NETGEAR, Inc. (NTGR) Q1 2019 Earnings Report, Transcript and Summary

Good afternoon, my name is Jodie, and I will be your conference operator today. At this time, I would like to welcome everyone to the NETGEAR First Quarter 2019 Earnings Conference Call. [Operator Instructions] Chris Genualdi, Director of Investor Relations, you may begin your conference.

Thank you, operator. Good afternoon, and welcome to NETGEAR's first quarter of 2019 financial results conference call. Joining us from the company are Mr. Patrick Lo, Chairman and CEO; and Mr. Bryan Murray, CFO. The format of the call will start with a review of the financials for the first quarter provided by Bryan, followed by details and commentary on the business, provided by Patrick, and finish with second quarter of 2019 guidance provided by Bryan. 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 includes 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 Mr. Bryan Murray.

Thank you, Christopher, and thank you, everyone, for joining today's call. Results for the first quarter of 2019 came in at the high end of our guidance range for net revenue, slightly above the range in non-GAAP operating margin. Our success was driven by the Orbi line of Mesh WiFi systems, the Nighthawk Pro Gaming line, cable modems and gateways and our SMB switching portfolio. Overall, NETGEAR net revenue for the first quarter ended March 31, 2019, was $249.1 million, which is up 1.6% on a year-over-year basis, and down 13.8% on a sequential basis. Sequential decline is primarily due to typical seasonality as consumer spending slows following the holiday season. Looking at net revenue by geography, we generated $148 million of net revenue in the Americas, which is down 7.5% year-over-year, and down 22.2% on a sequential basis. The year-over-year drop in North America was due to reduced service provider sales. In Q1, the U.S. retail WiFi market declined 8% relative to the prior year comparable period. This was primarily due to the accelerated decline of the 11ac router market, excluding the gaming category. Despite this, we were able to achieve our forecasted revenue for North America, driven by new product introductions. It is incumbent upon us to return the market to growth in order for us to be able to achieve our financial goals, including exiting the fourth quarter at 11% to 12% non-GAAP operating margin. Patrick will comment in a moment on how we hope to achieve this. Net revenue for EMEA was $57 million, which is up 20.1% year-over-year and down 3.1% quarter-over-quarter. We experienced healthy year-over-year growth in both the service provider and non-service provider channels in EMEA. Furthermore, we saw increased orders from our U.K. partners in anticipation of the originally scheduled Brexit deadline of March 29 in an effort to mitigate potential supply interruption. APAC net revenue was $44.1 million for the first quarter, which is up 16.8% from the prior year comparable quarter, and up 10.8% quarter-over-quarter. Growth in APAC was driven by the service provider channel. For the first quarter 2019, we shipped a total of approximately 3.8 million units, including 2.5 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 1.4 million units for the first quarter of 2019. The net revenue split between home and business products was about 68% and 32%, respectively. The net revenue split between wireless and wired products was about 64% and 36%, respectively. Products introduced in the last 15 months constituted about 27% of our first quarter shipments, while products introduced in the last 12 months contributed to about 23% of our first quarter shipments. We expect to see improvement here in the quarters ahead given our new product introductions planned for the remainder of the year. From this point on, [schedule] points will focus on non-GAAP numbers. The reconciliation from GAAP to non-GAAP in our earnings release distributed earlier today. The non-GAAP gross margin in the first quarter of 2019 was 33.3%, which is up 180 basis points year-over-year compared to 31.5% in the prior year comparable quarter, and up 160 basis points compared to 31.7% in the fourth quarter of 2018. We are pleased with the improvement that we've seen in gross margin lines in recent quarters. Total non-GAAP operating expenses came in at $60.2 million, which is down 9.9% year-over-year and down 6.6% sequentially. As always, we manage our expenses prudently, while providing the growth areas of our business the resources necessary to succeed. Our non-GAAP R&D expense for the first quarter was 7.1% of net revenue as compared to 8.2% of net revenue in prior year comparable period and 6.2% of net revenue in the fourth quarter of 2018. R&D investment remains critical to the future success of our business, and we will continue to invest here in the quarters to come. Our headcount decreased by a net of 9 people during the quarter, landing at 828 as of March 31. Our non-GAAP tax rate was 16.5% in the first quarter of 2019. The better-than-expected tax rate for the quarter resulted from the settlement of a foreign tax audit that was accounted for as a discrete benefit during the quarter. Looking at the bottom line for Q1, we reported non-GAAP net income of $19.8 million and non-GAAP diluted EPS of $0.60 per diluted share. Turning to the balance sheet. We ended the first quarter of 2019 with $212.7 million in cash. As expected, during the quarter, we used $37.2 million in cash flow from continuing operations as a result of working capital needs to help support our manufacturing migration out of China in the first half of the year to mitigate imposed tariffs. Additionally, we used $6 million in purchase of property and equipment during the quarter. We remain confident in our ability to generate meaningful levels of cash. In Q1, we spent $15 million to repurchase approximately 436,000 shares of NETGEAR common stock at an average price of $34.41 per share. Since the start of our repurchase activity in Q4 2013, we have repurchased approximately 12.8 million shares. Our fully diluted share count is approximately 32.9 million shares as of the end of the first quarter. There are 1 million shares remaining under our approved buyback program, and we plan to opportunistically repurchase our stock in the quarters to come. Now turning to the results of our product segments. The Connected Home segment, which includes the industry-leading Nighthawk, Orbi, Nighthawk Pro Gaming and Meural brands, generated net revenue of $169.4 million during the quarter, which is down 2.8% on a year-over-year basis and down 21.5% sequentially. The year-over-year decline is due to reduced service provider revenue for Connected Home, which was down $5 million from the first quarter of 2018. The sequential decline reflects normal post-holiday seasonality with the added effect of 2 fewer selling days from Q4 to Q1. We held our U.S. retail WiFi market share at 50% in the first quarter of 2019. The SMB segment generated net revenue of $79.7 million for the first quarter of 2019, which is up 12.5% on a year-over-year basis and up 8.8% sequentially. Our PoE+ and ProAV switching line continue to perform well. Additionally, we benefited from extra shipments in the U.K. in anticipation of the Brexit deadline, which ultimately was delayed. I'll now turn the call over to Patrick for his commentary, after which I will provide guidance for the second quarter of 2019.

Thank you, Bryan, and hello, everyone. As Bryan just highlighted, we had a strong Q1 met by Orbi, Nighthawk Pro Gaming, cable modems and gateways and our SMB switches. Additionally, we've begun rolling out the first wave of mini WiFi 6 products to the market. Extended NETGEAR armor to the Orbi platform. Continued rolling out Meural to new channel partners and growing its content and library. That means successfully recruiting ProAV installers and have made significant progress in converting our installed base to registered users and increasing the number of registered app downlands. I'd like to thank everyone at NETGEAR for making so many amazing things happen in such a short amount of time. During the quarter, as mentioned by Bryan, we saw the 11ac router market decelerate at a higher than expected rate. This poses significant risk to our growth trajectory in the second half of this year. As a result, we're taking strong proactive steps to mitigate this. U.S. consumer WiFi market declined approximately 8% year-over-year compared to being flat year-over-year in Q4 '18. Growth in the mesh systems and gaming routers was unable to fully offset the decline in 11ac routers. As the market leader in consumer WiFi was 50% market share in the U.S., it's up to us to reverse this trend. We must stimulate demand with new technology. And therefore, we have aggressively introduce 2 additional models of WiFi 6 routers at the end of first quarter. Additionally, we recently announced the super premium Nighthawk tri-band WiFi 6 routers coming in May. By next month, we'll have 4 premium WiFi 6 routers on the market, ranging in prices from $199 to $599, which provide a lineup of good, better, best and elite. We will be driving early adoption of these products with increased install marketing spend in the second quarter, which we believe will kick start the transition to WiFi 6. Just as new and much anticipated WiFi 6-enabled smartphones and laptops are hitting the market. We believe this will establish NETGEAR as the early leader in WiFi 6. Our channel partners are aligned with us in this strategy and are looking to NETGEAR to lead the market in this push. Reversing the current market trend is a necessary for us to deliver mid-single-digit growth in the second half of 2019 and to exit the year at double-digit operating margins. New WiFi 6 technology clearly is the best tool to entice consumer demand. While turning the market around will be a challenge, we remain optimistic given the strength of our product lineup coming in the remainder of 2019. Beyond the full WiFi 6 Nighthawks hitting the market in the first half, we will be refreshing the rest of the Nighthawk portfolio with WiFi 6 in the back half of the year, allowing us to address every price point in the market. Furthermore, our WiFi 6 Orbi Mesh products will come to market in the second half of 2019 and future Marvell models. On the cable side of the business, we are going to continue to push our product line forward with 2 technology inflections: the shift from DOCSIS 3.0 to 3.1; and move from 11ac to WiFi 6. Clearly, we have a lot of to look forward to in the product pipeline for the year ahead. Gaming routers continue to be a growth area in consumer WiFi. During the quarter, we debuted the latest addition to our family of Nighthawk Pro Gaming routers at South by South West 2019. The Nighthawk Pro Gaming XR300 is designed to minimize ping and latency no matter what the consumer's gaming preference is, be it Xbox, PlayStation, Nintendo Switch, PC or mobile device. At just $199, it rounds up our Nighthawk Pro Gaming portfolio with good, better and best, so that we now address all types of gamers from the casual to the hardcore. We continue to view gaming as a significant growth opportunity and will continue to invest in this category. The mesh systems also continue to be a growth area in consumer WiFi. A Forbes article published this March wrote that, there is no denying that NETGEAR's hardware is top-of-the-line. If you need a strong, reliable, fast signal, Orbi is worth the money. At Coscto, we recently rolled out Orbi with 1 year or about a month cybersecurity solution bundled into the offering, and look forward to seeing user renewals after the first year of service. We plan to further expand this new category of armor bundled products with more models in more channels throughout the rest of the year. We are excited about the potential of any large number of service subscribers to our install base with bundled solutions such as these. Rounding out CHP, we recently added a digital marketplace to the Meural content library. So now Meural users can purchase and own individual pieces and playlists of world renowned art and photography that they can display exclusively on the Meural digital campuses in their homes. We also continue to grow the content available from Meural and have recently added work from prominent artist like Norman Rockwell, Georgia O'Keefe, Keith Herring, Friedrich Cartlow and Shawn Michelle Bakay. Meural is currently carried in Bloomingdale's, Crutchfields [ph] and at over 20 experiential stores worldwide. During the second quarter, we will be launching the new 21-inch Meural of a lower price point for consumers versus our current 27-inch canvas, which we are very excited about. Meanwhile, our SMB segment had a fantastic Q1, growing 12.5% year-over-year. We saw growth in both switching and wireless LAN during the quarter and are particularly pleased with the growth we've seen in ProAV and PoE switching. Our market share in switches sold through the U.S. retail channel was strong at 58% in Q1. We continue to see ProAV switching as a tremendous opportunity. We have been hard at work recruiting AV installers expanding our channel with global AV equipment manufacturers such as Savant, ZeeVee and Aurora. Our M4300 switches are helping a growing number of AV installers transition from 1080p, HD-base TV to 4K SD video. We're excited about the growth potential here as 2020 Olympics will broadcast a 100% in 4K video. We're heading the world's transition from 1080p to 4K video. You can expect more proAV switches from us in the second half of 2019. Across NETGEAR, we are making progress towards building recurring revenue streams. This is an initiative that we expect will have a significant impact on our bottom line and the stability of earnings in the future. As the -- at the end of first quarter, we had 10.4 million registered users, which represents approximately 40% of our install base. Our registered app user count has grown to 2 million, which is over 200% growth in the short 6 months since September of 2018. We currently have 9 services available on the market and are continuing to role services out across our product portfolio. We remain bullish on the value-creation opportunity of our service initiative. On the service provider side, we had a good Q1 and about $38 million of sales. However, 2 of our major service provider customers significantly called down the demand from 4G mobile Hotspot in Q2. The tune of approximately $13 million, as they are balancing their inventory in preparation for the impending rollout of 5G. Service providers sales have always been lumpy. I would believe that we will be able to recover in the second half of 2019 and maintain our full year target of $140 million of service provider net revenue. I would now turn the call back to Bryan for second quarter guidance.

Thank you, Patrick. As just mentioned, our current quarter forecast for service provider revenue is expected to be down approximately $13 million sequentially. With Q2 seasonality, and the aforementioned WiFi market slowdown, our second quarter forecast net revenue is expected to be in the range of $215 million to $230 million. Given this decline in our top line and the increased marketing spend for our WiFi 6 initiatives, our Q2 GAAP operating margin is expected to be in the range of 0% to 1%, and non-GAAP operating margin is expected to be in the range of 4% to 5%. Our GAAP tax rate is expected to be approximately 28.5%, and our non-GAAP tax rate is expected to be 23.5% for the second quarter of 2019. We expect our operating margin will significantly improve in the second half when service provider revenue and marketing spend should both return to normal levels. With strong new product introductions and a big marketing push in Q2, we hope to return the WiFi retail market to flat or slight growth in the second half of the year. Thus, making possible our objective of growing mid-single digits in the second half of 2019 relative to the second half of 2018. We hope to exit the fourth quarter delivering GAAP operating margins of 8% to 9% and non-GAAP operating margin of 11% to 12%. And deliver double-digit non-GAAP operating margin for the second half of 2019. Operator, that concludes our comments, and we can now take questions.

[Operator Instructions] And your first question comes from the line of Adam Tindle of Raymond James.

I just wanted to start on service provider. I understand it can be lumpy but I think you've talked about, in the past, how you typically get line of sight, maybe 6 or 12 months out. So I'm just hoping to understand maybe first, what changed in the level of visibility there? And why you're confident in that it comes back so quickly? Is it contractual? Is there anything you can help us with? And does get to the $35 million to $40 million in Q3 [technical difficulty] that you talked about in the past?

Well, you hit it right on the head. I mean, the visibility about 6 to 12 months out but it's lumpy. They could order more 1 quarter, not in the quarter, so that's why in the longer-term perspective, we still believe that we're in the $35 million quarter range, which we reconfirmed it just now. It's just that they now -- they want less inventory on the 4G and later on, I mean, they would replenish that. And we [are short-term demand] with 5G inventories as we can see it in the next 6 months.

Okay. So with that coming down, we would think that should help margins from a mix standpoint, but operating margin for 2Q is probably 500 or 600 basis points below what we would have thought. Obviously, there are other variable here, the increase in marketing spend. So just hoping maybe you can help us quantified this? How much is the impact from that? Where does it hit? Is it contra-revenue? And then the timing to normalization, does that spend continue in Q3 and come out by Q4? Just a quantity, where it hits and the timing to normalization?

Well, as a matter of fact, we've been pretty successful in the last few years to correct the profitability of our service provider business, which actually is equal if not better. The profitability than the nonservice provider channel. So a smaller portion or downward drag on the service provider revenue doesn't really increase the profitability because it's similarly profitable for the rest of the business. And we do believe that, in the Q2, we mentioned that the loss of leverage, I mean, if all of sudden, the top line drops so much, we cannot adjust our operating expenses. So that much is by keeping operating expenses flat, that is cutting half of the shortfall. And the other half, you're right, is mainly contra-revenue marketing that we're going to spend. So we're going to have in app, I mean on the web, banner pages and more of the marketing tools online, end caps in the stores, all those are contra-revenue exercises that we're going to pay for. We believe that it's necessary because by doing more of that, we get WiFi 6 more in front of people and when people step up, from a, let's say, 11ac router, which they normally would pay $149 into 11ax router, which would pay -- they pay out $199 or the other cases, 11ac router, they pay for $249 and step up and pay for $399 11ax router. That would basically lift ASP pretty significantly. As we have been doing in the last 3, 4 years, right, our major tool to expand the market, to keep the market from declining is not by reversing the unit decline, it's basically by boosting the ASP. So that strategy we believe has worked for us in the last 5, 6 years and it should work for us in next few quarters.

Okay. And Patrick, I just kind of maybe continue on that thought. I know you tend to be very thoughtful about spending and kind of continuing your thought on the increased marketing spend. Are there key quantitative metrics or results that you're looking to drive on the other side of this to justify this as a good investment? Is there a certain level of revenue growth? Or just give us a view on why it's important for us to hang in there for the other side of this dip?

Well, I mean for us, I mean, it's important to understand we own 50% of the North America WiFi retail market. So you can safely say we are the market. So that means if the market doesn't grow, it's certainly would -- basically make us -- our life is pretty difficult to grow at all. So it is upon us. And so as we said, the channels look to us to really reverse the trend of the market. And as any tech company leaders, I mean, the only way to reverse the trend is by introducing some exciting new products that people will open the wallet for. So I think a good measure of whether this marketing push and these new product introduction that we do, the market will actually have the positive effect that we see, is to see where the market returns to flat, slight growth rather than 8% decline year-over-year and that's a good metric. Because seriously, if the market contract 8% and we own 50% of the market, for us to grow 5% year-over-year, that's a pretty tall order.

Right. I guess one quick one, if I could get 1 in for Bryan. You mentioned you're confident in generating meaningful cash. Obviously, you have a short-term reset here and the stocks indicated down meaningfully. Maybe just talk about how you're thinking about buybacks from here? Is there any prohibiting you from stepping up the level of buybacks? I know you did the $15 million in the quarter but just kind of a potential elevated level if you're confident in the more intermediate term where the market seems to be doubting you based on the after hours?

Yes. The cash for the first quarter is kind of directionally what we had said back in February that we expected to consume some cash in relation to the inventory movement and moving the manufacturing out of China. So we're pleased with that, and we expect that to be online with what we said. In terms of buyback, we will remain opportunistic buyers of the stock, and we've said that consistently.

Your next question comes from the line of Woo Jin Ho of Bloomberg.

Patrick, as you look into the second half, we're still going to require a fair amount of 802.11ac volume to hit better retail numbers. I mean what's your confidence that you can actually see an uptick in demand in 802.11ac in addition to your WiFi 6 efforts?

Well, basically our focus on stimulating the market is really getting people to move into the newer categories. So we have the newer categories such as of Orbi, right, Orbi is 11ac primarily. But we will strengthen that with 11ax Orbi in the second half. Orbi is absolutely a growth factor, and if we could accelerate the growth of that with the addition of 11ac, that will help the market. And then with 11ax, as I just mentioned, 1 for 1. Every 11ac purchase, if it turns into 11ax purchase, it's automatically increase the volume by a one third, the dollar volume by one third, that's pretty significant. So even if only one third of the people who intended to buy ac router become an ax router, we can flatten the market, we don't need to have a declining market. And then on the 11ac front, I think another growth area we have is the gaming router, which we're the only game in town and that's growing very robustly and we just introduce another 11ac gaming router, which is XR300 at $199, of course, pretty high price point compared to an ordinary 11ac router. But again, one more gamer who convert into that gaming router that, again, is a step up of about one third of the ASP. And we do believe that at $199 versus the ongoing $299 entry price point, we will entice quite a bit of people stepping into the gaming router RAM. So we feel pretty confident that with all these there's got to be some movement in the market. And we certainly hope that movement will entail the market back in the flatline or slight growth rather than the 8% decline that we saw in Q1, which certainly is not planned because through our last year it wasn't like that.

Got it. And then in terms of WiFi 6 competitive landscape, I know there are a handful of vendors who are out there; however, your channel distribution is unparalleled. I mean, do you expect to maintain that leadership and flood the market with WiFi 6 products in the second half? I mean we've already seen multiple SKUs, but is that the strategy that you're trying to deploy?

That's exactly what we said in the second half where we'll refresh the entire line of 11ac routers with WiFi 6 at all price points. So if you look at that, right, we already own 3 to 4 space -- show space for our WiFi 6 router and coupled with a new gaming router and then coupled with the 11ax Orbi coming out, there isn't much room for our competitors to get any shelf space.

All right. And in terms of the mobile Hotspot in the service provider opportunity here, you have your 5G Hotspot with 1 service provider. Is the thought in terms of the improvement of service provider in the second half more along the lines of an expansion to other service providers? Or is it channel refresh out with the -- your 1 particular service provider?

No. We do believe that our -- the current 5G deployment is relatively limited because the coverage is very, very limited and the initial model of the chipset from Qualcomm as well as our companion system that we produce are pretty expensive. So it will be the next generation of 5G mobile Hotspot with a more extended network that will really enable the uptick of the 5G mobile Hotspot. Then we expect more than 1 operators will roll out 5G mobile Hotspots towards the end of the year.

Got it. And then one last one for me in terms of the second half margin commentary. How much of that is -- I understand that revenue is going to be the principal lever here, but do you expect a gross margin improvement, 33.3% for the first quarter, it's fairly nice for you guys. Is that going to be something that is sustainable going forward?

Yes. We try to focus everybody on operating margin rather than gross margin because the gross margin is affected by whether we do contra-revenue marketing or we just do TV advertising. So it -- I think it's the bottom line that's important. We've done the financial models, and in the second half, if indeed the market kind of retracts from negative 8% decline to a more favorable environment, then we feel pretty confident that we would be able to deliver double-digit operating margin. Now within that framework, I mean how we're going to spend marketing dollars, how are we going to do the product mix will have a significant impact on the gross margin, so we rather not focus on the gross margin but on the operating margin.

[Operator Instructions] And our final question comes from the line of Hamed Khorsand of BWS Financial.

Just first want to start off with that comment you said earlier about the -- your Brexit partners, the concern there. It's not showing up on your distribution channel line, right? And so if it -- was it all service provider related?

No. It's distributor related in the U.K. Now we did not split out the distributors by country, so it's kind of lumped into -- is lumped into the overall European distribution, yes.

Correct. But it's down from 4.1, it's now 4.0, and it was 4.1 in December.

That means somebody's not taking enough inventory, like the Germans.

And that's what I was trying to get to is how much of this is a balancing act in Q2 with the guidance you're giving?

No. I mean we've taken that into account. We certainly have to help this distributor. But then again, Brexit is not going away. I mean they're talking about May, so they're not going -- they are going to hold on to their inventory until Brexit is a little bit clearer.

And is there I mean -- I would imagine you have some controls over there. Are you monitoring that situation so you're not too exposed to something like this from the lumpiness standpoint?

No. I mean, I think by managing overall distribution channel inventory, then we know how to smooth it out, right. We certainly have no control on Brexit.

And then on your commentary about the WiFi slowdown, is much of that you anything to do with Amazon buying Eero at all and having impact in your business?

No, I mean Eero transaction wasn't closed until end of March, so they had no effect. And furthermore Eero doesn't play in the 11ac router market, they're mostly in the mesh market. So our suspicion is more like people waiting for WiFi 6, all right. They basically say, "Gee, there's a big technology transition going on here." It's pretty much like a long period in August, September, for iPhone sales that people waiting for the new iPhones to launch.

And my follow-up question is just given that there is this transition going on, are you exposed to having to discount inventory a lot from here?

No. I mean we have been managing inventory quite well. So we certainly hope not. All right, our operations team is first rate, and they have been very successful. And so we believe that we don't need to discount significantly and that's why we just say that we're focusing on really getting WiFi 6 to be very successful, enticing consumer demand get the markets back to flat or slight growth and then we will have a very good second half.

There are no further questions at this time. I'll turn the call back over to Patrick Lo, CEO.

Thank you for joining today's call once again. We're very pleased with the successful quarter 1 that we just had and are excited about the opportunities that lie ahead, such as the increased WiFi 6 adoption, our subscription services push, the Nighthawk Pro Gaming, secured WiFi routers and mesh, the new 21-inch Meural, the ProAV switches and the rollout of 5G. And I look forward to updating you all again on our second quarter earnings call in July. Thank you.

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