NETGEAR Inc (NTGR) 2005 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen, and thank you for holding. (OPERATOR INSTRUCTIONS). A replay will be available immediately after the call today, through midnight Eastern standard time on November 2. The replay dial in number is 201-612-7415, with account code 3055 and pass code 171454. The replay will also acceptable at www.netgear.com.

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

Good afternoon, and welcome everyone to NETGEAR's third quarter 2005 results call. Joining us today from the Company are Patrick Lo, Chairman and CEO 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 Lu (ph) 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 product, willingness of consumers to purchase and use the Company's products, and ability to increase distribution and marketshare 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. The future demand for the Company's products may be lower than anticipated. Consumers may choose not to adapt 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 costs of developing new products in manufacturing and distribution of its existing offerings. Channel inventory information reported is estimated based on the average number of weeks of inventory on hand in 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, dated 19 through 28 in the Company's quarterly report on Form 10-Q for the fiscal quarter ended July 3, 2005 filed with the Securities and Exchange Commission on August 12, 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 an anticipated 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 now like to turn the call over to Patrick Lo. Please go ahead, sir.

Thanks everyone for joining us on today's call. Quarter three was an exciting quarter for us. Demand for our products was robust worldwide, led by back to school activities in the U.S., and renewed market strength in Europe beginning in the September time frame.

Sell through was strong in all three of our regional markets, North America, Europe and Asia. We steadily grew our business during the third quarter. Newly introduced products led the way, highlighted by Storage Central, our groundbreaking innovative data storage solution. This followed a very successful launch of our RangeMax Wi-Fi products in late quarter one.

Storage Central is the world's first mirrored scalable and shareable network disk storage controller for home and small businesses at a price point below $150. Initial market response has been very strong for this product. Like the RangeMax family before it, we believe Storage Central will be a must have home networking product this holiday season. We also feel it represents a major new product category beyond the wireless router for the home.

Another notable new product release during the third quarter was our Unified Threat Management solution. This solution incorporates Trend Micro's comprehensive virus protection and heuristic anti-spam engine into both our 200 and our 550 Series ProSafe VPN Firewall products. We also expanded our Layer 3 switch line with our first stackable gigabit switch with 10 gigabit uplink. In total, we introduced 15 new products in the third quarter. We plan to introduce at least 13 new products in the fourth quarter, which will bring total new products for the full year to at least 58.

We achieved $111.3 million of net revenue in Q3, slightly below our prior guidance. This was partly attributable to shipment delay, which increased our deferred revenue from 2.7 million at the end of Q2 to 4.7 million as of the end of this quarter.

There was also extra backlog that we could not fulfill during the quarter. Non-GAAP operating margin again improved to a record 12.7%. Looking forward, our profitability and strong balance sheet will enable us to invest more in R&D and operations in order to stay ahead in innovation, quality and logistics.

Revenue in the third quarter from service providers represents approximately 7% of total revenues, reflecting weak demand from them during the summer months. However, we believe the trend we are seeing is positive, and we expect to have heightened demand from service providers in the next couple of quarters.

Of note, we recently made a significant inroad into Telenet, one of the biggest cable service provider in Benelux, with our Powerline home network products for the their interactive TV service.

Sequentially our North America shipments grew 7%, while Europe, the Middle East and Africa, or EMEA, shipments grew 3%, and our Asia-Pacific shipments declined 10%. Both North American and European shipments were hampered by shipment delays and unfulfilled backlog. We saw seasonal weakness in Korea and Australia. In the Asia-Pacific region we benefited from robust growth in Japan and China. We believe demand in Korea will pick up in Q4, while Australia will continue to be seasonally slow in its summer months of December and January. On a year over year basis shipments in North America, EMEA and Asia-Pacific were up about 3%, 15% and 35% respectively. Please note that there were 14 weeks in Q3 of last year while there were 13 weeks in Q3 this year.

In terms of core product detail, our overall ethernet networking product shipments were up 21% quarter on quarter, led by the growth in our Smart and Managed switches. Shipment of wireless nodes totaled approximately 1.9 million nodes in the third quarter of 2005, a 12% increase over the second quarter of 2005.

Shipments of our wired and wireless broadband routers and gateways together increased approximately 7% to roughly 1 million units in the third quarter. Products introduced in the last 12 months constituted about 29% of our Q3 revenue. And products introduced in the last 15 months constituted about 33% of our Q3 revenue.

Looking forward, we're optimistic as we enter the fourth quarter, historically the strongest for NETGEAR. We start saw our product momentum continuing from September into October, and we believe it will continue. We're poised to introduce at least 13 new products in Q4, including again some innovative technology. We expect to grow sequentially in all three regions in the U.S., Europe and in the Asia-Pacific.

Before turning the call over to Jonathan, I would like to take a moment to recognize the continuing commitment and excellence of NETGEAR's employees. In October of this year we were ranked 54th on Forbes Magazine list of 200 Best Run Small Companies in America. This honor followed NETGEAR being selected in June by Business Week as the 17th among the Hottest 100 Small Cap Growth Companies. We have always had a tremendous team of people at NETGEAR, and I look forward to succeeding with them as we continue to grow our business.

Let me now turn the call over to Jonathan for details on our financials.

Let me now provide a summary of the financials for you. Third quarter 2005 net revenue increased 10% to 111.3 million, compared to 101.2 million for the third quarter of 2004. Net revenue in the third quarter of 2005 derived from North America was 59 million. The Europe, Middle East and Africa region was 41.6 million. And the Asia-Pac region was 10.7 million.

Moving onto the product category basis, the quarter three net revenue split between wireless and wired was about 58% and 42% respectively in revenue, compared to 61% and 39% for the second quarter of 2005. The quarter three net revenue split between home and small resource product was about 57% and 43% respectively, as compared to 60% and 40% for the second quarter.

On units shipped, we shipped about 2.6 million units in the third quarter, representing 8% growth over the second quarter. Total unit shipments of our ethernet product, such as hubs, switches and network adapters increased 12% in units, and 21% in dollars. Shipments of all wired and wireless routers combined increased about 7% in units over quarter 2 2005, and essentially flat in shipment value.

Non-GAAP cost of sales for the third quarter came in at 72.2 million, or 64.8% of sales, which compares to $68.7 million, or 67.9%, in the year ago period. Non-GAAP gross margin in the third quarter was 35.2%, up significantly from 32.1% in the third quarter of 2004, but down slightly from 35.9% in the second quarter 2005. The year-over-year improvement in non-GAAP gross margin was due to increased sales mix in higher margin product.

Moving to non-GAAP operating expenses, total non-GAAP operating expenses, which excludes litigation reserves and stock-based compensation costs came in at 25 million, compared to 22.6 million in the year ago period, and 25.2 million in the prior quarter. This was 22.5% of net revenue in the third quarter of 2005, as compared to 22.3% of net revenue in the third quarter of 2004, and 23.4% in the second quarter of 2005.

Sales and marketing expenses were at 18.1 million, which compared to $18.2 million in the prior quarter, and $15.4 million in the year ago period. As a percentage of net revenues, sales and marketing was 16.3% compared to 15.2% in quarter three of last year, and 16.9% of prior quarter.

R&D rose to $3.3 million from $2.7 million in the year ago period, and 3.2 million in the second quarter of 2005. This represented 3% of net revenue in quarter three of this year, and 3% of quarter 2 -- sorry, 3% of quarter 2 2005, and 2.7% for quarter three 2004.

G&A expenses in the third quarter were $3.5 million or 3.2% of net revenue, compared to $4.4 million or 4.4% of net revenue in the year ago period, and $3.8 million or 3.5% of net revenue in the second quarter of 2005.

Operating income on a GAAP basis, which includes litigation reserves of 600,000, and non-cash stock-based compensation expense of 211,000 came in at 13.3 million compared to 13.1 million in the second quarter of 2005, and $9.5 million in the year ago third quarter. This continues the trend of our positive sequential operating income.

Net income. On a GAAP basis the Company had net income of $8.6 million or $0.26 per basic share and $0.25 per diluted share for the third quarter of 2005, compared to net income of $8.3 million or $0.26 per basic share and $0.25 per diluted share in the second quarter of 2005.

On a non-GAAP basis net income for the third quarter ended October 2, 2005 increased to 9.1 million as compared to $6.3 million for the year ago period, and $8.3 million for the second quarter of 2005. This represents earnings per share of $0.28 per basic share and $0.27 per diluted share in the third quarter of 2005, compared to $0.21 per basic and $0.20 per diluted share in the third quarter of 2004, and $0.26 for basic and $0.25 per diluted share in the second quarter 2005.

I would like to note that for the purpose of calculating non-GAAP basic earnings per share we used 32,697,000 shares for quarter 3 2005. On a diluted basis we used 34,314,000 shares for quarter 3 2005. The third quarter 2005 non-GAAP net income excludes net charges of $510,000, consisting of litigation reserves, net of taxes of 362,000, non-cash stock-based compensation expense of 211,000, and a 63,000 net tax benefit from exercises of stock options. Non-GAAP tax rate was 38.9%.

Moving on to the balance sheet. We ended the quarter with 152.6 million in cash, cash equivalents and short-term investments, up from 147.9 million at the end of the second quarter.

In terms of inventory turns, we are pleased with our continued success at executing our inventory plan for the channel. The U.S. retail channel inventory decreased to about 8.7 weeks in the third quarter from about 10.1 weeks in the second quarter. U.S. distribution channel inventory increased to about 4.1 weeks in the third quarter compared to 3.3 weeks in the second quarter 2005. European distribution channel inventory declined from about 3.9 weeks of the second quarter 2005 to about 3.5 weeks. Asia-Pacific distribution inventory also declined from about 5.3 weeks to about 5 weeks. We ended the quarter with inventory of 46.9 million, 6.2 turns compared to 44.1 million and 6.3 turns at the end of second quarter 2005.

Here so days sales outstanding was 73 days in the third quarter of 2005 compared to 66 days in the second quarter of 2005. Total assets, 316.2 million at October 2, 2005 compared to 294.6 million at July 3, 2005.

Now let me take a moment on the fourth quarter. We remain confident in our outlook as we enter the seasonally stronger fourth quarter. We expect to benefit frown NETGEAR's strong product line up, holiday demand, and shipment of existing backlog. For the fourth quarter we believe net revenue will be approximately $124 million to $130 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%. We look forward to achieving new levels of revenue and profitability in the coming quarter.

Operator, we would be now happy to take questions.

(OPERATOR INSTRUCTIONS). Samuel Wilson with JMP Securities.

This is Jonathan Curtis calling in for Sam Wilson. Could you give us a little more detail on what drove the delays? What region of the world was it? And when did you start seeing the delays appearing? And then if you give us a little bit of color on how channel preparations are going for the seasonally strong holiday quarter coming up. Are you guys being able to fill the channel per your plan? A little color there would be great.

Sure. We always try to keep a very tight lead on inventory, because that is an absolute necessity in this rapid cost and price erosion environment. The penalty we pay by keeping a tight lid on inventory is that once our forecast of the mix is off, then we will put a lot of pressure towards the end of the quarter to change the production from one product to another, from one country version to another.

In the overall scheme of things, the sell-through of the three regions are very robust. That is what we planned. However, the mix of channels and the mix of products are a little bit off from what we originally anticipated. For example, the carrier service provider channel is a little bit weaker then what we originally anticipated. So we have got to towards the end really shift the production over to some unanticipated high demand on the products, such as our Storage Central. We introduced in early September and the response was so overwhelming that it basically flooded our production capabilities.

This particular delay in shipment applies to both the U.S. and Europe, not so much to Asia, because in Asia all our production facilities are in Asia. So it is much easier to turnaround and satisfy the demand. While in Europe and in the U.S. it involves at least some air freight to getting there. And because our revenue accounting is basically based on the contract terms that we have with our customers, so if the contract terms is actually to be FOB destination warehouse, then we have to make sure that the goods actually will arrive at their warehouse before the end of the quarter in order to count for revenue.

So the due to some air freight delay, and some truck delay and they didn't arrive in time, and that drove up our deferred revenue in these two places. And needless to say, we feel very good about it, because most of the shortfall was actually centered around two unique products to us, the Storage Central and the RangeMax. In a general scheme of things when you cannot fulfill backlog, the backlog is gone because most likely our resellers will sell our competitors' products. But because the shortfall is primarily concentrated in these two, then because they are unique to us, that we didn't lose the sale. So that basically what the overall thing is.

Now going into the fourth quarter, we talk extensively with our channel partners, both our retailers as well as our distributors around world. For our particular category of product they all feel very positive about it. And the initial sell-through in October is very encouraging. The volume of our two most popular products, the Storage Central and RangeMax continue to ramp. And we have some another new breakthrough technology to be announced in this quarter. So overall the channel is well-prepared for us to go into the holiday season.

And then just one quick question on service providers. It seems like they've (technical difficulty) another quarter of it going down. Any color there on what is happening?

Yes. Yes, certainly we are seeing the weakness in the summer months. However, as you probably know, the sales cycle of the service provider channel is actually pretty long. As I mentioned, in the call I just mentioned that we have some significant new customers such as Telenet in Benelux. We could foresee that in the next two quarters the carriers -- the service provider channel revenues is going to go up both in absolute dollars as well as a percentage of our overall revenue sale.

Jiong Shao with Lehman Brothers.

A couple of questions. First, would you be able to quantify the unfulfilled backlog during the quarter?

Yes. Actually as I mentioned just now, we had about extra $2 million of deferred revenue as compared to a normal quarter. Those actually got fulfilled, but could not be counted as revenue. There is another $2 million worth of Storage Central and RangeMax that we could not fulfill in the last week of the quarter, but we quickly get it done in the beginning of the quarter. And there are about another $2 million worth of other products that we cannot fulfill, so a total of about $6 million.

Let me just add to what Patrick said. Patrick talked about the incremental backlog in this quarter. There is other backlog which we don't share, except the end of the year in the 10-K.

Sure. Okay, great. I was wondering could you please also common on whether or not you saw any impact from consumer behavior from the past gas price and the hurricane?

As I just mentioned, we talk extensively with our reselling partner, both distributors as well as retailers, around world. As they all agreed, that it would affect the overall purchase pattern of the consumers, however, there are three categories of they do not feel that will be impacted, and we are luckily one of them. And the three categories are MP3 players, digital cameras, as well as networking products.

Excellent. And last question is that on the operating margin -- I know the operating margin was 12.7% last quarter and you guided toward 12.5 for the December quarter. First off, why it was a bit lower than what it just did? And also any comments you can share for the operating margin for '06 will be highly appreciated.

As I mentioned just now in my call, we think that right now we're sitting on a very comfortable level of profitability and cash generation. And if we see opportunities, we would like to invest a little bit more in research and development to further come up with more innovative products. We also would like to invest a little bit more in our IT tools to help us to forecast the mix even better, so that we won't have these high deferred revenues scenario in the future.

In view of that, we want to be conservative to guide in operating margin at the 12 to 12.5% range, but as usual we always want to do better.

Ben Atkinson with Gagnon Securities.

Congratulations. It sounds like the quarter went very well overall. My question is on your European inventories in the channel they look fairly low. Is that normal for this time of year? Is that where maybe some of your missed revenue opportunities were? I would just like to get a little bit more color, and also a little bit more color on your comment that Europe seems to becoming back.

Yes. Actually, you pointed out right. Actually Europe is at least half a week below what we want it to be in terms of inventory. A multitude of reasons, as I mentioned, the Europeans want our RangeMax and our Storage Central. We couldn't supply enough.

And secondly, they also are selling very hot on our Super G and G DSL 2+ gateway, which we also see some shortage as well. So, yes, given a choice I would like to see the European inventory more like a four weeks or maybe even a little bit higher going into a very strong selling season. But then we feel confident that we quickly corrected that at the beginning of the quarter, that we're well-prepared for the tremendous holiday season that we see coming forward.

Where did you see things getting better in Europe?

Actually it is across the board. It is very surprising to us that the strength came across the board, starting at the beginning of September. We were a little bit worried going into mid-August, but came September the momentum is just tremendous, especially after we went through the tour with the Storage Central product in Europe in September. It is roaring right back in every single market that we compete in in Europe.

Can I ask another question? Can you look into your crystal ball and tell us when you think we will see the 802.11n product hit the shelves next year?

It depends how you define 802.11n.

Either the Atheros lead renegade group or the actual IEEE group, whoever actually gets to market.

If you define it that broadly, then I would expect that product would come out late Q1, early Q2.

Are you onboard with either group, just depending on who can get you some good product?

I think if I tell you something that I shouldn't say, then I will be excluded from any group. I'm not going to make any comment on it.

Good answer.

Anton Wahlman with the Needham Group.

This whole server provider stuff, it seems to me that there are some markets there you're not actually even addressing at all. For example, the hot thing in cable right now is a cable modem with a phone jack, packet cable certified and a battery. It doesn't seem to me that you are addressing the battery inclusive market, but rather you had a device that is wireless, but with no battery. Would that be a market that you're going to go after the Iris' and Motorolas and Scientific Atlantas of this world, or are you not going to hit that particular corner of the market?

We always look at the market to see its growth potential, its profitability potential, and see whether we have any advantage in that particular space to be able to be a significant player. And we look at a multitude of products, and certainly we're not going to preannounce or preview any potential R&D projects that we are working in, but I could assure you that we are absolutely looking into every single possible offering for the cable operators.

As I made the comment in the call that we just got into Telenet in Holland. That they are rolling out interactive TV service that is using our Powerline, because that is a very unique technology that we have, and they find it very reliable to be able to transmit over the Internet all the commands in front of the TV back to the interactive TV central office. So I think we will continue to look for opportunities that we can excel, that we could win, and there is good profitability there for us to get into the business. As I mentioned, we look forward to the oncoming quarters with increased revenue as well as percentage of revenue sales in the carrier market.

Turning to DSL, obviously you have had some success there, and in a few places in Europe and plus Australia. In the U.S. market for DSL is that something to which you're going to be devoting resources into trying to sell a product in there? I know it has been difficult for anyone to displace -- I know Westel has been exclusive and Verizon since at least 1999, maybe going back to the experimental days in 1995. But would you devote more resources to try to attack that little corner of the market as well?

As a matter of fact, the bigger the prize, the longer the work, the harder the work is going to be, and we realize that. Of course the crown jewel of the DSL service providers will be those big operators in the U.S. So trying to get into there requires a lot of dedication and investment. Frankly, in that particular area we have significant increase to the team in terms about both R&D engineers, field engineers and salespeople who -- even the hire people from our competitors to strengthen the team. And we believe that we will continue to work on it, and we will make a breakthrough. And we're not giving up on that particular market. And of course when look at any possible means. For example, in with some unique technology, unique product, in with some more cost-effective product, or if the opportunity comes around, we might even win by acquisition.

Finally then I haven't heard anything in a while on your wide area wireless stuff. You had an early sort of product, early developed and announced with Flarion many, many, many months ago. Any update on that area?

We're still in the trial phase, both in the United States as well as in Europe. And if any of those trials are successful and go into rollout then we will be part of the whole supply. And certainly we're not going to limit ourselves only to the Flarion OFDM. We are making R&D efforts in going into the other technologies such as EVDO as well.

Mark Sue with RBC Capital Markets.

Can you just talk about the weakness in Asia, specifically South Korea and Australia, and maybe if you could discuss the trajectory for sequential improvement in the December quarter, and some of the data that you're getting for your confidence level for these two countries?

Australia's seasonally weak in Q3 vs. Q2, because of the financial year. Their financial year end in Q2, so everybody spends money and tries to get tax credit in Q2. We knew going into Q3 that Australia is going to be weak. As a matter of fact, actually the decline in sell-in and sell-through this year is less severe than last year. However, when we first got into the quarter, we thought that we would be able to counter the seasonality with some of our new product introductions. But then unfortunately all the new product allocation went over to Europe and U.S. and we didn't supply them. So that hurt us a little bit.

We're not overly worried about Australia, because our trend is actually more favorable than historical in terms of the decline. As you probably know, Q4 Christmas is their summer month -- is their summer holiday. We do not see there'll be significant sequential uptick in Australia.

Korea is a different story. Korea was a complete surprise to us. And we're still trying to research why. One of the explanations is that, as you probably know, the consumer market in Korea has been ruled by the credit cards, the debt issues that they are trying to clean up, and we probably were caught into it. However, looking into Q4 we certainly see Korea coming back very well.

Overall the growth in China, in Japan, both on a sequential and on a year-on-year basis are very, very good. And we see them continue to do so in the coming quarters, except of course in Q1. In China you would have long Chinese New Year holiday. And it certainly will be a negative quarter for Q1 for China. But other than that, we see a positive trend over there.

As a conclusion, we still feel there is a very good likelihood that Q4 will be a sequentially growth quarter for Asia-Pacific. And if you take a look at that, Asia-Pacific on a year-on-year basis grew 35%. That is based on that 13 weeks versus 14 weeks. Overall we feel very, very good -- feeling very good about our Asia-Pacific growth. And we believe that Japan and China combined next year will be more than 25% of our revenue in Asia-Pacific.

Jonathan, just the moving parts for gross margins. I have a sense you might say you're above your target of 35%. But if you look at the mix, the price, the region, the volumes should gross margins actually improve from here?

You gave me the answer before I can give it, which is we don't comment on improvement because our goal -- I think earlier Patrick also talked about it -- our focus is operating margin. Our emphasis is operating margin. And we may give on gross margin to gain market share. But -- so we're not giving any guidance on gross margin. But you can bet that we will be very cautious in how we manage our business, etc., to focus on improving operating margin.

Lastly, Patrick, in terms of your service provider push, any interest in buying (indiscernible) a company like Nutopia?

We're not going to comment on acquisition targets specifically in the earnings call. But needless to say, but we're constantly looking for acquisition opportunities in three areas, as I have been saying all along, any new product categories that we're not in that would significantly augment our channel powers, any new channel opportunities like going into the carrier channel in the U.S., or any new geographic entries such as a major brand in Russia, which there isn't today, or in Japan or in India or in China. Those are always on our radar screen.

Brantley Thompson with Goldman Sachs.

I wonder if you could talk a little bit about how we should think about the pace of new product introduction over the next couple of quarters? The last couple of quarters you brought out, I think, 17 a few quarters ago -- or 17 a quarter, the last quarter your guidance (technical difficulty) it is closer to I think south of 15 now. I just wonder how we should think about that.

And in your comments on potential needs to make acquisitions and increase R&D, kind of is there -- this is the first time I think I heard you really talk about acquisition as a need in terms of driving to new markets. Could you give us ideas to the pace of new product introduction be accelerating from here or decelerating? How should we think about that?

As far as new product introductions we always set a goal. For example, last year the goal was 12. This year it is 13 per quarter. And sometimes we go over that by a bigger margin, and sometimes we are closer to the goal. I think -- I evaluate new product introductions both from a quantity, but more importantly from quality standpoint as well.

And going forward we still believe that we can maintain a pace of about 13 per quarter. But what we're trying to do is really to have a really -- what we call a signature technology introduction every quarter. So that is the thing that we're looking forward to.

And in terms of acquisitions for new product categories, actually I have been saying it from day one all along. We haven't made any acquisitions yet, because we try to be cautious to make sure that we buy at the right price, and also it truly will be accretive, and we will be augmenting our powers in the channel. But when opportunity strikes with our strong balance sheet, with our strong operational structure, we believe that we will be able to snap it up pretty fast. Will that answer your question?

Alex Henderson with Citigroup.

This is Mike Kennedy for Alan. First of all, great job guys on the margin. But when we look at the consumer business, clearly it was down sequentially. It looks like about $1 million quarter over quarter in your reported revenue. I understand what you are saying about the backlog issues, but if we leave that out, were either of the carrier channel sales for the U.S. back to school demand -- how did those compared to the expectation you had going into the quarter? And did either fall short of your expectation going into the quarter?

As a matter of fact, if you look at sell-through, the U.S. back to school is actually above our expectation. And as a matter of fact, NPD data will show that. Both the market growth, as well as our share in the market is above our expectation. Certainly I mean our carrier business is below our expectations. There is no secret about it. So that affects our consumer -- total overall consumer revenue as well. When all is said and done, we are very pleased with our overall consumer demand.

Now certainly in Europe, because there's still two months of summer months, and we're just banking on September, we always think that Europe will be just slightly up from Q2, not a significant up. Europe's big quarter is Q4, not Q3. So Europe is right on our expectation as ticking up. And U.S. on the consumer sell-through in the noncarrier channel is actually above our expectation. But certainly the carrier channel is below our expectation. No doubt about it.

Pat, this is Alex. Could you give us a little bit better sense of what the adoption rate on the MIMO products look like?

The adoption rate is tremendous. As a matter of fact, the MIMO product right now will comprise over 10% of the revenue of our productline, and we continue to see it growing.

Do you have a target for that by year-end?

We believe that by year-end -- frankly we would like to push up to 20.

Actually, just one more question. So on the carrier stuff, was that more of an issue then in the U.S. than it was in Europe -- the shortfall there?

No, actually it is across the board. So that is why we kind of think it might be either because we don't have too much visibility into the -- actually installation rate or on hand inventory, or it is indeed that is the summer months that they actually install less to their customers. So we're still learning the seasonality among the carrier service provider business. But then again, we see the outlook very well. I mean, we see the outlook to be very good in the next two quarters.

Maynard Um with UBS.

Apologies I missed this. Can you just give us the split again on wireless vs. wired units relative to the 2.6 million total units?

Sure. The wireless percentage is 58%, and the wired business is 42%.

When I look at total units it appeared to come in better than what I was expecting, but revenues came in a little bit light. Was that a mix shift in the quarter that impacted ASPs, or was this a result of may be higher rebating or warranty expenses that falls into the contra revenue?

There are things. One, the units, we did not -- because it is very difficult for us to segregate, we do not take out the deferred revenue piece. So when we reported 2.6 million units shipped, that includes those actually we did not recognize as revenue. So in a deferred piece. Then on the overall scheme of things, I think the ASP is relatively flat. But, yes, certainly there's a little bit more consumer promotion in Q3 for the rebates and for activities in the channel, which is more contra revenue. You're right.

Next quarter when we look and if the deferred revenue start to kick in onto the revenue line, you'll be reporting a lower actual unit shipment number?

No, I mean the unit number would not be different. But from a unit -- reported unit number versus the revenue, yes, you would see that. Hey, how come? The unit growth seems to be lower while the revenue growth is higher.

Following on a little to Brantley's question, typically you have leveraged the R&D of your partners. And you seem to indicate that -- is the higher R&D shift here a shift in strategy? And should we expect the R&D to increase as a percentage of revenue going forward as you focus more on development?

No, actually our R&D is a little bit different from a traditional R&D. Our R&D is basically working cooperatively with our partners. So for every single project NETGEAR will supply what we call an architect, as well as a project manager. That is to, number one, design the overall architecture of the product from a hardware and software standpoint, and then work with our partners. And then our project managers will orchestrate the project of the various components from the various partners to the fruition of the product.

As we engage in more product development -- instead of 13, let's say we engage in 17 or 18 or 19 or 20 products at the same time, naturally we have to hire more architects and more project managers, and that will increase our revenue -- I mean, increase our R&D spend. What we're going to invest going forward are possibly (technical difficulty) of the revenue, but not much, higher in R&D is by going into maybe a newer category of technology, as well as to enhance some sophistication and complexity of some of the existing technology that requires more architects and more project managers.

And then last question. In terms of stock option expensing kicking into the first quarter, what are your plans on reporting this to the Street? And will you give a pro forma number and strip out the stock option expensing so we can look at the pro forma number? Any color there would be helpful.

Again, we haven't drilled into that one to give you a specific answer. But you'll definitely have visibility, because as you can see from the pro forma today, stock option expense is about $1.4 million on a pro forma basis -- I mean as a note. So as we are projecting next year, we expect it to be in the same range. In which case $1.4 million is a material number. We would make sure that you are aware of it.

Christin Armacost with SG Cowen.

Most of my questions were answered, but can you just give us the headcount for the September quarter? And also if you tell us if your total operating expenses are going to increase on a dollar basis for the December quarter?

The headcount -- we ended a quarter with 302 employees in total NETGEAR employees -- at the end of the third quarter, compared to the prior quarter we were at 296. With respect to operating expenses, we don't provide guidance as to operating expenses, other than to share with you that this quarter we were slightly below the prior quarter of quarter 2 on operating expenses. We try to leverage our expenses as revenue grows. However, as Patrick pointed out, one area that we will not leverage, but we may spend a little bit more is R&D.

Stanley Kovler with Merrill Lynch.

Just a quick question on distribution. You typically have given us Ingram Micro and Tech Data as a percentage of revenues. I was wondering if you could give us an update on that?

I don't have the numbers at my fingertips. It will be out with the 10-Q.

No problem.

But it will be in the same range.

And can you talk about the litigation reserve that you took -- what was that for specifically?

As we disclosed in the entire SEC filing, there are two pending litigations that we are having right now. And certainly it is our policy not to comment any further beyond that on any litigation position.

Okay. No problem. Just looking at your DSO number and kind of trends in accounts receivable, I realized that it may have been pushed up a little bit by the -- some of the backlog events. But if I back out the difference there, it seems like DSO went up a bit as well. I was wondering if you can touch up on that.

Right. Again, when you just for that deferred revenue you may take out two days for the deferred revenue part, because that is in receivables but not in revenue. However, we have always said our guidance -- guideline for DSOs would be in the high 60s, low 70s. Again, the mix this quarter is slightly higher with like retail and some of the accounts that had terms of 60 days drives the DSO up very slightly. So it is within the guidelines of where we expect it to be. Other than the DSO -- the deferred revenue adjustment. And also when you compare it to last year adjusting with the deferred revenue you're right on track with last year's DSO.

If I could just lob in a quick one about the transit ethernet, maybe we can get a sense of how your Power over Ethernet ports did this quarter, and how pricing was -- I realize you had a little bit stronger revenue growth than unit growth. Maybe you could talk about some of the product dynamics there that drove that.

Yes. Certainly we're very pleased with our overall ethernet switching growth, which is about 21%, which is really, really nice as we saw it. From a Power over Ethernet growth perspective, we are seeing quarter on quarter close to a 50% growth in ports.

Ryan Hutchinson with WR Hambrecht.

A couple of quick follow-ups to the shipment delays here. Did the air freight -- could you quantify how much that impacted gross margins?

The air freight actually was already factored into our budget. We always -- because we know always at the end of the quarter, because of the forecast of mix, we have to spend air freight. It is nothing to do with the amount of money needed to air freight. It is just the airplane arrival and then the trucks getting into the warehouse of our customers. That is basically what it -- it has nothing to do with the gross margin.

Fair enough. And then just in the 2 million incremental backlog here. You talked about the RangeMax and the Storage Central. Clearly there was -- it was in tight supply at the end of the quarter. I was trying to get one myself on the Storage Central front.

You can't find them anywhere.

No, I do have one though now. How much of the Storage Central is in this 2 million backlog number?

It is about half and half.

What is the expectations against for going into Q4, and then longer-term with this family products, does this anticipate this being another 10% product here?

We really believe this line of product could be a 10% revenue line in about two, three quarters out. But right out of the chute, it is going to be quite significant as revenue. And certainly because it is so new, we don't know. Because we don't know how high can we supply. Because right now we're just filling backlog. And then the backlog got sold out -- more backlog. So we can never test what the real market demand is. While RangeMax, we kind of -- after six, seven months, we kind of know what its trajectory is. So that is why we expect that the RangeMax that ought to be worked down very fast, very easily. But the Storage Central is hard to imagine, because it is so new.

I was at Best Buy here and I saw some rebates associated with the Storage Central already. Can you maybe comment on that?

Basically last week was the first week that we run a promotion on Storage Central. And for Best Buy to put it on air in newspaper for the circulation nationwide, you have got to have a call to action -- activity, otherwise they wouldn't put it on the flyer. It is the 129 they are advertise for a $30 rebate. So that certainly drove the demand, which is a standard practice of introducing new products. Get it on the newspaper, and get it a call to action. When we introduced the RangeMax late in March immediately we put in a $20 rebate to get it on the newspaper. So it is 149 less 20. We are following pretty much the same trend.

And then one quick follow-up in terms of you made some comment about another breakthrough product here. Can you just quantify either the product itself or the market in general that it is targeting?

I'm sure a lot of my competitors are on this call as well, so I would keep my mouth shut.

Maybe just at a high level.

I can't do that.

Eric Suppiger with Pacific Growth Equities.

First of all, just the G&A was down a little bit. Was there any reason for that?

Not really. Not really -- when you say down compared to the prior quarter, it is very minimal dollars.

Moving on. You said you have a mix shift to higher margin products, but it wasn't the RangeMax, I presume. How did you get a product mix -- a favorable product mix?

Jonathan mentioned that it is a mix shift compared to year-over-year. And certainly when we compare to year-over-year, with a 3% off gross margin improvement, it is across the board. So it is not just mix shift to a high margin products for RangeMax, but it also for our PoE switches, Smart Switch's as well -- Super G DSL 2+ gateway and as well. So that is what he meant. And that is what we meant.

On the RangeMax, on the one hand I think you said that it was greater than 10%, but you want it to be 20% by the end of this year. Is that correct?

Yes, that is correct. We would love to get the RangeMax line of products to close at 20% of revenue at the end of the year.

Can you give us any more clarity on this quarter? It sounds like maybe 1 million of your backlog is explained by RangeMax, but -- by RangeMax -- so does that mean that it was well over 10% of revenue if you include that?

It is very difficult to do a hypothetical calculation, because if we actually could fulfill the quarter, we might sell more actually. It is elastic. It is very hard for us to say.

Were there -- and then the two primary products that had constraints were the RangeMax and the Storage Central. Any other key products that were constrained?

Yes. As I mentioned it just now, half an hour ago, that in Europe we also have key constraint on our Super G DSL 2+ gateway as well.

And then last question. Korea, can you give us a little bit of sense for how much Korea represented, or how much Australia represented, of your revenues?

For competitive reasons we don't do geographic breakdown on our revenue, because that is a piece of information that most of our competitors want to know.

Anton Wahlman with the Needham Group.

Patrick, the Powerline product that you're selling into Belgium and things. Is that the same one that you're selling into the U.S. market? Obviously, the plug is different, but is it used in the same way, or is this some new --?

No, is a little bit different.

It is not the 14 Meg nominal. It is a different chip. It is a different application. What is the difference?

It is a different application. What it is, is because they wanted to do interactive TV. But the content was on a push basis. However the command is sent back to the central office through the Internet. So in front of the TV they only have a settop box with a coax cable, and they don't have any Internet connection. The Internet connection comes through the house in the garage or in the basement. So they want to string the Internet connection all the way to in front of the TV. So the best way of doing it, and they have tested wireless, they have tested coax, they have tested our Powerline. And they found out that Powerline is the most reliable. So they are using that. The product we supply to them is specifically for that purpose.

So this is very low bandwidth stuff. You just essentially use that it as a back channel?

That is correct.

(multiple speakers) even done it using SMS over cell phones to (multiple speakers).

It has to be very reliable.

The other thing is, Jonathan, I'm sort of running the numbers on your guidance here. Just looking at your guidance numbers, let's say we take gross margins at 34.8. They come down a little bit. It seems to me that even then you have to jack up expenses enormously to get to a 12.5% operating margin. What sort of gives here? Either you're going to be spending like I don't know what -- a big party somewhere -- or you're going to have again a very, very strong gross margin -- much stronger.

A couple of things. One is remember that in the operating expenses there are variable elements in the sales and marketing line, etc. And as Patrick said, we like to give guidance where on the 12 to 12.5%, because that is long-term what we have always talked about as our goal. Allowing us the opportunity to invest in systems, if we need to. As Patrick talked about, logistics -- forecasting systems, etc. And also the gross margin we may want to invest in getting more market share.

Just taking your guidance at a gross margin for the hypothetical say case of 34.8%, up and arriving at your 12.5% operating margin, you would have to increase combined R&D, S&M and G&A in my calculation by 13% sequentially. That even -- within -- is that possible?

As I said, there are variable expenses in the breakdown. Tech support, as an example, is strictly variable. Freight out is in our expenses, right? In operating expenses freight out is there. Sales and marketing. And then some investment spending. Maybe there are opportunities, but we're giving guidance today wanting to make sure that we don't -- that we are able to achieve it.

I understand. You're giving yourself a lot of leeway here to meet these numbers. But revenue up say 14% sequentially, expenses up 13%. That seems like you could -- if this comes to pass on the top line with any reasonable gross margin, you should handily beat this flowing down. But anyway --.

We hope so.

I see your point. Thank you.

Samuel Wilson with JMP Securities.

Could you give a little bit of color on your newly announced SMB products here? How are your partners expecting them? And are you seeing any demand numbers that you're willing to talk about?

The SMB products that we have announced so far this year are primarily focusing in two areas, the switches and the firewalls. As a matter of fact, the switches, as we mentioned, is growing very nicely quarter on quarter in Q3. We had a null of products in Q2, which actually led us to a sequentially down quarter in Q2. But then we rolled right back in Q3. On a year on year basis the growth of our switches, particularly in the Smart Switch's in the Layer 2, Layer 3 switches and the PoE switches are very, very encouraging.

So needless to say our resellers are very happy with those products. On the firewall side we rolled out at Trend Micro Unified Threat Management in Q3. Initial response from our resellers are very favorable. I hope that will quickly turn into real revenue increase in the coming quarters.

Alex Henderson with Citigroup.

Just a quick one. What do you estimate your market share to be in the pre-end market?

In the pre-end market today in the U.S., we are probably in the range of 35 to 40%. And then in the European market is even more lopsided. We were reported by some of the market analysts there to be closer to 70%.

So you would definitely say then in the U.S. that you would be the number one market share?

Yes.

Maynard Um of UBS.

Just another clarification. The 58/42 split was that on revenues or units?

That was on revenue.

On revenue. What was it in units?

We didn't do that.

Gentlemen, there are no further questions at this time.

Great. I would like to close the call for thanking everybody to come to this call. And we will continue our dedication and execution. And the entire NETGEAR team is very excited about the new technologies that we introduced this year, and also for the yet to be announced new products coming soon. So stay tuned. And talk to you all in the next earnings call, probably in February. Thank you.

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