NETGEAR, Inc. (NTGR) Q1 2015 Earnings Report, Transcript and Summary

Greetings, and welcome to the NETGEAR Inc First Quarter 2015 Earnings Conference Call. At this time, all participants are in listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Christopher Genualdi, Investor Relations Manager for NETGEAR. Thank you. You may begin.

Thank you, operator. Good afternoon and welcome to NETGEAR’s first quarter 2015 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, and expense, 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 related to LTE, connected home and SMB vertical solutions. 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-K 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 or 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 first quarter of 2015, NETGEAR net revenue was $309.2 million, which is down 11.5% on a year-over-year basis and down 12.5% on a sequential basis. The decline in revenue is due to the exiting of certain service provided business that does not meet our financial metrics as discussed in our previous earnings call, as well as the negative impact of the strengthening dollar on our international business. I will expand upon this further in a moment. Non-GAAP diluted EPS for the first quarter of 2015 was $0.46 which is down 22% year-over-year. Our EPS was negatively impacted by the decrease of international revenue and profits, which Christine will discuss during her section of the call. For a full reconciliation of GAAP to non-GAAP financial results, please refer to the first quarter 2015 earnings press release. During the first quarter, net revenue for the Americas was $173.8 million down 10.8% year-over-year, and down 10.7% quarter-over-quarter. Revenue in the Americas was primarily impacted by our exiting of certain service provider business that did not meet our expected level of profitability. Both the retail business unit and commercial business unit performance in the Americas during the quarter met expectations. Europe, the Middle East and Africa, or EMEA, net revenue was $89.1 million, which is down 16.6% year-on-year and down 16.1% quarter-over-quarter. We had expected the strengthening U.S. to negatively impact EMEA results when translating revenues from local currencies into U.S. dollars. In addition to that, Europe underperformed more than expected due to increased volatility in the regions pricing environment. We believe this pricing volatility is a reaction to the fluctuating exchange rate and will continue for the rest of the year until the exchange rates are stabilized. Our Asia Pacific, or APAC, net revenue was $46.3 million for the first quarter of 2015, which is down 3.3% from the prior year’s comparable quarter and down 11.5% quarter over quarter. Similar to EMEA, our results for APAC were negatively impacted by the strengthening U.S. dollar as forecasted. All three BUs performed well against our targets in APAC. Overall, other than managing our service provider revenue to a reduced but more profitable level of $100 million to $105 million a quarter, we are seeing renewed difficulty in our European retail and commercial businesses because of the continuous upward trend of the U.S. dollar exchange rate in a sluggish economy. In Q1, we shipped 5.7 million units. We also introduced 19 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 first quarter of 2015, our products were sold in approximately 44,000 retail outlets around the world, and now the number of value added resellers stands at approximately 33,000. Now let’s turn to our review of the first quarter results of our three business units: retail, commercial, and service provider. For the retail business units, or RBU, net revenue came in at $121 million, which is up 2.3% on a year-on-year basis and down 18.2% sequentially. While RBU performed well in the Americas and in APAC, the environment in Europe has been challenging. I’d like to highlight our launch of the Arlo Smart Home Security Camera has been very successful. A big congratulations is due to the entire Arlo team that worked so hard to bring such an impressive and innovative product to market. Sales and customer interest among the very limited set of retail partners we had in Q1 are very encouraging. We look forward to building on this success by expanding the channel and regional reach of the Arlo Smart Home Security Camera in the coming quarters. As we continue to ramp our production capacity to full speed, we expect to reach full channelwide and worldwide distribution of Arlo cameras during Q3. The commercial business unit, or CBU, generated net revenue of $72.7 million for the first quarter of 2015, which is down 7.8% on a year-on-year basis and down 8.4% sequentially. While we were pleased with CBU’s performance in the Americas and APAC during the first quarter, which was driven by the switching category, our Q1 results show declines due to the headwinds caused by the strengthening dollar in Europe. The commercial business unit started the new year with the introduction of two innovative switches. At the low end we introduced the Click Switch, which allows for innovative mounting and cable management with USB charging ports. It is ideal for conference rooms, cubicles, and home theater rooms. I’d like to highlight that the Click Switch was recently awarded a prestigious Red Dot Product Design Award by an international panel of 38 design experts in Essen, Germany. At the high end we introduced the M6100 Chassis Switch, which we believe is the world’s best priced performance chassis switch with a densest 10 gigabit configuration for under $10,000. While it will take time for sales to ramp for both of these new switches, we are optimistic that they will be drivers for CM – C U’s performance in the second half of the year. For our service provider business unit, or SPBU, net revenue came in at $115.5 million for the first quarter of 2015. This is down 24.2% year-on-year and down 8.3% on a sequential basis. As stated on our prior earnings call, we had expected SPBU revenues to decline in Q1 as we have exited certain service provider businesses that did not meet our profitability metrics. Specifically, we have seen a decrease of service provider investment in the mature wireline technologies, and our competition in this market segment has been willing to take deals with low or negative profit margins. We on the other hand have chosen to pass on such deals. During the first quarter, we have received additional orders above our original plan from various service provider customers that allowed us to deliver upside to our forecast. Nevertheless, we continue to expect that SPBU revenue will be approximately $100 million per quarter for Q2 and the remainder of the year. The restructuring of the service provider business unit is ongoing as we continue to work on bringing SPBU’s expenses in line with this new revenue run rate. We expect that SPBU’s restructuring activity will be completed by the end of the second quarter. While we are throttling back our investments on the mature wireline side of the business, we continue to strategically invest in newer technologies such as LTE, where we expect future service provider spending to flow. We are also developing cutting edge DOCSIS 3.1 and VDSL products, but only for select wireline customers where we know that we can add value and be profitable. We continue to believe that NETGEAR can offer service providers unique value and expect that we can improve the profitability of the service provider business over time. While we are currently challenged by our reduced revenue outlook, we continue to maintain a high level of R&D effort to ensure future profitable growth with innovative products, as demonstrated by the initial success of Arlo. We continue to maintain our market leading position in 802.11 AC WiFi routers and gateways, WiFi extenders, and WiFi cable gateways sold through retail. On the commercial side of the business, the introduction of the Click Switch and the M6100 chassis switch proves that we are still the market leader in SMP switching. Meanwhile, SPBU was focused on being first to market with the latest LTE technology and delivering cutting edge DOCSIS 3.1 and VDSL products for our long term profitable accounts. All in all, we believe we are effectively navigating a choppy macro environment and making the right decisions to ensure the growth and profitability of the Company in the quarters to come. 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 a summary of the financials for the first quarter of 2015. As Patrick noted, net revenue for the first quarter ended March 29, 2015 was $309.2 million as compared to $349.4 million in the first quarter ended March 30, 2014 and $353.2 million in the fourth quarter ended December 31, 2014. We shipped a total of about 5.7 million units in the first quarter, including 4.4 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 2.7 million units for the first quarter of 2015. Moving to the product category basis, the first quarter net revenue split between wireless and wired was about 72% and 28% respectively. The first quarter net revenue split between home and business products was about 76% and 24% respectively. Products introduced in the last 15 months constituted about 48% of our first quarter shipment, while products introduced in the last 12 months constituted about 41% of our first 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 statement released earlier today. The non-GAAP gross margin in the first quarter of 2015 was 29.7% compared to 28.9% in the year ago comparable quarter and 29.3% in the fourth quarter of 2014. Total non-GAAP operating expenses came in at $63.4 million for the first quarter of 2015, which is down compared to $67 million in the year ago comparable quarter and down compared to the prior quarter’s total of $68 million. We saw a reduction in OpEx due to the SPBU restructuring in Q1, which we expect will continue into Q2. Our non-GAAP R&D expense for the first quarter was 6.3% of net revenue as compared to 5.9% in the year ago comparable period and 6.2% of net revenue during Q4 2014. Looking ahead to Q2, we expect our overall operating expenses to be sequentially down. However, we are maintaining our R&D spending in dollar terms to deliver innovative products in the coming quarters 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 in the future. Our headcount decreased by net 59 people to 979 during the quarter. The decrease is primarily a result of the restructuring of the service provider business unit during the first quarter. Our non-GAAP tax rate was 43.6% in the first quarter of 2015, as compared to 35.2% in the first quarter of 2014 and 36.7% in the fourth quarter of 2014. With the decrease of international revenues during Q1, due to the challenging currency environment, and the corresponding decrease in profit, our tax rate increased meaningfully, which negatively impact our net income and EPS results for the quarter. Looking at the bottom line for Q1, we have reported non-GAAP net income of $16.3 million and non-GAAP diluted earnings per share of $0.46 per diluted share. Our balance sheet remains strong. We ended the first quarter of 2015 with $247.4 million in cash, cash equivalents, and short term investments, compared to $257.1 million at the end of the fourth quarter of 2014. For the first quarter of 2015, we used approximately$400,000 in cash flow from operations due to changes in our working capital. We continue to remain very confident in NETGEAR’s ability to generate meaningful levels of cash. During the trailing four quarters, we generated approximately $103 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 deploy cash to enhance shareholder value. In Q1, we spent $8.3 million to repurchase approximately 266,000 shares of NETGEAR common stock at an average price of $31.39 per share, which resulted in no benefit to non-GAAP diluted earnings per share for the quarter. Since the start of our recent repurchase activity in Q4 2013, we have repurchased approximately 5.1 million shares, or 13% of the fully diluted share count at the beginning of that period. Our number of diluted weighted average shares is now pre-2010 levels. We continue to believe that it is important to return cash to our shareholders in excess of our operating and strategic needs and that the stock repurchase program is an effective means of accomplishing this. We expect that we will continue to be active buyers of NETGEAR stock in 2015. DSOs for the first quarter of 2015 were 73 days as compared to 74 days in the first quarter of 2014 and 73 days in the fourth quarter of 2014. Our net inventory for the first quarter of 2015 ended at $200.9 million, compared to $201.6 million in the first quarter of 2014, and $222.9 million at the end of the fourth quarter 2014. First quarter ending inventory turns were 4.4, as compared to five turns in Q1 2014 and 4.5 turns in the fourth quarter of 2014. Let’s turn to our channel inventory. Our channel partners report inventory to us on a weekly basis and we used a six-week trailing average to estimate weeks of stock. Our U.S. retail inventory came in at 7.7 weeks of stock. Current distribution inventory levels are 11.5 weeks in the U.S., 4.4 weeks of stock for distribution in EMEA, and 7.4 in APAC. For the second quarter of 2015, we anticipate revenue will be in the range of approximately $270 million to $285 million. The revenue decline is primarily due to the decline of service provider revenue to the $100 million level, as well as the typical seasonality of the RBU and CBU business, combined with the headwinds from the strengthening U.S. dollar. Second quarter non-GAAP operating margin is expected to be in the range of 6% to 7%, despite the revenue reduction we continue to maintain a high level of R&D in the categories that will benefit our top line in the second half of 2015 and beyond. Our non-GAAP tax expense is expected to be approximately $9 million to $11 million for the second quarter of 2015. Despite Q2’s challenges, we believe that we will see meaningful improvement in the second half of 2015 when we expect the service provider business unit restructuring to be complete, Arlo to be fully distributed worldwide, and the usual second half seasonal uptick in the retail business unit and the commercial business to kick in. Operator, that concludes our comments and we can now take questions.

Thank you. We will now begin – conducting a question-and-answer session. [Operator Instructions] The first question today comes from Ryan Hutchinson of Guggenheim Securities. Please go ahead.

Hi, this is Nate Cunningham on for Ryan. I wanted to ask about ARRIS’ acquisition of Pace. Do you think this deal could cause any digestion and open doors for you with your cable modem business? And how do you see that playing out? Thanks.

Yes, primarily right now, it fosters the line of business. I think we have different customers and different accounts. And certainly, if there is any opportunity that is left open, we would definitely be interested and going to take advantage of it. For the time being, I think our best winning chance is really focus on our innovative products, lines that will be based on the best WiFi, like the Wave 2 WiFi, as well as the DOCSIS 3.1. We believe that as long as we continue to maintain the product leadership, opportunities will open up.

Great, thanks.

The next question comes from Kent Schofield of Goldman Sachs. Please go ahead.

Great, thank you. First question around the currency movements. You talked about obviously they are continuing to be at current rates, a headwind throughout the year. How can you respond to that? Do you have to discount? Do you have to work with your channel? What sort of things can you combat that, assuming rates, like you said, stay where they’re at? It’s going to be a pretty big headwind going forward. So how can you execute against that?

You’re right. I mean, it is definitely a big challenge on a year-over-year basis both euro, Japanese yen, and Australian dollars have depreciated somewhere between 15% to 20% and a lot of our competition in those markets were local, which are priced in the local currency. So either we lowered our U.S. dollar prices or we have to price at local currency, which means that there will be big hit in the top line when we transfer it back into U.S. dollars, but even bigger hit is on the margin. We estimated that on a constant currency basis, we are losing about 240 basis points in operating margin because of this currency fluctuation year-on-year. So that is a big thing to overcome. So we’re taking it in three aspects. The first aspect, of course, is to work with our supply source to constantly reduce our costs, so that we’ll be able to cushion this big hit. But of course, it would take time, so we expect that it will take another quarter or so, so that we can bring the costs in line with the current exchange rate. And then, the second piece, of course, is try to really shift the mix of the products. And we would like to shift the mix of the products to the ones that we have higher margin, which are generally the newer, more innovative products. So that would help to really rebalance our portfolio towards more higher margin products. Third is to really introduce newer products that we could price at a higher margin price point. And that’s why we made the decision that in Q2 despite the challenge of the top line we will maintain our R&D dollars level, so that we’ll be able to bring newer products that will carry a higher margin in those markets. We’ve seen the success of this strategy in Asia where the economy is actually doing better. So our customers in Japan and Australia, in China are really, really receptive to our newer higher end, higher priced products. In Europe, we are seeing less success of that. So we need to in Q2 and Q3 for the rest of the year to – also introducing some more innovative products that might be of middle price point, but still high margin, to attract our European customers to buy into it. However, overall, we believe that the Arlo line is going to be a really, really interesting opportunity for us. The indication in the limited distribution in the U.S., in North America in Q1, indicates that it really it really fits the desire of many smart home users. And we’re starting to put it into limited distribution in Europe and this indication is very encouraging. So we will continue to use these innovative products to really offset the headwinds of currency. But it will take time. However, we are looking forward to the second half when all these new products are fully in place and they will help us to offset the currency headwind.

Patrick, thank you for the detail there and that’s actually a perfect segue for my second question, which is around Arlo. It seems like you – like you said, you have some innovative products there. But how do you differentiate in what seems like a very fragmented market? You’ve obviously got Google there and they have their brand name. But how do you break away and become a number one player or a strong number two or number three? What’s it going to take to make that happen?

As a matter of fact we’re very encouraged by the feedback from the users. If you go to Amazon, which is our limited retail partner, and half of the Best Buy stores, and you could also get some feedback on BestBuy.com. I think the biggest differentiation of ours versus all our competitors is in the super ease of installation and use. If you look at that, I mean, we have a patented technology that put us uniquely that we would be able to operate these cameras by battery, all right, which nobody else could do. By using battery, we are able to produce a camera that is very small and is weatherproof. You could use it – you could install it outside, outdoors, with ease without having to look for power, without having to look for protective gear. And furthermore, we added night vision to it. So when you combine all of that, it is very difficult for anybody to duplicate. And we have really good patents to protect all of these technologies come together. So quickly we’ve seen that our market share has shot up in the first quarter in the U.S. We’re not in the top three as yet, but we fully expect that we’ll be in the top two by the second half of the year because of that unique differentiation. And as a matter of fact, in Asia Pacific and in Europe I don’t think that the Drop Cam from Google is a major competitor because in those countries there is no unlimited data plan for most of the internet users. And given the fact that Drop Cam records 24/7 to the cloud, it would be very difficult for them to compete against us when we only record when there is motion. So we’re pretty confident that we have a very unique differentiation that we will be able to attract customers. And the initial indication is very encouraging. It’s all four stars no matter where you look. So in the Amazon review and in the BestBuy.com review.

Thank you, Patrick.

Sure.

The next question comes from Mark Sue of RBC Capital Markets. Please go ahead with your questions.

Christine, this is Spencer for Mark Sue.

Hi.

You guys mentioned that within service provider that you did receive some additional orders within particular products that helped out in the quarter, offsetting some of the headwinds with regards to restructuring. Hoping you could talk a little bit about those products and really how we might see the product focus change post-restructuring in the back half of the year.

That is actually from multiple customers. It seems like these multiple customers ran some promotions through their install base. It involves 11ac routers. It also involves high end gateways, cable gateways, and also our Air Card Mobile Hot Spot. So from multiple customers, from multiple geographies, that they actually ran some promotions in Q1 to attract subscribers which require a bit more than planned quantities from us.

Okay. And then, briefly, if I may. With regard to the operating margin guide, how much or how should we think about FX headwinds as being a part of that?

Sure. When I look at Q2 and I look at sort of year-over-year, it’s about 230 basis points on a year-over-year look at that. And it it’s an additional say 30 basis quarter-over-quarter.

Okay, perfect. Thank you.

The next question comes from Hamed Khorsand of BWS Financial. Please go ahead.

Hi. Can you just – from a unit standpoint can you talk about how much of the drop off in units shipped was the seasonal aspect of things versus the competitive nature?

The bulk of the drop off is in the service provider side. So that’s a big drop off in units. And on the commercial and RBU side, commercial practically has very little drop off in units. In the RBU side, on a sequential basis it’s primarily driven by the number of selling days also. There are four left selling days in Q1 versus Q4. That affects the shipment units.

Okay. And then, also just from a competitive standpoint. You were talking about Europe being weak. In many of the local markets aren’t you already a higher price point than the local brand?

That is true. But then on the other hand, if the gap widens there is a point that people aren’t going to – willing to pay the difference.

I understand. No, what I was trying to lead to was what is your strategy given what’s happening with the foreign exchange market and the currency? I mean, are you going to pursue it down aggressively as far as pricing goes to try to narrow the gap and just sell units? What’s the strategy?

We have no choice but to keep the local currency gap constant, which means that we have to drop prices in U.S. dollar terms. That put headwinds on both the units as well as the – I mean, not the unit, but on the dollar, as well as on the margin. So that’s why we’re trying to mitigate that by really looking at the source, by reducing our cost of acquisition of those products, and also by shifting the mix and as well as introducing new products.

Okay. All right. That’s it for me. Thank you.

Sure.

[Operator Instructions] The next question comes from Ryan Flanagan of Buckingham Research. Please go ahead.

Hey, guys. Thanks for taking my question. Most of my questions have been answered already. I was just curious on your thoughts on where you guys think we are in the 802.11ac cycle? And secondarily, if on the high end consumer router? And I apologize if it’s already asked – if you see any price erosion there.

The first one is the 11ac penetration in North America is significantly better than in Europe, as I talked about earlier. The U.S. is pretty much close to 65% to 70% 11ac, as I predicted in previous earnings call. By Christmas this year, probably 90% will be 11ac. Europe is significantly behind that. They are less than 40% 11ac, which really hurts our position over there because we’re all spearheading towards 11ac, while competitors are into the 11n yet. So we expect that when we introduce a little bit moderately price 11ac because our 11ac products today are primarily in the high end. AC is 1650 and above. But starting in Q2, we are starting to introduce AC750, AC1200, more low end products into Europe that probably would be the right approach that we should have taken a little bit while ago. But now we are there, so we believe that our position in Europe will be strengthened and it would help the market to move to 11 AC a little bit more. However, we still believe that Europe will be lagging behind. By Christmas they will still be probably 40% at 11n and 60% on 11 AC. So Asia Pacific is pretty much like the U.S. phenomenon. It has all moved to 11ac, while we are primarily in the high-end, while the local vendors are primarily in the low end in 11 AC750. So, Europe is definitely the laggard. So that’s where we’re at from the 11 AC penetration. I forgot about the second question. Could you repeat that?

Oh, yes. I was asking about any price erosion on the high end pricing on the consumer horizon.

No, on the high end 11ac router the price erosion is pretty minimal. If you go to Amazon.com, you will see that most of our 11ac products are probably at the most $10 off from it was introduced. If you look at the R7000, which is our flagship Nighthawk, today I just looked on Amazon and I think it sold at $189 versus what we introduced $199 about two years ago. And then the Nighthawk X6, which is our top end. I think [indiscernible] is still selling at Amazon $289 versus $299 price point that we introduced about a year ago.

Great, I appreciate the detail.

Okay.

There are no further questions at this time. I would now like to hand the call back over to Patrick Lo for concluding comments.

Yes, what I would like to say is that we’re confident in the pipeline of new products of the three business units in the second half on the RBU side. Clearly we are very excited about Arlo, further products from the Arlo line, as well as from the Nighthawk line in the second half. And then on the CBU side, there’ll be more introduction on the 10 gig and POE switches, together with a refreshed line of Ready Now. And then, on the service provider side, we are still going to be first to market for the next generation Cat 9 products of LTE. And that’s why – I mean, we believe that our prudent staff are protecting the R&D dollars was Q2 would really benefit us in the long term. And we expect that when those products hit and the existing Arlo camera gets full distribution in Q3, we will see a much better outlook for the second half of this year and beyond and I look forward to report that progress back to you in the next earnings call in July. So in the meantime, thank you very much for joining us today and look forward to talking to you again in July. Thank you.

Ladies and gentlemen, this concludes today’s conference call. You may now disconnect your lines. Thank you.