NETGEAR Inc (NTGR) 2008 Q3 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the NETGEAR Inc. Third Quarter 2008 Results Conference Call. (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, operator. Good afternoon, and welcome, to NETGEAR's third quarter 2008 results call. Joining us from the Company are Patrick Lo, Chairman and CEO and Christie Gorjanc, CFO. The format of the call will be a brief business review by Patrick followed by Christie providing detail on the financials. We'll 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 words anticipate, expect, believe, will, may, should, estimate, project, outlook, forecast or other similar words are used to identify such forward-looking statements. However, the absence of these words does not mean that the statements are not forward-looking.

The forward-looking statements represent NETGEAR Inc.'s expectations or beliefs concerning future events based on information available at the time such events were made and include statements, among others, regarding NETGEAR's expected revenue, earnings, operating income and tax rate on both a GAAP and non-GAAP basis, the effect of the global economic environment on the Company's business, the possibility that NETGEAR may repurchase its shares under the repurchase program, the belief that the Company's stock represents an attractive investment opportunity at current market prices, the long-term future of NETGEAR's business, our controlled success in the SMB market, our ability to innovate, 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, product performance may be adversely affected by real world operating conditions, the Company may be unsuccessful or experience delays in manufacturing and distributing its new and existing products, telecommunication 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 in manufacturing and distribution of it's existing offerings, channel inventory information reported is estimated based on the average number of weeks of inventory on hand on the last Saturday of the quarter as reported by certain of NETGEAR's customers, changes in the level of NETGEAR's cash resources and the Company's planned usage of such resources, changes in the Company's stock price and developments in the business that could increase the Company's cash needs.

Further, certain forward-looking statements are based on assumptions as to future events that may not prove to be accurate. Therefore, actual outcomes and results may differ materially from what is expected or forecast in such forward-looking statements.

Further information on potential risk 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 28 through 39, in the Company's quarterly report on Form 10-Q for the quarterly period ended June 29th, 2008, filed with the SEC on August 8, 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 the 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 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, Joseph. Thank you everyone for joining today's call. This was a challenging quarter for us due to current global economic slowdown. Net revenue in Q3 decreased 6% to $179.4 million compared to the year ago period and decreased 12% as compared to Q2 this year. The September quarter showed an overall weakness in consumer demand led by the softening of the global economy and tightening in the credit markets.

In light of the recent economic environment, we experienced declining sales for our consumer products across both retail and service provider channels and in all geographies. The performance of our emerging markets including China, Eastern Europe, the Middle East and Brazil continued to be strong in Q3. Specifically, our Asian-Pacific revenue was about $24 million in Q3, a growth of 22% year-over-year. Despite the lower than expected revenue, our operating margin remained stable in Q3 due to our continuous efforts in both product and operating cost reductions, healthy sales of ReadyNAS and Smart Switches, and the reduction in air freight cost requirements as a result of our increased on hand inventory.

Looking forward, we foresee the current market weakness and global financial uncertainty lasting through 2008 and into 2009. In the interim, as we have previously shared with you, we continue to execute our core growth strategy of launching innovative products, expanding upon our current customer base and penetrating new emerging markets.

We also intend to put more resources behind our R&D efforts in order to accelerate new product introductions. Our SMB demand in Q3 held well despite the slowing of the greater macro economic environment. In late September we were very pleased to enter the high growth SMB security appliance market with the signing of a definitive agreement to purchase certain assets of CP Secure, a leading provider of integrated security solutions that protects organizations and businesses from Internet originated web and email based mal-ware threats. With this acquisition we can further strengthen our share in this market by ensuring that our SMB customers are provided with the most integrative solutions to safe guard their networks from Internet threats and ensure their overall business continuity.

From the product perspective our ReadyNAS Network attached storage and Gigabit Smart Switches continued to enjoy strong appeal around the world in Q3. Among the 14 new products introduced in the third quarter, we have launched the super-fast 6 bay ReadyNAS Pro, which has seen great success in the marketplace.

Moreover, we have been pleased to bring our new energy efficient high performance wireless end router and wireless and DLS modem router to the market. We foresee a continued transition in the market to high-speed, energy efficient products and we believe our complete line of wireless and technology will position us for revenue growth and share gain going forward in this area. We will continue to introduce additional models of Smart Switches and ReadyNAS, further consolidating our technology and market share leadership in these two fast growing areas of SMB Networking and Storage.

For Q3 our service provider revenue was approximately $31.4 million, about 18% of our total revenue as compared to 22% in the year ago quarter and 27% in the second quarter of 2008. In Q3 we have over 29,000 retail outlets worldwide. We continue to maintain an extensive value added reseller base of about 41,000 globally.

In the upcoming fourth quarter we expect continued weakness in retail demand due to the overall softness in the economic environment. We are also seeing further slowdown among our service provider's customers due to the tight credit market leading to reduction in the CapEx expenses. However, we are following our successful strategy that we employed last time when the market froze after September 11, 2001. We will continue to invest in innovation, improve operational efficiency, reduce our inventory exposure and focus on generating cash. We are confident that we will emerge even stronger once economic growth and consumer confidence return to the global market.

At the same time, we remain confident in the Company's prospects and we are reaffirming that confidence today by announcing that our Board of Directors has authorized a share repurchase program of up to 6 million shares of the Company's outstanding common stock, representing approximately 16.9% of our outstanding shares. After reviewing our current cash needs against our current and projected financial performance the Board has determined that this is an appropriate use of a portion of our net cash balance, but one which will have no effect on the Company's core growth strategy, which we and the Board remain fully committed to.

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

Thank you, Patrick. Now, let me provide you with a summary of the financials for Q3. As Patrick just noted, net revenue for the third quarter ended September 28th, 2008 was $179.4 million, a 6% decrease as compared to $191.7 million in the comparable prior quarter and 12% decrease, as compared to $204.5 million in the previous quarter.

Net revenue in the third quarter of 2008 by geography was $73.7 million for North America, $81.6 million for the Europe, Middle East and Africa region and $24 million for the Asia-Pacific region. We shipped about 4.3 million units in the third quarter including 3.2 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 2.1 million units.

Moving to the product category basis, the third quarter net revenue split between wireless and wired was about 55% and 45% respectively. The third quarter net revenue split between home and small business products was about 56% and 44%. Products introduced in the last 15 months constituted about 34% of our third quarter shipments, while products introduced in the last 12 months constituted about 26% of our third quarter shipments.

Non-GAAP gross margin for the third quarter of 2008 was 35.5%, as compared to 34% in the year ago comparable quarter and 33.2% in the second quarter of 2008. Moving to non-GAAP operating expenses, total non-GAAP operating expenses, which excludes a facility's restructuring charge related to vacating our headquarters facility, litigation reserves and acquisition related retention compensation as a non-cash stock based compensation cost came in at $43.7 million for the third quarter 2008. This compares to non-GAAP operating expense of $42.8 million in the third quarter of 2007 and $44.4 million in the second quarter of 2008.

Q3 2008 operating expenses represented 24.4% of net revenue. This represents an increase as compared to 22.3% in the third quarter of 2007 and 21.7% in the second quarter of 2008. Non-GAAP sales and marketing expenses were $29.4 million. As a percentage of net revenue sales and marketing expenses were 16.4% in Q3 of 2008, as compared to 15.5% in Q3 of 2007 and 14.8% in Q2 of 2008.

Non-GAAP R&D expenses were $7.3 million. This represents 4.1% of net revenue in Q3 2008, as compared to 3.6% in Q3 of 2007 and 3.5% in Q2 of 2008. Non-GAAP G&A expenses in the third quarter were $7 million or 3.9% of net revenue compared to 3.2% in the year ago period and 3.4% in the second quarter of 2008. Non-GAAP operating profit for the September quarter came in at $19.9 million or 11.1%.

Operating income on a GAAP basis was $14.7 million, which includes $1.3 million in charges for amortization of purchased intangibles and acquisition related retention compensation, as well as non-cash stock based compensation of $2.9 million, $964,000 in facilities restructuring charges and $85,000 in litigation reserves. This compares to GAAP operating income of $18.5 million in the year ago third quarter and $18.8 million in the second quarter of 2008.

On a GAAP basis the Company reported net income of $3.1 million or $0.09 per diluted share for the third quarter of 2008, compared to net income of $13.3 million or $0.37 per diluted share for the third quarter of 2007 and $11.1 million or $0.31 per diluted share in the second quarter of 2008.

Net income on a non-GAAP basis for the third quarter of 2008 was $6.9 million, as compared to non-GAAP net income of $16 million for the third quarter of 2007 and non-GAAP net income of $14.5 million for the second quarter of 2008. Non-GAAP net income was $0.19 per diluted share in the third quarter of 2008 compared to $0.44 per diluted share in the third quarter of 2007 and $0.41 for the second quarter of 2008.

For calculating the earnings per share we use a fully diluted stock count that's 35.7 million shares for Q3 versus 35.8 million shares for the prior quarter and 36 million shares for Q3 2007. In Q3 of 2008 there was a currency loss of $4.7 million, as compared to a gain of $1.7 million in Q3 of 2007 and no currency impact in Q2 of 2008.

The non-GAAP tax rate was 57.7% in the third quarter of 2008 compared to 38.4% in the prior year third quarter and 40.6% in the second quarter of 2008. We had an exceedingly high tax rate in the September quarter due to two reasons. The share of US profit increased in Q3 at the same time we experienced a lower than planned share of international profit, which was negatively impacted by the strengthening of the U.S. dollar. This causes a shift in profits to higher tax regions and raised our effective tax rate. Also, the absolute tax expense for the quarter, including the catch-up adjustment for prior quarters is spread over an unexpected lower overall profit amount, thus pushing the tax rate higher. 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 third quarter with $202.2 million or approximately $5.66 per diluted share in cash, cash equivalents and short-term investments compared to a total of $177.2 million at the end of the third quarter 2007 or approximately $4.93 per diluted share and $186.8 million at the end of the second quarter 2008 or approximately $5.22 per diluted share.

In terms of inventory trends, we ended the third quarter 2008 with inventory at $125.7 million with ending inventory turns at 3.7, compared to 6.5 turns at the end of the third quarter 2007 and 5.2 turns at the end of the second quarter 2008. We increased our inventory levels in order to minimize the need for air freight. However, we intend to lower the inventory level in Q4 and bring the inventory turns closer to our normal 5 to 6 turns range.

Day sales outstanding were 76 in the third quarter of 2008, compared to 66 days in the third quarter of 2007 and 71 days ended second quarter 2008. This was slightly higher than our historical range of 65 to 75 days.

Total assets were approximately $602.4 million at the end of the third quarter 2008, compared to $500 million at the end of the third quarter of 2007 and $569.3 million at the end of the second quarter 2008.

Deferred revenue increased to $13.3 million, as compared to $4.3 million at the end of the prior quarter and $7.8 million at the end of the third quarter 2007. We defer revenue to adhere to customer contractual terms including title passage, delivery and payment terms.

The weakness in consumer demand and the global economic slowdown will continue to test growth in the coming quarters. Despite these market challenges, we are focused on the opportunities in the SMB market, which will help us partially offset weaker demand for our consumer products. The impending closing of the assets of CP Secure will provide us with differentiated technology in the form of our new ProSecure line at Security Appliances for SMB. We will continue to drive innovation in the SMB market with our Smart Switches and ReadyNAS products.

For the fourth quarter of 2008 we expect lower than normal consumer demand due to the current global economic slowdown. Specifically, we expect fourth quarter net revenue to be approximately $155 million to $165 million. We expect non-GAAP operating margins to be in the range of 9.5% to 10.5%.

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

(Operator Instructions) Our first question comes from the line Samuel Wilson with JMP Securities.

A couple small questions-- Christine, you spoke a little faster than I can write today. I missed head count, cash from operations and CapEx please.

Okay head count at the end of the quarter was 568, CapEx $2.2 million and cash flow from operations $16.8 million.

16.8?

Yes.

Okay and then you made some comments about inventory. You've got inventory up a little bit because you're air freighting less but you're going to bring it back down. I wanted to get a sense on two things here. One is are you bringing the inventory levels down because the end customers are ordering less or you're just preparing for them to potentially order less in the future? And B is there any changes to your logistics at all involved with air freighting now that oil prices have come down or is the plan still to sort of boat more than you air?

We're just trying to bring the inventory turns back up into a traditional 5 to 6 turns so with out forecast revenue in that $155 million to $165 million range then we certainly do not need $127 million of inventory level so we would bring down the inventory value in order to get our turns back in between 5 to 6, which is a reasonable turn.

Okay and then my last question for you is as far back as my model goes the last time that you sort of witnessed this type of poor seasonality was around 2001 so one of the questions I had is on the guidance is part of this thought process here on the 155 to 160 down sequential that you're letting the channel or the end customers burn through channel inventory to bring those levels down?

Correct.

You can ship less and, therefore, you do recognize revenue on selling. That's part of the problem is you need to get channel inventories down?

That's exactly it. I mean when the market is going up then you tend to ship a little bit more than they actually sell through but when the market demands going the other way then you are going to sell in a little bit less than what is sell through.

Okay so hypothetically speaking at some point if this turns god knows when, you'll actually have to rebuild channel inventories.

That's correct.

Maynard Um with UBS.

So I guess starting with the big picture as we look out and maybe there's not a whole lot of visibility but in this kind of subdued environment what do you think the overall market, which is typically growing about 15 to 20%, how should we think about how or how do you view the overall market growing as we enter next year?

Well, I mean we wish that we would have the crystal ball but all we can say is at this type of current grand global economic environment, which is basically pretty doom and gloom, there's practically no growth in the consumer market. There is still a little bit of growth on the SMB side but if the economic slowdown persists then we will expect that would be pretty much the same but hopefully that we will see the economic slowdown to end pretty soon within the next quarter or two.

Okay and then I guess if as we look into the fourth quarter if your revenue guidance assumes some burning through of inventory is there any way to look at kind of a normalized revenue run rate just to kind of help us think about how we-- you know in terms of looking into the March quarter?

Well I mean, as we mentioned and we forecast, 155 to 165 million of sell in. That will be slightly below the sell out so we would assume that probably the sell out would be probably $5 million, $10 million about that. That would be the way to look at it, so if you take that into account then you could probably argue Q4 would flat from Q3 from a sell through perspective.

Okay perfect and then I guess I am a little surprised that the SMB market is holding up fairly well. Can you just talk about why that market is holding up and whether your guidance assumes that continues into the next quarter?

Well, we for two reasons I think we are competing in a few product categories that are still growing. One is network storage, which is still growing, albeit not as fast as before and the fact that we are the newcomer and we have been grabbing market share from all the incumbents that helped us. The other one is Smart Switches. Smart Switch is a relatively new category that we invented about four years ago so we're still the leader and that market is still robust and it's growing. That market is actually eating into the market of layer two, layer three managed switch which we don't quite compete, so the shrinking of that piece of the market doesn't really hurt us while the growth of the Smart Switch market really benefits us so that's why we see the FMB side is still holding well.

Okay and the last one for me just your margin guidance against your top line implies some fairly large OpEx savings or gross margin expansion. Can you just talk about where in particular between those lines most of those savings are going to come from? Thanks.

We're going to work on both. We'll work on the gross margin line by further reducing cost of our product as well as our services and you bet we're going to negotiate big time with our freight orders and at the same time we are also holding our own expenses down so we're tackling it from both places.

Rohit Chopra from Wedbush Morgan.

A couple of questions here-- I just wanted to get a sense. Did Wal-Mart perform to your expectations this quarter?

Actually yes they continue to perform at a level that is very satisfying.

So I guess obviously it was the other channels. Can you talk a little bit about price moves of competitors and you anticipate another round of price cuts maybe to stimulate any demand as you head into a weaker fourth quarter.

We do not believe that under this environment any price move will stimulate any further demand. I mean the fact of the matter is you only have a group of people who have the surplus money to either upgrade or lock into a home network and we have been holding our price pretty steady and we have been advocating that in the industry and I think everybody right now believes that we were right so the pricing environment has stabilized.

Okay, which is good. That's positive and then just lastly on 11n adoption any changes there that you've seen?

No I think the 11n is right on the path that we predicted. Right now it is by Christmas as we predicted the n should be 50% of the market. I think it's heading that way on the retail side and on the service provider side it is still primarily 11g but we expect that by Christmas of next year the same thing will happen, more than 50% or maybe even higher on the service provider side will be on 11n.

Hamed Khorsand with BWS Financial.

Two questions here-- are service providers reducing the inventory on hand or has there been a material slowdown in the subscribers additions?

It's the same like the retail channel. They are doing both. Actually as a matter of fact, they are seeing a slowing down of subscribers net new subscribers additions and because of that they also want to reduce their inventory as well, so both hit us.

Okay and then were there any 10% customers in the quarter?

Oh yes definitely.

Yes typically it's Tech Data and Ingram and we expect that still the same.

Any of the service providers material?

No.

No we haven't had a service provider at 10% in several years.

For a long time yes.

(Operator Instructions) Mark Sue with RBC Capital Markets.

This is actually [Tres Isback] calling for Mark. I was just wondering if you could help me bridge the gap a little on gross margins. I mean all things considered they were obviously pretty good this quarter, up sequentially and if I look at number of units you said you sold it was sort of flat from last quarter so implying ASPs are down so how do I get to the 200 basis point plus improvement?

Well, the gross margin is affected by multiple areas. One is the marketing dollars that we spend in the channel so that is a reduction of sales. That means the less we spend in the channel for rebates, for promos, for end caps, that would help to boost the gross margin and certainly given the fact that we're not seeing the kind of demand stimulation that is effective in the normal year, we actually cut back on those in channel marketing activities that's boosting the gross margin.

And then secondly that if you notice that there is a shift of the mix towards the SMB side and, as we mentioned the last two quarters that because of the pricing environment on the retail side the SMB business is getting more profitable for us compared to the retail side and when the shift is more towards the SMB then naturally that will boost up the gross margin as well. So even though the ASP has declined the gross margin has gone up because of those two reasons plus that you probably know that we mentioned that we use a lot less air freight and the overall freight charges actually come down as the price of the oil continues to come down.

Okay great thanks. And then on just following up on the question before looking at 4Q guidance on operating margin I mean is it fair to assume that most of that leeway is in sales and marketing?

In the fourth quarter there is still a lot of uncertainty that we could not see. For example, the currency would have a significantly impact on our operating margin from a cost perspective as well as from a selling price perspective because we're selling to service providers worldwide in local currency so if the US dollar continues to strengthen then the margin for those sales will be lower. That will affect our overall operating margin and so that's one area that would change.

And then certainly if our forecast is still to be too aggressive, let's say we come at the low end of our range then because our fixed costs for people cost is already there and certainly they would negate any improvement that we can make on the operating margin. The reverse is true so let's say if the US dollar softens a little bit and if we come in and revenue is at the higher end, then our operating margin will be at the higher end.

Stanley Kovler with Merrill Lynch.

Thanks, just a few questions on line here-- Patrick, I was wondering if you can go over just some of the logic that you started to discuss with the channel inventory? If we're at about 170 million or so sell through and you're selling in a lower amount should we assume that the market overall based on the sell through is going to stay flattish or that we might potentially see some growth into Q1 as far as the sell through?

Well on Q1 it's too early to tell. We do not know how this thing is going to pan out and everyday you read Wall Street Journal there's some new news so we not going to go that far but as far as Q4 is concerned we believe that as just we mentioned that sell through will be pretty flat from Q3. However, we will see our channel partners across the world are going to reduce their channel inventory and that means that we were selling less and that's just a natural behavior of our channel.

Got it and just going over the geographic trends if we see Europe was on a dollar basis declined more than any other region when we think about Q4 shall we again assume that your declines further? Is that where the weakness is going to be concentrated or is it going to shift over more to other geographies?

I think you're right. I mean the weakness will continue to be concentrated in Europe, the reason being is that in Europe that's our number one region and also the proportion of our service provider is selling in local currency, is also in Europe as well, so unless it is in local currency they decline as much as the US but if the US dollar strengthens that means on the dollar basis they will decline even more. But again, I mean none of us would predict how the currency is going to go. I mean, as we've seen the last week, just the last week, the US dollar has been going crazy so it's hard to predict but certainly I think the general observation is right that we will see the weakness will continue to be in Europe.

And just lastly on the operating expenses I think I missed the point about the mix between the operating expenses. R&D and G&A look like they could continue to go up and then you get the savings in sales and marketing?

No actually as a matter of fact if you compare that we have been growing in all three areas in absolute dollars both from a year-on-year basis but from a quarter-on-quarter basis then you will see that primary growth is in R&D and that will continue to be the case. We will continue to work on a quarter-on-quarter decline in the G&A and sales and marketing expenses but will continue to invest on a quarter-on-quarter growth in R&D.

(Operator Instructions) We have a follow-up question from the line of Maynard Um with UBS.

Just a question on the interest income side, do you think your assets are now appropriately re-measured or should we expect further losses in the quarter with the US dollar strengthening?

I mean I think if you just look at what the US dollar has done in October you know we don't know how it's all going to end up but it's definitely gotten stronger.

Okay and then lastly just on the tax rate, how should we think about the tax rate in the fourth quarter?

We're not really going to give guidance on the fourth quarter. Again, the ForEx rate has a lot to do with the tax rate and exactly which jurisdiction we earn our money in so I mean I would look on the income statement to kind of the nine month year-to-date rate.

At this time it appears there are no further questions. I would like to turn the floor back to management for closing remarks.

Thank you very much. Certainly we all know that the market is very challenging to say the least. However, it is not the first time we saw this. We've seen it before and we had a very successful strategy last time and we believe the same strategy will apply, which is no different, that the core of NETGEAR is being the innovative leader so we will continue to win with innovation. That's why we'll continue to invest in R&D to come up with innovative products that will give us gain in market share as well as in gross margin.

On the other hand we will also focus on cash generation, which will be brought on by our continued control of expenses as well as continued work own or our inventory exposure so coupled with innovative products that drive the margin up we believe that when the economic growth returns we will be stronger and as competitors will continue to win share from our weaker competitors in the market just like last time.

So I certainly will come back and report to you in the next earnings call how our progress is towards those goals. Thank you very much for joining us today.

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