NETGEAR, Inc.
Q1 2021 Earnings Call Transcript

Published: 21 Apr 2021

[Operator:]

Ladies and gentlemen, thank you for standing by. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. I would now like to turn the conference over to Erik Bylin. Please go ahead, sir.

[Erik Bylin:]

Thank you, Mike. Good afternoon, and welcome NETGEAR’s first quarter of 2021 financial results conference call. Joining us from the Company are Mr. Patrick Lo, Chairman and CEO; and Mr. Bryan Murray, CFO. Format of the call, we’ll start with a review of the financials for the first quarter provided by Bryan, followed by details and commentary on the business provided by Patrick, and finish off with second quarter of 2021 guidance provided by Bryan. We’ll then have time for any questions. If you have not received a copy of today’s press release, please visit NETGEAR’s Investor Relations website at www.netgear.com.

[Bryan Murray:]

Thank you, Erik, and thank you, everyone, for joining today’s call. We delivered a great start to the year, setting the pace to achieve the full year target we put out at last December at our Analyst Day. We reported net revenue just above our guided range as both sides of the business perform well, and we saw supply constraints ease slightly. Our operations team navigated around chip constraints and the continuing elongated transportation times to bring product in from our suppliers while significantly lowering our freight spend from the fourth quarter levels. Net revenue for the first quarter ended March 28, 2021 was $317.9 million, up 38.3% year-over-year, driven primarily by strong CHP growth in the retail channel and better than expected SMB performance. Our leading WiFi 6 offerings continued their momentum in the first quarter across both businesses. Additionally, the work we continue to do to focus on the right products in support the work-from-home networking market coupled with strong Pro AV growth resulted in continued upward trajectory for our SMB business, delivering 17.9% year-over-year growth. In the first quarter, we generated a record non-GAAP operating income of $42.3 million. This translated into a non-GAAP operating margin well above the top end of our guidance range at 13.3%, an improvement of 970 basis points over the first quarter of 2020 and 230 basis points over the fourth quarter of 2020. Relative to our guidance range, we experienced better than expected performance from our SMB business, which carries higher margins. Additionally, we saw an improved mix of business coming from the higher margin e-commerce channel. As mentioned previously, our operations team was able to lower spend on airfreight meaningfully below planned levels. All three factors contributed to non-GAAP operating margin coming in well above our initial expectations.

[Patrick Lo:]

Thank you, Bryan. As we progress through 2021, we are seeing the progress of the world’s slow recovery from the pandemic. New cases remain high and variants from other continents are becoming prevalent in many states. However, unprecedented federal spending plans and accelerated vaccine rollout and state reopening plans point to a light at the end of the tunnel. Businesses, small and large, are planning for growth off of a difficult 2020 with signs of business offices, and sports and entertainment venues steering towards reopening, albeit at dialed back capacity. It is clear that the pandemic has accelerated multiple years of technological progress into one year, and people adjusted surprisingly quickly to more time and activities from home. However, to enable this transition, highly reliable, high-speed internet connectivity that covers the entire home and even patio or yard has become a necessity. This spurred the rapid growth of the premium segment in home WiFi, spearheaded by WiFi 6 mesh with tri-band architecture, which NETGEAR pioneered and continues to be the leader in the market.

[Bryan Murray:]

Thank you, Patrick. Our net revenue for the second quarter is expected to be in the range of $305 million to $320 million. GAAP operating margin expected to be in the range of 6.5% to 7.5%. And non-GAAP operating margin is expected to be in the range of 9% to 10%. As our channel inventory progresses to healthy levels, we do expect Q2 will present an opportunity to selectively turn promotions back on, including participation in key sales events with some of our channel partners, allowing us to continue to grow market share and to drive paid subscriber acquisition. Additionally, while airfreight cost will stay at the Q1 level, we see sea transport costs rising to 2 to 3 times their normal rate. Our GAAP tax rate is expected to be approximately 27%, and our non-GAAP tax rate is expected to be 24.5% for the second quarter of 2021. While we are confident in our ability to provide guidance at this time, we do so with the caveat that considerable uncertainty remains in the market due to the COVID-19 pandemic and, should unforeseen events occur, in particular, related to transportation delays into any of our regional distribution centers, our actual results could differ from the foregoing guidance. We would now like to answer any questions from the audience.

[Operator:]

Your first question comes from the line of Jeffrey Rand from Deutsche Bank. Please go ahead.

[Jeffrey Rand:]

Hi. Thanks for taking the question. You talked about participating in more promotional activities in the second quarter. With global chip supply still being relatively tight and demand remaining strong, can you just discuss the thought process for running more promotional activities?

[Patrick Lo:]

Yes. As we have said that we would like to continue the momentum to regain share, and also we actually have to be in lock steps with our channel partners. So, our channel partners have planned for some promotional activities in a seasonally weaker Q2, and we would like to continue to keep the momentum going. And we believe that this is the most opportune time for us to gain share. And the importance of the gaining shares, of course, is to try to continue to have a really good installed base to work with to increase our paid subscribers, which is a very long-term benefit for us. We have found out over the last two years that the most opportune time to recruit service subscribers is at the point when they install a new product, and that’s the reason why driving our decision.

[Jeffrey Rand:]

And just as my follow-up, how are you thinking about the trajectory of your SMB business as the global economy continues to open? Will that partially be offset by less people setting up home offices as we approach or return to the more traditional office?

[Patrick Lo:]

We don’t believe so. We’re actually seeing a three-legged stool on the SMB business, we’re very encouraged by. I think there are a lot of entrepreneurs who has left the workforce and started to become entrepreneurs to open businesses at home. And then also, there are other small business owners and professionals who actually would split time between home office and their main office, such as accountants, architects and interior designers and so forth. So, the activities of entrepreneurial home-based business buying our, what we call, sophisticated home office solution is unabated. Secondly, as we have seen also, these small businesses who are starting to reopen and get back into the office, they have not been for over a year, found out, well, now they have just upgraded their home offices to WiFi 6, but their office is stuck with WiFi 5. And we’re seeing quite a bit of upgrade opportunities happening in the actual office. So, that’s also driving what we call the reopening trade. And our wireless business is still continuing to grow tremendously. And then, third piece is the Pro AV business. We’re seeing a lot of sports events reopening, entertainment reopening and a lot of video productions going on, all driving the demand of our Pro AV businesses as AVs -- aging close more into ultra-high definition, productions and things like that. And so, those three-legged stools give us confidence that our SMB momentum will continue on in the upcoming few years.

[Operator:]

Your next question comes from the line of Hamed Khorsand from BWS Financial. Your line is open.

[Hamed Khorsand:]

Hi. I just want to first ask is -- how do you feel about the current market environment as far as comparing it to previous cycles as far as seasonality is concerned? How are you going about -- with the inventory that you built up? Is that being consumed in channel, or are you holding it off for particular promotion in Q2?

[Patrick Lo:]

No. I mean, so the channel inventory is “just in time”. So, we ship to the channel in anticipation of the weekly run rate of the channel. And we typically want to keep it at the forward-looking run rate of anywhere between 8 to 10 weeks, which we are thinking is in the optimal. Of course, there are some pockets products that are still below that level. And then, when promotions happen, we will shift to that maybe two, three weeks before the promotion starts. So, we will not preload the channel for a promotional activity to be done much later on. The market is pretty encouraging because for the first three weeks of this quarter and the last two weeks of last quarter, we’re actually comping last year’s to onset of the COVID-19 lockdowns. And as we have expected, the market is staying at an elevated level. And of course, it will go back to the usual seasonality that Q2 is slightly lower than Q1 and then Q3 is a big step up and then Q4 will be flat to Q3. So, we believe that seasonality will happen but at an elevated level, so -- which is very encouraging. The reason why we feel confident about this is because we saw that phenomenon in Asia, which really hasn’t been hit hard by COVID in some markets where they have always been resuming back-to-office work and without having any gathering, lockdowns. So, we’re pretty encouraged by what we have seen so far.

[Hamed Khorsand:]

And Bryan, what’s transpired in the business that your Q2 guidance is a little different than the qualitative guidance that you provided, than past comments?

[Bryan Murray:]

Yes. I think, it’s actually what Patrick just touched on. We’ve gotten the channel into a healthier place, a bit ahead of schedule. It bodes well in terms of our ability to start to regain the market share in the second quarter, start to build the subscriber base. But, as we said early on in the call, we expect the full year targets that we set out back in December, we think we’re on track for those. And what that means is the back half of the year is probably steering more towards the 10% growth over the first half, as we had said back in December. We said, they would be on the lower side because we thought there would more channels happening early on. But -- so we think it will be about 10% over the first half of the year. Some of that’s driven by the service provider business, which again is lumpy. This quarter for Q2, we think it will be about $30 million. So, still below the $35 million on average that we still believe will hit for the full year. But also, the strength of the SMB business is also contributing to the overall profile for the rest of the year. But again, we think the second half will be up on the first half, about 10%.

[Operator:]

Your next question comes from the line of Liz Pate from Cowen and Company. Your line is open. Your next question comes from the line of Adam Tindle from Raymond James. Your line is open.

[Unidentified Analyst:]

Hi. Thanks. This is Alex on for Adam. I’m just curious about how you’re thinking about kind of the margin impacts from promotional spend, how are you thinking about the return on investment for that. And then kind of side on margins, you mentioned that shipping costs were up about 2 to 3 times. So just kind of curious about how that kind of flows through the gross margins. Is shipping a large component of gross margin?

[Bryan Murray:]

Yes. I would say, the Q2 steer relative to the Q1 performance, I’d say about a third of the movement from the 13.3% operating margin to the 9% to 10% range is going of driven by the sea cost, the transportation cost for sea freight. So, it is significant, certainly. And then, the other two-thirds I would say is tied to the promotional activities. In terms of the return on investment, I think Patrick touched on that earlier. It’s all about assisting us in gaining additional paid subscribers, which is the long-term goal that we have of pushing that up and getting to our long-term target of 15% operating margin that is key to us sitting here.

[Unidentified Analyst:]

Okay, perfect. Thanks. And then, again, just on promotional activity. Which products in particular do you think you’re going to kind of lean more heavily into it, more on the gaming side, more on the SMB side, home office side, and just kind of the cadence of that?

[Patrick Lo:]

Different channels would have different focus. Generally speaking, it would be on the midrange WiFi 6 products. That would be the focus. And we believe that that is the place -- it serves multiple purpose. One, it’s relatively high ASP; secondly, relatively high chance of those new users or the installation users to attach to our paid subscription services. And they generally have a little bit higher margin. So, I think those are the areas that we’ll focus on.

[Operator:]

Your next question comes from Woo Jin Ho from Bloomberg. Your line is open.

[Woo Jin Ho:]

Couple of questions, Patrick. I’m actually looking at the gross margin in a different way. I mean, there’s a lot of things that could potentially pressure gross margin. You got the higher freight costs; you’ve got a lower mix of SMB. And traditionally, when you have these gross margin impacts, first promotional activity, your operating margin really sinks because of gross margin -- low gross margin. But implied to that, it almost seems as if you’re kind of holding the gross margin roughly around the 28% to 30% level. I’m just curious if there are any other factors that’s helping to prop up the gross margin going into your outlook.

[Bryan Murray:]

In terms of -- I think, we just went through kind of the bridge of some of the gross margin numbers that peak levels that we saw in Q1 of 35%, the freight cost and the promotional activities will steer downwards. And I would say, the entirety of the bridge from Q3 -- sorry, Q1 to Q2 is going to be in the gross margin. I don’t think -- obviously, with the revenue guide that there’s not going to be a change in operating leverage on the business, but that would be the driving forces there. But again, long term, we’re going to try and push that up by adding subscribers and keep growing the premium segment of the market.

[Woo Jin Ho:]

Are you seeing any positive impacts from subscription revenue on gross margin?

[Bryan Murray:]

Yes, yes. I think if you look at our Analyst Day deck that we put out in December, I think if you look at the ASP that we communicated, which was about $48, we said it would probably contributed close to 80 basis points on this year’s margin. So, it is starting to contribute. But again, we’re trying to grow that as quickly as possible, as you saw with us increasing our target from $1 million to $2 million.

[Woo Jin Ho:]

And secondly, Patrick, you kind of called out your cable gateway business. And given some of the recent industry dynamics, I mean, how much of an opportunity do you see in a cable gateway business going forward, given some of the, I guess, the divestitures that’s going in the industry?

[Patrick Lo:]

Well, I mean, the cable gateway and cable modem segment of the retail WiFi has always been pretty steady somewhere around 20% of the total market. And as you probably know, there’s just only one other major competitor. Because it’s not easy, you have to get certified by all the cable operators in the U.S. We have a commanding market share. And I mean, theoretically, we can get 100% market share in this segment that means that we’ll have a base of 20% market share of U.S. WiFi. So, it’s pretty lucrative. Yes.

[Woo Jin Ho:]

Got it. And then, lastly for me. You mentioned fairly briefly about getting a growing sales in your online store. I’m curious how large is that business? And why is the return dynamic different on your online store versus your traditional retailers to help on the gross margin side?

[Patrick Lo:]

Actually, when Bryan talked about return, it’s not limited only to our own online stores, but also to our partner online stores such as Amazon, such as . So basically, online -- as you probably know, the online stores are very, very nimble in reacting to price fluctuations much more than brick-and-mortar. And actually, 99% of the returns are no trouble found and the most frequent reason for people to return is they bought this at store A, and then found in store B having a promotion is cheaper. So, they would return one to store and buy the one from store B to enjoy that price arbitrage. Such situation will be much less online because the online stores are very nimble. They will match any lowest price already in the market today. So generically speaking, the online stores are low in return rate. It doesn’t matter whether it is the Amazon or is it B&H or netgear.com store. It’s the same story.

[Operator:]

Next question comes from the line of from Cowen.

[Unidentified Analyst:]

I wanted to ask you, like as you normalize your inventory levels in the channel, I assume, like your revenue was mostly selling. Any color you can provide on the delta between sell-in versus sell-through revenue for this year that you expect?

[Bryan Murray:]

For the rest of this year, as we said, we think we’re pretty much there in terms of filling in the channel. So, from here forward, there shouldn’t be much delta, so.

[Unidentified Analyst:]

So basically, your sell-in would -- your sell-through would be similar to your sell-in revenue growth?

[Bryan Murray:]

That’s correct.

[Unidentified Analyst:]

Okay. And I know you’ve maintained your guidance for this year, but any initial color you can provide on what your growth would look like into calendar ‘22?

[Bryan Murray:]

We’ll get there eventually. But at this point, we’re focused on executing and navigating this operational environment for 2021, but we’ll get there.

[Unidentified Analyst:]

Okay. And as you look to reinvest your incremental growth into promotional expenses, how should we look at incremental, like anything you can provide on how do we model incremental operating margins in your business and what the trajectory on the operating margins would look like as we go through the year? Thank you.

[Bryan Murray:]

Yes. I think as we see the mix of SMB increase, it certainly bodes well for our margins. But, in a normal year will we typically see seasonality lift the back half of the year. That’s usually when we get the most operating leverage just given the top line steer there. But as I said earlier, we’re maintaining that -- the targets we set out for the full year, both on the top line and operating margin standpoint is what we’re striving to for 2021. And to your earlier question, the one bit I would remind you of in terms of 2022 is that we think the market has risen. It’s been elevated. We think it will maintain at these elevated levels. And then from here forward, we kind of get back into the business of increasing the market probably in the low single digits, all driven by ASP expansion. That’s what we do. We keep innovating and we keep bringing our products in the premium portion of the market that lays ASPs.

[Operator:]

That was our last question. At this time, I would like to turn the call back over to Patrick Lo.

[Patrick Lo:]

Thank you. Thanks, everybody, for joining us today. As you can see from our results, the team at NETGEAR is operating at a very high level in a difficult environment to produce excellent results. I remain confident on the tailwinds that have buoyed our business will continue. And we will continue to execute well to produce results for all of our stakeholders. And I look forward to sharing more of that in the coming quarters with all of you. Thank you.

[Operator:]

This concludes today’s conference call. You may now disconnect.