NETGEAR, Inc. (NTGR) Q2 2015 Earnings Report, Transcript and Summary

Greetings, and welcome to NETGEAR Second Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. 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, Christopher Genualdi, Investor Relations Manager. Thank you, Mr. Genualdi. You may now begin.

Thank you, operator. Good afternoon and welcome to NETGEAR’s second 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. Before we begin the formal remarks, we advise you that today’s conference call contains forward-looking statements. Forward-looking statements include among other things statements regarding expected revenue, operating margins, tax rates, expenses and future business outlook. Actual results or trends could differ materially from those contemplated by these forward-looking statements. For more information, please refer to the risk factors discussed in NETGEAR’s periodic filings with the SEC, including the most recent Form 10-Q. Any forward-looking statements that we make on this call are based on assumptions as of today and NETGEAR undertakes no obligation to update these statements as a result of new information or future events. In addition, several non-GAAP financial measures will be mentioned on this call. A reconciliation of the non-GAAP to 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 everyone for joining today’s call. For the second quarter of 2015, NETGEAR net revenue was $288.8 million, which is down 14.5% on a year-over-year basis and down 6.6% sequentially. As discussed on the prior earnings call, the decline in revenue is due to the exiting of certain service provider business that does not meet our financial metrics as well as the negative impact of the strong dollar on our international business. Non-GAAP diluted EPS for the second quarter of 2015 was $0.29, which is down 50% year-over-year. For a full reconciliation of GAAP to non-GAAP financial results, please refer to the second quarter 2015 earnings press release. During the second quarter, net revenue for the Americas was $172.5 million, which is down 8% year-over-year and slightly down quarter-over-quarter. The year-over-year revenue decline in the Americas, reflect our exiting of service provider accounts that did not meet our expected level of profitability. Despite service provider headwinds, the retail business unit had a strong quarter in the Americas driven by the success of some of our newer products. Europe, the Middle East and Africa, or EMEA, net revenue was $68 million, which is down 32.3% year-over-year and down 23.7% quarter-over-quarter. As we already discussed on the prior earnings call, the fluctuating exchange rate in Europe has challenged our performance in the region. We also exited several service provider accounts, which did not meet our margin targets. Our Asia-Pacific, or APAC net revenue was $48.3 million for the second quarter of 2015, which is down 2.6% from the prior year’s comparable quarter and up 4.5% quarter-over-quarter. We are pleased with the modest sequential growth demonstrated by our APAC business despite a difficult year-over-year comparison due to ForEx headwinds. In Q2, we shipped 5.4 million units. We also introduced 19 new products during the quarter. As always, sales channels development is the key focus for the company as our sales channel remains a critical strategic asset. By the end of the second quarter of 2015, our products was sold in approximately 39,000 retail outlets around the world and our number of value-added resellers stands at approximately 31,000. Now, let’s turn to a review of the second quarter results for our three business units: retail, commercial and service providers. For the retail business unit or RBU, net revenue came in at $131.8 million, which is up 19.1% on a year-over-year basis and up 9% sequentially. Quarter-over-quarter growth for RBU during Q2 is our first in NETGEAR’s history as seasonality typically suggest a second quarter sequential downtick for the business revenue. We are very pleased with RBU’s performance during the quarter, which was led by the strength of our Arlo wire-free IP camera, Nighthawk routers and gateways sales worldwide. Arlo revenue is continuing to grow as consumers are becoming increasingly aware of the benefits of a wire-free home lifestyle in security and monitoring camera solutions. We have succeeded by expanding Arlo’s distribution during the quarter and by driving consumer awareness of our products unique differentiation in the market. In only six short months, we have taken a leadership position in the consumer IP camera market in North America, Europe and Australia. I look forward to reporting our continued progress with Arlo in Q3 as we continue the broadened distribution into additional retail accounts in international markets. At the same time, our core home networking products continue to gain share with our Nighthawk series of routers, gateways and extenders. We recently announced the lightning fab Nighthawk AC1900 WiFi cable gateway, which is the first cable gateway that we are releasing under our premium Nighthawk brand. This product became available at major retailers at the end of Q2 and is selling at a price point of about $280. With the momentum of Nighthawk, we have taken the number one market position in North America for cable gateways and grown the market size more than 60% year-over-year. We also introduced our first Nighthawk VDSL gateway in Europe and Australia to further strengthen our leadership positions in both markets. Our Nighthawk line of premium 802.11ac routers has continued to be a hit with consumers. Over the last 2 years, we have successfully proven that there is significant demand within the consumer retail market worldwide for higher quality routers and gateways with the latest in-home networking technology suitable for the growing number of smart connected homes. In the coming quarters, we expect to further expand upon our high-end Nighthawk line as well as continue to drive average selling price increases in all markets worldwide. The Commercial Business Unit, or CBU, generated net revenue of $63 million for the second quarter of 2015, which is down 16.5% on a year-over-year basis and down 13.4% sequentially. The revenue decline in CBU was primarily the result of a difficult business market climate in Europe caused by currency headwinds. In addition, we are experiencing a channel shift in our CBU products as online sales ramp. Since online retailers in North America mostly buy direct from us, over time, we expect less distribution channel inventory will be required. Such a reduction in CBU products distribution channel inventory in North America would continue to weigh on CBU revenue in the coming quarters. The bright spot for the Commercial Business Unit continues to be the switching category. Infonetics Research, our research firm recently released a report that named NETGEAR as having unseeded the incumbent for the number one market share position in the web managed fixed configuration Ethernet switches worldwide. We believe that we have positioned well as the SMB market shifts towards switches with web management, power over Ethernet and 10-gigabit. We continue to innovate ahead of our competition. The day build of our click switches at the Consumers Electronic Show back in January, further strengthened our lead in the web manageable switch category. The click switches combining web-based network management, a flexible click on mounting mechanism and USB ports charging for smartphones are ideal for home theater setup, conference rooms and work benches at businesses of all sizes. The market reception of this class of switches has been very positive and it well be the growth engine for our entire switch line in the second half of the year. For our Service Provider Business Unit, or SPBU, net revenue came in at $94 million for the second quarter of 2015. This is down 38% year-over-year and down 18.6% on a sequential basis. As stated on our prior earnings call, SPBU revenue have declined as we have exited certain service provider accounts that did not meet our profitability metrics. The restructuring of the Service Provider Business Unit is more or less complete. We continue to strategically invest in newer technologies, such as 4G LTE, DOCSIS 3.1 and VDSL instead of going after mature low margin opportunities. We believe that this is the appropriate action to take, given the current outlook for the service provider industry. We continue to believe our SPBU revenue will be around $100 million a quarter for the rest of the year and we expect the contribution margin of this business will significantly improve in the second half. In summary, we believe that we are effectively navigating a choppy macro-environment and making the right decisions that positions the company for growth in our seasonally better second half of the year. We are gaining traction with our new products and plan to keep up this momentum throughout 2015. 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 second quarter of 2015. As Patrick noted, net revenue for the second quarter ended June 28, 2015 was $288.8 million as compared to $337.6 million for the second quarter ended June 29, 2014 and $309.2 million in the first quarter ended March 29, 2015. We shipped a total of about 5.4 million units in the second quarter, including 4.3 million nodes of wireless products. Shipments of our wired and wireless routers and gateways combined were about 2.5 million units for the second quarter of 2015. Moving to the product category basis, second quarter net revenue split between wireless and wired was about 74% and 26% 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 49% of our second quarter shipments, while products introduced in the last 12 months constituted about 42% 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. The non-GAAP gross margin in the second quarter of 2015 was 27.9% compared to 29.7% in the year ago comparable quarter and 29.7% in the first quarter of 2015. Total non-GAAP operating expenses came in at $60 million for the second quarter of 2015, which is down compared to $66.3 million in the year ago comparable quarter and down compared to the prior quarter’s total non-GAAP operating expenses of $63.4 million. Our non-GAAP R&D expense for the second quarter was 7% of net revenue as compared to 6.3% in the year ago comparable period and 6.3% of net revenues during Q1, 2015. As always, 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 12 people to 967 during the quarter. Our non-GAAP tax rate was 50.9% in the second quarter of 2015 as compared to 36.5% in the second quarter of 2014 and 43.6% in the first quarter of 2015. As detailed on our prior call, currency headwinds caused a decrease in international revenues and corresponding profits, which drove our tax rate to be higher than usual. Looking at the bottom line for Q2, we reported non-GAAP net income of $9.9 million and non-GAAP diluted EPS of $0.29 per diluted share. Our balance sheet remains strong. We ended the second quarter of 2015 with $202.9 million in cash, cash equivalents and short-term investments compared to $247.4 million at the end of the first quarter of 2015. For the second quarter of 2015, we generated approximately $38.9 million in cash flow from operations. We continue to remain confident in NETGEAR’s ability to generate meaningful levels of cash. During the trailing four quarters, we generated approximately $104.8 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 and to enhance shareholder value. In Q2, we spent $76.2 million to repurchase approximately 2.5 million shares of NETGEAR common stock at an average price of $30.90 per share, which resulted in a benefit of $0.01 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 7.6 million shares or approximately 19% of the fully diluted share counts at the beginning of that period. We continue to believe that it is 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 has authorized a new program to repurchase up to 3 million shares of the company’s common stock or approximately 9.3% of the outstanding shares. This is in addition to the approximate 266,000 shares remaining at the end of Q2 on the company’s previous share repurchase program. We plan to remain opportunistic buyers of our stock. DSOs for the second quarter of 2015 were 78 days as compared to 76 days in the second quarter of 2014 and 73 days in the first quarter of 2015. Our net inventory in the second quarter of 2015 ended at $188.7 million compared to $194.5 million in the second quarter of 2014 and $200.9 million at the end of the first quarter of 2015. Second quarter ending inventory turns were 4.5 as compared to 4.9 turns in Q2, 2014 and 4.4 turns in the first quarter of 2015. Let’s turn to our channel inventories. Our channel partners report inventory to us on a weekly basis and we used a 6-week trailing average to estimate weeks of stock. Our U.S. retail inventory came in at 7 weeks of stock. Current distribution inventory levels are 10.1 weeks in the U.S., 4.8 weeks of stock for distribution in EMEA, and 7.1 weeks in APAC. For the third quarter of 2015, we anticipate revenue will be in the range of approximately $315 million to $330 million driven by typical back-to-school seasonality and the success of our new products. Third quarter non-GAAP operating margin is expected to be in the range of 8.5% to 9.5%. Our non-GAAP tax expense is expected to be approximately $11 million to $13 million, which implies a tax rate of approximately 41% for the third quarter of 2015. As was the case in Q2, the higher than normal tax rate for the third quarter is the result of currency headwinds affecting our international business. Operator, that concludes our comments and we can now take questions.

Thank you. At this time, we will be conducting a question-and-answer session. [Operator Instructions] Thank you. Our first question is from the line of Ryan Hutchinson with Guggenheim Securities. Please go ahead with your question.

Hi, this is Nate Cunningham on for Ryan. Could you comment on the magnitude of Arlo on your retail business in the quarter and where you are in terms of geographic distribution for that product? And then could you quantify the FX impact on overall business in the quarter?

We generally do not split our product revenue. So we cannot comment on the specifics of Arlo revenue. However, we do know that with short six months, we are up top in market share in all three markets Europe, Asia, as well as North America. And distribution right now, I would say we are pretty widely distributed online. In all the markets, we are probably in the top tier distribution – top tier retailers. And then we are expanding into the secondary and tertiary retail locations. And we expect that when our supply becomes bigger, we will be able to further go down to our very other resellers even for the commercial space. From a ForEx effect I would like to turn it over to Christine.

Sure. Just kind of looking year-over-year on the FX on the operating margin, it’s about 233 basis points.

Okay, thanks.

Okay.

Thank you. Our next question is from the line of Tavis McCourt with Raymond James. Please go ahead with your question.

Hi guys. Thanks for taking my question. Patrick, I know you don’t want to give kind of exact sales data for Arlo, but I wonder if you could frame how you guys view the market opportunity this year, how big is that market maybe in retail in terms of what you would expect this year. And then just to clarify your comments in terms of market share does indicate your top market share in all those regions or just amongst the top market shares in all those regions?

Okay. We have very solid data to indicate that we are either a clear number one or closed entire number one in North America market. We do not have third party data in Australia and in Europe, but based on our retailers and our numbers we believe that we are at least in the top three. Actually, in our latest Investor Relations presentation, which we just put up at 1 o’clock on our website, we actually show the market size of IP camera in North America. This is according to NPD, of course the projections according to our projection of the market growth rate. So in 2015, we believe that the IP camera market at end user price level is about $350 million, which will go close to $500 million next year and then close to $600 million year after that. It’s certainly, a very fast growth market. We intend to, I mean take our fair share and our fair share would mean anywhere 30% to 50% that’s our market share, generally benchmark for all categories. For example, our router market share in North America is like 40%, our Gateway market share is like 50%, our WiFi extender market is like 60%. So that’s typically the market share target that we would go after.

Got it. And then on the – Christine, the gross margins were low this quarter, which was little surprising to me because service provider was a smaller part of the mix. And then I imagine you expect them to bump up next quarter given the operating margin targets next quarter, but just kind of – if you could talk about the puts and takes there for this quarter, next quarter that will be great? Thanks.

Sure. While we don’t forecast it, I would say gross margin we do have the restructuring for service provider took a couple of quarters. And so we do have some stuff that ran through that this quarter and we do expect contribution profit to go up in the back half of the year, which would assume that, that would improve there. And that’s really the main reason looking at that. There is a little bit of FX in there, depending on whether you are – how you are comparing year-over-year.

Great. Thanks very much.

Sure.

[Operator Instructions] The next question is coming from the line of Hamed Khorsand with BWS. Please go ahead with your question.

This is actually Vahid calling in for Hamed. With regards to gross margin, could you give us some insight on why and how you plan to get it back to 10% or higher?

Yes. So, the operating margin, well it was definitely guided….

Yes, operating margin thing.

Definitely guided to 8.5% to 9.5% coming into this quarter and we will continue to grow the revenue and optimize the expenses on that. And some of that is recovering from the currency strengthening in the U.S. dollar. As new products come out, we are going to price those higher and work on those margins. So, we believe we definitely have a path to move up to the double-digits.

You said in this past quarter you have a stronger retail segment, but it’s not really visible in the operating margin, is that still because of currency headwinds?

Well, this quarter Q2 when we guided that, we knew we were spending some development dollars if you noted, I think R&D 7% of the net revenue. We were definitely spending for the future, which we believe positions us well for the back half and for next year. So, Q2 was definitely something that we chose to do to move forward to grow.

Okay. And my last question kind of going with everything you are talking about here, when you have R&D at 7% and you have operating margin still below 10%, but you have a new share repurchase program – was that the best route to go than increasing R&D for future revenue?

Yes. We believe I mean we did both. We actually kept spending on R&D and repurchase shares and we do believe that, that was the optimal solution for us.

It’s reflected in our expenses in R&D line as well as in the operating margin line. We certainly are putting a lot of – I mean our first priority is in R&D. Without R&D, we will not be able to introduce the Arlo products. Without R&D, we certainly will not be able to introduce the mobile hotspots into the nine categories, without R&D we won’t be able to introduce the click switches, all these significant in-house differentiated R&D and we – and certainly needless to say that Nighthawk, I mean the Nighthawk is a huge R&D effort. So, you are right, I mean, number one priority is pumping money into R&D.

Okay, thank you.

Our next question is from the line of Mark Sue with RBC. Please go ahead with your question.

Hi, good afternoon. This is Spencer for Mark. Just going back to Europe a bit, outside of the currency, can you talk a little bit about what you have seen product wise that’s going to drive insurance in Europe? Thanks.

Yes. I mean, basically if we look at the market size, the shrinkage is all because of currency. If you look at the local euro-based, the market is pretty much flat. Then as a matter of fact, the business climate over there affected more the small business than the consumers, has proven that the consumers over there are quite enthusiastic to our Arlo and our Nighthawk. Now, because of some difference in WiFi regulations, we did not introduce our Nighthawk X6 until early this year. And the reception over there has been phenomenal since we introduced that. Same thing, Arlo, I mean it was a good happy surprise for us. We thought that given the fact that in Europe, generally speaking, they live in apartments and they are more secure than we hear, they would not be buying the mini cameras, but we were happily surprised that the inception of the Arlo camera in Europe even though the price point is very high, the consumers are well prepared to buy it and the small business have been holding back. Because of the business climate, I cannot attribute to anything, but it could be because everybody is worried about what this Greek exit is going to happen. And that’s why it’s holding back a lot of what we call higher end switch purchase and that’s really affecting our CBU performance as a double whammy and not only that the euro is shrinking the market, the small businesses are holding back in buying those. So, if you look at market share basis, we did not lose any market share in all the categories. So, the market is just not as good as what we would have liked.

And if I may on the R&D line again, noticing that you are investing or you did invest more in 2Q for future growth. Is this time that we should expect to be elevated for time being? Is there more investment needed to reposition for the – in the service provider segment or do you think you’ve kind of seen the highs as far as the upfront R&D goes?

No. We believe that we will continue to doubled on in R&D in all three business units. We do believe in order to push our gross margin up differentiated product is very, very important. And also one of the pillar of us of growth in the existing core market is by pushing up the ASP, the average selling price and increase in value and that requires quite a bit of R&D. So we do believe that we will not let up in R&D spending in quarters to come. Now what we would like to see is the compensation of that. Alright, in terms of gross margin, alright, so hopefully increased R&D would in the few quarters time, because you always had a lag time, in a few quarters time, the gross margin will come back and be raised in order to cover the increased R&D spending.

Great. Thanks, Patrick. Thanks.

Thank you. At this time, we have reached the end of our Q&A session. I will turn the floor right to management for closing comments.

Sure. I mean we are clearly very exited about the back-to-school, because generally that is the seasonal uptick across the well. And this year is especially exciting because we have so many new products. For example, we just introduced our new Nighthawk Cable Gateway, our new Nighthawk VDSL gateway those are all first in the industry. Arlo is having significant momentum. And we are potentially seeing to double the retail presence of Arlo in third quarter versus second quarter. So all those exciting things that we look forward to and clearly we are not going to stopping at that, you would see more introduction of new products along the Click Switch line, the Arlo line, as well as the Nighthawk line. And we look forward to put back in the next earnings call for all those – performance of all these new exciting lines of products that will fuel our growth in the next few quarters. Thank you, and talk to you next time.

This concludes today’s conference. Thank you for your participation. You may now disconnect your lines at this time.