Ladies and gentlemen thank you for standing by and welcome to NETGEAR fourth quarter 2019 results conference call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions]. I would now like to turn the conference over to your speaker today, Erik Bylin. Thank you. Please go ahead, sir.

Thank you David. Good afternoon and welcome to NETGEAR's fourth quarter and full year 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 we will start with a review of the financials for the fourth quarter and full year provided by Bryan, followed by details and commentary on the business provided by Patrick and finish with first quarter 2020 guidance provided by Bryan. We will then have time for any questions. If you have not received a copy of today's press 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 the 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 forward-looking statements as a result of new information or future events. In addition, several non-GAAP financial measures will be mentioned on the call today. A reconciliation of the GAAP to non-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 Erik and thank you everyone for joining today's call. Net revenue for the fourth quarter ended December 31, 2019, was $253 million, near the top end of our guidance range, but down 12.4% year-over-year and down 4.8% on a sequential basis. As anticipated, we saw visible quarter-over-quarter declines in the Greater China region, while all other regions enjoyed the seasonal holiday boost from an end-user demand perspective. We were able to take the initial step of adjusting channel inventory worldwide to prepare for the strong push to WiFi 6 in 2020. For the full year 2019, NETGEAR net revenues were $998.8 million, which was down 5.7% compared to the year ended December 31, 2018. As presented at our Analyst Day this past November, we are committed to growing our top and bottom lines going forward with our strategy of delivering leading products during technology inflections, expanding into new adjacent markets and developing a robust subscription revenue stream. We saw early success in Q4 in WiFi 6, Pro AV and subscriber growth and we will continue to push in these directions in 2020. We remain confident our strategy will pay off in the years to come. Our non-GAAP operating margins for the fourth quarter came in at 4.4%, just below the low end of our guidance range. It was a very competitive holiday season due to the arrival of a new competitor in the U.S. We were prepared for this and we took advantage of additional opportunities to promote products to increase our market share and generate revenue. We feel confident that in 2020 we will improve our non-GAAP gross and operating margins throughout the course of the year as we benefit from our production outside of China reaching full efficiency which will remove the cost headwinds we felt…

Thank you Bryan and hello everyone. We are excited about the progress we have made in the fourth quarter along the three pillars of our growth strategy. We were the first to debut WiFi 6 Mesh which garnered a strong reception and we accelerated growth and market shift to Power over Ethernet Plus technology in switching. We also debuted the new 21-inch Meural digital Canvas worldwide and we won the first Pro AV project for the 2020 Olympics during the quarter. On the paid service subscriber side, we increased our subscriber total to 177,000 with strong sequential and year-over-year growth and we are in a race now to double that count in 2020. We kicked off the holiday selling season with our top of the line WiFi 6 tri-band Orbi Mesh at $699 for two nodes. It was well received worldwide by both the tech press and consumers. Many reviewers commented that it is the fastest and best WiFi money can buy. We are proud to quickly follow that offering up with the Nighthawk WiFi 6 dual-band mesh at $229 for two nodes in early January for our consumers with smaller homes that desire fast WiFi in every corner of their house. Our industry-first WiFi 6 DOCSIS 3.1 cable gateway won the CES innovation honoree award in Las Vegas in January. Our strong line-up of leading-edge technology and well-executed promotions in Q4 allowed us to continue to gain share in the all important North America retail market. We had a very successful CES in Las Vegas in January. Beyond showcasing the products that I just mentioned, we also introduced a new WiFi 6 extender, the second in our line-up plus a new second generation 5G mobile router that will include WiFi 6. We now have a comprehensive line-up of WiFi…

Thank you Patrick. Our net revenue for the first quarter is expected to be in the range of $205 million to $220 million. We currently believe that our service provider revenue will be approximately $25 million on average per quarter for the first half of 2020. We would expect it to return to $35 million per quarter on average in the second half of the year, when 5G deployments gain more momentum. In addition, we expect to continue our efforts to rebalance the channel inventory mix towards WiFi 6 in the first quarter of 2020. GAAP operating margin is expected to be in the range of negative 1.8% to negative 0.8% and non-GAAP operating margin is expected to be in the range of 2% to 3%. Our GAAP tax rate is expected to be approximately 16% and our non-GAAP tax rate is expected to be 25% for the first quarter of 2020. Operator, that concludes our comments and we can now take questions.

Thank you. [Operator Instructions]. Your first question comes from the line of Adam Tindle with Raymond James. Your line is open.

Good afternoon. This is Madison, on for Adam and thanks for taking my questions. Patrick, there are only a few competitors out there with WiFi 6 products in the market and most notably, the larger players have yet to introduce this new standard into their product but have chosen to be more aggressive on pricing of legacy technology. So as you think about this upgrade cycle versus prior ones, do you think this heavy discounting of legacy products is affecting the cadence of the upgrade cycle versus prior years? And maybe if you could add any more details kind of comparing and contrasting this cycle versus prior ones?

We don't believe so. I think it is pretty typical that in the first six months to 12 months of the upgrade cycle, it will primarily be early adopters, the technology leaders, as well as those consumers, who absolutely need the fastest speed of the WiFi. So, that's why we introduced our products still mainly in the high end. On the router side, our most popular WiFi 6 routers are $300 and above. Similarly for the WiFi 6 Mesh. So those are not really contested by any of our competitors and we are really pleased with the adoption of those WiFi 6 products. As a matter of fact, I mean, we looked at the WiFi 6 router market because of the introduction of our WiFi 6 routers, even though there is serious competition, especially in price in the lower end, we were able to see our router market share as well as our router end market demand to be growing. So we believe that the discounting in the legacy product is out of desperation from some of our competitors. But actually it would not deter the early adopters and the technology leaders us to adopt WiFi 6. Now, as we progress, of course, we will have more WiFi 6 products that will span lower price points. And then the mass market will be able to look at with a low delta premium, they would be going to WiFi 6 as more and more of the phones and tablets and PCs around the world are switching over to WiFi 6. I think this transition will actually be faster than before from multiple angles because the cellphone, the tablets and the PC providers like to see the upgrade cycle. And for us, of course, we would like to see the upgrade cycle and the channel partners also would like to see the upgrade cycle. So our estimate is this probably would be one of the fastest transitions. And we believe that by Christmas this year, WiFi 6 products in the market will constitute more than 50% of the overall market.

Okay. Thanks for all the color there. And then just a follow-up for Bryan. At the Analyst Day, you laid out a target to get to 8% to 9% operating margin in 2020. It looks like based on guidance that it seems like that's going to need to be reset here. So can you just help us with how we can think about the progression of improving operating margin from here? And you are starting, obviously at a much lower point this year in Q1 than last year. So do you think it's plausible that you can actually see operating margin expansion year-over-year? Thanks.

Yes. And we definitely believe we will see margin expansion this year as we laid out in November. A lot of that will come from the removal of the tariffs and the inefficiencies that came with migrating our supply chain to the tune of 240 basis points. So we expect to see that margin expansion. And we still think that we can see the growth of the low to mid single digits on the topline and the operating margin target that we put out there. Clearly in the first quarter, with the reduced service provider revenues, which are kind of coming down, call it $10 million or so off of the most recent run rate of $35 million on average per quarter, coupled with our need to continue to shift the channel inventory mix towards WiFi 6, we are losing some topline leverage in the first quarter, which is the culprit and the reason the operating margin is at the 2% to 3% range. But we do expect to see margin expansion as we move through the year. And as we take these efforts in the first quarter to continue to shift the mix towards WiFi 6, I expect that we will see a little bit of a lift in Q2 in our revenues where normal seasonality for CHP, excluding the service provider, would be flat. I do expect that we will see a mid to high single digit growth there as we execute the majority of this channel shift in Q1.

Okay. Thanks again for the details, guys.

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

Hi. Thanks for taking my call. Just help us understand why is it so important to drive revenue gains when operating margin seem to be going in the wrong direction?

Well, I think is important that we continue to move the market to WiFi 6. And as we do that, we naturally gain share and also gain shelf-space and also gain the number of customers we are acquiring, which form the basis of our service subscription revenue drive. So we believe that this is a short term thing as we work through the cost overhead that's thrown at us by the trade war and the tariff. But we do believe that we would quickly get back on to the operating margin growth. So in the short term, it seems like the paths are divergent. But actually if you look beyond a quarter or two, the path will be converging again. We are very confident of that.

Okay. Just related to that, help me understand on the WiFi 5. It seems like that inventory level is remaining pretty much the same? Or is it going down as your focus is still on WiFi 6, regarding moving the WiFi 5 products?

Well, the WiFi 5 inventory in the channel as well as in our own inventory is definitely going down. But it's not going down as fast as we originally anticipated in Q4 because as we mentioned, we actually get some open additional promotional slots for WiFi 5 in Q4 from some of our channel partners. And then we took advantage of that and in order to do that, we shipped more of WiFi 5 products into the channel. So that's why we are going to continue to do that adjustment in Q1. And we saw a positive tick up in our market share in the U.S. So right now, we are in a very good position to really occupy more shelf-space and thus be able to display more of our WiFi 6 products which will lay the groundwork for us to continue to improve our operating margin as well as our market share and topline as we progress through 2020.

And you talked a little bit in the prepared comments about competitiveness in Q4. Where are you seeing that competitiveness? And how is that translating into your product offering in your price points?

Well, the competition primarily comes from two areas, right. One is from shelf-space. And needless to say, everybody knows who that competitor is, that's Amazon's Eero. The competition on shelf-space is both on its own Amazon website as well as in Best Buy. And the competition in price is naturally because they get pretty aggressive as we have seen in all the other hardware products that they put out, from the Fire TV to the Ring cameras to the Echo Dot. Every time they come into the market, they come in with pretty aggressive pricing. We anticipated that. So for us, it's important that we hold our share so that we can hold our shelf-space and better yet that we could expand our shelf-space. Then we will be able to bring out both WiFi 5 to compete with them as well as WiFi 6, additional shelf-space for WiFi 6. From a market share gain perspective, this strategy worked in Q4 and we do believe that it would pay off as the year progresses.

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

Hi. Thanks for taking the question and apologize for any background noise. But I think this is the first quarter where you actually provided paid service subscribers in your presentation at 177,000. So I was just wondering if there is any additional quantitative metrics that you might be able to share there, whether that's ARPU, general growth rate expectations, maybe subscriber churn? Any color there would be helpful.

Yes. Actually, see, it's our second time. I mean, we disclosed the subscriber number on our Analyst Day back in November last year. At that time, it was mid-November, it was 150,000 subscribers. So from between then and end of December, we added another 27,000. And we just, in our prepared remark, we said that our aim is going to double that number. That 177,000, we want to double that this year. That, of course, include the churns of the existing 177,000. We have a good plan and we believe that we could execute on that. Right now, we do not have break up of further details, because still even at even 350,000-plus, I think the revenue impact and the bottomline impact would not be very material. But I think once we reach closer to 0.5 million subscribers, then it would be meaningful and we will start disclosing more numbers in terms of ARPU, churn rate, et cetera.

Okay. Great. And then, just on the weakness that you saw in China, can you expand and give us a little bit more information there? And just how long do you kind of anticipate these headwinds to last?

Well, I mean, so first and foremost, it's the trade war. And the trade war basically put a lot of damper in Chinese state-directed economy to purchase American enterprise networking goods. So our SMB products which used to sell into a lot of Chinese state entities such as schools, universities, manufacturing, have declined pretty significantly. Secondly from the consumer basis, there was a time that there were some intention to buy China rather than buying American. Fortunately that phase has passed by. Unfortunately, that now we are confronted with this Coronavirus. So, those are the two headwinds we are facing in Mainland China. And then in Hong Kong, everybody knows that Hong Kong ever since July of last year has been in significant social unrest. And it's just not many people out in the street and shopping. So that really affects both our SMB and consumer business. So at first, we thought that with the first phase of trade agreement signed, with the blow-over of buy local for the consumers kind of passing away, things will get better. But now with the new outbreak of Coronavirus in both places in Mainland China and Hong Kong, then we cannot count on that upswing.

Okay. Thank you.

[Operator Instructions]. Your next question comes from the line of Paul Silverstein with Cowen. Your line is open.

Thanks Patrick and Bryan. I appreciate you taking the questions. I have got several that are of a clarification nature. First off, did I hear you correctly that you are expecting Q2 to go back to year-over-year growth? Bryan, I thought I heard you say on the order of 5% to 10% [but maybe I misheard or misunderstood.

Yes. What I referenced is actually sequential growth, talking about the seasonality of our consumer business when you exclude service provider revenues. Typical seasonality, you would see Q2 flat to Q1. But as we said, we are taking some efforts in Q1 to further shift the mix in the channel to WiFi 6. And thus, we actually think that we will see sequential growth in that portion of the business to the tune of mid to high single digits.

Got it. I appreciate the clarification. So when do you think you will see return to year-over-year growth? Has your thinking changed on that issue?

We definitely expect to see year-over-year growth this year. I think it could be as early as Q2. But certainly as we go into the back half of the year, we will see it.

Okay. And then with respect to your commentary about market share and I think you answered the question in your last response or the response before. But when we are talking about enterprise-focused company, obviously market share is critical in terms of translating future revenue. When we are talking about retail customers, where the one-time buy until the next iteration of the technology, whether g, ac, n et cetera, is the interest of the shelf-space, that's why market share is so important, you have got to have sufficient share to have sufficient shelf-space in order to be in front of consumers going forward and thereby drive revenue growth. Otherwise, I trust the markets you are already in, I mean, so it's not there.

You are exactly right. In the retail space, our shelf-space phasings are very important. And more market share will give you more shelf-space and phasings. And as much as we think that everything is online, there is still 75% of the sales happened in physical stores. And when people walk into the stores, whatever is presented to them clearly has a lot of influence on sales. I mean if you walk into the Costco stores, you are presented with whatever they present you and that is the number one, number two brands that they are going to sell and that will influence a lot of your future topline and bottomline. So the retail space is very important to have market share.

Got it. One last question for me, if I may. So with respect to Amazon Eero, I trust, clearly, they are not going away. They are a permanent fact of life. And I trust there is a permanent impact on pricing and thereby margins and it's critical for you to cost reduce in order to enhance margin profile going forward. But that's a bit of pressure. It's a constant battle for you to maintain yourselves fit and thereby drive revenue growth and improve margin structure. I mean, that's stating the obvious, no?

Yes, absolutely. And that's why, for us, it's so important to develop the subscription services revenue, all right. So in the worst case scenario, we have to compete with them on all the, what we call WiFi systems and on toe-to-toe in terms of cost, all right. Now we still have a lot of other categories that they don't compete with us. We are pretty unique such as in mobile, such as in cable gateways and cable modems, such as in WiFi extenders. Those categories, they do not compete. However, in the WiFi routers/mesh system space, we definitely are prepared to continue to compete pretty aggressively, competitively with them toe-to-toe on cost. And then to really and reach our capability to make money is basically on the subscription revenue that we derive from our loyal customer base.

Fair enough. I appreciate the responses. I will get back in the queue. I will take the rest offline. Thanks.

Sure.

Your next question comes from the line of Robert Gutman with Guggenheim Securities. Your line is open.

Thanks for taking the question. Of all the, I am not sure I heard of all the numbers that you recapped. In first quarter, what do you expect the sequential growth to be in CHP, ex-service provider? Because that was a decline of about 12% to 15% before. And I am not sure with all the changes, where that number is now?

Yes. You are right. So normal seasonality would be a decline of 20% for CHP, excluding service provider. And what we had said back in November is that we thought it would be a bit muted, given the efforts that we were taking in Q4 to shift the mix in the channel. And we thought, at the time, it would be low to mid single digit decline. But as Patrick said earlier, we saw an opportunity in the channel to increase some promotions on WiFi 5 products that we shipped in which allowed us to gain some share. So we still have some work to do on the channel inventory mix. So I think you are probably looking somewhere between 15% to 20%, kind of back into the normal seasonality range.

Okay. And that compares to, 15% to 20% that compares with the Analyst Day, I think for that number, you said 12% to 15%?

Correct.

Okay. But then, that implies, I think with $25 million or so in service provider, I think that implies like a mid teens year-over-year growth or mid teens year-over-year decline on the SMB side to get to overall the midpoint of your guidance for revenue? So if it does that, what would be the reason?

That's right, Rob. So, if you recall, Q1 of 2019 was an exceptional quarter for SMB. We had a fairly large pull-in because the original Brexit deadline was end of March. And at the time, we had said some of our channel partners in the U.K. holding inventory into Q1 and we saw that correction occur into Q2. So I think it's probably more appropriate from a comparative standpoint to look at the average between Q1 and Q2 of last year.

Got it. Okay. And I am sorry, one other thing, if I may. Just I know you talked about the cadence of margin through the year, but I just want to make sure I heard it right. So the guidance for 1Q is 2% to 3%, a small uplift in the second quarter, but that would imply to get to the same guidance, full year guidance of 8% to 9%, significant much higher margin than the last two quarters of the year. So I know there is the 240 basis points for the tariffs. But is that right? Or is there any more way to quantify that?

Yes. You are actually right and that's a normal seasonal pattern that we would see where we see Q3 lift from back-to-school, in Q4 the holiday promotions, we get more topline leverage. So we typically experience our higher non-GAAP operating margins in the back half of the year.

Okay. Got it. Thanks for taking the questions.

Your next question comes from the line of Paul Silverstein with Cowen. Your line is open.

There is always one more. Bryan, I might have missed this. If I did, I apologize. But can you quantify what the China impact was?

Yes. So I would say, the bulk of the 16% decline in the APAC region would be attributable to that region. We did have some service provider declines there as well but the bulk of that decline would be attributable to the Greater China region.

And Patrick or Bryan, your confidence about China coming back, but for the Coronavirus this year, the thought arises that unless the state is similarly directing universities and other state-controlled, state-directed institutions that they will buy from the U.S. as part of geopolitical rapprochement, if you will. The thought arises that those institutions, they may be happy enough buying Chinese. There may be less impacts on the Chinese psyche in terms of buying American which is, let's say, they may never come back to you or any other American supplier. What underlies your confidence that, but for Coronavirus, it would be coming back?

Let me make it a little bit clearer. I was referring to the consumer side and referring to the SMB on the Hong Kong side. You are right. I mean, on the SMB side in Mainland China, it may never come back for the SMB purchase. But on the consumer side, as you have seen it, for iPhone 11, after the wind is blowing over, they did pretty well. So we were riding a dovetail what the success over there on the consumer side, that's the original hook. And then, for the Hong Kong, we assume just about that the business is coming back, it's back to normal, because the unrest has finally calming down in January. And that's what I was referring to.

All right. Patrick, to be clear, so you and Bryan are not expecting a return of China Mainland SMB business?

No, we are not. That is factored into our full year view.

All right. But it begs the question, how much of the China decline was SMB as opposed to consumer?

Well, I mean, both are declining very rapidly so far.

But, were they two 50-50 in terms of your China business? [Indiscernible].

Yes, pretty much. Pretty much, 50-50.

I appreciate that. Thank you.

Sure.

There are no further questions at this time. I will turn the call back over to Patrick Lo.

Thank you for joining today's call. We are excited about our opportunities in 2020 because it further positions ourselves as the premium technology leader in consumer and SMB networking. And it also offers new opportunities for us in the new markets of Pro AV and digital canvas market. And most importantly, it will be a significant step towards building a robust service revenue stream. And I will update you on all those angles in every earnings call going forward and I would talk to you all in two months in April. Thank you.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.