NETGEAR, Inc. (NTGR) Q2 2019 Earnings Report, Transcript and Summary

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 of 2019, which is down 6.3% from the prior year comparable quarter and down 30.6% quarter-over-quarter. The year-over-year decline is all due to the downturn in Australia, both in currency and market demand, while the sequential decline in APAC net revenue was due to reduced service provider sales and typical Q2 seasonality. For the second quarter of 2019, we shipped a total of approximately 3.4 million units, including 2.4 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 1.4 million units for the second quarter of 2019. The net revenue split between home and business products was about 73% and 27%, respectively. The net revenue split between wireless and wired products was about 67% and 33%, respectively. Products introduced in the last 15 months constituted about 27% of our second quarter shipments, while products introduced in the last 12 months contributed about 19% of our second 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 second quarter of 2019 was 28.8%, which is down 300 basis points compared to 31.8% in the prior year comparable quarter, and down 450 basis points compared to 33.3% in the first quarter of 2019. The year-over-year decline in gross margin was driven by our investments in channel marketing activities as well as an impact from the strengthening of the U.S. dollar. Total non-GAAP operating expenses came in at $56.3 million, which is down 20.1% year-over-year and down 6.4% sequentially. As always, we manage our expenses prudently, while also investing appropriate resources to the growth portions of our business although they have the support they need to succeed. Our headcount decreased by a net of four people to 824 heads as of the end of the quarter. Our non-GAAP R&D expense for the second quarter was 7.6% of net revenue as compared to 8.2% of net revenue in the prior year comparable period and 7.1% of net revenue in the first quarter of 2019. 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 non-GAAP tax rate was 21.8% in the second quarter of 2019. Looking at the bottom line for Q2, we reported non-GAAP net income of $8.9 million and non-GAAP diluted EPS of $0.28 per diluted share. Turning to the balance sheet. We ended the second quarter of 2019 with $218.3 million in cash. During the quarter, we generated $27.3 million in cash flow from continuing operations, which brings our total cash used in continuing operations over the trailing 12 months to $45.9 million. We used $3.5 million in purchase of property and equipment during the quarter, which brings our total cash used for capital expenditures over the trailing 12 months to $15.8 million. As always, we remain confident in our ability to generate meaningful levels of cash. In Q2, we spent $17 million to repurchase approximately 570,000 shares of NETGEAR common stock at an average price of $29.80 per share. Since the start of our repurchase activity in the fourth quarter of 2013, we have spent approximately $484.8 million to repurchase approximately 13.4 million shares. Our fully diluted share count is approximately 32.1 million shares as of the end of the quarter. Our Board of Directors has authorized the repurchase of up to 4.5 million shares or approximately 14.5% of our common stock outstanding. This brings our total shares available for repurchase to approximately 5 million shares when including the remaining amount on our previous authorization. We plan to continue to opportunistically repurchase our stock in the quarters to come. Now turning to the results for our product segments. The Connected Home segment, which includes the industry-leading Nighthawk, Orbi, Nighthawk Pro Gaming and Meural brands, generated net revenue of $167.5 million during the quarter, which is down 10.2% on a year-over-year basis and down 1.1% sequentially. The year-over-year decline is due to reduced service provider revenue for Connected Home, which is down $19.4 million from Q2 2018. Our market share in consumer WiFi continues to be strong at 51% for the second quarter, which is an improvement over the prior quarter. The SMB segment generated net revenue of $63.4 million for the second quarter of 2019, which is down 8% on a year-over-year basis and down 20.5% sequentially. As mentioned on our prior calls, SMB benefited from increased shipments in Q1 to the U.K. ahead of the originally scheduled Brexit deadline. And as expected, we saw a normalization of shipments into the channel in the second quarter. Meanwhile, Our PoE+ and ProAV switching lines continue to perform well in the market. Our market share in switches sold through U.S. retail channel was also strong at 55% for the second quarter. I'll now turn the call over to Patrick for his commentary, after which I will provide guidance for the third quarter of 2019.

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 selling Orbi bundled with one-year of NETGEAR Armor service at Costco and look forward to seeing these users renew after the first year of service. We are continuing to expand this new category of Armor bundled products with new models coming to market such as the recently announced Nighthawk cyber-secured AC2300 WiFi router. We have been encouraged by the reception that Armor has received with consumers worldwide, and we believe that our solution is solving a critical need in today's environment where data security and cyber attack prevention of in-home devices is our priority. Beyond Armor, we continue to make progress with our initiative to build recurring revenue streams. This is especially important as we expect that it will have a significant impact on both our bottom line and the stability of NETGEAR's earnings in the future. At the end of the second quarter, we have approximately 11.2 million registered users, which represent approximately 45% of our estimated install base. Our registered app user count has grown to 2.8 million, which represents approximately 40% sequential user growth over the prior quarter. We remain very excited about the transformative value-creation opportunity of this initiative. Rounding out CHP. During Q2, we expanded our gaming product lineup with the first Nighthawk Pro Gaming Mesh WiFi System. This new Mesh WiFi Systems for gamers consist of a prepared pro gaming WiFi router and a tri-band mesh extender, which together deliver a high-performance gaming experience throughout the home. Additionally, we continued our rollout of the Meural digital campus, most recently debuting it on HSN in May. We look forward to continuing to build both of these premium consumer brands in the quarters to come. Turning to the SMB segment. As Bryan mentioned, during Q2, we saw the U.K. channel digest the inventory that was purchased in Q1 ahead of the anticipated Brexit deadline. As of the end of the quarter, U.K. channel inventory had returned to healthy levels. We continue to be pleased with the growth we are seeing in ProAV and PoE+ switching. Our market share in switches sold through U.S. retail channel was strong at 55% in Q2. At this year's InfoComm 2019, we announced new additions to our suite of M4300 switches that are specifically designed to streamline AV over IP and eliminate complexity in AV deployment. One of these switches is the M4300-16X, the world's first 16-port 10GBASE-T copper switch which can deliver PoE+ across all ports. Lower cost, increased distance and a wider range of applications are rapidly shifting AV distribution to Ethernet networks instead of HDMI. And as an industry leader in AV over IP networking, NETGEAR is positioned to lead in this space. Furthermore, we announced a partnership with ZeeVee in creating an HDMI connection module for our M4300 series switches. We remain very excited about the growth potential of ProAV, especially at the 2020 Olympics, which will be broadcast in 100% 4K video. In summary, we effectively navigated a challenging quarter and are now looking forward to the usual seasonal lift in the back half of the year. I will now turn the call back to Bryan for the third quarter guidance.

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.