NETGEAR, Inc. (NTGR) Q2 2017 Earnings Report, Transcript and Summary

Greetings and welcome to the NETGEAR Incorporated Second Quarter 2017 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, Chris Genualdi, Senior Investor Relations Manager.

Thank you, operator. Good afternoon and welcome to NETGEAR’s second quarter of 2017 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 of 2017 guidance provided by Christine. We will then have time for any questions. If you have not received a copy of today’s release, please visit NETGEAR’s Investor Relations’ 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 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-K. 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 today’s press release on our Investor Relations website. At this time, I'd now like to turn the call over to Ms. Christine Gorjanc.

Thank you, Christopher, and thank you everyone for joining today’s call. We were pleased with the results for the second quarter of 2017 which were driven by the phenomenal growth of our Arlo segment as well as the strong performance of our Connected Home segment. Overall, NETGEAR net revenue for the second quarter ended July 2, 2017 was $330.7 million which is up 6.1% on a year-over-year basis and up 2.2% on a sequential basis. NETGEAR net revenue by geography reflects our ongoing strength in North America as well as improvement in the EMEA. Net revenue for the Americas was $226.9 million, which is up 7.6% year-over-year and up 7.2% on a sequential basis. EMEA net revenue was $55.2 million, which is up 6.9% year-over-year and down 5.5% quarter-over-quarter. Our APAC net revenue was $48.6 million for the second quarter of 2017, which is down 1.1% from the prior year comparable quarter and down 9.4% quarter-over-quarter. For the second quarter of 2017 we shipped a total of approximately 5.1 million units, including 4.1 million nodes of wireless products. Shipments of our wired and wireless routers and gateways combined were about 1.9 million units for the first quarter of 2017. The net revenue split between home and business products was about 80% and 20%, respectively. The net revenue split between wireless and wired products was about 75% and 25%, respectively. Products introduced in the last 15 months constituted about 45% of our second quarter shipments, while products introduced in the last 12 months constituted about 38% of our second quarter shipments. From this point on, my discussion points will focus on non-GAAP numbers. A 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 2017 was 28.4% compared to 32.3% in the prior year comparable quarter, and 30.9% in the first quarter of 2017. Our non-GAAP gross margin was down year-over-year and sequentially due to increased investments in channel marketing that we made with key customers during the quarter as we continue to drive market share higher in both our Arlo and Orbi product lines. As we discussed in the prior earnings call the majority of this additional marketing spend hits our P&L with contra revenue therefore affecting our gross margin levels. Total non-GAAP operating expenses came in at $65.8 million, which is up 1.9% year-over-year and down 2.7% sequentially. As always, we manage our expenses prudently while also ensuring that the growth portions of our business have the resources necessary to succeed. Our headcount increased by net of 2 people to 953 heads during the quarter. We expect to continue to add additional headcount in key areas of the business during the third quarter of 2017. Our non-GAAP R&D expense for the second quarter was 6.6% of net revenue as compared to 6.6% of net revenue in both the year ago comparable period and the prior quarter. R&D is critical to our success and therefore we expect this expense to continue to grow as needed in absolute dollars. Our non-GAAP tax rate was 31.2% in the second quarter of 2017. We came in slightly below our guidance due to onetime benefit that we do not expect to repeat in subsequent quarters. Looking at the bottom line for Q2, we reported non-GAAP net income of $19.9 million and non-GAAP diluted earnings per shares of $0.60 per diluted share. Turning to the balance sheet, we ended the second quarter of 2017 with $305.5 million in cash. For the second quarter of 2017, we used approximately $8.6 million of 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 our ability to generate meaningful levels of cash and expect this free cash flow to improve significantly in the second half of the year. During the trailing four quarters, we generated approximately $19.4 million in free cash flow, which included a $1.6 million benefit from a presentation reclassification in historical cash flow statement. We continue to focus on optimizing the business and generating cash, providing us operational flexibility as well as the ability to strategically deploy cash to enhance shareholder value. In Q2, we spent $45 million to repurchase approximately 929,000 shares of NETGEAR common stock at an average price of $48.44 which resulted in a $0.01 benefit to non-GAAP diluted earnings per share for the quarter. Since the start of our repurchase activity in Q4 2013, we have repurchased approximately 10.6 million shares and our diluted share count is lower by 15.5% as compared to the beginning of that period. The fully diluted share count is approximately 33.1 million shares at the end of Q2, 2017. We have 3.2 million shares remaining on our current buyback authorizations and plan to continue to repurchase shares opportunistically. Now turning to the results for our three produce segments. The Connected Home segment, which includes the industry-leading Nighthawk and Orbi brands, generated net revenue of $185.9 million during the quarter which is down 6.4% on a year-over-year basis and down 4.4% sequentially. The year-over-year decline is due to reduced service provider revenue for Connected Home, which is down $12.9 million from Q2, 2016. Excluding service provider sales, the Connected Home segment net revenue was up slightly year-over-year. The Arlo segment’s net revenue came in at $78.7 million for the second quarter of 2017. This is up 104% year-over-year or about $40.1 million from the prior year, and up 29.7% on a sequential basis. I would like to highlight that the Arlo segment generated more revenue during Q2, 2017 than it did during Q4, 2016 despite the fourth quarter seasonal strength. We believe that this sets the business up for a very strong back half of the year. The hyper growth of the Arlo's segment continues to exceed expectations and we strongly believe that this business has plenty of room for further growth both in hardware sales and monetization of the installed base. The SMB segment generated net revenue of $66.1 million for the second quarter of 2017, which is down 11.2% on a year-over-year basis and down 3.6% sequentially. During the quarter we experienced softness in both the switch and storage category. While we continue to dominate the retail switch market the gigabit switch market is contracting. The 10 gig and multi-gig switch markets are growing. However, their growth is not currently enough to compensate for the contraction in gigabit switches. Nevertheless, we see opportunities to drive growth in SMB including the transition to software designed video over Ethernet or SDVoE as the professional AV market moved from circuit switching to package switching. NETGEAR is a founding member of the SDVoE alliance which is standardizing the hardware and software to make this transition possible. We believe our switching portfolio is very well positioned to benefit from this transition. I will now turn the call over to Patrick for his commentary, after which I will provide guidance for the third quarter of 2017.

Thank you, Christine, and hello, everyone. It was a very exciting quarter for us here at NETGEAR. Our top-line was fueled by the performance of the Arlo, Orbi and Nighthawk product lines. We launched [indiscernible] for both the Arlo and Orbi product families and we reached an all time record market share level for NETGEAR in the IP camera market while continuing to dominate the high end WiFi router market share. Needless to say, we have been quite busy these last few months. I would not like to spend some time discussing our vision for the Alro business. As our quarterly results show the Arlo business continues to grow at a phenomenal rate posting 104% year-over-year growth for the second quarter of 2017. We have never seen a business of this size grow so rapidly in more than 20 years that we had been in business. We strongly believe that our unique innovative technology trusted brand, and superior distribution separate us from the competition in the IP camera market and will continue to allow us to drive share gain in this category. Our market share in the IP camera category increased to 41% during Q2, up from 33% during the prior quarter. NETGEAR internal estimate suggest that the IP camera market in the U.S. will grow 30% to 40% year-over-year becoming at least an $800 million market in 2017 which is larger than we had previously expected. During the second quarter we extended Arlo’s technology and brand to new markets with the launches of both Arlo Go and Arlo Baby. A review published last week by Tech Hi gave Arlo Baby 4.5 out of 5 stars and noted that to say the Arlo Baby is an improvement over conventional baby monitors is a gross understatement. TechHive put Arlo baby at the top of their list of favored baby camps. Meanwhile our Arlo Go cameras are now available online in retail stores and through search provider channels. We continue to be very excited about the market potential for both of these new products. Additionally, we're very pleased to report that the Arlo business showed improvement in profitability during Q2. Posing a contribution margin of 4% up from 0.5% during the prior quarter. We remain committed to not only growing topline for Arlo but also ensuring that it is a healthy and profitable business once if which is scale. We have a clear vision for the Arlo business. We are creating the best home security solution on the market by building an integrated hardware plus software plus mobile plus cloud plus artificial intelligence offering. We will continue to differentiate from the competition with our superior hardware design. We will deliver intelligent services tailored to each individual users needs by leveraging our mobile app and the cloud. Currently, we are developing services that will make Arlo both smart and more robust. We plan to add service options for our customer that will improve the user experience as well as drive recurring revenue for the company. We are developing much deeper customer relationships than we ever have before in transforming the NETGEAR business in the process. It's no small undertaking but we're well on our way to realizing this vision. Since Arlo's launch in early 2015, we have shipped over four Mummying cameras worldwide, laying the foundation for a global installed bay. We will continue to grow this install base with new users as fast as we can, which also offering our existing user services that improve and enhance the Arlo experience. We are managing the Arlo segment for rapid growth and the eventual monetization of the installed base, once which is scale. This is very different than how we manage the other two segments. For the Connected Home and SMB segments, we are focused on market leadership; in hard way, margin dollar growth with enhanced software capability. Both the Connected Home and SMB segments are steady, very profitable predictable business that certain markets we have operated in for over 20 years. Combined, they have a contribution margin in the mid-to-high teen. With the interconnected home segment, we continue to see significant growth in the home Wi-Fi mesh category. We believe that the consumer Wi-Fi mesh market will nearly quadruple inside this year. To continue to attack this opportunity, we successfully launched two new additions to the Orbi family during Q2 that are designed for small and mid-sized homes. Our Orbi line has been consistently praised by critics and customers alike. A review by the Wirecutter which is a product recommendation site owned by the New York Times wrote that after spending over 50 hours testing nine mesh Wi-Fi networking kit in a large complicated multilevel home, we are confident that the NETGEAR Orbi kit is the best choice for most people. The Orbi kit has the best throughput in range of the kits we tested. Even with only two units to the other kits free. Well, the market has spoken and is clear that Orbi is the best solution available for whole home Wi-Fi coverage. We are pleased to report that our market share in home Wi-Fi mesh is holding strong in the mid-30s gaining slightly amidst fierce competition. As a result, we reached an all-time high in market share for Q2 in the U.S. retail online channels for combined Wi-Fi routers, gateways and mesh systems. We continue to stay ahead of the competition by leveraging our second and none expertise in Wi-Fi, broad product portfolio, our well established brand and our global distribution channel. Consumers worldwide know that NETGEAR is synonymous with the fastest and most reliable home Wi-Fi. And furthermore, no one can match the breadth and depth of our channel relationships. We have lot still afford to as we enter our seasonally stronger back half of the year. First, we will continue to build on the momentum that we have with Arlo and Orbi to gain market share as paid services and drive growth for the overall company. Second, Arlo will expand into a new non-camera product category allowing us to further enhance the Arlo platform and grow our term, will announce this new product not later than on our Analyst Day in November 2017. I will now turn the call back to Christine for the Q3 guidance.

Thank you, Patrick. With the third quarter of 2017, we anticipate revenue will be in the range of approximately $340 million to $355 million. Third quarter GAAP operating margin is expected to be in the range of 6.5% to 7.5% and non-GAAP operating margin in the range of 9% to 10%. Our GAAP tax rate is expected to be approximately 35% and the non-GAAP tax rate is expected to be approximately 33.5% by the third quarter of 2017. Operator, that concludes our comments and we can now take questions.

[Operator Instructions] Our first question is from Rob Cihra of Guggenheim Partners. Please proceed with your question.

Two things if I could. One on, so Connected Home as you said ex-service provider was basically call flat year-over-year. I guess, not to just somewhere from Q1. And the question here is so Orbi is obviously growing, you mentioned I think Nighthawk being good in the release. So, I'm just curious what sort of going on with the mix there in terms of Orbi going up, is Nighthawk, what's Nighthawk holding in versus Orbi and then for our legacy products. And I have a follow-up, that's okay.

Yes. The biggest change over the last 12 months particularly in the last six months is the takeover of Time Warner Cable from Charter. Time Warner Cable just like Comcast used to rent cable modems and Wi-Fi to their subscribers. So, many subscribers actually prefer instead of paying $10, $12 a month to actually buy cable modems and gateways in retail from us that saves them a lot of money. Charley had a different policy, they gave, not quite gave but they bundled the modem rental fees in their TV and internet fees, though people would do not have an option not to get modem from them and they saw just significantly shrank the retail market for cable modems and cable gateway, and since we are the bigger shareholder, market shareholder in that particular category of products, we got hit the hardest. Forever, we do believe that with the continuous growth of the Wi-Fi mesh market, 1) The ASP of the rest of the market will grow to offset the decline, 2) We are spending money to educate the customers even though they get a free modem from Charter. Their Wi-Fi actually is not up just now. And you should actually supplement their modem with our Orbi. So, we do believe things will that the total accessible market of home Wi-Fi in retail in the second half will turn around and grow again.

Okay, great, thanks. And then if I could ask a question on gross margin. So, as you guys had guided where the gross margin came down in Q2, a lot of that being the contra-revenue hit from the channel marketing. From here, I know you don’t guide gross margin specifically but you mean normally your seasonally your gross margins' down a bit maybe a point or so call it in Q3 but -- well, actually so I guess with last year you'd be fired with -- but I'm just curious ex-seasonality have you already sort of taken the hit from the sort of more aggressive marketing, does it get steeper from here, does it start to improve a one point, I was just kind of curious of how that, how your plans lay out there. Thanks.

Let's say we're still spending money on marketing, obviously optimizing that as we continue to move forward. We got a really good growth in the Arlo market share and that and again kind of slight growth in mesh in maintaining. So, we'll continue to spend the marketing dollars. I do think as you can see the revenue guidance will hire in Q3, you'll get a little scale out of that as you go forward. But we will continue to spend that money obviously optimizing it. You can see the guidance is up a bit from Q2 and so we will continue to do both. We want to improve the bottom line but we also want to make sure we do the right thing for the long run for both the Orbi and the Arlo category.

Yes. On the other hand, as you see the Arlo market is going very rapidly. And we're gaining share rapidly and with that increased scale we certainly could leverage into our buying as well as our pricing power in the market. So, as Arlo becomes a bigger part of the overall business, the profitability of Arlo has a significant bearing on the overall profitability of the company.

Great. Thanks, very much.

Our next question is from Tavis McCourt of Raymond James. Please proceed with your question.

Hey guys, thanks for taking my question. My first one is on Arlo and then I've got a couple of financial questions, Christine. So, I think you show on the slideshow Arlo was 41% share, if I'm wrong it was up a lot from Q1. That's a U.S. share number. What I'm wondering is what is your sense on the share outside the U.S. and how that market is developing outside the U.S.?

It's pretty similar in Europe. And we actually have significant even higher share in Australia. Now, we haven’t entered China yet but we will. And we haven’t really started Japan yet, we will. We believe that those two markets will offer even more attractive opportunities for us going forward. So, we're very confident around the world.

And then, financially I guess run through some of the reasons for the working capital usage this quarter and kind of more broadly in the first half of the year and should we expect DSOs and inventory returns to normalize by the end of the year or is this a new normal given the mix of business?

Yes. I think we said we expect to see significant improvement in the free cash flow in the back half of the year but clearly the use is since the beginning -- since the end of the calendar year, our inventory accounts receivable and also our payables are sort of that an all-time low. So, we do expect receivables is all about timing, we always collect everything, so that really is not an issue. Inventory is always a balance between air and sea freight, and that and also some of our customers our larger one don’t keep as much inventory. So, you've seen our inventory go up some, so we make sure we optimize that. We are focused, we believe the DSOs will come down a bit next quarter, then we get the seasonal date interim again in Q4. Inventory will continue to balance going forward. So, we believe we will generate significant improvement in the cash flow in the back half of the year.

Got you. And then, can you repeat the tax rates that you utilize for the non-GAAP earnings in the June quarter again, like I got the tax rate guidance for next quarter?

At 31.22%, non-GAAP.

Okay, right. Well, thanks very much.

Sure.

Our next question is from Woo Jin Ho of Bloomberg. Please proceed with your question.

Great, thank you. Quick question on the guidance. So, you guys have promised about 5% sequential growth rate which is relative to the prior two years, let's just say less than seasonal. And I understand that there are some factors that are going on there. I'm trying to better understand especially giving that you're putting investments into your higher USB products. Why is the guidance or how did you construct that guidance especially given that you are making these investments too to boost share in Arlo as well as in Orbi?

Well, I think we construct the guidance the same way every time. We roll the numbers up. I think we have, definitely you are seeing a fast growing Arlo category, you're seeing again Orbi and the Nighthawk but balancing against that, we also as we mentioned in the SMB area, we are – there is – the market is actually contracting a bit so we will move against that with some of our new products and the 10 gig switches but right now we got to catch up with that and same thing that Patrick mentioned on the cable side in the Connected Home as we go forward we are looking at those numbers and that's on a year-over-year comp that’s down.

Okay and then and Patrick one for you. Could you dig a little bit deeper in terms of the competitive environment for both Arlo as well as Orbi. It looks like there is a couple of product refreshes that have gone over the past quarter as well as some traditional competitors coming out with new more powerful mesh products. Could you just talk about what's happening on the competitive landscape?

Yes, I mean on the Arlo side it's pretty clear by the market share numbers that we continue to grab share because of our unique wire-free technology. All the products that are really leading in market including the Arlo Pro as well as the Arlo Go are all wire-free and so far that wire-free technology as unparalleled there is no competition in this area that could match our battery life, our WiFi or LTE connectivity robustness as well as the cloud and mobile app capabilities. I think even though our competition tries they have not been able to get anywhere close to the combination of the technology that we have put together. So we are pretty confident that we will continue to gain share in that regard and use that platform to continue to expand into other areas that might not necessarily be 100% wire-free such as the Arlo Baby. And then on the other hand on the Orbi side is the same thing now we have the very unique technology called Tri-Band mesh and as we mentioned in the discussion just now that wire cutter said hey, no matter how you test it, no matter how you look at it we beat everybody hands down even with only a kit of two versus everybody else with a kit of three or four, five or even seven especially in large homes. So we continue to believe that our unique technology which we patent that quite a bit of the Tri-Band secret source that will continue to lead. And then of course, I mean we have some really big name competitors which despite inferior technology because of their brand and because of their price they will continue to be formidable competitive but we decided competing against them with price is not the way to go but rather with technology is the way to go. So that's where we are heading and I believe that we’re confident will get 45% market share eventually.

And then one last thing from me in terms of the pricing environment, it just amazes me for the past couple of years that your Nighthawk and your Orbi product line as well as your Arlo product line pricing has remained stable and kudos to you guys to being ahead of everyone else, ahead of the curve in terms of offering good product and good technology. I mean how long do you think this product environment is going to stay stable for you because you have been able to successfully offset slightly declining units with your strong pricing?

Yes, we are pretty confident that as long as the internet speed goes both from a wired cable or fiber optics or from the wireless on LTE or 5G basis as long as the speed continue to rise we will still continue to lead with high ASP. I mean, just imagine in these days there was no internet the phone average price will now get to 800 dollars. Because of the internet because of the speed of the internet people want to use the phone to watch video and that's why the phones could keep going up in ASP. The same thing is true if the internet speed both from the LTE, 5G perspective from a fiber optic or cable perspective continue to rise people always want faster routers, faster WiFi mesh and then faster mobile hotspots that will enable us to continue to charge more because we are pretty confident which we are at least about three to five years ahead of any of our competition in terms of all these radio frequency expertise and tuning of WiFi and LTE coverage. So there is just no reason to believe that the internet speed is going to slow down. If you look at I mean what we have been able to do with our Nighthawk M1 mobile router with the first one to demonstrate 1 gigabit download on an LTE network and Qualcomm has already announced that the next generation before 5G arrives will actually get to 1.6 gigabit and then 5G is promising 10 gigabit. If 5G could do 10 gigabit I am pretty sure fiber optic and cable would get there too. So DOCSIS 3.1 already promised that kind of speed so think about that when you have 10 gigabit coming into your house or into your surrounding you absolutely want the best Wi-Fi not only around every single corner of your house but every single corner of your front and backyard.

Thank you.

Our next question is from Hamed Khorsand of BWS Financial. Please proceed with your question.

Hi, first off I want to ask you as far as the pricing strategy goes with gig wireless AC. How is that going to affect given that some of the units that don’t have, Nighthawk brands are now being priced competitively at lower price points versus Nighthawk and how are you going to market that to individuals?

As we are going over to the 11AX which is coming around the corner is pretty clear at this time as to the time to call our IP for the 11N. All right so basically what we want to do is to eliminate the really low end of the 11N and replace that with low end 11AC of a higher ASP than to low end of 11N. So you see as also while we’re busy introducing high end Nighthawk such as the Nighthawk X10, we’re also busy introducing lower end of 11AC. We recently in Q2 introduced 11AC, AC750 as well as AC1200 in various retail channels. Our objective is very simple, we would like to cover our customer base all the way from a smaller dingy apartment all the way to a single family home with front yard and backyard with the hugest state. So we spend across entire spectrum of price points in technologies and that’s why in Q2 we saw our historic high market share in overall home Wi-Fi market.

Okay. Then changing up to the Baby Arlo, are you making any changes and improvements given the reviews have been pretty mixed on Amazon?

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Well, the consumer reviews are now something like three stars out of five on Amazon for the Baby Arlo.

Oh, oh I think, I think you missed probably the last 20, 30 reviews if you go back to look at the last 20, 30 reviews they’re all 4 and 5 stars. So the 3 stars reviews are mostly when we just launched the product which we admitted. We had some software bugs especially on the android app platform. We fixed it so I encourage everybody to look at the last 20, 30 reviews. They’re all 4 and 5 stars, we’re pretty confident.

Okay and my last question is just on the operating margin guidance is there much of a change is the pricing strategy and this guidance purely volume driven with scale or is there some change to pricing as far as no more deep discounts like there was in Q2?

Well, I mean do deep discounts I mean, we’re just doing the channel marketing but as I mentioned in the prior discussion you saw it fully clearly right, when Arlo went from $47 million to some $70 million the profitability went up to 350 basis point and there’s no reason to expect that Arlo’s revenue is not going to grow in the second half which is seasonally strong and clearly the Arlo profitability will grow in commensurable manner and if we do a simple arithmetic if Arlo goes higher in their contribution margin it certainly will be a favorable factor to our overall operating margin.

I guess the same question for the Nighthawk line as well?

The Nighthawk is pretty steady, we don’t see any movements in terms of its profitability.

Great, thank you.

Sure.

Our next question is from Tavis McCourt with Raymond James. Please proceed with your question.

Just had a follow-up on the deferred revenues Christine, they were up quite a bit year-over-year and a little bit sequentially. Can you remind us what the driver is there?

Couple of thing, first of all, if it doesn’t qualify to go to revenue it’s not shipped on time and not delivered and typically that there’s also a carve out in there from Arlo, with Arlo you get seven days of free cloud storage. So the more Arlo we carve out a piece of that to account for the storage and advertise that over the life of Arlo and as Arlo grows so does the carve out.

Helpful, great, thanks.

Sure.

Once again, we are now conducting a question-and-answer session. [Operator Instructions]. Ladies and gentlemen, we have reached the end of question-and-answer session. Now, I would like to turn the call back to management for any closing remarks.

Well, thank you all for joining today’s call, we’ve a lot to look forward to in our seasonally stronger back of the year. I look forward to updating you all on our progress in October when we announce our third quarter results. Talk to you later, thank you. Bye, bye.

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