NETGEAR, Inc. (NTGR) Q1 2018 Earnings Report, Transcript and Summary

Good evening. My name is Chris and I will be your conference operator today. At this time, I would like to welcome everyone to the NETGEAR First Quarter 2018 Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. Christopher Genualdi, Director of Investor Relations, you may begin the conference.

Thank you, operator. Good afternoon and welcome to NETGEAR's first quarter 2018 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 first quarter provided by Christine, followed by details and commentary on the business provided by Patrick and finish with second quarter of 2018 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 would now like to turn the call over to Ms. Christine Gorjanc.

Thank you, Chris, and thank you everyone for joining today's call. Results for the first quarter of 2018 came in at the high end of our guidance driven by the success of our Orbi lines, the new Nighthawk Pro Gaming Router, Arlo Pro 2 and our SMB switching lines. Overall, NETGEAR net revenue for the first quarter ended April 1, 2018, was $345 million, which is up 6.6% on a year-over-year basis and down 13.1% on a sequential basis. The sequential decline is the result of Q1's seasonality as consumer spending slows following the holiday season. NETGEAR net revenue by geography once again reflects continued strength in North America and the EMEA regions. Net revenue for the Americas was $233.6 million, which is up 10.4% year-over-year and down 15.1% on a sequential basis. EMEA net revenue was $66.6 million, which is up 14% year-over-year and down 14.7% quarter-over-quarter. Our APAC net revenue was $44.7 million for the first quarter of 2018, which is down 16.5% from the prior year comparable quarter and up 1.9% quarter-over-quarter. For the first quarter of 2018, we shipped approximately 5 million units, including 4 million nodes of wireless products. Shipments of our wired and wireless routers and gateways combined were about 1.6 million units for the first quarter of 2018. The net revenue split between home and business products was about 79% and 21%, respectively. The net revenue split between wireless and wired products was about 76% and 24%, respectively. Products introduced in the last 15 months constituted about 43% of our first quarter shipments, while products introduced in the last 12 months constituted about 35% of our first quarter shipments. 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 first quarter of 2018 was 30.7%, compared to 30.9% in the prior year comparable quarter and 26.5% in the fourth quarter of 2017. The quarter-over-quarter improvement in non-GAAP gross margins was primarily due to reduced investments in channel marketing as we exited the holiday season as well as reduced air freight costs. As mentioned on the prior calls, the majority of our channel marketing spend hits our P&L with contra revenue therefore, affecting our gross margin levels. Total non-GAAP operating expenses came in at $80.2 million, which is up 18.5% year-over-year and up 5.1% sequentially. This included $879,000 of costs associated with the separation of Arlo and the corresponding dis-synergies created as we hired talent to duplicate certain roles to prepare that business to stand up on its own. As always we managed our expenses prudently while also ensuring that all portions of our business have the resources necessary to succeed. Our headcount increased by a net of 39 people to 1,047 heads during the quarter. We are adding resources as we continue down the path to separate the Arlo business as well as continuing to invest in the key growth areas of our business. We expect to continue to add additional headcount during the second quarter of 2018. Our non-GAAP R&D expense for the first quarter was 7.9% of net revenue as compared to 6.6% of net revenue in the prior year comparable period and 6.1% of net revenue in Q4 of last year. R&D is critical to our business and therefore we expect this expense to continue to grow in absolute dollars as well as in percentage in Q2 as we continue to ramp the R&D spend in Arlo. We are actively investing in R&D for software, cloud, apps and services across all three business segments. As for Arlo, Q2 is a heavy R&D investment quarter as we invest in premium paid services and new products for the second half of the year. Our non-GAAP tax rate was 23.8% in the first quarter of 2018. Looking at the bottom line for Q1, we've reported non-GAAP net income of $20.4 million and non-GAAP diluted earnings per share of $0.62 per diluted share. Turning to the balance sheet, we ended the first quarter of 2018 with $386.2 million in cash or cash equivalents. During the quarter, we generated a healthy $53.8 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. Free cash flow for the trailing 12 months was an impressive $121.8 million. We continue to remain very confident in our ability to generate meaningful levels of cash. Now turning to the results for our three product segments. The Arlo segment's net revenue came in at $96.2 million for the first quarter of 2018. This is up 58.5% year-over-year or about $35.5 million from the prior year and down 25.1% on a sequential basis. The seasonality of IT Cameras is particularly pronounced going from the holiday season to Q1, more so than the Q1 seasonality of consumer networking. The Connected Home segment, which includes the industry leading Nighthawk and Orbi brands generated net revenue of $177.8 million during the quarter which is down 8.5% on a year-over-year basis and down 10.5% sequentially. The year-over-year decline is primarily due to reduced service provider revenue for the Connected Home, which is down $11.4 million from Q1, 2017. We also continue to see headwinds for cable products in North America retail. However, we expect these decline to slow in the coming quarters. The SMB segment generated net revenue of $71 million for the first quarter of 2018, which is up 3.5% on a year-over-year basis, and up 1.6% sequentially. We are seeing strength in our switching lines especially in the areas of 10-gig power over Ethernet and Pro AV, where we lead in both product portfolio and in brands. We are continuing to move forward with our previously announced separation of our Arlo business from next year as contemplated and have recently submitted a confidential draft registration statement on Form S-1 to the SEC relating to the proposed initial public offering of common stocks of Arlo Technologies, Inc. I'll now turn the call over to Patrick, for his commentary. After which, I will provide guidance for the second quarter of 2018.

Thank you Christine and hello everyone. We're pleased with our results for the first quarter of 2018, which came in at the high end of our guidance range for both the top and the bottom line. The Arlo segment posted $96.2 million in revenue for the quarter representing an impressive 38.5% year-over-year growth. Arlo's growth during the quarter was largely driven by their success of Arlo Pro 2 which was launched in the fourth quarter of 2017. PC Magazine recently named Arlo Pro 2, their favorite camera for outdoor surveillance. Meanwhile Digital Trends and Online Millennial focused publication wrote that it's not cheap but this is the best home security cam we've ever tested. Pro 2 improves on the original Arlo Pro with crisp 1080p video, optional plug in power for 24/7 monitoring, support the activity zones and a wider-view viewing [indiscernible]. We're also excited to be approaching the 2 million registered user mark, with over 1.9 million registered users as of April 1, 2018 as we continue to expand our install base to which we will promote our paid subscription services. We are in the final beta trial of our AI based Arlo Smart paid service and we intend to roll it out in the next 60 days. We believe that it will significantly enhance our ability to expand our premium service subscription attach rate, thus ramping our recurring revenue stream. Looking forward as we have already shared publicly, we expect to launch the Arlo Security Light during the spring of 2018. This will be our first known camera product added to the Arlo family. I look forward to updating you on this during our next earnings call in July. Turning to the Connected Home segment, Q1 was a strong quarter on the bottom line, as CHP's contribution margin improved meaningfully on a sequential basis. Q1 marked CHP's highest contribution margin in the last four quarters. We expect this trend to continue into Q2. Additionally we gained a point of market share in the U.S., during the quarter from the competition, thanks to our industry leading WiFi products. CHP's success in the first quarter was driven by both Orbi line and the new Nighthawk Pro Gaming router. As may all of you know Orbi is our industry leading consumer Mesh WiFi solution, that will bunk at every corner of your home in high speed WiFi. While our competitors currently offer one or maybe two models of Mesh WiFi product, we currently have six different models on the market and more are on the way. This enables consumers to choose the perfect Mesh configuration for their specific connectivity needs. Tom's Guide, a well respected tech review publication recently evaluated all of the Mesh systems available in the market and determined that the NETGEAR Orbi is the best Mesh router that we tested. We continue to stay ahead of the competition by delivering the best WiFi performance on the market, engineered by our world class WiFi engineering team. Meanwhile the Nighthawk Pro Gaming router topped the market by storm with its industry leading WiFi performance and more importantly its cutting edge software that optimizes ones gaming experience. By providing geo-filtering, ping stabilization, lag spike reductions, bandwidth allocation and a host of other unique features, the Nighthawk Pro Gaming router is the undisputed best home networking solution for gamers worldwide. A review by PC Gamer of the gaming routers available in the market, recently named the Nighthawk Pro Gaming Router, the best gaming router for most users. The Nighthawk Pro Gaming Router has been a hit straight out of the gate and it marks just the beginning of our push into the gaming space. Additionally, during the first quarter we continued rolling out Circle, Parental Control Subscription Services to some of our existing router customers. We believe service revenue will gradually become a meaningful contributor to CHP's bottom-line in the coming years. Our SMB segment had a strong first quarter, posting year-over-year and sequential revenue growth, which was primarily driven by our switching line. We gained 5 points of market share in U.S. retail channel switching market. Additionally, SMB experienced strength in the international market, particularly in Germany and Japan. From a product category perspective, our Power-over-Ethernet and 1-gig switches continue to be strong performers during Q1. Like CHP, SMB delivered a strong quarter on the bottom line posting its highest contribution margin of the last four quarters. Again we expect this uptrend to continue into Q2 for SMB. Looking forward, we expect that our app managed Insight switches ProAV and multi-gig switches will be ramping up in revenue throughout the rest of the year. In summary, we are very encouraged by the continuous top line growth for both Arlo and SMB as well as the improvement in contribution margin and market share gains for both the CHP and SMB segments. For Arlo, we are excited by the continuous growth in the number of the registered users, pending introduction of Arlo Smart, the launch of Light in Q2 and more new premium paid services and products coming in the second half of the year. I'll now turn the call back to Christine for the Q2 guidance.

Thank you, Patrick. For the second quarter of 2018, we anticipate revenue will be in the range of approximately $340 million to $355 million. First quarter GAAP operating margin is expected to be in the range of negative 1.2% to negative 0.2%, which includes approximately $10 million of one-time costs associated with the separation which includes professional service fees for various advisory and audit related costs. Non-GAAP operating margin is expected to be in the range of 5.5% to 6.5%, which includes approximately $4million of costs associated with the separation of Arlo and the corresponding dis-synergies created as we hire talent to duplicate certain roles to prepare that business to stand up on its own. Furthermore, we expect to increase our R&D spend as a percentage of overall revenue due to investment across all three product segments and Arlo in particular. Our GAAP tax rate is expected to be approximately 30% and the non-GAAP tax rate is expected to be approximately 25% for the second quarter of 2018. Operator, that concludes our comments and we can now take questions.

[Operator Instructions] Your first question comes from Rob Cihra from Guggenheim. Your line is open.

Hi, thank you very much. A few questions if that's okay. One just you called out the improved profitability in Connected Home. Any chance that you would give us actual numbers for segment profits or do we have to wait for the Q? And then the $4 million in reducing the non-GAAP operating margin with that $4 million not the 10. So I mean are those that sort of dis-synergies. I mean does that $4 million, sort of $4 million per quarter ahead of the separation or is that 4 going to go higher or just curious sort of how the balance of the year plays out, even though I recognize the balance of the year at one point it will be two companies? And then I just have one follow if that's okay.

Okay. So we will file the Q shortly and we'll have all the segment contribution results in the Q. And related to the $4 million, that again is headcount, its license fees, and again duplicate expenses that we are incurring. I would expect that to go up in Q3 as we continue to add headcount for Arlo as a standalone company. And at some point you're right, it will be totally separate companies and you'll see the structures more in both. So we're standing up complete operations in IT organizations and finance. And -- you have one more question?

Yeah, just on the, so on the promotional spending or discounting. I mean you said actually seasonally it was a little better as shown in the gross margins. Is that -- if you go back sort of a year ago when you guys started getting more ambitious with your promotions to drive market share up in particularly I think Arlo and Orbi. I mean where are you now kind of a year later, I mean you have been gaining share, do you sort of feel like you still have to be aggressive with that or is there sort of some areas where you're still being aggressive and others where you feel like you've kind of gotten the way you wanted to be? I'm just curious sort of from a strategic standpoint, how you feel about that sort of aggressive spending? Thanks.

From an overall perspective, I mean we're pleased with the market share gain that we have. And the competitive configurations we're not going to pre-tell our competitors when we are going to be hard on promotions, when we're not going to be. But generically speaking, I mean in Christmas season it's probably with Black Friday, with November 11 in China that will be the most promotional quarter, [indiscernible] is only some of that.

Right. That makes sense. Okay great, thank you very much.

Thanks.

Your next question comes from Woo Jin Ho with Bloomberg. Your line is open.

Great, thank you for taking my questions. Couple of things in terms of your full year guidance, and I know that the full year guidance is probably taking off primarily because of the pending Arlo spend. But are you still -- if there was one business year-end, are you still sticking to the 10% growth for the year?

Yes. That's our intent and we're working very hard to get to that objective. I think we're still on track.

Okay. And then, but given your second quarter guidance, you'll need a fairly strong second half to achieve roughly the $500 million in Arlo revenue that you intended and then if you are still looking at flattish Connected Home and SMB. How are you thinking about that Arlo business in the second half and how should we start thinking about the Connected Home in the second half as well given that there will be two separate businesses?

As Christy just pointed out, the Arlo business is more seasonal than our traditional home networking business. So that means the Arlo business will have a much bigger second half than the first half and as Arlo's base get bigger than their seasonal path in the second half will have a much -- made no dramatic effect on the overall revenue. So we feel pretty confident on that 10%. And as I just mentioned, our CHP business -- the headwinds of the CHP business both from the service provider decline as well as the cable side decline is moderating as we go forward. So -- and then we are really happy to see that our switching line in powering the growth of the SMB both on a sequential and annual basis. We have -- what we have together, we believe that we continue to execute we should be able to get to our annual guidance on top line.

Got it. Just a couple of more, if I may. One of the drivers for the NETGEAR growth in 2015 and 2016 were ASPs, how should we sort of thinking about the product ASPs going forward? It looks like its tailing off a little bit especially as Orbi starts to anniversary and then we are trying to get some anniversary of the Arlo products?

Yeah I mean we will continue to introduce products of higher ASP. And a good example is the gaming router. The gaming router is you know almost like a 35% increase in the comparable range for routers and then Pro 2 that we introduced in Q4 last year, is another 25% jump from Pro. You expect us to continue to do the same thing in the second half.

Okay, and then one strategic question for me. Given all the M&A activity that's happening in the Smart Home segment, Patrick, is the IPO the only way for the Arlo business or would you be open to a third-party M&A if the price is right?

Clearly I mean, responsible for our shareholders, we look at all options, and we are going to [preclude] one from the other. For now I mean we are all focused on executing on the IPO, all of Arlo which we believe is tremendous fact.

Great, thank you very much.

Your next question comes from Trip Chowdhry with Global Equities Research. Your line is open.

Thank you, congratulations on a very solid execution. I was wondering if you think about Arlo and you did mention within next 60 days we are going to get Arlo Smart. The beta version -- the beta that you launched had object classification to include people, vehicles and animals. Do you think you will still have all the three object classification when it starts or we may only get a subset of it and the other objects later?

Well, we just finished our second round of beta. For this second round of beta we focused on three functionalities; one is person identification. The other one is which notification, the third one is E911 and so when I talked about rolling out the Arlo Smart service in the next 60 days it will be surrounding those three functionalities. We are not precluding what we are going to roll out in the second half is I just mentioned I am not going to pre-tell my competitors what am I going to do. But as you probably heard from me, saying that -- or actually from Christie that Q2 is a heavy R&D quarter for Arlo, because there'll be more Arlo Smart services in the second half and there will be more new products from Arlo in second half, so I mean I will stop at that.

I was wondering, do we have any sense on the subscription service fees at this moment or we will have to wait for 60 days to…

You have to wait, within the 60 days and we think that it will be very attractive.

My other question I had is regarding Arlo Pro 2, do you think the sales of Arlo Pro 2 have exceeded the sales of Arlo Pro yet or there's still a lot of gap between the two?

We don't break down product by product revenue. I mean, for obvious reasons. So we are not going to comment on that.

No worries. Last question I had is, we know that Arlo Light is coming. Do you think there are some other devices we may expect in the second half from Arlo? I mean device like hardware device versus a subscription service?

The only thing I would say is, in just the discussion, we are investing heavily in Q2 for Arlo because of new Arlo Smart services and new products in the second half and I think that's more than enough for our investment community. If I talk more, then our competitors will know exactly what we are going to do.

Well understood. Again, thanks a lot and congratulations.

Sure. Thanks.

Thank you.

[Operator Instructions] Your next question comes from Rob Cihra with Guggenheim. Your line is open.

Great, thanks back in, just two more questions since I'm given the chance. Service provider, I'm assuming looking at the quarter that still you're thinking sort of $50 million to $55 million a quarter is that now do you feel kind of a stable run rate for that business?

With the combination of Arlo, CHP and a tiny little bit of SMB. Yes, that's about right.

Okay. And then looking at Connected Home and your expectations for their declines there to moderate and perhaps grow for the year. How much of that is kind of anniversarying the mix impact throughout last year of the growth in Orbi Mesh versus sort of personal or legacy WiFi versus kind of getting past the weakness in U.S. carrier cable -- sorry, retail cable modems that you had call out? Is the one bigger than the other?

The mix for the service provider products, for any one of our product segments will be changing over time. So right now, for CHP's products into the service providers is primarily composed of the mobile hotspot and then the traditional in-home WiFi products and as well as the new Mesh WiFi products. We expect to see more of the in-home WiFi Mesh products to be increasing and the traditional WiFi single routers, gateways to be decreasing and mobile hotspots to be stable. So that's why we see this dynamic pretty moderate going forward from a decline standpoint. But again I mean next year we see tremendous opportunity that 5G could bring to us and because of 5G then WiFi Mesh is more important than ever. So that might play into our hands, we don't know but we never forecast that long. All we could say for the rest of this year, this decline compared to last year it will be moderating. But you're right, you said last year we declined about a bit already so it's easier comp.

Right. Okay great. Thank you very much.

Your next question comes from Hamed Khorsand with BWS Financial. Your line is open.

Hi guys. First question from our point is Patrick do you have any competitive pressures increasing on you with Foxconn, Belkin earlier this quarter?

No. I mean, because Foxconn is a huge conglomerate as you probably know. I think over $100 million in sales and as a matter of fact, it's a very complicated group with many subsidiaries doing business with different people. The group that is supplying to us is actually a subsidiary listed in Singapore and the primary facilities as well as engineering capabilities and manufacturing capabilities are based in Vietnam. And the group that's buying Belkin is actually listed in Hong Kong which is primarily involved in providing Apple peripherals, cables, Ethernet USB cables so on and so forth. That's why they brought Belkin. But their capabilities are primarily in the U.S. as well as in China. So they are too very distant. So I don't think there is a lot of crossover. And of course we get assurances and we're pretty confident that the firewall pretty solid and distant between these two subsidiaries of Foxconn.

Okay. Now that you are at 1.9 million nodes, for you to get to around in other [two] quarters is 2 million nodes. How much are you willing to put more focus on generating the recurring revenue subscription model versus this accounting zone [fall ups] more? What are you putting more focus on?

I mean we prioritize what we do buy. I mean as right now, I think our number one priority as described in our previous Analyst Day as well as our January separation presentation. Our number one priority right now is to increase the install base. The number of registered users of Arlo. So you could term it as in a user acquisition mode. So that's what we do. And that's why I mean we have been providing [73] basic service to our customers to get more customers to be our registered Arlo users. Our second priority is to ramp up our premium paid services beyond the basic service that the customer is actually prepaid when they brought the hardware is not really free but it's prepaid. But anyway, so that's our second priority. So I hope that I made it clear enough.

Yeah. And then lastly I guess following up on the other peoples' questions here. Can you just describe how you think that issue of the operating margin guidance gains have been similar to last year if we're now in low-single digits for the first half of the year?

Well the operating margin guidance we made in our Analyst Day last year was without the Arlo separation. So I don't think it is of any reference anymore. I think the best way to look at it is to follow our quarterly guidance in terms of operating margin. Because seriously I mean we had no clue on how much all these advisory fees and audit fee is going to be for the separation, so very difficult. But on the other hand, every quarter we tell you what those fees are and what are the dis-synergies and duplicate costs and then we are pretty confident when you take that into account, we are pretty much track in what we do.

Got it. Thank you.

Your last question comes from Woo Jin Ho with Bloomberg. Your line is open. Woo Jin Ho with Bloomberg, you do have an open line.

Thanks, I was on mute. So, I understand that the service provider was a headwind for the Connected Home business, but even if you exclude the Connected Home business Patrick, the Connected Home business was down 4% on a year-on-year basis. I mean there is an improvement from last quarter, but how should we start thinking about the revenues for Connected Home, when should we start to thinking about a return to growth, number one? And then in terms of the year-over-year declines ex-service provider, is that mix driven or is that volume driven?

I thought that I explained it already that other than service provide headwind we also have the cables headwind in North America retail because as we explained in previous three conference calls that Charter took over the Time Warner territories and once they took it over they kind of bundled the cable modem fees into the internet subscription fees. So, people do not have the option to go to retail and buy their own cable modems. So that really hurts us. And because it took them a year and a half to rollover all that policy to all the Time Warner territories that they acquire, so we suffered that headwind. However we are towards the tail end of that taking over. So that end of course I mean we have easier comps from a year ago and that's why we see that headwind is going to be subsiding. So we believe that once -- that has completely gone away -- of course if Comcast or the other are going to follow the same thing, is going to be a problem. But assuming the Comcast and the other cable operators are not doing the same thing, I think that will be behind us, so our growth in Orbi, [indiscernible] and Pro Gaming will be able to more than cover and generate growth for the first service providers defined. And as I just mentioned, looking into 2019, we see opportunities even on the service provider side if 5G does deliver the promise of the speed of into the house.

Okay, and then switching on to the Connected Home stream, you mentioned Circle and then wrapping that up. But then also at the Analyst Day you did talk about advanced services for the Connected Home. Where are you on that and how should we start thinking about that going forward?

Yes. I mean putting the other -- actually the gaming services is already rolled out, I forget to mention about it, in a very, very small scale in China and we are going to roll it out to the rest of the world later on. And for the Cyber Security Services, the NETGEAR Armor is a little bit more difficult than we originally thought. So we are not in a position to even roll it out for beta. Yes, so I would say from this year we are pretty confident that we'll have the Parental Control and the gaming services out. And then the Cyber Security Services, should be out in the second half of this year.

Great. Thank you very much.

Sure.

This concludes the Q&A session for the conference. I would now like to turn it back to Patrick Lo for closing remarks.

Thank you everyone for joining today's call. We are really excited about the progress that we've made in terms of profitability as well as market share gains in the SMB and CHP segments and also the continued improvement in terms of our registered number of users and rolling out of our -- pending rollout of our Arlo Smart services on the outline. Clearly on top of that, we are working very diligently in preparation for the separation of the Arlo Technologies into an independently listed company. Lot of things are going on, we are very excited about it and I look forward to updating all of you on all of those fronts in the next earnings call. Look forward to it. Thank you.

This concludes today's conference call. You may now disconnect.