NETGEAR, Inc. (NTGR) Q3 2015 Earnings Report, Transcript and Summary

Greetings, and welcome to NETGEAR Third 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, Mr. Chris Genualdi. Thank you, you may begin.

Thank you, operator. Good afternoon and welcome to NETGEAR’s third 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 like to now 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 third quarter of 2015, NETGEAR net revenue was $341.9 million, which is down 3.2% or about $11 million on a year-over-year basis and up 18.4% or about $53 million sequentially. The sequential uptick in revenues is primarily due to our success in North America where we experienced a robust back-to-school season and strong demand for our flagship product lines such as Nighthawk and Arlo. Additionally, our revenues in Q3 was augmented by higher than normal demand from our service provider customers. Despite the higher than normal demand our service provider segment revenue in Q3 is down $37 million year-over-year due to our decision to exit certain businesses that did not meet our financial metrics. During the third quarter, net revenue for the Americas was $219.7 million which is up 13.3% year-over-year and up 27.4% quarter-over-quarter. We were especially pleased with the performance of the retail business unit and commercial business unit in this region. The retail business unit executed exceptionally well with multiple new products on the shelves during the back-to-school season. We are particularly pleased that our Arlo wire free cameras continue to be more broadly distributed and has now become the clear number one IP home security monitoring camera in North America retail. Europe, the Middle East and Africa or EMEA, net revenue was $77.7 million which is down 28.3% year-over-year and up 14.3% quarter-over-quarter. While EMEA results continue to be challenged by tough year-over-year comps due to the very unfavorable exchange rate. We are encouraged by the sequential improvement shown in this region. With new products continuously being introduced at higher price point, we expect improvement both in top and bottom line in the EMEA in coming quarters. Our Asia-Pacific or APAC net revenue was $44.4 million for the third quarter of 2015, which is down 12.9% from prior year’s comparable quarter and down 8.1% quarter-over-quarter. Like EMEA, the APAC region’s results are challenged year-over-year due to the ForEx headwinds particularly in Australia and Japan. In Q3, we shipped 6.1 million units. We also introduced 21 new products during the quarter. As always, sales channel development is the key focus for the company as our sales channel remains a critical strategic asset. By the end of the third quarter of 2015, our products were sold in approximately 38,000 retail office around the world and our number of value added resellers stands at approximately 30,000. Now let’s turn to our review of the third quarter results for our three business units; retail, commercial and service provider. For the retail business unit or RBU, net revenue came in at $164.1 million which is up 24.9% on year-over-year basis and up 24.5% sequentially. The retail business unit had a record quarter in terms of revenue driven by the strength of our Arlo wire-free IP camera, Nighthawk routers and gateway as well as a robust back-to-school season. Arlo revenue continued to grow as we further expanded the product lines distribution during the quarter and maintained the momentum with that since launching the product in January. We are now the leader in the consumer IP camera market in North America, Europe and Australia. I encourage you all to join us at our Analyst Day on November 4 in San Francisco where we will provide market share data and discuss our strategy in the smartphone market. Turning to the Nighthawk line of premium routers, gateways and extenders, we recently announced the release of the Nighthawk X8 which posed retrofitting combined Wi-Fi speed of 5.3 gigabits per second. The Nighthawk X8 features Wave 2 802.11ac Wi-Fi with Multi-User MIMO-capability coming soon. A 1.4 gigahertz dual core processor for faster connections, the industry’s first patent pending active antennas to boost range and three Wi-Fi bands with Quad-streams is the best router on the market for homes ready for increasing amounts of streaming 4k video content and gaming. The Nighthawk X8 is available now in the U.S. from major retailers in stores and online and at recommended retail price of $399. The commercial business unit or CBU, generated net revenue of $65.2 million for the third quarter of 2015 which is down 9.4% on a year-over-year and up 3.4% sequentially. As discussed on the prior earnings call, the year-over-year decline in CBU is primarily the result of the difficult small business market climate in Europe cost by currency headwinds. As we mentioned in the last quarter, we are also seeing a channel shift to online for many of our CBU products. As a result of this shift, our U.S. distribution channel is reducing inventory which you can see in the associated weeks of stock. Our online channel partners carry much best stocks, so this channel shift is a revenue headwind. We expect this channel shift and normalize as we enter the year 2016. The commercial business unit continues to be driven by the switching category. We are positioned well as the SMB market shifts towards switches with web management, power over Ethernet and 10-gigabit speed. Our recent introduction of the industry’s first 28 port 10-gigabit smart switch was an instant success. It has joint our prior 12 port version as one of our top 10 switches. We will discuss our success in switching in more detail at the upcoming Analyst Day. Earlier this month, we launched two new business class wireless 802.11ac access point for SMBs, K-12 and hospitality. We are capable of operating in standalone mode or in the new NETGEAR Ensemble Mode Management. Ensemble enables centralized configuration and management by the access point of up to 10 access points as a single group without requiring additional hardware licenses or support fees. They are truly designed with the SMB market in mind. For our Service Provider Business Unit, or SPBU, net revenue came in at $112.6 million for the third quarter of 2015. This is down 24.9% year-over-year and up 19.9% on a sequential basis. We believe this Q3 uplift is a onetime event due to special promotions from some of our service provider customers. We expect we’ll back to $100 million per quarter level in the coming quarter. As stated on our prior earning’s call, SPBU revenues have declined year-over-year as we have exited or turned away certain service provided business that did not meet our profitability metrics. During the quarter, we announced two industry first mobile hotspot; first, is the AirCard 810S for Telstra Australia which sets a world record of 540 megabits per second download speed in Telstra’s 4G mobile data network. The AirCard 810S implements the latest cat 11 mobile data standard and clearly set NETGEAR apart as the leader in mobile hotspot technology. We also introduced our AirCard 791S hotspot to Verizon wireless subscribers in the United States under the brand name Verizon Jetpack 4G LTE mobile hotspot. This Cat 6 device is the first Jetpack from Verizon that supports 4G LTE advanced technologies. We’re excited to be adding Verizon wireless to our list of mobile hotspot customers. We will continue to manage the service provider business unit by focusing on higher margin strategic customers where newer technologies such as 4G LTE, DocSys 3.1, and VDSL our key. As stated, we continue to believe our SPBU revenue will be around $100 million for Q4. In summary, we are pleased with our third quarter results and believe that we are well positioned for a successful holiday season in the fourth quarter. I’ll 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 third quarter of 2015. As Patrick noted, net revenue for the third quarter ended September 27, 2015 was $341.9 million as compared to $353.3 million for the third quarter ended September 28, 2014 and $288.8 million in the second quarter ended June 28, 2015. We shipped a total of about 6.1 million units in the third quarter, including 5 million nodes of wireless products. Shipments of our wired and wireless routers and gateways combined were about 2.8 million units for the third quarter of 2015. Moving to the product category basis, third quarter net revenue split between wireless and wired was about 77% and 23%, respectively. The third quarter net revenue split between home and business products was about 80% and 20%, respectively. Products introduced in the last 15 months constituted about 48% of our third quarter shipments, while products introduced in the last 12 months constituted about 37% of our third quarter shipments. From this point on, my discussion points will focus on non-GAAP numbers. For a full reconciliation of GAAP to non-GAAP financial results please refer to the third quarter 2015 earnings release. The non-GAAP gross margin for the third quarter of 2015 was 29%, compared to 29.9% in the year ago comparable quarter, and 27.9% in the second quarter of 2015. Total non-GAAP operating expenses came in at $63.8 million for the third quarter of 2015, which is down compared to $68 million in the year ago comparable quarter, and up compared to the prior quarter's total non-GAAP operating expenses of $60 million. Our non-GAAP R&D expense for the third quarter was 6.1% of net revenue, as compared to 6.2% in the year ago comparable period, and 7% of net revenue in the second quarter of 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 8 people to 959 during the quarter. Our non-GAAP tax rate was 38.2% in the third quarter of 2015, as compared to 29.4% in the third quarter of 2014, and 50.9% in the second quarter of 2015. Looking at the bottom line for Q3, we reported non-GAAP net income of $21.7 million and non-GAAP diluted EPS of $0.67 per diluted share. This represents 6.9% year-over-year decline in EPS. However, note that in the third quarter of 2014 it included a $0.4 diluted share benefit as a result of year-to-date catch up that reduce tax expense for the quarter. Our balance sheet remained strong. We ended the third quarter of 2015 with $263.8 million in cash, cash equivalents, and short-term investments, compared to $202.9 million at the end of the second quarter of 2015. For the third quarter of 2015, we generated approximately $77.1 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 $157.1 million in cash flow from operations. We're 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 Q3, we spent $20.6 million to repurchase approximately 642,000 shares of NETGEAR common stock at an average price of $32 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 8.2 million shares, or approximately 20.9% of the fully diluted share count at the beginning of that period. DSOs for the third quarter of 2015 were 73 days, as compared to 72 days in the third quarter of 2014, and 78 days in the second quarter of 2015. Our net inventory in the third quarter of 2015 ended at $170 million, compared to $206.5 million in the third quarter of 2014, and $188.7 million at the end of the second quarter of 2015. Third quarter ending inventory turns were 5.8, as compared to 4.9 turns in the third quarter of 2014, and 4.5 turns in the second quarter of 2015. Let's turn to our channel inventories. Our channel partners report inventory to us on a weekly basis and we use a six-week trailing average to estimate weeks of stock. Our U.S. retail inventory came in at 9.2 weeks of stock. Current distribution inventory levels are 7.9 weeks in the U.S., 5.3 weeks of stock for distribution in EMEA, and 7.3 in APAC. For the fourth quarter of 2015, we anticipate revenue will be in the range of approximately $335 million to $350 million. We are confident in retail strength during the upcoming holiday season and believe that our new products will be a hit with customers. We also expect service provider revenue will step back to $100 million revenue range from the elevated $112 million level in Q3. Fourth quarter non-GAAP operating margin is expected to be in the range of 9.5% to 10.5%. And we can now take questions.

At this time, we’ll be conducting a question-and-answer session. [Operator Instructions] Our first question comes from line of Hamed Khorsand from BWS Financial. Please proceed with your question.

Hi. Just a few questions. First one, did you have a 10% product this quarter?

No. We did not.

Okay. And then, could you comment as far as the help of Arlo and Nighthawk as beyond just the statement -- general statements you just made. How much saturation do you have in the marketplace given that you expanded [technical difficulty]? Can you just be little bit more granular as far as the potential here?

We can say at this point in time that we are clearly the number one market share holder for both product categories in the United States and we encourage you to come to our Analyst Day where we will prepare more detail market share data of us versus our competitors.

Okay. I’m just – sense is to how much more run way do you have – you are very confident this will go beyond just at the typical holiday season spending?

Yeah, I mean clearly we are poised to take more share in the coming quarters, that’s what we believe and clearly that will be propelled by new products and we just introduced the Nighthawk X8 three weeks ago, so I think that would help us to gain more share [technical difficulty]

One up this past quarter, but just doesn’t seem like there is much momentum there, if I look at the numbers. But you used the word momentum in your commentary so where is the misconnect I mean only 1 or 2 million from last quarter?

Yes, as Christy mentioned I think we have some headwinds of our distribution channel inventory destocking and we went from roughly 10 weeks to right now about 8 weeks. So you got two weeks of destocking when you take that into the account exactly growing more than 2 million quarter on quarter on the actual sale through. So we are pretty pleased with that.

Okay. Got you. I appreciate. Thank you.

Sure, yeah.

Well next question comes from the line of Tavis McCourt from Raymond James. Please proceed with your question.

Hey, guys. This is Tavis [technical difficulty] CapEx in the quarter and then some explanation on the lower inventories in the quarter. I don’t know if that’s seasonally normal or certainly down quite a bit year-over-year.

Sure. So CapEx for the quarter was about $2.9 billion spend for the quarter and looking internally at our inventories I believe given the significant increase we had in the revenue quarter-over-quarter that brought down inventory and looking at our partner’s inventory you saw retail has gone up and as they are getting preparing for the holiday season and during back fiscal when I think also was some of our new products and then we again saw distribution inventory in the channel go down several weeks this quarter which we had mentioned in Q2 we saw some of that and we would – we think that will normalize as we walk into the 2016.

Okay. So if we look at inventory [technical difficulty] in the past?

I think we’ll always going to balance inventory versus air freight and the customer demand and then try to take the least amount of risk in your provider customers with the product they want. So we always balance that and we have a very careful process on that.

Okay. Patrick, two service provider questions for you. First, the mobile hotspot you’ve announced at Verizon. Is that the first one that you guys have done for Verizon? Or it’s just first one that’s LTE advanced?

It’s the first one we get for Verizon in the last 10 years and it’s the first LTE advanced mobile hotspot for Verizon.

Okay. So just to be clear that was an account you were not in previously. Correct?

No, we were not in previously and they never had an LTE advance.

I think AT&T is talking about using some government subsidy funding to build out some rural markets with a fixed LTE product and I presume they need LTE gateways. You haven’t talked about that product line for a while, but is that an opportunity that you'll go after either if you want to come on AT&T specifically or do you see other carriers that you may have relationships launching anything similar to that.

We actually -- we're not comment on customer-specific projects, but we actually have launched multiple LTE gateways with multiple operators before. Sometimes it comes in a normal format like what we usually do which is kind of the modem plus the router in a box. But recently we actually use a different format which is the router and the modem [technical difficulty] the router is appeared in a cradle and then slot the modems into the cradle and make it a gateway so that means it kind of dual use, when you're not in the house, you can take the mobile hotspot around, but once you're inside in the house will slot it and make it a household gateway. That format is catching on pretty well and we sell quite a few of them in Australia with Telstra as well as selling quite a few of them in the Middle East.

And I know you've announced LTE gateways that are for sale or available or work with a few different carriers in the U.S. Was AT&T one of those?

No. I mean what we have announced what we're in the market was with Verizon and US Cellular and Sprint.

Great. Thanks very much.

Sure.

This is Nate Cunningham on for Ryan. So, last month Comcast announced that it will be adding Arlo to its smart home platform and I just wanted to ask if you could give us a little more detail around your strategy there. And whether we should expect that to be one of the major selling motions for Arlo moving forward?

Well, I mean absolutely we would like to make Arlo as the must have smart home device for every single household, just Nighthawk router is. And we're going to work with any popular platform of a smart home out there. We've announced before we participating in the AllSeen alliance. We've also actually -- we actually went on the same stage with Samsung in the last few years that we would be on their smart home platform. And now we're on the XFINITY X1 platform. We'll continue to make our Arlo cameras to be available on any popular platform of this [technical difficulty] device that is the Arlo camera. So, we don't have any provoke preference that it must work on our platform. We’ll rather work with four other popular platforms out in the market.

Okay. And then on the commercial segment, it looks like it reached basically the lowest percentage of total revenue in quite some time. Can you walk us through your investment plans for that product line and maybe what we can expect for next year if there's a rebound?

Yeah. I mean clearly as we just mentioned, we're working towards some headwinds of channel shift. As more and more of our CBU products are sold through online channel, they will use the distribution that much. They buy direct from us. So, the distributor sees that the portion of our business that they occupy is getting less, so that's why they are destocking. So, we have to go through [technical difficulty] account actually very pleased with the switch sales and even though, it is 20% of our revenue as you probably look at the previous 10-Q, you will see that this particular segment is very profitable for us. The margin of this segment is higher than either the retail business unit or the service provider business unit. So, it’s a very important source of profit margin dollars and we're not going to neglect it. Also if you look at the switch category where we had a tremendous huge market in managed switches and we invented the web managed switches and we also have the number one market shareholder of the web managed switches, we're not going to relinquish that. And as a matter of fact we will give you more detail of how fast that web managed switch market is [technical difficulty] both will move the industry as growth move our market share. So, please come to our Analyst Day in two weeks' time.

Sounds good. Thanks Patrick.

Thanks.

[Operator Instructions] Okay, management it appears there's no further questions at this time. Would you like to make any closing remarks?

Sure. Thank you. Thank you all for joining us on today's call. I would hope that you can attend our Analyst Day on November 4th in San Francisco where our management team will discuss the future of the smart home and how NETGEAR will continue [technical difficulty]. If you would like to attend please reach out to NETGEAR Investor Relations. If you cannot join us in person, then please access our Investor Relations' website where the event will be webcasted at 1 PM Eastern, 10 AM Pacific on November 4th. Thank you very much. Hope to you see you all soon on the Analyst Day.