NETGEAR, Inc. (NTGR) Q2 2016 Earnings Report, Transcript and Summary

Greetings, and welcome to the NETGEAR Incorporated Second Quarter 2016 Earnings Conference Call. At this time, all participants are in a 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 to your host today Mr. Chris Genualdi, Manager of Investor Relations. Thank you, Sir. You may begin.

Thank you, operator. Good afternoon and welcome to NETGEAR’s second quarter 2016 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 start with a review of the financials for the second quarter provided by Christine, followed by details and commentary on the business provided by Patrick and finish with third quarter guidance provided by Christine. We will then have time for any questions. If you have not received a copy of the release, please call NETGEAR Investor Relations or go to NETGEAR’s corporate website at www.netgear.com. 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 Ms. Christine Gorjanc.

Thank you, Chris. Result for the second quarter of 2016 came in above the high end of our guidance, driven by the performance of both our retail business units and our commercial business units. For the second quarter ended July 3, 2016, net revenue was $311.7 million, which is up 7.9% on a year-over-year basis and slightly up on a sequential basis. NETGEAR net revenue by geography continues to emphasize our strength in North America. Net revenue for the Americas was $210.9 million, which is up an impressive 22.3% year-over-year and up 8.8% on a sequential basis. EMEA net revenue was $51.7 million, which is down 24% year-over-year and down 19.9% quarter-over-quarter. Our APAC net revenue was $49.1 million for the second quarter of 2016, which is up 1.6% from the prior year’s comparable quarter and down 5.4% quarter-over-quarter. For the second quarter of 2016 we shipped a total of approximately 5.2 million units, including 4 million nodes of wireless product. Shipments of our wire and wireless routers and gateways combined were about 2.1 million units for the second quarter of 2016. The net revenue split between home and business products was about 76% and 24% respectively. Product introduced in the last 15 months constituted about 36% of our second quarter shipments, while product introduced in the last 12 months, consequent about 28% of our second quarter shipment. From this point on, my discussion points will focus on non-GAAP numbers. The reconciliation from GAAP to non-GAAP is detailed in our earnings release distributed earlier today. The non-GAAP gross margin in the second quarter of 2016 was 32.3% compared to 27.9% in the prior year comparable quarter and 33.3% in the first quarter of 2016. The year-over-year gross margin improvement reflects the reduction in service provider revenue, which typically carries a lower gross margin. Total non-GAAP operating expenses came in at $64.6 million which is up 7.6% year-over-year and down 2.9% sequentially. While we always manage our operating expenses carefully, we will look to continue to invest in research and development as we add new product offerings to our portfolio. Our headcount decreased by net nine people to 928 in part due to a realignment of sales and marketing resources to take advantage of the channel shift and change in buying behaviors that we've seen in the SMB market recently. As a result, we took a restructuring charge during Q2 of $1.3 million. We expect to add headcount in the key areas of the business during the third quarter in order to drive further growth. Our non-GAAP R&D expense for the second quarter was 6.6% of net revenue, as compared to 7% in the year ago comparable period and 6.9% of net revenue during Q1 2016. We continue to believe that our investment in R&D is key to our business and we expect this expense to grow in absolute dollars. Our non-GAAP tax rate was 34% in the second quarter 2016. Looking at the bottom line for Q2 we reported non-GAAP net income of $24.1 million and non-GAAP diluted earnings per share of $0.72 per diluted share. Turning to the balance sheet, we ended the second quarter of 2016 with $352.7 million in cash, cash equivalents and short term investments. For the second quarter of 2016 we generated approximately $23.8 million in free cash flow, which is calculated as cash flows from operating activities as presented in the statement of cash flows under GAAP less capital expenditures. We continue to remain very confident in NETGEAR’s ability to generate meaningful levels of cash. During the trailing four quarters, we generated approximately $149.7 million in free cash flow. We continue to be focused on optimizing the business and generating cash, which gives us flexibility with our operational needs as well as the ability to strategically deploy cash to enhance shareholder value. In Q2, we spent $13.2 million to repurchase approximately 314,000 shares of NETGEAR common stocks at an average price of $42.13 per share, which resulted in no benefit to non-GAAP diluted earnings per share for the quarter. Despite our buyback activities over the last year, our fully diluted share count has trended upwards slightly over each of the last three quarters. Nevertheless since the start of our repurchase activity in Q4 2013, we’ve repurchased approximately 9.2 million shares and our diluted share count is lower by 14.6% as compared to the beginning of that period. Now turning to the results of our three business units, the retail business unit or RBU generated net revenue of $170.6 million during the quarter, which is up 29.5% on a year-over-year basis and up 8.3% sequentially. The commercial business units or CBU generated net revenue of $73.7 million for the second quarter of 2016, which is up 16.9% on a year-over-year basis and up 7.7% sequentially. For our service provider business unit or SPBU net revenue came in at $67.3 million for the second quarter of 2016. This is down 28.3% year-over-year and down 20.1% on a sequential basis. Our service provider results during the first half of 2016 reflect was like typical service provider lumpiness, as our Q1 service provider revenue was greater than expected and Q2 was less than expected. Overall we're pleased with our ability to manage this businesses' revenue downward, while maintaining a healthy contribution margin and believe that the lower revenue contribution for service provider is not a major concern for our business. Looking forward to the second half of 2016 we expect service provider to deliver approximately $65 million in revenue per quarter. I will now turn the call over to Patrick for his commentary on the results of the three business units as well as the overall business after which, I will then provide guidance for the third quarter of 2016.

Thank you, Christine and thank you everyone for joining today’s call. We're very pleased with our second quarter results, which reinforce our belief that we're managing our business effectively and taking advantage of the opportunities in the market. Our retail business unit clearly had a stellar Q2, bucking the trend of what is typically slower second quarter seasonality. Our premium Nighthawk routers, Cable Gateways and Arlo lines all performed especially well during the quarter. On our prior earnings call, I discussed how consumer WiFi is evolving given the proliferation of connected devices and streaming media in the home. Our retail results for the second quarter are not only a reflection of this ongoing trend, but also a reflection of how NETGEAR is the leader in home connective and IOT. For most of our 20-year history we have been building superior WiFi solutions with innovative features and designs to meet the ever changing needs of technology consumers and this is what sets us apart from our competition. Our Nighthawk line of home routers continue to be the go standard for home WiFi worldwide. As such, our Nighthawk X6, which sports Tri-band 802.11ac connectivity was just named the best router by the EHA in the 2016 European Hardware Awards competition. This honor is testament to the industry-leading R&D effort that our team puts into every Nighthawk router that is brought to market. Additionally another member of the Nighthawk family of routers the Nighthawk X4S was recently recognized by PC Gamer Magazine as the best WiFi gaming router on the market. This recognition is a significant achievement because the gaming audience is very scrutinizing in the selection of technologies that they choose to adopt. You can expect a further innovation and expansion for our Premium Nighthawk line in the months to come. Turning to the Arlo side of the business, our line-up of IP security cameras continued to be the industry leader during Q2. Over one year after the original Arlo wire-free cameras were launched. there were two new software features that I would like to highlight at this time. First, during the quarter, we rolled out new automation [indiscernible] such as geofencing, which enables user to set up a virtual fence or parameter around their home and automatically on or just off their Arlo system when their mobile device is inside or outside of the virtual fence. Second, we rolled out IFTTT integration during Q2, which enables users to create If This Then That recipes that connect to other smart home apps and products. This has been a highly requested feature from our users and as of July 20, over 350,000 unique IFTTT recipes have been recorded only two months after launching the integration. One example of an IFTTT recipe, if my front door Arlo camera sensors motion at night, turn on my smart light and at Arlo cameras start recording. Also during Q2, Tom's Guide named the NETGEAR Arlo Q as the best wireless security camera overall for 2016 highlighting its superior hardware, flexible options and affordable cloud storage subscription plan. In the healthy crowded and impeditive space of home security cameras, we believe that we have the expertise to make great products that both provide peace of mind and delight our customers. Looking forward for RBU you can expect us to release more products in the near future that address the ever increasing number of WiFi enabled devices in the home, the need to have high speed WiFi connectivity in every corner of the house and the need for reliable security in and around consumer's properties. Next I would like to provide a few words on the commercial business unit. We're very pleased with the year-over-year and sequential growth generated by CBU during Q2. Last quarter we saw the U.S. distribution channel inventory stabilize and we have been able to capitalize on that stabilization since then. Looking at the market, SMBs are continuing to upgrade to multi gig and 10 gig switching. A 2016 study of the U.S., U.K. and German IT managers conducted by Palmer Research found that while only a third of surveyed business currently have 10 gig switching, the expectation is that 75% will have it deployed by the end of 2017. To continue to address this need and tackle the bandwidth bottlenecks created by IOT, video streaming and cloud services, we expanded our switching line during the second quarter with the release of three new 10 gig switches that provide powerful network performance and capacity. These switches are available now and retail at prices between $1,500 and $8,500. Our service provider business unit steps down in revenue during Q2, yet we maintained a healthy contribution margin despite this. We're pleased with the effective pricing and cost management that our SPBU team has shown through this revenue volatility, which has resulted in profitability levels that are expected of our service provider business unit. As Christine alluded to, our service provider business always had a lumpy revenue profile, but as our other two business units grow, we have been able to mitigate the impact of that lumpiness, but we continue to focus on maximizing profitability for this business unit and expect the service provider business unit will have a run rate of approximately $65 million per quarter in the second half. To summarize, the second quarter exceeded our expectations and we continue to gain share in Home WiFi, Home Security Cameras and Switching. I will now turn the call back over to Christine for our Q3 guidance.

For the third quarter of 2016 we anticipate revenue will be in the range of approximately $315 million to $330 million. Third quarter non-GAAP operating margin is expected to be in the range of 10.5% to 11.5%. Our non-GAAP tax rate is expected to be approximately 35% for the third quarter of 2016. Operator, that concludes our comments and we can now take questions.

Thank you. At this time, we'll conduct a question-and-answer session. [Operator Instructions] Our first question comes from Ryan Hutchinson with Guggenheim. Please proceed with your question.

Hey, good afternoon. I guess the one question that I have is, is the service provider, now that it is expected to step down again and I recognize you do guide to operating margins, but just want to get a sense, should we anticipate gross margins to stay at or above the level that we've seen over the last couple of quarters?

Yeah, I really don’t guide to the gross margin again. It's something you go into the back half of the year whether more highly promotional quarters for retail in that and we’re not share where our marketing expenses will be. Whether there will be in OpEx or above the line. So, we would just again guide to the 10.5% to 11.5% operating margin. I think this quarter it was also around $65 million.

Okay. Yeah and I guess the reason for the question is just to try and understand where the investments will be made on the operating -- within the operating expenses, but it sounds like there will be somewhat of mix between the two and R&D in absolute dollars will continue to move higher. Is that kind of the way to think about it, okay.

Yeah, absolutely.

Okay. And then on let’s see, you talked about Nighthawk and may be just an update on Arlo, what are the expectations for the back half of the year?

We certainly continue -- Arlo to continue to do very well in multiple ways, first is in the expansion of distribution. We just entered the Chinese market and we would also expand into new retail. We just entered in the Verizon stores. So we certainly expect the Arlo continue to grow pretty rapidly. On the second half, we would continue to roll our new Arlo products in the second half and clearly and we alluded to that when we introduced new category before the end of the year.

Okay. Great. I’ll pass on.

Great. Thank you.

Thank you. Our next question comes from Tavis McCourt with Raymond James. Please proceed with your question.

Hey guy. Thanks for taking my question. First a housekeeping item, Christine I was wondering if you could break out the components of free cash flow in the quarter between cash flow from ups and CapEx.

Sure, cash flow from operations is $26.8 million. CapEx is about $3 million and then free cash flow $23.8 million.

Got you and then a couple few Patrick, in the commercial business especially if you look at the work you did on channel distribution this quarter, it looks like [filter] was actually quite strong year-over-year and I’m wondering is that in the core switch business or some of the ancillary products starting to sell better.

Well, clearly switch is the strongest of them all and we're also seeing initial momentum on the new wireless line products that we introduced.

Okay. And in terms of what you see for commercial in Q3, I guess what I’m trying to get was there anything artificial in terms of channel fill in Q2 that we should expect any big movement as we look sequentially into Q3 or to be normal seasonality?

No I think really if you look we saw that U.S. distribution channel inventory be right around in the five. It looks good. So, we’re not expecting anything unusual as far as stocking, destocking of that.

Thanks. And then Patrick in your prepared remarks, you talked little bit about kind of what to expect for new products within the retail business unit and I caught the part on security around the house. So what else were you referring to in those comments?

Unfortunately I won't be able to give you a little in more detail because of I think many of our competitors on this call. So stay tuned.

All right. But you're still holding to a new product category this holiday season?

Correct, correct.

Okay. Thanks.

Thank you. Our next question comes from Matt Robinson with Wunderlich. Please proceed with your question.

Thanks, first my housekeeping question is depreciation, what that was in the quarter? I'd like to -- despite what you just said about competition Patrick, I would like to get your views on the need that you see in offering a mesh solution for home networking and if you guys are offering unified management between your switches and your commercial WiFi products and when we might be able to see that and then lastly I would be interested to know how the growth of the LTE was as part of the service provider business?

Yes, one answer at a time. So regarding the home mesh network, clearly different people have different needs and we believe that most of the market a day really would like to have really, really fast WiFi connectivity for devices close to routers even at the edge of the homes. And that’s to say our Nighthawk serves that exact purpose, I’d say for 90% of the houses. But of course, there are many people who live in 6,000 square feet house that a single router might not be suffice and we applaud the validation of our stance that you do need good hold-on WiFi coverage including the 1%. So we do believe that the reason we traction some home mesh WiFi networks sales by that niche market. However, it does validate our stance that home WiFi coverage is important. Now traditionally NETGEAR has been servicing the masses, which is the 99%, but it doesn't mean that we ignore that 1% and clearly we will have our solutions for the 1% as well. On the same question about unified switch management, clearly we believe that the world is moving towards cloud based management and we certainly are working on that front and you're already seeing some of it coming out from our wireless solution that is offering cloud management and clearly our directions provide that type of management across our SMB lines and we unify them all under one platform. But this is not a small feet. This is a pretty significant development. So it would take us a few years to get there, but we're clearly on that path.

And on the depreciation, we actually don't normally give that number until we file the Q. So what I would tell you is I think if you just look back over the past couple of quarters, it will be in that ballpark.

Thanks. Any comment on LTE?

Oh! The LTE growth, clearly we have been seeing very strong demand on our LTE advanced products, that’s where we're focusing in and clearly the non-advanced products we typically call it CAT3, CAT4, those are clearly very commoditized and we're seeing a lot of Chinese competition. So we purposely are not participating in that particular market. We're focusing our efforts on the LTE advanced and we're seeing significant interest and demand of our products both in North America as well as in Australia and in Europe for that class of products. And you expect us to continue to push and look forward. As a matter of fact at Mobile World Congress, we actually jointly with Ericsson and Telstra demonstrated a CAT15, CAT16 LTE advanced, which could do a gigabit download speed and which we will introduce pretty soon and that's a very exciting part too.

As you manage the service provider business for profitability should we expect LTE to rise to the some number -- kind of in line with an 80-20 rule or how they can mix do you think you can get to be?

Oh! Well, clearly we are technology agnostics. As we mentioned, we're focusing on the bleeding edge, high software content, proprietary technology area of the service provider unit. So that’s why you see us moving away from the ordinary LTE, moving away from DocSys 3.0, moving from ADSL, while pushing forward into LTE Advanced, CAT9 and above and moving into VDSL, moving -- channel bonding VDSL moving into Arlo, those are the areas we believe that we have edge and certainly DocSys 3.1 we will be the first to get certify DocSys 3.1 in for retail. And so I think those are the areas that we believe that we will win and those are where we're going. And we're not going to really shift with certain mix, we will basically supply our bleeding edge technology to any customers who value our contribution.

Okay. Thanks so much for let me having so much time on the call.

Sure.

Thank you. Our next question comes from Hamed Khorsand with BWS Financials. Please proceed with your question.

Hi, just a couple of questions here. Can you talk about the weakness in EMEA and it almost feels like NETGEAR’s been squeezed out and what you're trying do to rectify that?

Well, EMEA clearly as we have observed naturally in a recent article coming out on the internet, making comment that European operators are generally very price conscious, due to the fact all of them actually pay a hefty amount of money to get bandwidth spectrum and that’s why they are much backwards in terms of technology deployment. They're laggard in LTE Advanced deployment, they're laggard in DocSys 3.1 development, they're laggard in VDSL deployment. So the market has become very commoditized and that’s why not only us but if you look at even their local Nokia, Alcatel Lucent and Ericsson has been basically squeezed out by really cheap Chinese competitors. So we do not believe that we could make any descent profit amongst the service provider market in Europe and that’s why over the last 18, 24 months, we’ve been gradually exiting that market once the contract is finished. Of course we have to deliver what we promise but once the contract is done we're just not in position to bid for next contract, which is another commodity product with lower margin, lower price. So what you see in the decrease in our European revenue is basically our continued refocused pivoting primarily to CBU and RBU, which is growing very nicely for us. While on the other hand, in North America and in APAC, the operators are lot more advance in terms of technology and deployment. For example, in North America both Verizon and AT&T are really LTE Advanced adaptors and Telstra has always been at the forefront of pushing the envelope of LTE Advanced. So we have been able to maintain more of the service provider revenue in North America as well as in Asia. And that’s why you see this change. We believe that this condition continue to go forward. And that’s why you see this is apparent weakness of the EMEA, but if you look deeper, actually the non-carrier part obviously Europe is actually doing pretty nicely for us.

Okay. And can you say how much is left in EMEA as far as the service provider goes?

We're reading out, but you could pretty much look at year-over-year at the same quarter.

Okay. And the other question I had is given the demand you saw on Q2 and the guidance you're providing for Q3 as far as RBU, do you think this is seasonal demand in Q4 is going to be there and do you think that business is still seasonal?

Yeah, clearly it's a combination of two. Is both seasonal, which is kind of demand driven right, but it is also supply driven as well. The fact that we have been able to buck the trend in Q2 is because of the supply revenue products. Our Arlo and the new Arlo like Arlo Q, Arlo Q Plus, like the new switches that we introduced, we introduce three really good 10 gig switches very unique in the market, the most compact in form factor with the highest concentration 10 gig managed ports. All of those are generating demand. These are new supplies. So it's a combination. So we're very confident about the demand, the market demand during Q4 the coming Christmas season, but then whether we could do better than that it really depend on the new products that we’re going to introduce before them.

Okay. Thank you.

Okay.

[Operator Instructions] Our next questions comes from Rohit Chopra from Buckingham Research. Please proceed with your question.

Thanks very much and hey Christy I just want to ask my housekeeping question, wired versus wireless, do you have a split there? The other question I had as you look for that is where there any FX issues, as you view towards the end of the quarter?

I would say FX issues are pretty minimal. So, nothing to speak about and wired versus wireless is 73% and 27%.

27% alright and then the other question I had was related to Arlo and at the end of last year, I think there was the big release and it was a big push into the holiday season. Can you maintain those kind of comps? Is that the kind of growth you're seeing right now or are the comps just that difficult as you go into the back half of this year for Arlo.

Well I just made a comment, we looked at the market of IP security camera is growing 45% year-over-year both in the North America market as well as in the German market. So from a demand perspective, we see very strong and clearly we’re going to introduce new products. So, again as I just made a comment to Hamed, we're very confident about the market demand. Whether we can do better than that it depends on the success of the new products we will be introducing in the next two quarters.

Okay. And then my last question and its related to what Hamed was asking on the non-SP business in Europe. Are you seeing any type of slowdown related to the macro in the U.K. or anything like that, it is one of your larger territories?

Well, what I like to point out is that U.K. is an important market for us for sure, but in the overall scheme of Europe, they're not over-dominating. In Europe right now, we have a very balanced distribution of revenue across the -- now the European Union, ex U.K. and especially Germany is really big clearly and so is France, so is Italy, so is Nordic. So we do believe that with the new products that we introduce, we should be able to offset any type of the Brexit.

Thanks Patrick. Thanks Christy.

Sure.

Thank you. At this time I’d like to turn the call back over to management for closing comments.

Thank you everybody for joining the call today. We're certainly very excited by the performance of our new products in the marketplace. So we clearly have invested quite a bit in R&D to the tune of about 6.5% to 7% every quarter for the last six to eight quarters and is starting to be bear fruit. However, there will be more new products to come in the second half of this year. Some of them are into new product categories that nobody ever has ventured into. So we're very excited about it and certainly would like to share more of that in the next earnings call and would like to talk to you all in October. Thank you.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time and have a great day.