NETGEAR Inc (NTGR) 2008 Q2 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the NETGEAR Inc. second-quarter 2008 results conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Joseph Villalta of The Ruth Group. Thank you, Mr. Villalta. You may begin.

Thank you. Good afternoon and welcome to NETGEAR's second-quarter 2008 results call. Joining us from the Company are Patrick Lo, Chairman and CEO, and Christine Gorjanc, CFO. The format of the call will be a brief business review by Patrick, followed by Christine 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 go to NETGEAR's corporate website at www.netgear.com.

Before we begin the formal remarks, the Company's attorneys advise us that today's conference call contains forward-looking statements within the meaning of the US Private Securities Litigation Reform Act of 1995. The forward-looking statements represent NETGEAR's expectations or beliefs concerning future events and include statements, among others, regarding NETGEAR's expected revenue, earnings, operating income and tax rate on both a GAAP and non-GAAP basis; anticipated new product offerings; current and future demand for the Company's existing and anticipated new products; willingness of the 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 its new and existing products; telecommunications service providers may choose to slow their deployment of the Company's products or 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. General inventory information reported is estimated based on average number of weeks of inventory on hand on the last Saturday of the quarter as reported by certain of NETGEAR's customers.

Further information on potential risks and factors that could affect NETGEAR and its business are detailed in the Company's periodic filings with the SEC, including but not limited to those risks and uncertainties listed in the section entitled Part 2, Item 1A, Risk Factors, pages 23 through 34 in the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 30, 2008, filed with the Securities and Exchange Commission on May 9, 2008. 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 occurrence of 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 in our press release on 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, Joseph, and thank you, everyone, for joining today's call. This was a solid quarter for us, despite a challenging market environment. Net revenue in Q2 increased 24% to $204.5 million compared to the year-ago period and increased 3% as compared to Q1 of 2008.

We enjoyed very healthy revenue growth in Q2 due to a strong performance in Asia-Pacific and the successful launch of NETGEAR products in Wal-Mart stores in the US. The performance of our emerging markets, including China, India, Eastern Europe, the Middle East and Brazil, continued to be strong in Q2. Specifically, our Asia-Pacific revenue was $31 million in Q2, a growth of 79% year over year and 49% quarter on quarter.

Our operating margin saw much improvement in Q2 due to our successful efforts in both product and operating cost reductions. We also had increased sales of Smart Switches, which carry slightly higher margin. We increased our on-hand inventory in order to better meet demands with less airfreight. With the introduction of newer and lower-cost 802.11n WiFi products in the second quarter, we are also better positioned to compete with the lower-priced offerings from our primary competitors.

Looking forward, we foresee the current market weakness and uncertainty in both the UK and the US lasting into 2009. In the interim, as we have previously shared with you, we continue to execute our core growth strategy of releasing innovative products, winning new customers and penetrating emerging markets. We also intend to put more resources behind our R&D efforts in order to accelerate new product introductions. In addition, in Q3 of this year, we will bring online our new ERP system, which will make our supply chain management more efficient in the intermediate and long term.

From the product perspective, our ReadyNAS network attached storage and Gigabit Smart Switches continued to enjoy strong reception worldwide in Q2. Among the 11 new products released in the second quarter, notable launches include our low-cost, high-performance 11n router and 11n upgrade kit for any installed 11g routers, and our two industry-first Layer 3 Smart Switches.

We foresee a strong transition in the market to 11n in the second half of 2008, and we believe our complete lineup of 11n products with the differentiated RangeMax technology position us for revenue growth and share gain. We will continue to introduce additional models of Smart Switches and ReadyNAS in the second half of the year, further consolidating our technology and market share leadership in these two fast-growing areas of SMB networking and storage.

On the channel side, we are pleased to have added TV Cabo in Portugal and Cablemas in Mexico to our service provider customer list. For Q2, our service provider revenue was approximately $55 million, about 27% of our total revenue, as compared to 24% in the year-ago quarter and 28% in the first quarter of 2008.

We ended the second quarter with a significant increase in retail outlets due to our launch into the Wal-Mart stores in the US. Now we have over 28,000 retail outlets worldwide. We continue to maintain an extensive value-added reseller base of about 42,000.

In the upcoming third quarter, we expect lower than normal back-to-school demand due to the economic climate in the US and the UK. In spite of the challenging environment, we have decided to increase our emphasis in R&D in the coming quarters to increase our pipeline of new, differentiated products.

We also will spend more in IT as we bring up a new ERP system in Q3. This new ERP system will enable us to be more efficient in our supply chain management down the road, as well as increasing the visibility of critical business metrics. By continuing to invest in innovation and operational efficiency enhancements, we are confident that we will emerge even stronger once economic growth resumes in the US and the UK.

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

Thank you, Patrick. Let me now provide you with a summary of our financials for Q2. As Patrick just noted, net revenue for the second quarter ended June 29, 2008, was $204.5 million, a 24% increase as compared to $164.3 million for the second quarter ended July 1, 2007, and a 3% increase as compared to $198.2 million in the first quarter ended March 30, 2008.

Net revenue in the second quarter of 2008 by geography was $75.9 million for North America, $97.6 million for the Europe, Middle East and Africa region, and $31 million for the Asia-Pacific region. We shipped about 4.3 million units in the second quarter, including 3.5 million nodes of wireless products. Shipments of our wired and wireless routers and gateway combined were about 2.3 million units.

Moving to the product category basis, the second-quarter net revenue split between wireless and wired was about 62% and 38%, respectively, relatively unchanged from the first quarter of 2008. The second-quarter net revenue split between home and small business products was about 62% and 38%, unchanged from Q1. Products introduced in the last 15 months constituted about 34% of our second-quarter shipments, while products introduced in the last 12 months constituted about 33% of our second-quarter shipments.

Non-GAAP gross margin in the second quarter of 2008 was 33.2% as compared to 35.5% in the year-ago comparable quarter and 32.9% in the first quarter of 2008. Moving to non-GAAP operating expenses, total non-GAAP operating expenses, which exclude litigation reserves and acquisition-related retention compensation, as well as noncash stock-based compensation costs, came in at about $44.4 million for the second quarter of 2008. This compares to non-GAAP operating expense of $39.8 million in the second quarter of 2007 and $46.4 million in the first quarter of 2008.

Q2 2008 operating expenses represented 21.7% of net revenue. This is a decrease of 250 basis points compared to the second quarter of 2007 and a decrease of 170 basis points compared to the first quarter of 2008.

Non-GAAP sales and marketing expenses were $30.3 million. As a percentage of net revenue, sales and marketing expenses were 14.8% in Q2 of 2008 as compared to 16.7% in Q2 of 2007 and 15.2% in Q1 of 2008. This decrease is reflective of the Company's cost saving efforts.

Non-GAAP R&D expenses were $7.2 million. This represents 3.5% of net revenue in Q2 of 2008 as compared to 3.7% in Q2 of 2007 and 4% in Q1 of 2008. The decrease in R&D expense is due to the timing of product certification costs.

Non-GAAP G&A expenses in the second quarter were $6.9 million or 3.4% of net revenue compared to 3.8% in the year-ago period and 3.2% in the first quarter of 2008. The increase compared to Q1 is due to increased professional service fees in the areas of legal and finance.

Operating income on a GAAP basis was $18.8 million, which includes $1.7 million in charges for amortization of purchased intangibles and acquisition-related retention compensation, as well as noncash stock-based compensation of $2.9 million. This compares to GAAP operating income of $9.6 million in the year-ago second quarter and $14.7 million in the first quarter of 2008.

On a GAAP basis, the Company recorded net income of $11.1 million or $0.31 per diluted share for the second quarter of 2008 compared to net income of $6.1 million or $0.17 per diluted share for the second quarter of 2007 and $11.2 million or $0.31 per diluted share in the first quarter of 2008.

Net income on a non-GAAP basis for the second quarter of 2008 was $14.5 million as compared to non-GAAP net income of $13.7 million for the second quarter of 2007 and non-GAAP net income of $14.1 million for the first quarter of 2008.

Non-GAAP net income was $0.41 per diluted share in the second quarter of 2008 compared to $0.38 per diluted share in the second quarter of 2007 and $0.39 for the first quarter of 2008. For calculating the earnings per share, we use a fully diluted stock count of 35.8 million shares for Q2 versus 35.9 million shares for the prior quarter and 35.8 million shares for Q2 of 2007. In Q2 of 2008, there was no currency gain as compared to a gain of $1.1 million in Q2 of 2007 and a gain of about $2.8 million in Q1 of 2008.

The non-GAAP tax rate is 40.6% in the second quarter of 2008 compared to 37.3% in the prior-year second quarter and 39.2% in the first quarter of 2008.

The reconciliation of GAAP to non-GAAP is detailed in our financial statements released earlier today.

Moving on to the balance sheet, we ended the second quarter with $186.8 million or approximately $5.22 per diluted share in cash, cash equivalents and short-term investments compared to a total of $155.8 million at the end of the second quarter of 2007 or approximately $4.35 per diluted share and $200.8 million at the end of the first quarter of 2008 or approximately $5.59 per diluted share.

In terms of inventory trends, we ended the second quarter 2008 with inventory at $106.4 million, with ending inventory turns of 5.2 compared to 5.1 turns at the end of the second quarter 2007 and 5.5 turns at the end of the first quarter 2008. We increased our inventory levels in order to better meet demand while minimizing the need for airfreight.

Days sales outstanding were 71 in the second quarter of 2008 compared to 75 days in the second quarter of 2007 and 71 days ended the first quarter 2008. This remains within our historical range of 65 to 75 days. Our channel inventory is slightly higher than prior quarter due to the channel's preparation for back to school, which begins in mid-July.

Total assets were approximately $569.3 million at the end of the second quarter 2008 compared to $481.6 million at the end of the second quarter of 2007 and $562.7 million at the end of the first quarter 2008.

Deferred revenue decreased to $4.3 million as compared to $7.5 million at the end of the prior quarter and $8.7 million at the end of the second quarter of 2007.

For the third quarter of 2008, we expect lower than normal back-to-school consumer purchases in the US and UK due to the challenging economic climate. Specifically, we expect third-quarter net revenue to be approximately $208 million to $212 million. With additional investment in R&D and IT infrastructure, we expect the non-GAAP operating margin in the range of 9.5% to 10.5%. Finally, we expect the non-GAAP effective tax rate to be approximately 39.5%.

Operator, that concludes our comments, and we can now take any questions.

(OPERATOR INSTRUCTIONS) Tom Lee, Goldman Sachs.

A few questions. First one is, can you give a little bit more granularity in terms of what was driving the strength in Asia-Pac? And then was it specifically -- was it in small and medium business, or was it in more kind of consumer markets that you were seeing that shrink?

It was across the board.

Across the board. And it was primarily APAC as opposed to, like, Eastern Europe or Middle East?

We specifically said it was Asia-Pacific.

Got it. And then can you talk a little bit about your visibility? Is that still -- has that changed at all since the last quarter, or is that relatively the same?

We certainly are seeing the trend in the market, and based on the trend, that is why we gave the guidance.

And then can you -- what was your operating cash flow in the quarter?

Operating cash flow for Q2 is a negative $6.6 million.

Got it. And then last question is regarding your commentary around strong transition to 11n in the back half of the year. Can you give a little bit more color in terms of what gives you the confidence that we will see a strong pickup in 11n? And is that likely more in the developed markets? And if you can just help kind of reconcile some of the comments about the slowing macro or slowing -- the tough macro conditions in both the US and Europe, as well as expectations of strong 11n adoption?

Yes. We see definitely the overall unit purchase is slowing down because of the economic climate. But in the overall unit sales, the percentage of 11n sales is going to be bigger as compared to the first half.

Got it. So there is no -- because I think I thought you said previously that you thought that 11n was going to be more of a 2009 story because of what was going on with the standards being ratified, but is that not an issue anymore?

Basically, we were surprised by the price moves of our competitors on the 11n products across the board. I think that really tilted the scale, especially in the consumer aspect.

Samuel Wilson, JMP Securities.

A couple of small questions also. First, last quarter's conference call, you mentioned you weren't 100% sure how you were going to recognize revenue on Wal-Mart, given the lack of experience with the customer. Can you just talk about how you recognized this quarter for that?

We are recognizing the revenue of Wal-Mart just as we did with all the other retailers such as RadioShack, as well as Best Buy, which is based on sell-in. And the reason we took that approach is because the sell-through was very encouraging. So we believe that it is prudent to do the sell-in, because they actually bought all the products.

Perfect. Second, a couple more questions for Christine. Can I get CapEx? And I'm sorry, I missed headcount.

Sure. Headcount is 563 at the end of the quarter. And CapEx is $7.2 million. And there is about $3.6 million of that that is a building that we're moving into that we capitalized, but we actually won't really pay for. We will be reimbursed for that.

Got it. And then Patrick, you started talking about this in the last question, but maybe if you could just talk a little bit more, just sort of the status of the pricing pressure being put in the marketplace by Linksys in the US. Any change, any change throughout the quarter? Any noticeable difference from last quarter?

No. As a matter of fact, as we said, that we predict that they will continue to put price pressure on the market. And as back-to-school season is about to start, they lower the price one more time, which we were expecting anyway, because we heard winds of that at the beginning of last quarter. So all our actions in terms of bringing our product costs down, as well as preparing for the third quarter, has that in mind.

Great. And then my last question for you, Patrick. You had some products on exclusivity with Best Buy and others that came off here over the summer. Can you just talk a little bit about how the uptake of those products has been as you have been able to push the distribution broader?

Yes. It is very well received around the world. Right now, we have our RangeMax in dual-band routers and dual-band adapters sold in every single channel in every single country. And the reception was very, very encouraging.

Lynn Um, Lehman Brothers.

Just a quick question geographically speaking. I know last quarter you said, particularly with EMEA, the weakness was contained to the UK retail. I'm just wondering if you're seeing perhaps any spillover into any of the service provider segments, either in the UK or other parts of Europe?

As a matter of fact, you're right. The UK market continued to be very, very weak. And outside of the UK, our growth is still very, very high. As a matter of fact, if we take the UK market out, our EMEA revenue actually grew 70% year over year. Unfortunately, the weakness in the UK market has spread beyond the retail, actually into the service provider as well. But fortunately, the rest of Europe has been able to more than make it up.

Great, thanks. And just another quick question on the Wal-Mart piece. I know it is still probably a little bit early on, but just generally speaking, would you say it has been tracking in line with your expectations, maybe ahead? I know you had initially been guiding conservatively. Any color there would be helpful.

It is definitely ahead of our very conservative estimation. And we can say that we are really happy that we enter into Wal-Mart and immediately get our fair share of the market share over there, as we did in the rest of the channel.

Okay, great. Thanks, and good luck next quarter.

Hamed Khorsand, BWS Financial.

Congratulations on the quarter. Just one question -- where in the APAC region were you strong? What execution did you see that worked for you this quarter that you have not been seeing in the past quarters?

I think our Asia-Pacific growth has been pretty strong in most of the quarters. The primary reason is that our base in countries such as China, such as India are still small relative to our competitors, and because of our differentiated technologies such as ReadyNAS, such as RangeMax, and our approach to the channel help us to really significantly grow in those two markets. On top of that, our established base in Australia, which we have a pretty significant market share, continued to do well for us.

Any improvements in Russia?

No. Russia is not part of Asia-Pacific, unfortunately, and we're still not seeing any success over there yet.

Mark Sue, RBC Capital Markets.

Just on the price cuts from Cisco, as a clarification, so it is three major cuts that we saw, and it's still no worse in terms of deterioration?

What do you mean by deterioration? I'm sorry.

I mean it is not getting any worse. We should count on additional price cuts going forward?

As I just mentioned, they just cut another round ahead of the back-to-school.

So that is three that we've seen?

Yes, pretty much. We don't rule out that they would do another round before Christmas.

Okay. And then just on operating margin improvements, what components of that do you think are repeatable, understanding that you can't really predict mix? Can you reduce cost a little bit more, better predict freight requirements? How should we model operating margins going forward?

I think we are not focused on one area only. The philosophy at NETGEAR is just like the Japanese manufacturing, is basically every little bit helps, continuous improvement. So we're looking at all areas, product costs for sure, and operating costs for sure, freight costs for sure. So all those areas are areas that we will continue to focus on.

Does that mean we get back to the 11% to 12%?

We guided 9.5% to 10.5%.

Okay. And then just lastly, I'm not sure why economic cycles will temper back-to-school demand. You still have to go to school, and the penetration is still low. Maybe if you -- are you just being extra conservative on the back-to-school season?

Well, as you probably know, having a router at a home may not be 100% necessary. They might decide to just have the kids share that broadband connection by [Wapnet]. These days, as you probably heard that, customers are buying less apparel for back-to-school. So we have seen the trend. And also, there could be that instead of buying the dual-band and router, they could opt for buying the low-cost-end router. So there are a lot of things at work. And we do believe that for most people in the US and the UK, they are basically bombarded with the higher oil prices, the high food prices, and they just have to make choices.

Sure, got it. That is helpful. Thank you, Patrick. Thank you, Christine.

Ryan Hutchinson, Lazard.

Just a quick follow-up to Mark's question on the guidance as it relates to OpEx. I know you're going to be prudent across the board here, but specifically as it relates to R&D, should we expect that that should be the largest quarter-over-quarter increase compared to the other line items there?

As we mentioned just now, we're going to put some more emphasis in R&D, as well as in the IT infrastructure. So clearly, the R&D line item will go up, both in absolute dollars as well as in percentage. So is G&A. We believe that those are prudent investments because it will help us in the long term.

Should we expect that that would continue moving into Q4?

Yes, definitely. Those percentages will be higher for both R&D and G&A in Q4. But certainly, we hope that those investments will help us improve our overall standard margin in Q4 for the products as well.

Okay. And then the upside here on the top line, did that surprise you? I guess the question is, what was your assumption in pricing? Was it better or worse as we got towards the end of the quarter here?

You mean for Q2?

Yes.

Well, basically, when we guided for Q2, we were unsure of a few things. First is what is the scenario of the launch into Wal-Mart. And we have no experience over there. And our products are the most expensive of our competitors, so we don't even know how our products will be received in that particular chain store. So that is something that we do not know until we get in there. So certainly, we are surprised, happily surprised, by the well-received sales in Wal-Mart. I think that is good.

Second one is the strength in Asia-Pacific. We understand that we will continue to grow in Asia-Pacific, but we are a little bit also surprised on the upside, that our business in both India, China and Australia are doing better -- a little bit better than what we expected.

Okay. And then finally, one just for modeling purposes here. You obviously had a benefit on the other income line item in Q1, flat in Q2. I'm assuming that moving forward we expect that to essentially be at or near zero. Is that fair?

That would be fair, because in Q2 we really had zero.

(Operator Instructions). Stanley Kovler, Merrill Lynch & Co.

I have a question on the guidance. I just want to understand a little bit better how the growth, both year over year and sequentially, is constructed. When I look at the retail segment of the market and expecting the weaker back-to-school season, even if we assume very low-digit sequential growth for retail and we also assume a very slow growth in service provider business quarter over quarter, overall there is strong seasonality in your SMB business, if I'm correct. So that in and of itself should typically lead to strong growth. And I'm wondering if I'm thinking about this correctly. And I have another question on the guidance. Thanks.

Well, basically, we're looking at the trends, as you rightly point out. The service provider, not necessarily we have sequential growth of any significant magnitude. And the retail side, as a matter of fact, the back-to-school in the US will be muted and the UK decline has not stopped. So even with the back-to-school, and the UK is looking at best to be staying at the Q2 level, if not lower.

So even though the SMB will continue to carry the day for us -- and remember, in Q3 it is the seasonally low quarter in Australia, which is our biggest country in Asia-Pacific, because Q2 is the financial year end and Q3 is the beginning of the new financial year, which is generally the slowest season. So when you add all those factors together, I think our guidance is prudent.

So essentially -- actually, Asia was my next question. The weakness in Australia, you expect the growth in areas like India and China off the small base to be pretty much offset, and that is why you are seeing very limited growth overall when you put all the numbers together?

That's correct.

Maynard Um, UBS.

You have historically leveraged best-of-breed technologies in the market for new products in terms of keeping your R&D dollar low. Can you just talk about what has changed now that requires you to spend more from an R&D standpoint? And I guess more to another question asked earlier, what is the right level of R&D as a percentage as we go forward?

Well, when we say more in R&D, we don't mean that we're increasing R&D from 3.5% to 6%. We're talking about bringing it back to the level that, in previous quarters, like closer to 4%. We have been at that level since about a year ago with the acquisition of Infrant technology, of the ReadyNAS product line. So we don't think that we are out of line. We still believe in leveraging the best-of-breed technology from around the Valley. And I think 4% is a reasonable level, and we're still significantly lower than a lot of traditional networking companies in the Valley.

Okay. So does that presume that most of the R&D spend is going towards ReadyNAS, or is this across your other product portfolios?

It's across all the other portfolios.

Okay. And then secondly, I'm trying to reconcile your comments on, you know, you look at the higher channel inventories, what you said was the result of balancing demand and also airfreight. How do I reconcile that against the weakening demand or the slower demand into back-to-school? I would understand Asia inventories potentially rising because the demand there seems to be pretty good. But can you help us understand the rise in the other regions?

Well, the two things are separate. Our on-hand inventory is nothing to do with the channel inventory. So the reason why we increased the on-hand inventory level is because that with more in-hand inventory we have a better chance of meeting the market demand, no matter what the mix is, so that we can minimize airfreight costs. And when we minimize airfreight costs, our operating margin will go up. So that is the first part.

The second part regarding the higher channel inventory in preparation for back-to-school, there are actually multiple elements that go into it. The number of weeks of channel inventory is calculated as the last six weeks' average. So if the overall market is weak, that means the weekly POS is lower; then the channel inventory goes up. So that reflects one element.

The other element is that we just entered into over 3500 stores in Wal-Mart. So it is exactly like two years ago when we got into RadioShack at exactly about the same timing. The channel inventory also has gone up to over 13 weeks.

And thirdly, no matter what, the back-to-school is still going to happen and the retailers just will not like to miss any uptake. So that is why they generally will stock up for the beginning of July. So when you add all that up, it explains why our channel inventory is high, relatively speaking.

Okay. So as we go into the next quarter, would you expect that to come back down to normal levels across the region?

And as far as the retail channel inventory is concerned, it will gradually come down, just like what we did when we entered into RadioShack. It took us almost two years to gradually work the 13 weeks of channel inventory back down to about eight to 10 weeks. We expect the process will take just as long.

Okay. And then lastly, just in terms of your food chain, the suppliers from your chipset perspective, have there been any changes there? And the reason why I ask is some of your competitors have moved to companies like -- solutions from companies like [Raylink] to help lower their costs and then also ostensibly to lower their ASPs. Have you made any of those shifts, and if you have, how long does it typically take to come to the market commercially?

We haven't, but of course we thank our competitors moving to those chips, which put downward pressure on the price of their competitors', our suppliers' chipset as well. So we do enjoy the similar cost reductions. We believe that sticking to our existing supplier will give our products the stability and the superior performance that we are known for in the market.

Okay, so you are benefiting from a lower cost on your chipsets?

Definitely.

Neil Gagnon, Gagnon Securities.

I'm wondering on Wal-Mart what percent of a normal business did you do in the quarter? Because you were ramping up during the quarter, so it really wasn't a full quarter of business.

Correct. Well, certainly, for competitive reasons, we are not disclosing what percentage of the revenue is. And certainly, Wal-Mart is in a pretty good scale. They are the number two retailers of such products in the US after Best Buy. So they are pretty significant for us.

Okay. I wasn't asking how much was Wal-Mart. I was saying if they were running normally, [such as it is], you really didn't have a full quarter. What percent might that be?

Again, for competitive reasons, that we would not like to disclose that. So, again, because we're still in a ramp-up mode, it is very difficult to predict it. We're still going to see week-by-week improvement.

Rohit Chopra, Wedbush Morgan.

This is Sanjit Singh on behalf on Rohit Chopra. Just a couple quick questions. First off, any ideas on how many new products you plan to release next quarter?

About 12 to 13.

12 to 13, got it. And then kind of related to fuel costs, could you perhaps give us maybe some detail on the ratio of air versus land shipping, or by sea?

We don't give that specific out. But certainly, the cost of airfreighting a unit by air is about seven to 10 times that of by sea.

I wasn't asking the relative cost, but maybe how much -- to what extent did you shift to air -- or sorry, ground and sea shipping versus air?

Unfortunately we will not be disclosing that. That is a very important metric that our competitors would like to know.

Got it. Okay. And maybe you could provide us a little more detail on the relative price positioning versus Linksys, maybe on the high end versus the low end, maybe some detail on that?

We are generally maintaining a $10 price differential above them.

$10 on the high end?

You know, across the board.

Across the board. Okay. Got it. Thank you.

(Operator Instructions). Stanley Kovler, Merrill Lynch & Co.

I just wanted to go back to the on-hand inventory and look at the sequential increase and the amount that you have on hand versus the expected growth in the third quarter. So in other words, you're expecting the back-to-school season to be pretty weak, and yet you have grown inventory, which I assume was to help shipping costs.

So going into the third quarter, how much risk is there that you will need to airfreight again or perhaps that you might have to build additional inventory, given that you have already built up a lot in June and don't expect a lot of sequential growth?

We certainly will see how the market reacts to the economic changes. If the market gives us a happy surprise that we need to airfreight, then we will have to make a decision whether the additional revenue will bring us additional absolute bottom line. We will make those decisions as we go along. We increased the inventory level because we have a financial plan that we believe that we need to execute.

Got it. And just on the gross margin, is there any chance that, because [n] is going to increase as a percentage of your shipments, that there is sequential growth in gross margin percentage, or will pricing just wash that out

As we mentioned many a time, gross margin is relatively irrelevant, because in Q3, as you probably know, it is back-to-school season no matter what. We're going to run a lot of channel promotion programs. And that will be a reduction of revenue. And that will affect the gross margin. But on the other hand, we will reduce our marketing expenses in advertising and [PB yet] or so on, so forth. So it really is meaningless to look at the gross margin. We internally just look at standard margin and operating margin.

Great. Thank you. But just in terms of the component cost savings, I think that was mainly what I was asking about, because that would flow through to the bottom margin as well.

Definitely. As you saw in Q2, so when we had product cost reduction, it would flow through into the bottom line. In Q3, we expect that we will continue to get the benefit of reduction in cost of the product that will increase our standard margin. However, as we mentioned, we are going to increase our operating expenses by putting more money behind our R&D and IT infrastructure. So when you add the two together, we guide 9.5% to 10.5% operating margin.

Thanks a lot. Much clearer.

Ben Atkinson, Gagnon Securities.

Patrick, you were guiding to 9% to 10% operating margins for Q2 and you ended up at 11.5%. Was that all because of the higher than expected revenue or were there any other factors?

I think that certainly has a big part to play. And then there is another part, is I think we have to thank our operation folks, which have been able to bring the product cost down, which increased our standard margin. That helps. And thirdly, we have to thank the entire staff that really hold down a lot of ordinary expenses, and our OpEx has come down. So all those contribute to it, but certainly the increased revenue would help significantly.

Okay. And on the service provider, in the past you have told us what you thought revenue, you know, what percentage of your revenue would be in that category in coming quarters. Could you give us any sense for what you think service provider will be as a percentage of revenue in Q3?

It will be at a similar level.

Thank you. There are no further questions. Gentlemen, do you have any closing comments?

Yes. We are very excited by the fact that, even though the market is challenging, we are making the right moves. And we are excited for the new products that are going to come out in the second half, which will benefit us certainly, probably later in the year or next year. We continue to see share gain across the board. And we are looking forward to an even more successful market share gain in the market once these new products are flowing through beginning in the fourth quarter.

So thank you very much for joining us today, and look forward to talking to you again in our next earnings call in October. Thank you.

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