Adestella Investment Management’s Arlo Technologies (ARLO) Investment Thesis

Adestella Investment Management, a long/short equity investment management firm, published its fourth quarter 2020 investor letter – a copy of which can be downloaded here. A return of 24.8% was recorded by the fund in the fourth quarter of 2020 and 93.3% for the whole year, outperforming its S&P 500 benchmark that delivered a 12.1% and 18.4% returns respectively in the same period. You can view the fund’s top 5 holdings to have a peek at their top bets for 2021.

Adestella Investment Management, in their Q4 2020 investor letter, mentioned Arlo Technologies, Inc. (NYSE: ARLO) and emphasized their views on the company. Arlo Technologies, Inc. is a California-based home automation company that currently has a $648 million market capitalization. Since the beginning of the year, ARLO delivered a 3.34% return, impressively extending its 12-month gains to 310.71%. As of March 11, 2021, the stock closed at $8.05 per share.

Here is what Adestella Investment Management has to say about Arlo Technologies, Inc. in their Q4 2020 investor letter:

“Arlo Technologies (ARLO): Longtime readers will know that some of our favorite investment situations are ones where a highly valuable segment or a business model shift is obscured in the consolidated financials by the impact of growth investments or the presence of a another less appealing segment. Such situations are often fertile ground for mispricings, as few investors do the work required to analyze the pieces separately and get to an accurate estimate of fair value. We think Arlo Technologies, a new addition to the portfolio, is one such opportunity.

Arlo makes high-end home security cameras and video doorbells. Standard features include high resolution video, motion detection, smart speaker integration, and AI capable of differentiating people, animals, and vehicles; all of this comes in a wireless device that works from negative temperatures to over 100° F. With people tending to spend much more time indoors during the last year, consumer demand has increased significantly as people invest in their homes. Arlo’s range of cameras have received almost universally positive reviews from both testers and consumers who are willing to pay up for superior quality.

What makes ARLO interesting as an investment is that the company is in the midst of a successful shift away from one-off product sales to recurring service-based revenue. Up until the first quarter of 2020, ARLO offered free 7-day cloud storage of “triggered events” (for example, someone coming to the front door) along with a 30-day trial of Arlo Smart, its cloud-based suite of monitoring and detection notification tools. Unfortunately, this model was only leading to a 5% conversion rate to an Arlo Smart subscription upon trial expiry, as most customers were content to simply review anything captured within the following week. This left the company reliant on continued device sales for further growth.

In Q2, ARLO pivoted its busines model and Smart Service offering. The company extended the length of the free trial from one month to three but removed the free 7-day triggered event storage; instead, customers who choose not to subscribe would only get live view after the trial expired with no access to the collated collection of triggered events. In essence, while both models are razor and blades, ARLO decided to lean into the latter

While such a sizable change was certainly a risk, early results of this shift have been excellent. In the three quarters since the change, conversion rates have gone from 5% to 50%, and paid account growth has accelerated in each of the periods (see chart).

This success is not immediately apparent from a quick glance at the financials, as total revenue fell in 2020 (due to lower device sales) and consolidated margins are not impressive. This, however, masks the rapid development of the service segment, which grew revenues at a 70%+ clip in the latest quarter while expanding gross margins by over 20% YoY (see chart).

While service revenues are still a relatively small piece of the total, with growth rates like these, it won’t take long for the impact of the business model shift to start to be appreciated by the market. Furthermore, the company seems to have significant room for future price hikes (and thus further margin expansion), given that it currently offers plans for as low as $2.99 a month.

At the current ~$7 stock price, we think it’s easy to pencil out at least 40% upside for ARLO even under modest assumptions. At the current run-rate, the company generates about $86 M in service sales. Assuming service sales grow 50-60% in the next twelve months (recall they accelerated above 70% in the latest quarter) and the company can maintain its ~58% segment gross margins (which we think will actually continue to expand), we triangulate a fair multiple of at least 7-8x sales based on SaaS comps with similar growth and profitability profiles. At a 7x multiple, the unit is worth over $600 M, well above the current EV. We value the hardware sales at 1x LTM revenue, which is below consumer tech hardware peers like GRMN and GPRO, as well below the Fitbit takeout price. Adding the company’s net cash position and applying a 15% SOTP discount gets us to a ~$10 price target.

While the above already represents an attractive-risk reward, further upside is possible if the company’s paid account growth remains robust, service margins continue to expand, multiples converge toward peers, or if ARLO manages to break into commercial verticals or related markets such as baby monitors. While insiders own less of the equity than we’d like, much of their compensation is in the form of options with an ~$11.50 WA strike, meaning they’re incentivized to see a much higher stock price as well.”

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Our calculations show that Arlo Technologies, Inc. (NYSE: ARLO) does not belong in our list of the 30 Most Popular Stocks Among Hedge Funds. As of the end of the fourth quarter of 2020, Arlo Technologies, Inc. was in 17 hedge fund portfolios, compared to 16 funds in the third quarter. ARLO delivered a 1.77% return in the past 3 months.

The top 10 stocks among hedge funds returned 231.2% between 2015 and 2020, and outperformed the S&P 500 Index ETFs by more than 126 percentage points. We know it sounds unbelievable. You have been dismissing our articles about top hedge fund stocks mostly because you were fed biased information by other media outlets about hedge funds’ poor performance. You could have doubled the size of your nest egg by investing in the top hedge fund stocks instead of dumb S&P 500 ETFs. Here you can watch our video about the top 5 hedge fund stocks right now. All of these stocks had positive returns in 2020.

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Disclosure: None. This article is originally published at Insider Monkey.