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.
Business and Executive Overview
Arlo combines an intelligent cloud infrastructure and mobile app with a variety of smart connected devices that transform the way people experience the connected lifestyle. 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 inDecember 2014 , we have shipped over 15.8 million smart connected devices, and, as ofDecember 31, 2019 , our smart platform had approximately 4.02 million cumulative registered accounts across more than 100 countries around the world. We conduct business across three geographic regions-theAmericas ;Europe ,Middle-East andAfrica ("EMEA"); andAsia Pacific ("APAC") and we primarily generate revenue by selling devices through retail, wholesale distribution and wireless carrier channels and paid subscription services through in-app purchases. International revenue was 48.6%, 22.6% and 24.6% of our revenue for the years endedDecember 31, 2019 , 2018 and 2017, respectively. For the years endedDecember 31, 2019 , 2018 and 2017, we generated revenue of$370.0 million ,$464.9 million and$370.7 million , respectively. Loss from operations was$85.2 million for the year endedDecember 31, 2019 compared with Loss from operations of$74.8 million for the year endedDecember 31, 2018 and Income from operations of$5.7 million for the year endedDecember 31, 2017 . Income (loss) from operations for the year endedDecember 31, 2019 , 2018 and 2017 included separation expense of$1.9 million ,$27.3 million , and$1.4 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. In addition, management's incentive compensation is partially determined using certain of these key business metrics. 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 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. 52
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Table of Contents As of and for the Year Ended December 31, (1) 2019 % Change 2018 % Change 2017 (In thousands, except percentage data) Cumulative registered accounts 4,015 40.9 % 2,850 70.7 % 1,670 Cumulative paid accounts 230 59.7 % 144 84.6 % 78 Devices shipped for the period 4,060 (20.2 )% 5,086
34.9 % 3,770
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(1) Starting with this Annual Report Form 10-K, Service Revenue is included as a line item in the consolidated statement of operations in Item 8 of Part II of this Annual Report on Form 10-K. 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. 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 have changed our definition from registered users to registered accounts 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. 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). During the second quarter of 2019, we factored in an adjustment to the first quarter of 2019 paid account number and have subsequently revised the first quarter of 2019 paid accounts total to 162,000. We have redefined paid subscribers as paid accounts to include customers that were transferred to Verisure as part of the disposal of our commercial operations inEurope because we will continue to provide services to these European customers and receive payments under the Verisure Agreements. Devices Shipped. Devices shipped represents the number of Arlo cameras, lights, and doorbells that are shipped to our customers during a period. Devices shipped does not include shipments of Arlo accessories and Arlo base stations, nor does it take into account returns of Arlo cameras, lights, and doorbells. The growth rate of our revenue is not necessarily correlated with our growth rate of devices shipped, as our revenue is affected by a number of other variables, including but not limited to returns from customers, end-user customer rebates and other channel sales incentives deemed to be a reduction of revenue per the authoritative guidance for revenue recognition, sales of accessories, and premium services, the types of Arlo products sold during the relevant period and the introduction of new product offerings that have differentU.S. manufacturer's suggested retail prices.
Comparability of Historical Results
The operating results of Arlo have historically been disclosed as a reportable segment within the consolidated financial statements of NETGEAR, enabling the identification of directly attributable transactional information, functional departments, and headcount. ThroughJuly 1, 2018 , Revenue and Cost of revenue, with the exception of channel sales incentives, were derived from transactional information specific to Arlo products and services. Directly attributable operating expenses were derived from activities relating to Arlo functional departments and headcount. Arlo employees also historically participated in NETGEAR's stock-based incentive plans, in the form of restricted stock units ("RSUs"), stock options, and purchase rights issued pursuant to NETGEAR's employee stock purchase plan. Stock-based compensation expense has been either directly reported by or allocated to Arlo based on the awards and terms previously granted to NETGEAR's employees. The consolidated statements of operations of the Company as presented reflect the directly attributable transactional information specific to Arlo and certain additional allocated costs throughJuly 1, 2018 . The allocated costs for corporate functions included, but were not limited to, allocations of general corporate expenses from NETGEAR including expenses related to corporate services, such as executive management, information technology, legal, finance and accounting, 53
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human resources, tax, treasury, research and development, sales and marketing, shared facilities and other shared services. These costs were allocated based on revenue, headcount, or other measures the Company has determined as reasonable. FollowingJuly 1, 2018 , the consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The amount of these allocations from NETGEAR reflected within operating expenses in the consolidated statements of operations was$30.6 million fromJanuary 1, 2018 to the date of the completion of the IPO, which included$9.4 million for research and development,$10.0 million for sales and marketing, and$11.2 million for general and administrative expense. For the year endedDecember 31, 2017 , allocations amounted to$40.0 million , which included$11.8 million for research and development,$13.1 million for sales and marketing and$15.1 million for general and administrative expense.
The management of Arlo believes the assumptions underlying the consolidated financial statements, including the assumptions regarding the allocated expenses, reasonably reflect the utilization of services provided, or the benefit received by Arlo during the periods presented. Nevertheless, the consolidated financial statements may not be indicative of Arlo's future performance and do not necessarily reflect Arlo's results of operations, financial position, and cash flows had Arlo been a standalone company during the periods presented.
Our Relationship with NETGEAR OnAugust 2, 2018 , in connection with the IPO, the Company entered into a master separation agreement, a transition services agreement, an intellectual property rights cross-license agreement, a tax matters agreement, an employee matters agreement, and a registration rights agreement, in each case with NETGEAR, which effect the Separation, provide a framework for the Company's relationship with NETGEAR after the Separation and provide for the allocation between NETGEAR and the Company of NETGEAR's assets, employees, liabilities and obligations (including its investments, property and employee benefits assets and liabilities) attributable to periods prior to, at and after the Separation. NETGEAR has provided certain of the services on a transitional basis following the Distribution pursuant to the Transition Services Agreement ("NETGEAR TSA"). Under the NETGEAR TSA, NETGEAR charges a fee that is consistent with our historical allocation for such services. During the year endedDecember 31, 2018 , we incurred$6.3 million in NETGEAR TSA related costs, which included$0.4 million for research and development,$1.6 million for sales and marketing, and$4.3 million for general and administrative expense. During the year endedDecember 31, 2019 , we incurred$0.7 million in NETGEAR TSA related costs, which included$0.1 million for cost of revenue,$0.3 million for research and development,$0.1 million for sales and marketing, and$0.2 million for general and administrative expense. We do not expect to incur any NETGEAR TSA related costs during fiscal year 2020. In addition, to operate as a standalone company, we incurred costs to replace certain services that were previously provided by NETGEAR, which were higher than those reflected in our historical combined financial statements. The most significant component of these costs was IT-related costs, including capital expenditures, to implement certain new systems, including infrastructure and an enterprise resource planning system. As ofDecember 31, 2018 , we have fully completed the implementation of these new systems. We are subject to the reporting requirements of the Exchange Act, and we are required to establish procedures and practices as a standalone public company in order to comply with our obligations under the Exchange Act and related rules and regulations, as well as rules of theNew York Stock Exchange . As a result, we will continue to incur additional costs, including internal audit, investor relations, stock administration, and regulatory compliance costs. These additional costs may differ from the costs that were historically allocated to us by NETGEAR.
Components of Our Operating Results
Revenue
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Our gross revenue consists primarily of sales of devices and prepaid and paid subscription service revenue. 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 prepaid services primarily pertain to devices which are sold with our Arlo prepaid services offering, providing users with the ability to store and access data for up to five cameras for a rolling seven-day period, one-year free subscription for basic services. Prepaid services also include one year ofArlo Smart bundled with our for ourArlo Ultra products launched in early 2019, and three-month free subscription forArlo Smart services for ourArlo Pro 3 products launched in lateSeptember 2019 and Arlo Video Doorbell launched in lateNovember 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 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 inEurope for all channels, and will non-exclusively distribute our products through its direct channels globally. Revenue associated with the NRE arrangement under the Supply Contract is not significant for the year endedDecember 31, 2019 . We expect that our revenue and profitability inEurope will improve over the life of the Supply Agreement. We expect that our revenue and gross margin for the first half of 2020 will be negatively impacted by delayed delivery of components from suppliers located in regions affected by COVID-19 and other potential impacts of COVID-19 on our operations.
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 purchasing, product planning, inventory control, warehousing and distribution logistics, third-party software licensing fees, inbound freight, 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. 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 mix, sales channel mix, registered user 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 corporate 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, 55
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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 to support the connected lifestyle market. We expect research and development expense to fluctuate depending on the timing and number of development activities in any given period, and such expense could vary significantly as a percentage of revenue, depending on actual revenue achieved in any given period.
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 amortization of certain intangibles. We expect our sales and marketing expense to fluctuate based on the seasonality of our business for the foreseeable future.
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, corporate IT and facilities overhead, strategic initiative expense, and other general corporate expense. We expect our general and administrative expense to moderately decrease in absolute dollars. However, we also 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.
Separation Expense
Separation expense consists primarily of costs associated with our separation from NETGEAR, including third-party advisory, consulting, legal and professional services for separation matters including IPO-related litigation, IT-related expenses directly related to our separation from NETGEAR, and other items that are incremental and one-time in nature. To operate as a standalone company, we have incurred separation costs of$27.3 million and$1.9 million during the years endedDecember 31, 2018 and 2019, respectively, to replicate certain services previously provided by NETGEAR. The significant reduction during the year endedDecember 31, 2019 was as a result of the substantial completion of our Separation from NETGEAR onDecember 31, 2018 .
Gain on sale of business
Gain on sale of business represents the gain on sale of the Company's commercial
operations in
Interest Income
Interest income represents interest earned on our cash, cash equivalents and short-term investments.
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 in Other income.
Income Taxes
We record our provision for income taxes in our consolidated financial statements using the asset and liability method. Under this method, we recognize income tax liabilities or receivable for the current year. We also recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting 56
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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. We record a valuation allowance to reduce our deferred tax assets to the net amount that we believe is more likely than not to be realized. Our assessment considers the recognition of deferred tax assets on a jurisdictional basis. Accordingly, in assessing our future taxable income on a jurisdictional basis, we consider the effect of its transfer pricing policies on that income. We have placed a valuation allowance againstU.S. federal and state deferred tax assets and certain foreign tax attribute carryforwards since we do not anticipate to realize the benefits of deferred tax assets. We recognize tax benefits from uncertain tax positions only if we believe 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 we expand internationally, we will face increased complexity in determining the appropriate tax jurisdictions for revenue and expense items. Our policy is to adjust these reserves when facts and circumstances change, such as the closing of a tax audit or refinement of an estimate. 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 our financial condition and operating results. The provision for income taxes includes the effects of any accruals that we believe are appropriate, as well as the related net interest and penalties. The Tax Cuts and Jobs Act of 2017 ("Tax Act") introduced the global intangible low-taxed income ("GILTI") provisions effective in 2018, which generally impose a tax on the net income earned by foreign subsidiaries ofU.S company in excess of a deemed return on their tangible assets. We recognize the tax on GILTI as a period cost when the tax is incurred. 57
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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, 2019 2018 2017 (In thousands, except percentage data) Revenue: Products$ 323,242 87.4 %$ 427,113 91.9 %$ 341,581 92.2 % Services 46,765 12.6 % 37,805 8.1 % 29,077 7.8 % Total revenue 370,007 100.0 % 464,918 100.0 % 370,658 100.0 % Cost of revenue: Products 307,348 83.1 % 354,023 76.1 % 270,382 72.9 % Services 26,855 7.3 % 18,820 4.0 % 9,042 2.4 % Total cost of revenue 334,203 90.3 % 372,843 80.2 % 279,424 75.4 % Gross profit 35,804 9.7 % 92,075 19.8 % 91,234 24.6 % Operating expenses: Research and development 69,384 18.8 % 58,794 12.6 % 34,683 9.4 % Sales and marketing 56,985 15.4 % 52,593 11.3 % 34,340 9.3 % General and administrative 47,624 12.9 % 28,209 6.1 % 15,096 4.1 % Separation expense 1,913 0.5 % 27,252 5.9 % 1,384 0.4 % Gain on sale of business (54,881 ) (14.8 )% - - % - - % Total operating expenses 121,025 32.7 % 166,848 35.9 % 85,503 23.1 % Income (loss) from operations (85,221 ) (23.0 )% (74,773 ) (16.1 )% 5,731 1.5 % Interest income 2,737 0.7 % 1,239 0.3 % - - % Other income (expense), net 913 0.3 % (1,177 ) (0.3 )% 1,946 0.5 % Income (loss) before income taxes (81,571 ) (22.0 )% (74,711 ) (16.1 )% 7,677 2.1 % Provision for income taxes 4,380 1.2 % 772 0.1 % 1,128 0.3 % Net income (loss)$ (85,951 ) (23.2 )%$ (75,483 ) (16.2 )%$ 6,549 1.8 % 58
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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, 2019 % Change 2018 % Change 2017 (In thousands, except percentage data) Americas$ 289,160 (23.3 )%$ 376,805 28.7 %$ 292,671 Percentage of revenue 78.1 % 81.0 % 79.0 % EMEA$ 57,232 (12.6 )%$ 65,462 11.3 % $
58,795
Percentage of revenue 15.5 % 14.1 % 15.9 % APAC$ 23,615 4.3 %$ 22,651 18.0 % $
19,192
Percentage of revenue 6.4 % 4.8 % 5.1 % Total revenue$ 370,007 (20.4 )%$ 464,918 25.4 %$ 370,658 Revenue decreased 20.4% across all geographic regions for the year endedDecember 31, 2019 compared to the prior year. The decrease was primarily driven by a slowdown in our customer demand for connected cameras, increased competition, higher marketing expenditures deemed to be a reduction of revenues, increased in provisions for price protection that are deemed to be a reduction of revenue, offset by higher service revenue. We launchedArlo Ultra , with 4K video resolution capability, in the first fiscal quarter of 2019,Arlo Pro 3, with 2K video resolution capability, in the third fiscal quarter of 2019 and Arlo Video Doorbell with 180 degree viewing angle, in the fourth quarter of 2019. Service revenue increased by$9.0 million , or 23.7%, for the year endedDecember 31, 2019 compared to the prior year, as our paid subscribers increased compared to the prior year. Revenue increased 25.4% across all geographic regions for the year endedDecember 31, 2018 compared to the prior year. The increase was primarily driven by continued rollout of ourArlo Pro 2 camera, which launched in the fourth quarter of fiscal 2017. Additionally, service revenue increased by$8.7 million , or 30.0%, for the year endedDecember 31, 2018 compared to the prior year. We experienced a slowdown in end user demand for our cameras in the fourth quarter of 2018.
Cost of Revenue and Gross Margin
The following table presents cost of revenue and gross margin for the periods indicated: Year Ended December 31, 2019 % Change 2018 % Change 2017 (In thousands, except percentage data) Cost of revenue: Products$ 307,348 (13.2 )%$ 354,023 30.9 %$ 270,382 Services 26,855 42.7 % 18,820 108.1 % 9,042 Total cost of revenue$ 334,203 (10.4 )%$ 372,843 33.4 %$ 279,424 Gross margin 9.7 % 19.8 % 24.6 % Cost of revenue decreased for the year endedDecember 31, 2019 , due primarily to a decline in product revenue compared to the prior year. Service cost of revenue increased for the year endedDecember 31, 2019 , in line with the service revenue growth and due to our continued investment in our cloud service offerings to improve our customer experience and to enhance our security profile. Gross margin decreased significantly for the year endedDecember 31, 2019 compared to the prior year, due to a combination of both product and service margin declines. The product margin decline is primarily due to increased marketing expenditures deemed to be a reduction of revenues, increased provisions for price 59
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protection that are deemed to be reductions of revenue, increased warranty costs, product overhead and freight-related costs, offset by less charges for excess or obsolete inventory. Service margin decreased for the year endedDecember 31, 2019 compared to the prior year, primarily due to higher service cost growth which included the cost of the free 3-month and 12-month trials ofArlo Smart included in our new product offerings in fiscal 2019. Cost of revenue increased for the year endedDecember 31, 2018 , due primarily to revenue growth compared to the prior year. Gross margin decreased for the year endedDecember 31, 2018 compared to the prior year due primarily to higher channel marketing promotion activities deemed to be a reduction of revenue and due to an increase in inventory reserves for excess and obsolete products as well as excess materials from our original design manufacturers ("ODMs"). The decrease was partially offset by higher revenue and product margin, mainly from the continued rollout of ourArlo Pro 2 camera. During the fourth quarter of 2018, we experienced a decline in our gross margin mainly from increased marketing expenditures that are deemed to be a reduction in revenue.
Operating Expenses
For the year endedDecember 31, 2019 , our operating expenses, which reflect a full year as a standalone public company, were expected to increase compared to historical periods. The full year of 2017 and first and second quarters of 2018, are based on carve-out financials and reflect the transactions which are directly attributable to Arlo and certain allocated costs, whereas third quarter and fourth quarter of 2018 and 2019 are based on our actual results for the periods as a standalone public company.
Research and Development
The following table presents research and development expense for the periods indicated: Year Ended December 31, 2019 % Change 2018 % Change 2017 (In thousands, except percentage data)
Research and development expense
Research and development expense increased for the year endedDecember 31, 2019 compared to the prior year due to increases of$2.5 million in personnel-related expenses and$8.3 million in corporate IT and facilities overhead. The increased expenditures on personnel-related expense and engineering projects were due to continuous investment in strategic focus areas, principally the expansion of our Arlo product and service offerings and the growth of our cloud platform capabilities. The increase in corporate IT and facilities overhead is due to the fact that starting in late 2018 Arlo moved to separate facilities globally and for the whole of 2019 Arlo maintained its own facilities and IT infrastructures and systems globally as a standalone public company. Research and development expense increased for the year endedDecember 31, 2018 compared to the prior year due to increases of$11.6 million in personnel-related expenses,$9.2 million in corporate IT and facilities overhead,$2.5 million in engineering projects and outside professional services, and$0.4 million in NETGEAR TSA related expense. The increased expenditures on personnel-related expense, engineering projects and outside professional services were due to continuous investment in strategic focus areas, principally the expansion of our Arlo product and service offerings and the growth of our cloud platform capabilities. 60
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Sales and Marketing
The following table presents sales and marketing expense for the periods indicated: Year Ended December 31, 2019 % Change 2018 % Change 2017 (In thousands, except percentage data)
Sales and marketing expense
Sales and marketing expense increased for the year endedDecember 31, 2019 compared to the prior year, primarily due to an increase in outside professional services of$2.0 million , corporate IT and facilities overhead of$2.7 million , and personnel-related expenses of$1.2 million . The increases were partially offset by a decrease NETGEAR TSA related expenses of$1.5 million . The increased in corporate IT and facilities overhead is due to the fact that starting in late 2018 Arlo moved to separate facilities globally and for the whole of 2019 Arlo maintained its own facilities and IT infrastructures and systems globally as a standalone public company. Sales and marketing expense increased for the year endedDecember 31, 2018 compared to the prior year, primarily due to an increase in personnel-related expenses of$7.7 million , digital advertising, media and other costs of$7.1 million , IT and facilities overhead of$2.3 million , NETGEAR TSA related expense of$1.6 million , and sales freight out expenses of$0.7 million . The increase was partially offset by a decrease in marketing expenditures of$1.1 million further to the launch of ourArlo Pro 2 camera in fiscal 2017.
General and Administrative
The following table presents general and administrative expense for the periods indicated: Year Ended December 31, 2019 % Change 2018 % Change 2017 (In thousands, except
percentage data)
General and administrative expense
General and administrative expense increased for the year endedDecember 31, 2019 compared to the prior year, primarily due to higher corporate IT and facilities overhead of$9.7 million , higher personnel-related expenditures of$6.0 million , higher legal and professional services of$5.3 million , and transaction costs of$1.9 million related to the disposal of our commercial operations inEurope , partially offset by$4.2 million decrease in NETGEAR TSA related expenses. The increase in general and administrative expense was driven by the increase in related corporate IT and facilities overhead due to the fact that starting in late 2018 Arlo moved to separate facilities globally and for the whole of 2019 Arlo maintained its own facilities and IT infrastructures and systems globally, increased customary public company costs, including outside legal and audit fees, insurance and other costs as our company became a standalone public company sinceAugust 2018 . General and administrative expense increased for the year endedDecember 31, 2018 compared to the prior year, primarily due to higher personnel-related expenditures of$7.0 million , NETGEAR TSA related expense of$4.3 million , and higher legal and professional services of$1.8 million . Refer to Overview for further detail about the NETGEAR TSA. 61
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Separation Expense
The following table presents separation expense for the periods indicated:
Year Ended December 31, 2019 % Change 2018 % Change 2017 (In thousands, except percentage data)
Separation expense
**Percentage change not meaningful. Separation expense consists primarily of charges for third-party advisory, consulting, legal and professional services, IT-related expenses, and other items that are incremental and one-time in nature related to our separation from NETGEAR. There was a significant reduction in our separation expense in the fiscal year endedDecember 31, 2019 as we completed our Separation from NETGEAR onDecember 31, 2018 .
Gain on sale of business
Year Ended December 31, 2019 % Change 2018 % Change
2017
(In thousands, except percentage data)
Gain on sale of business
**Percentage change not meaningful.
Our disposal of our commercial operations inEurope generated a gain on sale of business for the year endedDecember 31, 2019 of$54.9 million in the fourth quarter of 2019. There was no gain or loss for the year endedDecember 31, 2018 . Refer to Note 4, Disposal of business, in 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. Interest Income and Other Income (Expense), Net The following table presents other income (expense), net for the periods indicated: Year Ended December 31, 2019 % Change 2018 % Change 2017 (In thousands, except percentage data) Interest income 2,737 ** 1,239 ** - Other income (expense), net 913 ** (1,177 ) ** 1,946
**Percentage change not meaningful.
During the year endedDecember 31, 2019 , we earned interest income of$2.7 million from our cash equivalents and short-term investments. Other income (expense), net increased for the year endedDecember 31, 2019 compared to the prior year, due primarily to Verisure TSA related income of$798 thousand and higher foreign currency transaction gains, mainly as a result of theU.S. dollar strengthening against transaction currencies. During the year endedDecember 31, 2018 , we earned interest income of$1.2 million from our cash proceeds from the IPO and from our cash equivalents and short-term investments. Other income (expense), net decreased for the year endedDecember 31, 2018 compared to the prior year, due primarily to higher foreign currency transaction losses, mainly as a result of theU.S. dollar strengthening against transaction currencies. We entered into a foreign currency hedging program during the third quarter of fiscal 2018, which effectively reduced volatility associated with hedged currency exchange rate movements. For a detailed discussion of our hedging program and related foreign currency 62
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contracts, refer to Note 7, Derivative Financial Instruments, in Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K.
Provision for Income Taxes Provision for income taxes and effective tax rate consisted of the following: Year Ended December 31, 2019 % Change 2018 % Change 2017 (In thousands, except percentage data)
Provision for income taxes
(5.4 )% (1.0 )% 14.7 % The increase in provision for income taxes for the year endedDecember 31, 2019 compared to 2018 was primarily due to higher foreign earnings in 2019 and gain on sale of certain assets related to the Company's commercial operations inEurope during the fourth quarter of 2019. Losses incurred predominantly in theU.S continue to be subject to a full valuation allowance. The decrease in provision for income taxes for the year endedDecember 31, 2018 compared to 2017 was primarily caused by the deemed repatriation of foreign earnings in 2017 following the 2017 U.S. Tax Act. The negative 1.0% effective tax rate was a result of losses in theU.S for which the Company was not recognizing a tax benefit due to its fullU.S federal and state valuation allowance.
Liquidity and Capital Resources
Following the completion of the IPO, our capital structure and sources of liquidity changed significantly from our historical capital structure as we became a standalone public company. We are no longer participating in cash management and funding arrangements managed by NETGEAR. Arlo maintained a separate cash management and financing function for our operations.
We have a history of losses and may continue to incur operating and net losses for the foreseeable future. As ofDecember 31, 2019 , our accumulated deficit was$131.5 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 ofDecember 31, 2019 , we had cash, cash equivalents and short-term investments totaling$256.7 million . InNovember 2019 , we entered into a business financing agreement withWestern Alliance Bank providing for a credit facility to up to$40.0 million and as ofDecember 31, 2019 , 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 such business financing agreement. InDecember 2019 , we received a total of$75.2 million from Verisure for the disposal of our commercial operations inEurope , including a$20.0 million prepayment for product purchases and a$2.5 million installment payment for the NRE Services under the Supply Agreement.
As of
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earnings. The cash and cash equivalents balance outside of the
Based on our current plans, business financing agreement withWestern Alliance Bank , and market conditions, we believe that such sources of liquidity will be sufficient to satisfy our anticipated cash requirements for at least the next 12 months. However, in the future, including sooner as may be anticipated, we may require or desire additional funds to support our operating expenses and capital requirements or for other purposes, such as acquisitions, and may seek to raise such additional funds through public or private equity or debt financings or collaborative agreements or from other sources. To preserve the tax-free treatment of our separation from NETGEAR, we have agreed in the tax matters agreement with NETGEAR to certain restrictions on our business, which generally will be effective during the two-year period following the Distribution that could limit our ability to pursue certain transactions including equity issuances. We have no commitments to obtain such additional financing and cannot assure you that additional financing will be available at all or, if available, that such financing would be obtainable on terms favorable to us and would not be dilutive. Our future liquidity and cash requirements will depend on numerous factors, including the introduction of new products, the growth in our service revenue, as well as the ability to increase our gross margin dollars and continue to maintain controls over our operating expenditures.
Cash Flow
The following table presents our cash flows for the periods presented.
Year Ended December 31, 2019 2018 2017 (In thousands) Net cash provided by (used in) operating activities$ 9,171 $ (17,686 ) $ (38,985 ) Net cash provided by (used in) investing activities 76,262 (71,285 ) (4,315 ) Net cash provided by (used in) financing activities (38 ) 244,287 43,188 Net increase (decrease) in cash and cash equivalents and restricted cash$ 85,395 $ 155,316 $ (112 ) Operating activities Net cash provided by operating activities increased by$26.9 million for the year endedDecember 31, 2019 compared to the prior year, due primarily to improved working capital management, offset by a$55.0 million year over year decrease in the adjusted net loss from operations. Our cash inflow from changes in assets and liabilities increased by$81.9 million year over year as a result of increased accounts receivable collections, prepayments from Verisure product purchases and NRE services under the Supply Agreement and lower inventory balance. Net cash used in operating activities decreased by$21.3 million for the year endedDecember 31, 2018 compared to the prior year, due primarily to the favorable net working capital changes offset by the net loss incurred. Changes in operating activities also reflected the movements of the balances for Statements of Cash Flows purposes since the balances contributed by NETGEAR on or before the initial public offering reflects the contributed balances to us as per the master separation agreement between Arlo and NETGEAR and related documents governing the Contribution. Our days sales outstanding ("DSO") decreased to 97 days as ofDecember 31, 2019 as compared to 125 days as ofDecember 31, 2018 . Inventory decreased to$68.6 million as ofDecember 31, 2019 from$124.8 million as ofDecember 31, 2018 , primarily due to better inventory management. As a result, ending inventory turns were 5.9x in the three months endedDecember 31, 2019 down from 3.6x turns in the three months endedDecember 31, 2018 . Our accounts payable increased to$111.7 million as ofDecember 31, 2019 from$82.5 million as ofDecember 31, 2018 , primarily as a result of extended payment terms with our suppliers. 64
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Investing activities
Net cash provided by investing activities increased by$147.5 million for the year endedDecember 31, 2019 compared to the prior year, primarily due to the more maturity of short-term investments in the amount of$55.0 million , less purchases of short-term investments of$24.9 million , less purchases of property equipment of$15.0 million , and proceeds from sale of our commercial operations inEurope in the amount of$52.7 million . Net cash used in investing activities increased by$67.0 million for the year endedDecember 31, 2018 compared to the prior year, primarily due to the purchase of short-term investments of$54.6 million and the increased capital expenditures as we implement certain new systems, including infrastructure and an enterprise resource planning system. In the year endedDecember 31, 2017 , we made a$0.7 million payment in connection with our Placemeter acquisition.
Financing activities
Net cash used in financing activities was
Net cash provided by financing activities was$244.3 million in the year endedDecember 31, 2018 , primarily due to net proceeds from IPO of$173.4 million and net investment from parent of$70.9 million . Prior to the completion of the IPO, because cash and cash equivalents were held by NETGEAR at the corporate level and were not attributable to Arlo, cash flows related to financing activities primarily reflect changes in Net parent investment.
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 ofDecember 31, 2019 , we had a backlog of$5.4 million , compared to$18.9 million as ofDecember 31, 2018 and$15.6 million as ofDecember 31, 2017 . As we typically fulfill orders received within a relatively short period (e.g., within one week for our top three customers) after receipt, our revenue in any fiscal year depends primarily upon orders booked and the availability of supply of our products in that year. In addition, most of our backlog is subject to rescheduling or cancellation with minimal penalties. As a result, our backlog as of any particular date may not be an indicator of revenue for any succeeding period. Similarly, there is a lack of meaningful correlation between year-over-year changes in backlog as compared with year-over-year changes in revenue. Accordingly, we do not believe that backlog information is material to an understanding of our overall business, and backlog as of any particular date should not be considered a reliable indicator of our ability to achieve any particular level of revenue or financial performance.
Contractual Obligations
The following table summarizes our non-cancelable operating lease commitments
and purchase obligations as of
Payments due by period Less Than 1-3 3-5 More Than Total 1 Year Years Years 5 Years (In thousands)
Operating leases
- - -$ 70,626 $ 35,275 $ 11,324 $ 9,358 $ 14,669 65
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Operating leases
We entered into several office lease agreements under non-cancelable operating leases with various expiration dates throughJune 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 year endedDecember 31, 2019 , rent expense was$7 million . For the year endedDecember 31, 2017 and six months endedJuly 1, 2018 , rent expense reflected allocations from NETGEAR and may not be indicative of our results. Rent expense was$1.4 million after the Separation throughDecember 31, 2018 .
Letters of Credit
In connection with the lease agreement for the headquarters located inSan Jose, California , we executed a letter of credit with the landlord as the beneficiary. As ofDecember 31, 2019 , we had approximately$3.6 million of unused letters of credit outstanding, of which$3.1 million pertains to the lease arrangement.
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 ofDecember 31, 2019 , we had$29.6 million in non-cancelable purchase commitments with suppliers. We expect to sell all products for which we have committed purchases from suppliers.
Uncertain tax position
As ofDecember 31, 2019 , the total gross unrecognized tax benefits and related interest and penalties was$0.7 million . The timing of any payments that could result from these unrecognized tax benefits will depend upon a number of factors. The unrecognized tax benefits have been excluded from the contractual obligations table because reasonable estimates cannot be made of whether, or when, any cash payments for such items might occur. We do not expect to reduce our liabilities for uncertain tax positions in any jurisdiction, where the impact would affect the statement of operations, in the next 12 months. We do not estimate any long-term liability related to a one-time transaction tax that resulted from the passage of the Tax Act. Off-Balance Sheet Arrangements As ofDecember 31, 2019 , we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
Critical Accounting Policies and Estimates
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted inthe United States of America and pursuant to the regulations of theSEC . 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 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 66
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consolidated financial statements. We have listed below our critical accounting policies that we believe to have the greatest potential impact on our consolidated financial statements.
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 we expect 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, and service providers). 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 we expect to be entitled to in exchange for the transferred goods. We sell paid subscription services to our end user customers where we provide customers access to our 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, we also sell 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, 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.
Contracts with Multiple Performance Obligations
Some of our 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, we account 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, we consider 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. After identifying the separate performance obligations, the transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. Standalone selling prices are generally determined based on the prices charged to customers or using an adjusted market assessment. Standalone selling price of the hardware 67
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is directly observable from add-on camera and base station sales. Standalone 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
We have entered into a Supply Agreement as part of the disposal of our commercial operations inEurope 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 month warranty. Verisure assumes responsibilities for all warranty claims, returns on products and certain technical support to the end users. We provide technical support for paid subscription services where Verisure can not resolve the issue. Verisure is responsible for any marketing and promotion of our products and services sold inEurope . Products are priced at a cost plus markup based on markups specified in the 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 that 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. We allocate 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 we receive and accept the customer purchase order (PO). Each product with a valid PO is a single performance obligation. We recognize variable consideration for products upon delivery and for services when the monthly service is rendered for paid subscription services and basic services. The non-refundable prepayment does 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 the prepayment. We also expect that prepayment will be fully utilized by Verisure within one year, hence, no additional accounting consideration is necessary for breakage. We also concluded that we are acting as the principal in the Supply Agreement and determined that revenue should be presented gross.
Non-recurring Engineering ("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 our commercial operations inEurope . 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 arrangement. The output (or work-in-progress of such output) typically has no alternative use to us given the customized nature of the arrangement and we have enforceable rights given that the non-refundable milestone payments are prepayments in nature; control for NRE development services therefore transfers over time. We determined that the most appropriate measure of progress for revenue recognition is the input method based on cost because we can reasonably estimate the total costs for the NRE, and the costs incurred reasonably reflects our 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 68
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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 revenue and costs 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.
Allowances for Warranty Obligations and Returns due to Stock Rotation
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. 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 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.
Sales Incentives
We accrue for sales incentives 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.
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 saleable. 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 69
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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.Goodwill Goodwill pertains to the acquisitions ofAvaak, Inc. ("Avaak") andPlacemeter, Inc. ("Placemeter").Goodwill represents the purchase price exceeds the estimated fair value of net assets of businesses acquired in a business combination. We perform an annual impairment assessment of goodwill at the reporting unit level on the first day of the fourth fiscal quarter. 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, we will perform the impairment test as those events or indicators occur. Examples of such events or circumstances include: a significant decline in our expected future cash flows, a sustained, significant decline in our stock price and market capitalization, a significant adverse change in the business climate and slower growth rates. We test goodwill 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 our stock price. If the reporting unit does not pass the qualitative assessment, we estimate its fair value and compare the fair value with the carrying amount of the reporting unit, including goodwill. If the fair value is greater than the carrying amount of the reporting unit, we do not record an impairment. We also test goodwill for impairment by performing a quantitative assessment, which is used to identify both the existence of impairment and the amount of impairment loss. The quantitative assessment compares the fair value of a reporting unit with its carrying amount, including goodwill. 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 that reporting unit. We would record any impairment charge within earnings in the consolidated statements of operations. A quantitative assessment of goodwill was performed on the first day of the fourth quarter of fiscal 2019. We identified that we had one reporting unit for the purpose of goodwill impairment testing and the reporting unit is at the same level as the operating segment and reportable segment. We utilized our market capitalization as a proxy for fair value of the business and compared it to the carrying amount as ofOctober 1, 2019 . Based on the results of the quantitative assessment, the respective fair value was substantially in excess of the carrying amount by$68.0 million , or 38%. We updated our quantitative test as ofDecember 31, 2019 at which time the fair value of the business was substantially in excess of the carrying amount by$115.7 million , or 57%. No goodwill impairment was recognized for the years endedDecember 31, 2019 and 2018. However, included in our accounting for the disposal of our commercial operations inEurope was a derecognition of$4.6 million of goodwill associated with the disposal of our commercial operations inEurope .
We do not believe it is likely that there will be a material change in the estimates or assumptions we use to test for impairment loss on goodwill. However, if the actual result is not consistent with our estimates or assumptions, we may be exposed to an impairment charge that could be material.
Stock-based compensation
Our employees have historically participated in NETGEAR's stock-based compensation plans. Stock-based compensation expense has been allocated to us based on the awards and terms previously granted to our employees as well as an allocation of NETGEAR's corporate and shared functional employee expenses. We measure stock-based compensation at the grant date based on the fair value of the award. The fair value of stock options and the shares offered 70
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under the employee stock purchase plan is estimated using the Black-Scholes option pricing model. Estimated compensation cost relating to restricted stock units ("RSUs") is based on the closing fair market value of NETGEAR's common stock on the date of grant. Equity awards granted under our own stock-based compensation plans on or after the completion of the IPO are comprised of performance-based stock options (the "PSOs"), stock options, and RSUs. We use the fair value method of accounting for its equity awards granted to employees and measures the cost of employee services received in exchange for the stock-based awards. We recognize these compensation expenses generally on a straight-line basis over the requisite service period of the award. The fair value of stock options and PSOs is estimated on the grant or offering date using the Black-Scholes option pricing model and the forfeitures recorded as they occur. The fair value of RSUs is measured on the grant date based on the closing fair market value of our common stock. The stock-based compensation cost is recognized ratably over the period during which an employee is required to provide service in exchange for the awards, usually the vesting period, which is generally four years for stock options and three to four years for RSUs. For PSOs, stock-based compensation expense of individual performance milestone is recognized over the expected performance achievement period when the achievement becomes probable. Our 2018 Employee Stock Purchase Plan ("ESPP") is intended to provide employees with the opportunity to purchase our 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 our 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. We determine the fair value using the Black-Scholes Model using various inputs, including our estimate of expected volatility, term, dividend yield and risk-free interest rate. We recognize compensation costs for the ESPP on a straight-line basis over the requisite service period of the award.
Income Taxes
We record our provision for income taxes in our consolidated financial statements using the asset and liability method. Under this method, we recognize income tax liabilities or receivable for the current year. We also recognize 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. We record a valuation allowance to reduce our deferred tax assets to the net amount that we believe is more likely than not to be realized. Our assessment considers the recognition of deferred tax assets on a jurisdictional basis. Accordingly, in assessing our future taxable income on a jurisdictional basis, we consider the effect of its transfer pricing policies on that income. We have placed a valuation allowance againstU.S. federal and state deferred tax assets and certain foreign tax attribute carryforwards since we do not anticipate to realize the benefits of deferred tax assets. We recognize tax benefits from uncertain tax positions only if we believe 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 we expand internationally, we will face increased complexity in determining the appropriate tax jurisdictions for revenue and expense items. Our policy is to adjust these reserves when facts and circumstances change, such as the closing of a tax audit or refinement of an estimate. 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 our financial condition and operating results. The provision for income taxes includes the effects of any accruals that we believe are appropriate, as well as the related net interest and penalties. The Tax Act introduced the global intangible low-taxed income ("GILTI") provisions effective in 2018, which generally impose a tax on the net income earned by foreign subsidiaries ofU.S company in excess of a deemed return on their tangible assets. We recognize the tax on GILTI as a period cost when the tax is incurred. 71
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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 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. 72
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