NETGEAR Inc (NTGR) 2005 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by. (OPERATOR INSTRUCTIONS). A replay will be available after 8:30 PM Eastern Daylight time through midnight Eastern Daylight time on May 5th. The replay dial-in number is 719-457-0820 with passcode 3544950. The replay will also be accessible at www.netgear.com.

I would now like to turn the conference over to Mr. David Pasquale. Please go ahead, sir.

Thank you. Good afternoon and welcome to NETGEAR's first-quarter 2005 results call. Joining us from the Company today are Patrick Lo, Chairman and Chief Executive Officer, and Jonathan Mather, Chief Financial Officer. The format of the call will be a brief business review by Patrick, followed with Jonathan providing detail on the financials. We will then have time for any questions. If you have not yet received a copy of today's earnings release, please call Sharon Lou of The Ruth Group at 646-536-7026, or you can get a copy of the release off of NETGEAR's website.

Before we begin the formal remarks, the Company's attorneys advise that today's conference call contains forward-looking statements. The forward-looking statements represent NETGEAR's expectations or beliefs concerning future events and include statements among others regarding NETGEAR's expected revenue, earnings, operating income and tax rate on both a GAAP and non-GAAP basis, anticipated new product offerings, current and future demand for the Company's existing and anticipated new products, willingness of consumers to purchase and use the Company's products, and ability to increase distribution and market share for the Company's products domestically and worldwide.

These statements are based on management's current expectations and are subject to certain risks and uncertainties including without limitation the following. Future demand for the Company's products may be lower than anticipated. Consumers may choose not to adopt the Company's new product offerings or adopt competing products. The Company may be unsuccessful or experience delays in the manufacturing and distributing of its new and existing products. Telecommunications service providers may choose to utilize competing products. The Company may be unable to collect receivables as they become due. The Company may fail to manage costs, including the cost of developing new products and manufacturing and distribution of its existing offerings. Channel inventory information reported is estimated based on the average number of weeks of inventory on hand on the last Saturday of the quarter as reported by certain of NETGEAR's customers.

Further information on potential risk factors that could affect NETGEAR and its business are detailed in the Company's periodic filings with the Securities and Exchange Commission, including but not limited to those risks and uncertainties listed in the section entitled, "Risk Factors Affecting Future Results" pages 26 through 35 in the Company's annual report on Form 10-K for the fiscal year ended December 31, 2004 filed with the Securities and Exchange Commission on March 16, 2005. NETGEAR undertakes no obligation to release publicly any revisions to any forward-looking statements contained herein to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

In addition, several non-GAAP financial measures will be mentioned on this call. Information relating to the corresponding GAAP measures and reconciliation of the non-GAAP and GAAP measures can be found in our press release in the Investor Relations site at www.netgear.com.

At this time, I would now like to turn the call over to Patrick Lo. Please go ahead, sir.

Thank you, David. And once again thank you everyone for joining us on today's call. The first quarter was another strong one for NETGEAR. We are extremely pleased with our results as we really hit the ball out of the park this quarter. Revenues came in above the high end of our prior guidance at $109 million despite this being a traditionally slower quarter. Prior guidance was for revenues to be in the range of 105 to 107 million.

Jonathan will review the details, but I wanted to note that we are obviously pleased with our execution on our general inventory plan and expect continued execution in Q2.

Equally impressive is the fact that we further improved our profitability levels. Non-GAAP gross margin was 33% with non-GAAP operating margin of 11.5% coming in at the top of our prior guidance level.

Our success continues to be driven by overall robust market demand and the superior value of our products. The strength of the NETGEAR brand and our innovative products continue to differentiate us in the market place.

A great example of this is our RangeMax Wi-Fi MIMO products. We started to get inventory out late in Q1. We have all the retail in online channel stocked by now. The initial sell-through of this product line is very encouraging. The stylistic design and the outstanding range and speed of this product differentiate us from our competition.

Our RangeMax Wireless Router is fully compatible with any Wi-Fi devices and is capable of boosting performance of any existing 802.11b or g or Super G clients by up to 50%, making it one of the most effective solutions on the market today. The solution utilizes seven intelligent internal antennas capable of transmitting the signal in 127 different directional patterns, thereby providing optimal speeds for the longest range and eliminating blind spots.

Our RangeMax product family has already received the Mobile Focus Award from the Laptop Magazine as the best Wireless Networking product for 2005. We expect that the excitement these products have generated will carry over into coming quarters.

The consumer and media excitement around RangeMax box bodes well for our future success for several reasons. The key is that people really want to increase wireless speed and range in their homes and business. As a result, we are benefiting from repeat purchasers who are following the quick pace of technological advances in order to increase their productivity, as well as the continuous stream of new users who are looking for the best future proved products.

These users are generally less price sensitive. They are interested in acquiring the latest technologies because they see this as a tool to increase productivity or to expand home entertainment and multimedia. Our goal is to continue to drive innovations that are clear commercial successes.

In quarter one we introduced an all-time high 13 new products. We expect a similar pace in Q2. Moreover, because we introduced a record number of new products, we were able to achieve record unit sales while maintaining a flat ASP, average selling price.

Aside from the great reception our RangeMax introduction received, we're also very happy with the success of our latest Smart Switch addition. This line is a real winner for us, and we expect to see further expansion this year.

Finally, we also expanded shipments of our voice over Internet protocol or voice-over-IP products in the U.S. and Europe in the first quarter. This is a longer-term adoption cycle product for us. Most people use traditional land line phones. Others have migrated to using just cellphones. The move to voice over IP is the start of the bell curve. The technology is clearly there. The benefits from a cost and feature standpoint are extremely compelling, and we have the hardware out now for consumers to use voice over IP in a manner more natural to them. We view this as a growth area for us that will be an important contributor several quarters out.

You will remember that we had the same outlook for the carrier channel long ago. We have successfully grown this channel revenue from nothing to 12% of our total revenues in quarter one. We expanded shipments of our voice over IP and Gateway products in quarter one and expect to see further gains in Q2 based on the strength of our partners and our products.

We are very pleased with the sell-through in the U.S., which is up from Q4 enabling us to bring the overall channel inventory down as planned. The new channel partners we brought on in the U.S. added momentum to our sell-through. We are extremely pleased with the 49% sequential revenue growth in Asia-Pacific powered by growth across all countries except Korea.

Europe remains in the fury of home network market expansion catching up with the U.S.. We have a tremendous market position over there that is more than able to capitalize on the opportunities. Japan is also a hotbed market in home networking; however, it is dominated by local brands, and being the only viable foreign challenger, it does take a lot more patience and persistence to bring about brand awareness.

The home network market in China has yet to catch up given the per capita GDP there. However, we are very pleased with the distribution channel we set up there with Nanova Group's (ph) digital China distribution arm and with Founders Group. We are aligned with the two big names in consumer PCs in China, and we feel good about our prospect in that market. We currently have over 350 retail outlets and over 400 value-added resellers in China. We believe China will be our number two market in Asia after Australia by next year.

In terms of core product detail, our overall ethernet network products shipment was slightly up quarter on quarter. Our Smart Switch grew 13% sequentially. Our gigabit switches shipment grew 18% quarter on quarter. Our ethernet network interface card sales continue to decline as expected. We continue to believe that we are gaining share in the fast-growing switch market for small businesses led by our momentum in Smart and gigabit switches.

Shipments of wireless notes were about 1.8 million units in the first quarter of 2005, a 3% sequential growth over the fourth quarter of 2004. Shipments of our wired and wireless broadband routers and gateways combined were about flat at about 900,000 units in the first quarter of this year.

Products introduced in the last 12 months constituted about 37% of our quarter one revenue, and products introduced in the last 15 months constituted about 52% of our quarter one revenue.

On a year-over-year basis, sales in North America were up 6% with Europe, Middle East and Africa up 48% and the Asia-Pacific region was up 30%. On a sequential basis, North America declined 5%, EMEA was up 6% and Asia-Pacific increased 49%.

Looking forward we are in a great position entering the second quarter, even though it is the industry's seasonally slowest quarter. We expect to build on the sales momentum generated by our RangeMax products in the first quarter with another round of very promising new products planned for the second quarter. The planned launches include additional Smart Switch products, more Layer 2 managed switches, more gigabit switches and low-cost firewalls and most exciting of all, our new home storage product, the Storage Central.

The Storage Central enables customers to store tremendous amounts of multimedia contents such as photos, songs, videos, etc. with automatic backups and easy storage space expansion. Additionally, we expect our relationship with Trend Micro will be a sales driver over the next couple of quarters as we promote the use of Trend Micro securities threat management software with our firewalls, especially the very successful VPN Firewall 200 model introduced in the fourth quarter last year. Taking all of these exciting developments into consideration, we are confident in our outlook for the second quarter and our business prospects longer-term.

Now let me turn over the call to Jonathan for details on the financials.

Thank you, Patrick. Let me now provide a summary of the financials for you. As Patrick said earlier, the first-quarter 2005 net revenue increased 23.3% to 109 million compared to 88.4 million for the first quarter of 2004. Net revenue in the first quarter of 2005 derived from North America was 51.1 million, the Europe, Middle East and Africa region was 47 million, and the Asia-Pacific region was 10.9 million.

On a product category basis, the quarter one net revenue split between wireless and wired was about 58% and 42% respectively in revenue compared to 59% and 41% for the fourth quarter of 2004. The quarter one net revenue split between home and small-business products was also about 58% and 42% respectively as compared to 59% and 41% for the fourth quarter.

On unit shipments, we shipped about .5 million units in the first quarter, a roughly 4% increase over the prior fourth quarter. Total unit shipments of our ethernet products such as hubs, switches and network adapters grew slightly in units and dollars. The shipment of all wired and wireless routers combined declined about 6% in dollars over quarter four 2004, but was more than offset by an increase in wireless adapter cards and access points which increased 12% quarter-over-quarter.

Non-GAAP cost of sales for the first quarter came in at 73 million or 67% of sales which compares to 60.9 million or 68.9% in the year ago period. Non-GAAP gross margin in the first quarter was 33%, up significantly from 31.1% in the first quarter of 2004 and up slightly from 32.9% in the fourth quarter 2004.

The year-over-year improvement in non-GAAP gross margin was due to increased volume leverage in our buying power and operational efficiencies.

Moving to non-GAAP operating expense, total non-GAAP operating expenses, which excludes stock-based compensation cost, came in at 23.3 million compared to 20.3 million in the year ago period and 22.5 million in the prior quarter. This was 21.4% of net revenue in the first quarter of 2005 as compared to 22.9% in the net revenue of the first quarter of 2004 and 21.4% in the fourth quarter of 2004.

Sales and marketing expense were at $16.9 million, which compares to 16.3 million in the prior quarter and 0.8 million in the year ago period. As a percentage of net revenue, sales and marketing was even with prior quarter at 15.5% compared to 16.7% in the quarter one of last year.

Research and development rose to 2.8 million from 2.3 million in the year ago period. It was 2.6% of net revenue in quarter one of this year and last year and 2.4% for quarter four of last year.

G&A expense in the first quarter were $3.6 million or 3.3% of net revenue compared to 3.2 million or 3.6% of net revenue in the year ago period and dollars 3.7 million or 3.5% in the fourth quarter of last year. Operating income on a GAAP basis, which includes non-cash stock-based compensation expense of $361,000 came in at $12.2 million compared to 11.6 million in the fourth quarter of 2004 and 6.8 million in the year ago first quarter. This continues the trend of our positive operating income growth.

Net income. On a GAAP basis, the Company had net income of $7.9 million or $0.25 per basic and $0.24 per diluted share for the first quarter of 2005 compared to net income of $4.2 million or $0.14 per basic and $0.13 per diluted share in the first quarter of 2004.

On a non-GAAP basis, net income for the first quarter ended April 3, 2005 increased 78% to 8.2 million as compared to $4.6 million non-GAAP net income for the quarter ended March 28, 2004. This represents earnings per share of $0.26 per basic share and $0.25 per diluted share in the first quarter of 2005 compared to $0.16 for basic and $0.14 per diluted share in the first quarter of 2004.

I would like to note that for purposes of calculating non-GAAP basic earnings per share we used 31,661,000 shares for quarter one 2005. On a diluted basis, we used 33,280,000 shares for quarter one 2005.

First quarter of 2005 non-GAAP net income excludes the non-cash stock-based compensation expense of 361,000 and also excludes a 48 (inaudible) net tax benefit from exercise of stock options. Non-GAAP tax rate, 38.5%.

Moving on to the balance sheet, we ended the first quarter with 138.6 million in cash, cash equivalents and short-term investments, down from 141.7 million at the end of the fourth quarter. As noted in the release, we were able to pay vendors early in order to earn favorable discounts. Actions led to a reduction in our Accounts Payable balance to 25.4 million at the end of the first quarter compared to 52.7 million at the end of the fourth quarter 2004.

In terms of inventory trends, we are pleased with our continued success at executing our inventory plan for the channel. The U.S. retail channel inventory declined to 7.5 weeks in the first quarter from 9.3 weeks in the fourth quarter. U.S. distribution channel inventory also declined to 4.3 weeks in the first quarter compared to 5.6 weeks in the fourth quarter of 2004. European distribution channel inventory ended at about 4.5 weeks. Asia-Pacific distribution inventory ended at about 4.6 weeks.

In quarter one we were able to correct on-hand inventory balance at the end of quarter four last year. At the end of the quarter with inventory at $47 million, 6.2 turns compared to 53.6 million and 5.3 turns at the end of the fourth quarter of 2004.

Days sales outstanding, DSO, was 67 days in the first quarter of 2005 compared to 70 days in the fourth quarter of 2004. Total assets, 187.3 million at the end of the first quarter compared to 300.2 million at December 31st, 2004.

Now let me make a comment on the second quarter. As Patrick said earlier, we feel good in our outlook for the second quarter of 2005 based on the momentum in our business, recent product introductions and a strong pipeline of new products. Our goal remains to grow faster than average industry growth.

For the second quarter 2005, we expect net revenue to be in the range of 108 million to 110 million with non-GAAP operating margin in the range of 11.3% to 11.5%. Finally, we expect the non-GAAP effective tax rate to remain at 38.5%.

Operator, we would now be happy to take questions.

(OPERATOR INSTRUCTIONS). Samuel Wilson, JMP Securities.

Good afternoon. I have one question with six parts, jokingly. Patrick, can you just give us an update a little bit on what you're thinking in terms of geographic expansion into Eastern Europe, India and some of the emerging markets? And can you give us an update on the number of worldwide retail storefronts and the number of worldwide VARs that you have, just a general number?

And then Jonathan, could you give us cash flow from operations, CapEx and I missed headcount, please?

Well, let me take the questions on first regarding the geographic expansion. We are making plans this year to go into India, as well as in Russia. But then we are in the middle of the paperwork of registering our Company in those two countries then, as well as to look for our country managers in these two areas. It is proceeding a little bit longer than what we would like, but we believe that we will be positioned to really get in there by the beginning of summer. So we're very pleased with what we could achieve over there.

And regarding the overall channel that you talked about in terms of the number of retail outlets around the world, today our retail outlets are pretty well spread out over all three continents certainly with the numbers mostly in Europe and in the U.S. We respectively have about over 5000 retail outlets in the U.S., and we have about 1200 retail outlets in Asia-Pacific, and then we have roughly about a total of 3000 retail outlets in Europe.

And in terms of number of VARs, right now we estimate the latest count on the registered VARs that is doing business with us in any particular quarter is close to 30,000 right now, and certainly with the concentration actually skewed towards the European countries, we have close to 15,000 active VARs in Europe and about 10,000 in the U.S. So that is pretty much the statistics.

Jonathan?

Okay. Sam, the question regarding cash flow in quarter one we used up cash in the operating activities of 3.6 million mainly in the working capital by as we pointed out Accounts Payable drop from 53 million to 25 million. So the net cash for operating activities -3.6 million, capital expenditure $1 million, and so we were negative quarter-over-quarter from 141.7 to 135.5.

And headcount, next question, at the end of December, we had 269, and at the end of April 3rd, our quarter one end was 280.

Alex Henderson, Smith Barney.

I wanted to probe into this cash flow stuff relative to the gross margins if I could. And I was also hoping to get a data point on the mix between retail and SMB.

So on the cash flow and gross margin side, to what extent are your gross margins being helped by pushing the terms with the suppliers by paying down these terms ahead of time? How much benefit did you have on the gross margins? And if there was a benefit, what was the offset to that assuming that the gross margins were fairly steady sequentially?

Jonathan, do you want to take this?

Yes, Alex, to the gross margin there are many factors that go in when it happened, too, yes, the net improvement was from 32.9 to 33%. The cash discounts, we have been earning cash discounts previously, and the improvement from prior quarter to this quarter was $200,000.

Help me understand, why would you pay down $25 million worth of payables to get $200,000 benefit?

Again, the timing of those payables to get into a little bit more detail, Alex, those payables, the end of December with the inventory and if you looked at the inventory number and that included transit, those would have been due in the first quarter. So not that -- and they would have earned their discounts in the first quarter.

So in addition to the Accounts Payable coming down normally because of timing when you buy the product -- okay -- and the fact that we had a few more vendors who we were able to benefit with cash discounts.

Well, I mean just to play devil's advocate, there is no evidence of that happening in prior quarters in the first quarter. Why is it happening here? That is a pretty significant change in payables. I'm not sure I understand what the benefit from that change in payables was.

Okay. Let me -- go back to quarter four when we had the earnings call back in February for quarter four, the question was, why was Accounts Payable $53-odd million. And I think we tried to explain one of the main reasons (technical difficulty)-- (multiple speakers)

Moving it out there. Okay, fine. I've got it.

The purchases and the transit was pretty high in that time preparing for the generally strong January as well as with the Chinese New Year, etc. So the payables, the transit is much higher. It was (technical difficulty)- - first weeks of January.

Okay. And the second question or the second piece of the question was, what is the mix between the retail and SMB?

Within (inaudible), SMB is what we share, and we give that information, 50 -- the home was 59% (multiple speakers) 58%. 58 and 42.

Mark Sue, RBC Capital.

(technical difficulty) -- the number of days this quarter versus last quarter and the number of days that you are using in the June quarter?

And then, Jonathan, the question is, are there any more favorable rebates left on the balance sheet? Maybe you could quantify that for us. I would imagine you have more buying power coming up in the upcoming quarter, and if you can help us understand the impact on gross margins and what your targets might be there?

Okay. Let me see whether I remember your questions though. Ask me if I miss anything. The first one is number of days. In this quarter, it is a 13-week quarter less -- basically effectively almost 13 weeks is 91 days this quarter had 93 days. Okay? And quarter two will be 91 days. 13 weeks. Okay?

The next question was with respect to rebates. You were referring to rebates from our suppliers?

Yes, from your suppliers, and also if I take that in conjunction with your buying power, does gross margins actually improve from here? Can we get to maybe 34, 35% on the gross margin line?

We don't want to -- we have always said our range for gross margin has been 30 to 33%. Yes, we are at 33%. Our focus is to get our net margin from 11.5% driving it to our 12% target. That is our emphasis and focus, so we're not here to give you a range, be improving our gross margin.

To go back to the question regarding the rebates, we continue to enjoy good rebates as well as product cost discounts because of the leverage by getting -- our volume continues to grow.

Got it. And Patrick, not to be a skeptic, but it seems like things turned around very dramatically from last quarter. Can you just give us your level of confidence that you can maintain this level of growth as you go into the June quarter and that we won't see China inventories actually increase in the upcoming quarter?

Well, I mean, market, I would just like to go back. We have always been maintaining the position that the market demand based on high-speed Internet access requirement is always there because it is a necessity. It is not a luxury anymore. So we believe the market growth has continued to be there, and we always commit, and the whole team of NETGEAR always has been executing to outgrow the market. So we believe that growth will continue, and as I mentioned in the script, as well as in the releases, that the reception of our new products such as the RangeMax is very encouraging. So we do have very good confidence that we’ll continue to outgrow the market.

So in terms of channel inventory, I would like to just remind -- to note one more time that as a matter of fact that at the end of last quarter the channel inventory was intentionally set at a slightly higher level because of first our closing of the warehouse for the first week of the quarter, as well as the promotions that we put in place in retail channel for the first week of the quarter, which is the busiest week of the quarter in January.

So with that, we also have the plan going into the quarter to work the inventory back down to a more normal level. So if you look forward at the end of Q2, then we will still be executing a channel plan according to the market requirement. So distribution because we're not closing the warehouse anything in July, so it will be very close to the four weeks in the U.S. and Europe.

As a matter-of-fact for Asia-Pacific, it should be six weeks. We actually worked the channel inventory, too, down at 4.6 weeks in this quarter. So we probably will inch back up to six weeks.

Now in the retail channel, as you probably know, starting July is the back to school. So we might slightly increase the retail channel inventory to prep for that back to school promotions. So that is the channel plan that we execute all the time.

Tim Luke, Lehman Brothers.

Nice job on the quarter, Patrick and Jonathan.

Thank you, Tim.

It looked like you had a very significant uptick in the sales in Asia. Patrick, I was wondering if you could just talk through that?

Sure. I think the last time in our earnings call in Q4 we also mentioned that Q4 was seasonally weaker because of our number one market in Asia is Australia. And in Q4 that is their summer holiday. So in Q1 they all come back and work and driving towards their financial year-end which is Q2, and that is why that gives us a significant uptick in the Asia-Pacific revenue.

On the other hand, we also see our good growth as well both in Japan and in China. So that really drives our first-quarter increase in Asia-Pacific revenue.

Seasonally Q2 actually in Asia-Pacific will be the strongest. So because that is the end of financial year for Australia, and with Chinese New Year behind, China should be stronger in Q2 as well. So we expect the growth to continue.

Anton Wahlman, Needham & Co.

Voice over IP. You mentioned briefly in your prepared remarks that you had seen an improvement there. Can you go in a little bit more detail there in terms of, first of all, the major accounts where you were looking to get in or finalize products such as AT&T where I believe you had started shipping last time and Vonage where you may have not started shipping last time. And also if you have a word on the migration away from integration into the router to a handset product at some point in the future?

Okay. Yes, actually we're very pleased with the progress that we are making getting certification from the various service providers. As you just mentioned that we probably -- you probably also read it from some press releases out there, we are actually certified by AOL for their voice-over-IP service, and we are also certified by SIPgate in Europe for their voice over-IP services. So we expanded shipment of our voice-over-IP Wireless Routers, as well as the voice-over-IP adapters to these accounts.

We are in the final stretch of getting certification by AT&T. We feel very good about it. Barring any last-minute happening, we believe that we will start shipping to the AT&T customers as well in the coming quarter.

So that is the current situation, and we will continue to proceed to generate more variations of both the handset adapters, as well as the Wireless Routers, and as you say, the handsets itself as we go forward.

Ben Atkinson (ph), Gagnon Securities.

It was a great quarter. I appreciate all the hard work you're doing.

Thanks.

My question is, on your program for the international restructuring to one of the benefits of which will be to lower your tax rate, can you just give us a little update there and again give us a sense for timing and how much (multiple speakers) lower your tax rate?

Sure. I think, Jonathan, you might be better to answer this question. Go ahead.

As you may recollect, we started this project two years ago, then we shelved it for the IPO, and then again we've postponed it because we were all very busy with the Sarbanes-Oxley project last year, which we are pleased we successfully completed.

So we have again kicked off the tax restructuring, and our goal is to have that completed this year. We have been busy at that where, again, we see the plan and the restructuring and the fact that a higher percentage of our revenue is coming from international. That benefits us. We should see a blended tax rate -- seeing the reduction beginning. And if we have it completed this year, which we feel everything is set to have it completed this year, next year we will start seeing reduction in tax rates gradually with a four-year outlook where the tax rate can drop 10, 12 points.

Brantley Thompson, Goldman Sachs.

I was wondering if you could touch on a few things. An idea of kind of how the bookings trended through the quarter? And also talk about how you expect pricing to behave as we move into this next quarter given that you have stepped up the number of new products and are continuing to run at that pace as we move into the second quarter?

Sure. As usual, we do not comment on the middle of the quarter on how it is progressing. But we would like to reiterate that we are giving the guidance that in Q2 our revenue level will be in the range of 108 to $110 million.

As far as pricing is concerned, I think the market is still behaving as we anticipated. It is the same path and not that much different from previous years, and we do not see any significant changes so far. So we are pretty confident on the progress of the quarter and the guidance of the revenue and the operating margin.

Maynard Um, UBS.

I missed your total unit shipments in the quarter. Can you just repeat that number?

2.5 million units.

2.5 million. Thank you. And just to focus on North America, you saw the nice growth in revenue for both Asia and the EMEA regions, but a sequential decline in North America. Was this just a function of seasonality in the inventory correction in the quarter or weakness in the SMB market that seemed to be impacting some of your competitors?

No actually because our revenue recognition is selling, so it is more a channel correction, a channel inventory correction as we planned originally. If we look at the sells-out report that we receive from the channel, we actually increased quite a bit in the sells-out in Q1.

So the market growth is still there. Certainly it is a flat quarter on an overall market size which is the normal pattern after a strong Q4. So we don't see the market slowing down, and our sells-out in Q1 is very encouraging. So we believe that we gained significant share in Q1 in the U.S.

Christin Armacost, SG Cowen.

I wondered if you could talk about some of the home media products that you have announced and how they are contributing to revenues and what your expectations are for 2005?

Sure. As we said that the multimedia product is a new category of products that we are still experimenting in the market to see how it is going to hit home.

As we maintained all along, since the introduction of our first media product, which is audio-based, the media product is very content driven. And today from the Internet most of the content -- actually almost exclusively -- the content is through audio. So we are still seeing very good pickup on our audio portion of this offering. But on the video side, not until there is abundance of legal content on the Internet, we do not see that to be taking off. I would have to say the audio part is contributing well to the revenue, but not the video part.

Arthur Winston (ph), Pilot Advisors.

By my calculations, the return on equity excluding your cash is about 50% unleveraged. So I was curious, can you use some of this cash to invest so we can continue to get the 50% return on the business?

Yes, as we mentioned all along, that we always look at the various options in front of us to continue to maintain the very high return on equity. As a matter of fact, we measure ourselves every quarter on a few very important metrics, and one of it is return on equity. Certainly the operating profit dollar generated per employee is also very important as well. All options are in front of us, and we constantly review it. We actually have monthly if not bi-weekly board meetings and review all those functions. But rest assured we're very, very dear to our heart to make sure that we maintain that high return on equity.

Ryan Hutchinson, WR Hambrecht.

Just a couple of quick ones here. Patrick, can you just remind us what the long-term operating target is for margins here? And then I know you touched on gross margins, but is this sustainable at least into next quarter?

As I mentioned, as we mentioned all along, since we became public it has been seven quarters now, we always maintain to the investors that our operating margin will be from 10 to 12%, and we have already broken the 10% mark. We have not reached the 12% top end as yet, which we are inching towards. So the whole team is focused on getting the operating margin up to 12%.

Regarding to the gross margin, we believe that we have reached our top end of 33%, and we will certainly continue to maintain a level close to that as our guidance in this quarter of 11.3 to 11.5% operating margin, we feel good because of the momentum of our new products, as well as our market position in the channel.

Greg Spiegel (ph), Pilot Advisors.

Congratulations on the quarter. Nice job. Two quick questions. The first one is regarding AOL. If you could just give us some color on when you were certified and when you started shipping product, and kind of how meaningful you think the relationship could be?

And then I had a follow-up regarding the two board seats still occupied by Pequot, and at what point you think given their lack of ownership in the equity, at what point you think you'll be able to replace those guys with somebody that can add more value?

I'm sorry. I'm not going to comment on the last one. But on the -- you know we certainly will continue to look at the board composition, and if we come across really high-value board members that could strengthen the overall quality and ability of the board in guiding the business, then we absolutely would be looking towards that.

Now returning back to the voice-over-IP products, we were actually certified by AOL towards the end of Q4. We shipped some quantity -- quite good quantities in Q4, and then, of course, we expanded on that in Q1.

And as I mentioned to them, we got certified also by SIPgate during Q1. We shipped meaningful quantities to them as well, and we believe that we are very close to the very final stretch of getting certified by AT&T.

Erik Zamkoff, IRG Research.

Congrats, very nice quarter. I was wondering getting back to the operating model, if you could comment on operating expenses as a percent of revenue, as a portion of that operating margin guidance range?

And then I was hoping you could talk a little bit about potential for embedding the Wireless Router and other home media products, and where you stand in terms of plans for that type of migration?

Jonathan, will you take on the operating expense first?

Again, our guidance looking forward has always been revenue and operating margin. We do not provide guidance on operating expenses or gross margin.

Having said that, what you can see is that we have continued to improve our gross margin as well as our operating margin. That is why we are making sure we manage our expenses very tightly and efficiently. So the focus is operating margin to continue to improve that to achieve our target of 12%.

And then regarding the embeddedness of the Wireless Router, I assume that you mean that as more and more of the wireless functions or the Wireless Routing functions possibly be embedded into PCs or other devices what we're going to do? Is that what you mean?

So if that is what you meant, then basically what we're doing is certainly we are embedding our Wireless Router as well into voice-over-IP products, into cable and DSL modem products, as well as into the multimedia product as well. But we believe that even going forward, let's say the new television or the new PCs or new stereos have wireless included, there is still a lot of installed base of Legacy devices. There are hundreds of millions of TVs. There are hundreds of millions of stereos and installed PCs that will still need the external Wireless Router to connect them over. So this transition will be for a long, long time to come. And then we are talking about billions of phones out there that needs to be wired as well. So I don't believe that there is any shortage of things for us to wire both in the office as well as in the house.

Erik Suppiger, Pacific Growth Equities.

First off, your accrued liabilities, other component I presume that includes sales and marketing promotion. Can you comment what happened in the sales and marketing promotions component to that?

Jonathan?

The total accrued liabilities paid somewhat consistent to the prior quarter, right at the $50 million. And the components basically were in line with the prior quarter.

Tim Luke, Lehman Brothers.

Could you just give us some color on your perception of the market share dynamics maybe in Europe and in the U.S. in terms of who you think is vulnerable and who you think is doing well?

Well, I mean basically as I mentioned, our sell-through, sell-out in Europe -- in the U.S., in Europe and Asia are all very good. So obviously we're gaining share because we are outgrowing the market. The market is actually flat to down in Asia -- I mean in U.S. and Europe, and in Asia it is growing, but we are growing much faster than the market.

So we believe that in all three markets we're gaining share. Certainly we are gaining share against the weaker players. So those are generally Taiwanese players.

Maynard Um, UBS.

Just following up on that, in the North American channel, SMC appears to have left the retail channel early in the year. In terms of the market share gains, can you give us a sense of who you are taking share from? Is it the second-tier players, or also are you seeing gains from the Tier 1 guys, Linksys and eLink? And when do you expect to see continued consolidation in the market?

Well, basically SMC was never a major force in the market. I think at their peak they had less than 1% of the market. So even if they left the market, it really did not quite give anybody anything.

So in order to gain meaningful market share right now in the U.S., we basically have to gain against the Tier 1 players. That is what we're doing.

Erik Suppiger, Pacific Growth Equities.

Jonathan, I am sorry. I just want to follow-up on that point. Your sales and marketing promotions have grown steadily rapidly over the course of last year. How come that leveled off in the March quarter when your revenues are still growing?

Again, when you said compared to the prior year in 2004, it is a function of how much has been paid. So this is a liability tool. But when you talk about revenue growth, look at our North America where most of the promotions are.

So to answer your question, it is difficult to answer that question from here other than to say the accruals are for GAAP, as well as depending on when the claims are made and the timing of the promotions, etc.

As an example, if there were heavy promotions in the first quarter, general or in the first month, the claims would have been made within the quarter and paid within the quarter. So it would not show as a liability.

However, in the fourth quarter, you had -- I'm just giving an example of how it works. If the promotions were in the month of December or end of November, the claims would be in Janurary or February. So it would (inaudible) in accrual.

So going back to answer that question, other than tell you that the accruals are strictly according to GAAP and well adequately reserved for, I cannot answer the question regarding last year why it was lower because of timing and promotions, etc.

Anton Wahlman, Needham & Co.

Just a quick thing. You didn't mention Vonage. Is that not happening anymore?

Unfortunately the products with Vonage are much, much slower than what we would have liked.

Ryan Hutchinson, WR Hambrecht.

Just a quick -- I missed something here. The new products as a percentage of revenue, could you just provide that for me? Thanks.

It is 37% for those products introduced in the last 12 months, and it is 52% for those products introduced in the prior 15 months.

This concludes our question-and-answer session for today. I would like to turn the call back over to our speakers for any additional or closing remarks.

So, this is Patrick Lo. Once again, thank you so much for everybody joining the call, and we are very pleased with the momentum that we have gathered in Q1. We believe that we really start off the year with tremendous lineup of new products, and we believe that we will be continuing on to outgrow the market both on the consumer as well as the SMB side, both in the U.S. as well as in Europe and in Asia Pacific. We're looking forward to a very successful year again for next year. Thank you.

That does conclude today's conference call. Thank you for your participation. You may now disconnect.