NETGEAR, Inc. (NTGR) Q2 2014 Earnings Report, Transcript and Summary

Greetings, and welcome to the NETGEAR, Inc. Second Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Christopher Genualdi, Investor Relations Manager. Thank you, Mr. Genualdi, you may begin.

Thank you, operator. Good afternoon, and welcome to NETGEAR's Second Quarter 2014 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, market trends and opportunities, competition, research and development efforts, sales and marketing efforts, new product introductions and our growth strategy. Forward-looking statements 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, 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 these forward-looking statements. Potential risks are detailed in the company's periodic filings with the SEC, including 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.

Thank you, Christopher, and thank you, everyone, for joining today's call. Before we begin, please note that Q2 2014 will be the first quarter in which the AirCard acquisition is included in all comparable quarters. For the second quarter of 2014, NETGEAR net revenue was $337.6 million, which is down 5.6% on a year-over-year basis and down 3.4% on a sequential basis. Non-GAAP diluted EPS for the second quarter of 2014 was $0.58, which is down 6.5% year-over-year. Please see the second quarter 2014 earnings press release for a full reconciliation of GAAP to non-GAAP financial results. During the second quarter, net revenue for the Americas was $187.5 million, down 6.6% year-over-year and down 3.7% quarter-over-quarter. The year-over-year decline is due to last year's large Q2 sell-in of our new line of storage products in North America. Additionally, we saw a reduction of service provider shipments in North America compared to the same quarter last year. Europe, the Middle East and Africa, or EMEA, net revenue was $100.4 million, which is down 7.3% year-over-year and down 6% quarter-over-quarter. Europe continues to be a difficult market for us, so during Q2, we took some proactive measures to address this. In the Northern European region, especially in the German-speaking countries, the market has become more concentrated in fewer, larger resellers. Accordingly, we have realigned the Northern European RBU and CBU sales channels to focus on these fewer but higher-volume top-tier accounts. We believe that this action will benefit NETGEAR in the long term with the goal of gaining market share and improving profitability in Northern Europe. Our Asia Pacific, or APAC, net revenue was $49.6 million, which is up 2.3% from the prior year's comparable quarter and up 3.8% quarter-over-quarter. While we saw strong year-on-year growth in APAC's service provider shipments during Q2, it was partially offset by weakness in non-service provider shipments. In Q2, we maintained a high level of shipments with 6.2 million units shipped. We also introduced 14 new products during the quarter. As always, sales channel development is a key focus for the company as our sales channel remains a critical strategic asset. By the end of the second quarter, our products were sold in approximately 44,000 retail outlets around the world and our number of value-added resellers stands approximately 37,000. Now let's turn to a review of the second quarter results for our 3 business units: retail, commercial and service provider. For the Retail Business Unit, or RBU, net revenue came in at $110.7 million, down 5.7% year-over-year and down 6.4% sequentially. While we are not satisfied with the year-over-year performance of RBU, primarily due to the issues in Europe, we believe we are well positioned for second half growth with some strong product introductions kicking off in Q3. At the beginning of this month, we announced the release of the Nighthawk X6, the world's first tri-band WiFi router, with 6 high-performance antennas and 3 network bands, one 2.4 gigahertz and two 5 gigahertz bands, the Nighthawk X6 delivers the industry's fastest combined WiFi speed, up to 3.2 gigabits per second. Today's homes are adding connected devices at a stunning rate. The WiFi speed in these devices varies. Therefore, consumers who want the highest aggregate WiFi speed need tri-band routers to group WiFi devices into 3 different bands, each for devices of similar speeds such as slow, medium and high. The Commercial Business Unit, or CBU, generated net revenue of $75.4 million for the second quarter of 2014, which is down 14.7% on a year-over-year basis and down 4.3% sequentially. This is a tough comparison quarter for CBU because Q2 last year was a major shipping quarter for our new line of storage products. With the recent announcement of our ReadyRECOVER solutions, we are working with our channel partners worldwide to drive further storage growth in the second half. Our Commercial Business Unit continues to be focused on addressing the underserved markets of K-12 education, hospitality and health care facilities. In Q2, we introduced the new 7600 series WLAN controller which supports 10-gigabit LAN interface and newer models of access points. The market reception of this new WLAN controller has been very encouraging. We have been leveraging our strength in switching to increase our presence among SMB channels worldwide with our 10-gig and PoE switches driving sales for CBU. For our Service Provider Business Unit, or SPBU, net revenue came in at $151.5 million for the second quarter of 2014. This is flat on a year-over-year and quarter-over-quarter basis. Strength in Australia was offset by softness in North America. Europe was flat year-over-year. During the quarter, the Service Provider Business Unit released the STS7000, a new Android touchscreen for home monitoring and automation solutions. The STS7000 enables end users to manage their connected security and home automation devices from anywhere in the home through a simple and easy-to-use graphical user interface. Also during the quarter, NETGEAR and Telstra introduced Australia's first prepaid mobile hotspot with an integrated data usage monitor. The biggest hurdle with consumer adoption of mobile hotspots is the fear of exceeding one's data plan. By offering a prepaid mobile hotspot solution and adding a data usage meter, we are able to address this concern and help consumers become more comfortable with owning one of our AirCard mobile hotspots. We continue to believe our greatest opportunity in SPBU for the immediate -- intermediate-term is the proliferation of 4G LTE data devices and the increased popularity of service provider provisions, home monitoring and automation equipment and services. We continue to position ourselves to benefit as the Internet of Things becomes a reality in homes and offices. We lead in WiFi technology and just introduced the world's first tri-band WiFi router, the ideal connectivity solution for the Internet of Things environment in the home. We continue to be at the forefront of shipments of home monitoring and automation products to our service provider partners such as ADP. We have a great cloud-based line of home monitoring cameras that are completely wire-free, operate on batteries and can easily be placed indoor or outdoor for any location. To extend WiFi coverage to the far corners of the home, we have the world's widest portfolio of WiFi extenders. We continue to invest in R&D to expand our cloud platform capabilities, grow our camera and home automation devices line-up and develop innovative core home WiFi coverage solutions. Once the smart-connected home market reaches a meaningful size, we expect to be among the first to benefit from this trend. We expect this market will be a revenue growth driver for both RBU and SPBU. I will now turn the call over to Christine for further details on our financials for the quarter.

Thank you, Patrick. I will now provide you with a summary of the financials for the second quarter of 2014. As Patrick noted, net revenue for the second quarter ended June 29, 2014, was $337.6 million as compared to $357.7 million for the second quarter ended June 30, 2013, and $349.4 million in the first quarter ended March 30, 2014. We shipped a total of about 6.2 million units in the first quarter including 4.9 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 3.2 million units for the second quarter of 2014. Moving to the product category basis, second quarter net revenue split between wireless and wired was about 73% and 27%, respectively. The second quarter net revenue split between home and business products was about 77% and 23%, respectively. Products introduced in the last 15 months constituted about 48% of our second quarter shipments, while products introduced in the last 12 months constituted about 37% of our second quarter shipments. 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 second quarter of 2014 was 29.7% compared to 29.8% in the year-ago comparable quarter and 28.9% in the first half of 2014. Total non-GAAP operating expenses came in at $66.3 million for the second quarter of 2014. We continue to manage operating expenses in a disciplined fashion. Our non-GAAP R&D expense for the second quarter was 6.3% of net revenue as compared to 6.4% in the year-ago comparable period and 5.9% of net revenue during Q1 2014. We continue to spend R&D dollars strategically in the key areas that we expect will drive future growth and profitability for the company. We remain committed to driving further optimization in our sales channel, supply chain and support functions, which should result in further operating margin leverage. Our headcount increased by net 10 people to 1,033 during the quarter. We expect additional headcount will be added in the current and future quarters. Our non-GAAP tax rate was 36.5% in the second quarter of 2014 as compared to 32.9% in the second quarter of 2013 and 35.2% in the first quarter of 2014. Looking at the bottom line for Q2, we reported non-GAAP net income of $21.4 million and non-GAAP diluted EPS of $0.58 per diluted share. Looking at the balance sheet, we ended the second quarter of 2014 with $242.7 million in cash, cash equivalents and short-term investments compared to $240.3 million at the end of the first quarter of 2014. Our balance sheet and our ability to generate cash remain strong. During the second quarter of 2014, we generated approximately $37.2 million in cash flow from operations. During the trailing 4 quarters, we generated $73.5 million in cash flow from operations. In Q2, we spent $27.2 million to repurchase approximately 841,000 shares of NETGEAR common stock at an average price of $32.37 per share, which resulted in a $0.01 per share benefit to non-GAAP diluted earnings per share for the quarter. Over the last 3 quarters, we have repurchased 3.3 million shares. Our number of diluted weighted average shares outstanding now stands at the level that it was at the end of 2010. We continue to believe that it's important to return cash to our shareholders in excess of our operating and strategic needs and that a stock repurchase program is an effective means of accomplishing this. Furthermore, we believe in our long-term growth prospects and our cash flow generation capability. We plan to remain opportunistic buyers of our stock. DSOs for the second quarter of 2014 were 76 days as compared to 73 days in the second quarter of 2013 and 74 days in the first quarter of 2014. As always, we closely manage our collections and strive to efficiently mitigate collection risk. Our second quarter net inventory ended at $194.5 million compared to $185.4 million in the second quarter of 2013 and $201.6 million at the end of the first quarter of 2014. Second quarter ending inventory turns were 4.9 as compared to 5.5 turns in Q2 2013 and 5 turns in the first quarter of 2014. Let's turn to our channel inventory. 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 10.5 weeks of stock. As a reminder, we are now including our online retail resellers in this figure, and in our earnings release, we have conformed historical periods to include these as well. Current distribution inventory levels are 12 weeks of stock in the U.S., 4 weeks of stock for distribution in EMEA and 9 weeks of stock in APAC. For the third quarter of 2014, we anticipate revenue will be in the range of $345 million to $360 million. Third quarter non-GAAP operating margin is expected to be in the range of 9.5% to 10.5%. Our non-GAAP tax rate is expected to be approximately 37% for the third quarter of 2014. Operator, that concludes our comments and we can now take questions.

[Operator Instructions] Our first question comes from the line of Jeff Kvaal with Northland.

Patrick, Christine, I've got a couple of things on my mind. I was wondering first of all, Patrick, would you help us understand a little bit about the retail optimism that you were talking about for the third quarter product launches? What is going into that? And how should that shake out between the third quarter? And then what does that mean for the fourth quarter? And then for you, Christine, I was wondering if you could help us understand a little bit about the seasonality in the fourth quarter and how that may shape up relative to prior years? As I know that storage has been an area of some concern and that may finally be a little bit better here.

Sure. Yes. On the retail side, Jeff, we just announced the tri-band WiFi router at $299 price point which is a first in the industry in multiple ways. It's the highest price point ever in retail. And secondly, it's simultaneously introduced in all the territories that tri-band is allowed. Europe, so far, has not allowed tri-band as yet. But in Asia as well as North America, it's allowed and we introduced it simultaneously. And we have been selling it for about 2, 3 weeks. And the reception has been encouraging. So -- and this will not be the first of these high-end routers that we're going to introduce and we'll continue to introduce more in -- I'm sorry?

Not the last, you mean?

Not the last, yes. So we will continue to introduce more of these type of high-end routers at these kind of price points throughout the second half of this year. And also the other thing that we have been making pretty good progress is increasing our share on the online channels. And if you go online, I mean, you go to Amazon, you could see a lot of our routers in the top 10. So I think we make a very good progress in building a sales team specifically for online around the world. So we're trying to do the same for the German-speaking and Nordic countries as well. That's the last piece of the puzzle that we have to plug. So from a product line-up standpoint, we feel very strongly about these new high-end routers being introduced. From a channel perspective, we believe that not only that we're consolidating our market share in the brick-and-mortar, we are making good progress on the online channel as well. So that's why we think that the second half will see growth over the first half for the Retail Business Unit.

And just to seasonality, I think, Patrick, seasonally, retail is typically better in the back half of the year with back-to-school, holiday season and that product introduction. I think on the CBU side, what we're expecting is a steady growth on the CBU side. As like you said, the storage in that, we continue to grow those product lines. As far as service provider goes, that's the one that's lumpy, and it could have a good Q4, it could have a slower Q4 because maybe everyone spent their money during the year. So that will remain lumpy, and we'll guide that as we get to Q4.

All right. Do you think then as a company, you are on the cusp of returning to year-over-year growth here heading into the second half of the year, one of these quarters, nudge above 0?

Yes. We definitely are working very hard across all 3 BUs to really grow on a year-over-year basis as well as to keep improving our margin. And rest assured, the entire team here is very focused on top line, margin and EPS.

Our next question comes from the line of Tavis McCourt with Raymond James. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: I've got a couple of them. First, in terms of the Q3 guidance, can you give us some trajectory on the 3 BUs, either on a year-over-year or sequential basis, if anything -- we should be building in anything dramatic? Also have a question on the gross margins this quarter, I think were up quite a bit sequentially, even though I think service provider was a bigger part of the mix. So can you talk about what led to that sequential increase? And then, Patrick, in your commentary, you mentioned some new home automation products sold to the service provider channel. And I'm wondering, are these being actively sold today or are they still in the process of being pitched to the service providers?

Sure. Tavis, let me take your gross margin question, just so it definitely was up not quite a full point from last quarter. Service provider was about 44% of the mix last quarter, 45% this quarter, so it's relatively the same. That's just based on all of the components that go into that. Because if you look a year ago, it's also about -- we were about 29.8% in gross margin. So we're within that range of somewhere around 29% up or down 100 basis points in any one quarter, with service provider around 40% to 45% of the total.

But clearly, as we introduce the higher technology routers, we expand the gross margin bit by bit overall. And talking to your second question, are we pitching these higher-end products to service provider channels? Clearly, yes, we do. Right now, it's already in retail channel for the -- prevalent [ph]. And for the 11ac technology, both on router as well as in cable gateway, and also the vDSL gateway, we're definitely pitching it to service provider customers worldwide.

Tavis, lastly, you asked about guidance within the BUs. I mean, Patrick just alluded to, we expect to have a better half of the year in Retail Business Unit. And seasonally, that is when they're traditionally up over Q1 and Q2. From a CBU standpoint, again, we're expecting a steady growth. The seasonality isn't as profound when you're looking at CBU. And on Service Provider, I think that's the one we will guide to when we get there in Q4. That is -- they've been steady for about 4 quarters now, and so we'll continue to look through that business unit and see what comes in, in Q4.

Our next question comes from the line of Mark Sue with RBC Capital Markets.

If I look at the dynamics in Europe and the revenue run rate over the last -- I guess, last 3 or 4 years, we're kind of stuck in this revenue bracket. And I guess the working premise was that the macro was really the issue. Tactically, you're making some changes. Patrick, is that enough? What are some of the things that we can actually do? Because Europe is kind of holding you back. I'm trying to see what moving parts still remain in terms of improving your execution and just the opportunities in Europe?

Yes. I mean, Europe is definitely a little bit more difficult than what we anticipated. The market has stabilized, as what we have pointed out, and on a very, very slow recovery. However, the market is diverging from the rest of the world as we find out. One, Europe is actually lagging behind the rest of the world in adoption of technology. For example, they are significantly behind in adopting 4G LTE and even on 11ac. Secondly is that their shift to online channel is actually much faster than the rest of the world. While in the U.S., the online channel represents probably around 20% to 25% of overall sales; in Europe, it's closer to 40% to 50%. So basically, we, right now, have to -- well, certainly, we try to build a very, very good online sales team around the world. However, from a product set standpoint, it's almost now, we have to have 2 set of products: 1 set for the rest of the world, which is more 4G LTE, 11ac, tri-band, all these high-end oriented; but in Europe, we still have to be a little bit backwards in the 11n and the 3G. So yes, we need to get -- make some adjustments in order to specifically target the European environment. And as such actually, it has been benefiting the local brand in Europe because they don't have to go outside of Europe. So they seem to be able to adapt to this non-change better than we do. So clearly, we need some work to do.

Understood. If I look at the difference from a unit -- business unit point of view, from retail, small and medium business and also service provider, are there moving parts as it relates to profitability by business unit once we do the proper allocation of share cost across the business units? Is there a way you can actually start looking at improving profitability by segments?

Absolutely. I mean, it's the effort of every single business unit to look at how they could improve their margin and their profitability.

Which one is the lowest at the moment?

The service provider. And in service provider, the profitability, it is actually the lowest among the 3. And clearly, because the service provider's purchase is concentrated in a few bigger hands, so naturally, that cost a little bit more for us to do business and that's less margin. But it doesn't mean that they don't have the opportunity to improve their profitability as well. All 3 BUs are working very closely at how they utilize, capitalize on our unique R&D, intellectual property, so that we could command a little bit higher price, so that we could expand the margin. Secondly is that we also look at the logistics, all right? How do we for example, like reduce the size of the product or we reduce the freight cost while not antagonizing the end user. How do we increase the usability so that not only that we can sell more because customers like it, but it will cost us significantly less in returns, in warranty, in tech support. So all those areas, all 3 BUs are working on.

Our next question comes from the line of Hamed Khorsand with BWS Financial.

I just wanted to start off with, if you could just touch on gross margin, really operating margin, a little bit further. Because if I'm looking at the segments, you touched on this a little earlier, there really hasn't been much change, right? And if I'm looking at the price point of your -- the average product you're selling, it's also -- you're indicating that it's going to increase with the higher-end units. So why can't operating margin increase? What's dragging operating margin down on the guidance?

Well, I think actually, on the guidance, we did guide 9.5 to 10.5 this quarter, which was up from prior quarter. And clearly, each business unit has been in a range on their contribution margin but then there's other costs that we have as far as all of the operational, like Patrick mentioned, logistics, how to save money there, and the gross margin. It depends on whether there's air freight, all sorts of things you're setting up in carried cost. So we're clearly trying to work on those numbers, obviously, achieve efficiencies and get more leverage.

I mean, overall, what I'm trying to get to, it sounds like in this quarter, there's a lot of hesitation on your end as far as what to expect for Q3. And that's a little bit different than in prior Q3s, when back-to-school has been very important, robust for you guys. So I'm just trying to get an understanding why the tone, why it's different this time around? I mean your guidance, you're not bumping it up a lot from Q2 sequentially from the low end, right? 345 from a 337 base.

We always do a range. I mean, we want to be able to ensure that we have 100% confidence that we can hit the range. So I mean, clearly, we're striving to -- as we always want to do, is to hit the higher end of the range. And the thing is, today, RBU is no more 70% of the business. RBU actually is only about 40% -- 35%, 40% of the business. So even RBU is going to have a good Q3 and Q4, we got to get the other BUs to come along. On the other hand, the SPBU is really lumpy, and it's really depending on whether they would be able to get a new account before they could grow. I mean, that's pretty much what it is. I mean, so if the RBU is, let's say -- we didn't have the breakdown yet. But last year -- I mean last quarter, in Q1, it's somewhere around $118 million. Even a quarter-on-quarter growth of 15%, all right, that is representing about a little bit over $20 million -- less than $20 million. So that's what the RBU contribution is. For us to grow the entire business on a sequential basis, on a much bigger magnitude, the other 2 BUs have to come along as well. Now we do expect CBU to grow steadily, but SPBU's growth is lumpy. It really depends on whether they get -- land on a new project or a new account.

Okay. And then my last question's around the service provider line. What are you expecting in Q3? I mean, from your customer base, what have they been saying? It sounded like in Q2, it was flat, but you guys were coming off of a pretty good buying moment in Q1. So what's -- is it just promotion-driven right now?

No, I think our service provider is still at a steady rate of either new subscriber addition or upgrade of their subscribers. As of now, because we have 13-week lead time requirement for our service providers, we do see Q3 is pretty much flat over Q2 for service provider revenue.

Okay. Sorry, one last question, easy one. I didn't hear it. Is there an expectation what the tax rate will be this -- in Q3?

Yes, we guided approximately 37%.

Our next question comes from the line of Kent Schofield with Goldman Sachs.

This is Justin Jordan, filling in for Kent. Could you give us just a quick update on sort of your competitive positioning with ReadyNAS product line? And I know you guys have been making some improvements. Do you feel that the product is now competitive in the market? Or do you still need more improvements to be made?

Yes, we do believe we have a very competitive product line especially on the high end. Our data protection capability is second to none. And then we have been able to win over a lot of customers. Recently, we just announced a new packaged appliance called ReadyRECOVER together with StorageCraft is very well received in the market. So in the high end, we do believe that we are well positioned and we are gaining share, we're going to gain share. It's in the entry level that we need to continue to work on the usability and the cloud capability at the entry level. But then on feature standpoint, we still believe that we have a very competitive set of features even at the entry level. It's just that usability that we still need to continue to work on. And of course, our competitors are not standing still. So over last year, they had made also their improvement on usability as well, so we just have to keep up.

Our next question is a follow-up question from the line of Tavis McCourt with Raymond James. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: Patrick, I wanted to ask a little bit about the U.S. K-12 market in relation to the E-rate program. I think there's some discussion about the SEC setting aside some funding going forward specifically for wireless LAN deployments in K-12. And I guess a twofold question. Are you seeing any pause in spending ahead of that? And is that a program that you expect to be able to benefit from given the upgrade you've done to the wireless LAN portfolio of late?

Yes. There's certain costs to the spending on that program in the market. I think we are less affected by that. We have been selling pretty steadily into the K-12 market, both in the public and private schools around the world. And because our products are so much lower in the total cost of ownership, I think we have appealed to a steady group of customers. However, I think what we have been affected a little bit more in the last 2 quarters is our introduction of the new wireless controller, the 7600 series. That caused some pause from the customers waiting for this new series to come out. Now it's finally out in May, and we're seeing very good uptick in June. So we are pretty confident that the 7600 series will be well received in the second half by the K-12 customers that we have. As a matter of fact, we believe that with the additional release of this fund, it will benefit the industry as a whole as well as us.

There are no further questions at this time. I'd like to turn the floor back over to management for closing comments.

Thank you so much for everyone joining this call, and we're very excited about a few new products that we introduced that we mentioned in the call already, especially the Nighthawk X6 as well as the wireless controller 7600, and also the mobile hotspots with a usage meter, our lower cost mobile hotspots, that we believe that we will have a wide adoption in other markets beyond just Australia. So looking forward to talking to you again in the next earnings call in October. Thank you.

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