Arlo: A Cheap Way to Play The Connected Home Theme?

Arlo Spin-off Background

On December 31, 2018, Netgear (NTGR) spun off its remaining 62,500,000 shares of Arlo Technologies (ARLO), which is focused on smart video cameras, to existing shareholders.

The first day of trading post this distribution will be today (January 2, 2018). Given the large distribution (Arlo’s float will increase by over 500%) there is the possibility of selling pressure on the stock.

As a reminder, Netgear proceeded in August 2018 with a partial IPO (11.77MM shares) of its Arlo division. ARLO is currently trading at $9.98, down 38% from its $16 IPO price. However, it has performed well in recent weeks (it’s up ~12% from its trough).

Arlo Business Overview

ARLO is a connected device company. It’s main product line consists of smart, Wi-Fi connected security cameras, but it expanding into other productions including smart security lights, smart doorbells, and baby monitors.

ARLO is a key player in the connected home market….

….and has demonstrated impressive growth.

What is the Upside?

On a precedent transaction basis, ARLO looks attractive.

It trades at 0.9x ‘19 revenue. Competitors, Dropcam (acquired by Google), Nest (acquired by Google), and Ring (acquired by Amazon), were acquired at 8.3x forward sales, 6.9x forward sales and 3.3x forward revenue, respectively.

When you look at the public comps, it’s a different story.

ARLO doesn’t have pure play comps, but I’ve included public “connected device” hardware companies which are trying to transition to subscription companies.

As you can see, ARLO doesn’t look as cheap on an EV / ‘19 revenue basis. In fact, it is trading at a slight premium to peers. ARLO does have significantly higher revenue growth than all peers except Roku.

If you believe Arlo deserves to trade more inline with Roku, than it is very cheap. However, Roku is already generating positive (albeit, barely positive) EBITDA and seems better positioned to generate recurring revenue given its dominant position on the smart TV market.

One other technical point.

Arlo will be added to the relevant Russell and S&P indexes. I’m working to determine ARLO’s new weighting in each index, but upward pressure on the stock should materialize in the coming weeks given expected index/ETF buying.

So what is the upside case for ARLO? I think it’s reasonable to assume that ARLO could trade at an EV / ‘19 revenue multiple of 1.5x if sentiment improves given precedent transactions and ROKU’s valuation. This would yield a price of ~$15.50 (~55% upside).

What is the Downside?

I don’t believe that precedent transaction multiples for ARLO are terribly relevant.

Do Amazon, Google and other major tech players need to acquire another connected video manufacturer when they are already established in the space?

Further, ARLO is a tax-free spin-off which means it can’t be acquired for two years without giving up its tax free status.

I think the upside case for ARLO is dependent on an acquisition. Major tech players are interested in connected device manufacturers as it enables them to gain more data on their customers and better sell advertising (in the case of Google or Facebook) or products (in the case of Apple or Amazon). As such, paying 3.0x to 8.0x revenue for an acquisition isn’t a big deal when you have a $500BN+ market cap.

On a stand alone basis, ARLO’s business model isn’t compelling. The company sells low margin devices. In the bull case scenario, ARLO will generate more revenue from annuity like service offerings. However, Google, Apple, and Amazon will compete in the same space and they will likely heavily subsidize their service offerings to drive other advertising and/or product revenue.

So what’s the downside?

I think a fair downside case is ARLO trades at 0.4x 2019 revenue inline with Fitbit. This scenario yields a $6 stock price or ~40% downside.

Where does that leave us?

The upside case is +55% and the downside case is -40%. Not a compelling risk/reward. To be fair, the upside scenario is probably more likely than the downside scenario. If we assume the upside scenario has a 60% chance of occurring and the downside case has a 40% probability, a reasonable weighted price target is $11.72, implying ~17% upside.

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