NETGEAR, Inc.
Q3 2013 Earnings Call Transcript

Published: 25 Oct 2013

[Operator:]

Greetings, and welcome to the NETGEAR, Inc. Third Quarter 2013 Earnings Conference Call. [Operator Instructions] It is now my pleasure to introduce your host, Christopher Genualdi, Investor Relations Manager. Thank you. Mr. Genualdi, you may now begin.

[Christopher Genualdi:]

Thank you, operator. Good afternoon, and welcome to NETGEAR's Third Quarter 2013 Financial Results Conference Call. Joining us from the company are Mr. Patrick Lo, Chairman and CEO; and Ms. Christine Gorjanc, CFO. The format of the call will be a brief business review by Patrick, followed by Christine providing detail on the financials and other information. We will then have time for any questions. If you have not received a copy of today's release, please call NETGEAR Investor Relations or go to NETGEAR's corporate website at www.netgear.com. Before we begin the formal remarks, the company advises that today's conference call contains forward-looking statements. Forward-looking statements include statements regarding expected revenue, operating margins, tax rates, cash generation and other projected financial results, expected market share gains, market trends and opportunities, competition, research and development efforts, sales and marketing efforts, new product introductions and our growth strategy. Forward-looking statements are made -- during the call are being made as of today. If this call is replayed or reviewed after today, the information presented in the call may not contain current or accurate information. Further, certain forward-looking statements are subject to certain risks and uncertainties and are based on assumptions as to future events that may not prove to be accurate. Therefore, actual outcomes and results may differ materially from what is expected or forecast in such forward-looking statements. Information on potential risk factors are detailed in the company's periodic filings with the SEC, including, but not limited to, those risks and uncertainties listed in the company's most recent Form 10-Q filed with the SEC. NETGEAR undertakes no obligation to release publicly any revisions to any forward-looking statements contained herein to reflect events or circumstances after the date hereof, or to reflect the accuracy of unanticipated events. In addition, several non-GAAP financial measures will be mentioned on this call. Information relating to the corresponding GAAP measures, as well as a reconciliation of the non-GAAP measures and GAAP measures, can be found in our press release on the Investor Relations website at www.netgear.com. At this time, I would now like to turn the call over to Mr. Patrick Lo. Please go ahead, sir.

[C. S. Lo:]

Thank you, Christopher, and thank you, everyone, for joining today's call. Before we begin, I'd like to invite you all to join us for our 2013 Analyst Day, being held in New York City on November 7. The Analyst Day will provide an excellent opportunity to meet our management team, including our new Commercial Business Unit General Manager, Mr. John McHugh. We will discuss our vision for the future and what technologies we believe we can master to win and thus grow our business for the long term. For additional details on this event, please reach out to NETGEAR Investor Relations on the Investor Relations portion of our website. Moving on to our financial results. For the third quarter of 2013, NETGEAR's net revenues were $361.9 million, which is up 14.8% on a year-over-year basis and slightly above our guided range. Non-GAAP diluted EPS came in at $0.58 per diluted share. Please see the third quarter 2013 earnings press release for a full reconciliation of GAAP to non-GAAP financial results. During the third quarter, net revenue for the Americas was $220.5 million, up 24.1% year-over-year and up 9.8% quarter-over-quarter. The sequential results include full quarters of the AirCard acquisition in both Q2 and Q3 quarters, but the year-over-year results do not. The Americas continue to show modest strength in an uncertain global economy, and the third quarter marked another successful back-to-school season for NETGEAR. Europe, the Middle East and Africa, or EMEA, net revenue was $97.2 million, down 6.8% year-over-year and down 10.3% quarter-over-quarter. The unfavorable economic climate in Europe continues to weigh on all 3 business units, and we expect continued headwinds in coming quarters. Our Asia Pacific, or APAC, net revenue was $44.2 million, which is up 33.1% from the prior year's comparable quarter, and down 8.9% quarter-over-quarter. Note that this also includes full quarters of the AirCard acquisition in both the Q2 and Q3 quarters, but the year-over-year results do not. The sequential decline in APAC is typical of seasonality in Australia when Q3 is the start of their financial year. In Q3, we maintained a high level of shipments with 7.4 million units shipped. We also introduced 21 new products during the quarter. By the end of the third quarter of 2013, our products were sold in approximately 45,000 retail outlets around the world, and our number of value-added resellers stands at approximately 39,000. Now let's turn to a review of the third quarter results for our 3 business units

[Christine M. Gorjanc:]

Thank you, Patrick. I will now provide you with a summary of the financials for the third quarter of 2013. As Patrick noted, net revenue for the third quarter ended September 29, 2013, was $361.9 million as compared to $315.2 million for the third quarter ended September 30, 2012, and $357.7 million in the second quarter ended June 30, 2013. We shipped a total of about 7.4 million units in the third quarter, including 5.8 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 3.5 million units for the third quarter of 2013. Moving to the product category basis. Third quarter net revenue split between wireless and wired was about 70% and 30%, respectively. The third quarter net revenue split between home and business products was about 78% and 22%, respectively. Products introduced in the last 15 months constituted about 40% of our third quarter shipments, while products introduced in the last 12 months constituted about 31% of our third quarter shipment. From this point on, my discussion points will focus on non-GAAP numbers. As mentioned previously, the reconciliation from GAAP to non-GAAP is detailed in our preliminary financial statements released earlier today. Non-GAAP gross margin in the third quarter of 2013 was 28.9% compared to 31.6% in the year-ago comparable quarter and 29.8% in the second quarter of 2013. The margin decrease, as compared to the prior year quarter, is due to the higher mix of service provider revenue in the current period. Total non-GAAP operating expenses came in at $68.7 million for the third quarter of 2013. We continue to invest in research and development in order to drive innovation in all 3 business units. Our non-GAAP R&D expense for Q3 was 6.2% of net revenue as compared to 5.3% in the year ago comparable period and 6.4% of net revenue during Q2. We continue to spend carefully on the key initiatives that we expect will drive the future growth for the company. Our headcount increased by net 5 people during the quarter, bringing our total headcount to 1,100 at the end of Q3. The non-GAAP tax rate was 37.2% in the third quarter of 2013 as compared to 30.3% in the third quarter of 2012 and 32.9% in the second quarter of 2013. The tax rate increase in the third quarter of 2013 is due to geographical mix and profits, which are weighted more towards North America. Looking at the bottom line for Q3, we reported non-GAAP net income of $22.9 million and non-GAAP EPS at $0.58 per diluted share. Looking at the balance sheet, we ended the third quarter of 2013 with $301.4 million in cash, cash equivalents and short-term investments compared to $288.1 million at the end of the second quarter of 2013. Our balance sheet and our ability to generate cash remains strong. During the second quarter of 2013, we generated approximately $16.6 million in cash flow from operations. Over the last 4 quarters, we generated $90.3 million in cash flow from operations. DSOs for the third quarter of 2013 were 68 days as compared to 72 days in the third quarter of 2012 and 73 days in the second quarter of 2013. As always, we closely manage our collections and try to effectively mitigate collection risk. Our third quarter net inventory ended at $211.3 million compared to $178.9 million in the third quarter of 2012 and $185.4 million at the end of the second quarter of 2013. Third quarter ending inventory turns were 4.9 as compared to 4.9 turns in Q3 '12 and 5.5 turns in the second quarter of 2013. Let's turn to our channel inventories. Our channel partners report inventory to us on a weekly basis, and we use a 6-week trailing average to estimate weeks of stock. Our U.S. retail inventory came in at 11.5 weeks of stock. Current distribution inventory levels are 9.9 weeks in the U.S., 4.5 weeks of stock for distribution in EMEA and 8.2 in APAC. Our short and immediate-term visibility remains limited caused by the continued economic headwinds faced in Europe and the lumpiness of the Service Provider Business. We are focused on continuing to launch new products and improving the operational efficiencies within NETGEAR. For the fourth quarter of 2013, we expect to incur a restructuring charge between $3 million and $4 million as we will be realigning resources to better focus on the key growth markets we are pursuing. We expect fourth quarter 2013 revenue to be in the range of approximately $340 million to $355 million, as the consolidation activities of cable operators in Europe continues to delay purchasing among our customer base. We expect non-GAAP operating margin to be in the range of 9.5% to 10.5%, and our non-GAAP tax rate to be approximately 39% for the fourth quarter of 2013. As Patrick mentioned, we look forward to seeing you on November 7 in New York City at our 2013 Analyst Day. Operator, that concludes our comments. And we can now take questions.

[Operator:]

[Operator Instructions] Our first question comes from Rohit Chopra from Wedbush Securities.

[Rohit N. Chopra:]

Patrick, I just want to get a sense on the CBU. What specifically was the cause of the weakness there? You already had some problems, I think, a couple of quarters ago. I thought those were resolved with some of the storage products. And then related to that, when do you expect a rebound in the CBU? That's my first question.

[C. S. Lo:]

Yes. It's pretty clear that our competitors has upped their game. And then we just have to continue to up our game as well. So that's why we refreshed to Rackmount Storage in Q3, and we just introduced the first mobile app that provides really, really good user-friendly cloud access to our storage. There is no other way to win in this market by better products, and that's one. The second one is that we believe that even though we have a superior product, I think our marketing program has not been effective in Q3. So we are revamping the marketing programs. We are going all-out in online and social media, and installed base, digital marketing to really get the message out. And then certainly, I mean, we have just hired a very experienced Commercial Business Unit general manager. And I think by combining all those areas, we're looking forward to a much-improved performance in the coming quarters.

[Rohit N. Chopra:]

Okay. A question for Christie. Have you guys thought or has the board been able to bring up a buyback again? Is that being thought about?

[Christine M. Gorjanc:]

It's discussed every quarter. And we're definitely looking at our cash balances at how we're going to deploy that, and we will move forward with that with acquisitions, with a buyback. We'll continue to look at that to make appropriate decisions.

[Rohit N. Chopra:]

Got it. And last question was on AC. I think, you gave some metrics for Q1 and Q2, what was AC as a percentage of the sales in Q3?

[C. S. Lo:]

Yes. As we -- we'd like to give you a little bit more color on that one. In the market today in the latest NPD report, AC is about 37% of the U.S. retail market, and we're pretty much in line with that. However, with the just rollout of the Nighthawk 11ac router, which is the best in the world, I will believe that we would, one, accelerate the market even further; two, gain more market share.

[Operator:]

Our next question comes from Tavis McCourt from Raymond James.

[Tavis C. McCourt:]

Christine, just a technical one for you and then a couple for Patrick. The 39% non-GAAP tax rate, just to be clear, that was a non-GAAP number? And as long as the geographic mix remains similar to where we are today, is that a reasonable go-forward rate beyond 2013?

[Christine M. Gorjanc:]

Yes, as long as the geographic mix remains the same. As -- when we see Europe recover, you will see the rate come down. But right now, you can see that North America is the biggest piece of the pie and drives more towards the higher rate.

[Tavis C. McCourt:]

And is there any portion of your cash that is inaccessible?

[Christine M. Gorjanc:]

No, we really don't have -- we don't have anything really locked offshore at this point, given the fact that our structure hasn't been in place for a bit -- maybe about 4 years.

[Tavis C. McCourt:]

Okay. And then, Patrick, for you, I was wondering if you could give us an update on the commercial Wireless LAN business. I think you guys have launched more scalable controllers this year. Is that meaningful as a percentage of the Commercial Business yet? And do you see an opportunity to take your share up, or is it still going to be a business unit driven mostly by switching?

[C. S. Lo:]

It is definitely a meaningful portion of our Commercial Business Unit, which is primarily composed of 3 product lines

[Tavis C. McCourt:]

Got you. And then I wondered if you could give a little more clarification on the impact of the cable consolidation in Europe. I think you guys had guided last quarter for Q3 to be impacted by that. Was this just delayed 1 quarter? Or did Q3 see an impact, but was offset by other things in Service Provider? And then is there a potential carry-on impact in 2014, or is the numbers getting to relatively low estimates by 2000 -- by the end of this year?

[Christine M. Gorjanc:]

Yes, Tavis, one thing we did mention on the call is we did experience a little bit of slowdown from that consolidation this quarter, but it was offset by a couple orders from some other customers that we were able to fulfill. So you see Service Provider revenue relatively flat, if not slightly up quarter-on-quarter. We do expect to see that in Q4. And just recently, there's another series of consolidation. So we do hope to see that get back on track as they make decisions because we do know ultimately they will buy products, and so we're moving forward with that. And right now, our visibility really is into Q4, and we see that, that will slow us down until the end of the year, which is included in our guidance.

[Operator:]

Our next question comes from Hamed Khorsand from BWS Financial.

[Hamed Khorsand:]

I just want to touch on a couple of things. One is, talking about the retail market. You're talking about getting more products as far as range extenders and all sorts of different accessories, and especially with the AC upgrade. But then I'm looking at your revenue trend, and we're not going anywhere, right? I mean in 2011, we were at 127, now we're at 130. And I'm very certain in 2011, we didn't -- consumers weren't buying range extenders. So what's the drawback? Where has the growth gone to?

[C. S. Lo:]

Well, clearly, if you look at the geographic breakdown, I mean, EMEA is the culprit. I mean, the EMEA economic uncertainty and the recession, the shrinkage is really causing a significant havoc. Even though we have grown tremendously in America as well as in Asia, it was fully negated by the decline in EMEA which is pretty severe. So not until we really stabilize the European market, we will not see the full benefit of all those things you talked about, the explosive growth of the WiFi extender market, the continued upgrade of 11ac in the North American market. Primarily, yes, I mean, we have been fighting this battle of EMEA.

[Hamed Khorsand:]

Okay. And then in Q3, operating margins were up considerably, and it seems like you guys weren't spending a lot on marketing. What was the strategy there, and what's the strategy in Q4 that you're guiding operating margins back down to that 10% range?

[Christine M. Gorjanc:]

So this quarter, Hamed, we had 9.9% non-GAAP operating margin, and we're guiding 9.5% to 10.5%. So I think we're still in that range. Obviously, we're careful with where we're spending money. But a lot of our marketing spend, you would see netting out of revenues. You wouldn't necessarily see the dollars. And as we do walk into the back half of the year with retail, we do see marketing promotions, and that typically go up a little bit. But typically, that's affected in your revenue number.

[Hamed Khorsand:]

Okay. Are we going to see any benefit of that, of the Sierra Wireless acquisition at all this quarter? How is that fitting into the model now?

[Christine M. Gorjanc:]

So we always said that AirCard assets would fit in on the Service Provider Business Unit and fit in with Service Provider contribution margin. So we've been seeing that since we picked them up. It also makes Service Provider a bigger piece of the pie on the revenue side, which then is why we are guiding 9.5% to 10.5%. Now hoping to see LTE gateways in that, we'll hope to win some of those in 2014 like we originally said.

[Operator:]

Our next question comes from Ryan Hutchinson from Lazard Capital Markets.

[Ryan Hutchinson:]

Great. I have a couple. Just on the Service Provider dynamics here at the quarter end. Can you talk to specifically if the wind was in the U.S. and if it was telco or MSO, and if it was part of AirCard at all? That would be my first question. Second would be just a clarification on what the AirCard contribution was in the quarter. And then I have a third, but let's just start there.

[Christine M. Gorjanc:]

As far as where the wind goes on Service Provider. I mean, I think, what you can see from our overall results is the strength is in North America this quarter as opposed to EMEA. So I'll let you draw your conclusion on that. And then, secondly, we really don't break out AirCard, it is part of the Service Provider Business Unit. And I think if you look at any one of the contribution margins to those, which we will publish in our Qs, a 4-quarter average will -- it's maintaining right in the average of the regular Service Provider over the last several years, and we have...

[Ryan Hutchinson:]

Okay. So the AirCard piece is within -- it hasn't fallen off significantly below expectations in terms of what the historical run rate has been, is that fair?

[Christine M. Gorjanc:]

No, not at all. We've been quite happy at this point.

[Ryan Hutchinson:]

Okay. And then I just want to understand the business unit mix going into Q4. So you've touched on it in some previous questions, but I just want to be clear about this. So the run rate last quarter for Service Provider was roughly $145 million to $155 million a quarter. You are at high end of that. What's the expectation going into the fourth quarter? And I'll start there. And if you're not willing to give some parameters around Service Provider, in general, do we expect retail and commercial to grow sequentially?

[Christine M. Gorjanc:]

Yes. Well, I would say, we really have in the guidance taken into account Service Provider. We're expecting it to be down in Q4 from a seasonal standpoint, and that's part of our guidance as we mentioned on the consolidations with some of the operators we're seeing in Europe. As far as retail, that's typically up a little bit more in Q4, had a good back-to-school in Q3. And we definitely, on the commercial side, would like to recover and start moving that business up and really plan to do that.

[Ryan Hutchinson:]

Okay. So if retail and commercial kind of grow roughly in line with historicals or slightly below, we're looking at Service Provider that's well below that $145 million to $155 million run rate that you've alluded to in the past, and something along the lines of probably down 20% to 25%, sequentially, is that fair?

[Christine M. Gorjanc:]

I don't know. I mean, I would just say Service Provider will be down and it will be more or less offset by the retail and the commercial.

[Ryan Hutchinson:]

Okay. And then finally, did the shortened lead times, how much did those impact gross margins, with anything with airfreight or anything we should be aware of?

[Christine M. Gorjanc:]

You always have some airfreight up in the gross margin and some other things, but not too much. I mean, I think we would never do anything and airfreight something if it didn't add to the bottom line. Again, it may hit gross margin, but the bottom line was positive.

[Ryan Hutchinson:]

Well, 50 -- 50 to 100 basis points, or is that...?

[Christine M. Gorjanc:]

No, I mean, no. We don't really say anything on that. I mean, we spend airfreight every quarter. We spend airfreight getting our new Nighthawk to market in some places in that. So that's typical of every quarter. It just depends on what's going on within the quarter, how we allocate that budget.

[C. S. Lo:]

Yes, the thing about it is, if we treat our customers nicely, they would treat us nicely as well.

[Operator:]

Our next question comes from Mark Sue from RBC Capital Markets.

[Mark Sue:]

Recognizing that EMEA has been weighing on your results for a while, and now we have the cable service provider consolidation to contend with, when do you feel that things might actually turn around from EMEA? From a macro level, most companies are saying things are stabilizing there. Should we plan for an uptick in maybe the second half of 2014, just maybe some broad color on how you're feeling about EMEA for next year?

[Christine M. Gorjanc:]

Well, what I could say is no one would be happier to see that than us and report that in our results. So we're clearly aligning our resources to make sure that we pursue the revenue opportunities that we see. And going in and promoting the new storage products in that in EMEA. So we will make sure that everything is targeted so EMEA can grow. We're just really hamstrung a bit by the economic climate, and we will be the first one to tell you when those numbers come back up.

[Mark Sue:]

Okay. The service provider customer, which came late in the quarter, was that a competitive displacement? Usually you have a good lead into a lot of these things and better visibility. It's good to see you responded. But I'm just wondering how that popped up very suddenly?

[Christine M. Gorjanc:]

A lot of times when that pops up, they just want more than they originally ordered and they want some more from the next quarter and the next, over their overall program. So we're happy, that means their program is working well, and they're going to deliver more to the customers.

[Mark Sue:]

Okay. But that's not a European account, it was elsewhere, was that correct?

[Christine M. Gorjanc:]

Well, I think, we sort of -- if you look where the revenue grew the most, it was probably the Americas. So you could draw your conclusions on that.

[Operator:]

Our next question comes from Kent Schofield from Goldman Sachs.

[Kent Schofield:]

I was wondering if you could talk a little bit about Smart Home, and how much of a percentage of revenues in retail is that at this point? Or if you don't want to provide that, can you help us just kind of understand how much of a growth driver it was with, say, the seasonalities on back-to-school in September?

[C. S. Lo:]

Well, it depends. I mean, our view of the Smart Home is basically the home of modern days, fully covered with WiFi, with all kinds of gadgets. So to us, anything beyond just the standard router is part of -- I mean, even the routers should be part of Smart Home. So clearly, as most people rightfully pointed out, in the developed world, most people have a router already. And so you could conclude a Smart Home addition is primarily the WiFi extenders, our new TV equipment, and also the storage, and as well as the camera. And then, of course, recently, you've seen some other participants in the market introducing thermostats, smoke detectors. So all of those are Smart Homes. And they're getting bigger and bigger every day. And as we mentioned -- I think, I believe, that I mentioned it last time, when you add up all those things beyond router, it's already 60% of size of the router market. And it's growing rapidly. So because it's growing so rapidly, there is no seasonality as much as yet. They're still growing sequentially. But certainly, we expect that in this holiday season, there will be a lot of sales of these types of products, WiFi extenders, new TV streamers, and the [ph] views on cameras in our competitors' equipments.

[Kent Schofield:]

Got it. So outside of routers, is it 20% of retail revenues at this point? Or is that just not in the ballpark?

[C. S. Lo:]

Well, it was 60% over 160%. That's probably around 30 -- 40 percent-ish, 38% to 40%

[Kent Schofield:]

Okay, okay. That's helpful. And then on the service provider side of things, with the consolidation, you've talked about there being a pause through the end of this year. What's your visibility on that? I mean, can that roll into Q1 of next year? Have you been able to talk to your customer and know that it will be cleared up by then? Just a little color there would be helpful.

[Christine M. Gorjanc:]

Obviously, we're talking to our customers all the time and making as much communication as we can. We don't know exactly when that will all roll out, but we do know they will have to buy. So we don't have an exact date, but we are absolutely talking with them and showing them everything we can do for them to win more business.

[C. S. Lo:]

And these consolidations keep coming. First is Softbank buying Sprint, then is Liberty Global buying Virgin. Just 2, 3 weeks ago, it's Telenor buying Tele2. I mean, there's a lot of activities going on.

[Operator:]

[Operator Instructions] We appear to have no further questions. I'd like to turn the call back over to our speakers for closing comments.

[C. S. Lo:]

Yes. Thank you so much, operator. As we said all the time, NETGEAR is very, very committed to help connect the world onto the Internet, so that their lives could be enhanced. And we do believe there is a long way to go for us to accomplish that mission for everyone on Earth. So the market space is tremendous and opportunity is boundless. And we're going to discuss all that in our Analyst Day on November 7. And of course, for each BU, we're going to present the management team, as well as the expertise, the secret sauce that we have in each BU that we believe that we can master and win in those future vision. So we look forward to seeing everyone of you over there. And until then, goodbye.

[Operator:]

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.