NETGEAR Inc (NTGR) 2005 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions). A replay will be available after 8 PM today through midnight on August 4. The replay dial-in number is 201-612-7415 with account code 3055 and passcode 157830. The replay will also be accessible at www.NETGEAR.com. I would now like to turn over the conference over to David Pasquale. Please go ahead, sir.

Thank you, operator. Good afternoon and welcome to NETGEAR's second-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 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 a 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 the 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 products offerings or adopt competing products; the Company may be unsuccessful or experience delays in the manufacturing and distributing of its new and existing products; telecommunication 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 as 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 17 through 25 in the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended April 30, 2005, filed with the Securities and Exchange Commission on May 13, 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 on our press release in the Investor Relations site at www.NETGEAR.com.

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

Thank you, David. Thank you, everyone, for joining us on today's call. This was yet another strong quarter for us, driven by the success of some new products, such as our RangeMax family of MIMO Wi-Fi products. The RangeMax pricing is attractive, while providing our customers with innovative first-to-market technology.

Gross and operating margins in the second quarter were the highest in NETGEAR's history. Given our strong financial performance, we were able to invest in strengthening our sales and marketing staff in emerging markets such as Eastern Europe, Russia and India. We also ran significant in-store branding campaign such as sales associates training, point-of-sales material displays and channel seat units in the established markets of the United States and Western Europe.

These are very significant initiatives for us and ones that we expect will pay off for us down the road. Expanding our brand into key emerging networking markets will position us for further market share gain. Having an early physical presence in these developing markets is a must. It is also essential to our continued success that we have strong in-store support. This ranges from being in consumer spaces with compelling point-of-sales displays to having sales associates trained.

Sales associate are faced with the task of selling and supporting a constantly changing product area. Our goal is to get them as excited about NETGEAR as we are by educating them on our product and technology differentiators. We are also stressing the aesthetics of our product design and ease-of-use. Ease-of-use is one of the most important points for sales associates because we want customers to keep coming back.

As I mentioned, we were able to gain further momentum based on the strength of earlier new product introductions and with a record 17 new products introduced in the second quarter. This is ahead of the 12 new products per quarter rate we were at last year and the 13 introduced in quarter one of this year.

Based on our current product roadmap, we would expect to introduce at least 13 new products in both the third and the fourth quarters, bringing our total for the full year to 56 or more. Of note, our RangeMax line, which quickly became the number one selling MIMO Wi-Fi products in the market, has been our most successful product introduction so far this year. Consumers have been enthusiastic for our RangeMax routers and wireless cards, based on the significant improvement in range, coverage and speed they offer.

RangeMax strongly validates our strategy of product innovation and capturing higher margins by delivering additional customer value through unique new features. We expect to see continued volume increases in RangeMax over the next few quarters as we benefit from positive product reviews and recommendations, numerous industry awards and NETGEAR's high brand recognition. This is why brand visibility and in-store training and recommendation are so important in our business.

Additionally, our industrial design concept, Platinum II, on which our RangeMax routers are based, was bestowed the prestigious 2005 Industry Design Excellence Gold Award by the Industry Designers Society of America and featured in BusinessWeek.com in June. This is important because when evaluating purchase decisions, the look of the product is playing an increasingly prominent role in the consumers' minds.

Many consumers are pushing their routers in a centralized location, like the kitchen or family room. In these environments, the router needs to needs to blend in, as our designs have accomplished.

We're also excited about inroads we continue to make in the carrier market. Revenue in the second quarter from the service providers segment represented approximately 9% of total revenues. In the second quarter, we shipped a new cable broadband gateway to Cox Communications. We also introduced three new Voice over Internet, or VoIP, products for three different operators -- AT&T and AOL in the United States and Engin in Australia. We will continue to roll out more certified Voice over IP products in the balance of the year and beyond.

We continue to have high confidence on our carrier business growth worldwide. We believe we'll continue to gain market share worldwide. We are extremely pleased with our 8% sequential revenue growth in North America. Asia-Pacific was also strong for us in Q2, increasing 10% sequentially. Europe declined 14% on a sequential revenue basis due to three reasons. We experienced softer-than-expected business product line sales in the economically weak markets, such as Germany and France. Secondly, our distributors there also took the precautionary steps in reducing their inventories. Finally, in the first quarter of 2005, we started selling in local currencies in both Germany and France and selected channels in the UK. During the second quarter, the dollar rapidly strengthened against the euro and pound, which had an unfavorable effect on our U.S. dollar-based revenue.

On a year-over-year basis, sales in North America were up about 19%, with Europe, Middle East and Africa or India up about 24%, and the Asia-Pacific region was up about 29%. In terms of core product detail, our overall ethernet network products shipment was down 10% quarter-on-quarter. Shipments of wireless nodes were about 1.7 million in the second quarter of 2005, a 4% decline over the first quarter of 2005. Shipments of our wired and wireless broadband routers and gateways were up about 3% quarter-on-quarter and about 925,000 units.

Products introduced in the last 12 months constituted about 29% of our Q2 revenue, and products introduced in the last 15 months constituted about 41% of our Q2 revenue. Looking forward, we are optimistic as we enter the seasonally strong third quarter. Our confidence is based on NETGEAR's strong new product lineup and anticipated back-to-school demand. We expect to grow sequentially in all three regions, in the U.S., Europe and in the Asia-Pacific region.

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

Thank you, Patrick. Let me now provide a summary of the financials for you. Second-quarter 2005 net revenue increased 21.7% to 107.6 million compared to 88.4 million for the second quarter of 2004. Net revenue in the second quarter of 2005 derived from North America was 55.2 million. The Europe, Middle East and Africa region was 40.4 million, and the Asia-Pacific region was 12 million.

In the first quarter of this year, we started selling in local currency to our customers in Germany, Australia and selected channels in the UK. We believe that the strengthening of the U.S. dollar in the second quarter had an unfavorable exchange rate impact on our net revenue and profits. Also, under the income/expense, we are reporting an exchange loss of approximately $784,000.

Moving on to the product category basis, the quarter two net revenue split between wireless and wired was about 61% and 39%, respectively, in revenue compared to 58% and 42% for the first-quarter 2005. The quarter two net revenue split between home and small-business product was about 60% and 40%, respectively, as compared to 58% and 42% for the first quarter.

On unit shipments, we shipped about 2.4 million units in the second quarter, roughly flat as prior first quarter. Total unit shipments of our ethernet products, such as hubs, switches and network adapters, declined 3% in units and 10% in dollars. The shipments of all wired and wireless routers combined increased about 3% in dollars and units over quarter-one 2005.

Non-GAAP cost of sales for the second quarter came in at $68.9 million or 64% of sales, which compares to 60 million or 67.9 million -- sorry, 67.9% in the year-ago period.

Non-GAAP gross margin in the second quarter was 35.9%, up significantly from 32.1% in the second quarter of 2004 and up from 33% in the first quarter of 2005. The year-over-year improvement in non-GAAP gross margin was due to increased sales mix in high-margin products, slightly offset by the strengthening of the U.S. dollar.

Moving to non-GAAP operating expenses, total non-GAAP operating expenses, which excludes stock-based compensation costs, came in at 25.2 million, compared to 20.5 million in the year-ago period and 23.3 million in the prior quarter. This was 23.4% of net revenue in the second quarter of 2005 as compared to 23.2% of net revenue in the second quarter of 2004 and 21.4% in the first quarter of 2005.

Sales and marketing expenses were at 18.2 million, which compares to 16.9 million in the prior quarter and 15 million in the year-ago period. Expenses in this quarter included significant branding campaigns such as sales associate training and costs associated with expansion into new markets.

As a percentage of net revenue, sales and marketing were 16.9%, compared to 17% in Q2 of last year and 15.5% of prior quarter one. R&D, research and development, rose to $3.2 million from 2.3 million in the year-ago period and $2.8 million in the first quarter of 2005. This represented 3% of net revenue in Q2 of this year and 2.6% of Q1 -- of 2005 and Q2 2004.

G&A expenses in the second quarter were $3.8 million, or 3.5% of net revenue, compared to $3.2 million or 3.6% of net revenue in the year-ago period and 3.6 million or 3.3% of net revenue in the first quarter of 2005.

Operating income on a GAAP basis, which excludes non-cash stock-based compensation expense of 324,000 came in at $13.1 million, compared to 12.2 million in the first quarter of 2005 and 7.4 million in the year-ago second quarter. This continues the trend of our positive sequential operating income growth.

Net income. On a GAAP basis, the Company had net income of $8.3 million or 26 per basic share and 25 per diluted share -- $0.25 per diluted share for the second quarter of 2005, compared with net income of $7.9 million or $0.25 per basic share and $0.24 per diluted share in the first quarter of 2005.

On a non-GAAP basis, net income for the second quarter ended July 3, 2005, increased to 8.3 million, as compared to 8.2 million non-GAAP net income for the first quarter of 2005 and 5.3 million for the year-ago period. This represents earnings per share of $0.26 per basic share and $0.25 per diluted share in the second quarter of 2005, compared to $0.26 per basic share and $0.25 per diluted share in the first quarter of 2005 and $0.18 for basic and $0.17 per diluted share in the second quarter of 2004.

I would like to note that for the purposes of calculating non-GAAP basic earnings per share, we used 32,146,000 shares for quarter two 2005. On a diluted basis, we used 33,716,000 shares for quarter two 2005.

The second quarter of 2005, non-GAAP net income excludes non-cash stock-based compensation expense of 344,000 and also excludes 325,000 net tax benefit from exercises of stock options. Non-GAAP tax rate was 38.8% in quarter two.

Moving onto balance sheet. We ended the second quarter with 147.9 million in cash, cash equivalents and short-term investments, up from 138.6 million at the end of the first quarter. In terms of inventory trends, we are pleased with our continued success at executing our inventory plan for the channel. The U.S. inventory channel increased to 10.1 weeks in the second quarter from 7.5 weeks in the first quarter, reflecting anticipated back-to-school demand.

U.S. distribution channel inventory declined to 3.3 weeks in the second quarter, compared to 4.3 weeks in the first quarter of 2005. European distribution channel inventory declined to 3.9 weeks. Asia-Pacific distribution inventory increased to about 5.3 weeks. We ended the quarter with inventory of 44.1 million, which is 6.3 turns compared to 47 million and 6.2 turns at the end of first-quarter 2005. Days-sales-outstanding -- DSO -- was 66 days in the second quarter of 2005 compared to 67 days in the first quarter of 2005. Total assets were $294.6 million at July 3, 2005, compared to 287.3 million at April 3, 2005.

Now, let me take a moment and comment on the third quarter. We remain confident in our outlook as we enter the seasonally strong third quarter. As Patrick noted earlier, our confidence is based on NETGEAR's strong product lineup and anticipated back-to-school demand and momentum in our business worldwide. Our goal remains to grow faster than average industry growth.

For the third quarter, we believe net revenue will be approximately 113 million to 118 million, with non-GAAP operating margin in the range of 12% to 12.5%. Finally, we expect the non-GAAP effective tax rate to be approximately 39%.

Operator, we will now be happy to take any questions.

(Operator Instructions). Tim Luke, Lehman Brothers.

Nice job on the margins. I was wondering with respect to the margin guidance, first, if -- how should we see the operating expense investments? Patrick, you mentioned investing in your channel. Should we expect a similar level of uptick in sales and marketing as we see in R&D in the calendar third quarter?

And I was also wondering if you could talk about whether in the third quarter you would expect an uptick in revenue across all three of the geographies, whether you would -- how you expect Europe in particular to trend in the calendar third quarter? And then, Jonathan, I was also wondering if you could just comment on the -- it looks like your U.S. disti inventory is lower while the retail inventory is higher. If you could talk about how you expect the trends to develop there on the inventory side, that would be helpful. Thank you.

Thank you, Tim. Let me first start with some of the questions regarding the overall business climate in terms of the gross margin. You know, as we mentioned and many a times as we actually in the past eight quarters, we would rather give guidance on the operating margin because that's where our focus is.

We would continue to make effort to provide sequential improvement on the operating margin. When we see the gross margin ticking up, that give us opportunity to invest, like in R&D -- you know, generating 17 new products. We grabbed it. Like putting some more brain activities in the channel that will give us a longer-term premium pricing advantage. We grabbed it. So we will do the same thing in Q3 as we see the gross margin going up or down. Then we will be able to adjust our activities to maintain the target operating margin level.

And so that's the tactic that we will continue to use. But we have some baseline. For example, we will make sure that we will continue to produce at least 13 new products every quarter, and we will continue to make investments into the emerging markets, like those that I mentioned about.

And then, getting back to your comment about what do we see the Q3 is going to shape up for all three regions. As I mentioned in the tail end of my discussion just now, we believe that very strongly that all three regions will have sequential growth going into the Q3, and even Europe, as we all know, that the economy is quite bad in the euro zone, which certainly affects our SMB customers.

However, with seven new ethernet switching products introduced in Q2, we're very confident that we'll be able to continue to push ahead and then gain market share in that region, and thus we'll be able to generate sequential revenue growth. Our momentum in the RangeMax products in Europe is doing very well, so that will enable us to continue to capitalize on the consumer market over there after their summer vacation, which should start probably about towards the mid of August, when they are all coming back from their summer vacation.

So, overall, we feel good about it, and so we do think strongly that we will have a good sequential growth across all three regions.

Now, do you think your share was stable in Europe in the second quarter, or was there any change in the share, do you think?

Actually, as a matter of fact, we believe that we overall gained share in Europe in the second quarter. And based on the reports that we are able to see, I think we are gaining share particularly in countries such as the Benelux, Italy, Nordic as well as the UK. I think we're holding shares in Germany as well. And certainly in the new markets, like in Eastern Europe and Russia, of course we are gaining share because we've gone from zero. So, we're still feeling very good in Europe about continuing to gain share, even though we're already the dominant market share holder. And Jonathan, your channel inventory?

Yes. Again, Tim, to your question on channel inventory. Our target is retail. Our target must be around eight weeks and distribution around four weeks. But as we said at the beginning of this quarter, as in quarter two -- ending quarter one earnings call, we did say we would be getting prepared for the back-to-school demand, especially in U.S. retail, and therefore as expected, and as we have indicated, our channel inventory in retail was slightly higher than the eight weeks' target. So, on the distribution side, yes, it is lower than our target. But that's what we reported.

Do you think you're going to need to now raise your operating target model somewhat with the sort of the 12, 12.5% operating margin guidance? What's the long-term outlook for your operating margin and maybe the gross margin?

Yes, Tim, you know, going back two years, our goal was gross margin to get to 30 to 33% operating margin, to get to 10 to 12%. We have now achieved a 12% operating margin. We're not ready at this stage to redo our goal. While Patrick did mention our goal is to continue to work towards improving operating margin sequentially, once we are ready to come up with a new goal, we will definitely announce that.

I would like to add a little bit to it, Tim. As a matter of fact, I mean, we purposely led the U.S. retail inventory to go all the way up to 10 weeks. You probably have already noticed in the last two weeks that we put out two press releases of our very aggressive and strong trade of the RangeMax program for the back-to-school. So we feel that we're getting a lot of traction over there, and we believe that is prudent to let it go to 10 weeks, and we believe that it will come down towards the end of the quarter three. And on distribution side, yes, we're absolutely making an immediate effort to correct that, to get it back up to four weeks and above.

Samuel Wilson, JMP Securities.

A couple of small questions also. One is once again on the margins. Was there anything on the gross margin side that was one-time in nature during the second quarter? And then just, Patrick, a sense for you, do you think you will continue to kind of aggressively spend on the sales and marketing side in the third quarter? And then also, can you just give us some sense of last quarter when we left you, you really hadn't kind of started to do business in Eastern Europe and Russia and India. Kind of where does that stand? Do they start collecting revenues intra-quarter? Kind of what's the color there?

On the gross margin side, there is no one-time event, but you could argue that the introduction of the RangeMax is a one-time event. But we will continue to introduce product as good as RangeMax, which is very unique feature and very -- delivering the things that the customers want and certainly that will help our margin, and we'll continue to do that.

In terms of the going-forward and the (technical difficulty) investment that we made in the emerging market, for example, that we opened up a Moscow office -- we actually have a permanent office right now in Moscow. We actually have already hired three people over there. And we're starting to do sales and marketing activities. We have already sold the first lot of products.

We also have hired and assigned distribution in Poland, Hungary, Czech and Slovenia. We are already bidding on projects over there. And in India, we also have three people in the sales and marketing team in two different locations. We have yet to have a formal office as yet, which we intend to do in Q3.

So, to answer your call, yes, in Q3, we will continue to invest heavily in absolute dollar terms in sales and marketing. Now, but because Q3 usually is a pretty good uptick from Q2 on our revenue dollars, so from a percentage basis, it will certainly come down on sales and marketing. So that is where the picture is going to be like.

Anton Wahlman, Needham & Company.

On the service provider world, both DSL and cable, it looks to me like the trend is continuing to start including integrated products that included router and wireless in one common device. And of course, you are racing down that path as well and trying to capture that market coming from the opposite direction. Do you think you are progressing as fast as you need to over time to prevent an erosion of your sales opportunities to consumers there, or do you think that you'll need to do something new beyond just your generic in-house efforts in that regard?

Anton, I agree with you, absolutely, that, I mean, the trend of integrating more functions into a single box is actually what is going to be the future and actually has benefited us. You know, if it's pure modem, pure router, then we would not be able to get into those accounts. But, right now, because they're integrating all these things together, that really opens up the opportunity for us to go into actually either replace or mend the incumbents, because we have the -- you know, the latest technology in terms of Wi-Fi, as was firewall.

For example, we had been bidding a few big projects because of our RangeMax technology. We are already readying products that will integrate more than just Wi-Fi and routers and firewall. The obvious one is the integrating Voice over IP in it, both on the SIP protocol as well as the PacketCable protocol. And then of course we are readying on other products, such as the triple play, as most people are talking about.

So those are in the pipeline. And as a matter of fact, we're also showcasing some of our other technologies that uniquely that we're providing such as power -- ethernet over power cable lines, you know, is very popular, actually, in a certain part of Europe for that product. And some of the carriers, service providers over there is interested having gateways that instead of Wi-Fi, but using the ethernet over electrical cable technology.

So, we'll continue to do that and we're very excited about the fact that in Q3, we'll be introducing Storage Central, which is our first market what we call shareable disk on an IP address technology, which is having a lot of interest from the service providers as well, which we have another thing that we can integrate in the future.

What's the price point on the Storage Central? Where is that going to start?

The Storage Central is going to start at somewhere around 149 without a disk drive, and then certainly we're working with the disk drives co-marketing partners to make a very compelling offer that would provide storage capacity anywhere ranging from 100 GB to a terabyte at a market breakthrough pricing.

A week ago, Cisco just announced the acquisition of KiSS in Denmark, which has of course also set-top boxes and advanced DVD players and even some foray into portable disk players and even some minor TVs. Is there any of those areas that you would not consider moving into, or is a move in that direction either generically internally or at some point via an acquisition also a goal of yours?

Well, as we said from a few earnings call back, that I think our strategy is slightly different from Cisco, that we would like to remain as a networking pure play. That means we will not go into the appliance -- consumer electronic appliance area. We will not provide a TV, and we will not provide a sofa. And as well as the KiSS technology people do provide.

But we're absolutely going to provide what we call the multimedia adapter, the multimedia player, which will enable customers to connect their legacy devices via an ordinary TV, plain old telephone, stereo, boombox, onto the Internet. And this particular multimedia player we will not preclude from including the TV out capabilities in it. So that is the direction -- you will see us bring out those products pretty quickly. That's the first difference.

The second difference is, as you probably notice, over the last nine years that we have been in existence, we bring our innovative technology to the market, not by doing it in-house. We actually always partner with the latest and the greatest technology supplier in the market. I mean, these technologies like multimedia integration, like Wi-Fi, is evolving so fast that there is always a new player emerging. And we would like to be able to have the opportunity to work with all of them instead of just using our in-house capability. And then, whoever is the latest and greatest that will be able to productize them, and that strategy has worked for us very well and that's how we grow our technologies such as Super AG with Fellowes, Smart Switches with Broadcom, and RangeMax with Video54, and we certainly will bring technology in the integrated multimedia player with some technology supplies in the not too long future.

Finally, just one word on VoIP. Clearly at some point you -- I think you were certified in the early part of the year for AT&T Call Advantage. Can you give an update on where you get products going into the various VoIP players?

You know, Anton, as we mentioned in our press release as well as in the discussion I had previously, we were relieved that in Q2 we were finally certified against AT&T Call Advantage and we have started shipping products that would work with AT&T's Call Advantage in the retail channel. And, you know, hopefully we will be soon shipping to AT&T direct as well. And we're shipping also products direct to AOL. We are certified with their Voice over IP service as well. And we continue to ship SIPgate in Europe. And in Q3 -- Q2, actually, we started shipping to Australia as well, to three Voice over IP operators. And now we're shipping to Engin in Australia as well. So, we have four operators in Australia using our Voice over IP products.

The Vonage thing didn't happen yet?

The Vonage thing didn't happen yet. You are right.

Alex Henderson, Citigroup.

There was a couple of comments made last conference call about readjusting your tax rate going forward or improving your tax rate, and the language that was used around it was a little bit confusing. I wasn't sure exactly what you meant by it. You'd suggested that there is a potential to get a number of point improvement in your tax rate. Can you give us an update on what's going on with that?

Sure, Alex. I think it's also the timing. During this year, we don't expect an improvement in the tax rate for the quarters, and the guidance we gave is that next quarter, in quarter three, the tax rate at 39%. However, we have started on the tax restructuring project, which we expect to complete early next year. And once that project is completed, we will start seeing gradual decreases in tax. As an example, in 2007, while we have not giving guidance -- we don't give guidance that far out -- on the tax rate, we would expect it to drop by 2%, which means (multiple speakers)

Two percentage points?

Yes. Instead of 39 it could be 37. Okay? And again, that is an estimate. Okay? And then, the real benefit of a tax restructuring provided the tax laws remain the same is that four years out -- after four years, the tax rate can drop quite significantly from, let's say from a 40% gain -- estimate can drop to like 25, 26%.

Wow. That's a big change in your tax rate.

But that is four years after the implementation.

Understand. Second question is you talked a lot about success in the service provider arena, but it looks to me like there was two areas of disappointment in the quarter, one being the currency hit in Europe and a little bit slower results in Europe than I think people were expecting. But the other one that surprised me was the service provider appears to have declined by 3 percentage points of revenue. Can you talk to why that declined from 12% to 9%?

Yes, as we mentioned, we're still learning that business as we go along. I think first and foremost, because half of our service provider business is actually in the national market. So, there is a seasonality involved over there that we get a hit on that, and certainly, some currency hit as well. And on the other hand, on the domestic front, I think we were delayed in the certification of our new version of our cable gateway that also basically hurt us in the shipment in Q2 as well.

So, we're learning as we go along. One thing we would like to point out as important is that because we have a real balance in multiple channels, so that's why we will not be tripped too much by one channel with some hiccups, and then we would be able to balance that out with other channels. And we believe that we will continue to make progress.

Well, so just to follow through that line of logic, if the timing of the relation -- of the release of the certified product was the issue, do you expect to see a snap-back in the service provider business to something in the 12%-plus vicinity pretty quickly? I would assume that driving that from 12 to something higher was the goal, not driving from 12 to something lower.

That's absolutely our goal.

Okay. A third question. I'm a little confused about the inventory stuff. We went through a calculation here that would imply that the inventory in the channel was essentially flat in the current quarter. Now, my understanding is that most geographies would be building inventory for the back-to-school period at this point. And it didn't look like that happened. If you would normally would be adding a couple of weeks, shouldn't you have seen -- or is there going to be a catch-up in the inventory in the upcoming quarter as that inventory obviously has to be built up in order to satisfy the back-to-school process?

Back-to-school is only a U.S. phenomenon. There's no such thing in Asia nor in Europe. And that's why in those markets, yes, especially in Europe, we're reacting to the economic downturn. So rather than putting on more inventory, they actually want to reduce inventory, and that's the behavior that we see, especially in the euro zone.

In the U.S., you're right, the retailers have already stocked up inventory pretty heavily. The distributors are a little bit below what we expected, but we're correcting it as we speak very quickly. Rest assured we'll have enough product supply in the distribution channel inventory. As you probably some of you have seen, that there is huge promotion that we're going on with Dell. They just sent out a big catalog a week ago featuring our products, and that's why we must have enough supply in the distribution channel inventory to supply them.

One last question. What was the SMB enterprise as a percentage of revenues in the quarter?

In Q2, it was 40%.

Neil Gagnon, Gagnon Securities.

This is for Jonathan. The tax rate in Q3 as projected looks like it's up from Q2. What are you thinking for Q4?

Again, from Q4 -- sorry, Q2 we were at 38.8 to 39, a very slight tick-up, and again for quarter three, we said 39%. We haven't given guidance for quarter four. What I would suggest is use the quarter three. As you make more profits, since the R&D credit is somewhat constant, the higher the profits, the tax rate goes up.

So it was roughly the same in Qs three and four?

Yes. But we're not giving guidance for quarter four, just as an indicator.

Mark Sue, RBC Capital Markets.

Maybe just one last question on gross margins. If you could help us understand the major moving parts of the gross margins. Is it the mostly product mix, material costs, warranty, inventory provisions? And if I read between the lines, am I right to assume that margins should normalize from here with the absence of some of the newer products?

Mark, as we mentioned all along, to improve our margin we had multiple knobs to turn. And as I mentioned all along, in our business, the success of the business is the ability to manage multiple knobs. One is inventory; two is the cost of production; three is new product mix -- so those are all imported areas and they all improved in Q2.

As you see, our inventory came down even further, and our production costs was driven down faster than our selling price. And then for new products, we introduced 17 new products, which is a record, in Q2. And the uptick of the RangeMax product in the market -- all that shift of mix to these newer, higher-margin products helped us. So it's a combination of all those factors, and we will continue to turn those three knobs to benefit our margin.

Got it. And Jonathan, what happened to interest income and how should we model that going forward?

Yes, you know, as you so, cash continued to increase. Interest rates have increased. And we earned interest in this quarter of close to $900,000. So, until we find the use of the cash in some other form, that money is going to hopefully stay, because we have a cash-positive company, and at the average rate that you saw in quarter two. So, it will be in that range just like it has been.

Got it. And lastly, in the past, you would only add about two weeks to your U.S. retail channel inventories going from the June quarter to the September quarter. Should we read into anything from the increase from 7.5 to 10.1?

No, I think it's as I mentioned during the discussion -- in the answering of the previous question, normally we would get it to nine weeks, but this year we are little bit more aggressive simply because the two RangeMax promotion programs that we announced in the last two weeks -- one is basically targeting the students and the other one is targeting for upgrading any other vendors, including ours, old routers, into RangeMax. So, we believe that this is the right thing to do.

Got it. Patrick, are you in the mood for any EPS guidance?

We're still trying to learn that yet, so we're not ready to do it right now.

Maynard Um, UBS Warburg.

I was wondering if you could just give the wireless products as a percentage of revenue?

The wired products?

Wireless.

The wireless product was 61% -- or 61% of the total revenue, and the wired product is 39.

Thank you. And then that's just on the gross margin -- maybe asking a different way. How much of the gross margin was an increase in sales and marketing and kind of turning off the offset in contract revenue?

There was a slight improvement, yes, in the sales and marketing contract revenue element, but also, as Patrick said, there are many other factors that went into the improvement of the gross margin. The main one is, which we talked about, are the product mix and the profit on the -- for example, the RangeMax. So the new products have those.

But we had improvements in some of the other period expenses. Warranty is an example. You'll see when we file the 10-Q, when we show you what the warranty reserve was, a slight deduction in the warranty reserve requirement because of all the work we have been investing in usability, quality of our product, we have been seeing slight improvement in the warranty. I just gave you one example. So, those are all contributions towards improving our gross margin.

Great. And with regard to your recent Board appointment, should we read into this as potentially NETGEAR kind of moving into things more in the wide area network technologies, or can you talk a little bit about kind of looking maybe a year or two years down the road?

Well, I mean, NETGEAR is committed to provide whatever networking solutions are needed by our target customers to connect to the high-speed Internet, and we will always adapt to their needs. In a year or two, or maybe even sooner, that there is a wide area high-speed broadband access you bet, we'll be in there.

Christin Armacost, SG Cowen & Co.

I want to ask some questions on the service provider. Did the decline in the service provider business have a favorable impact on your gross margins?

Yes, certainly, it does. But then, as we mentioned all along, that the operating margin impact is nothing.

Okay. And then also on the Pre-N, Broadcom had indicated that they had seen some slowness in the Pre-N wireless in advance of the standards base. And just wondered what you had seen in that category of product for you?

Well, I mean, basically the IEEE is a very democratic forum, so the penalty we pay is that to get the consensus view on the Pre-N standard is being delayed and pushed out longer and longer. But I think that our RangeMax products, which was just introduced about five months ago, would be able to fill the gap in between, that customers are getting extended range they need, and customers are getting the consistency of higher throughput they need. And we believe that that will be a good technology to bridge over until IEEE or some other parties would come out with a de facto and standards. And you bet we will be first on it.

And just lastly, back on the service provider business, in our prior discussions with you, Patrick, you had indicated sort of a target range of revenue for service provider not to really exceed 15%, because that's not the business model you wanted to be in. So just wanted to see, with the commentary from the press release saying it's a strategic part, if you've changed your viewpoint on that.

No, we haven't changed our viewpoint. We still believe in a balanced channel approach.

Tal Liani, Merrill Lynch.

This is actually Stan Kovler (ph) for Tal Liani. My question is about wireless shipments. It seems like they were about flattish with the prior quarter, and as a percentage of ,revenue they went up. So I was wondering if you could touch on pricing there? Thank you.

Well, yes, you had a great observation, as a matter of fact, that while a lot of our competitors are still trying to clear their inventory on the Varial (ph) 11B -- 11 megabit products, we've already completely got out of that about a quarter or two ago and we focused on selling our higher-priced RangeMax products. So it's a mix shift.

Thank you. And can you also give us perhaps the power over ethernet ports that you shipped this quarter?

I'm sorry that I do not have a good number off the top of my head. As a matter of fact, that we probably would not divulge that, and for competitive reasons. But it's a very healthy growth for us. With a complete lineup of power ethernet products, I believe that we probably are the only vendor today that would have power over the ethernet products from a managed to lightly managed our Smart Switch to fully managed layer 3. So, we have the most complete product today for the SMB customers.

Then perhaps you could address it maybe in a sequential growth rate?

We do not have that particular breakout right now, so maybe next quarter we will do that.

Thanks. And what was the blended ASP, if you can divulge that?

Well, I think it's pretty -- relatively simple calculation, that our unit shipment was flat and our dollar shipment was pretty flat -- slightly down. So ASP didn't change much.

Ryan Hutchison, WR Hambrecht.

Quick question here on the SMB enterprise business. It looks like it was down about 6% quarter-over-quarter, up a percentage year-over-year. Weren't we expecting this to be up sequentially given the June quarter? And then just a quick follow-up as it relates to headcount. I didn't catch that number. Thanks.

Regarding the sequential growth, we will strive to grow every single product line according to what our guidance is. So if somebody could go faster, we would love it. So you could calculate in that range. In terms of headcount, Jonathan, do you have the latest?

Yes. At the end of the quarter, we had 296 employees. We still average over 1.5 million revenue per employee.

Okay, let me ask it maybe a different way. I mean, was the SMB down sequentially as a result of the weakness in Europe?

Yes, that's pretty much it.

Okay, and then I guess what percentage of the weakness in Germany and France do you attribute to -- how short of it was it of your target versus the local currency impact as well?

You know, for competitive reasons, we'll not go down to that level. But as you probably could imagine, when you add Germany and France, that's a pretty big portion of our European business.

So, would it be 50% weakness attributed to the economic condition and 50% to the local currency exchange, or--?

You know, we do not break it down to that granularity, but they both contribute, yes.

Ben Atkinson, Gagnon Securities.

Congratulations on the RangeMax. A great success there. Did you start shipping Storage Central during the second quarter?

No, not yet. Because Storage Central is a very new product and because we know that it's first-to-market and people are going to store their valuable files such as video and photos and songs on it, we took the liberty to do more extensive testing before we roll it out to the market. All the launch activities are still being prepared and you should expect to see it very soon on the market.

Okay. And did you say, Jonathan, that there is a $784,000 currency exchange loss in the quarter?

Yes.

Where did that hit the income statement?

Under income from operations. Off income from operations, you have interest income of 897 and other income/expense, 780,000, which is exchange loss.

Okay, thanks. And finally, on the issue of the yuan revaluation, what sort of challenges or opportunities does that create for NETGEAR?

From the yuan revaluation, I mean, initially, it's only 2%, which is pretty negligible. I think all our suppliers can absorb that. We believe at this point in time, at least this is political posture. Now, we don't know what behind the scene the negotiation is between the U.S. and the Chinese government, but I don't believe the Chinese government would take a drastic act to rapidly bring down the yuan value versus U.S. dollars, and if anything, it will be a gradual process.

We have always been, you know, putting pressure on our subcontract manufacturers in China that they have to continue their productivity improvement so that they absorb any increase in costs, either, you know, in terms of the currency or in terms of local inflation. So, we believe that they should be able to work with us to make that happen.

As a matter of fact, there's still a good portion of the costs of our products are based on components which are all U.S. dollar-denominated, and so that's the second point. The third point is that, as we mentioned all along, we are not standing still and just making our manufacturing in the two Chinese locations. We're always constantly looking for other locations to manufacture, which will give us the lower costs. I think the yuan revaluation prospect is just one area that we consider for our long-term strive to lower our manufacturing.

Mike Hughes, Delaware Investments.

Yes, back to the $780,000 other expense line. Assuming the average currency is the same in the third quarter as the second quarter, would that number repeat itself, or how does that work?

Yes, if the rate stays constant, then it is very unlikely that that number will repeat itself. If you look back at quarter two as an example to your question, take the euro. The beginning of the quarter, the euro was $1.29, too, at $1.29. We ended the quarter at $1.19, an 8% drop. Follow me?

Yes.

So if it stays constant, we don't believe the 780,000 loss would be -- it will be the same as that. It will be much less.

Okay, so that penny and a half drag could potentially go away in the third quarter.

Hope so.

Alex Henderson, Citigroup.

I wanted to go back to the business side a little bit, talk a little bit more about the SMB piece. It's my understanding that you introduced a lot of products out at network interop this quarter. And we were expecting the SMB piece to increase as a percentage of sales, not decline as a percentage of sales. I understand your explanation in Europe, but could you give us some sense of what SMB did domestically so that we could have at least some sense of what the business trends on that arena are independent of the exchange rates and economic conditions in Europe?

As far as SMB is considered domestically, we believe that we are flat quarter on quarter. And yes, we introduced a lot of new products in network interop, but true to form, the engineers don't get it all shipped towards the later part of the quarter. So, all those new products are actually going to benefit Q3 rather than Q2.

So there is a delivery and timings issue, then?

Exactly. And unfortunately, in Q1, we had very little SMB products introduced towards that market. So that didn't help us in Q2.

So would we expect the S&P piece to buck the normal seasonal trend in the third quarter, where normally SMB would decline in the U.S. in the third quarter?

Believe so -- we believe so, we definitely will buck the trend, and we will have sequential growth in SMB in all three regions in Q3.

We will now take our last question from Anton Wahlman, Needham & Company.

It was now I believe over a year ago that you introduced your -- or I believe announced that you were going to have a Clarion-compatible product at some point, assuming that sort of took off, and clearly it hasn't taken off to date or have been launched at all, and maybe it never will. But Patrick, could you just tell us something about are there any particular 3G or 4G or other fixed wireless technologies which you are presently enamored in your thinking? For example, we've got IP wireless, Nevane (ph), there's WiMAX -- any thinking along those lines?

The only thing I would comment is stay tuned, Anton.

Okay.

All right? So this concludes our session today, operator.

Yes sir, there are no further questions at this time. I would now like to turn the floor over to management for any closing comments.

So once again, thank you very much, everybody, for joining us on the call. We're very excited about NETGEAR. We're excited about the marketplace. And we're very pleased that we're serving our customers well with all the latest technology. For example, the reception of our RangeMax further validates our contribution to the market, and the broadband Internet connectivity to everybody on earth is a very, very exciting revolution. And we're very thrilled to be right in the middle of it, and we will continue to enhance the world by providing the best products and thus bringing value to our customers, to our investors, as well as to our employees, and look forward to talking to all of you in the near future. Thank you.

Ladies and gentlemen, this concludes today's teleconference. Thank you for your participation. You may disconnect your lines at this time.