NETGEAR, Inc.
Q1 2008 Earnings Call Transcript

Published: 26 Apr 2008

[Operator:]

Greetings and welcome to the NetGear, Inc. first quarter 2008 results conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Joseph Villalta of The Ruth Group. Thank you. Mr. Villalta, you may begin.

[Joseph Villalta:]

Thank you. Good afternoon and welcome to NetGear's first quarter 2008 results call. Joining us from the company are Patrick Lo, Chairman and CEO, and Christine Gorjanc, CFO. The format of the call will be a brief business review by Patrick followed by Christine providing detail on the financials. We will then have time for any questions. If you have not received a copy of today's earnings release, please call The Ruth Group at 646-536-7026 or go to NetGear's corporate web site at www.netgear.com. Before we begin the formal remarks, the company's attorneys advise us that today's conference call contains forward-looking statements within the meaning of the US Private Securities Litigation Reform Act of 1995. The forward-looking statements represent NetGear Inc.'s expectations or beliefs concerning future events and include statements, among others, regarding NetGear's expected revenue, earnings, operating income, and tax rate on both a GAAP and non-GAAP basis, anticipated new product offerings, current and future demand for the company's existing and anticipated new products, willingness of consumers to purchase and use the company's products, and ability to increase distribution and market share for the company's products domestically and worldwide. These statements are based on management's current expectations and are subject to certain risks and uncertainties, including without limitation the following

[Patrick Lo:]

Thank you, Joseph. Thank you for everyone for joining today's call. Net revenue in Q1 increased 14% to $198.2 million compared to the year ago period and flat as compared to Q4 2007. We enjoyed very healthy growth in Q1 in both Asia Pacific and North America regions, as well as in service provider channels worldwide. We grew our revenue in North America 20% year-on-year and 14% quarter-on-quarter. The performance of our emerging markets, including China, India, Eastern Europe, the Middle East, and Brazil, continued to be strong in Q1. The growth of this group on a percentage basis continues to be significantly higher than our corporate average, specifically our Asia Pacific revenue was $20.8 million in Q1, a growth of 39% year-over-year. We believe we'll continue to gain share in Asia Pacific and other emerging markets. However, we were challenged in Q1 to meet our revenue and operating margin targets, mainly due to two factors

[Christine Gorjanc:]

Thank you, Patrick. Let me now provide you with a summary of the financials for Q1. As Patrick just noted, net revenue for the first quarter ended March 30, 2008 was $198.2 million, a 14% increase as compared to $173.6 million for the first quarter ended April 1, 2007 and flat as compared to $198.3 million in the fourth quarter ended December 31, 2007. Net revenue in the first quarter of 2008 by geography was $79.2 million for North America, $98.1 million for the Europe, Middle East, and Africa region, and $20.8 million for the Asia Pacific region. We shipped about 4.2 million units in the first quarter, including 3.6 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 2.3 million units. Moving to the product category basis, the first quarter net revenue split between wireless and wired was about 61% and 39%, respectively, relatively unchanged from the first quarter of 2007. The first quarter net revenue split between home and small business products was about 62% and 38% compared to a 65/35 split in the fourth quarter of 2007. Products introduced in the last 15 months constituted about 31% of our first quarter shipments, while products introduced in the last 12 months constituted about 30% of our first quarter shipments. Non-GAAP gross margin in the first quarter of 2008 was 32.9% as compared to 34.7% in the year ago comparable quarter and 32.4% in the fourth quarter of 2007. Moving to non-GAAP operating expenses, total non-GAAP operating expenses, which excludes litigation reserves and acquisition-related retention bonuses, as well as non-cash stock-based compensation costs, came in at $46.4 million for the first quarter of 2008. This compares to non-GAAP operating expense of $38.9 million in the first quarter of 2007 and $42.8 million in the fourth quarter of 2007. Q1 2008 operating expenses represented 23.4% of net revenue. This is an increase of 100 basis points compared to the first quarter of 2007 and an increase of 180 basis points compared to the fourth quarter of 2007, both primarily due to our incremental investment in R&D and in emerging markets. Non-GAAP sales and marketing expenses were $32.2 million. As a percentage of net revenue, sales and marketing expenses were 16.2% in Q1 of 2008 as compared to 15.7% in Q1 of 2007 and 15.4% in Q4 of 2007. The increase year-over-year in sales and marketing expenses is due to additional payroll-related costs driven by our sales force expansion. Non-GAAP R&D expenses were $7.9 million. This represents 4% of net revenue in Q1 of 2008 as compared to 3.1% in Q1 of 2007 and 3.2% in Q4 of 2007. The increase in R&D year-over-year includes the addition of the ReadyNAS team and the quarter-over-quarter increase is due to ramping up the introduction of differentiated new products in Q2 and beyond. Non-GAAP G&A expenses for the first quarter were $6.4 million or 3.2% of net revenue compared to 3.6% in the year ago period and 2.9% in the fourth quarter of 2007. The increase compared to Q4 is due to payroll-related costs as well as professional fees. Operating income on a GAAP basis was $14.7 million, which includes $1.2 million in charges for amortization of purchased intangibles and acquisition-related retention bonuses, a $51,000 charge for litigation reserves, as well as non-cash stock-based compensation of $2.8 million. This compares to GAAP operating income of $19.1 million in the year ago first quarter and $17.9 million in the fourth quarter of 2007. On a GAAP basis, the company reported net income of $11.2 million or $0.31 per diluted share for the first quarter 2008 compared to net income of $14 million or $0.40 per diluted share for the first quarter of 2007 and $12.5 million or $0.35 per diluted share in the fourth quarter of 2007. Net income on a non-GAAP basis for the first quarter of 2008 was $14.1 million as compared to non-GAAP net income of $15.6 million for the first quarter of 2007 and non-GAAP net income of $14.8 million for the fourth quarter of 2007. Non-GAAP net income was $0.39 per diluted share in the first quarter of 2008 compared to $0.44 per diluted share in the first quarter of 2007 and $0.41 for the fourth quarter of 2007. For calculating the EPS, we used a fully diluted stock count of 35.9 million shares for Q1 versus 36.1 million shares for the prior quarter and 35.4 million shares for Q1 of 2007. In Q1 of 2008, there was a currency gain of $2.8 million compared to a gain of $272,000 in Q1 of '07 and a gain of about $146,000 in Q4 of '07. This represents roughly $0.05 a share in EPS for Q1 '08. The non-GAAP tax rate was 39.2% in the first quarter of 2008 compared to 34.9% in the prior first quarter and 37.4% in the fourth quarter of 2007. The reconciliation of GAAP to non-GAAP is detailed in our financial statements released earlier today. Moving on to the balance sheet, we ended the first quarter with $200.8 million or approximately $5.59 per diluted share in cash, cash equivalents, and short-term investments compared to a total of $216.2 million at the end of the first quarter of 2007 or approximately $6.11 per diluted share and $205.3 million at the end of the fourth quarter 2007 or approximately $5.69 per diluted share. Please note that during 2007, we paid $60 million cash for the acquisition of Infrant Technologies and its ReadyNAS line of network-attached storage products. In terms of inventory trend, we ended the first quarter 2008 with inventory at $97.6 million with ending inventory turns of 5.5 compared to 6.6 turns at the end of the first quarter of 2007 and 6.5 turns at the end of the fourth quarter of 2007. The increase in inventory is due to the preparation for entry into the stores of our new mass retailer customer, as well as to drive reductions in air freight costs. Days sales outstanding were 71 in the first quarter of 2008 compared to 65 days in the first quarter of 2007 and 73 days ended the fourth quarter of 2007. This remains within our historical range of 65 to 75 days. Total assets were approximately $562.7 million at the end of the first quarter 2008 compared to $451.2 million at the end of the first quarter of 2007 and $551.1 million at the end of Q4 2007. Deferred revenue decreased slightly to $7.5 million as compared to $7.6 million at the end of the prior quarter and an increase as compared to $7.6 million at the end of the prior quarter and an increase as compared to $5.8 million at the end of the first quarter of 2007. We expect normal seasonality in the historically weaker Q2, specifically, we expect second quarter net revenue to be approximately $195 million to $200 million, with non-GAAP operating margin in the range of 9% to 10%. Finally, we expect the non-GAAP effective tax rate to be approximately 39.5%. Operator, that concludes our comments and we can now take any questions.

[Operator:]

Thank you. (Operator instructions) Our first question comes from Samuel Wilson with JMP Securities. Please proceed with your question.

[Samuel Wilson:]

A few small questions for you. First, I'm sorry if I missed this, but can you give me what headcount was and the number of retail locations and the number of VARs?

[Patrick Lo:]

The number of retail locations has increased to over 24,000. The number of VARs also have increased to over 42,000. And the number of headcount is total exactly 565 at the end of Q1 versus 514 at the end of Q4.

[Samuel Wilson:]

Can you give me a sense of what your hiring plans are, what you're thinking for the next couple of quarters?

[Patrick Lo:]

We believe that we will continue to do some strategic hiring in Q2, but not very big since it's usually a flat-to-down quarter. But then we will resume our hiring in Q3 and Q4 again. But, certainly, our hiring will still be pegged around normal $1.5 million per revenue per employee kind of level.

[Samuel Wilson:]

Got it. And then, Patrick, can you talk a little bit about pricing pressure or pricing action that you saw in North America? It sounds like Linksys was the main culprit here. Did you match pricing? Did you try to keep premium pricing and give up a few sales? Were you doing a lot of rebating? Can you just give us a lot more color there on what you were seeing there at the end of the quarter?

[Patrick Lo:]

Certainly, I mean normally, we price at parity with them on the high end such as RangeMAX, MIMO and N. And then we price below them10%, 15% in the 11g range. And we saw them in March, all through March, first, price their g routers to our level, at parity. And then, they moved the N and the MIMO pricing actually $10 to $20 below us, which is really an act that we have never seen before. We are taking this opportunity, of course, to take a premium price position. But, certainly, we could not let the gap to be more than $10. So, we did move our price to close the gap a little bit. But, right now, we believe that because of our RangeMAX N, which is based on a patent-pending metro-material antenna technology, we should be able to price at a slight premium. And as the indications from the market reports, we have been able to continue to gain share.

[Samuel Wilson:]

And do you think, I mean, it's now, I don't know, three weeks into April? Was it a March-only phenomenon or have they been all the way through, starting in the April being really aggressive with pricing also?

[Patrick Lo:]

According to our observation and market intelligence, I think they are going to continue.

[Samuel Wilson:]

Got it. And then lastly, can you just give us your final color on – just your general sense on how the emerging market initiative is going, are you achieving the milestones you thought you would achieve over the last few years, which one of the emerging markets is doing the best and maybe which one is doing the worst?

[Patrick Lo:]

Well, actually as a matter of fact, all the emerging markets are generally referred as BRIC for Brazil, Russia, India, and China. Other than Russia, we are doing very well in all the other three countries. We are progressing very well in terms of brand awareness, market share gain, as well as revenue growth.

[Samuel Wilson:]

Terrific. Thank you very much.

[Patrick Lo:]

Thank you.

[Operator:]

Our next question comes from Maynard Um with UBS. Please proceed with your question.

[Maynard Um:]

Hi, thanks. Can you just talk about your revenue guidance and the makeup of that in the second quarter between service provider and non-service provider? What I'm trying to understand is just how much visibility you have to the revenue, given kind of this environment?

[Patrick Lo:]

Yes, that's a good question. As we mentioned before, service provider revenue is 13 weeks – 10 to 13 weeks ahead of booking, so we have pretty good visibility with the service provider revenue. So we expect the service provider revenue portion in Q2 will be similar to Q1. And then for the rest, typically seasonality indicates a flat to slightly down quarter. So we believe that without – unless there is further market deterioration, which we believe that we have taken that into account given the phenomenon we saw in March and that's how we projected. And on top of that, we believe that we will have slight benefit at least from the new retail distribution that we are adding in the US. Albeit [ph] that we have put a very conservative number on that one.

[Maynard Um:]

Okay. And then secondly, in terms of currency, so you told us on the bottom line what the impact is. How much did it help the revenue line?

[Christine Gorjanc:]

It helped the revenue line a little bit, and then also had the same effect on the expenses. So the net effect is not a material number.

[Maynard Um:]

Okay. And then lastly, just on the major US retailer that you're entering into, I guess, are you waiting for the customer to make that announcement? Or I guess, if you can give a little more detail there, who the incumbent vendors there are today, if there are any. Thanks.

[Patrick Lo:]

Yes, there are incumbent vendors over there. As a matter of fact, this retail customer as you said will make the announcement later on, so we are not supposed to get ahead of that. The reason that we are going into this retailer is because they have already been carrying other competitors' products and have achieved a number two market share position in selling Wi-Fi home network products in the United States. They have over 3,000 retail outlets. Certainly, they are carrying our number one competitor. So we think this is the perfect time going in there, given the fact that they have built a very, very big business and we believe that the inventory turn for our products on the shelves over there will be justifiable for us to be able to be there to be profitable.

[Maynard Um:]

Great. Thank you.

[Operator:]

Our next question is from Thomas Lee with Goldman Sachs. Please proceed with your question.

[Thomas Lee:]

Hi, thank you for taking my call.

[Patrick Lo:]

Sure, my pleasure.

[Thomas Lee:]

I had a question on the cost side. I was wondering, are you guys seeing a more challenging environment I guess either from component costs? You indicated higher freight costs, but how much of that is kind of baked into your lower operating margin guidance?

[Patrick Lo:]

Yes, component costs actually for active components, we continue to see the decline of pricing. The passive components, such as PCB, such as packaging, that we see continuous pressure going up. Also as you probably know, the label cost in China has also been going up as well. So, we have factored all that into our operating margin guidance. Now certainly, we're not standing still. We are continuing to cut costs in a few areas. One is by moving more of our products over the boat, over the sea, so that we don't have to pay more air freight. We are actually cutting into smaller packagings, so that the weight will be less and the volume will be less. That will reduce our both production material costs, as well as the freight cost. Those things would be done over the next few quarters and the results will be seen over the next few quarters.

[Thomas Lee:]

But, is it fair to say of the lower guidance, the margin guidance, I mean, is it 50% attributed to higher cost and 50% maybe to the lower – the pricing pressure you're seeing in the US? Can you just give us a sense in terms of how much of that is impacting your margin?

[Patrick Lo:]

We [ph] analyzed it pretty carefully and it's pretty much primarily based on the pricing pressure.

[Thomas Lee:]

It is? Okay.

[Patrick Lo:]

And as I just mentioned that we do not believe that this is the end of it. We anticipate they will be moving prices further and that's why we take that into account as well.

[Thomas Lee:]

Got it. And then, just looking for a little bit of color on your weakness in Europe. So, it looked like it was pretty much contained in the UK. Have you seen any weakness in the non-UK regions, countries in Europe? Why couldn't that spill over?

[Patrick Lo:]

Interesting. It's really, really well contained in the UK market. We try to kind of ask our country managers why that is the case, the only theory we could come up with is the UK housing market is very similar to the US. While in the other markets, for example, like in Germany, there are more renters than homeowners, and the mortgage is structured totally differently. So, that might be the reason.

[Thomas Lee:]

Got it. Okay, thank you.

[Operator:]

(Operator instructions) Our next question is from Stanley Kovler with Merrill Lynch. Please proceed with your question.

[Stanley Kovler:]

Thanks very much. Patrick, I was wondering if you can add some color to trends in the US. I'm looking at your revenue growth, it seems like you've still managed to post some nice revenue growth in the US, both sequentially and year-over-year. And you did very well in the SMB market, but obviously it was a smaller dollar growth. So, there must've been some benefit there from the service provider market and you mentioned that the retailers were weak. Just wondering if you can frame that for us a little bit better to see where that (inaudible) came from?

[Patrick Lo:]

Yes, if you calculate – because we disclose the service provider revenue component every quarter, so if you compare this quarter versus last year first quarter, our service provider revenue actually grew 55% and that's pretty much across the globe in all three regions. And if you look at the sequential growth, our service provider revenue also grew 23%. That's pretty much spread across all three regions and there you could see it helped the US growth.

[Stanley Kovler:]

Got it. And if I may, a question on Asia, Asia-Pac was down quarter-over-quarter in dollar terms and you mentioned that emerging markets were very strong. Obviously, China's in there. Was that really seasonality from more of mature region such as Australia, or what was the cause of that lack of growth?

[Patrick Lo:]

It's just the reverse. As more and more our revenue is derived from China, then the Chinese New Year effect [ph] will have more on us.

[Stanley Kovler:]

Okay. And just lastly, clarification on the guidance. The retailer that you won, how much of that is factored into the guidance? When you look out into 2Q, the guidance you provided, you said that there is upside. So, should we assume that you are accounting for some level of – you have some visibility in terms of growth into that account, but there could be fluctuations, plus or minus? Or you're not including that retailer in the guidance at all?

[Patrick Lo:]

As a matter of fact, because we have no historical run rate of this particular retailer, so even though it has quite a significant number of stores, there is no way for us to model how much incremental revenue it's going to bring to us, so that we would just use the most conservative approach of a similar retailer with similar number of stores and reduce it by a certain percent. But, how it's going to perform, we will know after the finish of Q2, when we have actual run rate data for about six to eight weeks.

[Stanley Kovler:]

Great. Thank you very much.

[Operator:]

(Operator instructions) Our next question is from Alex Dannin with Morningstar. Please proceed with your question.

[Alex Dannin:]

Hey, guys. I was wondering if you could talk about just in general terms the way you look at new markets in terms of profitability, like how long does it take to get a new market up to about average profitability, and how different is it once they are mature, is it vastly different between the different regions or is it about the same? If you could give any – what are your goals and how do you determine – well, if you could just talk about that, I'd appreciate it. Thanks.

[Patrick Lo:]

Sure. We could divide the world into three portions. We could first look at what we call the typical Western markets. We entered into new Western markets such as Spain, Italy, Benelux, just in the last two, three years. The market structures are pretty similar to the US or the UK or Australia. So the channel structure, the technology reception are pretty similar. For those markets, we expect to gain profitability on par with other mature markets in a very rapid rate, usually within three years. And then we have the second area, which is primarily the really, really emerging markets like Brazil, China, India that generally have a lower cost of entry, however, has a much different infrastructure, as well as reception of technology and a different set of competitors and a different set of products requirement. For those, we expect that it will take longer, maybe five or maybe even seven years to get to the comparable profit contribution to our more mature markets. Then we have a third piece is somewhere in between there we have absolutely no clue and we still have no clue, which is Russia. We still haven't found a way to get there yet. But, we just hired a good country manager and we hope that we'll be able to find a model there.

[Operator:]

Mr. Lo, there are currently no further questions. Would you like to make any closing comments?

[Patrick Lo:]

Yes. Certainly, we were surprised by the reaction of some of our competitors in terms of how they handled the slowing down of the market. We believe that we have always been competing on technology and products. It looks like that the game has changed, but we welcome the challenge. We are always up to the challenge. And now, even the last weapon is used, so we know how to deal with it. We think that we're going to live through a few quarters of rough time, but we still believe that our strategy is sound, which is basically diversifying into new product lineups with differentiated patented technology, as well as to diversify into new distribution channel such as new service providers and new retailers and, of course, running as fast as we can, better than our competitors in the emerging markets. I think it will pay off for us. It has paid off for us for the last ten years. It will pay off for us in the next few quarters, especially when the economy of the US and the UK comes back. We are very confident on our strategy and certainly, the whole NetGear team is very committed to continue executing to its fullest and continue to be the winner in the market. So, thank you very much and we will update you in the next quarter on how successful we are in competing in this new environment. But, we have every confidence that we will prevail.

[Operator:]

Thank you. Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.