NETGEAR, Inc. (NTGR) Q3 2014 Earnings Report, Transcript and Summary

Greetings, and welcome to the NETGEAR Incorporated Third Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to Mr. Christopher Genualdi. Thank you, sir. You may begin.

Thank you, operator. Good afternoon, and welcome to NETGEAR's Third 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 details 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 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, 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. For the third quarter of 2014, NETGEAR net revenue was $353.3 million, which is down 2.4% on a year-over-year [ph] basis and up 4.7% on a sequential basis. Non-GAAP diluted EPS for the third quarter of 2014 was $0.72, which is up 24.1% year-over-year. Please note that there is a $0.04 benefit on the EPS due to a favorable tax benefit in the quarter. For a full reconciliation of GAAP to non-GAAP financial results, please refer to the third quarter 2014 earnings press release. During the third quarter, net revenue for the Americas was $193.9 million, down 12.1% year-over-year and up 3.4% quarter-over-quarter. Retail had a successful back-to-school season in Q3, but this was offset by lower Service Provider demand and less shipments to the distribution channel in the U.S. Europe, the Middle East and Africa, or EMEA, net revenue was $108.4 million, which is up 11.5% year-over-year and up 8% quarter-over-quarter. While our realignment of the Northern European RBU and CBU sales channels is ongoing, we are pleased with the progress we have shown thus far in the region. Also, we saw a sizable year-over-year uptick in Service Provider revenue in Europe in Q3. Our Asia Pacific, or APAC, net revenue was $51.0 million, which is up 13.4% from the prior year's comparable quarter and up 2.8% quarter-over-quarter. The introduction of the Nighthawk series of routers in APAC clearly held our market share and revenue gain in the region for the Retail channel. We also saw healthy year-on-year growth in Service Provider customer revenue. In Q3, we maintained a high level of shipments with 6.3 million units shipped. We also introduced 24 new products during the quarter. As always, sales channel development is a key focus for the company, and our sales channel remains a critical strategic asset. By the end of third quarter of 2014, our products were sold in approximately 45,000 retail outlets around the world, and our number of value-added resellers stands at approximately 36,000. Now let's turn to our review of the third quarter results for our 3 business units: Retail, Commercial and Service Provider. For the Retail Business Unit, or RBU, net revenue came in at $131.3 million, which is essentially flat on a year-over-year basis and up 18.7% sequentially. We experienced some supply constraints on recently introduced new products due to higher-than-expected demand during the third quarter, leading to a decline in the retail channel inventory level in North America. At the beginning of September, we announced the release of the Nighthawk X4, the newest addition to our award-winning line of high-performance Nighthawk routers. The X4 is our first 802.11ac 4x4 router. 802.11ac 4x4 technology allows the router to support 4 streams of data transmission simultaneously. Thus, achieving an aggregate speed of up to 2.3 gigabits per second. The Nighthawk X4 is the fastest dual-band Wi-Fi router we have ever introduced. At $279, the X4 further expands our high-end selection of home networking routers for consumers with high bandwidth needs. The Nighthawk family of routers now consists of: the Nighthawk at $199; the Nighthawk X4 at $279; and Nighthawk -- flagship Nighthawk X6 at $299. All 3 Nighthawk routers were introduced within the last 12 months. Our channel partners are very excited about this high-end line of routers because it has proven to be the driving force for growing ASPs in the home router market. Together with our channel partners, we look forward to further penetration of the Nighthawk family in the consumer's homes, propelling growth for RBU. Suffice to say, the flow of high-end 11ac products would continue in each coming quarter. The Commercial Business Unit, or CBU, generated net revenue of $72 million for the third quarter of 2014, which is down 6.5% on a year-over-year basis and down 4.6% sequentially. The decline in CBU revenue is primarily driven by reduced shipment in the distribution that led to a reduction of North America distribution inventory. U.S. distribution inventory declined from 12 weeks in Q2 2014 to 10.6 weeks in Q3 2014. In Q3, our switching line continued to perform well, driven by the 10 gigabit and Power-over-Ethernet categories. We saw strength across the Unmanaged, Plus, Smart and Managed switch categories around these 2 technologies. We believe we are winning and will continue to win market share in all 3 regions with our strong pipeline of new switches in the coming quarters. We also released 2 new access points in Q3: one for outdoor use; and one for indoor use. Both have Power-over-Ethernet point-to-point manage capabilities and will help expand our footprint in the growing wireless LAN market worldwide. Additionally, we have been making progress towards winning back share in desktop storage. After the recent introduction of the ReadyRECOVER storage solution for our high-end rack mount products, we believe we will also make progress in gaining share for rack mount storage in the coming quarters. For our Service Provider Business Unit, or SPBU, net revenue came in, in $150 million for the third quarter of 2014. This is down 3% year-over-year and down 1% on a sequential basis. While Service Provider had a solid third quarter, we expect revenues to decline during the fourth quarter due to weakness in CapEx spending in certain major service providers in both North America and in Europe. Our focus remains on improving profitability while investing in core strategic growth areas. The areas that we continue to target are mobile 4G LTE, 802.11ac, the Internet of Things, or IoT, for the homes and the underserved SMB market, especially in switching, wireless LAN and storage. We are focusing our R&D efforts on these organic growth opportunities where we believe that we can win. I hope that you can all join us in person or via webcast in 2 weeks for our 2014 Analyst Day in San Francisco on November 5, where we will dive into the strategy and focus areas for each of the business units in more depth. Additionally, you are all invited to join us before the Analyst Day begins for a special press event starting at 9:00 a.m. Pacific Time on that day, where we will outline the vision of the next phase of the Internet of Things in the homes. This will also be webcast on our website at that time. Please reach out to NETGEAR IR at netgear.com for more details. I will now turn the call over to Christine for further commentary on our financials for the quarter.

Thank you, Patrick. I will now provide you with the summary of the financials for the third quarter of 2014. As Patrick noted, net revenues for the third quarter ended September 28, 2014 was $353.3 million, as compared to $361.9 million for the third quarter ended September 29, 2013 and $337.6 million from the second quarter ended June 29, 2014. We shipped a total of about 6.3 million units in the third quarter including 5 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 3.1 million units for the third quarter of 2014. Moving to the product category basis, third quarter net revenue split between wireless and wired was about 75% and 25%, respectively. The third quarter net revenue split between home and business products was about 79% and 21%, respectively. Products introduced in the last 15 months constituted about 42% of our third quarter shipment, while products introduced in the last 12 months constituted about 35% of our third quarter shipments. From this point on, my discussion points will focus on non-GAAP numbers. As mentioned previously, a 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 2014 was 29.9%, compared to 28.9% in the year ago comparable quarter and 29.7% in the second quarter of 2014. Total non-GAAP operating expenses came in at $68 million for the third quarter of 2014. We continue to manage operating expenses in a disciplined manner. Our non-GAAP R&D expense for the third quarter was 6.2% of net revenue, as compared to 6.2% in the year ago comparable period and 6.3% of net revenue during Q2 2014. We continue to spend R&D dollars carefully and 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 function, which should result in further operating margin leverage. Our headcount increased by net 14 people to 1,047 during the quarter. Our non-GAAP tax rate was 29.4% in the third quarter 2014, as compared to 37.2% in the third quarter of 2013 and 36.5% in the second quarter of 2014. The favorable tax rate in Q3 was due to catch-up benefit resulting from improved profits generated from our international business. Looking at the bottom line for Q3, we reported non-GAAP net income of $26.2 million and non-GAAP diluted EPS of $0.72 per diluted share. Again, the tax benefit amounts were approximately $0.04 per share. Our balance sheet remains strong. We ended third quarter 2014 with $242.6 million in cash, cash equivalents and short-term investments compared to $242.7 million at the end of the second quarter of 2014. For the third quarter of 2014, we've generated approximately $24.8 million in cash flow from operations. During the trailing 4 quarters, we generated $81.7 million in cash flow from operations. We are very focused on optimizing the business and generating free cash flow, which gives us flexibility with our business needs as well as the ability to strategically employ cash to enhance shareholder value. In Q3, we spent $25.5 million to repurchase approximately 785,000 shares of NETGEAR common stock at an average price of $32.47 per share, which did not result in a material benefit to non-GAAP diluted EPS for the quarter. Over the last 4 quarters, we have repurchased approximately 4.1 million shares. Our number of diluted weighted average shares is now nearing 2009 level. At the end of the third quarter 2014, approximately 706,000 shares remained on the repurchase program previously authorized by the company's Board of Directors in October 2008. 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. With this in mind, our Board of Directors have authorized a new program to repurchase up to 3 million shares of the company's common stock or approximately 8.5% of the outstanding shares. This is in addition to the approximate 706,000 shares remaining at the end of Q3 on the company's previous share repurchase program. We plan to remain opportunistic buyers of our stock. DSOs for the third quarter of 2014 were 72 days, as compared to 68 days in the third quarter of 2013 and 76 days in the second quarter of 2014. Our third quarter net inventory ended at $206.5 million, compared to $211.3 million in the third quarter of 2013 and $194.5 million at the end of the second quarter of 2014. Third quarter ending inventory turns were 4.9, as compared to 4.9 turns in Q3 2013 and 4.9 turns in the second quarter of 2014. Let's now 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 7.7 weeks of stock. As a reminder, we are now including our online resellers in this figure. And in our earnings release, we have conformed historical period to include these as well. Current distribution inventory levels are 10.6 weeks in the U.S; 4.4 weeks of stock for distribution in EMEA; and 6.8 in APAC. For the fourth quarter of 2014, we anticipate revenue will be in the range of approximately $335 million to $350 million; fourth 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 35% for the fourth quarter of 2014. Operator, that concludes our comments, and we can now take questions.

[Operator Instructions] Our next question comes from Tavis McCourt with Raymond James. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: A couple of housekeeping ones. First, Christine, I wonder if you could give us the cash flow from operations and capital spending in the quarter.

Sure. Let me just look. Capital spend for the quarter is -- okay, cash spending from operations is about $25 million, and CapEx is about $4 million. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: Great. And then, Patrick, I mean, so the Internet of Things products that I guess you'll be announcing, 2 questions related to that product line. You've dabbled in it over the last couple of years largely in the Service Provider segment. Is what you're announcing or launching in November meaningful to this year's holiday selling season? Or is this something that bills over time and is going to be more impactful to next year? And as a follow-up to that, is this something that you could do entirely through internal efforts? Or at some point, does it take a tuck-in acquisition? Or it just doesn't make sense to do a tuck-in acquisition versus all internal development?

Okay. It's a pretty loaded question. First and foremost, we are not going to going to specific about whether it is going to affect the Christmas season for competitive reasons. And -- but certainly, we do believe that it will be meaningful for next year, especially for RBU. And I hope that you would be able to join us and understand how excited we are about this new product line. And acquisition, we have always been active in looking at whatever complementary technology that we would like to add. As you probably recall, our first acquisition in the Internet of Things was done about 2 years ago with a line of special patented technology of wire-free cameras. I will continue to look for strategic opportunities. But we do believe that we have a lot of internal intellectual property to build on, to expand. And we're going to look for -- not only for strategic acquisition, but also for strategic alliances to really build out the entire solution of the Internet of Things for the homes.

Our next question comes from Hamed Khorsand from BWS Financial.

So first off, just want to see if -- what challenges are you facing on the Commercial end that we're still stuck at this revenue base around $70 million and change?

As we talked about, while we are doing very well on the switching side, I think we still need to make some more progress on the storage side, which we believe we're making a little bit of progress especially on the desktop side. We still need to make more progress on the rack mount side. I think once we get that storage thing going, you would see more progress. On the other hand, actually, as a matter of fact, we -- our CBU revenue was weighed down by the depletion in the channel inventory. So as a matter of fact, if we did not destock or the channel did not destock, we actually have seen a growth of the CBU revenue. But I think it's good for the long-term benefit of CBU because less channel inventory means more profitable because we would have to pay less price protection. So there's always a fine balance between whether we could load up the channel inventory, so that we can get more sales through, or are we going to give up more profitability because we have to pay more price protection, and we load up the channel inventory. I think we are definitely making progress, and when we get more new products and new programs in the channel, they are successful on the storage side, then you'll see, we make progress. I would say that -- and we would love to see that we could break the $80 million mark.

Okay. Just looking at the retail segment, it seems as though you're making quite a bit of headway with your higher-end products. Are you seeing a lot more competition on the lower end of the spectrum there?

As a matter of fact, we have a very good market share in the mid and low end, and I don't think we have seen a lot of competition at all. And I think we created this high-end category, and now we're attracting all of our competitors trying to come after us at the high end. But we've got [ph] that, we dealt with that because when you have less competition in the other end of the market, you make a little bit more money, right?

Okay. And then the other question I had was, just looking at the guidance, is all of the shortfall were just related purely to Service Provider?

Absolutely.

Okay. And last question is that, any currency issues given the strength in dollar right now?

Yes, definitely. I mean, we're certainly seeing that our profitability in Europe is going to be hurt, and that's why we factored into our guidance for operating margin in Q4. Of course, it takes a it little bit of adjustment in order to lower our cost of goods sold and by squeezing our supplier. But then in Q4, certainly, it would have a downward pressure on our operating margin. But we've taken that into account when we provide the guidance of operating margin range.

Our next question comes from Kent Schofield with Goldman Sachs.

To follow-up on the Commercial side of things. Is -- our -- when we look at the storage side of the business, is it more a function of products at this point? Or do you think you have the right products out there, and you need to figure out kind of the channel side of things? What's left to do there, so that you can start to have that business do better?

Yes. I mean, clearly, anything that we want to be successful, you have to be successful both on product and channel. I think we're working on both. There is clearly -- we have a set of products that we believe are very superior to our competitors. We just have to improve on its usability, as well as you're getting a clear message out to the market, which is marketing-related. From a channel perspective, I think the desktop storage, we need to follow the ship of the channel more to online. I think we have to do more programs online rather than -- traditionally, we sell the storage through the -- our channel. And on the high end, clearly, we have to do some more recruitment of the higher-end storage, who traditionally, we sell HP, Dell, and we'd like to attract them to sell our ReadyDATA and our rack mount storage. So we clearly know what we need to do, and we are going to continue to do that in the coming quarters, and we believe that it will eventually pay off.

Got it. And then on the switching side of things, is there -- do you feel like you're doing equally well in kind of the high and low end there? You talked about managed and managed plus, I think that is a little bit more high end. So is there a difference? Are you seeing more challenges on the low end? Or do you think you're doing well there as well?

Yes, we're doing well across the board from the low end, which we mentioned. The low end are primarily Unmanaged, Plus and the Smart, and the high ends are primarily the layer 2 and layer 3 Managed. And we're doing well across the board, primarily by sticking our neck out and really push things a bit. And Power-over-Ethernet, which we started quite a few years back, has now proven that it's very, very right on the mark.

Okay. And you mentioned online around storage. How do you feel like your positioned heading into this holiday season may be relative to last year when we think about online retail heading into the holidays for NETGEAR?

Well, I mean, previously, we're seeing storage are primarily sold by value-added resellers so we kind of neglect the online channel that's why we go to Amazon and look at the top 10 storage, and see whether you find it, you probably don't, so -- because we didn't pay much attention to it. So it's a concerted effort from our sales force around the world that we absolutely, in this Christmas season, need to break in to the top 10 in the online storage sales ranking.

Got it. And to -- the Retail router side as well?

Yes. The retail routers side, we have consistently been the #1 vendor in the top 10 rankings. We have the most number of routers in the top 10. So we absolutely are not going to concede that. We're going to continue to push more dominance in that top 10. We're also -- we have the most, in the top 10, for Wi-Fi expanders as well, and we'll continue to push for bigger share. Clearly, it's a focus of our retail sales force around the world.

Our next question comes from Jeff Kvaal with Northland.

2 questions for you, I think. Patrick, could you talk about the impact of the ac-ASP lift or the transition outside of the Retail channel? To what extent does that factor in to your ability to command higher prices with other -- either commercial or service provider customers? And then, Christine, for you, I know we talked about this a bunch, but to what extent is the visibility on the tax rate ideally coming down a little bit over time? It does seem to bounce around quite a bit from quarter-to-quarter as you know.

Yes, first question about 11ac. Clearly, it's the driving force of upping the ASP in the retail channel, and the fact of the matter is it gives you an idea that in the retail channel because of the almost full penetration of Wi-Fi in broadband homes in the Western world, the U.S. sales are not growing, and actually, it's declining in single digits. But because of the increase in ASP, the market is actually increasing. It's increasing in single digit, so that tells you the 11ac's power in really driving the market upwards. So the ASP increase for the retail home market has been in double digit. So we're very happy to see that. Now we're actually starting to see that happening on the Service Provider side as well, more and more, especially on the MSO side. The service providers are providing 11ac CPE, and we believe that is going to be followed soon on the telco, DSL, vDSL side. Then again, it would have been a push up on the ASP.

And Jeff, on the tax side. So definitely, the rate was up in 2011 and '12 as Europe's profitability was down, and even their revenue was down as low as $97 million. So you did see it go up to $108 million in revenue this quarter, and correspondingly, the profits are also going up. And that's why you see our tax rate trending down in the guidance at 35% for Q4. So that would definitely be a couple of points off of last year. And as we can see Europe get incrementally better are -- or on the international side, then we could also see that rate come down incrementally.

Yes. For us, it's important to push -- to continue to push the growth of Asia Pacific, as well as maintain our strength in Europe. So -- I mean, it would be ideal if we could get a 50-50 split between international and domestic. That will certainly help our tax rate.

Okay. Maybe one follow-up and that is, given to the mix changing in the -- between the 3 business units, wouldn't one expense the margin structure to drift to the higher end of the 9.5% to 10.5% range that you've been talking about over the course of the last few quarters?

Well, certainly, the whole team in NETGEAR is striving to improve the margin all the time. And you're right, I mean, the favorable mix would help us to achieve that a little bit easier. However, in Q4, as we just mentioned to Hamed previously, that we're having some headwinds on the strong U.S. dollar. We could not change our price just overnight nor we can change the cost overnight, so we have to eat that. We have to take that in margin. And so also in Q4, typically, it's a very heavy retail season that, traditionally, we spend quite a bit in promoting through Thanksgiving as well -- Black Friday as well as Christmas. So we intentionally do that because that gave us the opportunity to gain even more market share. So it's kind of an investment season. So needless to say, I mean, we are trying to maximize our operating margin.

Yes, okay. You're right. I was thinking about a 2015 trajectory rather than 4 Qs...

Yes, 2015, definitely, that's the -- the goal is to continue to improve our that range.

[Operator Instructions] We have a follow-up question from Tavis McCourt with Raymond James. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: I wanted to dig a little bit into the revenue splits that you gave in the wired, wireless routers gateways. Those unit numbers you gave, which looks like they've been down kind of 10% year-over-year in the last few quarters, is that a measure of the units shipped in to your Service Provider channel? Or is that including Retail?

Oh, that includes Retail as well. As I just mentioned that because of the saturation or the pretty much full penetration of Wi-Fi in the broadband homes, the unit sales of the entire Western market is actually declining. So that's why, in order to grow, we have to up the ASP, and that's why the 11ac technology, the introduction of the Nighthawk line is very critical for us to continue to grow our revenue and help them, the industry, to grow the market. And it's pretty clear that in Q3, we have demonstrated to our retail partners that it is instrumental in really returning the retail market to growth because of the ASP expansion. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: Got you. And then on the home and business split, the 79%, 21%, what is that a measure of? Is that overall revenues?

The measure of revenue. It's a measure of net revenue. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: Okay. So your -- within your Service Provider, you'll split that out whether it's going into service provider, homes versus businesses?

Actually, yes. But the service provider to business is tiny. It's almost immaterial. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: Okay. All right. So that's a measure of the Commercial business, basically?

Exactly. It's Commercial, but you have the 2 BUs add together.

Our next follow-up is from Kent Schofield with Goldman Sachs.

Did you end up having a 10% plus customer for the third quarter?

No, we didn't have one this quarter. We haven't actually really had one all year.

Yes, okay. I just wanted to confirm. And then just as a follow-up to that, is there any sort of clarity as to that one used to be or a 10% plus customer virtual media in terms of how they're thinking about their plans for calendar '15 given Liberty?

No. We haven't heard much yet. I mean, as far as we're concerned, I mean, we have to continue to be their supplier for 2015.

Okay. Okay, great. And then when we think about the weakness you talked about and the go forward on the Service Provider side of things, is that in both the kind of core or if you want to call it legacy NETGEAR business as well as the AirCard business? Or was it disproportionate to either businesses?

Well, I mean, for competitive and client confidentiality reasons, we're not going to break it out. Needless to say, basically, everybody is -- pretty much know by now that there was a huge CapEx contraction across the carriers around the world. I mean, this Q4 is unusually big, and we're not going to specifically call out any particular customers for confidentiality reasons.

There are no further questions in queue at this time. I would like to turn the call back over to management for closing comments.

Great. Once again, I would like to thank everyone for joining us today, and would like to extend my sincere invitation to join us on November 5 in San Francisco at the InterContinental Hotel on Howard Street. We will have a press conference starting at 9:00 a.m., announcing our new vision and a set of products for our Internet of Things for the homes, which I personally feel very excited about and certainly will be material for our next few years of revenue and growth. And then following that, we're going to have our Analyst Day starting at 10:30 in the same hotel in the different floor, and I look forward to seeing all of you.