operations. In addition, if stock market analysts or our stockholders do not support or believe in the value of the acquisitions that we choose to undertake, our stock price may decline.
The success of our business depends on customers’ continued and unimpeded access to our platform on the internet.
Our users must have internet access in order to use our platform. Some providers may take measures that affect their customers’ ability to use our platform, such as degrading the quality of the data packets we transmit over their lines, giving those packets lower priority, giving other packets higher priority than ours, blocking our packets entirely, or attempting to charge their customers more for using our platform.
39
In December 2010, the Federal Communications Commission (the “FCC”), adopted net neutrality rules barring internet providers from blocking or slowing down access to online content, protecting services like ours from such interference. Recently, the FCC voted in favor of repealing the net neutrality rules, and it is currently uncertain how the U.S. Congress will respond to this decision. To the extent network operators attempt to interfere with our services, extract fees from us to deliver our solution, or otherwise engage in discriminatory practices, our business, results of operations, and financial condition could be materially adversely affected. Within such a regulatory environment, we could experience discriminatory or anti-competitive practices that could impede our domestic and international growth, cause us to incur additional expense, or otherwise materially adversely affect our business, results of operations, and financial condition.
Changes in tax laws or exposure to additional income tax liabilities could affect our future profitability.
Factors that could materially affect our future effective tax rates include, but are not limited to:
•changes in tax laws or the regulatory environment;
•changes in the valuation allowance against deferred tax assets;
•increases in interests and penalties related to income taxes;
•changes in accounting and tax standards or practices;
•changes in the composition of operating income by tax jurisdiction; and
•changes in our operating results before taxes.
We are subject to income taxes in the United States and numerous foreign jurisdictions. Because we do not have a long history of operating as a separate company after the Separation from NETGEAR and we have significant expansion plans, our effective tax rate may fluctuate in the future. Future effective tax rates could be affected by operating losses in jurisdictions where no tax benefit can be recognized under GAAP, changes in the composition of earnings in countries with differing tax rates, changes in deferred tax assets and liabilities, or changes in tax laws.
As of December 31, 2021, our U.S. federal and state net operating loss carryforwards were approximately $109.3 million and approximately $62.5 million, respectively. Moreover, our U.S. federal and state research and development tax credits were approximately $4.7 million and approximately $3.8 million, respectively. The utilization of our net operating loss and tax credit carryforwards may be subject to annual limitation due to ownership changes as provided by Sections 382 and 383 of the Code and similar state provisions. Such an annual limitation could result in the expiration of portions of our net operating loss and tax credit carryforwards before utilization. In the event that we experience ownership changes due to future transactions in our stocks, the utilization of net operating loss and tax credit carryforwards to reduce our future taxable income and tax liabilities may be limited, which could affect our profitability.
The Internal Revenue Services ("IRS") and several foreign tax authorities have increasingly focused attention on intercompany transfer pricing with respect to sales of products and services and the use of intangibles. Tax authorities could disagree with our intercompany charges, cross-jurisdictional transfer pricing or other matters and assess additional taxes. If we do not prevail in any such disagreements, our profitability may be affected.
In addition, the Organization for Economic Co-operation and Development (“OECD”) has been working on new laws on the taxation of the digital economy to provide taxing rights to jurisdictions where the customers or users are located. Some countries have enacted, and others have proposed the new laws to tax digital transactions. These developments may result in material impacts to our financial statements.
40
We are subject to income tax examinations by taxing authorities globally. We apply judgment in determining our provision for income taxes and other tax liabilities. While we believe our estimates are reasonably adequate, there are many transactions where the final tax determination is uncertain. If any adverse outcome from an examination determines the taxes we owe are higher than accrued or drives an increase in our effective tax rates, our results of operations could be affected.
We must comply with indirect tax laws in multiple jurisdictions, as well as complex customs duty regimes worldwide. Audits of our compliance with these rules may result in additional liabilities for taxes, duties, interest and penalties related to our international operations which would reduce our profitability.
Our operations are routinely subject to audit by tax authorities in various countries. Many countries have indirect tax systems where the sale and purchase of goods and services are subject to tax based on the transaction value. These taxes are commonly referred to as value-added tax (“VAT”) or goods and services tax (“GST”). In addition, the distribution of our products subjects us to numerous complex customs regulations, which frequently change over time. Failure to comply with these systems and regulations can result in the assessment of additional taxes, duties, interest, and penalties. While we believe we are in compliance with local laws, we cannot assure that tax and customs authorities will agree with our reporting positions and upon audit such tax and customs authorities may assess additional taxes, duties, interest, and penalties against us. Adverse action by any government agencies related to indirect tax laws could materially adversely affect our business, results of operations and financial condition.
We are subject to governmental export and import controls, economic sanctions, and anti-corruption laws regulations, that could impair our ability to compete in international markets and subject us to liability if we are not in full compliance with applicable laws.
Our business activities are subject to various restrictions under U.S. export controls and similar laws and regulations, including the Export Administration Regulations and economic sanctions administered by the Office of Foreign Assets Control. We also incorporate encryption technology into certain of our solutions. These encryption solutions and underlying technology may be exported outside of the United States only with the required export authorizations or exceptions, including by license, a license exception, appropriate classification notification requirement, and encryption authorization.
Furthermore, our activities are subject to U.S. economic sanctions laws and regulations that prohibit the shipment of certain products and services without the required export authorizations, including to countries, governments, and persons targeted by U.S. embargoes or sanctions. Obtaining the necessary export license or other authorization for a particular sale may be time consuming, and may result in delay or loss of sales opportunities even if the export license ultimately is granted. While we take precautions to prevent our solutions from being exported in violation of these laws, including using authorizations or exceptions for our encryption products and implementing IP address blocking and screenings against U.S. government and international lists of restricted and prohibited persons and countries, we have not been able to guarantee, and cannot guarantee, that the precautions we take will prevent all violations of export control and sanctions laws, including if purchasers of our products bring our products and services into sanctioned countries without our knowledge. Violations of U.S. sanctions or export control laws can result in significant fines or penalties and incarceration could be imposed on employees and managers for criminal violations of these laws.
Also, various countries, in addition to the United States, regulate the import and export of certain encryption and other technology, including import and export licensing requirements, and have enacted laws that could limit our ability to distribute our products and services or our end-users’ ability to utilize our solutions in their countries. Changes in our products and services or changes in import and export regulations may create delays in the introduction of our products in international markets. Any decreased use of our solutions or limitation on our ability to export or sell our solutions could adversely affect our business, results of operations and financial condition.
We are also subject to various domestic and international anti-corruption laws, such as the United States Foreign Corrupt Practices Act, as well as other similar anti-bribery laws and regulations. These laws and regulations generally prohibit companies and their employees and intermediaries from authorizing, offering, providing, and accepting improper
41
payments or benefits for improper purposes. These laws also require that we keep accurate books and records and maintain compliance procedures designed to prevent any such actions. Although we take precautions to prevent violations of these laws, our exposure for violating these laws increases as our international presence expands and as we increase sales and operations in foreign jurisdictions.
We are subject to, and must remain in compliance with, numerous laws and governmental regulations concerning the manufacturing, use, distribution, and sale of our products, as well as any such future laws and regulations. Some of our customers also require that we comply with their own unique requirements relating to these matters. Any failure to comply with such laws, regulations, and requirements, and any associated unanticipated costs, could materially adversely affect our business, results of operations, and financial condition.
We manufacture and sell products which contain electronic components, and such components may contain materials that are subject to government regulation in both the locations where we manufacture and assemble our products, as well as the locations where we sell our products. For example, certain regulations limit the use of lead in electronic components. To our knowledge, we maintain compliance with all applicable current government regulations concerning the materials utilized in our products for all the locations in which we operate. Since we operate on a global basis, this is a complex process which requires continual monitoring of regulations and an ongoing compliance process to ensure that we and our suppliers are in compliance with all existing regulations. There are areas where new regulations have been enacted which could increase our cost of the components that we utilize or require us to expend additional resources to ensure compliance. For example, the SEC’s “conflict minerals” rules apply to our business, and we are expending resources to ensure compliance. The implementation of these requirements by government regulators and our partners and/or customers could adversely affect the sourcing, availability and pricing of minerals used in the manufacture of certain components used in our products. In addition, the supply-chain due diligence investigation required by the conflict minerals rules will require expenditures of resources and management attention regardless of the results of the investigation. If there is an unanticipated new regulation which significantly impacts our use of various components or requires more expensive components, that regulation could materially adversely affect our business, results of operations, and financial condition.
One area that has a large number of regulations is environmental compliance. Management of environmental pollution and climate change has produced significant legislative and regulatory efforts on a global basis, and we believe this will continue both in scope and in the number of countries participating. These changes could directly increase the cost of energy, which may have an impact on the way we manufacture products or utilize energy to produce our products. In addition, any new regulations or laws in the environmental area might increase the cost of raw materials we use in our products. Environmental regulations require us to reduce product energy usage, monitor and exclude an expanding list of restricted substances, and participate in required recovery and recycling of our products. While future changes in regulations are certain, we are currently unable to predict how any such changes will impact us and if such impacts will be material to our business. If there is a new law or regulation that significantly increases our costs of manufacturing or causes us to significantly alter the way that we manufacture our products, this could have a material adverse effect on our business, financial condition, and results of operations.
Our selling and distribution practices are also regulated in large part by U.S. federal and state as well as foreign, antitrust and competition laws and regulations. In general, the objective of these laws is to promote and maintain free competition by prohibiting certain forms of conduct that tend to restrict production, raise prices or otherwise control the market for goods or services to the detriment of consumers of those goods and services. Potentially prohibited activities under these laws may include unilateral conduct or conduct undertaken as the result of an agreement with one or more of our suppliers, competitors, or customers. The potential for liability under these laws can be difficult to predict as it often depends on a finding that the challenged conduct resulted in harm to competition, such as higher prices, restricted supply, or a reduction in the quality or variety of products available to consumers. We utilize a number of different distribution channels to deliver our products to customers and end-users and regularly enter into agreements with resellers of our products at various levels in the distribution chain that could be subject to scrutiny under these laws in the event of private litigation or an investigation by a governmental competition authority. In addition, many of our products are sold to consumers via the internet. Many of the competition-related laws that govern these internet sales were adopted prior to the advent of the internet and, as a result, do not contemplate or address the unique issues raised by online sales. New interpretations of existing laws and regulations, whether by courts or by the state, federal, or foreign governmental
42
authorities charged with the enforcement of those laws and regulations, may also impact our business in ways we are currently unable to predict. Any failure on our part or on the part of our employees, agents, distributors, or other business partners to comply with the laws and regulations governing competition can result in negative publicity and diversion of management time and effort and may subject us to significant litigation liabilities and other penalties.
We are exposed to the credit risk of some of our customers and sublease counterparties and to credit exposures in certain markets, which could result in material losses.
A substantial portion of our sales are on an open credit basis, with typical payment terms of 30 to 60 days in the United States and, because of local customs or conditions, longer in some markets outside the United States. We monitor individual customer financial viability in granting such open credit arrangements, seek to limit such open credit to amounts we believe the customers can pay and maintain reserves we believe are adequate to cover exposure for doubtful accounts.
Any bankruptcies or illiquidity among our customer base or sublease counterparties could harm our business and have a material adverse effect on our financial condition and results of operations. To the degree that turmoil in the credit markets makes it more difficult for some customers or sublease counterparties to obtain financing, our customers’ or sublease counterparties' ability to pay could be adversely impacted, which in turn could materially adversely affect our business, results of operations, and financial condition.
In June, 2021, we entered into a sublease agreement, with a term that runs concurrent with the term of the head lease, for our San Jose office space in light of the COVID-19 pandemic and its impact on the changing nature of office space use by our workforce. We believe we have secured a quality subtenant with appropriate sublease terms. However, if the subtenant default on their sublease obligations with us or otherwise terminate their sublease with us, we may experience a loss of planned sublease rental income, which could result in a material charge against our operating results. If that were to happen, we may be unable to enter into a new sublease on acceptable terms or at all and even if we do, such sublease may result in our incurring liabilities and expenses in future periods or the rent payments we receive from a new subtenant being less than our rent obligations under the head lease. Under these circumstances, we would be responsible for any shortfall.
If our products are not compatible with some or all leading third-party IoT products and protocols, we could be materially adversely affected.
A core part of our solution is the interoperability of our platform with third-party IoT products and protocols. We have designed the Arlo platform to seamlessly integrate with third-party IoT products and protocols, such as Amazon Alexa, Apple HomeKit, Apple TV, Google Assistant, IFTTT, Stringify, and Samsung SmartThings. If these third parties were to alter their products, we could be adversely impacted if we fail to timely create compatible versions of our products, and such incompatibility could negatively impact the adoption of our products and solutions. A lack of interoperability may also result in significant redesign costs, and harm relations with our customers. Further, the mere announcement of an incompatibility problem relating to our products could materially adversely affect our business, results of operations, and financial condition.
In addition, to the extent our competitors supply products that compete with our own, it is possible these competitors could design their technologies to be closed or proprietary systems that are incompatible with our products or work less effectively with our products than their own. As a result, end-users may have an incentive to purchase products that are compatible with the products and technologies of our competitors over our products.
The marketability of our products may suffer if wireless telecommunications operators do not deliver acceptable wireless services.
The success of our business depends, in part, on the capacity, affordability, reliability, and prevalence of wireless data networks provided by wireless telecommunications operators and on which our IoT hardware products and solutions operate. Growth in demand for wireless data access may be limited if, for example, wireless telecommunications operators
43
cease or materially curtail operations, fail to offer services that customers consider valuable at acceptable prices, fail to maintain sufficient capacity to meet demand for wireless data access, delay the expansion of their wireless networks and services, fail to offer and maintain reliable wireless network services, or fail to market their services effectively.
We are exposed to adverse currency exchange rate fluctuations in jurisdictions where we transact in local currency, which could materially adversely affect our business, results of operations, and financial condition.
Because a significant portion of our business is conducted outside the United States, we face exposure to adverse movements in foreign currency exchange rates. These exposures may change over time as business practices evolve, and they could have a material adverse impact on our financial condition, results of operations, and cash flows. Although a portion of our international sales are currently invoiced in U.S. dollars, we have implemented and continue to implement for certain countries and customers both invoicing and payment in foreign currencies. Our primary exposure to movements in foreign currency exchange rates relates to non-U.S. dollar-denominated sales primarily in Australia, as well as our global operations, and non-U.S. dollar-denominated operating expenses and certain assets and liabilities. In addition, weaknesses in foreign currencies for U.S. dollar-denominated sales could adversely affect demand for our products. Conversely, a strengthening in foreign currencies against the U.S. dollar could increase foreign currency-denominated costs. As a result, we may attempt to renegotiate pricing of existing contracts or request payment to be made in U.S. dollars. We cannot be sure that our customers would agree to renegotiate along these lines. This could result in customers eventually terminating contracts with us or in our decision to terminate certain contracts, which would adversely affect our sales.
We established a hedging program after our initial public offering (the "IPO") to hedge our exposure to fluctuations in foreign currency exchange rates as a response to the risk of changes in the value of foreign currency-denominated assets and liabilities. We may enter into foreign currency forward contracts or other instruments. We expect that such foreign currency forward contracts will reduce, but will not eliminate, the impact of currency exchange rate movements. For example, we may not execute forward contracts in all currencies in which we conduct business. In addition, we may hedge to reduce the impact of volatile exchange rates on revenue, gross profit and operating profit for limited periods of time. However, the use of these hedging activities may only offset a portion of the adverse financial effect resulting from unfavorable movements in foreign exchange rates.
Risks Related to Our Separation from NETGEAR
If the Distribution (as defined below), together with certain related transactions, does not qualify as a transaction that is generally tax-free for U.S. federal income tax purposes, NETGEAR, Arlo and Arlo stockholders could be subject to significant tax liabilities, and, in certain circumstances, we could be required to indemnify NETGEAR for material taxes and other related amounts pursuant to indemnification obligations under the tax matters agreement.
In November 2018, NETGEAR announced that its board of directors had approved a special stock dividend (the “Distribution”) to its stockholders, consisting of 62,500,000 shares of our common stock owned by NETGEAR. In connection with the Distribution, NETGEAR received an opinion from outside tax counsel regarding qualification of the Distribution, together with certain related transactions, as a transaction that is generally tax-free for U.S. federal income tax purposes under Sections 355 and 368(a)(1)(D) of the Code. The opinion was based upon and relied on, among other things, certain facts and assumptions, as well as certain representations, statements and undertakings of NETGEAR and us, including those relating to the past and future conduct of NETGEAR and us. If any of these representations, statements or undertakings are, or become, incomplete or inaccurate, or if we or NETGEAR breach any of the respective covenants in any of the separation-related agreements, the opinion of the outside tax counsel could be invalid and the conclusions reached therein could be jeopardized.
Notwithstanding the opinion of the outside tax counsel, the IRS could determine on an audit that the Distribution, together with certain related transactions, should be taxable if it determines that any of the facts, assumptions, representations, statements or undertakings were incorrect or had been violated, or if it disagrees with the conclusions in the opinion. The opinion of counsel is not binding on the IRS or the courts, and we cannot assure that the IRS or a court
44
would not assert a contrary position. NETGEAR has not requested, and does not intend to request, a ruling from the IRS with respect to the treatment of the Distribution or certain related transactions for U.S. federal income tax purposes.
The consolidated U.S. federal income tax return for the calendar year 2018 that we filed with NETGEAR to report the Distribution together with certain related transactions is currently under audit by the IRS. If the Distribution, together with certain related transactions, were to fail to qualify as a tax-free transaction for U.S. federal income tax purposes under Sections 355 and 368(a)(1)(D) of the Code, in general, NETGEAR would recognize taxable gain as if it had sold our common stock in a taxable sale for its fair market value, and NETGEAR stockholders who receive shares of our common stock in the Distribution would be subject to tax as if they had received a taxable distribution equal to the fair market value of such shares.
We entered into the tax matters agreement with NETGEAR to indemnify NETGEAR for any taxes (and any related costs and other damages) resulting from the Separation and Distribution, and certain other related transactions, to the extent such amounts were to result from (i) an acquisition after the Distribution of all or a portion of our equity securities, whether by merger or otherwise (and regardless of whether we participated in or otherwise facilitated the acquisition), (ii) other actions or failures to act by us or (iii) any of the representations or undertakings contained in any of the Separation-related agreements or in the documents relating to the opinion of counsel being incorrect or violated. Any such indemnity obligations arising under the tax matters agreement could be material.
NETGEAR has agreed to indemnify us for certain liabilities. However, we cannot assure that the indemnity will be sufficient to insure us against the full amount of such liabilities, or that NETGEAR’s ability to satisfy its indemnification obligation will not be impaired in the future.
Pursuant to the master separation agreement entered into between us and NETGEAR and certain other agreements with NETGEAR, NETGEAR has agreed to indemnify us for certain liabilities. The master separation agreement provides for cross-indemnities principally designed to place financial responsibility for the obligations and liabilities of our business with us and financial responsibility for the obligations and liabilities of NETGEAR’s business with NETGEAR. Under the intellectual property rights cross-license agreement entered into between us and NETGEAR, each party, in its capacity as a licensee, indemnifies the other party, in its capacity as a licensor, as well as its directors, officers, agents, successors and subsidiaries against any losses suffered by such indemnified party as a result of the indemnifying party’s practice of the intellectual property licensed to such indemnifying party under the intellectual property rights cross-license agreement. Also, under the tax matters agreement entered into between us and NETGEAR, each party is liable for, and indemnifies the other party and its subsidiaries from and against any liability for, taxes that are allocated to such party under the tax matters agreement. In addition, we have agreed in the tax matters agreement that each party will generally be responsible for any taxes and related amounts imposed on us or NETGEAR as a result of the failure of the Distribution, together with certain related transactions, to qualify as a transaction that is generally tax-free, for U.S. federal income tax purposes, under Sections 355 and 368(a)(1)(D) and certain other relevant provisions of the Code, to the extent that the failure to so qualify is attributable to actions, events or transactions relating to such party’s respective stock, assets or business, or a breach of the relevant representations or covenants made by that party in the tax matters agreement. The transition services agreement generally provides that the applicable service recipient indemnifies the applicable service provider for liabilities that such service provider incurs arising from the provision of services other than liabilities arising from such service provider’s gross negligence, bad faith or willful misconduct or material breach of the transition services agreement, and that the applicable service provider indemnifies the applicable service recipient for liabilities that such service recipient incurs arising from such service provider’s gross negligence, bad faith or willful misconduct or material breach of the transition services agreement. Pursuant to the registration rights agreement, we have agreed to indemnify NETGEAR and its subsidiaries that hold registrable securities (and their directors, officers, agents and, if applicable, each other person who controls such holder under Section 15 of the Securities Act) registering shares pursuant to the registration rights agreement against certain losses, expenses and liabilities under the Securities Act, common law or otherwise. NETGEAR and its subsidiaries that hold registrable securities similarly indemnify us but such indemnification will be limited to an amount equal to the net proceeds received by such holder under the sale of registrable securities giving rise to the indemnification obligation.
45
However, third parties could also seek to hold us responsible for any of the liabilities that NETGEAR has agreed to retain, and we cannot assure that an indemnity from NETGEAR will be sufficient to protect us against the full amount of such liabilities, or that NETGEAR will be able to fully satisfy its indemnification obligations in the future. Even if we ultimately succeed in recovering from NETGEAR any amounts for which we are held liable, we may be temporarily required to bear these losses. Each of these risks could materially adversely affect our business, results of operations, and financial condition.
Risks Related to Ownership of Our Common Stock
We may change our dividend policy at any time.
Although we currently intend to retain future earnings to finance the operation and expansion of our business and therefore do not anticipate paying cash dividends on our capital stock in the foreseeable future, our dividend policy may change at any time without notice to our stockholders. The declaration and amount of any future dividends to holders of our common stock will be at the discretion of our board of directors in accordance with applicable law and after taking into account various factors, including our financial condition, results of operations, current and anticipated cash needs, cash flows, impact on our effective tax rate, indebtedness, contractual obligations, legal requirements, and other factors that our board of directors deems relevant. As a result, we cannot assure you that we will pay dividends at any rate or at all.
Future sales, or the perception of future sales, of our common stock may depress the price of our common stock.
The market price of our common stock could decline significantly as a result of sales or other distributions of a large number of shares of our common stock in the market. The perception that these sales might occur could depress the market price of our common stock. These sales, or the possibility that these sales may occur, might also make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate.
The 11,747,250 shares of our common stock sold in the IPO are freely tradable in the public market. On December 31, 2018, NETGEAR completed the Distribution to its stockholders of the 62,500,000 shares of Arlo common stock that it owned. As of December 31, 2021, we have 84,453,212 shares of common stock outstanding.
In the future, we may issue our securities in connection with investments or acquisitions. The amount of shares of our common stock issued in connection with an investment or acquisition could constitute a material portion of our then-outstanding shares of our common stock.
Any impairment of goodwill, other intangible assets, and long-lived assets could negatively impact our results of operations.
Under generally accepted accounting principles, we review our intangible assets and long-lived assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is required to be tested for impairment at least annually. Factors that may be considered when determining if the carrying value of our goodwill, other intangible assets and long-lived assets may not be recoverable include a significant decline in our expected future cash flows or a sustained, significant decline in our stock price and market capitalization.
If, in any period our stock price decreases to the point where the fair value of our assets (as partially indicated by our market capitalization) is less than our book value, this could indicate a potential impairment and we may be required to record an impairment charge in that period. Our valuation methodology for assessing impairment requires management to make judgments and assumptions based on projections of future operating performance. We operate in highly competitive environments and projections of future operating results and cash flows may vary significantly from actual results. As a result, we may incur substantial impairment charges to earnings in our financial statements should an impairment of our goodwill, other intangible assets and long-lived assets be determined resulting in an adverse impact on our results of operations. If there is a decline in the Company’s stock price based on market conditions and deterioration of the
46
Company’s business, the Company may have to record a charge to its earnings for the associated goodwill impairment of up to $11.0 million.
We are subject to securities class action and derivative litigation.
We are subject to various securities class action and derivative complaints, as more fully discussed in the heading under “Litigation and Other Legal Matters” in Note 11, Commitments and Contingencies, in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K.
Regardless of the merits or ultimate results of the above-described litigation matters, they could result in substantial costs, which would hurt the Company's financial condition and results of operations and divert management’s attention and resources from our business. At this point, however, it is too early to reasonably estimate any financial impact to the Company resulting from these litigation matters.
Your percentage ownership in Arlo may be diluted in the future.
In the future, your percentage ownership in Arlo may be diluted because of equity awards that Arlo may grant to Arlo’s directors, officers, and employees or otherwise as a result of equity issuances for acquisitions or capital market transactions. In addition, following the Distribution, Arlo and NETGEAR employees hold awards in respect of shares of our common stock as a result of the conversion of certain NETGEAR stock awards (in whole or in part) to Arlo stock awards in connection with the Distribution. Such awards have a dilutive effect on Arlo’s earnings per share, which could adversely affect the market price of Arlo common stock. From time to time, Arlo will issue additional stock-based awards to its employees under Arlo’s employee benefits plans.
In addition, Arlo’s amended and restated certificate of incorporation authorizes Arlo to issue, without the approval of Arlo’s stockholders, one or more classes or series of preferred stock having such designation, powers, preferences and relative, participating, optional and other special rights, including preferences over Arlo’s common stock respecting dividends and distributions, as Arlo’s board of directors generally may determine. The terms of one or more classes or series of preferred stock could dilute the voting power or reduce the value of our common stock. For example, Arlo could grant the holders of preferred stock the right to elect some number of Arlo’s directors in all events or on the happening of specified events or the right to veto specified transactions. Similarly, the repurchase or redemption rights or liquidation preferences that Arlo could assign to holders of preferred stock could affect the residual value of the common stock.
We are an emerging growth company, and we cannot be certain if the reduced reporting requirements applicable to emerging growth companies will make our common shares less attractive to investors.
We are an “emerging growth company,” as defined in the Jumpstart Our Business Act ("JOBS Act"). For as long as we continue to be an emerging growth company, we may take advantage of exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including exemption from compliance with the auditor attestation requirements of Section 404 of the Sarbanes Oxley Act of 2002 ("Section 404"), reduced disclosure obligations regarding executive compensation and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. We will remain an emerging growth company until the earliest of (1) December 31, 2023, (2) the last day of the fiscal year in which we have total annual revenue of at least $1.07 billion, (3) the last day of the fiscal year in which we become a large accelerated filer, which means that we have been public for at least 12 months, have filed at least one annual report and the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last day of our then most recently completed second fiscal quarter, or (4) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period.
Even after we no longer qualify as an emerging growth company, we may still qualify as a “smaller reporting company,” which would allow us to take advantage of many of the same exemptions from disclosure requirements
47
including exemption from compliance with the auditor attestation requirements of Section 404 and reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements.
We cannot predict if investors will find our common stock less attractive because we may rely on these exemptions. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our share price may be more volatile.
Certain provisions in our amended and restated certificate of incorporation and amended and restated bylaws and of Delaware law may prevent or delay an acquisition of Arlo, which could decrease the trading price of our common stock.
Our amended and restated certificate of incorporation and amended and restated bylaws contain, and Delaware law contains, provisions that are intended to deter coercive takeover practices and inadequate takeover bids by making such practices or bids unacceptably expensive to the bidder and to encourage prospective acquirers to negotiate with our board of directors rather than to attempt a hostile takeover. These provisions include, among others:
•the inability of our stockholders to call a special meeting;
•the inability of our stockholders to act without a meeting of stockholders;
•rules regarding how stockholders may present proposals or nominate directors for election at stockholder meetings;
•the right of our board of directors to issue preferred stock without stockholder approval;
•the division of our board of directors into three classes of directors, with each class serving a staggered three-year term, and this classified board provision could have the effect of making the replacement of incumbent directors more time consuming and difficult;
•a provision that stockholders may only remove directors with cause while the board of directors is classified; and
•the ability of our directors, and not stockholders, to fill vacancies on our board of directors.
In addition, because we have not elected to be exempt from Section 203 of the Delaware General Corporation Law (the “DGCL”), this provision could also delay or prevent a change of control that you may favor. Section 203 provides that, subject to limited exceptions, persons that acquire, or are affiliated with a person that acquires, more than 15% of the outstanding voting stock of a Delaware corporation (an “interested stockholder”) shall not engage in any business combination with that corporation, including by merger, consolidation or acquisitions of additional shares, for a three-year period following the date on which the person became an interested stockholder, unless (i) prior to such time, the board of directors of such corporation approved either the business combination or the transaction that resulted in the stockholder becoming an interested stockholder; (ii) upon consummation of the transaction that resulted in the stockholder becoming an interested stockholder, the interested stockholder owned at least 85% of the voting stock of such corporation at the time the transaction commenced (excluding for purposes of determining the voting stock outstanding (but not the outstanding voting stock owned by the interested stockholder) the voting stock owned by directors who are also officers or held in employee benefit plans in which the employees do not have a confidential right to tender or vote stock held by the plan); or (iii) on or subsequent to such time the business combination is approved by the board of directors of such corporation and authorized at a meeting of stockholders by the affirmative vote of at least two-thirds of the outstanding voting stock of such corporation not owned by the interested stockholder.
We believe these provisions will protect our stockholders from coercive or otherwise unfair takeover tactics by requiring potential acquirers to negotiate with our board of directors and by providing our board of directors with more
48
time to assess any acquisition proposal. These provisions are not intended to make Arlo immune from takeovers. However, these provisions will apply even if the offer may be considered beneficial by some stockholders and could delay or prevent an acquisition that our board of directors determines is not in the best interests of Arlo and its stockholders. These provisions may also prevent or discourage attempts to remove and replace incumbent directors.
Our amended and restated certificate of incorporation contains exclusive forum provisions that may discourage lawsuits against us and our directors and officers.
Our amended and restated certificate of incorporation provides that unless the board of directors otherwise determines, the state courts in the State of Delaware or, if no state court located within the State of Delaware has jurisdiction, the federal court for the District of Delaware, will be the sole and exclusive forum for the following types of actions or proceedings under Delaware statutory or common law: any derivative action or proceeding brought on behalf of Arlo, any action asserting a claim of breach of a fiduciary duty owed by any director or officer of Arlo to Arlo or Arlo’s stockholders, any action asserting a claim against Arlo or any director or officer of Arlo arising pursuant to any provision of the DGCL or Arlo’s amended and restated certificate of incorporation or bylaws, or any action asserting a claim against Arlo or any director or officer of Arlo governed by the internal affairs doctrine under Delaware law. This provision would not apply to suits brought to enforce a duty or liability created by the Exchange Act. Furthermore, Section 22 of the Securities Act creates concurrent jurisdiction for federal and state courts over all such Securities Act actions. Accordingly, both state and federal courts have jurisdiction to entertain such claims. To prevent having to litigate claims in multiple jurisdictions and the threat of inconsistent or contrary rulings by different courts, among other considerations, our amended and restated certificate of incorporation further provides that the federal district courts of the United States will be the exclusive forum for resolving any complaint asserting a cause of action arising under the Securities Act. While the Delaware courts have determined that such choice of forum provisions are facially valid, a stockholder may nevertheless seek to bring a claim in a venue other than those designated in the exclusive forum provisions. In such instance, we would expect to vigorously assert the validity and enforceability of the exclusive forum provisions of our amended and restated certificate of incorporation. This may require significant additional costs associated with resolving such action in other jurisdictions and there can be no assurance that the provisions will be enforced by a court in those other jurisdictions. These exclusive forum provisions may limit the ability of Arlo’s stockholders to bring a claim in a judicial forum that such stockholders find favorable for disputes with Arlo or Arlo’s directors or officers, which may discourage such lawsuits against Arlo and Arlo’s directors and officers. Alternatively, if a court were to find one or more of these exclusive forum provisions inapplicable to, or unenforceable in respect of, one or more of the specified types of actions or proceedings described above, Arlo may incur further significant additional costs associated with resolving such matters in other jurisdictions or forums, all of which could materially and adversely affect Arlo’s business, financial condition, or results of operations.
Our board of directors has the ability to issue blank check preferred stock, which may discourage or impede acquisition attempts or other transactions.
Our board of directors has the power, subject to applicable law, to issue series of preferred stock that could, depending on the terms of the series, impede the completion of a merger, tender offer or other takeover attempt. For instance, subject to applicable law, a series of preferred stock may impede a business combination by including class voting rights, which would enable the holder or holders of such series to block a proposed transaction. Our board of directors will make any determination to issue shares of preferred stock on its judgment as to our and our stockholders’ best interests. Our board of directors, in so acting, could issue shares of preferred stock having terms which could discourage an acquisition attempt or other transaction that some, or a majority, of the stockholders may believe to be in their best interests or in which stockholders would have received a premium for their stock over the then prevailing market price of the stock.
49
General Risks
The market price of our common stock could be volatile and is influenced by many factors, some of which are beyond our control.
The market price of our common stock could be volatile and is influenced by many factors, some of which are beyond our control, including those described above in “Risks Related to Our Business” and the following:
•the failure of securities analysts to cover our common stock or changes in financial estimates by analysts;
•the inability to meet the financial estimates of securities analysts who follow our common stock or changes in earnings estimates by analysts;
•strategic actions by us or our competitors;
•announcements by us or our competitors of significant contracts, acquisitions, joint marketing relationships, joint ventures or capital commitments;
•our quarterly or annual earnings, or those of other companies in our industry;
•actual or anticipated fluctuations in our operating results and those of our competitors;
•general economic and stock market conditions;
•the public reaction to our press releases, our other public announcements and our filings with the SEC;
•risks related to our business and our industry, including those discussed above;
•changes in conditions or trends in our industry, markets or customers;
•the trading volume of our common stock;
•future sales of our common stock or other securities; and
•investor perceptions of the investment opportunity associated with our common stock relative to other investment alternatives.
In particular, the realization of any of the risks described in these “Risk Factors” could have a material adverse impact on the market price of our common stock in the future and cause the value of your investment to decline. In addition, the stock market in general has experienced extreme volatility that has often been unrelated to the operating performance of particular companies. These broad market and industry factors may materially reduce the market price of our common stock, regardless of our operating performance. In addition, price volatility may be greater if the public float and trading volume of our common stock is low.
We incur significant costs as a result of operating as a public company, and our management devotes substantial time to complying with public company regulations.
Prior to the Separation, we historically operated our business as a segment of a public company. As a standalone public company, we have additional legal, accounting, insurance, compliance, and other expenses that we had not incurred historically. We are obligated to file with the SEC annual and quarterly reports and other reports that are specified in Section 13 and other sections of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We are also required to ensure that we have the ability to prepare financial statements that are fully compliant with all SEC reporting
50
requirements on a timely basis. In addition, we are and will continue to become subject to other reporting and corporate governance requirements, including certain requirements of the New York Stock Exchange ("NYSE"), and certain provisions of the Section 404 and the regulations promulgated thereunder, which will impose significant compliance obligations upon us.
Section 404, as well as rules subsequently implemented by the SEC and the NYSE, have imposed increased regulation and disclosure and required enhanced corporate governance practices of public companies. We are committed to maintaining high standards of corporate governance and public disclosure, and our efforts to comply with evolving laws, regulations and standards in this regard are likely to result in increased selling and administrative expenses and a diversion of management’s time and attention from revenue-generating activities to compliance activities. These changes will require a significant commitment of additional resources. We may not be successful in implementing these requirements and implementing them could materially adversely affect our business, results of operations and financial condition. In addition, if we fail to implement the requirements with respect to our internal accounting and audit functions, our ability to report our operating results on a timely and accurate basis could be impaired. If we do not implement such requirements in a timely manner or with adequate compliance, we might be subject to sanctions or investigation by regulatory authorities, such as the SEC and the NYSE. Any such action could harm our reputation and the confidence of investors and customers in us and could materially adversely affect our business and cause our share price to fall.
Failure to achieve and maintain effective internal controls in accordance with Section 404 of Sarbanes-Oxley could materially adversely affect our business, results of operations, financial condition, and stock price.
As a public company, we are required to document and test our internal control procedures in order to satisfy the requirements of Section 404, which requires annual management assessments of the effectiveness of our internal control over financial reporting. Upon loss of status as an “emerging growth company” as defined in the JOBS Act, an annual report by our independent registered public accounting firm that addresses the effectiveness of internal control over financial reporting will be required. During the course of our testing, we may identify deficiencies which we may not be able to remediate in time to meet our deadline for compliance with Section 404. Testing and maintaining internal control can divert our management’s attention from other matters that are important to the operation of our business. We also expect the regulations under Section 404 to increase our legal and financial compliance costs, make it more difficult to attract and retain qualified officers and members of our board of directors, particularly to serve on our audit committee, and make some activities more difficult, time consuming, and costly. We may not be able to conclude on an ongoing basis that we have effective internal control over our financial reporting in accordance with Section 404 or our independent registered public accounting firm may not be able or willing to issue an unqualified report on the effectiveness of our internal control over financial reporting. If we conclude that our internal control over financial reporting is not effective, we cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or their effect on our operations because there is presently no precedent available by which to measure compliance adequacy. If either we are unable to conclude that we have effective internal control over our financial reporting or our independent auditors are unable to provide us with an unqualified report as required by Section 404, then investors could lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock.
If securities or industry analysts do not publish research or reports about our business, if they adversely change their recommendations regarding our stock, or if our operating results do not meet their expectations, our stock price could decline.
The trading market for our common stock will be influenced by the research, reports and recommendations that industry or securities analysts publish about us or our business. If one or more of these analysts cease coverage of us or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline. Moreover, if one or more of the analysts who cover us downgrades our stock or if our operating results do not meet their expectations, our stock price could decline.
51
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
We are a global company with corporate headquarters located in Carlsbad, California, where we occupy approximately 63,500 square feet of office space pursuant to a lease agreement that expires in November 2024. We also lease approximately 77,800 square feet of office space in San Jose pursuant to a lease agreement that expires in June 2029. In June 2021, we entered into a sublease agreement, with a term that runs concurrent with the term of the head lease, for our San Jose office space in light of the COVID-19 pandemic and its impact on the changing nature of office space use by our workforce.
During fiscal 2021, our international sales personnel were based out of local sales offices or home offices in Australia and Canada. Our international operations personnel use leased facilities in Hong Kong. We maintain our marketing and research and development facilities in San Jose (the United States), Irvine (the United States), Carlsbad (the United States), Richmond (Canada) and Taipei (Taiwan). In addition, we use third parties to provide warehousing services to us, consisting of facilities in Southern California, Texas, Tennessee, Mexico and Hong Kong. We also lease office space in Cork, Ireland.
We believe that the facilities described above are suitable and adequate for our present purposes and that the productive capacity in our facilities is substantially being utilized or we have plans to utilize it. Beginning in March 2020, our employees across all geographic regions have shifted to working from home due to the COVID-19 pandemic. Our focus remains on promoting employee health and safety as we carefully evaluate reopening plans and timelines. As of December 31, 2021, we have not terminated any significant lease arrangements. We believe our facilities are adequate for the conduct of our business should we decide to reopen our facilities in the next twelve months.
Item 3. Legal Proceedings
We are subject to legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. Our material legal proceedings are described under the heading “Litigation and Other Legal Matters” in Note 11, Commitments and Contingencies, in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K. For additional discussion of certain risks associated with legal proceedings, see Item 1A, Risk Factors.
Item 4. Mine Safety Disclosures
Not applicable.
52
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
Our common stock is listed and traded on the New York Stock Exchange (“NYSE”) under the symbol “ARLO”.
Holders of Common Stock
On February 25, 2022, we had 9 stockholders of record of our common stock. The number of record holders is based upon the actual number of holders registered on our books at such date and does not include holders of shares in “street names” or persons, partnerships, associations, corporations or other entities identified in security position listings maintained by depository trust companies, and we are unable to estimate the total number of stockholders represented by these record holders.
Dividends
We have not historically declared or paid cash dividends on our common stock. We do not anticipate paying cash dividends in the foreseeable future.
Securities Authorized for Issuance under Equity Compensation Plans
See Item 12 of Part III of this Annual Report on Form 10-K regarding information about securities authorized for issuance under our equity compensation plans.
Recent Sales of Unregistered Securities and Purchases of Equity Securities by the Issuer
None.
Stock Performance Graph
Notwithstanding any statement to the contrary in any of our previous or future filings with the SEC, the following information relating to the price performance of our common stock shall not be deemed “filed” with the SEC or “soliciting material” under the Exchange Act and shall not be incorporated by reference into any such filings.
The following graph shows a comparison from August 3, 2018 through December 31, 2021 of cumulative total return for our common stock, the NYSE Composite Index, the Standard and Poor’s 600 Information Technology Index, (“S&P 600 Information Technology Index”), the Standard and Poor’s Small Cap 600 Index (“S&P Small Cap 600 Index”) and the Russell 2000 Index. The measurement points in the graph below are August 3, 2018 (the first trading day of our common stock on the NYSE) and the last trading day of each fiscal quarter through the fiscal year ended December 31, 2021. The graph assumes that $100 was invested in Arlo common stock at the closing price of $22.10 on August 3, 2018 and in the NYSE Composite Index, the S&P 600 Information Technology Index, the S&P Small Cap 600 Index and the Russell 2000 Index on August 3, 2018, and assumes reinvestment of any dividends. The stock price performance shown in the following graph is not intended to forecast or be indicative of possible future stock price performance.
53
Item 6. [Reserved]
54
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion of our financial condition and results of operations together with the audited consolidated financial statements and notes to the financial statements included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those discussed under “Risk Factors” in Part I, Item 1A above.
We have elected to omit discussion on the earliest of the three years covered by the consolidated financial statements presented. Refer to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations located in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020, filed on February 26, 2021, for reference to discussion of the fiscal year ended December 31, 2019, the earliest of the three fiscal years presented.
Business and Executive Overview
Arlo combines an intelligent cloud infrastructure and mobile app with a variety of smart connected devices that is transforming the way people experience the connected lifestyle. Arlo’s deep expertise in product design, wireless connectivity, cloud infrastructure and cutting-edge AI capabilities focuses on delivering a seamless, smart home experience for Arlo users that is easy to setup and interact with every day. Our cloud-based platform provides users with visibility, insight and a powerful means to help protect and connect in real-time with the people and things that matter most, from any location with a Wi-Fi or a cellular connection. Since the launch of our first product in December 2014, we have shipped over 22.9 million smart connected devices, and as of December 31, 2021, our smart platform had approximately 6.1 million cumulative registered accounts across more than 100 countries around the world.
We conduct business across three geographic regions-the Americas; Europe, Middle-East and Africa (“EMEA”); and Asia Pacific (“APAC”) and we primarily generate revenue by selling devices through retail, wholesale distribution, wireless carrier channels, security solution providers, Arlo's direct to consumer store and paid subscription services. International revenue was 38.9% and 27.5% of our revenue for the years ended December 31, 2021 and 2020, respectively.
For the years ended December 31, 2021 and 2020, we generated revenue of $435.1 million and $357.2 million, respectively. Loss from operations was $60.1 million and $104.9 million for the years ended December 31, 2021 and 2020, respectively. Loss from operations for the years ended December 31, 2021 and 2020 included separation expense of $1.6 million and $0.2 million, respectively.
Our goal is to continue to develop innovative, world-class connected lifestyle solutions to expand and further monetize our current and future user and subscriber bases. We believe that the growth of our business is dependent on many factors, including our ability to innovate and launch successful new products on a timely basis and grow our installed base, to increase subscription-based recurring revenue, to invest in brand awareness and channel partnerships and to continue our global expansion. We expect to maintain our investment in research and development going forward as we continue to introduce new and innovative products and services to enhance the Arlo platform.
Key Business Metrics
In addition to the measures presented in our consolidated financial statements, we use the following key metrics to evaluate our business, measure our performance, develop financial forecasts and make strategic decisions. We believe these key business metrics provide useful information by offering the ability to make more meaningful period-to-period comparisons of our on-going operating results and a better understanding of how management plans and measures our underlying business. Our key business metrics may be calculated in a manner different from the same key business metrics used by other companies. We regularly review our processes for calculating these metrics, and from time to time we may
55
discover inaccuracies in our metrics or make adjustments to better reflect our business or to improve their accuracy, including adjustments that may result in the recalculation of our historical metrics. We believe that any such inaccuracies or adjustments are immaterial unless otherwise stated.
| Year Ended As of and for the Year Ended December 31, | |||||||||||||||||
| 2021 | % Change | 2020 | |||||||||||||||
| (In thousands, except percentage data) | |||||||||||||||||
| Cumulative registered accounts | 6,131 | 21.5 | % | 5,047 | |||||||||||||
| Cumulative paid accounts | 1,067 | 145.3 | % | 435 | |||||||||||||
| Annual recurring revenue | $ | 90,100 | 93.5 | % | $ | 46,552 | |||||||||||
Cumulative Registered Accounts. We believe that our ability to increase our user base is an indicator of our market penetration and growth of our business as we continue to expand and innovate our Arlo platform. We define our registered accounts at the end of a particular period as the number of unique registered accounts on the Arlo platform as of the end of such particular period, and includes accounts owned by Verisure. The number of registered accounts does not necessarily reflect the number of end-users on the Arlo platform, as one registered account may be used by multiple people. We changed our definition from registered users to registered accounts starting in the fourth quarter of 2019 due to the Verisure transaction. Verisure will own the registered accounts but we will continue to provide services to these European customers under the Verisure Agreements.
Cumulative Paid Accounts. Paid accounts worldwide measured as any account where a subscription to a paid service is being collected (either by the Company or by the Company’s customers or channel partners), plus paid service plans of a duration of more than 3 months bundled with products (such bundles being counted as a paid account after 90 days have elapsed from the date of registration). In the fourth quarter of 2019, we redefined paid subscribers as paid accounts to include customers that were transferred to Verisure as part of the disposal of our commercial operations in Europe because we will continue to provide services to these European customers and receive payments associated with them, under the Verisure Agreements.
Annual Recurring Revenue. Effective as of the third quarter of 2021, we adopted Annual Recurring Revenue ("ARR") as one of the key indicators of our business performance. We believe ARR enables measurement of our business initiatives, and serves as an indicator of our future growth. ARR represents the amount of paid service revenue that we expect to recur annually and is calculated by taking our recurring paid service revenue for the last calendar month in the fiscal quarter, multiplied by 12 months. Recurring paid service revenue represents the revenue we recognize from our paid accounts and excludes prepaid service revenue and NRE service revenue from strategic partners. The ARR for the comparative period presented was derived following the same methodology. ARR is a performance metric and should be viewed independently of revenue and deferred revenue, and is not intended to be a substitute for, or combined with, any of these items.
COVID-19 Effect on Financial Results
We continue to closely monitor developments and are taking steps to mitigate the potential risks related to the COVID-19 pandemic to us, our employees and our customers. The extent of the impact of the COVID-19 pandemic on our business operations will depend on future developments, including the duration of the pandemic, the broader implications of the macro-economic recovery and the impact on overall customer demand, all of which are uncertain and cannot be predicted. Our priorities and actions during the COVID-19 pandemic continue to be focused on protecting the health and safety of all those we serve, our employees, our customers, our suppliers and our communities, including implementing continuous updates to our health and safety policies and processes and progress made through vaccinations. We continue to instruct all but a limited number of our global workforce to work remotely as a precautionary measure intended to minimize the risk of the virus to them and the communities in which we operate, while we continue to focus on providing our team with the resources that they need to meet the needs of our customers and deliver new innovations to the markets we serve, despite challenges presented by the COVID-19 pandemic. We also continue to work with our suppliers to address any supply chain disruptions, which might include larger component backlogs, component cost increases, travel restrictions and logistics changes that can impact our operations. For example, increased demand for electronics as a result of the COVID-19 pandemic, effects of the U.S. trade war with China, increased demand for chips in the automotive
56
industry and certain other factors have led to a global shortage of semiconductors. As a result, we have experienced component shortages, including longer lead times for components and supply constraints, that have affected both our ability to meet scheduled product deliveries and worldwide demand for our products. Also, as a result of the COVID-19 pandemic, our supply chain partners are limited by production capacity, constrained by material availability, labor shortages, factory uptime and freight capacity, each of which constrains our ability to capitalize fully on end market demand. The increased lead time in production due to component shortages and supply chain disruption brought our inventory down to a record low level at $38.4 million as of December 31, 2021. In addition, as of December 31, 2021, international freight capacity has dropped, causing air and ocean freight rates to materially increase. Furthermore, transit times have also increased, causing us to rely more on air freight in order to meet our customers' demands. For the year ended December 31, 2021, we saw a 138% increase in freight-in expense compared to the prior year, as a result of the higher sea and air freight rates and component shortages which necessitated use of air freight to meet customer requested delivery dates. We expect supply chain constraints to persist in 2022. While we have been broadly successful in navigating COVID-19 related challenges to date, any further disruptions brought about by the COVID-19 pandemic to our supply chain and operations could have a significant negative impact on our net revenue, gross and operating margin performance.
In addition, as a result of the COVID-19 pandemic, we could experience material charges from potential adjustments of the carrying value of our inventories and trade receivables, impairment charges on our long-lived assets, intangible assets and goodwill, and changes in the effectiveness of our hedging instruments, among others. During the second quarter of 2021, we evaluated our existing real estate lease portfolio in light the COVID-19 pandemic and its impact on the changing nature of office space use by our workforce. This evaluation resulted in the decision to sublease our office space in San Jose, California. As a result, we recorded an impairment charge of $9.1 million, which includes $6.8 million associated with the right-of-use assets and $2.3 million associated with other lease related property and equipment. Refer to Note 5, Balance Sheet Components in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for further information about the impairment of the right-of-use asset and long-lived assets.
Throughout 2021, we remained focused on navigating these on-going challenges presented by the COVID-19 pandemic through preserving our liquidity and managing our cash flow through taking preemptive action to enhance our ability to meet our short-term liquidity needs. These actions include, but are not limited to, proactively managing working capital by closely monitoring customers' credit and collections, renegotiating payment terms with third-party manufacturers and key suppliers, closely monitoring inventory levels and purchases against forecasted demand, reducing or eliminating non-essential spending, and subleasing excess office space. We continue to monitor this rapidly developing situation and may, as necessary, reduce expenditures further, borrow under our revolving credit facility, or pursue other sources of capital that may include other forms of external financing in order to maintain our cash position and preserve financial flexibility in response to the uncertainty in the United States and global markets resulting from the COVID-19 pandemic.
Components of Our Operating Results
Revenue
Our gross revenue consists primarily of sales of devices, prepaid and paid service revenue and NRE service revenue from Verisure. We generally recognize revenue from product sales at the time the product is shipped and transfer of control from us to the customer occurs. Our first generation camera products under our old business model come with a prepaid service that provides users with rolling seven-day cloud video storage, the ability to connect up to five cameras and 90 days of customer support. Our second generation camera, doorbell and floodlight products under our new business model come with a prepaid service that includes a one-year free trial period of Arlo Smart bundled with our Arlo Ultra products launched in early 2019, and a three-month free trial period of Arlo Smart bundled with our products launched after September 2019. Upon device shipment, we attribute a portion of the sales price to the prepaid service, deferring this revenue at the outset and subsequently recognizing it ratably over the estimated useful life of the device or free trial period, as applicable. Our paid subscription services relate to sales of subscription plans to our registered accounts. Our services also include certain development services provided to Verisure under a NRE arrangement as part of the disposal of our commercial operations in Europe in the fourth quarter of 2019. Refer to Note 4, Disposal of Business in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for a complete discussion of the NRE arrangement.
57
Our revenue consists of gross revenue, less end-user customer rebates and other channel sales incentives deemed to be a reduction of revenue per the authoritative guidance for revenue recognition, allowances for estimated sales returns, price protection, and net changes in deferred revenue. A significant portion of our marketing expenditure is with customers and is deemed to be a reduction of revenue under authoritative guidance for revenue recognition.
Under the Supply Agreement, Verisure became the exclusive distributor of our products in Europe for all channels, and will non-exclusively distribute our products through its direct channels globally for an initial term of five years. Refer to Note 4, Disposal of Business in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for a complete discussion of the Supply Agreement.
Cost of Revenue
Cost of revenue consists of both product costs and costs of service. Product costs primarily consist of: the cost of finished products from our third-party manufacturers; overhead costs, including personnel expense for operation staff, purchasing, product planning, inventory control, warehousing and distribution logistics, third-party software licensing fees, inbound freight, IT and facilities overhead, warranty costs associated with returned goods, write-downs for excess and obsolete inventory, royalties to third parties; and amortization expense of certain acquired intangibles. Cost of service consists of costs attributable to the provision and maintenance of our cloud-based platform, including personnel, storage, security and computing, as well as NRE service costs incurred under the Verisure NRE arrangement.
Our cost of revenue as a percentage of revenue can vary based upon a number of factors, including those that may affect our revenue set forth above and factors that may affect our cost of revenue, including, without limitation: product and service mix, sales channel mix, registered accounts' acceptance of paid subscription service offerings, fluctuation in foreign exchange rates and changes in our cost of goods sold due to fluctuations in prices paid for components, net of vendor rebates, cloud platform costs, warranty and overhead costs, inbound freight and duty product conversion costs, charges for excess or obsolete inventory, and amortization of acquired intangibles. We outsource our manufacturing, warehousing, and distribution logistics. We also outsource certain components of the required infrastructure to support our cloud-based back-end IT infrastructure. We believe this outsourcing strategy allows us to better manage our product and services costs and gross margin.
Research and Development
Research and development expense consists primarily of personnel-related expense, safety, security, regulatory services and testing, other research and development consulting fees, and IT and facilities overhead. We recognize research and development expense as it is incurred. We have invested in and expanded our research and development organization to enhance our ability to introduce innovative products and services. We believe that innovation and technological leadership are critical to our future success, and we are committed to continuing a significant level of research and development to develop new technologies, products, and services, including our hardware devices, cloud-based software, AI-based algorithms, and machine learning capabilities. We expect research and development expense to stay relatively flat in absolute dollars as we manage our expenses while continuing to develop new product and service offerings. Research and development expense directly attributable to delivering the Verisure NRE is recognized in cost of service.
Sales and Marketing
Sales and marketing expense consists primarily of personnel expense for sales and marketing staff; technical support expense; advertising; trade shows; corporate communications and other marketing expense; product marketing expense; IT and facilities overhead; outbound freight costs; and credit card processing fees. We expect our sales and marketing expense to increase in the future as we invest in marketing to drive awareness of our brand and drive demand for our products and services.
58
General and Administrative
General and administrative expense consists primarily of personnel-related expense for certain executives, finance and accounting, investor relations, human resources, legal, information technology, professional fees, IT and facilities overhead, strategic initiative expense, and other general corporate expense. We expect our general and administrative expense to fluctuate as a percentage of our revenue in future periods based on fluctuations in our revenue and the timing of such expense.
Impairment Charges
During the second quarter of 2021, we reviewed certain of our right-of-use assets and other lease-related assets for impairment in conjunction with our decision to sublease our office space in San Jose, California. As a result, we recorded an impairment charge for the right-of-use asset and other lease-related assets included in the San Jose office asset group.
Separation Expense
Separation expense consists primarily of costs of legal and professional services for IPO-related litigation associated with our separation from NETGEAR.
Gain on Sale of Business
Gain on sale of business represents the gain on the sale of our commercial operations in Europe in the fourth quarter of 2019.
Interest Income
Interest income represents interest earned on our cash, cash equivalents and short-term investments. We expect our interest income in absolute dollars to stay relatively flat as we deploy our short-term investments and cash and cash equivalents to fund our operations, while interest rates are expected to increase.
Other Income (Expense), Net
Other income (expense), net primarily represents gains and losses on transactions denominated in foreign currencies, foreign currency contract gain (loss), net, and other miscellaneous income and expense. We have also included any reimbursement for the Verisure TSA and the Employee Retention Credit ("ERC") under the Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act") for qualified wages in Other income.
59
Results of Operations
We operate as one operating and reportable segment. The following table sets forth, for the periods presented, the consolidated statements of operations data, which we derived from the accompanying consolidated financial statements:
| Year Ended December 31, | |||||||||||||||||||||||
| 2021 | 2020 | ||||||||||||||||||||||
| (In thousands, except percentage data) | |||||||||||||||||||||||
| Revenue: | |||||||||||||||||||||||
| Products | $ | 331,620 | 76.2 | % | $ | 284,868 | 79.8 | % | |||||||||||||||
| Services | 103,517 | 23.8 | % | 72,286 | 20.2 | % | |||||||||||||||||
| Total revenue | 435,137 | 100.0 | % | 357,154 | 100.0 | % | |||||||||||||||||
| Cost of revenue: | |||||||||||||||||||||||
| Products | 285,334 | 65.6 | % | 263,905 | 73.9 | % | |||||||||||||||||
| Services | 41,768 | 9.6 | % | 37,860 | 10.6 | % | |||||||||||||||||
| Total cost of revenue | 327,102 | 75.2 | % | 301,765 | 84.5 | % | |||||||||||||||||
| Gross profit | 108,035 | 24.8 | % | 55,389 | 15.5 | % | |||||||||||||||||
| Operating expenses: | |||||||||||||||||||||||
| Research and development | 59,063 | 13.6 | % | 60,137 | 16.8 | % | |||||||||||||||||
| Sales and marketing | 48,909 | 11.2 | % | 49,064 | 13.7 | % | |||||||||||||||||
| General and administrative | 49,489 | 11.4 | % | 51,096 | 14.3 | % | |||||||||||||||||
| Impairment charges | 9,116 | 2.1 | % | — | — | % | |||||||||||||||||
| Separation expense | 1,596 | 0.4 | % | 248 | 0.1 | % | |||||||||||||||||
| Gain on sale of business | — | — | % | (292) | (0.1) | % | |||||||||||||||||
| Total operating expenses | 168,173 | 38.6 | % | 160,253 | 44.9 | % | |||||||||||||||||
| Loss from operations | (60,138) | (13.8) | % | (104,864) | (29.4) | % | |||||||||||||||||
| Interest income | 11 | 0.0 | % | 802 | 0.2 | % | |||||||||||||||||
| Other income (expense), net | 4,775 | 1.1 | % | 3,436 | 1.1 | % | |||||||||||||||||
| Loss before income taxes | (55,352) | (12.7) | % | (100,626) | (28.2) | % | |||||||||||||||||
| Provision for income taxes | 677 | 0.2 | % | 625 | 0.2 | % | |||||||||||||||||
| Net loss | $ | (56,029) | (12.9) | % | $ | (101,251) | (28.3) | % | |||||||||||||||
Revenue
We conduct business across three geographic regions: Americas, EMEA, and APAC. We generally base revenue by geography on the ship-to location of the customer for device sales and device location for service sales.
| Year Ended December 31, | |||||||||||||||||
| 2021 | % Change | 2020 | |||||||||||||||
| (In thousands, except percentage data) | |||||||||||||||||
| Americas | $ | 271,182 | 0.7 | % | $ | 269,395 | |||||||||||
| Percentage of revenue | 62.3 | % | 75.4 | % | |||||||||||||
| EMEA | $ | 134,232 | 117.1 | % | $ | 61,832 | |||||||||||
| Percentage of revenue | 30.8 | % | 17.3 | % | |||||||||||||
| APAC | $ | 29,723 | 14.6 | % | $ | 25,927 | |||||||||||
| Percentage of revenue | 6.8 | % | 7.3 | % | |||||||||||||
| Total revenue | $ | 435,137 | 21.8 | % | $ | 357,154 | |||||||||||
60
Revenue increased 21.8% across all geographic regions for the year ended December 31, 2021 compared to the prior year. Product revenue increased by $46.8 million, or 16.4% for the year ended December 31, 2021 compared to the prior year, primarily driven by a 117.1% increase in product sales to Verisure. The increase is also driven by customer mix and the associated contractual terms and the decreases in provisions for sales returns, price protection and marketing expenditures deemed to be a reduction of product revenue. Service revenue increased by $31.2 million, or 43.2%, for the year ended December 31, 2021 compared to the prior year, primarily due to increased paid accounts.
Cost of Revenue
The following table presents cost of revenue for the periods indicated:
| Year Ended December 31, | |||||||||||||||||
| 2021 | % Change | 2020 | |||||||||||||||
| (In thousands, except percentage data) | |||||||||||||||||
| Cost of revenue: | |||||||||||||||||
| Products | $ | 285,334 | 8.1 | % | $ | 263,905 | |||||||||||
| Services | 41,768 | 10.3 | % | 37,860 | |||||||||||||
| Total cost of revenue | $ | 327,102 | 8.4 | % | $ | 301,765 | |||||||||||
Cost of revenue increased 8.4% for the year ended December 31, 2021 compared to the prior year driven by increases in both product revenue and service revenue. Cost of product revenue increased $21.4 million, or 8.1% for the year ended December 31, 2021 compared to the prior year, primarily due to increases in shipped product costs and freight-in expense as a result of COVID-19 related supply chain disruption, partially offset by lower warranty cost and excess and obsolete inventory provision compared to the prior year. The decrease in warranty cost is a result of a lower scrap rate driven by increased and more profitable refurbished product sales, lower returns and fewer product transitions. The decrease in excess and obsolete inventory provision is due to fewer product transitions and more effective inventory management. Cost of service revenue increased $3.9 million, or 10.3% for the year ended December 31, 2021 compared to the prior year, driven by service revenue growth, offset by cost optimizations implemented.
Gross Margin
The following table presents gross margin for the periods indicated:
| Year Ended December 31, | |||||||||||||||||
| 2021 | % Change | 2020 | |||||||||||||||
| (In thousands, except percentage data) | |||||||||||||||||
| Gross margin: | |||||||||||||||||
| Products | $ | 46,286 | 120.8 | % | $ | 20,963 | |||||||||||
| Services | 61,749 | 79.4 | % | 34,426 | |||||||||||||
| Total gross margin | $ | 108,035 | 95.0 | % | $ | 55,389 | |||||||||||
| Gross margin percentage: | |||||||||||||||||
| Products | 14.0 | % | 7.4 | % | |||||||||||||
| Services | 59.7 | % | 47.6 | % | |||||||||||||
| Total gross margin percentage | 24.8 | % | 15.5 | % | |||||||||||||
Gross margin increased for the year ended December 31, 2021 compared to the prior year, due to a combination of both product and service margin increases. The product margin increase is primarily due to customer mix driving a decreased provision for price protection and lower marketing expenditures that are deemed to be reductions of revenue, decreased warranty costs and a lower excess and obsolete inventory provision, partially offset by higher freight-in costs as a result of COVID-19 related supply chain disruption. Service margin increased for year ended December 31, 2021, compared to the prior year, primarily due to an increase in paid service revenue coupled with various cost optimizations implemented.
61
Operating Expenses
Research and Development
The following table presents research and development expense for the periods indicated:
| Year Ended December 31, | |||||||||||||||||
| 2021 | % Change | 2020 | |||||||||||||||
| (In thousands, except percentage data) | |||||||||||||||||
| Research and development expense | $ | 59,063 | (1.8) | % | $ | 60,137 | |||||||||||
Research and development expense decreased for the year ended December 31, 2021 compared to the prior year, due to a decrease of $2.8 million in IT and facility overhead, partially offset by an increase of $0.9 million in personnel-related expenses and a decrease of $1.0 million in various research and development expenses that were attributed to the Verisure NRE arrangement. For the year ended December 31, 2021, research and development expenses amounting to $2.8 million were attributed to the Verisure NRE arrangement and classified as cost of service revenue.
Sales and Marketing
The following table presents sales and marketing expense for the periods indicated:
| Year Ended December 31, | |||||||||||||||||
| 2021 | % Change | 2020 | |||||||||||||||
| (In thousands, except percentage data) | |||||||||||||||||
| Sales and marketing expense | $ | 48,909 | (0.3) | % | $ | 49,064 | |||||||||||
Sales and marketing expense decreased for the year ended December 31, 2021 compared to the prior year, primarily due to a decrease of $1.8 million in outside professional services and a decrease of $1.7 million in marketing expenditures, partially offset by an increase of $2.1 million in personnel-related expenses, and an increase of $1.4 million in credit card processing fees driven by the growth in sales from Arlo's direct to consumer store and paid accounts service revenue.
General and Administrative
The following table presents general and administrative expense for the periods indicated:
| Year Ended December 31, | |||||||||||||||||
| 2021 | % Change | 2020 | |||||||||||||||
| (In thousands, except percentage data) | |||||||||||||||||
| General and administrative expense | $ | 49,489 | (3.1) | % | $ | 51,096 | |||||||||||
General and administrative expense decreased for the year ended December 31, 2021 compared to the prior year, primarily due to a decrease of $4.0 million in personnel-related expenditures partially brought about by the one-time charge for stock-based compensation expense recognized in the first quarter of 2020 upon the voluntary forfeiture of our CEO's stock options in January 2020, a decrease of $1.9 million in legal and professional services and a decrease of $0.8 million in Verisure transaction costs which was recognized in the first half of 2020, partially offset by an increase of $1.6 million in IT and facility overhead.
62
Impairment Charges
The following table presents impairment charges for the periods indicated:
| Year Ended December 31, | |||||||||||||||||
| 2021 | % Change | 2020 | |||||||||||||||
| (In thousands, except percentage data) | |||||||||||||||||
| Impairment charges | $ | 9,116 | ** | $ | — | ||||||||||||
| **Percentage change not meaningful. | |||||||||||||||||
During the second quarter of 2021, we reviewed certain of our right-of-use assets and other lease-related assets for impairment in conjunction with our decision to sublease our office space in San Jose, California. As a result, we recorded an impairment charge of $9.1 million, which included $6.8 million associated with the right-of-use assets and $2.3 million associated with the leasehold improvements and furniture, fixtures and equipment included in the San Jose office asset group. Refer to Note 5, Balance Sheet Components in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for further information about the impairment of the right-of-use asset and long-lived assets.
Separation Expense
The following table presents separation expense for the periods indicated:
| Year Ended December 31, | |||||||||||||||||
| 2021 | % Change | 2020 | |||||||||||||||
| (In thousands, except percentage data) | |||||||||||||||||
| Separation expense | $ | 1,596 | 543.5 | % | $ | 248 | |||||||||||
Separation expense consists primarily of the costs of legal and professional services for IPO-related litigation associated with our Separation from NETGEAR.
Gain on sale of business
| Year Ended December 31, | |||||||||||||||||
| 2021 | % Change | 2020 | |||||||||||||||
| (In thousands, except percentage data) | |||||||||||||||||
| Gain on sale of business | $ | — | ** | $ | (292) | ||||||||||||
| **Percentage change not meaningful. | |||||||||||||||||
In the fourth quarter of 2019, we sold our commercial operations in Europe which resulted in a gain on sale of business. In the first quarter of 2020, we recognized an additional gain of $0.3 million as a result of the final working capital adjustment. Refer to Note 4, Disposal of Business in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for a complete discussion of this disposal.
63
Interest Income and Other Income (Expense), Net
The following table presents other income (expense), net for the periods indicated:
| Year Ended December 31, | |||||||||||||||||
| 2021 | % Change | 2020 | |||||||||||||||
| (In thousands, except percentage data) | |||||||||||||||||
| Interest income | $ | 11 | (98.6) | % | $ | 802 | |||||||||||
| Other income (expense), net | $ | 4,775 | 39.0 | % | $ | 3,436 | |||||||||||
Interest income decreased for the year ended December 31, 2021, compared to the prior year, primarily due to the decrease in our short-term investments and cash and cash equivalents as we funded our operations and a decline in interest rates. Other income (expense), net increased for the year ended December 31, 2021 compared to the prior year, primarily due to the ERC under the CARES Act for qualified wages amounting to $1.8 million, which was recognized as Other income in the second quarter of 2021, partially offset by decreases in Verisure TSA related income. The CARES Act was signed into law on March 27, 2020 in response to the COVID-19 pandemic. The ERC, as one of the provisions that provide economic relief for individuals and businesses under the CARES Act, is a refundable payroll tax credit that encouraged businesses to keep employees on the payroll during the COVID-19 pandemic.
Provision for Income Taxes
Provision for income taxes and effective tax rate consisted of the following:
| Year Ended December 31, | |||||||||||||||||
| 2021 | % Change | 2020 | |||||||||||||||
| (In thousands, except percentage data) | |||||||||||||||||
| Provision for income taxes | $ | 677 | 8.3 | % | $ | 625 | |||||||||||
| Effective tax rate | (1.2) | % | (0.6) | % | |||||||||||||
Our effective tax rate for 2021 was lower than the U.S. federal income tax rate of 21% primarily due to a lower effective tax rate on foreign earnings and valuation allowance on our net U.S. deferred tax assets and certain foreign tax attributes as it is more likely than not that some or all of our deferred tax assets will not be realized.
The increase in provision for income taxes for the year ended December 31, 2021 compared to the prior year was primarily due to higher foreign earnings in 2021. Refer to Note 9, Income taxes in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for additional discussion.
Liquidity and Capital Resources
We have a history of losses and may continue to incur operating and net losses for the foreseeable future. As of December 31, 2021, our accumulated deficit was $288.8 million.
Our principal sources of liquidity are cash, cash equivalents and short-term investments. Short-term investments are marketable government securities with an original maturity or a remaining maturity at the time of purchase of greater than three months and no more than 12 months. The marketable securities are held in our company’s name with a high quality financial institution, which acts as our custodian and investment manager. As of December 31, 2021, we had cash, cash equivalents and short-term investments totaling $175.7 million. As of December 31, 2021, 7.4% of our cash and cash equivalents were held outside of the U.S. Starting in 2018, the Tax Cuts and Jobs Act of 2017 (the “Tax Act”) impact on the repatriation of foreign earnings is generally immaterial. The cash and cash equivalents balance outside of the U.S. is subject to fluctuation based on the settlement of intercompany balances. In October 2021, we entered into the Credit Agreement with Bank of America, N.A., providing for a credit facility of up to $40.0 million. In addition, the Credit
64
Agreement includes an uncommitted accordion feature that allows us to request the lender increase the loan commitments by up to an additional $25.0 million, subject to the satisfaction of certain conditions. As of December 31, 2021, we have not borrowed against this credit facility. Refer to Note 10, Debt in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for further details on the Credit Agreement.
Based on our current plans, the Credit Agreement with Bank of America, N.A., and market conditions, we believe that such sources of liquidity will be sufficient to satisfy our anticipated cash requirements for at least the next 12 months. However, in the future we may require or desire additional funds to support our operating expenses and capital requirements or for other purposes, such as acquisitions, and may seek to raise such additional funds through public or private equity or debt financings or collaborative agreements or from other sources. However, the COVID-19 pandemic continues to rapidly evolve and has already resulted in a significant disruption of global financial markets. If the disruption persists and deepens, we could experience an inability to access additional capital, which could in the future negatively affect our capacity to support our operating expenses and capital requirements or to make investments for other purposes, such as acquisitions.
We have no commitments to obtain such additional financing and cannot assure you that additional financing will be available at all or, if available, that such financing would be obtainable on terms favorable to us and would not be dilutive. Our future liquidity and cash requirements will depend on numerous factors, including the introduction of new products, the growth in our service revenue, as well as the ability to increase our gross margin dollars and continue to maintain controls over our operating expenditures.
Cash Flow
The following table presents our cash flows for the periods presented.
| Year Ended December 31, | |||||||||||
| 2021 | 2020 | ||||||||||
| (In thousands) | |||||||||||
| Net cash used in operating activities | $ | (23,197) | $ | (46,530) | |||||||
| Net cash provided by (used in) investing activities | 17,732 | (3,975) | |||||||||
| Net cash used in financing activities | (4,970) | (23) | |||||||||
| Net decrease in cash and cash equivalents and restricted cash | $ | (10,435) | $ | (50,528) | |||||||
Operating activities
Net cash used in operating activities decreased by $23.3 million for the year ended December 31, 2021 compared to the prior year. This decrease comprised a $48.7 million reduction in adjusted net loss for cash flows, offset by an increase in working capital used in operations of $25.4 million, mainly driven by an increase in accounts receivable and a decrease in deferred revenue, partially offset by increased accounts payable and lower inventory balance.
Our days sales outstanding (“DSO”) decreased to 50 days as of December 31, 2021 as compared to 64 days as of December 31, 2020, primarily due to more front-loaded shipments in the fourth quarter and slightly improved quarter end aging. Typically, our DSO in the fourth quarter is higher due to seasonal payment terms provided to our larger customers, while service revenue is typically a lower percentage of our revenue in the fourth quarter. Inventory decreased to $38.4 million as of December 31, 2021 from $64.7 million as of December 31, 2020, driven by longer production lead times, component shortages and supply chain disruptions, which necessitated extensive use of air freight, all of which were brought about by COVID-19-related issues, coupled with lower returns. Our ending inventory turns were 10.5x in the three months ended December 31, 2021 up from 5.0x turns in the three months ended December 31, 2020, primarily as a result of the lower inventory balance and extensive use of air freight, as previously discussed. Our accounts payable increased to $84.1 million as of December 31, 2021 from $62.2 million as of December 31, 2020, primarily as a result of higher inventory purchases in the fourth quarter of 2021.
65
Investing activities
Net cash used in investing activities decreased by $21.7 million for the year ended December 31, 2021 compared to the prior year, primarily due to maturity of our of short-term investments.
Financing activities
Net cash used in financing activities was $5.0 million for the year ended December 31, 2021 and comprised withholding tax from restricted stock unit releases of $13.2 million, offset by proceeds from our 2018 Employee Stock Purchase Plan contributions and exercises of stock options of $8.23 million.
Backlog
Our backlog consists of products for which customer purchase orders have been received and that are scheduled or in the process of being scheduled for shipment. As of December 31, 2021, we had a backlog of $4.4 million, compared to $5.7 million as of December 31, 2020. As we typically fulfill orders received within a relatively short period after receipt, our revenue in any fiscal year depends primarily upon orders booked and the availability of supply of our products in that year. In addition, most of our backlog is subject to rescheduling or cancellation with minimal penalties. As a result, our backlog as of any particular date may not be an indicator of revenue for any succeeding period. Similarly, there is a lack of meaningful correlation between year-over-year changes in backlog as compared with year-over-year changes in revenue. Accordingly, we do not believe that backlog information is material to an understanding of our overall business, and backlog as of any particular date should not be considered a reliable indicator of our ability to achieve any particular level of revenue or financial performance.
Operating Leases
We entered into several office lease agreements under non-cancelable operating leases with various expiration dates through June 2029. The terms of certain of our facility leases provide for rental payments on a graduated scale. We recognize rent expense on a straight-line basis over the lease period and have accrued for rent expense incurred but not paid. The amounts presented are consistent with contractual terms and are not expected to differ significantly unless a substantial change in our headcount requires us to exit an office facility early or expand our occupied space. For the years ended December 31, 2021 and 2020, gross rent expense was $7.0 million in both years.
Letters of Credit
In connection with the lease agreement for office space located in San Jose, California, we executed a letter of credit with the landlord as the beneficiary. As of December 31, 2021, we had approximately $3.6 million of unused letters of credit outstanding, of which $3.1 million pertains to the lease agreement.
Purchase Obligations
We enter into various inventory-related purchase agreements with suppliers. Generally, under these agreements, 50% of the orders are cancelable by giving notice of 46 to 60 days prior to the expected shipment date and 25% of orders are cancelable by giving notice 31 to 45 days prior to the expected shipment date. Orders are not cancelable within 30 days prior to the expected shipment date. As of December 31, 2021, we had $32.9 million in non-cancelable purchase commitments with suppliers. We expect to sell all products for which we have committed purchases from suppliers.
66
Critical Accounting Estimates
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and pursuant to the regulations of the SEC. The preparation of the consolidated financial statements requires management to make assumptions, judgments and estimates that can have a significant impact on the reported amounts of assets, liabilities, revenue and expenses. We base our estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. Actual results could differ significantly from these estimates. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. On a regular basis, we evaluate our assumptions, judgments and estimates and make changes accordingly. We also discuss our critical accounting estimates with the Audit Committee of the Board of Directors. Note 2, Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K describes the significant accounting policies used in the preparation of the consolidated financial statements.
We have listed below our critical accounting estimates which require management to make difficult, subjective and complex judgements often as a result of the need to make estimate on matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or assumptions. Actual results could differ from those estimates.
Revenue recognition
Revenue from all sales types is recognized at transaction price, the amount we expect to be entitled to in exchange for transferring goods or providing services. Transaction price is calculated as selling price net of variable consideration which may include estimates for future returns, sales incentives, and price protection related to current period product revenue. Our standard obligation to our direct customers generally provides for a full refund in the event that such product is not merchantable or is found to be damaged or defective. In determining estimates for future returns, management analyzes historical sales and returns data, channel inventory levels, current economic trends, and changes in customer demand for our products. Sales incentives and price protection are determined based on a combination of the actual amounts committed and estimated future expenditure based upon historical customary business practice. Typically variable consideration does not need to be constrained as estimates are based on predictive historical data or future commitments that we plan and control. However, we continue to assess variable consideration estimates such that it is probable that a significant reversal of revenue will not occur.
Our standard warranty obligation to our direct customers generally provides for a right of return of any product for a full refund in the event that such product is not merchantable or is found to be damaged or defective. At the time we recognize revenue, we record an estimate of future warranty returns to reduce revenue in the amount of the expected credit or refund to be provided to our direct customers. At the time we record the reduction to revenue related to warranty returns, we include within cost of revenue a write-down to reduce the carrying value of such products to net realizable value. Our standard warranty obligation to end-users provides for replacement of a defective product for one or more years. Factors that affect the warranty obligation include product failure rates, material usage and service delivery costs incurred in correcting product failures. We record the estimated cost associated with fulfilling the warranty obligation to end-users in cost of revenue. Because our products are manufactured by third-party manufacturers, in certain cases we have recourse to the third-party manufacturer for replacement or credit for the defective products. We give consideration to amounts recoverable from our third-party manufacturers in determining our warranty liability. Our estimated allowances for product warranties can vary from actual results, and we may have to record additional revenue reductions or charges to cost of revenue, which could materially impact our financial position and results of operations. As of December 31, 2021 and 2020, accrued warranty-related returns amounted to $18.0 million and $24.9 million, respectively.
In addition to warranty-related returns, certain distributors and retailers generally have the right to return products for stock rotation purposes. Upon shipment of the product, we reduce revenue by an estimate of potential future stock rotation returns related to the current period product revenue. We analyze historical returns, channel inventory levels, current economic trends and changes in customer demand for our products when evaluating the adequacy of the allowance
67
for stock rotation returns. Our estimated allowances for returns due to stock rotation can vary from actual results, and we may have to record additional revenue reductions, which could materially impact our financial position and results of operations. As of December 31, 2021 and 2020, accrued stock rotation amounted to $1.8 million and $4.2 million, respectively
We accrue for sales incentives offered to customers as a marketing expense if we receive an identifiable benefit in exchange and can reasonably estimate the fair value of the identifiable benefit received; otherwise, it is recorded as a reduction to revenue. As a consequence, we record a substantial portion of our channel marketing costs as a reduction of revenue. We record estimated reductions to revenue for sales incentives when the related revenue is recognized or ahead of customer or end customer commitment if customary business practice creates an implied expectation that such activities will occur in the future. As of December 31, 2021 and 2020, accrued sales and marketing amounted to $31.4 million and $38.6 million, respectively.
Valuation of Inventory
We value our inventory at the lower of cost or net realizable value, cost being determined using the first-in, first-out method. We continually assess the value of our inventory and will periodically write down its value to account for estimated excess and obsolete inventory based upon assumptions about future demand and market conditions. On a quarterly basis, we review inventory quantities on hand and on order under non-cancelable purchase commitments and compare those quantities to our estimated forecast of product demand for the next nine months to determine what inventory, if any, is not salable. We base our analysis on the product demand forecast but take into account market conditions, product development plans, product life expectancy and other factors. Based on this analysis, we write down the carrying value of the affected inventory to account for estimated excess and obsolete amounts. At the point of loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. As demonstrated during prior years, demand for our products can fluctuate significantly. If actual demand is lower than our forecasted demand and we fail to reduce our manufacturing accordingly, we could be required to write down the value of additional inventory, which would have a negative effect on our gross profit. At December 31, 2021 and 2020, excess and obsolescence reserve amounted to $2.7 million and $6.3 million, respectively.
Long-lived Assets and Right-of-use Assets Impairment
During the second quarter of 2021, we evaluated our real estate lease portfolio in light of the COVID-19 pandemic and the changing nature of office space use by our workforce. This evaluation included a decision to sublease our office space in San Jose, California. This change in the use of our San Jose office space led management to test the recoverability of the carrying amount of the asset group related to the sublease. On May 25, 2021, the carrying amount of the asset group exceeded the anticipated undiscounted value of the sublease income over the sublease term. Accordingly, we reviewed certain of our right-of-use assets and other lease related assets including leasehold improvements, furniture, fixtures and equipment under the sublease asset group for impairment.
As a result of the evaluation, we recorded an impairment charge of $9.1 million, which included $6.8 million associated with the right-of-use assets and $2.3 million associated with other lease related property and equipment, in the second quarter of 2021. The assets found to be impaired were written down to their fair value calculated using a discounted cash flow method (income approach). The fair value of the asset group was determined by utilizing projected cash flows from the sublease, discounted by a risk-adjusted discount rate that reflects the level of risk associated with receiving future cash flows. The inputs utilized in the analyses were classified as Level 3 inputs within the fair value hierarchy. Refer to Note 6, Fair Value Measurements and Note 11, Commitments and Contingencies in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K, for additional information about the fair value measured on a non-recurring basis and for further information about the sublease, respectively.
68
Goodwill Impairment
On the first day of the fourth quarter of 2021, we performed an annual assessment of goodwill at the reporting unit level. We operate as one operating and reportable segment. We performed a qualitative assessment in consideration of macroeconomic conditions, industry and market conditions, cost factors, overall company financial performance, and changes in our stock price. We believed that it was more-likely-than-not that the fair value of the reporting unit was greater than our respective carrying value and therefore performing the next step of impairment test for the reporting unit was unnecessary. No goodwill impairment was recognized in the years ended December 31, 2021, and 2020. If there are events occurred or circumstances changed (i.e. a decline in our stock price based on market conditions and deterioration of our business) that would more likely than not reduce our fair value below the carrying amount, we may have to record a charge to our earnings for the associated goodwill impairment of up to $11.0 million.
Uncertain Tax Position
We are subject to income taxes in the U.S. and numerous foreign jurisdictions. We apply significant judgement in determining our uncertain tax positions. Although we believe that our reserves of uncertain tax position are reasonably adequate, no assurance can be given that the final outcome of these matters will not be different from our reserves. When facts and circumstances change, our reserves are adjusted, such as the closing of a tax audit, the expiration of statute of limitation for a relevant taxing authority to examine a tax position, or when additional information becomes available. To the extent that the final tax outcome of these matters is different than the reserves recorded, such differences will affect the provision for income taxes in the period in which such determination is made and could have a material impact on our financial condition and operating results.
Recent Accounting Pronouncements
For a complete description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on financial condition and results of operations, refer to Note 2, Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K.
Emerging Growth Company Status
As an emerging growth company (“EGC”), under the Jumpstart Our Business Startups Act (“JOBS Act”), we are allowed to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are made applicable to private companies, unless we otherwise irrevocably elect not to avail ourselves of this exemption. While we have not made such an irrevocable election, we have not delayed the adoption of any applicable accounting standards.
69
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk
We do not use derivative financial instruments in our investment portfolio. We have an investment portfolio of fixed income securities that are classified as available-for-sale securities. These securities, like all fixed income instruments, are subject to interest rate risk and will fall in value if market interest rates increase. We attempt to limit this exposure by investing primarily in highly rated short-term securities. Our investment policy requires investments to be rated triple-A with the objective of minimizing the potential risk of principal loss. Due to the short duration and conservative nature of our investment portfolio, a hypothetical movement of 10% in interest rates would not have a material impact on our operating results and the total value of the portfolio over the next fiscal year. We monitor our interest rate and credit risks, including our credit exposure to specific rating categories and to individual issuers. There were no impairment charges on our investments during fiscal year 2021.
Foreign Currency Exchange Rate Risk
We invoice some of our international customers in foreign currencies, including the Australian dollar and Canadian dollar. As the customers that are currently invoiced in local currency become a larger percentage of our business, or to the extent we begin to bill additional customers in foreign currencies, the impact of fluctuations in foreign currency exchange rates could have a more significant impact on our results of operations. For those customers in our international markets that we continue to sell to in U.S. dollars, an increase in the value of the U.S. dollar relative to foreign currencies could make our products more expensive and therefore reduce the demand for our products. Such a decline in the demand for our products could reduce sales and materially adversely affect our business, results of operations, and financial condition. Certain operating expenses of our foreign operations require payment in local currencies.
We are exposed to risks associated with foreign exchange rate fluctuations due to our international sales and operating activities. These risks may change over time as our business evolves and could negatively impact our operating results and financial condition. As we grow our operations, our exposure to foreign currency risk could become more significant. In the third fiscal quarter of 2018, we established a hedge program to hedge foreign currency exchange risks and currently do not expect to enter into foreign currency exchange contracts for trading or speculative purposes. See Note 2, Summary of Significant Accounting Policies for more information regarding the hedge program.
As of December 31, 2021, we had net assets in various local currencies. A hypothetical 10% movement in foreign exchange rates would have an immaterial impact on our net loss for the period. Actual future gains and losses associated with our foreign currency exposures and positions may differ materially from the sensitivity analysis performed as of December 31, 2021 due to the inherent limitations associated with predicting foreign currency exchange rates and our actual exposures and positions. For the years ended December 31, 2021 and 2020, 6% and 10% of revenue was denominated in a currency other than the U.S. dollar, respectively.
70
Item 8. Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of Arlo Technologies, Inc.
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Arlo Technologies, Inc. and its subsidiaries (the “Company”) as of December 31, 2021 and 2020, and the related consolidated statements of operations, of comprehensive income (loss), of stockholders’ equity and of cash flows for each of the three years in the period ended December 31, 2021, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2021 and 2020, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2021 in conformity with accounting principles generally accepted in the United States of America.
Change in Accounting Principle
As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/PricewaterhouseCoopers LLP
San Jose, California
March 2, 2022
We have served as the Company's auditor since 2018.
71
ARLO TECHNOLOGIES, INC.
CONSOLIDATED BALANCE SHEETS
| As of December 31, | |||||||||||
| 2021 | 2020 | ||||||||||
(In thousands, except share and per share data) | |||||||||||
| ASSETS | |||||||||||
| Current assets: | |||||||||||
| Cash and cash equivalents | $ | 175,749 | $ | 186,127 | |||||||
Short-term investments (amortized cost of $— and $19,996) | — | 19,997 | |||||||||
Accounts receivable, net (net of allowance for credit losses of $337 and $519) | 79,564 | 77,643 | |||||||||
| Inventories | 38,390 | 64,705 | |||||||||
| Prepaid expenses and other current assets | 9,919 | 8,076 | |||||||||
| Total current assets | 303,622 | 356,548 | |||||||||
| Property and equipment, net | 9,595 | 15,821 | |||||||||
| Operating lease right-of-use assets, net | 14,814 | 23,998 | |||||||||
| Goodwill | 11,038 | 11,038 | |||||||||
| Restricted cash | 4,107 | 4,164 | |||||||||
| Other non-current assets | 4,314 | 2,399 | |||||||||
| Total assets | $ | 347,490 | $ | 413,968 | |||||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | |||||||||||
| Current liabilities: | |||||||||||
| Accounts payable | $ | 84,098 | $ | 62,171 | |||||||
| Deferred revenue | 29,442 | 53,142 | |||||||||
| Accrued liabilities | 97,377 | 121,766 | |||||||||
| Income tax payable | 12 | 267 | |||||||||
| Total current liabilities | 210,929 | 237,346 | |||||||||
| Non-current deferred revenue | 1,344 | 16,563 | |||||||||
| Non-current operating lease liabilities | 21,470 | 25,029 | |||||||||
| Non-current income taxes payable | 94 | 104 | |||||||||
| Other non-current liabilities | 1,001 | 1,159 | |||||||||
| Total liabilities | 234,838 | 280,201 | |||||||||
| Commitments and contingencies (Note 11) | |||||||||||
| Stockholders’ Equity: | |||||||||||
Preferred stock: $0.001 par value; 50,000,000 shares authorized; none issued or outstanding | — | — | |||||||||
Common stock: $0.001 par value; 500,000,000 shares authorized; shares issued and outstanding: 84,453,212 at December 31, 2021 and 79,336,242 at December 31, 2020 | 84 | 79 | |||||||||
| Additional paid-in capital | 401,367 | 366,455 | |||||||||
| Accumulated other comprehensive income | — | 3 | |||||||||
| Accumulated deficit | (288,799) | (232,770) | |||||||||
| Total stockholders’ equity | 112,652 | 133,767 | |||||||||
| Total liabilities and stockholders’ equity | $ | 347,490 | $ | 413,968 | |||||||
The accompanying notes are an integral part of these consolidated financial statements.
72
ARLO TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
(In thousands, except per share data) | |||||||||||||||||
| Revenue: | |||||||||||||||||
| Products | $ | 331,620 | $ | 284,868 | $ | 323,242 | |||||||||||
| Services | 103,517 | 72,286 | 46,765 | ||||||||||||||
| Total revenue | 435,137 | 357,154 | 370,007 | ||||||||||||||
| Cost of revenue: | |||||||||||||||||
| Products | 285,334 | 263,905 | 307,348 | ||||||||||||||
| Services | 41,768 | 37,860 | 26,855 | ||||||||||||||
| Total cost of revenue | 327,102 | 301,765 | 334,203 | ||||||||||||||
| Gross profit | 108,035 | 55,389 | 35,804 | ||||||||||||||
| Operating expenses: | |||||||||||||||||
| Research and development | 59,063 | 60,137 | 69,384 | ||||||||||||||
| Sales and marketing | 48,909 | 49,064 | 56,985 | ||||||||||||||
| General and administrative | 49,489 | 51,096 | 47,624 | ||||||||||||||
| Impairment charges | 9,116 | — | — | ||||||||||||||
| Separation expense | 1,596 | 248 | 1,913 | ||||||||||||||
| Gain on sale of business | — | (292) | (54,881) | ||||||||||||||
| Total operating expenses | 168,173 | 160,253 | 121,025 | ||||||||||||||
| Loss from operations | (60,138) | (104,864) | (85,221) | ||||||||||||||
| Interest income | 11 | 802 | 2,737 | ||||||||||||||
| Other income, net | 4,775 | 3,436 | 913 | ||||||||||||||
| Loss before income taxes | (55,352) | (100,626) | (81,571) | ||||||||||||||
| Provision for income taxes | 677 | 625 | 4,380 | ||||||||||||||
| Net loss | $ | (56,029) | $ | (101,251) | $ | (85,951) | |||||||||||
| Net loss per share: | |||||||||||||||||
| Basic | $ | (0.68) | $ | (1.30) | $ | (1.14) | |||||||||||
| Diluted | $ | (0.68) | $ | (1.30) | $ | (1.14) | |||||||||||
| Weighted average shares used to compute net loss per share: | |||||||||||||||||
| Basic | 82,688 | 78,084 | 75,074 | ||||||||||||||
| Diluted | 82,688 | 78,084 | 75,074 | ||||||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
73
ARLO TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
(In thousands) | |||||||||||||||||
| Net loss | $ | (56,029) | $ | (101,251) | $ | (85,951) | |||||||||||
| Other comprehensive income (loss), before and after tax: | |||||||||||||||||
| Unrealized gain (loss) on derivative instruments | (2) | 27 | (27) | ||||||||||||||
| Unrealized gain (loss) on available-for-sale securities | (1) | (22) | 25 | ||||||||||||||
| Total other comprehensive income (loss), before tax | (3) | 5 | (2) | ||||||||||||||
| Total other comprehensive income (loss), net of tax | (3) | 5 | (2) | ||||||||||||||
| Comprehensive loss | $ | (56,032) | $ | (101,246) | $ | (85,953) | |||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
74
ARLO TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
| Common Stock | |||||||||||||||||||||||||||||||||||
| Shares | Amount | Additional Paid-In Capital | Accumulated Other Comprehensive Income (Loss) | Accumulated Deficit | Total | ||||||||||||||||||||||||||||||
| (In thousands) | |||||||||||||||||||||||||||||||||||
| Balance as of December 31, 2018 | 74,247 | $ | 74 | $ | 315,277 | $ | — | $ | (45,849) | $ | 269,502 | ||||||||||||||||||||||||
| — | — | — | — | 281 | 281 | ||||||||||||||||||||||||||||||
| Net loss | — | — | — | — | (85,951) | (85,951) | |||||||||||||||||||||||||||||
| Stock-based compensation expense | — | — | 19,582 | — | — | 19,582 | |||||||||||||||||||||||||||||
| Issuance of common stock under stock-based compensation plans | 1,152 | 1 | 12 | — | — | 13 | |||||||||||||||||||||||||||||
| Issuance of common stock under Employee Stock Purchase Plan | 767 | 1 | 1,825 | — | — | 1,826 | |||||||||||||||||||||||||||||
| Restricted stock unit withholdings | (380) | — | (1,875) | — | — | (1,875) | |||||||||||||||||||||||||||||
| Change in unrealized gains on available-for-sale securities, net of tax | — | — | — | 25 | — | 25 | |||||||||||||||||||||||||||||
| Change in unrealized losses on derivatives, net of tax | — | — | — | (27) | — | (27) | |||||||||||||||||||||||||||||
| Balance as of December 31, 2019 | 75,786 | 76 | 334,821 | (2) | (131,519) | 203,376 | |||||||||||||||||||||||||||||
| Net loss | — | — | — | — | (101,251) | (101,251) | |||||||||||||||||||||||||||||
| Stock-based compensation expense | — | — | 27,418 | — | — | 27,418 | |||||||||||||||||||||||||||||
| Settlement of liability classified restricted stock unit | — | — | 4,242 | — | — | 4,242 | |||||||||||||||||||||||||||||
| Issuance of common stock under stock-based compensation plans | 3,720 | 3 | 1,727 | — | — | 1,730 | |||||||||||||||||||||||||||||
| Issuance of common stock under Employee Stock Purchase Plan | 1,110 | 1 | 3,024 | — | — | 3,025 | |||||||||||||||||||||||||||||
| Restricted stock unit withholdings | (1,280) | (1) | (4,777) | — | (4,778) | ||||||||||||||||||||||||||||||
| Change in unrealized losses on available-for-sale securities, net of tax | — | — | — | (22) | — | (22) | |||||||||||||||||||||||||||||
| Change in unrealized gains on derivatives, net of tax | — | — | — | 27 | — | 27 | |||||||||||||||||||||||||||||
| Balance as of December 31, 2020 | 79,336 | 79 | 366,455 | 3 | (232,770) | 133,767 | |||||||||||||||||||||||||||||
| Net loss | — | — | — | — | (56,029) | (56,029) | |||||||||||||||||||||||||||||
| Stock-based compensation expense | — | — | 24,792 | — | — | 24,792 | |||||||||||||||||||||||||||||
| Settlement of liability classified restricted stock unit | — | — | 15,095 | — | — | 15,095 | |||||||||||||||||||||||||||||
| Issuance of common stock under stock-based compensation plans | 6,538 | 8 | 5,261 | — | — | 5,269 | |||||||||||||||||||||||||||||
| Issuance of common stock under Employee Stock Purchase Plan | 602 | — | 2,962 | — | — | 2,962 | |||||||||||||||||||||||||||||
| Restricted stock unit withholdings | (2,023) | (3) | (13,198) | — | — | (13,201) | |||||||||||||||||||||||||||||
| Change in unrealized losses on available-for-sale securities, net of tax | — | — | — | (1) | — | (1) | |||||||||||||||||||||||||||||
| Change in unrealized losses on derivatives, net of tax | — | — | — | (2) | — | (2) | |||||||||||||||||||||||||||||
| Balance as of December 31, 2021 | 84,453 | $ | 84 | $ | 401,367 | $ | — | $ | (288,799) | $ | 112,652 | ||||||||||||||||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
75
ARLO TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In thousands) | |||||||||||||||||
| Cash flows from operating activities: | |||||||||||||||||
| Net loss | $ | (56,029) | $ | (101,251) | $ | (85,951) | |||||||||||
| Adjustments to reconcile net loss to net cash used in operating activities: | |||||||||||||||||
| Depreciation and amortization | 5,975 | 10,206 | 10,681 | ||||||||||||||
| Stock-based compensation expense | 38,030 | 35,247 | 22,894 | ||||||||||||||
| Impairment charges | 9,116 | — | — | ||||||||||||||
| Allowance for credit losses and inventory reserves | (3,125) | 964 | (2,921) | ||||||||||||||
| Gain on sale of business | — | (292) | (54,881) | ||||||||||||||
| Deferred income taxes | (296) | 50 | (210) | ||||||||||||||
| Premium amortization (discount accretion) on investments, net | (3) | 54 | (461) | ||||||||||||||
| Changes in assets and liabilities: | |||||||||||||||||
| Accounts receivable, net | (1,739) | 49,765 | 38,247 | ||||||||||||||
| Inventories | 29,258 | 2,862 | 53,604 | ||||||||||||||
| Prepaid expenses and other assets | (3,463) | 10,441 | 11,525 | ||||||||||||||
| Accounts payable | 22,156 | (49,282) | 28,791 | ||||||||||||||
| Deferred revenue | (38,919) | 3,607 | 22,567 | ||||||||||||||
| Accrued liabilities | (24,158) | (8,901) | (34,714) | ||||||||||||||
| Net cash provided by (used in) operating activities | (23,197) | (46,530) | 9,171 | ||||||||||||||
| Cash flows from investing activities: | |||||||||||||||||
| Purchases of property and equipment | (2,268) | (3,892) | (6,664) | ||||||||||||||
| Proceeds from sale of business | — | — | 52,694 | ||||||||||||||
| Purchases of short-term investments | — | (50,083) | (29,768) | ||||||||||||||
| Proceeds from maturities of short-term investments | 20,000 | 50,000 | 60,000 | ||||||||||||||
| Net cash provided by (used in) investing activities | 17,732 | (3,975) | 76,262 | ||||||||||||||
| Cash flows from financing activities: | |||||||||||||||||
| Restricted stock unit withholdings | (13,201) | (4,778) | (1,875) | ||||||||||||||
| Proceeds related to employee benefit plans | 8,231 | 4,755 | 1,837 | ||||||||||||||
| Net cash used in financing activities | (4,970) | (23) | (38) | ||||||||||||||
| Net increase (decrease) in cash and cash equivalents and restricted cash | (10,435) | (50,528) | 85,395 | ||||||||||||||
| Cash and cash equivalents and restricted cash, at beginning of period | 190,291 | 240,819 | 155,424 | ||||||||||||||
| Cash and cash equivalents and restricted cash, at end of period | $ | 179,856 | $ | 190,291 | $ | 240,819 | |||||||||||
| Non-cash investing and financing activities: | |||||||||||||||||
| Purchases of property and equipment included in accounts payable and accrued liabilities | $ | 379 | $ | 564 | $ | 1,086 | |||||||||||
| De-recognized fair value of build-to-suit lease | $ | — | $ | — | $ | (21,610) | |||||||||||
| Supplemental cash flow information: | |||||||||||||||||
| Cash paid for income taxes, net | $ | 964 | $ | 5,614 | $ | 960 | |||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
76
Note 1. The Company and Basis of Presentation
The Company
Arlo Technologies, Inc. ("Arlo" or "the Company") combines an intelligent cloud infrastructure and mobile app with a variety of smart connected devices that transform the way people experience the connected lifestyle. The Company's deep expertise in product design, wireless connectivity, cloud infrastructure and cutting-edge AI capabilities focuses on delivering a seamless, smart home experience for Arlo users that is easy to setup and interact with every day. The Company's cloud-based platform provides users with visibility, insight and a powerful means to help protect and connect in real-time with the people and things that matter most, from any location with a Wi-Fi or a cellular connection. The Company conducts business across three geographic regions - Americas; Europe, Middle-East and Africa (“EMEA”); and Asia Pacific (“APAC”), and primarily generates revenue by selling devices through retail channels, wholesale distribution, wireless carrier channels, security solution providers, its direct to consumer store and paid subscription services.
The Company's corporate headquarters is located in Carlsbad, California with other satellite offices across North America and various global locations.
Basis of Presentation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All periods presented have been accounted for in conformity with U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) and pursuant to the regulations of the U.S. Securities and Exchange Commission (“SEC”).
Fiscal periods
The Company’s fiscal year begins on January 1 of the year stated and ends on December 31 of the same year. The Company reports its results on a fiscal quarter basis rather than on a calendar quarter basis. Under the fiscal quarter basis, each of the first three fiscal quarters ends on the Sunday closest to the calendar quarter end, with the fourth quarter ending on December 31.
Use of estimates
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported periods. Management bases its estimates on various assumptions believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ materially from those estimates and operating results for the year ended December 31, 2021 are not necessarily indicative of the results that may be expected for any future period.
Note 2. Summary of Significant Accounting Policies
Cash and cash equivalents
The Company considers all highly liquid investments with an original maturity or a remaining maturity at the time of purchase of three months or less to be cash equivalents. The Company deposits cash and cash equivalents with high credit quality financial institutions.
77
Restricted cash
The Company maintains certain cash balances restricted as to withdrawal or use. Restricted cash is comprised primarily of cash used as a collateral for a letter of credit associated with the Company’s lease agreement for office space in San Jose, California. The Company deposits restricted cash with high credit quality financial institutions.
The following table shows reconciliation of cash and cash equivalents and restricted cash within the consolidated balance sheets to the amounts shown in the statements of cash flows:
| As of December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In thousands) | |||||||||||||||||
| Cash and cash equivalents | $ | 175,749 | $ | 186,127 | $ | 236,680 | |||||||||||
| Restricted cash | 4,107 | 4,164 | 4,139 | ||||||||||||||
| Total as presented on the consolidated statements of cash flows | $ | 179,856 | $ | 190,291 | $ | 240,819 | |||||||||||
Short-term investments
Short-term investments are comprised of marketable securities that consist of government securities with an original maturity or a remaining maturity at the time of purchase of greater than three months and no more than 12 months. The marketable securities are held in the Company’s name with a high quality financial institution, which acts as the Company’s custodian and investment manager. These marketable securities are classified as available-for-sale securities in accordance with the provisions of the authoritative guidance for investments and are carried at fair value with unrealized gains and losses reported as a separate component of stockholders’ equity.
Fair value measurements
The carrying amounts of the Company’s financial instruments, including cash equivalents, restricted cash, short-term investments, accounts receivable, and accounts payable approximate their fair values due to their short maturities. Foreign currency forward contracts are recorded at fair value based on observable market data. The Company determines the fair values of its financial instruments based on a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The classification of a financial asset or liability within the hierarchy is based upon the lowest level input that is significant to the fair value measurement. The fair value hierarchy prioritizes the inputs into three levels that may be used to measure fair value:
Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
Level 2: Quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; and
Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).
Derivative financial instruments
The Company’s subsidiaries have had, and will continue to have material future cash flows, including revenue and expenses, which are denominated in currencies other than the Company’s functional currency. The Company and all its subsidiaries designate the U.S. dollar as the functional currency. Changes in exchange rates between the Company’s functional currency and other currencies in which the Company transacts business will cause fluctuations in cash flow
78
expectations and cash flow realized or settled. Accordingly, the Company uses derivatives to mitigate its business exposure to foreign exchange risk. The Company enters into foreign currency forward contracts in Australian dollars and Canadian dollars to manage its exposure to foreign exchange risk related to expected future cash flows on certain forecasted revenue, cost of revenue, operating expenses and existing assets and liabilities.
The Company’s foreign currency forward contracts do not contain any credit risk-related contingent features. The Company is exposed to credit losses in the event of nonperformance by the counter-parties of its forward contracts. The Company enters into derivative contracts with high-quality financial institutions and limits the amount of credit exposure to any one counter-party. In addition, the derivative contracts typically mature in less than six months and the Company continuously evaluates the credit standing of its counter-party financial institutions. The counter-parties to these arrangements are large highly rated financial institutions and the Company does not consider non-performance a material risk.
The Company may choose not to hedge certain foreign exchange exposures for a variety of reasons, including, but not limited to, materiality, accounting considerations or the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign exchange rates. The Company’s accounting policies for these instruments are based on whether the instruments are designated as hedge or non-hedge instruments in accordance with the authoritative guidance for derivatives and hedging. The Company records all derivatives on the balance sheets at fair value. Cash flow hedge gains and losses are recorded in other comprehensive income (“OCI”) until the hedged item is recognized in earnings. Derivatives that are not designated as hedging instruments are adjusted to fair value through earnings in Other income (expense), net in the consolidated statements of operations.
Cash flow hedges
To help manage the exposure of operating margins to fluctuations in foreign currency exchange rates, the Company hedges a portion of its anticipated foreign currency revenue, cost of revenue and certain operating expenses. These hedges are designated at the inception of the hedge relationship as cash flow hedges. The effective portion of the gain or loss on the derivative instrument is reported as a component of accumulated other comprehensive income (loss) (“AOCI”) in stockholders’ equity and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The ineffective portion of the gain or loss on the derivative instrument is recognized in current earnings.
Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur within the designated hedge period or if not recognized within 60 days following the end of the hedge period. Deferred gains and losses in AOCI with such derivative instruments are reclassified immediately into earnings through Other income (expense), net. Any subsequent changes in fair value of such derivative instruments also are reflected in current earnings unless they are re-designated as hedges of other transactions.
Non-designated hedges
The Company enters into non-designated hedges under the authoritative guidance for derivatives and hedging to manage the exposure of non-functional currency monetary assets and liabilities held on its financial statements to fluctuations in foreign currency exchange rates, as well as to reduce volatility in other income and expense. The non-designated hedges are generally expected to offset the changes in value of its net non-functional currency asset and liability position resulting from foreign exchange rate fluctuations. Foreign currency denominated accounts receivable and payable are hedged with non-designated hedges when the related anticipated foreign revenue and expenses are recognized in the Company’s financial statements.
79
Trade accounts receivable
The Company is exposed to credit losses primarily through sales of products and services. The Company's allowance for current estimated credit losses for trade accounts receivable is developed using historical collection experience, current and future economic and market conditions and a review of the current status of customers' trade accounts receivables. Due to the short-term nature of such receivables, the estimated amount of accounts receivable that may not be collected is based on aging of the accounts receivable balances and the financial condition of customers. Additionally, specific allowance amounts are established to record the appropriate provision for customers that have a higher probability of default.
The Company’s monitoring activities include timely and regular account reconciliations, dispute resolution, payment confirmation, review of customers' financial condition and macroeconomic conditions. Balances are written off when determined to be uncollectible. The Company considered the current and expected future economic and market conditions surrounding the COVID-19 pandemic and determined that the estimate of credit losses was not significantly impacted. Although the Company has historically not experienced significant credit losses, it is possible that there could be a material adverse impact from potential adjustments of the carrying amount of trade receivables.
Concentration of credit risk
Financial instruments that potentially subject the Company to a concentration of credit risk consist of principally investments, derivative financial instruments, and accounts receivable. The Company believes that there is minimal credit risk associated with the investment of its cash and cash equivalents, restricted cash, and short-term investments, due to the restrictions placed on the type of investment that can be entered into under the Company’s investment policy. The Company’s short-term investments consist of investment-grade securities, and the Company’s cash and investments are held and managed by high credit quality financial institutions.
The Company is exposed to credit loss in the event of nonperformance by counterparties to the foreign currency forward contracts used to mitigate the effect of foreign currency exchange rate changes. The Company enters into derivative contracts with high-quality financial institutions and limits the amount of credit exposure to any counterparty. The Company’s foreign currency forward contracts do not contain any credit-risk-related contingent features. In addition, the derivative contracts typically mature in less than six months and the Company continuously evaluates the credit standing of its counterparty financial institutions. The counterparties to these arrangements are large highly rated financial institutions and the Company does not consider non-performance a material risk. The Company believes the counterparties for its outstanding contracts are large, financially sound institutions and thus, the Company does not anticipate nonperformance by these counterparties.
The Company’s customers are primarily retailers, wholesale distributors and security solution providers who sell or distribute the products to a large group of end-users. The Company regularly performs credit evaluations of the Company’s customers’ financial condition and performance and considers factors such as historical experience, credit quality, age of the accounts receivable balances, geographic or country-specific risks and current economic conditions that may affect customers’ ability to pay. The Company does not require collateral from its customers. Historically, a substantial portion of the Company’s revenue has been derived from a limited number of retailers and wholesale distribution partners. As of December 31, 2021, three customers accounted for 35.3%, 20.1% and 10.1% of the Company's total accounts receivable, net. As of December 31, 2020, three customers accounted for 32.7%, 18.5% and 15.3% of the Company’s total accounts receivable, net. No other customers accounted for 10% or greater of the Company's total accounts receivable, net.
80
Inventories
Inventories consist of finished goods which are valued at the lower of cost or net realizable value, with cost being determined using the first-in, first-out method. The Company writes down its inventories based on estimated excess and obsolete amounts, determined primarily based on demand forecasts, but takes into account market conditions, product development plans, product life expectancy and other factors. At the point of loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase of the newly established cost basis. While management believes the estimates and assumptions underlying its current forecasts are reasonable, there is risk that additional charges may be necessary if current forecasts are greater than actual demand.
Property and equipment, net
Property and equipment are stated at historical cost, less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets as follows:
| Asset Category: | Range of Useful Lives | |||||||
| Computer equipment | 2 years | |||||||
| Furniture and fixtures | 5 years | |||||||
| Software | 2-5 years | |||||||
| Machinery and equipment | 2-3 years | |||||||
| Leasehold improvements | Shorter of remaining lease term or 7 years | |||||||
Recoverability of assets to be held and used is measured by comparing the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of the asset exceeds its estimated undiscounted future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. The carrying value of the asset is reviewed on a regular basis for the existence of facts, both internal and external, that may suggest impairment.
Goodwill
Goodwill pertains to the acquisitions of Avaak, Inc. and Placemeter, Inc. Goodwill represents the amount by which the purchase price exceeds estimated fair value of net assets of businesses acquired in a business combination. The Company performs an annual impairment assessment of goodwill at the reporting unit level on the first day of the fourth fiscal quarter. The Company identified that it has one reporting unit for the purpose of goodwill impairment testing and the reporting unit is at the same level as its operating segment and reportable segment. The analysis may include both qualitative and quantitative factors to assess the likelihood of an impairment. Should certain events or indicators of impairment occur between annual impairment tests, the Company will perform the impairment test as those events or indicators occur. Examples of such events or circumstances include a significant decline in the Company’s expected future cash flows, a sustained, significant decline in the Company’s stock price and market capitalization, a significant adverse change in the business climate and slower growth rates.
Goodwill is tested for impairment at the reporting unit level by first performing a qualitative assessment to determine whether it is more likely than not (that is, a likelihood of more than 50%) that the fair value of the reporting unit is less than its carrying amount. The qualitative assessment considers macroeconomic conditions, industry and market considerations, cost factors, overall company financial performance, events affecting the reporting units, and changes in the Company’s stock price. If the reporting unit does not pass the qualitative assessment, the Company estimates its fair value and compares the fair value with the carrying amount of its reporting unit, including goodwill. If the fair value is greater than the carrying amount of its reporting unit, no impairment is recorded. If the fair value is less than the carrying amount, an impairment loss shall be recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to
81
that reporting unit. The impairment charge, if any, would be recorded to earnings in the consolidated statements of operations.
Revenue recognition
Revenue from contracts with customers is recognized when control of the promised goods or services is transferred to the customers in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services.
The majority of revenue comes from sales of hardware products to customers (retailers, distributors, security solution providers, service providers, and individual consumers through Arlo's direct to consumer store). Revenue is recognized at a point in time when control of the goods is transferred to the customer, generally occurring upon shipment or delivery, dependent upon the terms of the underlying contract. The amount recognized reflects the consideration the Company expects to be entitled to in exchange for the transferred goods.
The Company sells paid subscription services to its end user customers where it provides customers access to its cloud services. Revenue for subscription sales is generally recognized on a ratable basis over the contract term, beginning on the date that the service is made available to the customers at the time of registration. The subscription contracts are generally 30 days or 12 months in length, billed in advance. All such service or support sales are typically recognized using an output measure of progress by looking at the time elapsed, as the contracts generally provide the customer equal benefit throughout the contract period. In addition to selling paid subscriptions, the Company also sells services bundled with hardware products and accounts for these sales in line with the multiple performance obligations guidance.
Revenue from all sales types is recognized at transaction price, which is the amount the Company expects to be entitled to in exchange for transferring goods or providing services. Transaction price is calculated as selling price net of variable consideration which may include estimates for future returns, sales incentives, and price protection related to current period product revenue. The Company’s standard obligation to its direct customers generally provides for a full refund in the event that such product is not merchantable or is found to be damaged or defective. In determining estimates for future returns, management analyzes historical sales and returns data, channel inventory levels, current economic trends, and changes in customer demand for the Company’s products. Sales incentives and price protection are determined based on a combination of the actual amounts committed and estimated future expenditure based upon historical customary business practice. Typically variable consideration does not need to be constrained as estimates are based on predictive historical data or future commitments that are planned and controlled by the Company. However, the Company continues to assess variable consideration estimates such that it is probable that a significant reversal of revenue will not occur.
Contracts with multiple performance obligations
Some of the Company’s contracts with customers contain multiple promised goods or services. Such contracts include hardware products with bundled services, various subscription services, and support. For these contracts, the Company accounts for the promises separately as individual performance obligations if they are distinct. Performance obligations are determined to be considered distinct if they are both capable of being distinct and distinct within the context of the contract. In determining whether performance obligations meet the criteria for being distinct, the Company considers a number of factors, such as the degree of interrelation and interdependence between obligations, and whether or not the good or service significantly modifies or transforms another good or service in the contract. The embedded software in most of the hardware products is not considered distinct and therefore the combined hardware and incidental software are treated as one performance obligation and recognized at the point in time when control of product transfers to the customer. Services that are included with certain hardware products are considered distinct and therefore the hardware and service are treated as separate performance obligations.
82
After identifying the separate performance obligations, the transaction price is allocated to the separate performance obligations on a relative stand-alone selling price basis. Stand-alone selling prices are generally determined based on the prices charged to customers or using an adjusted market assessment. Stand-alone selling price of the hardware is directly observable from add-on camera and base station sales. Stand-alone selling price of the premium services are directly observable from direct sales to end users while the service is estimated using an adjusted market approach.
Revenue is then recognized for each distinct performance obligation as control is transferred to the customer. Revenue attributable to hardware is recognized at the time control of the product transfers to the customer. The transaction price allocated to the service is recognized over the specified service period or over the estimated useful life of the hardware, beginning when the customer is expected to activate their account. Useful life of the hardware is determined by industry norms, technical and financial relevance, frequency of new model releases, and user history.
Long-term Supply Arrangement - Verisure
The Company has entered into a Supply Agreement as part of the disposal of the Company's commercial operations in Europe as discussed in Note 4, Disposal of Business, where Verisure prepays future product purchases with a minimum product purchase commitment also required. The Supply Agreement includes product purchases, paid subscription services, basic services, and an option for Verisure to acquire development services by submitting a statement of work (“SOW”). Products sold come with a standard twelve months warranty. Verisure assumes responsibilities for all warranty claims, returns of products and certain technical support provided to the end users. The Company provides technical support for paid subscription services where Verisure cannot resolve the issue. Verisure is responsible for any marketing and promotion of the Company's products and services sold in Europe.
Products are priced at a cost plus markup based on markups specified in the Supply Agreement and that price varies based on the cost of the product. The paid subscription services and basic services pricing is based on the number of users monthly and is priced at a cost plus markup specified in the Supply Agreement, which varies based on the user and service type. The transaction price for products and paid subscription services is entirely variable because the consideration is dependent on the actual costs. The Company allocates variable consideration specified for products entirely to products, and variable consideration specified for the paid subscription services entirely to the paid subscription services. For development services, no contract exists until an SOW is submitted and approved by both parties. For products, since quantity and product types are not specified in the agreement, contracts are not deemed to exist until the Company receives and accepts the customer purchase order ("PO"). Each product with a valid PO is considered a single performance obligation.
The Company recognizes variable consideration for products upon delivery and for services when the monthly service is rendered for paid subscription service and basic service. The non-refundable product prepayments do not relate to future goods or services, as such no further assessment of material rights is required. Further, as the transfer of products is at the discretion of the customer (i.e. when Verisure issues a PO), a significant financing component does not exist as it relates to product prepayments. The Company also expects that the product prepayments will be fully utilized by Verisure within 12 to 18 months, hence, no additional accounting consideration is necessary for breakage. The Company also concluded that it is acting as the principal in the Supply Agreement and determined that revenue should be presented gross.
NRE Arrangement - Verisure
The Supply Agreement also provides for certain development services under an SOW to Verisure ("NRE arrangement") as part of the disposal of the Company's commercial operations in Europe as discussed in Note 4, Disposal of Business. In the NRE arrangement, Verisure pays non-refundable installments upon the commencement of agreed-upon milestones. There is a single performance obligation as the distinct goods and services promised under the SOW are highly interdependent or interrelated inputs that produce a single combined output given the nature of such arrangements. The output (or work-in-progress of such output) typically has no alternative use to the Company given the customized nature of the arrangement and the Company has enforceable rights given that the non-refundable milestone payments are prepayments in nature; control for NRE development services therefore transfers over time.
83
The Company determined that the most appropriate measure of progress for revenue recognition is the input method based on cost because the Company can reasonably estimate the total costs for the NRE, and the costs incurred reasonably reflects the Company’s efforts to satisfy the performance obligation. The NRE costs include labor, material, overhead as well as the use of outside services. The total estimated NRE costs are based on a combination of historical costs together with quotes from vendors for supplying parts or services towards the completion. Adjustments to cost and profit estimates are made periodically due to changes in scope of work, hours to complete and estimated profitability, including those arising from final contract settlements. These changes may result in revisions to costs and income and are recognized in the period in which the revisions are determined. Any losses expected to be incurred on contracts in progress are charged to operations in the period such losses are determined. If total NRE costs calculated upon completion in the current period are more than the estimated total costs at completion used to calculate revenue in a prior period, then the profits in the current period will be lower than if the estimated costs used in the prior period calculation were equal to the actual total costs upon completion.
Warranties
Sales of hardware products regularly include warranties to end customers that cover bug fixes, minor updates such that the product continues to function according to published specifications in a dynamic environment, and phone support. These standard warranties are assurance type warranties and do not offer any services in addition to the assurance that the product will continue working as specified for one or more years. Therefore, warranties are not considered separate performance obligations in the arrangement. Instead, the expected cost of warranties is accrued as an expense in accordance with authoritative guidance.
Sales incentives
The Company accrues for sales incentives offered to customers as a marketing expense if it receives an identifiable benefit in exchange and can reasonably estimate the fair value of the identifiable benefit received; otherwise, it is recorded as a reduction to revenue. As a consequence, the Company records a substantial portion of its channel marketing costs as a reduction of revenue.
The Company records estimated reductions to revenue for sales incentives when the related revenue is recognized or ahead of customer or end customer commitment if customary business practice creates an implied expectation that such activities will occur in the future.
Shipping and handling costs
The Company includes shipping and handling fees billed to customers in Revenue. Shipping and handling costs associated with inbound freight are included in Cost of revenue. In cases where the Company gives a freight allowance to the customer for their own inbound freight costs, such costs are appropriately recorded as a reduction in Revenue. Shipping and handling costs associated with outbound freight are included in Sales and marketing expenses. The Company has elected to account for shipping and handling activities related to contracts with customers as costs to fulfill the promise to transfer the associated products. Shipping and handling costs associated with outbound freight totaled $2.9 million, $2.7 million and $2.3 million for the years ended December 31, 2021, 2020 and 2019, respectively.
Contract costs
The Company recognizes the incremental costs of obtaining contracts as an expense when incurred if the amortization period of the assets that otherwise would have been recognized is one year or less. These costs are included in sales and marketing and general and administrative expenses. If the incremental costs of obtaining a contract, which consist of sales commissions, relate to a service recognized over a period longer than one year, costs are deferred and amortized in line with the related services over the period of benefit. Deferred commissions are classified as non-current based on the original amortization period of over one year. There were no deferred commissions as of December 31, 2021 and 2020.
84
Contract balances
The Company records accounts receivable when it has an unconditional right to consideration. Contract liabilities are recorded when cash payments are received or due in advance of performance. Contract liabilities consist of advance payments and deferred revenue, where the Company has unsatisfied performance obligations. Contract liabilities are classified as Deferred revenue on the consolidated balance sheets. Payment terms vary by customer. The time between invoicing and when payment is due is not significant. For certain products or services and customer types, payment is required before the products or services are delivered to the customer. Refer to Note 3, Deferred Revenue for detailed disclosures regarding changes in contract balances for the years ended December 31, 2021 and 2020.
Research and development
Costs incurred in the research and development of new products are expensed as incurred.
Advertising costs
Advertising costs are expensed as incurred. Total advertising and promotional expenses were $9.6 million, $12.7 million and $12.3 million for the years ended December 31, 2021, 2020 and 2019, respectively.
Stock-based compensation
The Company’s employees have historically participated in NETGEAR’s stock-based compensation plans. The Company’s consolidated statements of operations reflect compensation expense for the stock-based plans associated with the portion of NETGEAR’s plans in which Arlo employees participated. Equity awards granted by the Company under its own stock-based compensation plans are comprised of stock options, restricted stock units ("RSUs"), performance RSUs ("PSUs"), and market-based performance RSUs ("MPSUs"). The Company measures stock-based compensation costs at the grant date based on the fair value of the award. The fair value of stock options is estimated on the grant date using the Black-Scholes option pricing model. The fair value of RSUs and PSUs is measured on the grant date based on the closing fair market value of the Company’s common stock. The Company utilizes a Monte Carlo pricing model customized to the specific provisions of the 2018 Plan to value the MPSUs awards on the grant date. The fair value determined using the Monte Carlo simulation model varies based on the assumptions used for the expected stock price volatility, the correlation coefficient between the Company and Russell 2000 Index, risk-free interest rates, and dividend yield. The Company recognizes this compensation expense generally on a straight-line basis over the requisite service period, usually the vesting period, which is generally four years for stock options and to four years for RSUs. For PSUs, stock-based compensation expense associated with individual performance milestones is recognized over the expected performance achievement period when the achievement becomes probable. For MPSUs, stock-based compensation expense is recognized ratably over the performance period subject to achievement of market conditions. The Company records forfeitures as they occur.
The Company's 2018 Employee Stock Purchase Plan (“ESPP”) is intended to provide employees with the opportunity to purchase the Company's common stock through accumulated payroll deductions at the end of specified purchase period. Eligible employees may contribute up to 15% of compensation, subject to certain income limits, to purchase shares of the Company's common stock. The terms of the plan include a look-back feature that enables employees to purchase stock semi-annually at a price equal to 85% of the lesser of the fair market value at the beginning of the offering period or the purchase date. The duration of each purchasing period is generally six months. The Company determines the fair value using the Black-Scholes Model using various inputs, including its estimate of expected volatility, term, dividend yield and risk-free interest rate. The Company recognizes compensation costs for the ESPP on a straight-line basis over the requisite service period of the award.
85
Leases
Effective January 1, 2019, the Company adopted Accounting Standards Update ("ASU") No. 2016-02, Leases (Topic 842) utilizing the modified retrospective transition method through a cumulative-effect adjustment at the beginning of the first fiscal quarter of 2019.
The Company determines if an arrangement is a lease at inception. Under the new standard, operating leases are included in operating lease right-of-use (“ROU”) assets, accrued liabilities, and non-current operating lease liabilities in the consolidated balance sheets. Leases with an initial term of 12 months or less are not recorded on the balance sheet. Lease expense for fixed lease payments are recognized in the consolidated statements of operations on a straight-line basis over the lease term and variable lease payments in the period in which the obligation for those payments is incurred.
ROU assets represent the Company’s right to use an underlying asset over the lease term and lease liabilities represent its obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the leases do not provide an implicit rate, the incremental borrowing rate based on the information available is used at commencement date in determining the present value of lease payments. The Company uses the implicit rate when readily determinable. The operating lease ROU asset also includes any lease payments made before the lease commencement date less any lease incentives received. The lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise the options. The lease agreements with lease and non-lease components are generally accounted as a single component.
In addition, certain operating lease agreements contain tenant improvement allowances ("TIA") from the landlords. The Company records lessee-owned improvements as leasehold improvements within Property and equipment, net on its consolidated balance sheets and the TIA as a reduction to the ROU asset with the impact of the decrease recognized prospectively over the remaining lease term. The Company records lessor-owned improvements as a prepaid rent within Prepaid expenses and other current assets on its consolidated balance sheets and the TIA as a reduction to prepaid rent.
Sublease revenue from the Company's sublet office space in San Jose, California is recognized on a straight-line basis over the term of the sublease and is recorded as a reduction of rental expense.
Net loss per share
Basic net loss per share is computed by dividing the net loss for the period by the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of shares of common stock and potentially dilutive common stock outstanding during the period. Potentially dilutive common shares include common shares issuable upon exercise of stock options, vesting of restricted stock awards and performance shares, and issuances of shares under the ESPP, which are reflected in diluted net loss per share by application of the treasury stock method. Potentially dilutive common shares are excluded from the computation of diluted net loss per share when their effect is anti-dilutive.
Segment Information
The Company operates as one operating and reportable segment. The Company has identified its CEO as the Chief Operating Decision Maker (“CODM”). The CODM reviews financial information presented on a consolidated basis for purposes of allocating resources and evaluating financial performance.
86
Comprehensive income (loss)
Comprehensive income consists of net income (loss) and other gains and losses affecting stockholders’ equity that the Company excluded from net income (loss), including unrealized gains and losses related to fair value of short-term investments and the effective portion of cash flow hedges that were outstanding at the end of the year.
Foreign currency translation and re-measurement
The Company’s functional currency is the U.S. dollar. Foreign currency transactions of international subsidiaries are re-measured into U.S. dollars at the end-of-period exchange rates for monetary assets and liabilities, and at historical exchange rates for non-monetary assets and liabilities. Revenue is re-measured at average exchange rates in effect during each period. Expenses are re-measured at average exchange rates in effect during each period, except for expenses related to non-monetary assets and liabilities, which are re-measured at historical exchange rates. Gains and losses arising from foreign currency transactions are included in Other income (expense), net on the consolidated statements of operations.
Income taxes
The Company records its provision for income taxes in its consolidated financial statements using the asset and liability method. Under this method, the Company recognizes income tax liabilities or receivable for the current year. The Company also recognizes deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities, as well as for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using the tax rates that are expected to apply to taxable income for the years in which those tax assets and liabilities are expected to be realized or settled. The Company records a valuation allowance to reduce its deferred tax assets to the net amount that it believes is more likely than not to be realized. The Company's assessment considers the recognition of deferred tax assets on a jurisdictional basis. Accordingly, in assessing the Company's future taxable income on a jurisdictional basis, the Company considers the effect of its transfer pricing policies on that income. The Company has placed a valuation allowance against U.S. federal and state deferred tax assets and certain foreign tax attribute carryforwards since it does not anticipate to realize the benefits of deferred tax assets.
The Company recognizes tax benefits from uncertain tax positions only if it believes that it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. As the Company expands internationally, it will face increased complexity in determining the appropriate tax jurisdictions for revenue and expense items. The Company's policy is to adjust these unrecognized tax benefits in the period when facts and circumstances change, such as the closing of a tax audit, the expiration of statute of limitation for a relevant taxing authority to examine a tax position, or when additional information becomes available. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made and could have a material impact on the Company's financial condition and operating results. The provision for income taxes includes the effects of any accruals that the Company believes are appropriate, as well as the related interest and penalties.
The Tax Act introduced the GILTI provisions effective in 2018, which generally impose a tax on the net income earned by foreign subsidiaries of a U.S company in excess of a deemed return on their tangible assets. The Company recognizes the tax on GILTI as a period cost when the tax is incurred.
87
Certain risks and uncertainties
The Company’s products are concentrated in the connected lifestyle solution industries, which are characterized by rapid technological advances, changes in customer requirements and evolving regulatory requirements and industry standards. The success of the Company depends on management’s ability to anticipate and/or to respond quickly and adequately to such changes. Any significant delays in the development or introduction of products and services could materially adversely affect the Company’s business, results of operations and financial condition.
The Company relies on a limited number of third parties to manufacture all of its products. If any of the Company’s third-party manufacturers cannot or will not manufacture its products in required volumes, on a cost-effective basis, in a timely manner or at all, the Company will have to secure additional manufacturing capacity. Any interruption or delay in manufacturing could materially adversely affect the Company’s business, results of operations and financial condition.
Recent accounting pronouncements
Emerging Growth Company Status
As an emerging growth company (“EGC”), the Jumpstart Our Business Startups Act (“JOBS Act”) allows the Company to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are made applicable to private companies, unless the Company otherwise irrevocably elects not to avail itself of this exemption. The Company did not make such an irrevocable election and has not delayed the adoption of any applicable accounting standards.
Accounting Pronouncements Recently Adopted
There were no accounting pronouncements adopted during the year ended December 31, 2021.
Accounting Pronouncements Not Yet Effective
In March 2020, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2020-04, Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The ASU is intended to provide temporary optional expedients and exceptions to the U.S. GAAP guidance on contract modifications and hedge accounting to ease the financial reporting burdens related to the expected market transition from the London Interbank Offered Rate ("LIBOR") and other interbank offered rates to alternative reference rates. This guidance is effective beginning on March 12, 2020, and the Company may elect to apply the amendments prospectively through December 31, 2022. The Company is currently evaluating the impact this guidance may have on its financial statements and related disclosures.
With the exception of the new standard discussed above, there have been no other new accounting pronouncements that have significance, or potential significance, to the Company’s financial position, results of operations, or cash flows.
Note 3. Deferred Revenue
Deferred revenue consists of advance payments and deferred revenue, where the Company has unsatisfied performance obligations. Deferred revenue consists of prepaid services and customer billings in advance of revenues being recognized from the Company's subscription contracts. Advance payments include prepayments for products and NRE services under the Supply Agreement with Verisure. Refer to Note 4, Disposal of Business for a complete discussion of the Verisure transaction.
88
Transaction Price Allocated to the Remaining Performance Obligations
Remaining performance obligations represent the transaction price allocated to performance obligations that are unsatisfied or partially unsatisfied as of the end of the reporting period. Unsatisfied and partially unsatisfied performance obligations consist of contract liabilities, in-transit orders with destination terms, and non-cancellable backlog. Non-cancellable backlog includes goods and services for which customer purchase orders have been accepted and that are scheduled or in the process of being scheduled for shipment.
The following table includes estimated revenue expected to be recognized in the future related to performance obligations that are unsatisfied (or partially unsatisfied) as of December 31, 2021:
| 1 year | 2 years | Greater than 2 years | Total | |||||||||||||||||||||||
| (In thousands) | ||||||||||||||||||||||||||
| Performance obligations | $ | 36,028 | $ | 1,165 | $ | 191 | $ | 37,384 | ||||||||||||||||||
The performance obligation greater than one year pertains to revenue deferral from prepaid services.
Contract Balances
The following table reflects the changes in contract balances for the year ended December 31, 2021 and 2020:
| 2021 | 2021 | ||||||||||||||||||||||||||||
| Balance Sheet Location | December 31, 2021 | December 31, 2020 | $ change | % change | |||||||||||||||||||||||||
| (In thousands) | |||||||||||||||||||||||||||||
| Accounts receivable, net | Accounts receivable, net | $ | 79,564 | $ | 77,643 | $ | 1,921 | 2.5 | % | ||||||||||||||||||||
| Contract liabilities - current | Deferred revenue | $ | 29,442 | $ | 53,142 | $ | (23,700) | (44.6) | % | ||||||||||||||||||||
| Contract liabilities - non-current | Non-current deferred revenue | $ | 1,344 | $ | 16,563 | $ | (15,219) | (91.9) | % | ||||||||||||||||||||
For the year ended December 31, 2021, compared to the previous year, Accounts receivable, net increased, primarily driven by an increase in revenue in the fourth quarter of 2021, current portion of deferred revenue decreased, primarily due to utilization of Verisure prepayment for product purchases and Verisure NRE installment payments and recognition of prepaid service revenue; and Non-current deferred revenue decreased due to recognition of prepaid service revenue and utilization of Verisure prepayment for product purchases.
For the years ended December 31, 2021 and 2020, $88.7 million and $90.9 million of revenue was deferred due to unsatisfied performance obligations, primarily relating to over time service revenue and Verisure prepayments for product purchases, and $96.5 million and $67.3 million of revenue was recognized for the satisfaction of performance obligations over time, respectively. $22.9 million and $26.2 million of this recognized revenue was included in the contract liability balance at the beginning of the period. There were no significant changes in estimates during the period that would affect the contract balances.
Disaggregation of Revenue
The Company conducts business across three geographic regions: Americas, EMEA, and APAC. Sales and usage-based taxes are excluded from revenue. Refer to Note 14, Segment and Geographic Information for revenue by geography.
89
Note 4. Disposal of Business
On November 4, 2019, the Company and Verisure concurrently entered into an Asset Purchase Agreement (the “Purchase Agreement”) and Supply Agreement (the “Supply Agreement” and together with the Purchase Agreement, the “Verisure Agreements”). The Verisure Agreements created a strategic partnership that leverages both the Company and Verisure’s capabilities to create incremental scale to address the ever-growing demand for residential and commercial security. The strategic partnership will combine the Company’s innovative connected cameras and cloud services platform with Verisure’s professionally monitored security solutions to provide a new level of smart security for European customers. The Purchase Agreement provided that, upon the terms and subject to the conditions set forth in the Purchase Agreement, the Company transferred, sold and assigned to Verisure certain assets (the "Assets") related to the Company’s commercial operations in Europe (the "Business") to Verisure for $50.0 million in cash plus additional cash for certain inventory. The Purchase Agreement contains customary representations and warranties regarding Verisure, the Business and the Assets, indemnification provisions, termination rights and other customary provisions. The Company has agreed not to engage in any business that competes with the Business for a period of three years.
The transaction closed on December 30, 2019 pursuant to which the Company received $52.7 million including working capital adjustments, which resulted in a pretax gain of $54.9 million in the fourth fiscal quarter of 2019. In the first fiscal quarter of 2020, the Company recorded an additional gain of $292 thousand that was recorded in Gain on sale of business in the Company's unaudited condensed consolidated statements of operations as a result of the final working capital adjustment. As part of the transaction, certain employees were transferred to Verisure. These employees hold Company RSU awards, and the terms of the RSU awards were modified such that the RSU awards will continue to vest and settle after closing of the transaction in accordance with the original terms and conditions of RSU awards. Refer to Note12, Employee Benefit Plans for further detail relating to this modification.
The assets and liabilities sold and assigned to Verisure were determined to have met the criteria to be classified as held for sale as of November 4, 2019, the execution date of the Purchase Agreement. The transaction contemplated by the Purchase Agreement did not meet the criteria for discontinued operations as the Company is expected to have continued involvement in Europe through manufacturing and shipping of products to the region through sales to Verisure as part of the Supply Agreement and therefore no significant change in revenue from the region is expected; it was determined the transaction did not represent a strategic shift. The Company also assessed whether a loss is needed to be recorded upon initial classification of the assets and liabilities as held for sale to adjust its carrying amount to the fair value less cost to sell. As the carrying amount of the assets and liabilities was lower than fair value less cost to sell, no adjustment was necessary. As of the closing date of December 30, 2019, the Company concluded that no impairment exists for the assets and no adjustment was necessary for the liabilities. Further, the Company reassessed the fair value and cost to sell, and noted that they did not change since the initial classification of the assets and liabilities as held for sale. Given such, no loss adjustment was necessary.
Pursuant to the terms and subject to the conditions set forth in the Supply Agreement, Verisure is the exclusive distributor of Company products in Europe for all channels, and will non-exclusively distribute the Company's products through its direct channels globally for an initial terms of five years. During the five-year period commencing January 1, 2020, Verisure has an aggregate product purchase commitment of $500.0 million. As of December 31, 2021, $160.1 million of the product purchase commitment has been fulfilled. In 2019 and 2020, Verisure prepaid the Company $20.0 million for product purchases in fiscal 2020 and $40.0 million for product purchases in fiscal 2021 and fiscal 2022, respectively.
The Supply Agreement also provides certain NRE service to Verisure, including developing certain custom products specified by Verisure in exchange for an aggregate of $10.0 million, payable in installments upon meeting certain development milestones. In the second fiscal quarter of 2020, an additional $3.5 million was added to the contract price as a result of a modification to Verisure's specification for an Outdoor Custom Camera being developed under the Verisure Agreements. As of December 31, 2021, Verisure has paid $13.5 million for this NRE service. For the years ended December 31, 2021 and 2020, the Company has recognized service revenue of $5.9 million and $7.9 million, respectively, for this NRE service.
90
As part of the Purchase Agreement, the Company also entered into a Transition Services Agreement with Verisure (“Verisure TSA”) to assist Verisure with the transition of the Company’s European commercial operations. These transition services primarily include IT support and other services, including sales and marketing, operations and supply chain, finance, legal, and human resources. As compensation for these transition services, the Company will be reimbursed by Verisure based on actual direct costs plus allocation of overhead. For the years ended December 31, 2021 and 2020, the Company charged Verisure $2.8 million and $4.0 million, respectively, for Verisure TSA services which was recorded as Other income, given such services are not related to the primary business in which the Company operates. The related Verisure TSA expenses in the same amount were recognized as incurred and reported under their natural expense classification.
Note 5. Balance Sheet Components
Available-for-sale short-term investments
| As of December 31, 2021 | As of December 31, 2020 | ||||||||||||||||||||||||||||||||||||||||||||||
| Cost | Unrealized Gains | Unrealized Losses | Estimated Fair Value | Cost | Unrealized Gains | Unrealized Losses | Estimated Fair Value | ||||||||||||||||||||||||||||||||||||||||
| (In thousands) | |||||||||||||||||||||||||||||||||||||||||||||||
| U.S. Treasuries | $ | — | $ | — | $ | — | $ | — | $ | 19,996 | $ | 1 | $ | — | $ | 19,997 | |||||||||||||||||||||||||||||||
The Company’s short-term investments are classified as available-for-sale and consist of government securities with an original maturity or remaining maturity at the time of purchase of greater than three months and no more than twelve months. Accordingly, none of the available-for-sale securities have unrealized losses greater than twelve months. The Company did not recognize any other-than-temporary impairment losses related to available-for-sale short-term investments for the year ended December 31, 2019. During the years ended December 31, 2021 and 2020, the Company did not recognize any allowance for credit losses related to available-for-sale short-term investments.
Accounts receivable, net
| As of December 31, | |||||||||||
| 2021 | 2020 | ||||||||||
| (In thousands) | |||||||||||
| Gross accounts receivable | $ | 79,901 | $ | 78,162 | |||||||
| Allowance for credit losses | (337) | (519) | |||||||||
| Total accounts receivable, net | $ | 79,564 | $ | 77,643 | |||||||
The following table provides a roll-forward of the allowance for credit losses that is deducted from the amortized cost basis of accounts receivable to present the net amount expected to be collected.
| Years Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In thousands) | |||||||||||||||||
| Balance at the beginning of the period | $ | 519 | $ | 609 | $ | 127 | |||||||||||
| Adoption of ASU 2016-13, cumulative-effect adjustment to retained earnings | — | — | — | ||||||||||||||
| Provision for (release of) expected credit losses | (182) | 186 | 482 | ||||||||||||||
| Amount recovered due to collection | — | (276) | — | ||||||||||||||
| Balance at the end of the period | $ | 337 | $ | 519 | $ | 609 | |||||||||||
91
Property and equipment, net
| As of December 31, | |||||||||||
| 2021 | 2020 | ||||||||||
| (In thousands) | |||||||||||
| Machinery and equipment | $ | 13,302 | $ | 14,397 | |||||||
| Software | 13,928 | 13,192 | |||||||||
| Computer equipment | 4,062 | 4,083 | |||||||||
| Leasehold improvements | 4,922 | 8,023 | |||||||||
| Furniture and fixtures | 2,404 | 4,048 | |||||||||
| Total property and equipment, gross | 38,618 | 43,743 | |||||||||
| Accumulated depreciation | (29,023) | (27,922) | |||||||||
Total property and equipment, net (1) | $ | 9,595 | $ | 15,821 | |||||||
_________________________
(1) $2.4 million property and equipment, net was included in the sublease arrangement for the San Jose office building as of December 31, 2021. No property and equipment, net was included in the sublease arrangement for the San Jose office building as of December 31, 2020 as the sublease agreement became effective in the third quarter of 2021.
Depreciation expense pertaining to property and equipment was $5.9 million, $8.8 million and $9.2 million for the years ended December 31, 2021, 2020 and 2019, respectively.
Long-lived Assets and Right-of-use Assets Impairment
During the second quarter of 2021, the Company evaluated its real estate lease portfolio in light of the COVID-19 pandemic and the changing nature of office space use by its workforce. This evaluation included the decision to sublease its office space in San Jose, California. This change in the use of the San Jose office space led management to test the recoverability of the carrying amount of the asset group related to the sublease. On May 25, 2021, the carrying amount of the asset group exceeded the Company's anticipated undiscounted value of the sublease income over the sublease term. Accordingly, the Company reviewed certain of its right-of-use assets and other lease related assets including leasehold improvements, furniture, fixtures and equipment under the sublease asset group for impairment in accordance with Accounting Standards Codification ("ASC") 360 "Property, Plant, and Equipment".
As a result of the evaluation, the Company recorded an impairment charge of $9.1 million, which included $6.8 million associated with the right-of-use assets and $2.3 million associated with other lease related property and equipment, in the second quarter of 2021. The assets found to be impaired were written down to their fair value calculated using a discounted cash flow method (income approach). The fair value of the asset group was determined by utilizing projected cash flows from the sublease, discounted by a risk-adjusted discount rate that reflects the level of risk associated with receiving future cash flows. The inputs utilized in the analyses were classified as Level 3 inputs within the fair value hierarchy as defined in ASC 820, "Fair Value Measurement". Refer to Note 6, Fair Value Measurements, for additional information about the fair value measured on a non-recurring basis and Note 11, Commitments and Contingencies, for further information about the sublease.
Goodwill
There was no change in the carrying amount of goodwill during the year ended December 31, 2021, and the goodwill as of December 31, 2021 and December 31, 2020 was $11.0 million.
Goodwill Impairment
On the first day of the fourth quarter of 2021, the Company performed an annual assessment of goodwill at the reporting unit level. The Company operates as one operating and reportable segment. A qualitative assessment was performed
92
in consideration of macroeconomic conditions, industry and market conditions, cost factors, overall company financial performance, and changes in the Company's stock price. The Company did not believe it is more likely than not that the fair value of the reporting unit is less than its carrying amount and therefore performing the next step of impairment test was unnecessary. No goodwill impairment was recognized in the years ended December 31, 2021, 2020 and 2019. If there are events occurred or circumstances changed (i.e. a decline in the Company’s stock price based on market conditions and deterioration of the Company’s business) that would more likely than not reduce the fair value of the Company below its carrying amount, the Company may have to record a charge to its earnings for the associated goodwill impairment of up to $11.0 million.
Other non-current assets
| As of December 31, | |||||||||||
| 2021 | 2020 | ||||||||||
| (In thousands) | |||||||||||
| Net deferred taxes assets | $ | 1,565 | $ | 1,269 | |||||||
| Sublease initial direct cost | 1,471 | — | |||||||||
| Deposits | 122 | 122 | |||||||||
| Other | 1,156 | 1,008 | |||||||||
| Total other non-current assets | $ | 4,314 | $ | 2,399 | |||||||
Accrued liabilities
| As of December 31, | |||||||||||
| 2021 | 2020 | ||||||||||
| (In thousands) | |||||||||||
| Sales and marketing | $ | 31,417 | $ | 38,577 | |||||||
Sales returns | 19,960 | 37,689 | |||||||||
| Accrued employee compensation | 12,367 | 15,089 | |||||||||
| 4,609 | 4,400 | ||||||||||
| Freight | 8,086 | 3,558 | |||||||||
| Warranty obligation | 1,330 | 2,451 | |||||||||
| Other | 19,608 | 20,002 | |||||||||
| Total accrued liabilities | $ | 97,377 | $ | 121,766 | |||||||
93
Note 6. Fair Value Measurements
Fair Value Measurements - Recurring Basis
The following tables summarize assets and liabilities measured at fair value on a recurring basis as of December 31, 2021 and 2020:
| As of December 31, 2021 | |||||||||||||||||
| Total | Quoted market prices in active markets (Level 1) | Significant other observable inputs (Level 2) | |||||||||||||||
| (In thousands) | |||||||||||||||||
| Assets: | |||||||||||||||||
Cash equivalents: money-market funds (<90 days) | $ | 21,935 | $ | 21,935 | $ | — | |||||||||||
Available-for-sale securities: U.S. Treasuries (1) | — | — | — | ||||||||||||||
Foreign currency forward contracts (2) | 65 | — | 65 | ||||||||||||||
| Total assets measured at fair value | $ | 22,000 | $ | 21,935 | $ | 65 | |||||||||||
| Liabilities: | |||||||||||||||||
Foreign currency forward contracts (3) | $ | 47 | $ | — | $ | 47 | |||||||||||
| Total liabilities measured at fair value | $ | 47 | $ | — | $ | 47 | |||||||||||
| December 31, 2020 | |||||||||||||||||
| Total | Quoted market prices in active markets (Level 1) | Significant other observable inputs (Level 2) | |||||||||||||||
| (In thousands) | |||||||||||||||||
| Assets: | |||||||||||||||||
Cash equivalents: U.S. Treasuries (<90 days) | $ | 1,934 | $ | 1,934 | $ | — | |||||||||||
Available-for-sale securities: U.S. Treasuries (1) | 19,997 | 19,997 | — | ||||||||||||||
Foreign currency forward contracts (2) | 24 | — | 24 | ||||||||||||||
| Total assets measured at fair value | $ | 21,955 | $ | 21,931 | $ | 24 | |||||||||||
| Liabilities: | |||||||||||||||||
Foreign currency forward contracts (3) | $ | 199 | $ | — | $ | 199 | |||||||||||
| Total liabilities measured at fair value | $ | 199 | $ | — | $ | 199 | |||||||||||
_________________________
(1)Included in Short-term investments on the Company’s consolidated balance sheets.
(2)Included in Prepaid expenses and other current assets on the Company’s consolidated balance sheets.
(3)Included in Accrued liabilities on the Company’s consolidated balance sheets.
The Company’s investments in cash equivalents and available-for-sale securities are classified within Level 1 of the fair value hierarchy because they are valued based on quoted market prices in active markets. The Company enters into foreign currency forward contracts with only those counterparties that have long-term credit ratings of A-/A3 or higher. The Company’s foreign currency forward contracts are classified within Level 2 of the fair value hierarchy as they are valued using pricing models that take into account the contract terms as well as currency rates and counterparty credit rates. The Company verifies the reasonableness of these pricing models using observable market data for related inputs into such models. Additionally, the Company includes an adjustment for non-performance risk in the recognized measure of fair value of derivative instruments. As of December 31, 2021 and 2020 the adjustment for non-performance risk did not have a
94
material impact on the fair value of the Company’s foreign currency forward contracts. The carrying value of non-financial assets and liabilities measured at fair value in the financial statements on a recurring basis, including accounts receivable and accounts payable, approximate fair value due to their short maturities. As of December 31, 2021 and 2020, the Company has no Level 3 fair value assets or liabilities measured on a recurring basis.
Fair Value Measurements - Nonrecurring Basis
The Company measures the fair value of certain assets on a nonrecurring basis when events or changes in circumstances indicate that the carrying amount the asset may not be recoverable. In the second quarter of 2021, in connection with the long-lived assets and right-of-use assets impairment analysis, certain lease related property and equipment assets and right-of-use asset were measured and written down to fair value on a nonrecurring basis as a result of impairment. The fair value measurements were determined using a discounted cash flow method with unobservable inputs and were classified within Level 3 of the fair value hierarchy. The fair value of the asset group was calculated by utilizing projected cash flows from the sublease, discounted by a market derived discount rate of 8.0%. As of May 25, 2021, the date of measurement, the fair value of the right-of-use asset and other lease related property and equipment were $8.1 million and $2.8 million, respectively. The Company recorded an impairment charge of $9.1 million on the assets measured at fair value on a non-recurring basis, which includes $6.8 million associated with the right-of-use assets and $2.3 million associated with other lease related property and equipment assets, in the second quarter of 2021. Refer to Note 5, Balance Sheet Components, for further information about the impairment of the right-of-use assets and long-lived assets.
Note 7. Derivative Financial Instruments
Fair value of derivative instruments
The fair values of the Company’s derivative instruments and the line items on the consolidated balance sheets to which they were recorded as of December 31, 2021 and 2020 are summarized as follows:
| December 31, | December 31, | |||||||||||||||||||||||||||||||||||||
| Derivative Assets | Balance Sheet Location | 2021 | 2020 | Balance Sheet Location | 2021 | 2020 | ||||||||||||||||||||||||||||||||
| (In thousands) | (In thousands) | |||||||||||||||||||||||||||||||||||||
| Derivative assets not designated as hedging instruments | Prepaid expenses and other current assets | $ | 65 | $ | 22 | Other accrued liabilities | $ | 47 | $ | 199 | ||||||||||||||||||||||||||||
| Derivative assets designated as hedging instruments | Prepaid expenses and other current assets | — | 2 | Other accrued liabilities | — | — | ||||||||||||||||||||||||||||||||
| Total | $ | 65 | $ | 24 | $ | 47 | $ | 199 | ||||||||||||||||||||||||||||||
Refer to Note 6, Fair Value Measurements for detailed disclosures regarding fair value measurements in accordance with the authoritative guidance for fair value measurements and disclosures.
Gross amounts offsetting of derivative instruments
The Company has entered into master netting arrangements which allow net settlements under certain conditions. Although netting is permitted, it is currently the Company’s policy and practice to record all derivative assets and liabilities on a gross basis in the consolidated balance sheets.
The following tables set forth the offsetting of derivative assets and liabilities as of December 31, 2021 and 2020:
95
| As of December 31, 2021 | Gross Amounts Not Offset in the Consolidated Balance Sheets | |||||||||||||||||||||||||||||||||||||
| Gross Amounts of Recognized Assets | Gross Amounts Offset in the Consolidated Balance Sheets | Net Amounts of Assets Presented in the Consolidated Balance Sheets | Financial Instruments | Cash Collateral Pledged | Net Amount | |||||||||||||||||||||||||||||||||
| (In thousands) | ||||||||||||||||||||||||||||||||||||||
| Wells Fargo Bank | $ | 65 | $ | — | $ | 65 | $ | (47) | $ | — | $ | 18 | ||||||||||||||||||||||||||
| As of December 31, 2021 | Gross Amounts Not Offset in the Consolidated Balance Sheets | |||||||||||||||||||||||||||||||||||||
| Gross Amounts of Recognized Liabilities | Gross Amounts Offset in the Consolidated Balance Sheets | Net Amounts of Liabilities Presented in the Consolidated Balance Sheets | Financial Instruments | Cash Collateral Pledged | Net Amount | |||||||||||||||||||||||||||||||||
| (In thousands) | ||||||||||||||||||||||||||||||||||||||
| Wells Fargo Bank | $ | 47 | $ | — | $ | 47 | $ | (47) | $ | — | $ | — | ||||||||||||||||||||||||||
| As of December 31, 2020 | Gross Amounts Not Offset in the Consolidated Balance Sheets | |||||||||||||||||||||||||||||||||||||
| Gross Amounts of Recognized Assets | Gross Amounts Offset in the Consolidated Balance Sheets | Net Amounts of Assets Presented in the Consolidated Balance Sheets | Financial Instruments | Cash Collateral Pledged | Net Amount | |||||||||||||||||||||||||||||||||
| (In thousands) | ||||||||||||||||||||||||||||||||||||||
| Wells Fargo Bank | $ | 24 | $ | — | $ | 24 | $ | (24) | $ | — | $ | — | ||||||||||||||||||||||||||
| As of December 31, 2020 | Gross Amounts Not Offset in the Consolidated Balance Sheets | |||||||||||||||||||||||||||||||||||||
| Gross Amounts of Recognized Liabilities | Gross Amounts Offset in the Consolidated Balance Sheets | Net Amounts of Assets Presented in the Consolidated Balance Sheets | Financial Instruments | Cash Collateral Pledged | Net Amount | |||||||||||||||||||||||||||||||||
| (In thousands) | ||||||||||||||||||||||||||||||||||||||
| Wells Fargo Bank | $ | 199 | $ | — | $ | 199 | $ | (24) | $ | — | $ | 175 | ||||||||||||||||||||||||||
96
Cash flow hedges
The Company typically hedges portions of its anticipated foreign currency exposure which generally are less than six months. The Company entered into two forward contracts related to its cash flow hedging program for the year ended December 31, 2021 with an average size of $2.2 million equivalent related to its cash flow hedging program.
The effects of the Company’s cash flow hedges on the consolidated statements of operations for the years ended December 31, 2021, 2020 and 2019 are summarized as follows:
| Location and Amount of Gains (Losses) Recognized in Income on Cash Flow Hedges | ||||||||||||||||||||||||||||||||
| Year Ended December 31, 2021 | Revenue | Cost of revenue | Research and development | Sales and marketing | General and administrative | |||||||||||||||||||||||||||
| (In thousands) | ||||||||||||||||||||||||||||||||
| Statements of operations | $ | 435,137 | $ | 327,102 | $ | 59,063 | $ | 48,909 | $ | 49,489 | ||||||||||||||||||||||
| Gains (losses) on cash flow hedge | $ | 134 | $ | (1) | $ | — | $ | (8) | $ | (1) | ||||||||||||||||||||||
| Location and Amount of Gains (Losses) Recognized in Income on Cash Flow Hedges | ||||||||||||||||||||||||||||||||
| Year Ended December 31, 2020 | Revenue | Cost of revenue | Research and development | Sales and marketing | General and administrative | |||||||||||||||||||||||||||
| (In thousands) | ||||||||||||||||||||||||||||||||
| Statements of operations | $ | 357,154 | $ | 301,765 | $ | 60,137 | $ | 49,064 | $ | 51,096 | ||||||||||||||||||||||
| Gains (losses) on cash flow hedge | $ | (32) | $ | — | $ | 5 | $ | 4 | $ | — | ||||||||||||||||||||||
| Location and Amount of Gains (Losses) Recognized in Income on Cash Flow Hedges | ||||||||||||||||||||||||||||||||
| Year Ended December 31, 2019 | Revenue | Cost of revenue | Research and development | Sales and marketing | General and administrative | |||||||||||||||||||||||||||
| (In thousands) | ||||||||||||||||||||||||||||||||
| Statements of operations | $ | 370,007 | $ | 334,203 | $ | 69,384 | $ | 56,985 | $ | 47,624 | ||||||||||||||||||||||
| Gains (losses) on cash flow hedge | $ | 390 | $ | (3) | $ | (28) | $ | (44) | $ | (13) | ||||||||||||||||||||||
The Company expects to reclassify to earnings all of the amounts recorded in AOCI associated with its cash flow hedges over the next twelve months. For information on the unrealized gains or losses on derivatives reclassified out of AOCI into the consolidated statements of operations, refer to Note 8, Accumulated Other Comprehensive Income (Loss).
Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur within the designated hedge period or if not recognized within 60 days following the end of the hedge period. The Company did not recognize any material net gains or losses related to the loss of hedge designation as there were no discontinued cash flow hedges during the year ended December 31, 2021, 2020 and 2019.
Non-designated hedges
The Company adjusts its non-designated hedges monthly and enters into about six non-designated derivative per quarter with an average size of $2.3 million USD equivalent. The hedges range typically from 1 to 3 months in duration. The effects of the Company’s non-designated hedge included in Other income (expense), net on the consolidated statements of operations for the years ended December 31, 2021, 2020 and 2019 are as follows:
| December 31, | ||||||||||||||||||||||||||
| Derivatives Not Designated as Hedging Instruments | Location of Gains (Losses) Recognized in Income on Derivative | 2021 | 2020 | 2019 | ||||||||||||||||||||||
| (In thousands) | ||||||||||||||||||||||||||
| Foreign currency forward contracts | Other income (expense), net | $ | 116 | $ | (95) | $ | (24) | |||||||||||||||||||
97
Note 8. Accumulated Other Comprehensive Income (Loss)
The following table sets forth the changes in AOCI by component for the years ended December 31, 2021, 2020 and 2019:
| Unrealized gains (losses) on available-for-sale securities | Unrealized gains (losses) on derivatives | Estimated tax benefit (provision) | Total | ||||||||||||||||||||
| (In thousands) | |||||||||||||||||||||||
| Balance as of December 31, 2018 | $ | (2) | $ | 2 | $ | — | $ | — | |||||||||||||||
| Other comprehensive income before reclassifications | 25 | 275 | — | 300 | |||||||||||||||||||
| Less: Amount reclassified from accumulated other comprehensive income | — | 302 | — | 302 | |||||||||||||||||||
| Net current period other comprehensive income (loss) | 25 | (27) | — | (2) | |||||||||||||||||||
| Balance as of December 31, 2019 | 23 | (25) | — | (2) | |||||||||||||||||||
| Other comprehensive income (loss) before reclassifications | (22) | 4 | — | (18) | |||||||||||||||||||
| Less: Amount reclassified from accumulated other comprehensive loss | — | (23) | — | (23) | |||||||||||||||||||
| Net current period other comprehensive income (loss) | (22) | 27 | — | 5 | |||||||||||||||||||
| Balance as of December 31, 2020 | 1 | 2 | — | 3 | |||||||||||||||||||
| Other comprehensive income (loss) before reclassifications | (1) | 122 | — | 121 | |||||||||||||||||||
| Less: Amount reclassified from accumulated other comprehensive income | — | 124 | — | 124 | |||||||||||||||||||
| Net current period other comprehensive loss | (1) | (2) | — | (3) | |||||||||||||||||||
| Balance as of December 31, 2021 | $ | — | $ | — | $ | — | $ | — | |||||||||||||||
The following tables provide details about significant amounts reclassified out of each component of AOCI for the years ended December 31, 2021, 2020 and 2019:
| Year Ended December 31, 2021 | Year Ended December 31, 2020 | Year Ended December 31, 2019 | ||||||||||||||||||||||||||||||||||||||||||
| Gains (Losses) Recognized in OCI - Effective Portion | Gains (Losses) Reclassified from OCI to Income - Effective Portion | Gains (Losses) Recognized in OCI - Effective Portion | Gains (Losses) Reclassified from OCI to Income - Effective Portion | Gains (Losses) Recognized in OCI - Effective Portion | Gains (Losses) Reclassified from OCI to Income - Effective Portion | Affected Line Item in the Statements of Operations | ||||||||||||||||||||||||||||||||||||||
| (In thousands) | ||||||||||||||||||||||||||||||||||||||||||||
| Gains (losses) on cash flow hedge: | ||||||||||||||||||||||||||||||||||||||||||||
| Foreign currency contracts | $ | 122 | $ | 134 | $ | 4 | $ | (32) | $ | 275 | $ | 390 | Revenue | |||||||||||||||||||||||||||||||
| Foreign currency contracts | — | (1) | — | — | — | (3) | Cost of revenue | |||||||||||||||||||||||||||||||||||||
| Foreign currency contracts | — | — | — | 5 | — | (28) | Research and development | |||||||||||||||||||||||||||||||||||||
| Foreign currency contracts | — | (8) | — | 4 | — | (44) | Sales and marketing | |||||||||||||||||||||||||||||||||||||
| Foreign currency contracts | — | (1) | — | — | — | (13) | General and administrative | |||||||||||||||||||||||||||||||||||||
| $ | 122 | $ | 124 | $ | 4 | $ | (23) | $ | 275 | $ | 302 | Total * | ||||||||||||||||||||||||||||||||
_________________________
* There is no tax impact on all hedging gains and losses from derivative contracts due to the Company’s full valuation allowance of its deferred tax assets.
98
Note 9. Income Taxes
Income (loss) before provision for income taxes consisted of the following:
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In thousands) | |||||||||||||||||
| United States | $ | (59,370) | $ | (104,551) | $ | (103,836) | |||||||||||
| International | 4,018 | 3,925 | 22,265 | ||||||||||||||
| Total | $ | (55,352) | $ | (100,626) | $ | (81,571) | |||||||||||
Provision for income taxes consisted of the following:
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In thousands) | |||||||||||||||||
| Current: | |||||||||||||||||
| U.S. Federal | $ | — | $ | — | $ | — | |||||||||||
| State | 21 | 84 | 58 | ||||||||||||||
| Foreign | 989 | 438 | 4,524 | ||||||||||||||
| 1,010 | 522 | 4,582 | |||||||||||||||
| Deferred: | |||||||||||||||||
| U.S. Federal | — | — | — | ||||||||||||||
| State | — | — | — | ||||||||||||||
| Foreign | (333) | 103 | (202) | ||||||||||||||
| (333) | 103 | (202) | |||||||||||||||
| Total | $ | 677 | $ | 625 | $ | 4,380 | |||||||||||
The effective tax rate differed from the U.S. federal income tax rate as follows:
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| Tax benefit at U.S. federal income tax rate | 21.0 | % | 21.0 | % | 21.0 | % | |||||||||||
| State tax benefit, net of federal benefit | 2.9 | % | 4.4 | % | 3.0 | % | |||||||||||
| Impact of international operations | 1.3 | % | 0.8 | % | 1.4 | % | |||||||||||
| U.S. taxes on foreign entities | (3.9) | % | 2.5 | % | (3.6) | % | |||||||||||
| Stock-based compensation | (3.0) | % | (4.2) | % | (2.6) | % | |||||||||||
| U.S. federal tax credits | 1.6 | % | 1.6 | % | 1.6 | % | |||||||||||
| Change in valuation allowance | (20.3) | % | (26.4) | % | (23.8) | % | |||||||||||
| Non-deductible transaction costs | (0.6) | % | (0.1) | % | (0.7) | % | |||||||||||
| Goodwill derecognition | — | % | — | % | (1.2) | % | |||||||||||
| Other | (0.2) | % | (0.2) | % | (0.5) | % | |||||||||||
| Benefit (provision) for income taxes | (1.2) | % | (0.6) | % | (5.4) | % | |||||||||||
99
The significant components of net deferred tax assets consisted of the following:
| As of December 31, | |||||||||||
| 2021 | 2020 | ||||||||||
| (In thousands) | |||||||||||
| Deferred Tax Assets: | |||||||||||
| Accruals and allowances | $ | 10,369 | $ | 14,389 | |||||||
| Net operating loss carryforwards | 26,236 | 22,216 | |||||||||
| Stock-based compensation | 3,956 | 3,731 | |||||||||
| Lease liabilities | 6,170 | 7,063 | |||||||||
| Deferred revenue | 1,763 | 3,673 | |||||||||
| Tax credit carryforwards | 8,100 | 6,311 | |||||||||
| Depreciation and amortization | 3,989 | 2,810 | |||||||||
| Capitalized research and development expenses | 26,186 | 17,376 | |||||||||
| Total deferred tax assets | 86,769 | 77,569 | |||||||||
| Deferred Tax Liabilities: | |||||||||||
| Right-of-use assets | (3,462) | (5,804) | |||||||||
| Total deferred tax liabilities | (3,462) | (5,804) | |||||||||
| Valuation Allowance | (81,742) | (70,496) | |||||||||
| Net deferred tax assets | $ | 1,565 | $ | 1,269 | |||||||
Changes in valuation allowance for deferred tax assets were as follows:
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In thousands) | |||||||||||||||||
| Balance at the beginning of the period | $ | 70,496 | $ | 43,917 | $ | 24,477 | |||||||||||
Additions (1) | 11,246 | 26,579 | 19,440 | ||||||||||||||
Deductions (2) | — | — | — | ||||||||||||||
| Balance at the end of the period | $ | 81,742 | $ | 70,496 | $ | 43,917 | |||||||||||
________________________
(1) The increases in valuation allowance were primarily due to the increases in tax attribute carryforwards and capitalized expenditures for income tax purposes.
(2) There were no deductions presented because there has not been a reduction in the valuation allowance.
The fiscal 2020 and 2019 additions and deductions to the deferred tax assets roll-forward have been recast to conform with the fiscal 2021 classification, which is based on each tax jurisdiction. Prior to the recast, the additions and deductions in the deferred tax assets roll-forward were based on the positive and negative movements within the individual components of deferred tax assets.
Realization of the Company’s deferred tax assets is dependent upon future earnings, the timing and amount of which are uncertain. The Company does not anticipate to realize the net U.S. federal and state deferred tax assets and certain foreign tax attributes, which have been fully offset by a valuation allowance. As of December 31, 2021 and 2020, the valuation allowance was $81.7 million and $70.5 million, respectively.
The utilization of the Company's net operating loss and credit carryforwards may be subject to annual limitation due to the ownership changes provided by the Internal Revenue Code and similar state provisions. Such an annual limitation could result in the expiration of portions of the net operating loss and tax credit carryforwards before utilization.
100
As of December 31, 2021, net operating loss carryforwards consisted of the following:
| Amount | Beginning Year of Expiration | |||||||||||||
| (in thousands) | ||||||||||||||
U.S. federal (1) | $ | 14,028 | 2031 | |||||||||||
U.S. federal (1)(2) | 95,243 | Indefinite | ||||||||||||
| California | 18,655 | 2040 | ||||||||||||
| Other states | 43,804 | 2024 | ||||||||||||
_________________________
(1)All of the losses are subject to annual usage limitations under Internal Revenue Code Section 382.
(2)All of the losses are subject to usage limitation of 80% of taxable income in a year when the losses will be utilized.
As of December 31, 2021, tax credit carryforwards consisted of the following:
| Amount | Beginning Year of Expiration | |||||||||||||
| (in thousands) | ||||||||||||||
| U.S. federal | $ | 4,698 | 2040 | |||||||||||
| California | 3,848 | Indefinite | ||||||||||||
| Foreign | 1,839 | 2042 | ||||||||||||
As of December 31, 2021, withholding taxes and state income taxes expected to be incurred on the foreign subsidiaries’ earnings that are not indefinitely reinvested are immaterial.
A reconciliation of the beginning and ending amount of gross unrecognized tax benefits was as follows:
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In thousands) | |||||||||||||||||
| Balance at the beginning of the period | $ | 1,355 | $ | 704 | $ | 22 | |||||||||||
| Additions for tax positions taken during the current year | 444 | 503 | 674 | ||||||||||||||
| Additions (reductions) for tax positions taken during a prior year | (58) | 148 | 8 | ||||||||||||||
| Reductions as a result of a lapse of the applicable statute of limitations | (5) | — | — | ||||||||||||||
| Balance at the end of the period | $ | 1,736 | $ | 1,355 | $ | 704 | |||||||||||
The total amount of unrecognized tax benefits, including immaterial interest and penalties, was $1.7 million and $1.4 million as of December 31, 2021 and 2020, respectively. The Company recognizes interest and penalties accrued related to unrecognized tax benefits as part of the provision for income taxes.
The Company files income tax returns in the U.S. and numerous foreign jurisdictions. The Company is subject to income tax examinations by taxing authorities globally for years ending or after December 31, 2018. As a result of the spin-off of Arlo from NETGEAR in 2018, Arlo filed the consolidated U.S. federal and various combined state income tax returns with NETGEAR for the calendar year ended December 31, 2018. The IRS is currently examining NETGEAR’s U.S. federal income tax return for the calendar year of 2018. In addition, the California Franchise Tax Board began an examination of NETGEAR’s 2018 tax year. The Company's estimate of the potential outcome of any uncertain tax positions is subject to management’s assessment of relevant risks, facts, and circumstances existing at that time. The Company believes that the estimate has adequately reflected these matters. However, the Company's future results may include adjustments to estimates
101
in the period the audits will be resolved, which may impact the Company's effective tax rate. The Company does not expect a significant change in unrecognized tax benefits within the next twelve months.
Note 10. Debt
Revolving Credit Facility
On October 27, 2021, the Company entered into a Loan and Security Agreement (the “Credit Agreement”) with Bank of America, N.A., a national banking association, as lender (the “Lender”).
The Credit Agreement provides for a three-year revolving credit facility (the “Credit Facility”) that matures on October 27, 2024. Borrowings under the Credit Facility are limited to the lesser of (x) $40.0 million, and (y) an amount equal to the borrowing base. The borrowing base will be the sum of (i) 90% of investment grade eligible receivables and (ii) 85% of non-investment grade eligible accounts, less applicable reserves established by the Lender. The Credit Agreement also includes a $5.0 million sublimit for the issuance by the Lender of letters of credit. In addition, the Credit Agreement includes an uncommitted accordion feature that allows the Company to from time to time request that the Lender increase the aggregate revolving loan commitments by up to an additional $25.0 million in the aggregate, subject to the satisfaction of certain conditions, including obtaining the Lender’s agreement to participate in each increase. The proceeds of the borrowings under the Credit Facility may be used for working capital and general corporate purposes.
The obligations of the Company under the Credit Agreement are secured by substantially all of the Company’s domestic working capital assets, including accounts receivable, cash and cash equivalents, inventory, and other assets of the Company to the extent related to such working capital assets.
At the Company’s option, borrowings under the Credit Agreement will bear interest at a floating rate equal to: (i) the Bloomberg Short-Term Bank Yield Index rate plus the applicable rate of 2.0% to 2.5% determined based on the Company’s average daily availability for the prior fiscal quarter, or (ii) the base rate plus the applicable rate of 1.0% to 1.5% based on the Company’s average daily availability for the prior fiscal quarter. Among other fees, the Company is required to pay a monthly unused fee of 0.2% per annum on the amount by which the Lender’s aggregate commitment under the Credit Facility exceeds the average daily revolver usage during such month.
The Credit Agreement contains events of default, representations and warranties, and affirmative and negative covenants customary for credit facilities of this type. The Credit Agreement also contains financial covenants that require the Company to (a) until the Company achieves a fixed charge coverage ratio of at least 1.00 to 1.00 for two consecutive quarters, maintain minimum liquidity of not less than $20.0 million at all times and (b) thereafter, maintain a fixed charge coverage ratio, tested quarterly on a trailing twelve month basis, of at least 1.00 to 1.00 at any time a Financial Covenant Trigger Period (as defined in the Credit Agreement) is in effect. As of December 31, 2021, the Company is in compliance with all the covenants of the Credit Agreement.
If an event of default under the Credit Agreement occurs, then the Lender may cease making advances under the Credit Agreement and declare any outstanding obligations under the Credit Agreement to be immediately due and payable. In addition, if the Company files a bankruptcy petition, a bankruptcy petition is filed against the Company and is not dismissed or stayed within thirty days, or the Company makes a general assignment for the benefit of creditors, then any outstanding obligations under the Credit Agreement will automatically and without notice or demand become immediately due and payable.
No amounts had been drawn under the Credit Facility as of December 31, 2021.
On October 27, 2021, concurrent with completing the Credit Agreement with Bank of America, N.A., the credit agreement with Western Alliance Bank, an Arizona corporation, entered into on November 5, 2019, was terminated. There was no amount drawn under this credit agreement at termination.
102
Note 11. Commitments and Contingencies
Operating Leases
The Company primarily leases office space, with various expiration dates through June 2029. Some of the leases include options to extend such leases for up to five years, and some include options to terminate such leases within one year. The terms of certain of the Company’s leases provide for rental payments on a graduated scale. The Company recognizes lease expense on a straight-line basis over the lease term. Gross lease expense was $7.0 million for each of the years ended December 31, 2021, 2020 and 2019, respectively. The lease expense was recorded within Cost of revenue, Research and development, Sales and marketing, and General and administrative on the Company's consolidated statements of operations. Short-term and variable lease costs were included in the lease expense and they were immaterial.
In connection with the leases for the Company's offices in San Jose, California and Richmond, Canada, the Company received tenant improvement allowances ("TIA") of $3.5 million and $450 thousand, respectively, in the second fiscal quarter of 2020 from lessors for certain improvements the Company made to the leased properties. The improvement made to the leased property in San Jose, California is considered as lessee-owned, and the Company recorded the improvement as a leasehold improvement within property and equipment, net and the TIA as a reduction to the ROU asset with the impact of the decrease recognized prospectively over the remaining lease term. The improvement made to the leased property in Richmond, Canada is considered as lessor-owned, and the Company recorded the improvement as a prepaid rent within prepaid expenses and other current assets and the TIA as a reduction to prepaid rent.
Supplemental cash flow information related to operating leases was as follows:
| Year Ended December 31, | ||||||||||||||||||||
| 2021 | 2020 | 2019 | ||||||||||||||||||
| (in thousands) | ||||||||||||||||||||
| Cash paid for amounts included in the measurement of lease liabilities | ||||||||||||||||||||
| Operating cash flows from operating leases | $ | 6,497 | $ | 5,991 | $ | 4,888 | ||||||||||||||
| Right-of-use assets obtained in exchange for lease liabilities | ||||||||||||||||||||
| Operating leases | $ | 1,646 | $ | 461 | $ | 21,742 | ||||||||||||||
| Other non-cash increases in operating right of use assets | $ | — | $ | — | $ | 788 | ||||||||||||||
Weighted average remaining lease term and weighted average discount rate related to operating leases were as follows:
| As of December 31, | ||||||||||||||
| 2021 | 2020 | |||||||||||||
| Weighted average remaining lease term | 6.1 years | 6.9 years | ||||||||||||
| Weighted average discount rate | 5.77 | % | 5.69 | % | ||||||||||
The Company's future minimum undiscounted lease payments under operating leases and future non-cancelable rent payments from its subtenants for each of the next five years and thereafter as of December 31, 2021 were as follows:
103
| Operating Lease Payments | Sublease Payments | Net | |||||||||||||||
| (In thousands) | |||||||||||||||||
| 2022 | $ | 5,977 | $ | (1,673) | $ | 4,304 | |||||||||||
| 2023 | 5,552 | (1,891) | 3,661 | ||||||||||||||
| 2024 | 4,887 | (1,947) | 2,940 | ||||||||||||||
| 2025 | 3,178 | (2,006) | 1,172 | ||||||||||||||
| 2026 | 3,270 | (2,066) | 1,204 | ||||||||||||||
| Thereafter | 8,217 | (5,942) | 2,275 | ||||||||||||||
| Total future lease payments | $ | 31,081 | $ | (15,525) | $ | 15,556 | |||||||||||
Less: interest (1) | (5,002) | ||||||||||||||||
| Present value of future minimum lease payments | $ | 26,079 | |||||||||||||||
| Accrued liabilities | $ | 4,609 | |||||||||||||||
| Non-current operating lease liabilities | 21,470 | ||||||||||||||||
| Total lease liabilities | $ | 26,079 | |||||||||||||||
________________________
(1) Leases that commenced before November 5, 2019 were calculated using the Company’s incremental borrowing rate on a collateralized basis plus LIBOR rate that closely matches contractual term of most leases. Leases that commenced between November 5, 2019 and October 27, 2021 were calculated using the Company's borrowing rate defined in the credit agreement with Western Alliance Bank. Leases that commenced after October 27, 2021 were calculated using the Company's borrowing rate defined in the Credit Agreement with Bank of America, N.A.
During the second quarter of 2021, the Company reviewed certain of its right-of-use assets and other lease related assets in conjunction with the evaluation of its real estate lease portfolio and recorded an impairment charge of $9.1 million, which included $6.8 million associated with the right-of-use asset and $2.3 million associated with other lease related property and equipment in the second quarter of 2021. Subsequent to the impairment, lease expense for the lease payments related to the impaired right-of-use asset is no longer recognized on a straight-line basis. The associated lease liability is amortized using the same effective interest method as before the impairment charge. The impaired right-of-use asset, however, is subsequently amortized on a straight-line basis. Refer to Note 5, Balance Sheet Components for further information about the impairment of the right-of-use asset and long-lived assets.
On June 29, 2021, the sublease agreement dated May 25, 2021 (the "Sublease"), by and between the Company and Vocera Communications, Inc. (“Subtenant”) became effective whereby the Company agreed to sublease to Subtenant all of the approximately 78,000 rentable square feet of office space located at 3030 Orchard Parkway in San Jose, California. The Company’s decision to enter into the Sublease is a continuance of its evaluation of its real estate lease portfolio in light of the COVID-19 pandemic and its impact on the changing nature of office space use by its workforce. The initial term of the Sublease will commence on February 1, 2022, and will expire on June 30, 2029, unless earlier terminated in accordance with the Sublease. The Subtenant will pay to the Company an escalating base rent over the life of the Sublease of approximately $167,000 to $206,000 per month. In addition, the Subtenant will pay its pro rata portion of property expenses and operating expenses for the Subleased Premises. The Company classifies the Sublease as an operating lease. The accounting of the Sublease commenced on October 1, 2021. Sublease income is recognized over the term of the sublease on a straight-line basis. The Company recorded sublease income as reduction of lease expense, in the amount of $0.5 million for the year ended December 31, 2021.
Letters of Credit
In connection with the lease agreement for the Company's office space located in San Jose, California, the Company executed a letter of credit with the landlord as the beneficiary. As of December 31, 2021, the Company had approximately $3.6 million of unused letters of credit outstanding, of which $3.1 million pertains to the lease arrangement in San Jose, California.
104
Purchase Obligations
The Company has entered into various inventory-related purchase agreements with suppliers. Generally, under these agreements, 50% of orders are cancelable by giving a 46 to 60 days notice prior to the expected shipment date and 25% of orders are cancelable by giving a 31 to 45 days notice prior to the expected shipment date. Orders are non-cancelable within 30 days prior to the expected shipment date. As of December 31, 2021, the Company had approximately $32.9 million in non-cancelable purchase commitments with suppliers. As a result of the COVID-19 pandemic, the Company has experienced an elongation of the time from order placement to production primarily due to component shortages and supply chain disruptions. In order to reduce manufacturing lead-times and to ensure an adequate supply of inventories, the Company has worked with its suppliers to place longer lead-time purchase orders to ensure availability of components and materials from its supply chain. Under this circumstance, the Company may be obligated to purchase long lead-time component inventory procured in accordance with its forecasts. The Company may become liable for non-cancellable material components, such as chipsets purchased by the supplier to meet its purchase order, even if it is subsequently cancelled. The Company establishes a loss liability for all products it does not expect to sell for which it has committed purchases from suppliers. As of December 31, 2021, the loss liability from committed purchases was $0.4 million. From time to time the Company’s suppliers procure unique complex components on the Company’s behalf. If these components do not meet specified technical criteria or are defective, the Company should not be obligated to purchase the materials.
Warranty Obligations
Changes in the Company’s warranty liability, which is included in Accrued liabilities in the consolidated balance sheets, were as follows:
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In thousands) | |||||||||||||||||
| Balance at the beginning of the period | $ | 2,451 | $ | 3,169 | $ | 3,712 | |||||||||||
| Provision for (release of) warranty obligation made during the period | (655) | — | 260 | ||||||||||||||
| Settlements made during the period | (466) | (718) | (803) | ||||||||||||||
| Balance at the end of the period | $ | 1,330 | $ | 2,451 | $ | 3,169 | |||||||||||
Litigation and Other Legal Matters
Securities Class Action Lawsuits and Derivative Suit
The Company is involved in disputes, litigation, and other legal actions, including, but not limited to, the matters described below. In all cases, at each reporting period, the Company evaluates whether or not a potential loss amount or a potential range of loss is probable and reasonably estimable under the provisions of the authoritative guidance that addresses accounting for contingencies. In such cases, the Company accrues for the amount, or if a range, the Company accrues the low end of the range, only if there is not a better estimate than any other amount within the range, as a component of legal expense within litigation reserves, net. The Company monitors developments in these legal matters that could affect the estimate the Company had previously accrued. In relation to such matters, the Company currently believes that there are no existing claims or proceedings that are likely to have a material adverse effect on its financial position within the next 12 months, or the outcome of these matters is currently not determinable. There are many uncertainties associated with any litigation, and these actions or other third-party claims against the Company may cause the Company to incur costly litigation and/or substantial settlement charges. In addition, the resolution of any intellectual property litigation may require the Company to make royalty payments, which could have an adverse effect in future periods. If any of those events were to occur, the Company's business, financial condition, results of operations, and cash flows could be adversely affected. The actual liability in any such matters may be materially different from the Company's estimates, which could result in the need to adjust the liability and record additional expenses.
105
Beginning on December 11, 2018, purported stockholders of Arlo Technologies, Inc. filed six putative securities class action complaints in the Superior Court of California, County of Santa Clara, and one complaint in the U.S. District Court for the Northern District of California against the Company and certain of its executives and directors. Some of these actions also name as defendants the underwriters in the Company’s initial public offering ("IPO") and NETGEAR, Inc. ("NETGEAR"). The actions pending in state court are Aversa v. Arlo Technologies, Inc., et al., No. 18CV339231, filed Dec. 11, 2018; Pham v. Arlo Technologies, Inc. et al., No. 19CV340741, filed January 9, 2019; Patel v. Arlo Technologies, Inc., No. 19CV340758, filed January 10, 2019; Perros v. NetGear, Inc., No. 19CV342071, filed February 1, 2019; Vardanian v. Arlo Technologies, Inc., No. 19CV342318, filed February 8, 2019; and Hill v. Arlo Technologies, Inc. et al., No. 19CV343033, filed February 22, 2019. On April 26, 2019, the state court consolidated these actions as In re Arlo Technologies, Inc. Shareholder Litigation, No. 18CV339231 (the “State Action"). The action in federal court is Wong v. Arlo Technologies, Inc. et al., No. 19-CV-00372 (the “Federal Action”).
The plaintiffs in the State Action filed a consolidated complaint on May 1, 2019. The plaintiffs allege that the Company failed to adequately disclose quality control problems and adverse sales trends ahead of its IPO, violating the Securities Act of 1933, as amended (the "Securities Act"). The complaint seeks unspecified monetary damages and other relief on behalf of investors who purchased Company common stock issued pursuant and/or traceable to the IPO. On June 21, 2019, the court stayed the State Action pending resolution of the Federal Action, given the substantial overlap between the claims.
In the Federal Action, the court appointed a shareholder named Matis Nayman as lead plaintiff. On June 7, 2019, plaintiff filed an amended complaint. Lead Plaintiff alleges violations of the Securities Act and the Securities Exchange Act of 1934, as amended, based on alleged materially false and misleading statements about the Company’s sales trends and products. In the amended complaint, lead plaintiff sought to represent a class of persons who purchased or otherwise acquired the Company’s common stock (i) during the period between August 3, 2018 through December 3, 2018 and/or (ii) pursuant to or traceable to the IPO. Lead plaintiff seeks class certification, an award of unspecified damages, an award of costs and expenses, including attorneys’ fees, and other further relief as the court may deem just and proper.
On August 6, 2019, defendants filed a motion to dismiss. The court granted that motion, and plaintiff filed a second amended complaint. On June 12, 2020, plaintiff filed an unopposed motion for preliminary approval of a class action settlement for $1.25 million, which was also the amount that the Company had accrued for loss contingency. The settlement remains subject to further court approval. On September 24, 2020, the court entered an order preliminarily approving the settlement. On February 5, 2021, plaintiff filed a motion for final approval of the settlement. In October 2020, the Company made a $1.25 million payment an escrow account administered by the court and plaintiff’s counsel (the “Settlement Fund”). The Settlement Fund shall be deemed to be in the custody of the court and shall remain subject to the jurisdiction of the court until such time as the Settlement Fund is distributed pursuant to the settlement agreement and/or further order of the court.
On February 5, 2021, lead plaintiff filed a motion for final approval of the settlement. In advance of the final approval hearing, three of the named plaintiffs in the State Action requested exclusion from the settlement. The court held a final approval hearing on March 11, 2021, and, on March 25, 2021, entered an order and final judgment approving the settlement and, among other things, dismissing with prejudice all claims of lead plaintiff and the Settlement Class (as defined in the settlement agreement). On April 19, 2021, the Court issued an amended order and corrected judgment to include defendant NETGEAR, who had been inadvertently omitted from the prior order and final judgment. The Federal Action is now closed.
In the State Action, on May 5, 2021, the court held a status conference. At that conference, the state court instructed plaintiffs Perros, Patel, and Pham (“Plaintiffs”), who were the only Arlo stockholders to opt out of the federal settlement, to file an amended complaint by June 4, 2021. Plaintiffs filed their second amended complaint on June 4, 2021, asserting their individual Securities Act claims, but also purporting to represent a new class of Arlo stockholders who purchased Arlo shares between December 3, 2018 and February 22, 2019 and fell outside the Settlement Class (as defined in the federal settlement). On June 21, 2021, the Arlo defendants filed a motion to dismiss the State Action (for forum non conveniens) based on the federal forum provision in Arlo’s certificate of incorporation. Plaintiffs opposed on July 28, 2021, and the Arlo defendants
106
replied on August 13, 2021. On July 6, 2021, defendants filed multiple demurrers to the second amended complaint. Plaintiffs filed their oppositions on August 12, 2021, and defendants filed their replies on August 27, 2021. On September 9, 2021, the court issued an order granting the Arlo defendants’ forum non conveniens motion, and on September 17, 2021, the court issued a final judgment dismissing the State Action in its entirety. On November 16, 2021, Plaintiffs filed a Notice of Appeal. The appeal is pending before the California Court of Appeal, Sixth Appellate District. The court has not yet set a date for oral argument.
Leonard R. Pinto v. Arlo Technologies, Inc., et al.
In addition to the State Action and the Federal Action, a purported stockholder named Leonard Pinto filed a tagalong derivative action on June 13, 2019 in the U.S. District Court for the Northern District of California, captioned Pinto v. Arlo Technologies, Inc. et al., No. 19-CV-03354 (the “Derivative Action”). The Derivative Action is brought on behalf of the Company against the majority of the Company’s current directors. The complaint is based on the same alleged misconduct as the securities class actions but asserts claims for breach of fiduciary duty, waste of corporate assets, and violation of the Securities Exchange Act of 1934, as amended. On August 20, 2019, the court stayed the Derivative Action in deference to the Federal Action. On April 8, 2021, because it had granted final approval of the settlement in the Federal Action, the court lifted the stay in the Derivative Action and asked the parties to file a joint status report by April 22, 2021. In their status report, the parties stipulated to a schedule for plaintiff to file an amended complaint and for the parties to brief a motion to dismiss. Plaintiff filed his amended complaint on May 24, 2021. Defendants moved to dismiss the amended complaint on July 9, 2021. On August 23, 2021, plaintiff filed a second amended complaint. Defendants’ motion to dismiss the second amended complaint is due on December 17, 2021. Plaintiff’s opposition is due January 31, 2022, and defendants’ reply is due on March 2, 2022.
Skybell Technologies, Inc. v. Arlo Technologies, Inc.
On December 18, 2020, Skybell Technologies, Inc., SB IP Holdings, LLC, and Eyetalk365, LLC (collectively, “Complainants” or “Skybell”) filed a Section 337 complaint against the Company, Vivint Smart Home, Inc. (“Vivint”), and SimpliSafe, Inc. (“SimpliSafe”) (collectively “Respondents”) at the U.S. International Trade Commission (“ITC”). The action alleges that the Company’s cameras and video doorbell cameras infringe seven patents: 10,097,796 (“the ’796 patent”), 10,200,660 (“the ’660 patent”), 10,523,906 (“the ’906 patent”), 10,097,797 (“the ’797 patent”), 9,485,478 (“the ’478 patent”), 10,674,120 (“the ’120 patent”), and 9,432,638 (“the ’638 patent”) (collectively, “the Asserted Patents”) in violation of Section 337 of the Tariff Act of 1930. The Asserted Patents are all from the same family and generally directed to detecting a person at a camera and communicating video and audio from the camera to a cell phone along with various other features. The case was instituted on January 25, 2021 as Investigation No. 337-TA-1242.
On September 15, 2021, the Administrative Law Judge (“ALJ”) hearing the case at the ITC issued an Initial Determination (“ID”) ruling that all the Asserted Patents are invalid. The ALJ agreed with Respondents’ contention that there was an impermissible break in priority chains of the applications of the Asserted Patents during their prosecution – meaning that certain of Skybell’s prior issued patents fully anticipated or invalidated all the Asserted Patents. Therefore, the ALJ ruled that there can be no patent infringement or violation of Section 337 of the Tariff Act of 1930 by the Respondents.
Skybell appealed the ID by submitting its Petition for Review to the ITC on September 27, 2021, and the Respondents submitted their Response to the Petition to Review on October 4, 2021. On November 10, 2021, The ITC affirmed the ALJ’s ruling and did not grant any review of the ID, meaning that there is no trial on the ITC docket since there are no valid patents remaining, and the case is concluded at the ITC level. On January 9, 2022, Skybell filed its Notice of Appeal to the Federal Circuit to appeal the ITC’s rulings invalidating the Asserted Patents.
As of December 31, 2021, the Company is unable to predict the outcome of this matter, and, at this time, cannot reasonably estimate the possible loss or range of loss with respect to the legal proceeding discussed herein.
Indemnification of Directors and Officers
107
The Company, as permitted under Delaware law and in accordance with its bylaws, has agreed to indemnify its officers and directors for certain events or occurrences, subject to certain conditions, while the officer or director is or was serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum amount of potential future indemnification is unlimited; however, the Company has a director and officer insurance policy that will enable it to recover a portion of any future amounts paid. As a result of its insurance policy coverage, the Company believes the fair value of each indemnification agreement will be minimal. The Company had no liabilities recorded for these agreements as of December 31, 2021 and 2020.
Indemnifications
Prior to the completion of the IPO, the Company historically participated in NETGEAR’s sales agreements. In its sales agreements, NETGEAR typically agrees to indemnify its direct customers, distributors and resellers (the “Indemnified Parties”) for any expenses or liability resulting from claimed infringements by NETGEAR’s products of patents, trademarks or copyrights of third parties that are asserted against the Indemnified Parties, subject to customary carve-outs. The terms of these indemnification agreements are generally perpetual after execution of the agreement. The maximum amount of potential future indemnification is generally unlimited. From time to time, the Company receives requests for indemnity and may choose to assume the defense of such litigation asserted against the Indemnified Parties. The Company had no liabilities recorded for these agreements as of December 31, 2021 and 2020. In connection with the Separation, and after July 1, 2018, certain sales agreements were transferred to the Company, and the Company has replaced certain shared contracts, which include similar indemnification terms.
In addition, pursuant to the master separation agreement and certain other agreements entered into with NETGEAR in connection with the Separation and the IPO, NETGEAR has agreed to indemnify the Company for certain liabilities. The master separation agreement provides for cross-indemnities principally designed to place financial responsibility for the obligations and liabilities of its business with the Company and financial responsibility for the obligations and liabilities of NETGEAR’s business with NETGEAR. Under the intellectual property rights cross-license agreement entered into between the Company and NETGEAR, each party, in its capacity as a licensee, indemnifies the other party, in its capacity as a licensor, and its directors, officers, agents, successors and subsidiaries against any losses suffered by such indemnified party as a result of the indemnifying party’s practice of the intellectual property licensed to such indemnifying party under the intellectual property rights cross-license agreement. Also, under the tax matters agreement entered into between the Company and NETGEAR, each party is liable for, and indemnifies the other party and its subsidiaries from and against any liability for, taxes that are allocated to the indemnifying party under the tax matters agreement. In addition, the Company has agreed in the tax matters agreement that each party will generally be responsible for any taxes and related amounts imposed on it or NETGEAR as a result of the failure of the Distribution, together with certain related transactions, to qualify as a transaction that is generally tax-free, for U.S. federal income tax purposes, under Sections 355 and 368(a)(1)(D) and certain other relevant provisions of the Code, to the extent that the failure to so qualify is attributable to actions, events or transactions relating to such party’s respective stock, assets or business, or a breach of the relevant representations or covenants made by that party in the tax matters agreement. The transition services agreement generally provides that the applicable service recipient indemnifies the applicable service provider for liabilities that such service provider incurs arising from the provision of services other than liabilities arising from such service provider’s gross negligence, bad faith or willful misconduct or material breach of the transition services agreement, and that the applicable service provider indemnifies the applicable service recipient for liabilities that such service recipient incurs arising from such service provider’s gross negligence, bad faith or willful misconduct or material breach of the transition services agreement. Pursuant to the registration rights agreement, the Company has agreed to indemnify NETGEAR and its subsidiaries that hold registrable securities (and their directors, officers, agents and, if applicable, each other person who controls such holder under Section 15 of the Securities Act) registering shares pursuant to the registration rights agreement against certain losses, expenses and liabilities under the Securities Act, common law or otherwise. NETGEAR and its subsidiaries that hold registrable securities similarly indemnify the Company but such indemnification will be limited to an amount equal to the net proceeds received by such holder under the sale of registrable securities giving rise to the indemnification obligation.
108
Change in Control and Severance Agreements
The Company has entered into change in control and severance agreements with certain of its executive officers (the “Severance Agreements”). Pursuant to the Severance Agreements, upon a termination without cause or resignation with good reason, the individual would be entitled to (1) cash severance equal to (a) the individual’s annual base salary and an additional amount equal to his or her target annual bonus (for the Chief Executive Officer) or (b) the individual’s annual base salary (for other executive officers), (2) 12 months of health benefits continuation, and (3) accelerated vesting of any unvested time-based equity awards that would have vested during the 12 months following the termination date. Upon a termination without cause or resignation with good reason that occurs during the one month prior to or 12 months following a change in control, the individual would be entitled to (1) (a) cash severance equal to a multiple (2 times for the Chief Executive Officer and 1 times for other executive officers) of the sum of the individual’s annual base salary and target annual bonus, (2) a number of months of health benefits continuation (24 months for the Chief Executive Officer and 12 months for other executive officers) and (3) vesting of all outstanding, unvested equity awards (for the Chief Executive Officer) and the vesting of all outstanding, unvested time-based equity awards (for other executive officers). Severance will be conditioned upon the execution and non-revocation of a release of claims. The Company had no liabilities recorded for these agreements as of December 31, 2021.
On June 15, 2020 (the “Retirement Date”), Christine Gorjanc retired as the Chief Financial Officer, principal financial officer and principal accounting officer of the Company. In connection with her retirement, the Company, NETGEAR and Ms. Gorjanc entered into a Separation Agreement and Release (the “Separation Agreement”) pursuant to which Ms. Gorjanc received a $15,000 cash payment and accelerated vesting of (i) 8,749 shares subject to Company stock options, (ii) 43,216 shares subject to Company restricted stock units, (iii) 2,897 shares subject to NETGEAR stock options and (iv) 15,000 shares subject to NETGEAR restricted stock units. The Board of Directors of the Company appointed Gordon Mattingly as the Company's Chief Financial Officer, principal financial officer and principal accounting officer, effective as of the Retirement Date. In connection with his appointment as the Company’s Chief Financial Officer, the Company entered into a confirmatory employment letter (the “Employment Agreement”) with Mr. Mattingly. Pursuant to the Employment Agreement, Mr. Mattingly receives an annual base salary of $500,000 and is eligible to receive an annual target bonus of 70% of his annual base salary. Mr. Mattingly will also continue to be eligible to participate in the Company’s equity compensation plans and employee benefit plans available to other employees of the Company. The Company also entered into an updated change in control and severance agreement consistent with Mr. Mattingly’s new role of Chief Financial Officer.
On May 2, 2019, the Company and Patrick J. Collins III, the Company’s Senior Vice President of Products, entered into a Separation and Release Agreement (the “Separation Agreement”) regarding Mr. Collins’ separation from the Company, effective May 1, 2019. Pursuant to the Separation Agreement, Mr. Collins received cash severance equal to his annual base salary, 12 months of health benefits continuation and accelerated vesting of any of his unvested equity awards that would have vested during the 12 months following the termination date.
Environmental Regulation
The Company is required to comply and is currently in compliance with the European Union (“EU”) and other Directives on the Restrictions of the use of Certain Hazardous Substances in Electrical and Electronic Equipment (“RoHS”), Waste Electrical and Electronic Equipment (“WEEE”) requirements, Energy Using Product (“EuP”) requirements, the REACH Regulation, Packaging Directive and the Battery Directive.
The Company is subject to various federal, state, local, and foreign environmental laws and regulations, including those governing the use, discharge, and disposal of hazardous substances in the ordinary course of its manufacturing process. The Company believes that its current manufacturing and other operations comply in all material respects with applicable environmental laws and regulations; however, it is possible that future environmental legislation may be enacted or current environmental legislation may be interpreted to create an environmental liability with respect to its facilities, operations, or products.
109
Note 12. Employee Benefit Plans
2018 Equity Incentive Plan
The Company grants options and RSUs under the 2018 Equity Incentive Plan (the "2018 Plan"), under which awards may be granted to all employees. Award vesting periods for this plan are generally to four years. Options may be granted for periods of up to 10 years or such shorter term as may be provided in the agreement and at prices no less than 100% of the fair market value of Arlo’s common stock on the date of grant. Options granted under the 2018 Plan generally vest over four years, the first tranche at the end of 12 months and the remaining shares underlying the option vesting monthly over the remaining three years.
On July 28, 2021, the Compensation Committee of the Board of Directors (the “Committee”) unanimously approved an amendment to the 2018 Plan to, among other things, reserve an additional 1,500,000 shares of the Company’s common stock ("inducement pool") to be used exclusively for grants of awards to individuals who were not previously employees or non-employee directors of the Company (or following a bona fide period of non-employment with the Company), as an inducement material to the individual’s entry into employment with the Company within the meaning of Rule 303A.08 of the New York Stock Exchange (the “NYSE”) Listed Company Manual (“Rule 303A.08”). The 2018 Plan was amended by the Committee without stockholder approval pursuant to Rule 303A.08.
On March 3, 2021, the Company registered an aggregate of up to 3,966,472 shares of the Company’s common stock on Registration Statement on Form S-8, including 3,173,178 shares issuable pursuant to the Company's 2018 Plan that were automatically added to the shares authorized for issuance under the 2018 Plan on January 1, 2021 pursuant to an “evergreen” provision contained in the 2018 Plan and 793,294 shares issuable pursuant to the ESPP that were automatically added to the shares authorized for issuance under the ESPP on January 1, 2021 pursuant to an “evergreen” provision contained in the ESPP.
The Company’s employees have historically participated in NETGEAR’s various stock-based plans, which are described below and represent the portion of NETGEAR’s stock-based plans in which Arlo employees participated as of December 31, 2021. The Company’s consolidated statements of operations reflect compensation expense for these stock-based plans associated with the portion of NETGEAR’s plans in which Arlo employees participated.
The following table sets forth the available shares for future grants under the 2018 Plan as of December 31, 2021:
| Number of Shares | |||||
| (In thousands) | |||||
Shares available for grants as of December 31, 2020 | 3,113 | ||||
Additional authorized shares (1) | 4,673 | ||||
Granted (2) | (8,338) | ||||
| Forfeited/ cancelled | 1,037 | ||||
| Shares traded for taxes | 2,024 | ||||
Shares available for grants as of December 31, 2021 | 2,509 | ||||
_________________________
(1) Includes approximately 3.2 million shares authorized for issuance pursuant to the "evergreen" provision and 1.5 million shares authorized for issuance under the inducement pool.
(2) Includes approximately 1.0 million shares granted under the inducement pool.
110
Employee Stock Purchase Plan
The Company sponsors the ESPP, pursuant to which eligible employees may contribute up to 15% of compensation, subject to certain income limits, to purchase shares of Arlo’s common stock. The terms of the plan include a look-back feature that enables employees to purchase stock semi-annually at a price equal to 85% of the lesser of the fair market value at the beginning of the offering period or the purchase date. The duration of each offering period is generally six months, with the first offering period having commenced on February 15, 2019 and ended on August 14, 2019. As of December 31, 2021, approximately 1.3 million shares were available for issuance under the ESPP.
Option Activity
The Company’s stock option activity during the year ended of December 31, 2021 was as follows:
| Number of Shares | Weighted Average Exercise Price Per Share | Weighted Average Remaining Contractual Term | Aggregate Intrinsic Value (1) | ||||||||||||||||||||
| (In thousands) | (In dollars) | (In years) | (In thousands) | ||||||||||||||||||||
Outstanding as of December 31, 2020 | 3,434 | $ | 9.72 | ||||||||||||||||||||
| Granted | — | — | |||||||||||||||||||||
| Exercised | (782) | 6.73 | |||||||||||||||||||||
| Forfeited/ Cancelled | (46) | 16.00 | |||||||||||||||||||||
| Expired | (32) | 7.18 | |||||||||||||||||||||
| Outstanding as of December 31, 2021 | 2,574 | $ | 10.55 | 4.29 | $ | 4,333 | |||||||||||||||||
| Vested and expected to vest as of December 31, 2021 | 2,574 | $ | 10.55 | 4.29 | $ | 4,333 | |||||||||||||||||
| Exercisable Options as of December 31, 2021 | 2,507 | $ | 10.44 | 4.23 | $ | 4,311 | |||||||||||||||||
_________________________
(1) Representing the total pre-tax intrinsic values (the difference between the Company’s closing stock price on the last trading day of 2021 and the exercise price, multiplied by the number of shares underlying the in-the-money options) that would have been received by the option holders had all option holders exercised their options on December 31, 2021. This amount changes based on the fair market value of the Company’s stock.
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In millions, except per share data) | |||||||||||||||||
Total intrinsic value of options exercised | $ | 2.20 | $ | 0.20 | $ | — | |||||||||||
| Total fair value of options vested | $ | 2.60 | $ | 1.00 | $ | 3.10 | |||||||||||
| Weighted-average grant date fair value per share of options granted | NA | NA | $ | 2.59 | |||||||||||||
The following table summarizes significant ranges of outstanding the Company’s stock options as of December 31, 2021.
Options Outstanding | Options Exercisable | ||||||||||||||||||||||||||||
Range of Exercise Prices | Shares Outstanding | Weighted- Average Remaining Contractual Life | Weighted- Average Exercise Price Per Share | Shares Exercisable | Weighted- Average Exercise Price Per Share | ||||||||||||||||||||||||
| (In thousands) | (In years) | (In dollars) | (In thousands) | (In dollars) | |||||||||||||||||||||||||
3.90 - 6.68 | 577 | 2.18 | $ | 6.59 | 574 | $ | 6.60 | ||||||||||||||||||||||
6.90 - 8.76 | 967 | 4.57 | 8.35 | 967 | 8.35 | ||||||||||||||||||||||||
10.09 - 13.23 | 100 | 6.27 | 11.97 | 90 | 11.83 | ||||||||||||||||||||||||
14.39 - 14.39 | 496 | 6.07 | 14.39 | 486 | 14.39 | ||||||||||||||||||||||||
16.00 - 16.00 | 434 | 3.98 | 16.00 | 390 | 16.00 | ||||||||||||||||||||||||
3.90 - 16.00 | 2,574 | 4.29 | 10.55 | 2,507 | 10.44 | ||||||||||||||||||||||||
111
The following table sets forth the weighted average assumptions used to estimate the fair value of the Company’s stock options granted using Black-Scholes option pricing model during the years ended December 31, 2021, 2020 and 2019 and purchase rights granted under the ESPP during the years ended December 31, 2021 and 2020:
| Stock Options | ESPP | |||||||||||||||||||||||||||||||||||||
| 2021 | 2020 | 2019 | 2021 | 2020 | 2019 | |||||||||||||||||||||||||||||||||
| Expected life (in years) | NA | NA | 6.3 | 0.5 | 0.5 | 0.5 | ||||||||||||||||||||||||||||||||
| Risk-free interest rate | NA | NA | 2.28 | % | 0.07 | % | 0.84 | % | 2.49 | % | ||||||||||||||||||||||||||||
| Expected volatility | NA | NA | 73.0 | % | 63.8 | % | 102.0 | % | 97.6 | % | ||||||||||||||||||||||||||||
| Dividend yield | NA | NA | — | — | — | — | ||||||||||||||||||||||||||||||||
The Company’s common stock did not have sufficient history of being publicly traded at grant date, hence, the estimated term of the Company’s stock options granted was determined by a combination of using a simplified method, which is an average of the contractual term and vesting period of the stock options and using management best estimate of the expected term. The risk-free interest rate of stock options granted was based on the implied yield currently available on U.S. Treasury securities, with a remaining term commensurate with the estimated expected term. The estimated volatility assumption was calculated based on a compensation peer group analysis of stock price volatility on the grant date.
The risk-free interest rate of the purchase rights granted under the ESPP is based on the implied yield currently available on U.S. Treasury securities, with a remaining term commensurate with the estimated expected term. Expected volatility of the purchase rights granted under the ESPP is based on historical volatility over the most recent period commensurate with the estimated expected term.
NETGEAR’s stock option activity for Company employees during the year ended December 31, 2021 was as follows:
| Number of Shares | Weighted Average Exercise Price Per Share | Weighted Average Remaining Contractual Term | Aggregate Intrinsic Value | ||||||||||||||||||||
| (In thousands) | (In dollars) | (In years) | (In thousands) | ||||||||||||||||||||
| Outstanding as of December 31, 2020 | 16 | $ | 22.49 | ||||||||||||||||||||
| Exercised | (5) | 27.49 | |||||||||||||||||||||
| Forfeited/cancelled | — | — | |||||||||||||||||||||
| Expired | — | — | |||||||||||||||||||||
| Outstanding as of December 31, 2021 | 11 | $ | 20.11 | 0.69 | $ | 98 | |||||||||||||||||
| Vested and expected to vest as of December 31, 2021 | 11 | $ | 20.11 | 0.69 | $ | 98 | |||||||||||||||||
| Exercisable options as of December 31, 2021 | 11 | $ | 20.11 | 0.69 | $ | 98 | |||||||||||||||||
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In thousands, except per share data) | |||||||||||||||||
Total intrinsic value of options exercised | $ | 58 | $ | 634 | $ | 633 | |||||||||||
| Total fair value of options vested | $ | 35 | $ | 42 | $ | 810 | |||||||||||
| Weighted-average grant date fair value per share of NETGEAR’s stock options granted to employees specifically identifiable to Arlo | NA | NA | NA | ||||||||||||||
112
The following table summarizes significant ranges of outstanding NETGEAR’s stock options as of December 31, 2021.
Options Outstanding | Options Exercisable | ||||||||||||||||||||||||||||
Range of Exercise Prices | Shares Outstanding | Weighted- Average Remaining Contractual Life | Weighted- Average Exercise Price Per Share | Shares Exercisable | Weighted- Average Exercise Price Per Share | ||||||||||||||||||||||||
| (In thousands) | (In years) | (In dollars) | (In thousands) | (In dollars) | |||||||||||||||||||||||||
19.19 - 19.19 | 7 | 0.56 | $ | 19.19 | 7 | $ | 19.19 | ||||||||||||||||||||||
20.10 - 20.10 | 1 | 0.30 | 20.10 | 1 | 20.10 | ||||||||||||||||||||||||
21.86 - 21.86 | 3 | 1.10 | 21.86 | 3 | 21.86 | ||||||||||||||||||||||||
19.19 - 23.77 | 11 | 0.69 | 20.11 | 11 | 20.11 | ||||||||||||||||||||||||
RSU Activity
Arlo’s RSU activity, excluding PSU activity and MPSU activity, during the year ended of December 31, 2021 was as follows:
| Number of Shares | Weighted Average Grant Date Fair Value Per Share | Weighted Average Remaining Contractual Term | Aggregate Intrinsic Value | ||||||||||||||||||||
| (In thousands) | (In dollars) | (In years) | (In thousands) | ||||||||||||||||||||
Outstanding as of December 31, 2020 | 9,427 | $ | 4.42 | ||||||||||||||||||||
| Granted | 7,151 | 7.32 | |||||||||||||||||||||
| Vested | (5,539) | 5.64 | |||||||||||||||||||||
| Forfeited | (959) | 5.21 | |||||||||||||||||||||
| Outstanding as of December 31, 2021 | 10,080 | $ | 5.73 | 1.38 | $ | 105,739 | |||||||||||||||||
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In millions, except per share data) | |||||||||||||||||
Total intrinsic value of RSUs vested (the release date fair value) | $ | 36.38 | $ | 13.02 | $ | 5.51 | |||||||||||
| Total fair value of RSUs vested (the grant date fair value) | $ | 31.25 | $ | 22.15 | $ | 12.90 | |||||||||||
RSU granted weighted-average fair value per share | $ | 7.32 | $ | 3.03 | $ | 4.77 | |||||||||||
PSU Activity
The Company grants restricted stock units to its NEOs periodically that vested based on the Company's attainment of cash balance goals as of December 31, 2020 and December 31, 2021 and the NEO's continued employment through the vesting dates ("PSUs"). The vesting periods for the PSUs are three or four years. The maximum number of shares that NEOs can earn is 120% of the target number of the PSUs. The minimum number of shares that NEOs can earn is 75% of the target number of the PSUs. The Company determined the fair value of the PSUs using the closing price of the Company's common stock as of the grant date. For PSUs, stock-based compensation expense of performance milestone is recognized over the expected performance achievement period when the achievement becomes probable.
113
The Company's PSU activity during the year ended of December 31, 2021 was as follows:
| Number of Shares | Weighted Average Grant Date Fair Value Per Share | Weighted Average Remaining Contractual Term | Aggregate Intrinsic Value | ||||||||||||||||||||
| (In thousands) | (In dollars) | (In years) | (In thousands) | ||||||||||||||||||||
Outstanding as of December 31, 2020 | 494 | $ | 2.74 | ||||||||||||||||||||
| Granted | 231 | 7.44 | |||||||||||||||||||||
| Vested | (198) | 2.74 | |||||||||||||||||||||
| Forfeited | — | — | |||||||||||||||||||||
Outstanding as of December 31, 2021 (1) | 527 | $ | 4.80 | 1.12 | $ | 5,528 | |||||||||||||||||
_________________________
(1) Includes 329,178 shares of PSUs for the 2020 performance period, achieved at 120% of target, or 395,014 shares and vest over three years, and 197,823 shares of PSUs for the 2021 performance period, achieved at 120% of target, or 237,388 shares and vest over four years.
| Year Ended December 31, | |||||||||||
| 2021 | 2020 | ||||||||||
| (In millions, except per share data) | |||||||||||
Total intrinsic value of RSUs vested (the release date fair value) | $ | 1.21 | NA | ||||||||
| Total fair value of RSUs vested (the grant date fair value) | $ | 0.54 | NA | ||||||||
RSU granted weighted-average fair value per share | $ | 7.44 | $ | 2.74 | |||||||
MPSU Activity
The Company grants restricted stock units to its NEOs that vest based on the Company's stock price performance relative to a broad-market index over a performance period of three to four years and the NEO's continued employment through the vesting date ("TSR MPSUs"). The TSR MPSUs will vest at the end of the three or four-year periods that begin on the TSR MPSUs' grant date based on performance of the Company's common stock relative to the Benchmark during the three or four-year periods from the grant dates. A positive 3.3x or negative 2.5x multiplier will be applied to the total shareholder returns (“TSR”), such that the number of shares vested will increase by 3.3% or decrease by 2.5% of the target numbers, for each 1% of positive or negative TSR relative to the Benchmark. In the event the Company's common stock performance is below negative 30% relative to the Benchmark, no shares will be vested. In no event will the number of shares vested exceed 200% of the target for that tranche.
The Company's TSR MPSU activity during the year ended of December 31, 2021 was as follows:
| Number of Shares | Weighted Average Grant Date Fair Value Per Share | Weighted Average Remaining Contractual Term | Aggregate Intrinsic Value | ||||||||||||||||||||
| (In thousands) | (In dollars) | (In years) | (In thousands) | ||||||||||||||||||||
Outstanding as of December 31, 2020 | 643 | $ | 4.12 | ||||||||||||||||||||
| Granted | 198 | 11.77 | |||||||||||||||||||||
| Vested | — | — | |||||||||||||||||||||
| Forfeited | — | — | |||||||||||||||||||||
Outstanding as of December 31, 2021 | 841 | $ | 5.92 | 1.62 | $ | 8,817 | |||||||||||||||||
114
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In millions, except per share data) | |||||||||||||||||
Total intrinsic value of RSUs vested (the release date fair value) | NA | NA | NA | ||||||||||||||
| Total fair value of RSUs vested (the grant date fair value) | NA | NA | NA | ||||||||||||||
RSU granted weighted-average fair value per share | $ | 11.77 | $ | 4.11 | $ | 4.14 | |||||||||||
The Company also grants restricted stock units to its CEO that vest based on the Company's achievement of its stock price performance targets and the CEO's continued employment through the vesting dates ("CEO MPSUs"). The CEO MPSUs will vest over four years in substantially equal quarterly installments that begin on the CEO MPSUs' grant date in five equal tranches based on the Company's achievement of certain average daily closing prices per share of the Company's common stock, as reported on the NYSE, for any 30 consecutive trading days on or prior to July 28, 2025 (the "Performance Period End Date"), with the first tranche target at $7.57 per share, with the second tranche target at $8.69 per share, with the third tranche target at $9.97 per share, with the fourth tranche target $11.44 per share and with the fifth tranche target at $13.20 per share. To the extent that the stock price of the tranche does not achieve its corresponding price target prior to the Performance Period End Date, the CEO MPSUs expire or cancel. On December 1 and 29, 2021, the stock price performance targets for the first and second tranches were achieved, respectively.
The Company's CEO MPSU activity during the year ended of December 31, 2021 was as follows:
| Number of Shares | Weighted Average Grant Date Fair Value Per Share | Weighted Average Remaining Contractual Term | Aggregate Intrinsic Value | ||||||||||||||||||||
| (In thousands) | (In dollars) | (In years) | (In thousands) | ||||||||||||||||||||
Outstanding as of December 31, 2020 | — | $ | — | ||||||||||||||||||||
| Granted | 758 | 5.21 | |||||||||||||||||||||
| Vested | (19) | 5.64 | |||||||||||||||||||||
| Forfeited | — | — | |||||||||||||||||||||
Outstanding as of December 31, 2021 | 739 | $ | 5.20 | 1.82 | $ | 7,749 | |||||||||||||||||
| Year Ended December 31, | |||||
| 2021 | |||||
| (In millions, except per share data) | |||||
Total intrinsic value of RSUs vested (the release date fair value) | $ | 0.18 | |||
| Total fair value of RSUs vested (the grant date fair value) | $ | 0.11 | |||
RSU granted weighted-average fair value per share | $ | 5.21 | |||
115
The Company utilized a Monte Carlo pricing model customized to the specific provisions of the 2018 Plan to value the MPSUs awards on the grant date. The weighted average assumptions used in this model to estimate fair value at the grant date are as follows:
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| Expected life | 4.0 | 3.0 | 3.0 | ||||||||||||||
| Risk-free interest rate | 0.38 | % | 0.24 | % | 1.52 | % | |||||||||||
| Expected volatility | 69.5 | % | 69.3 | % | 65.1 | % | |||||||||||
| Dividend yield | — | — | — | ||||||||||||||
| Stock Beta | 0.45 | 0.48 | 0.30 | ||||||||||||||
NETGEAR’s RSU activity for Company employees during the year ended December 31, 2021 was as follows:
| Number of Shares | Weighted Average Grant Date Fair Value Per Share | Weighted Average Remaining Contractual Term | Aggregate Intrinsic Value | ||||||||||||||||||||
| (In thousands) | (In dollars) | (In years) | (In thousands) | ||||||||||||||||||||
| Outstanding as of December 31, 2020 | 127 | $ | 37.81 | ||||||||||||||||||||
| Vested | (76) | 36.60 | |||||||||||||||||||||
| Forfeited | (4) | 38.83 | |||||||||||||||||||||
| Outstanding as of December 31, 2021 | 47 | $ | 39.67 | 0.20 | $ | 1,363 | |||||||||||||||||
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In millions, except per share data) | |||||||||||||||||
Total intrinsic value of RSUs vested (the release date fair value) | $ | 2.9 | $ | 3.2 | $ | 5.8 | |||||||||||
| Total fair value of RSUs vested (the grant date fair value) | $ | 2.8 | $ | 4.5 | $ | 5.6 | |||||||||||
RSU granted weighted-average fair value per share | NA | NA | NA | ||||||||||||||
116
Stock-Based Compensation Expense
The Company's employees have historically participated in NETGEAR's various stock-based plans, which are described below and represent the portion of NETGEAR's stock-based plans in which Company employees participated. The Company's consolidated statements of income reflect compensation expense for these stock-based plans associated with the portion of NETGEAR's plans in which Company employees participated. The stock-based compensation expense for Company employees consist of Company RSUs, PSUs, MPSUs and stock options and NETGEAR RSUs and stock options granted to Company employees, employees' annual bonus in RSU form and the purchase rights under Company ESPP. The following table sets forth the stock-based compensation expense included in the Company’s consolidated statements of operations during the periods indicated:
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In thousands) | |||||||||||||||||
| Cost of revenue | $ | 3,917 | $ | 2,961 | $ | 2,013 | |||||||||||
| Research and development | 10,865 | 9,055 | 6,868 | ||||||||||||||
| Sales and marketing | 5,392 | 4,106 | 3,859 | ||||||||||||||
| General and administrative | 17,856 | 19,125 | 10,154 | ||||||||||||||
Total stock-based compensation expense (1) | $ | 38,030 | $ | 35,247 | $ | 22,894 | |||||||||||
_________________________
(1)There was no tax benefit as a result of the Company's net operating loss position.
The Company recognizes these compensation expenses generally on a straight-line basis over the requisite service period of the award.
As part of the Verisure transaction in 2019, certain employees who held Company RSU awards granted under the 2018 Plan, were transferred to Verisure. Such RSU awards continued to vest and settle after the closing of the transaction in accordance with the terms and conditions under the original award’s plan. Management determined that the modification of the RSUs awards was a Type III modification (improbable-to-probable) under ASC 718, under which any compensation expense previously recognized was reversed and the total fair value of the modified awards was recognized as a liability in the Company’s consolidated balance sheets on the closing date. Accordingly, the modification of the awards resulted in a liability of $859 thousand and total compensation expense of $623 thousand on the closing date in 2019.
In January 2020, the IPO Options granted to the CEO were voluntarily forfeited with no replacement award. The cancellation was treated as a settlement for no consideration and all remaining unrecognized compensation cost of $7.4 million was accelerated and recognized as stock-based compensation expense in the first fiscal quarter of 2020.
In the second fiscal quarter of 2020, $1.2 million of previously recognized compensation expense was reversed as a result of cancellation of unvested shares upon Ms. Gorjanc's separation from the Company. In addition, $0.4 million of compensation expense was recognized for Ms. Gorjanc's accelerated vested shares upon her separation from the Company.
As of December 31, 2021, $0.3 million of unrecognized compensation cost related to Arlo’s stock options was expected to be recognized over a weighted-average period of 0.6 years. $48.4 million of unrecognized compensation cost related to unvested Arlo’s RSUs, PSUs and MPSUs was expected to be recognized over a weighted-average period of 2.3 years.
As of December 31, 2021, there was no unrecognized compensation cost related to NETGEAR’s stock options for Arlo employees. $0.4 million of unrecognized compensation cost related to unvested NETGEAR’s RSUs for Arlo employees was expected to be recognized over a weighted-average period of 0.2 years.
117
401(k) Plan
In January 2019, the Company adopted the Arlo 401(k) Plan to which employees may contribute up to 100% of salary subject to the legal maximum. The Company matched 50% of contributions for employees up to a maximum of $4,000 before fiscal 2020 and $2,000 starting fiscal 2020 in employee contributions per fiscal year. During the years ended December 31, 2021, 2020 and 2019, the Company recognized $1.1 million, $0.9 million and $1.5 million in expenses for Arlo employees related to Arlo 401(k) Plan match, respectively.
Note 13. Net Loss Per Share
Basic net loss per share is computed by dividing the net loss for the period by the weighted average number of common shares outstanding during the period. Potentially dilutive common shares, such as common shares issuable upon exercise of stock options, vesting of restricted stock awards and performance shares, and issuance of shares under the ESPP, are typically reflected in the computation of diluted net loss per share by application of the treasury stock method. For certain periods presented, due to the net losses reported, these potentially dilutive securities were excluded from the computation of diluted net loss per share, since their effect would be anti-dilutive.
Net loss per share for the years ended December 31, 2021, 2020 and 2019 were as follows:
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In thousands, except for per share data) | |||||||||||||||||
| Numerator: | |||||||||||||||||
| Net loss | $ | (56,029) | $ | (101,251) | $ | (85,951) | |||||||||||
| Denominator: | |||||||||||||||||
| Weighted average common shares - basic | 82,688 | 78,084 | 75,074 | ||||||||||||||
| Potentially dilutive common shares | — | — | — | ||||||||||||||
| Weighted average common shares - dilutive | 82,688 | 78,084 | 75,074 | ||||||||||||||
| Basic net loss per share | $ | (0.68) | $ | (1.30) | $ | (1.14) | |||||||||||
| Diluted net loss per share | $ | (0.68) | $ | (1.30) | $ | (1.14) | |||||||||||
| Anti-dilutive employee stock-based awards, excluded | 5,041 | 5,623 | 9,692 | ||||||||||||||
Note 14. Segment and Geographic Information
Segment Information
The Company operates as one operating and reportable segment. The Company has identified its CEO as the CODM. The CODM reviews financial information presented on a combined basis for purposes of allocating resources and evaluating financial performance.
Geographic Information
The Company conducts business across three geographic regions: Americas, EMEA and APAC. Revenue consists of gross product shipments and service revenue, less allowances for estimated sales returns, price protection, end-user customer rebates and other channel sales incentives deemed to be a reduction of revenue per the authoritative guidance for revenue recognition, net changes in deferred revenue, and gains or losses from hedging. For reporting purposes, revenue by geography is generally based upon the ship-to location of the customer for device sales and prepaid services, while based upon a paid account's location for paid service revenue.
118
The following table shows revenue by geography for the periods indicated:
| Year Ended December 31, | |||||||||||||||||
| 2021 | 2020 | 2019 | |||||||||||||||
| (In thousands) | |||||||||||||||||
| Americas | |||||||||||||||||
| United States (“U.S.”) | $ | 265,844 | $ | 259,023 | $ | 274,592 | |||||||||||
| Americas (excluding U.S.) | 5,338 | 10,372 | 14,568 | ||||||||||||||
| EMEA | 134,232 | 61,832 | 57,232 | ||||||||||||||
| APAC | 29,723 | 25,927 | 23,615 | ||||||||||||||
| Total revenue | $ | 435,137 | $ | 357,154 | $ | 370,007 | |||||||||||
The fiscal 2020 and 2019 balances have been recast to conform with the fiscal 2021 classification of paid service revenue following the paid account's location. Prior to the recast, the paid service revenue was allocated and was reported based the ship-to location of the customer for device sales and prepaid services.
The Company’s Property and equipment, net are located in the following geographic locations:
| As of December 31, | |||||||||||
| 2021 | 2020 | ||||||||||
| (In thousands) | |||||||||||
| Americas | |||||||||||
| United States (“U.S.”) | $ | 7,302 | $ | 12,644 | |||||||
| Americas (excluding U.S.) | 520 | 629 | |||||||||
| EMEA | 402 | 234 | |||||||||
| APAC | |||||||||||
| China | 1,143 | 1,821 | |||||||||
| APAC (excluding China) | 228 | 493 | |||||||||
| Total property and equipment, net | $ | 9,595 | $ | 15,821 | |||||||
Significant Customers
Two customers accounted for 30.8%, and 13.0% of revenue for the year ended December 31, 2021. Four customers accounted for 20.6%, 17.3%, 14.6% and 12.2% of revenue for the year ended December 31, 2020. Two customers accounted for 32.3% and 10.1% of revenue for the year ended December 31, 2019. No other customers accounted for 10% or greater of the Company's revenue.
119
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
None.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to provide reasonable assurance that information required to be disclosed in our periodic and current reports that we file with the SEC is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable and not absolute assurance of achieving the desired control objectives. In reaching a reasonable level of assurance, management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. In addition, the design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures as of December 31, 2021. Based on their evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), were effective as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and (ii) accumulated and communicated to management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). Management conducted an assessment of the effectiveness of our internal control over financial reporting as of December 31, 2021 based on the criteria set forth in “Internal Control-Integrated Framework” (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management has concluded that our internal control over financial reporting was effective as of December 31, 2021 based on those criteria.
This Annual Report on Form 10-K does not include an attestation report of the Company’s registered public accounting firm due to the Company's EGC status and is exempted from the auditor attestation requirement of Section 404(b) of the Sarbanes-Oxley Act.
Changes in Internal Control over Financial Reporting
There have been no changes in our internal control over financial reporting during the fiscal quarter ended December 31, 2021 that have materially affected, or are reasonably likely to materially effect, our internal control over financial reporting. We have not experienced any significant impact to our internal controls over financial reporting despite the fact that most of our employees are working remotely due to the COVID-19 pandemic. The design of our processes and
120
controls allow for remote execution with accessibility to secure data. We are continually monitoring and assessing the COVID-19 situation to minimize the impact, if any, on the design and operating effectiveness on our internal controls.
Inherent Limitations on Effectiveness of Disclosure Controls and Procedures
It should be noted that any system of controls, however well designed and operated, can provide only reasonable assurance, and not absolute assurance, that the objectives of the system are met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals in all future circumstances.
Item 9B. Other Information
None.
Item 9C. Disclosure Regarding Foreign Jurisdictions that Prevent Inspections
Not applicable.
121
PART III
Item 10. Directors, Executive Officers and Corporate Governance
The information required by this item and not set forth below will be set forth in our definitive proxy statement for our 2022 Annual Meeting of Stockholders (the “Proxy Statement”) to be filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2021, and is incorporated herein by reference.
We have adopted a Code of Ethics that applies to our Chief Executive Officer and senior financial officers, including our Chief Financial Officer, as required by the SEC. The current version of our Code of Ethics can be found on our Internet site at http://www.arlo.com. Additional information required by this Item regarding our Code of Ethics is incorporated by reference to the information contained in the section captioned “Corporate Governance Policies and Practices” in our Proxy Statement.
We intend to satisfy the disclosure requirement under Item 5.05 of Form 8-K regarding an amendment to, or waiver from, a provision of our Code of Ethics by posting such information on our website at http://www.arlo.com within four business days following the date of such amendment or waiver.
Item 11. Executive Compensation
The information required by this item will be set forth in the Proxy Statement and is incorporated herein.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this item will be set forth in the Proxy Statement and is incorporated herein.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this item will be set forth in the Proxy Statement and is incorporated herein.
Item 14. Principal Accountant Fees and Services
The information required by this item will be set forth in the Proxy Statement and is incorporated herein.
122
PART IV
Item 15. Exhibit and Financial Statement Schedules
(a) The following documents are filed as part of this report:
(1) Financial Statements.
The following consolidated financial statements of Arlo Technologies, Inc. are filed as part of this Annual Report on Form 10-K in Item 8, Financial Statements and Supplementary Data.
| Page | |||||
Report of Independent Registered Public Accounting Firm (PCAOB ID:238) | |||||
Consolidated Balance Sheets as of December 31, 2021 and 2020 | |||||
Consolidated Statements of Operations for the three years ended December 31, 2021, 2020 and 2019 | |||||
Consolidated Statements of Comprehensive Income for the three years ended December 31, 2021, 2020 and 2019 | |||||
Consolidated Statements of Stockholders’ Equity for the three years ended December 31, 2021, 2020 and 2019 | |||||
Consolidated Statements of Cash Flows for the three years ended December 31, 2021, 2020 and 2019 | |||||
| Notes to Consolidated Financial Statements | |||||
(2) Financial Statement Schedules.
All financial statement schedules have been omitted as the information is not required under the related instructions or is not applicable or because the information required is already included in the consolidated financial statements or the notes to those consolidated financial statements.
123
(3) Exhibits.
INDEX TO EXHIBITS
| Incorporated by Reference | ||||||||||||||||||||||||||||||||
Exhibit Number | Exhibit Description | Form | Date | Number | Filed Herewith | |||||||||||||||||||||||||||
| 8-K | 8/7/2018 | 3.1 | ||||||||||||||||||||||||||||||
| 8-K | 8/7/2018 | 3.2 | ||||||||||||||||||||||||||||||
| S-1/A | 7/23/2018 | 4.1 | ||||||||||||||||||||||||||||||
| 10-K | 2/26/2021 | 4.2 | ||||||||||||||||||||||||||||||
| 8-K | 8/7/2018 | 10.1 | ||||||||||||||||||||||||||||||
| 8-K | 8/7/2018 | 10.2 | ||||||||||||||||||||||||||||||
| 8-K | 8/7/2018 | 10.3 | ||||||||||||||||||||||||||||||
| 8-K | 8/7/2018 | 10.4 | ||||||||||||||||||||||||||||||
| 8-K | 8/7/2018 | 10.5 | ||||||||||||||||||||||||||||||
| 8-K | 8/7/2018 | 10.6 | ||||||||||||||||||||||||||||||
| S-1 | 7/6/2018 | 10.7 | ||||||||||||||||||||||||||||||
10.8 * | 8-K | 8/7/2018 | 10.7 | |||||||||||||||||||||||||||||
10.9 * | 8-K | 8/7/2018 | 10.8 | |||||||||||||||||||||||||||||
10.10 * | 8-K | 8/7/2018 | 10.9 | |||||||||||||||||||||||||||||
10.11 * | 8-K | 8/7/2018 | 10.10 | |||||||||||||||||||||||||||||
10.12 * | 8-K | 8/7/2018 | 10.11 | |||||||||||||||||||||||||||||
10.13 * | 8-K | 8/3/2021 | 10.1 | |||||||||||||||||||||||||||||
10.14 * | 10-K | 2/22/2019 | 10.14 | |||||||||||||||||||||||||||||
10.15 * | 8-K | 8/7/2018 | 10.14 | |||||||||||||||||||||||||||||
10.16 * | S-1/A | 7/23/2018 | 10.16 | |||||||||||||||||||||||||||||
10.17 * | 10-Q | 8/27/2018 | 10.17 | |||||||||||||||||||||||||||||
| 8-K | 5/1/2019 | 10.1 | ||||||||||||||||||||||||||||||
10.19 * | 10-Q | 11/8/2019 | 10.1 | |||||||||||||||||||||||||||||
10.20 * | 10-Q | 11/8/2019 | 10.2 | |||||||||||||||||||||||||||||
10.21 * | 10-Q | 11/8/2019 | 10.3 | |||||||||||||||||||||||||||||
| 10-K | 2/28/2020 | 10.23 | ||||||||||||||||||||||||||||||
| X | ||||||||||||||||||||||||||||||||
| 10-Q | 8/6/2020 | 10.2 | ||||||||||||||||||||||||||||||
| 10-Q | 8/6/2020 | 10.3 | ||||||||||||||||||||||||||||||
| 10-Q | 8/6/2020 | 10.4 | ||||||||||||||||||||||||||||||
| 10-K | 2/26/2021 | 10.30 | ||||||||||||||||||||||||||||||
| 10-Q | 5/6/2021 | 10.1 | ||||||||||||||||||||||||||||||
| 10-Q | 8/5/2021 | 10.1 | ||||||||||||||||||||||||||||||
124
| 10-Q | 11/10/2021 | 10.2 | ||||||||||||||||||||||||||||||
| X | ||||||||||||||||||||||||||||||||
| X | ||||||||||||||||||||||||||||||||
| X | ||||||||||||||||||||||||||||||||
| X | ||||||||||||||||||||||||||||||||
| X | ||||||||||||||||||||||||||||||||
| X | ||||||||||||||||||||||||||||||||
| X | ||||||||||||||||||||||||||||||||
| X | ||||||||||||||||||||||||||||||||
| 101.INS | Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document | X | ||||||||||||||||||||||||||||||
| 101.SCH | Inline XBRL Taxonomy Extension Schema Document | X | ||||||||||||||||||||||||||||||
| 101.CAL | Inline XBRL Taxonomy Extension Calculation Linkbase Document | X | ||||||||||||||||||||||||||||||
| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document | X | ||||||||||||||||||||||||||||||
| 101.LAB | Inline XBRL Taxonomy Extension Label Linkbase Document | X | ||||||||||||||||||||||||||||||
| 101.PRE | Inline XBRL Taxonomy Extension Presentation Linkbase Document | X | ||||||||||||||||||||||||||||||
| 104 | 104 Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) | X | ||||||||||||||||||||||||||||||
| * | Indicates management contract or compensatory plan or arrangement. | |||||||||||||||||||||||||||||||
| † | Pursuant to Item 601(b)(10) of Regulation S-K, certain portions of this exhibit have been omitted by means of marking such portions with asterisks because the Registrant has determined that the information is both not material and is the type that the Registrant treats as private or confidential. | |||||||||||||||||||||||||||||||
Item 16. Form 10-K Summary
None.
125
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ARLO TECHNOLOGIES, INC. | ||||||||||||||||||||||||||
| Registrant | ||||||||||||||||||||||||||
| /s/ MATTHEW MCRAE | ||||||||||||||||||||||||||
| Matthew McRae | ||||||||||||||||||||||||||
| Chief Executive Officer | ||||||||||||||||||||||||||
| (Principal Executive Officer) | ||||||||||||||||||||||||||
| /s/ GORDON MATTINGLY | ||||||||||||||||||||||||||
| Gordon Mattingly | ||||||||||||||||||||||||||
| Chief Financial Officer | ||||||||||||||||||||||||||
| (Principal Financial and Accounting Officer) | ||||||||||||||||||||||||||
Date: March 2, 2022
126
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Matthew McRae and Gordon Mattingly, and each of them, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated:
| Signature | Title | Date | ||||||||||||
| /s/ MATTHEW MCRAE | Chief Executive Officer | March 2, 2022 | ||||||||||||
| Matthew McRae | (Principal Executive Officer) | |||||||||||||
| /s/ GORDON MATTINGLY | Chief Financial Officer | March 2, 2022 | ||||||||||||
| Gordon Mattingly | (Principal Financial and Accounting Officer) | |||||||||||||
| /s/ PRASHANT AGGARWAL | Director | March 2, 2022 | ||||||||||||
| Prashant Aggarwal | ||||||||||||||
| /s/ JOCELYN E. CARTER-MILLER | Director | March 2, 2022 | ||||||||||||
| Jocelyn E. Carter-Miller | ||||||||||||||
| /s/ RALPH E. FAISON | Director | March 2, 2022 | ||||||||||||
| Ralph E. Faison | ||||||||||||||
| /s/ CATRIONA FALLON | Director | March 2, 2022 | ||||||||||||
| Catriona Fallon | ||||||||||||||
| /s/ AMY ROTHSTEIN | Director | March 2, 2022 | ||||||||||||
| Amy Rothstein | ||||||||||||||
| /s/ GRADY K. SUMMERS | Director | March 2, 2022 | ||||||||||||
| Grady K. Summers | ||||||||||||||
127