Good afternoon. My name is Rob, and I will be your conference operator today. At this time, I would like to welcome everyone to the NETGEAR Second Quarter 2019 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be question-and-answer session. [Operator Instructions] Thank you. Mr. Chris Genualdi, Director of IR, you may begin your conference.

Thank you, operator. Good afternoon, and welcome to NETGEAR's second 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 second quarter provided by Bryan, followed by details and commentary on the business, provided by Patrick, and finish with third 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-Q. Any forward-looking statements that we make on this call are based on assumptions as of today, and NETGEAR undertakes no obligation to update these statements as a result of new information or future events. In addition, several non-GAAP financial measures will be mentioned on this call. A reconciliation of the non-GAAP to GAAP measures can be found in 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 second quarter of 2019 came in slightly above the high end of our guidance range for revenue and in line with the range for non-GAAP operating margin. We saw improvement in the U.S. retail WiFi market during the quarter, which was driven by the continued rollout of WiFi 6 Nighthawk routers and our various channel marketing activities. Overall, NETGEAR net revenue for the second quarter ended June 30, 2019 was $230.9 million, which is down 9.6% on a year-over-year basis and down 7.3% on a sequential basis. As discussed on our prior earnings calls, the decline during Q2 was driven by several factors: reduced service provider spending ahead of 5G rollout; increased channel marketing to counter a slowdown in the U.S. market for the legacy 11ac routers; normalization of the EMEA channel following a Brexit-driven U.K. sales pull-in during Q1; and second quarter seasonality. Looking ahead, we expect service provider revenue to rebound in Q3 to more normal levels and expect to benefit from Q3 back-to-school seasonality. I'll provide more detail on Q3 when I discuss our third quarter guidance. NETGEAR net revenue by geography reflects the Q2 headwinds I just mentioned. Net revenue for the Americas was $157.2 million, which is down 9.9% year-over-year driven by a decline in service provider revenue and up 6.2% on a sequential basis. EMEA net revenue was $43.1 million, which is down 10.6% year-over-year and down 24.4% quarter-over-quarter. The year-over-year decline is due to a reduction in service provider revenue and FX headwinds with the U.S. dollar strengthening, while the sequential decline is due to normalization of the EMEA channel following a Brexit-driven U.K. sales pull-in during Q1. Our APAC net revenue was $30.6 million for the second quarter…

Thank you, Bryan, and hello everyone. While the second quarter of 2019 was challenging on both on the topline and bottom line, we were successful in improving the U.S. retail WiFi market with our continued rollout of WiFi 6 Nighthawk routers in our various channel marketing activities. Additionally, as Bryan just highlighted, we expect service provider revenue levels to return to the normal quarterly run rate in the third quarter and expect to benefit from the typical Q3 seasonal lift driven by consumer back-to-school retail spending. We remain bullish on our opportunities in WiFi 6, gaming, 5G, rolling our services to our installed base and opportunities for SMB like ProAV and PoE+. As shared on our prior earnings call, during the first quarter of 2019, we saw the U.S. consumer WiFi market decline approximately 8% year-over-year. That decline moderated to approximately 4.5% during Q2, driven by the WiFi 6 activity that we undertook during the second quarter. We'll be releasing additional premium WiFi 6 Nighthawk routers during the current quarter as well as a new WiFi 6 Orbi Mesh system. We expect to have the entire Nighthawk lineup refreshed by the end of the year, furthering the transition from legacy WiFi products to new WiFi 6 products. As you can see from the online reviews, our currently available WiFi 6 routers have been incredibly well-received, and we are very excited about the additional WiFi 6 products we're building in the second half of the year. We also recently launched NETGEAR Armor Cyber Threat Protection to our global Orbi Mesh WiFi install base. We have been very encouraged by the initial traction with trial users. For the existing Orbi install base, we're now offering a free limited period trial of Armor made available through the Orbi app. Meanwhile, we are also…

Thank you, Patrick. Looking out to the third quarter of 2019, net revenue is expected to be in the range of $265 million to $280 million, which reflects the strong back-to-school season for consumer retail, a return to more normal revenue levels for service provider and a sequential rebound for SMB. GAAP operating margin is expected to be in the range of 5.2% to 6.2% and non-GAAP operating margin is expected to be in the range of 8.5% to 9.5%. Our GAAP tax rate is expected to be approximately 25%, and our non-GAAP tax rate is expected to be 22% for the third quarter 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 from Raymond James. Your line is open.

Okay. Thanks and good afternoon. Pat, I just wanted to start with a high-level question on the WiFi 6 upgrade cycle. Can you maybe just speak to your observations of this cycle versus previous cycles and maybe just compare the cadence? Is this a burst or a longer, milder tailwind and the magnitude in this lift due to that mid-single-digit growth profile you talked about the – at the Analyst Day as it materializes, so the cadence and magnitude of WiFi 6, and then I have a follow-up. Thanks.

I believe this WiFi 6 upgrade is significantly more appealing than the previous upgrades. This is akin to replacing a 2-lane freeway with a 8-lane freeway. And at the same time, the ownership of cars has exploded from 5% penetration of the household into 60% penetration of the household. You get more cars, and now you're welcoming a new multilane freeway. But we believe that the transition is going to be really, really rapid and in earnest. So normally, in previous cycles, it would take about five years to complete the transition, but I think in this cycle, it probably would take shorter. Plus, there is more variations to the WiFi 6 because we just only come out eight streams, eight lanes right. Theoretically we can go all the way up to 64 lanes. So there's a lot of headroom to go. And because of the OFMD protocol, there's a lot that we could play with to offer various things like cars, you can get turbo. You get the normal one. You get the fuel injection. Now you get the light rig. So it's a very exciting time.

Okay. That’s helpful. And maybe just as a follow-up for Bryan in light of this. I mean we're going to see the impact in the CHP segment, particularly ex-service provider. And at the last Analyst Day, you had talked about a seasonality for CHP ex-service provider up 11% in Q3 and up 14% in Q4 on a sequential basis. I think based on the guidance here, Q3 is going to be north of that. So I'm just trying to understand maybe how we can think about CHP ex-service provider seasonality in Q3 and in particular in Q4, given the changes as there's maybe a little bit more heavier weighted to Q3 and we don't see 14% in Q4. Just some help there would be helpful.

Yes, sure. I would say that we actually believe that we will see that normal seasonal trend in both Q3, Q4. Obviously, our Q3 guidance includes a return to a more normal level for service provider, which is obviously driving some of that sequential growth implied in the guidance. But from a CHP non-service provider, if you look at the last four or five years, we’ve typically seen about a 15% increase going into Q3, which we believe is about right. And in Q4 seasonality, we typically see about a 12% lift from Q3. And again, I think we remain confident, given the product pipeline, the success that we're seeing with the WiFi 6 adoption, that we'll see that continue at Q4 of this year.

Okay. Maybe I'll have to tweak up my Q3 SMB assumption then. Just one last follow-up. You had mentioned in the prepared remarks that you continue to invest in R&D. Previously, you had a goal to exit 2019 for operating margins in the 11% to 12% range. Is that still on track? Because I think that would also imply a pretty healthy jump from Q3. So is that still on track? Maybe the buckets in that assumption.

Yes. We remain confident that we can exit this year between 11% and 12%. Obviously, the seasonal lift on top of Q3 that you see in Q4 will help in that respect. But yes, we do remain confident that 11% to 12% is in reach.

Okay. Thank you very much.

And your next question comes from the line of Brian Yun from Deutsche Bank. Your line is open.

Hey guys, just a question on the SMB segment, maybe a broader question. Can you share with what you're hearing from your sales force or your sales channels? Where you're seeing pockets of strength and any headwinds that we should kind of be aware of in the second half of the year?

Clearly on the SMB side, I think we're seeing strength, both on the online channel as well as the traditional value added reseller channel. And as more and more of the sales, especially for small business installation, our products are pretty much do it yourself. It's very easy, especially now with a insight app. So we've seen more and more people just go online, buy them either through Amazon or through CDW. And they just bring it to their small business and set it up using these apps to control it. So we're seeing very good strength on that one. And then among the VAR channels, we have been focusing on the few industries that, that we see a lot of small VARs servicing a huge broad swath of industry, which is exactly, to our liking. We mentioned the two things and at the ProAV there is a huge movement in the market that the traditional HDMI audio-visual installers, because of the arrival of 4K video, that they are moving over, to audio visual over IP using that network. So that's a new breed of value-added resellers and installers that we are going to recruit. And they're very fragmented, I mean, they would range from installers who outfit at sports bar, to a theater, to maybe the Apple campus. So they vary in sizes, and they have never known Ethernet before. And we are very engaged with them, as I mentioned, in InfoComm and in many of the industry that specifically tailored to these installers. So we're seeing very good activity in there. The other one is in the IP surveillance market. I mean, as I mentioned the last time in the earnings call, I mean, unfortunately the world is getting scarier and scarier, and so IP surveillance is a big industry. Again, I mean, you have installers of IP cameras, big and small. And traditionally, as you probably know, security cameras run over DVR and it was linked through the video cable, but more and more, it's cutting over the Ethernet and cutting over to IP. And again, I mean, we are retraining these installers who would be able just doing a coffee shop or a small little 7-Eleven stores in Japan, doing a few cameras to a big apartment complex that spans about 600 apartment units and with cameras everywhere, even to banks. So we're seeing very active VAR activities. As a matter of fact, we see tremendous momentum in the VAR channels in second quarter, actually even more so than the other line channels. So we're very encouraged by these two particular verticals that we're going in. And we believe that those are offering really exciting opportunities for us.

Great. Thanks for that color. And then can you just expand on the reason for the gross margin decline this quarter? Are the channel marketing activities is that going to last for a few quarters? Or is it more of a onetime event?

You're right. It's the channel marketing activities that are the primary driver of the decline in gross margins, a little bit of FX headwinds when you're talking year-over-year. The Euro was down roughly 7%. In terms of how we expect those activities to go forward, I think we said it on the last call that we were – essentially, Q2 is typically a quite quarter. There's not a lot of promotional activity going on, but we pull that forward and we started to do it in Q2. In Q3, I would expect to be in kind of in the normal range for those back-to-school promotional activities.

And your next question comes from the line of Hamed Khorsand from BWS Financial. Your line is open.

Hi. First off, could you talk about the gross margins that surely being dependent on a lot of promotional activity in the quarter? And how will that trend now going into the second half of the year?

And as I've mentioned, the year-over-year impact is meaningful. We talked in April about the need to correct the U.S. WiFi market, which in Q1 we saw a declining 8% year-over-year. And so we employed a number of activities to really push our WiFi 6 products that we're rolling into the market. And go forward, we expect those promotional activities can get back in line with what we normally see in the back half of the year, which we see the lift with back-to-school, and then going into Q4 with the holiday promotional period.

Okay. And then on that topic as well, is that promotion activity essential for reducing your inventory balance? Its up considerably compared to this time last year?

Inventory, we took on some additional chipset to really buffer for the long-term, especially as we move some of the factories in the first half of the year out of China for production from goods coming into the U.S. We expect to work that inventory back down, as we've become more rooted in these new locations. So I don't think there is any concern with our inventory position.

And just given back to the promotion activity, is there any concern that there might be some push back with consumers as you introduce new products, the higher price points?

I don't believe so. In fact, I think we've seen very good reception on our higher end, WiFi 6 routers in the market. You can look at the reviews that are out there. We've been very pleased with the market reception of those higher priced routers.

Okay. Thank you.

And your next question comes from the line of Woo Jin Ho from Bloomberg Intelligence. Your line is open.

Great. Thanks for taking my questions. So the Connected Home ex-service provider in the second quarter held up a little bit better than I had thought. What was it primarily because of the WiFi 6 and the Orbi activity and offsetting some of the softness that you guys had anticipated on the single access point? Or has single access point routers held up a little bit better than you had thought?

Well, I mean is actually contrary what you just mentioned. Q2, definitely we see a healthy activities on the single point routers, because they were augmented by the WiFi 6, which as Bryan just mentioned the most popular ones are the $400 – $500 WiFi 6 routers. While on the mesh system side, because it's still on WiFi 5 and there is no WiFi 6 SKUs at all from us, nor from our competitors. So that market is on a wait and see basis. So it's a matter of fact the single point routers perform relatively better now in Q2, than the mesh system versus our plan. Yes.

Okay. And then in terms of the service provider normalization, is that typical channel fill that you are anticipating as it relates to some of your WiFi 6 products? Or is there anything else that's going on?

As we mentioned, the service providers are two, three years behind. So they are not going to pull-in WiFi 6 anytime soon. So no, I mean, Q3 is just the good old normal 4G mobile hotspot, 11ac gateways and 11ac, the WiFi 5, Orbi, it's the same old stuff.

Okay. And then if – think or look at your CHP business going into the second half, how much of that will be new product driven and additional skew driven versus volume driven of existing WiFi 6 products that came out in the second quarter?

I mean, we just mentioned, right, the percentage of products that shipped in the last 12 months is 19%. So that percentage of fluctuate on a good quarter of 25% – not so good quarter of 15%. So right now is at 19%. We do expect that percentage to perk up in the next two quarters. So that's a good indication how much are from these new price, how much from the legacy products?

Great. And then lastly for me, in terms of the U.S. retail channel, that's been fairly robust over the last couple of quarters. How should I think of that, especially given that you have new products that are coming online going into second half?

Well, as a matter of fact, I mean, we were a little bit disappointed by the retail channel performance in Q1. And even Q2 has improved; it's still below the trend line. The U.S. retail WiFi market was pretty much flat all through last year, and we thought that we will be able to maintain that. And clearly, we were wrong with our very strong WiFi 6 portfolio across the entire WiFi line, including single routers, including Mesh Orbi, including extenders that we saw even in Q2, it's still declining at a negative 4.5% year-over-year. However, with Q3, with more WiFi 6 routers are coming out and the first Orbi WiFi 6 coming out. We do expect the second half of the year, the U.S. WiFi markets decline will moderate even further or maybe even back to flat or slight growth.

Okay. Thank you, gentlemen.

[Operator Instructions] And there are no further questions at this time. I will turn the call back over to Patrick Lo for some closing remarks.

Great. Thank you everyone for joining today’s call. We're pleased with how we navigated and challenging the second quarter. And we are very excited about prospect across the business in the second half of the year. I look forward to updating all of you on our next earnings call in October, talk to you. That's it. Thank you.

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