NETGEAR Inc (NTGR) 2006 Q2 法說會逐字稿

Greetings, 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 8:00 PM Eastern daylight time today through midnight Eastern daylight time on August 3. The replay dial-in number is 201-612-7415 with account code 3055 and passcode 206304. The replay will also be accessible at www.NETGEAR.com.

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

Thank you, operator. Good afternoon and welcome to NETGEAR's second-quarter 2006 results call. Joining us today from the Company are Mr. Patrick Lo, Chairman and Chief Executive Officer, and Mr. Jonathan Mather, Chief Financial Officer. The format of the call will be a brief business review from 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 The Ruth Group at 646-536-7026, or you can go to NETGEAR's corporate website at www.NETGEAR.com.

Before we begin the formal remarks, the Company's attorneys advise that today's conference call contains forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. The forward-looking statements represent NETGEAR Inc.'s expectations or beliefs concerning future events and includes statements, among others, regarding NETGEAR's expected revenue, earnings, operating income and tax rate on both a GAAP and non-GAAP basis. Anticipated new product offerings, current and future demand for the Company's existing and anticipated new products, willingness of consumers to purchase and use the Company's products and ability to increase distribution and market share for the Company's products domestically and worldwide. These statements are based on management's current expectations and are subject to certain risks and uncertainties, including without limitation the following. Future demand for the Company's products may be lower than anticipated; consumers may choose not to adopt the Company's new product offerings or adopt competing products; the Company may be unsuccessful or experience delays in manufacturing and distributing in its new and existing products; telecommunications service providers may choose to utilize competing products; the Company may be unable to collect receivables as they become due; the Company may fail to manage costs, including the cost of developing new products and manufacturing and distribution of its existing offerings; channel inventory information reported 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.

Maximum wireless signal rates referenced today are derived from IEEE Standard 802.11 specifications. Actual data throughput will vary. Network conditions and environmental factors, including volume of network traffic, building materials and construction and network overhead lower actual data throughput. Further information on potential risk factors that could affect NETGEAR and its business are detailed in the Company's periodicals filings with the Securities and Exchange Commission, including but not limited to those risks and uncertainties listed in this section entitled, 1A Risk Factors pages 23 through 32 in the Company's quarterly report on Form 10-Q for the fiscal quarter ended April 2, 2006 filed with the Securities and Exchange Commission on May 12, 2006. NETGEAR undertakes no obligation to release publicly any revisions to any forward-looking statements contained herein to reflect events or circumstance after the date hereof or to reflect the occurrence of unanticipated events.

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

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

Thank you, David, and thank you, everyone, for joining us on today's call. Demand in the second quarter continued to be strong across all three regions, maintaining the momentum of the first quarter. Our product momentum is strong, and we are in the right markets with the right products at the right price. Company-wide, second-quarter net revenue increased to $130.7 million, a gain of nearly 22% compared to the year ago period. We benefited from increased demand across all three regions, maintaining the considerable business momentum we have established on a global basis.

Sequentially, our North American net revenue was essentially with Q1, while Europe, the Middle East and Africa or EMEA net revenue increased about 5%, and our Asia Pacific net revenue grew 2%. Comparing to quarter two of 2005, our North American net revenue grew 11%, EMEA increased 40% and Asia Pacific grew 4%.

As noted in the release, the strongest growth for us came from broadband gateways sold to service providers and our RangeMax line of wireless routers, including the newly introduced RangeMax Next Draft 11n products. We are very pleased with the market reception of our RangeMax Next Draft 11 products worldwide. Every day new initiatives announce some downloadable movies to advanced streaming and storage technology. Reliable bandwidth is critical to the user experience, and NETGEAR makes it happened with our RangeMax line of products. Our technology advantage, ease of use, and industrial design continues to be cited by major reviewers at many influential media outlets around the world.

Our pace of innovation has only accelerated. In quarter two, we successfully introduced another 17 new products, including eight RangeMax Next Draft 11n products. The pace of innovation sets NETGEAR apart. We believe we have the industry's leading development processes in place, and we believe we have a great sense of prioritizing what will be commercially successful.

Underscoring our success, NETGEAR just received two awards from Techworld, a leading UK tech magazine. One was for Infrastructure Product of the Year and the other for small-business product of the year. NETGEAR was the only company to win multiple awards.

We are also very encouraged by our growth in the service provider channel in Europe. Key new service providers added Q2 include BSkyB And AOL in the UK, [Telsom] in Denmark and [Blue Phase] in Ireland. We continue to gain momentum in this channel with more service provider customers expected in the future.

In line with this momentum, service provider revenue increased to 15% as a percentage of total revenue compared to 9% in the first quarter of 2006. In addition, in the second quarter of 2006, we added another 300 new retail outlets around the world. Our value-added reseller base stayed steady at 32,000.

Let me quickly touch on a few other points.

Supply constrains that were an issue in Q4 and Q1 were clearly not an issue in Q2. This was welcome news for us given anticipated demand for the back-to-school season and the need to build inventory levels. On the cost side, we continue to be (indiscernible). Wherever possible, we use the cost down strategy. For example, at the end of Q2, we forward billed inventory to take advantage of lower cost sea freights to satisfy our third-quarter demand.

On the product side, especially in relation to Skype WiFi phones, Skype decides the best quality experience for its customers and so do we. We have great working relationship together with Skype to bring innovative products to the market with great user experience. However, both of us find new technology in products more complex and challenging than we originally anticipated. Both of us are now very focused in getting the product shipped as soon as possible to the quality standard as set by Skype and ourselves. However, because of the delay, we can no longer enjoy the legal exclusivity anymore. As usual, NETGEAR is very focused on getting first to market with the best product for our customers, and we will continue to leverage our worldwide distribution and brand strength to win in the market.

Second quarter, however, was the most productive quarter for NETGEAR in terms of new product introductions and new account development. Overall we are very optimistic entering the second half of the year. Our product lineup and channel of distribution are at their strongest in the Company's 10-year history. We continue to bring significant advances in wireless and broadband applications to small office and home users globally through multiple channels -- retail, e-commerce, service providers, (indiscernible) resellers, and mail-order catalogs in the U.S., in Europe, as well as in Asia. There is a high level of energy across NETGEAR riding the momentum of the new products introduced and the new account relationships established in the second quarter.

On top of the existing 17 new products introduced in the second quarter, we expect to introduce at least 12 additional new products in the third quarter with an equally strong lineup in Q4. We also recently started to supply our Smart Switches to Korean Telecom for their wireless broadband implementation.

Today we also announced a definitive agreement to acquire SkipJam Corporation, a leader in integrated software for home entertainment and control. Our acquisition significantly strengthens our ability to expand our Multimedia Product portfolio and participate in the growing category of digital home entertainment and control.

SkipJam's technology will form the basis of our future Multimedia Products, including media centers, media players and audio players and complement our high-speed expanded range home network infrastructure solutions such as RangeMax Next Draft 11n products, as well as our newest 200 Mbps high-definition Powerline products that enable simultaneous streaming of multiple high-definition quality videos and devices like our Storage Central that stores digital entertainment files.

Under the terms of acquisition agreement, we will pay up to $9 million in cash for SkipJam, a portion of which is structured as a retention incentive program for the acquired engineering team. The acquisition is subject to various standard closing conditions and expected to close in the third quarter. Upon close of the acquisition, SkipJam's seasoned software engineering team and marketing expertise will be integrated into the NETGEAR engineering organization with Michael Spilo, CEO of SkipJam, becoming NETGEAR's VP of Engineering for multimedia products.

Finally NETGEAR will open the Nasdaq global market on August 3 in conjunction with our 10-year anniversary. We will be hosting an analyst and investor lunch reception. After which will be a great chance for you to see our second-half product lineup. If you did not already RSVP and would like to go, please call David Pasquale for our Investor Relations firm, The Ruth Group.

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

Thank you, Patrick. Let me now provide a summary of the financials for you. Net revenue for the second quarter ended July 2, 2006 was 130.7 million, a 21.5% increase as compared to 107.6 million for the second quarter ended July 3, 2005, an increase of 2.7% as compared to $127.3 million in the first quarter of 2006.

Net revenue in the second quarter of 2006 under the current geographical split method is about $56.5 million for North America, 59.8 million for Europe, Middle East and Africa regions, and 14.4 million for the Asia Pacific region. Under the prior methodology, the regions were $62.3 million, 55.1 million, and sorry -- 13.3 million respectively. Please see our quarter two release for the full description of the methodologies used.

On unit shipments, we shipped 3.1 million units in the second quarter and 2.3 million nodes of wireless products. Total units shipments of ethernet products such as hubs, switches, and ethernet network adapters were at about 900,000. Shipment of all wired and wireless routers, gateways combined, increased about 5% in units to 1.26 million units.

Moving onto the product category basis, the second-quarter net revenue split within wireless and wired was about 63% and 37% respectively in revenue compared to 61% and 39% for the first quarter 2006. The second-quarter net revenue split within home and small-business product was about 64% and 36% respectively. Products introduced in the last 12 months accounted for about 22% of total second-quarter shipments, and products introduced in the last 15 months contributed about 32% of our second-quarter shipments.

Non-GAAP cost of sales for the second quarter came in at $85.3 million or 65.2% of sales, which compares to $68.9 million or 64.1% in the year ago period and $82.6 million or 64.9% in quarter one of 2006. Non-GAAP gross margin in the second quarter of 2006 was 34.8% as compared to 35.9% in the year ago comparable quarter and 35.1% in the first quarter of 2006.

Moving to non-GAAP operating expenses, total non-GAAP operating expenses, which excludes stock-based compensation costs, came at $30.8 million compared to 25.2 million in the year ago period and 28.9 million in the prior quarter. This was 23.6% of net revenue in the second quarter of 2006 as compared to 23.4% of net revenue in the second quarter of 2005 and 32.7% in the first quarter of 2006.

Non-GAAP sales and marketing expenses were $22.4 million, which compares to 18.2 million in the year ago period and 20.4 million in the prior quarter. As a percentage of net revenues, sales and marketing was 17.2% compared to 16.9% in quarter two of last year and 16% of prior quarter.

We performed more sales and marketing activities in quarter two on the brand activities such as tradeshows and media advertising, and we also expanded our sales and marketing staff in Europe to support our rapid revenue growth in that region. Non-GAAP R&D expense was $3.8 million as compared to 3.2 million in the year ago period and 4.3 million in the first quarter of 2006. This represented 2.9% of net revenue in quarter two of this year and 3% for quarter two for 2005 and 3.4% for quarter one of 2006. Non-GAAP G&A expenses in the second quarter were $4.6 million or 3.5% of net revenue compared to (technical difficulty) million or 3.5% of net revenue in the year ago period and $4.2 million or 3.3% of net revenue in the first quarter of 2006.

As noted last quarter, we are setting up our new Ireland Internal Operations Center. The setup costs are reflected in higher G&A costs in the second quarter.

Operating income on a GAAP basis, was which includes non-cash stock-based compensation expense of $1 million, came in at 13.7 million. This compares to 13.1 million in the year ago second quarter, which includes non-cash stock-based compensation expense of 324,000 and $14.9 million in the first quarter of 2006, which includes non-cash stock-based compensation of 825,000. The increase in non-cash stock-based compensation expense from the prior year was due to the Company's adoption of FAS 123R as of January 1, 2006.

Net income. On a GAAP basis, the Company had a net income of $9.8 million or $0.29 per diluted share for the second quarter of 2006 compared to net income of 8.3 million or $0.25 per diluted share for the second quarter of 2005 and $9.9 million or $0.29 per diluted share in the first quarter of 2006. Non-GAAP net income for the second quarter of 2006 was $10.5 million or 26.5% increase compared to non-GAAP net income of $8.3 million for the second quarter of 2005 and relatively flat compared to non-GAAP net income of $10.5 million for the first quarter of 2006. Non-GAAP net income for the second quarter of 2006 excludes non-cash stock-based compensation net of tax of $622,000. Non-GAAP net income for the second quarter of 2005 excludes non-cash stock-based compensation of $324,000 and also excludes a $325,000 net tax benefit from exercises of stock options.

Non-GAAP net income for the first quarter of 2006 excludes non-cash stock-based compensation net of tax of $672,000. Non-GAAP net income was $0.30 per diluted share in the second quarter of 2006 compared to $0.25 per diluted share in the second quarter of 2005 and $0.31 for the first quarter of 2006. Non-GAAP tax rate was 39.4% in the second quarter of 2006.

Moving onto balance sheet. We ended the second quarter with 158.9 million or approximately $4.61 per diluted share in cash, cash equivalents or short-term investments compared to a total of $178 million at the end of the first quarter or approximately $5.22 per diluted share. We strategically used our cash to bolster our inventory level early on for quarter three demand in order to save on airfreight costs. We also made payments for taxes of approximately $11 million in the second quarter of 2006 as compared with $3.5 million in the first quarter of 2006.

In terms of inventory trends, we ended the second quarter with inventory at $69.3 million with ending inventory turns of 4.9 compared to $44.9 million with ending inventory turns of 7.4 at the end of first quarter 2006. And $44.1 million with ending inventory turns of 6.3 at the end of second- quarter 2005. We believe our forward inventory (indiscernible) is a prudent position to take advantage of lower sea freight.

Day sales outstanding, DSO, was 74 in the second quarter of 2006 compared to 77 days in the first quarter of 2006 and 66 days in the second quarter of 2005. Retail channel inventory in the U.S. end of the second quarter of 2006, higher than normal at 13.3 weeks due to preparation for the back-to-school season. We fully expect the U.S. retail channel inventory level to be closer to the 10 weeks level by the end of the third quarter. This compares to a 10.1 week in the second quarter of 2005 and 9.3 weeks in the first quarter of 2006. U.S. distribution channel inventory ended the second quarter of 2006 at 4.7 weeks as compared with 3.3 weeks in the second quarter of 2005 and five weeks in the first quarter of 2006. European distribution channel inventory ended the second quarter of 2006 at approximately 6.1 weeks as compared to approximately 5.2 weeks in the first quarter of 2006 and 3.9 weeks in the second quarter of 2005. Asia Pacific distribution channel inventory ended the second quarter of 2006 at approximately 5.1 weeks as compared to approximately 5.3 weeks in the second quarter of 2005 and 4.1 weeks in the first quarter of 2006.

Total assets were $367.9 million at the end of second quarter of 2006 compared with $357.5 million at the end of the first quarter of 2006 and $294.6 million at the end of second quarter of 2005.

Deferred revenue decreased to $6.9 million as compared to 7.7 million at the end of prior quarter and $2.7 million at the end of second-quarter 2005.

Now let me make a comment on third-quarter 2006. We expect net revenue for third-quarter 2006 will be approximately $138 million to $143 million with non-GAAP operating margin in the range of 11% to 12%. Finally, we expect the non-GAAP effective tax rate to be approximately 39.5%. Our guidance does not include any GAAP purchase price accounting adjustments for the SkipJam acquisition.

Operator, thank you. Questions?

(OPERATOR INSTRUCTIONS). Samuel Wilson, JMP Securities.

I hope you (indiscernible) I have a multi-part question, or a couple of questions here. First, on SkipJam, we know those products a little bit. They usually carry higher ASPs, a little bit higher end target customer. And so I just want to get a sense a little bit strategically what you are thinking there. It is the first acquisition for the company. Do you view this as product expansion or market expansion, and what's your thoughts there?

Also, can you give us an update -- RadioShack was a new retail distribution channel partner last quarter. Just how is that going, and how is retail expansion going in general?

And then third, competition. That's it.

That's a pretty fully loaded question, Sam. First and foremost for SkipJam, as we just talked about in the discussion I had, the primary driver for the SkipJam acquisition is about the people, as well as the base software technology that they have. As you probably know, our existing product in that category, the MP101, MP102 was pretty long in the tooth. And we believe that acquiring the expertise will help us to regain the leadership in this very important potential future new category of products.

So in absorbing the SkipJam marketing and engineering people, we believe that we will be able to generate more products based on their software platform, both in lower price, as well as higher features, and they will be able to help us expand -- understand, because they understand more about the market and the features into this particular market. So we believe that this is a new product category drive that will benefit us in the quarters to come.

And regarding the expansion in retail, as we mentioned also just now in the discussion, we added in another 300 retail outlets around the world. RadioShack is doing very well for us and actually slightly above our expectation. But then certainly because they have so many retail outlets, we absolutely will take time to help them manage the inventory to be able to help us to get an overall ideal situation in the [pan] retail channel-wide inventory level. But we are committed to that.

In terms of retail expansion -- we will continue to look for new opportunities not only in the United States, but as well as around the world, as well especially in the emerging markets such as in Russia, such as in China, such as in India.

Did I miss anything, Sam?

And just an update on competitive landscape. It seems like there's been less competition recently.

As far as the competition is concerned, I think the competitive landscape has been pretty much stable for the last year in individual countries/region. We have not seen any new players coming into the market, but we certainly saw some of our players getting weakened. That is way we see we are gaining share.

Jiong Shao, Lehman Brothers.

I've got a couple of questions as well. But first, I will follow-up on SkipJam. Will all the people be moving to the West Coast? And is the expense or the cost for SkipJam engineers already part of your operating margin guidance for this quarter?

Yes.

They are going to move to Santa Clara over the next 12 months. They are currently residing in New York, but we will give them a 12 months timeframe for them to move to Santa Clara. And as a matter of fact, part of the $9 million that we are going to pay them will be retained as an incentive for them to move to California.

In terms of expenses --

Yes. The operating expenses are included in the guidance. The only thing, as I pointed out, is that the guidance does not include any GAAP purchase price accounting adjustments. So hopefully that will be excluded from non-GAAP. Giving you non-GAAP guidance.

Right. Can you expect the deal will get closed sometime later this quarter toward the end?

That is our aim, to try to close it as quickly as possible in Q3.

My first real question is that -- obviously the numbers for the June quarter are very strong and the guidance is very strong. One of the potential concerns as you alluded to is the inventory level, I know you have talked about inventory a bit on the call. I was hoping you could expand a little bit because I know in the past that you don't want your U.S. retail channel inventory to go beyond 12 weeks. Could you just talk about some of the things you were seeing that made you decide to drive that to 13.4 weeks I think and your confidence level that's going to drop back to 10 weeks exiting this quarter?

Well, this year is a little bit special because as we explained in the discussion just now, we introduced to the U.S. retail channel our RangeMax Next Draft 11n products in mid-June. Because that was the first moment that the retailers are willing to reset their shelves and took on new SKUs.

Not only that, this is actually the first most important category introduction for us that carries so many retail SKUs. As a matter of fact, because we introduced a total of six retail SKUs, including three for 10-100, three for gigabit. We have never done it before. And the retailers certainly want to stock up for the back-to-school season, which is about to start now. So we have a choice to stop them from stocking it and then lose market share and sales, or we have to prove our point that we are confident about the technology as well.

So given a choice then, we basically allow the channel inventory into the U.S. retail to actually go up to a 13.3 week level. Now, we absolutely have the plan in place, and our retail partners understand as well that we would like to bring it down to 10 weeks of retail channel inventory. And we believe that, barring any unforeseen reasons with the back-to-school season right in front of us, we should be able to do that. In our guidance we have already factored that coming down in retail channel inventory.

Great. That is very clear. My second question is on the products. Could you just talk about the current expectation for the GA date for the Skype phone and the percentage of revenue you received from Storage Central last quarter?

Storage Central (multiple speakers).

The Storage Central -- for competitive reasons we never disclose the revenue particular on a particular product. But, as we always maintained, our Storage Central sell-through in the market is strong and is steady. There is no change significantly, and we believe that we can boost it further later on in the year when we introduce subsequent models of the Storage Central.

In terms of the Skype phone, as we talked about it in the discussion, it is the joint project between Skype and ourselves, and both Skype and us have very high standards of quality and both of us are working very, very closely together on respective parts to heighten -- to hasten the shipment of this particular product. And once the standards reach to the level that both Skype and us set, then we will ship it. At this point in time, we would not like to give a definitive date. But both of us are working very feverishly to try to get it out the door as quickly as we can.

A quick follow-up on both fronts. For Skype phone, is that fair to sort of expect at least sometime this year?

And Storage Central, just I think you had previously talked about -- maybe is that still reasonable to expect or to think it is 5 to 10% of total revenue, roughly?

Our aim is absolutely to have the Skype phone ship out not only before the end of the year -- if I had a choice, I would like to have it before the end of the month. But certainly the engineers, both at Skype and in our organization, know the importance because there are so many customers waiting for it that we would like to get it out as quickly as we can and hopefully within a very short time.

Regarding Storage Central, yes, our aim is still try to make it a new category that will generate a good chunk of revenue for us.

Brantley Thompson, Goldman Sachs.

It is [Natalie Haday] for Brant Thompson. I was wondering if you could talk a little bit about ASPs? It looks as though the ASPs went up sequentially, pretty heavily up 6% I think is what I am calculating versus kind of consistent declines before that. Could you just talk a little bit about the product mix, what contributed to that and how we should think about ASPs going forward?

Thank you for the question. As I just mentioned in the discussion, the two strongest category of products in Q2 was one, the broadband gateway that we shipped to the service providers. These broadband gateways have a broadband modem combined with a router, combined with wireless all in one box. And clearly they carry a higher ASP than the straight wireless routers that we sell in the retail channel.

Secondly, for the new products that we introduced, RangeMax Next, that is of a much higher ASP than our existing RangeMax and normal 11g routers. And because of the strength of these two products, the ASP went up in Q2.

Alex Henderson, Citigroup.

A couple of questions. First off, on the acquisitions, are we looking at roughly $1 million worth of labor costs that need to be feathered in over two quarters? Is that roughly what we're talking about here?

No.

No, and also it is not, Alex, and also we don't disclose the --

How many engineers did you pick up?

We picked up five engineers.

It's only five. I was thinking it was more like a dozen.

No.

Five engineers, thank you. The cost then would be roughly half this quarter, half next quarter on the ramp-up of that?

It really depends on when they are going to join us, when the deal is going to be closed.

On the inventory side, certainly increasing inventory in the channel is well above your historical norms. But the increase in inventory on the boats is even more striking. It seems a little unusual to be doing both simultaneously. Can you give us some granularity of what type of inventory is in the boats versus what's in the channel? Is there any difference in the composite -- in the mixture of that?

Definitely I'll not go into the granularity for obvious competitive reasons. But I would like to point out two things. One, as you can see in Q2, 15% of our revenue came from the service provider channel, and we expect that to happen again in Q3. And first provider orders were actually placed way in advance. And if we now how many we're going to ship, of course we would like to put it on the boat rather than on the airplane to save costs. And that is why that would help to explain some of the (indiscernible) in terms of the inventory in transit.

Secondly, as we probably know, this year is very, very, very strange -- not strange -- very severe in terms of the oil prices. So the oil prices is ever going up, is almost to the tune of $5 per barrel a month, and we anticipate that the airfreight costs of Q3 is not going to coming down -- it is going to go rise. So in view of that, we believe it's prudent to just to put the goods early on in our inventory so that we could avoid more expensive airfreight as time goes on for Q3, which is a very, very big quarter. So we don't want to be faced with a decision toward the mid to late of Q3 either we pay very expensive airfreight or we don't have goods. And combined with that, we left our on-hand inventory to go up, including both in the warehouse and in transit. But we believe that after Q3, then if we see the oil surcharges or freight coming to stabilize, then we will certainly take the level down to a more normal level.

Maynard Um, UBS.

A clarification in the question, if I could. You indicated the SkipJam acquisition is included in the guidance. It sounds like the revenue contribution is very small, so should we look at the revenue guidance that you gave as pretty much all organic growth?

Yes.

And then, inventories were -- you indicated were up to take advantage of the lower, I assume, inbound freight, which I thought would have helped gross margins because the freight accruals were pretty high in the past two quarters. Was there an increase in the warranty accruals or period costs or other items that might have offset the lower freight, or was it a function of lower product margins? Are these gross margin benefits that we should see in the second -- third quarter?

As we maintain all the time, we look at operating margin rather than gross margin as we discussed many a time before. Clearly the gross margins for the product sales to service providers are lower than to retail. So when your service provider revenue portion goes up, then gross margin will come down, but the key is the operating margin. So what we are focusing on is in operating margin.

Sanjiv Wadhwani, Miller Johnson.

Patrick, with back-to-school just about to start, any color on trends that you're seeing? Any color that your retailers have provided you?

And then second question on the inventory side, is it fair to assume that at least on the retail side, the inventory ramp-up was primarily on the Draft 11n products, or is it pretty broad-based?

In terms of the ramp up in the inventory in the channel, yes, it is very, very heavily skewed towards the RangeMax Next Draft 11n products, that is for sure.

Could you repeat your first part of the question again, I'm sorry? (multiple speakers) I forgot the first half of Sanjiv's question. Operator?

I am sorry. It seems that his line has gone mute. We do have another question coming in. Mark Sue, RBC Capital Markets.

Patrick, just one last clarification on Skype. Has the Skype phone production stopped for now? And if so, when will it resume resume?

Well, as will always be prudent, we will not start production until the product is really solidly engineering released.

So it's still likely that you can get revenues this quarter?

As we often mentioned in the discussion, we would not put it in the revenue forecast or guidance until we get a definitive run rate.

And just a broader question, Patrick, your higher revenues did not translate into higher earnings despite the higher interest income. Any thoughts on how you are managing the financial model for earnings growth, or should we still see continued swings in earnings going forward?

I think in our last earnings, we already mentioned that we expect Q2 to be a higher expense quarter, and we mentioned that we have to spend more money in billing up our European operations and also in the engineering expenses. So we did spend much more money in building up our Ireland operations. And on the engineering side, we get some nice surprise that we actually get some savings.

But on the other hand, we also have nice surprises in the service provider revenue in Europe, which costs us more compensation and also requires us to hire more people in Europe to handle that kind of business. So we believe that we are still managing our financials very well to our budget, and we will continue to do so.

And as we said all the time, that we will focus on improving our operating margin going forward.

And lastly, just an update on the CFO search?

The CFO search is progressing well.

So maybe by the end of the year definitely?

Definitely. Jonathan has to go by then.

Anton Wahlman, ThinkEquity.

Two quick things. First of all, on the sell-through of .11n, I mean there has been speculation in the marketplace to the effect that while the channel has been filled with lots of varied .11 product, allegedly very little has actually sold because of bad press about performance and so forth. How would you comment on that?

Well, as the matter of fact, what we see is very interesting. You'll always have some people who do not have the technology and will come out and stir up a lot of bad press about it, which is no different from about four years ago when the 11g products were introduced.

I don't think that is true. We have seen a lot of reviews. The performance is very good. As a matter of fact, there is a review that shows that our gigabit edition of our 11n products actually will achieve a speed all the way up to 120 to 150 megabits-per-second. So that is very, very good.

Now in terms of comparing the takeup in the market, I think the best comparison is comparing last year when we introduced RangeMax. We introduced RangeMax last year in April, and in July the weekly run rate of sell-through worldwide for our RangeMax router last year is almost identical to the RangeMax Next Draft 11n routers and gateway sales at this time.

Good. So basically nothing unusual. Basically, this is just another product introduction, nothing in particular unusual about it in terms of how it is acting in the marketplace just like your previous ones in the last few cycles?

Well, when we introduced RangeMax, we thought there was a pretty unusual -- unusually popular introduction. So if that becomes the norm, then you are right, then it's nothing unusual. But we still consider RangeMax as a pretty unusually popular product, then we could classify RangeMax Next also has a pretty unusually popular product as well.

Great. Second question then. Just in terms of [Vive] compliance and how it fits in with your acquisition today -- I mean obviously this is about buying people and software, but could you explain a little bit how this fits into your sort of Vive project and how far do you think you are or the market would be to be ready for accepting truly ready to go Vive I guess as 1.5 release type products?

And do you think that these will be very baseline products? That will be the kind of, I don't now, $99 price point or something? Or do you think there will be a whole class of more expensive Vive DMAs on top of it?

What I would like to stress again one more time is the whole notice of acquiring SkipJam is not for products. It is primarily for the expertise, as well as the base software they could bring in, and I believe that with the marketing expertise and the engineering expertise and the software they bring in, this group of people will be able to help us to come up with a very competitive line of products from low end to high end that will be Vive compliant all with additional features that will position us very well in this emerging category.

[Stanley Cosler], Merrill Lynch.

I just wanted to touch on the SMB business a little bit, wanted to discuss competitive trends that you are seeing, maybe from Linksys and D-Link and how you see that market progressing? Before you have noticed that the focus has been in terms of the major recent product introductions and major -- well, the acquisition that you have done here -- seems to be more on the home networking side. I am wondering if there is a disparity in the growth rate expectations you see for home networking and SMB? And maybe you can help us quantify that. And I have a follow-up.

Clearly because the penetration of home networks is lower than the SMB, and the market clearly is skewed in terms of growth on the home networking side. And also as we launch more and more into the service provider channel, which is very home-focused, you will see a disparity in terms of growth between our home-network products versus our small-business products. However, that doesn't mean that we do not intend to continue to gain share in the SMB side.

As you mentioned, from a competition standpoint on the SMB side, again, we are not seeing significant new -- we actually do not see any new entrants into the particular marketplace. It is the same usual suspects -- 3Com, HP, D-Link and Linksys and some local brands. It's good to see that some of these weaker brands are actually losing market share, and that's why it enables us to continue to gain share. We are very, very happy to see that we continue to make very good stride in our Smart Switches, as well as our layer 2, layer 3 switches.

And as a matter of fact, if you have come to Interop, one of the most exciting products that we introduced in Las Vegas in May in Interop and showcased and getting a lot of good feedback from our (indiscernible) resellers, is in our SSL VPN appliance. That is scheduled to ship in this coming quarter, and we are very excited about it.

And my follow-up was actually on the EMEA distribution. It seems like the weeks of inventory have gone up there, and I'm wondering if you could touch on the landscape in EMEA a little bit outside of service provider?

Actually, EMEA is a pure calculation. Because, as you probably know, in the month of June there is the World Cup. So nobody really works. So most of the sales were done in April and May. So because the way we calculate weeks of inventory, we only take the last six weeks of the quarter, and that's why you see a similarly higher number of weeks of inventory.

And just quickly, what was the headcount and also specifically, the sales and marketing headcount? And that is all for me.

We have 363 people at the end of the quarter. And for competitive reasons, clearly we do not like to disclose how many people are in sales and marketing.

Erik Suppiger, Pacific Growth Equities.

On the Skype phone, could you just talk a little bit about how you see the competitive landscape developing? Do you think it will be a couple of you when you get out there? Or is it going to be -- is there going to be kind of a slew of competitors at the get-go?

We believe that, since we don't have the exclusivity anymore, there's got to be competitors. And we would just do the same thing as we compete in any other products, be it our RangeMax Next Draft 11n or just the vanilla 11g products, we will compete on usability, quality, brand strength and distribution.

Would you expect the primary competitors to be the likes of Linksys and D-Link or anybody else that would be of note?

Anybody is possible.

Then a couple of quick questions, just for Jonathan. What was other income on the income statement?

Currency gains.

And on the R&D, you had noted that at the end of last year that the first half of this year would have additional expenses as you got your China facility working. Is there any decline or any -- now that the China facility is up and running, does that make any difference as we get into the September quarter?

As a matter of fact, we are actually behind in hiring. And that's why you saw in Q2 the R&D percentage was not as high as we actually wanted it to be. So we expect that. Hopefully, they will catch up in Q3 and Q4.

So R&D should actually have a increase as --

Current level --

Q3?

At least at the current level, if not higher -- slightly.

And then on the G&A. The Ireland facility, Jonathan, were you suggesting that will cause an increase in G&A going into the September quarter?

No, what we said before was quarter two had a bump-up in costs, hiring, setting it up, etc. But then it will taper down going forward because we take it into consideration in our guidance.

So it will be coming down. And will we see the tax benefit from that in '07? Can we anticipate an improved tax rate?

Yes. We are projecting that in '07 we should expect to see 100 to 300 basis points -- let's say, 200 basis points tax improvement year-over-year.

And is that a step function, or should we just assume 37.5% throughout the year?

Again, it will be 2007 rate for the full year and at that rate going forward for a couple of years until it drops drastically.

Alex Henderson, Citigroup.

I wanted to follow-up on the other income line. As I was sitting here working on my model, I had a similar question. So given the currency translation in the quarter, I assume that comes back down to what, a couple hundred thousand instead of that 850 that had been in there in the quarter?

Alex, the 800,000, most of it was the currency gains.

So we should be using essentially zero functionally going forward?

Going forward, that's what we do because we don't know how currency will --

And the second question is, when you sign this new contract with European service provider IEBB in UK, is there an inventory ship-in to them initially, and what would the timing of that look like?

No, the thing is, once they took inventory, that is revenue. So we shipped to them in Q2, in the end of Q2, and is sales, and they announced actually early July the rollout of the program. They do not give us any inventory data. But based on the trend of reordering, they seem to have already used a good chunk of what we shipped them. Remember, they're giving those things away when the subscribers subscribe their lines.

Yes, do you have any sense of what percentage of their placements would be your product versus some other or who else sells through that channel? What other product they use?

We are 100% there.

100%. So you should have a pretty good handle on it just by looking at their net adds, right?

If you look at the BSkyB net adds, yes.

So can you talk to whether the inventories shipped to that channel is consistent with their net add?

I do not track the net add, I am sorry. We just look at their reordering.

Overall, the spike up in the service provider channel as a percentage of sales, you had difficulty having visibility into that in the past. Do you have any better clarity this time around than you have had in entire periods? I mean, you had frustration with that last year, for instance, when it dropped from 13 down to 7.

We are still learning. We are trying to get more discipline and visibility on our sales force.

Well, why is it you don't track the net adds if that is the -- I mean, it has to be a one to one if they are exclusively using you to supply?

You are right. It is only 20 days after they started their service. I think it is pretty difficult to track that. I don't think they disclose it.

There are no further questions in queue at this time. Mr. Lo, do you have any closing comments?

Okay, yes. I would like to thank everybody for joining us today. As I mentioned, we are very excited about some of the new accounts that we have established in Q2, and the product is strong. We believe that in Q3, based on that foundation, we are very optimistic. We really would like to thank everybody for support, especially our employees, our customers, and we are absolutely committed to provide the best product in the market and hope to see you all again in the Q3 conference call. Thank you.

Ladies and gentlemen, this does conclude today's teleconference. We thank you for your participation, and you may disconnect your lines at this time.