NETGEAR Inc (NTGR) 2012 Q2 法說會逐字稿

It is now my pleasure to introduce your host, Christopher Genualdi. You may begin.

Thank you, operator. Good afternoon, and welcome to NETGEAR's second quarter financial results conference call. Joining us from the company are Mr. Patrick Lo, Chairman and CEO and Ms. Christine Gorjanc, CFO.

The format of the call will be a brief business review by Patrick, followed by Christine providing detail on the financials and other information. We will then have time for any questions. If you have not received a copy of today's release, please call the Ruth group or go to NETGEAR's corporate website at www. NETGEAR.com.

Before we begin the formal remarks, the Company advises that today's conference call contains forward-looking statements. Forward-looking statements include statements among others regarding expected revenue, earnings, growth, operating income and margins, tax rates and other projected financial results, share gains, expectations, the market for our products, business prospects, including back to school expectations, affects and expectations regarding 2012 Olympics coverage. , competition, research and development efforts, including software development, sales and marketing efforts, hiring efforts, market trends and opportunities , our growth strategy, expectations regarding our recent acquisitions and pace of new product introductions.

Forward-looking statements made during the call are being made as of today. If this call is replayed or reviewed after today, the information presented in the call may not contain current or accurate information. Further, certain forward-looking statements are subject to certain risks and uncertainties and 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. Information on potential risk factors are detailed in the Company's periodic filings with the SEC including, but not limited to, those risks and uncertainties listed in the Company's most recent form 10-Q filed with the SEC. 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 accuracy of unanticipated events.

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

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

Thank you, Christopher, and thank you everyone for joining today's call. During the second quarter of 2012, NETGEAR achieved year-over-year revenue growth across all three business units, as well as year-over-year revenue growth in all three geographic regions. Despite the tough economic environment in Europe, the Company delivered 10% year-over-year growth in net revenue. Non-GAAP diluted EPS was $0.64 per share.

During the second quarter, we again demonstrated our leadership in home networking technology by being first to market with the latest in WiFi networking solutions. On April 26th we announced the industry's first AO2.11 AC dual band gigabyte WiFi router, enabling fifth generation WiFi at gigabit speeds.

The release of NETGEAR's AO2.11 AC WiFi router marks the next generation of WiFi connectivity that is revolutionizing the way we consume multi-media content wirelessly by delivering internet speeds up to three times faster than its predecessors. On the commercial side we also launched the NETGEAR ReadyDATA 5200, the first of the new series of business class storage solutions, complementing our existing ReadyNas line of storage products for small businesses and professional uses. The ReadyDATA 5200 is our first product that carries an average selling price over $10,000.

It features enterprise class capability, such as 180 terabytes of storage, duplication and snapshots for cost of ownership that is hard to beat in the industry. We will continue to achieve industry firsts by exercising our strengths in new product innovation and second to none worldwide distribution. For Q2 our America's net revenue was $163.4 million. Europe, middle east and Africa, MEA, net revenue was $117.8 million, and our Asia Pacific or APAC net revenue was $39.4 million.

In the Americas we generated 9% year-over-year net revenue growth. In MEA we achieved 7% year-over-year net revenue growth despite economic recession in most of the region. We achieved an impressive 25% year-over-year net revenue growth and 22% sequential net revenue growth in Asia Pacific, reflective of our increasing penetration into this market, where demand for wireless internet connectivity is rapidly growing.

In Q2 we maintained a high level of shipment with 6.5 million units shipped. We also introduced 26 new products during the quarter. Among the new products are the Neo TV Pro HD streaming player and the NETGEAR ReadyNAS surveillance product sweep, as well as the previously-mentioned industry's first AO2.11 AC dual band gigabyte WiFi router and the previously-mentioned ReadyDATA family of enterprise class storage products.

We are starting to see results from our focused R&D plan and expanding product pipeline. (inaudible) channel investment continues to be a key focus for the Company as our sales channel remains at critical strategic assets. By the end of the second quarter of 2012, our products were sold in approximately 32,000 retail outlets around the world, which is a record, and our number of (inaudible) sellers stands at 42,000.

Now let's turn to a review of the second quarter results for our three business units; retail and service provider. In our retail business unit or RBU, net revenue came in at $113.8 million, down 12% quarter-on-quarter and up 5% year-over-year. The sequential decline in revenue for retail is typical of Q2 seasonality. However, with the tough macroeconomic environment, it was slightly more than we had planned.

With the introduction of the 11ac WiFi product at the end of Q2, however, we have seen worldwide market share gain in ASP growth heading into Q3. Based on third party market share data, we believe NETGEAR gained further market share in North America, Europe and Asia Pacific in the retail channels both on-line and in stores. Looking forward, we have a lot of exciting new products planned for the retail segment over the next 12 months. With the recent introduction of our 11ac routers into our exceptional sales channel we are confident that we will gain share in North America and Europe during the back-to-school season.

Net revenue for our commercial business unit, or CBU, came in at $80.6 million for the second quarter or 2012. That's up 8% on a sequential basis and up 5% year-over-year. We have seen a healthy growth in switching, particularly around new technologies such as 10 gigabytes, power over ethernet plus, and remote stacking. Our ready data 5200 instructions got the most attention among our resellers and install base in the history of our storage business.

The market situation in Europe has been challenging, and we see continuing uncertainty. However, with our strong new product lineup, we are confident we will achieve sequential revenue growth in Q3 and gain shares. In our service provider business unit, or SPBU, net revenue came in at $126.2 million the second quarter of 2012, up 3% sequentially and up an impressive 19% on a year-over-year basis. We continue to execute on the DOC 3.0 Gateway front, and we are able to deliver the volume and service our cable customers expect of us.

Service provider has done exceptionally well during the first half of 2012, driven by our ability to deliver on short notice and we believe that service providers are readying the networks for the 2012 London Olympics. We think this Olympics will mark a key change in delivery of online and delayed content. For example in the United States NBC Olympics.com has announced it will stream 3,500 hours of live coverage with a peak of 40 simultaneous streams. In the not too distant future we envision homes with four or more devices simultaneously receiving HD content, driving the continued need to upgrade home networks.

Post the Olympics we expect that volumes and service provider will drop as our service provider customers take a breather in their drive for new subscribers. As a result, we anticipating a decline in service provider revenue in Q3. We have recently completed two acquisitions. In June we acquired select assets of a small engineering operation in India to enhance our wireless product offerings in our commercial business units.

The technology and engineering capabilities acquired will be instrumental in enabling us to take the leadership position in the small to medium sized campus wireless land market, using the latest dual band 3 by 3 and 11N and 11ac WiFi standards. Secondly, on July 2nd, we closed the acquisition of privately held Avaak, Inc., creators of the VueZone home video monitoring system, expanding our presence into the smart home market. The VueZone cameras are unique because they are completely wire free, operating on batteries alone and communicating with home routers wirelessly over 2.4 gigahertz.

The cameras are elegant, unobtrusive and feature reach. Images can be streamed or recorded over the class via android and ois-based mobile devices or browser based laptops PCs. VueZone Products and services are currently sold online in the United States, and we plan to roll them out both in stores and online worldwide over the next 6 to 12 months. We expect the acquisition to be accrued in the second half of 2013. The product line will be sold in our retail business unit.

Both of these acquisitions have been factored into our Q3 guidance. We remain confident about our continued leadership in technology and product introductions, share gain around the world and higher penetration into emerging markets. We believe the demand for broadband internet connectivity will be stronger over the next few years, and we believe our leadership in channel presence and technology will enable us to grow faster than our competitors.

I will now turn the call over to Christine for further details on our financials.

Thank you, Patrick. I will now provide you with a summary of the financials for the second quarter of 2012. As Patrick noted, net revenue for the second quarter ended July 1st, 2012 with $320.7 million, compared to $291.2 million for the second quarter ended July 3, 2011 and $325.6 million in the first quarter ended April 1st, 2012.

We shipped a total of about 6.5 million units in the second quarter, including 5.5 million nodes of wireless products. Shipments of all wired and wireless routers in Gateway combined were about 3.8 million units in the second quarter of 2012.

Moving to the product category basis, second quarter net revenue split between wireless and wired was about 59% and 31% respectively. The second quarter net revenue split between homes and business products was about 75% and 25% respectively. Products introduced in the last 15 months constituted about 34% of our second quarter shipment. While products introduced in the last 12 months constituted about 28% of our second quarter shipment. From this point on, my discussion points will focus on non-GAAP numbers. The reconciliation from GAAP to non-GAAP is detailed in our preliminary financial statements released earlier today.

Non-GAAP gross margin in the second quarter of 2012 was 29.9%, compared to 31.7% in the year ago comparable quarter and 31% in the first quarter of 2012. Gross margin was down both year-over-year and quarter over quarter due to the heavier proportion of service provider business as a percentage of the total revenue.

Total non-GAAP operating expenses came in at $60.5 million for the second quarter of 2012. As noted during our last two earnings calls, we are continuing to invest more in R&D on an absolute dollar basis and as a percentage of net revenues.

Our R&D expense in Q2 increased to 4.4% of net revenues in comparison to 4.1% of net revenues during Q1. With our recent technology acquisitions, we expect our R&D expense to be approximately 5% of net revenues in the upcoming quarters.

We continue to invest these dollars in all three business units and almost all of the incremental investments will be in software development, which enables us to provide powerful differentiation against our competition and also provides us possible entries into new product categories in the future. We increased head count by eight people during the quarter, bringing our total head count to 818 at the end of Q2, and we expect to continue our hiring efforts in Q3 and for the rest of the year both in R&D and new market channel expansion. The non-GAAP tax rate was 31.4% in the second quarter of 2012, compared to 28.6% in the second quarter of 2011 and 30.1% in the first quarter of 2012.

Our tax rate was slightly higher due to proportionally lower European profit. Looking at the bottom line for Q2, we reported non-GAAP net income of $24.6 million and non-GAAP EPS at $0.64 per diluted share. Our balance sheet remains very strong, ending the second quarter with $360.4 million in cash, cash equivalence and short-term investments, which was driven by approximately $2.4 million in cash flow from operations.

In aggregate, we invested $31 million in cash for the two acquisitions, one of which closed in Q2 and the other in early Q3. DSO's for the second quarter 2012 were 77 days, as compared to 66 days in the second quarter of 2011 and 70 days in the first quarter of 2012. Our 10% customer in Q2 was Virgin Media in the U.K. Our second quarter net inventory ended at $152.8 million, compared to $137.8 million at the end of the second quarter 2011, and $134.3 million at the end of the first quarter 2012. Second quarter ending inventory turns were 5.9, as compared to 5.8 turns compared to 2011 and 6.7 turns in the first quarter of 2012.

Channel inventory remained at healthy levels. Our channel reports inventory to us on a weekly basis, and we use a six-week trailing average to estimate weeks of stock. Our U.S. retail inventory came in three weeks of stock. Current distribution inventory levels are 8.6 weeks in the U.S., 4.1 weeks of stocks in distribution in MEA and 5.7 in APAC.

In summary, our growth strategy of aggressively expanding in a new product categories, new geographic regions and new channels continues to produce positive results with industry-leading new product introductions, global brand recognition and extensive distribution, we feel confident in our ability to stay ahead of our competition as we move into the third quarter of 2012. Looking forward to the third quarter, we intend to roll out approximately 25 new products, and we look forward to the integration of our newly acquired businesses.

Specifically, we expect third quarter net revenue in the range of approximately $310 million to $325 million, which accounts for a reduction in our service provider revenue offset by expected increases in market demand in our retail and commercial business units, resulting from the back-to-school season. Additionally, non-GAAP operating margin is expected to be in the range of 11% to 12%, and our non-GAAP tax rate is expected to be approximately 33%. This increase non-GAAP tax rate reflects the tax affect of our newest acquisition. Operator, that concludes our comments, and we can now take questions.

Thank you. Our first question comes from the line of Mark Sue with RBC Capital Markets. Please proceed with your question.

Thank you, Good afternoon. If way look at the guidance, 325 it is almost $34 million from the consensus estimate for the upcoming quarter. When you say the reduced marketing from service providers, what does that really mean, and do you actually recover that in the subsequent quarters?

Basically we have visibility into 13 weeks of our service provider's order, and that's why we know pretty much how much we are going to ship to them, and the consumption of the Gateway is based on the amount of marketing activity they do amount they install base as well as the competitors install base. So the drop in volume from our service providers customers indicate to us that the possibility in slowing down in volume is a reduction in the marketing activity and as we explained just now, that because they did quite a bit of promotion before the Olympics arrive, so we believe that is in fact the post-Olympics. We don't have visibility into Q4 yes, but As the quarter progresses, we will see whether they will do the usual Christmas promotion in Q4. And we certainly will keep you updated as well as everybody updated in next earnings call.

So Patrick this is a broad thing. We recognize a lot of things were on hold front end loaded because of the Olympics, and now things are pausing. When it does resume, this should be your opportunity, and it shouldn't go to a competitor or anything else. Is that a fair assumption.

Yeah, certainly with keeping the relationship with our existing customers, and as we always been saying, that we try to get our more than fair share of purchase.

And then just the U.K. and your Virgin concentration, broadly speaking impact to the macro does that reduce your cut as well? And what sort of rebound or uptick in back to school are you planning vis-�-vis last year considering there are more macro headlines this year?

Well, certainly it is still too early in the quarter to expect how the back to school macro is comparable to last year. Clearly, with the uncertainty in Europe, we expect that the European rebound probably will be smaller than last year, but on the other hand, this year we have the 11ac launch in retail worldwide, which we believe would be positive, but overall we still feel pretty good about the sequential growth in both retail as well as the commercial. However, as Christine just mentioned, it was just about to offset the drop off in the service provider revenue, which always, as we said, is very lumpy from quarter to quarter.

Okay. And likewise, should we expect a bump in gross margins because of the mix of higher commercial and retail versus service provider in the near term and then reverts subsequently in the December quarter?

As we say as long as the proportion of serviceable, viable revenue is less than what we have today, which is 39%, yeah, the gross margin will go up.

Okay. That's helpful. Thank you and good luck.

Sure.

Our next question comes from the line of from Lynn Um with Barclays Capital.

Hi. Yes, thank you.

Hi, Lynn.

Hi. I was wondering if you could maybe just walk us through the retail business in a little more detail with a kind of broader macro weakness or where there certain geographies that were particularly weaker than others?

Well, the retail business actually certainly is affected by the macro environment. The overall market demand in the western world basically in Europe -- western Europe as well as the United States in Q2 actually was not growing compared to Q1 which grew year-over-year. So that certainly provides -- I mean more head wind for us.

Fortunately toward the end of Q2, we introduced the 11ac products, which is very exciting to the channel as well as to the end user customers. So we do believe that we rejuvenate the market and will set the market back on a growth trend again, [albeit single digit] for the overall market in Q3 on a year-on-year basis. And certainly that is assuming that the situation in Europe macro environment does not deteriorate any further.

So we are reticently confident given the current scenario that the retail market will grow in Q3 and we will grow much faster than the market because we are the leader in 11ac, and we will have our usual sequential bump in our retail business unit revenue from Q2 going to Q3 both in Europe as well as in the United States.

Our next question comes from the line of Kent Schofield from Goldman Sachs. Please proceed with your question.

Great, thank you. I was wondering if you could talk a little bit about the commercial business in particular your NASA products and how HD TV pricing is trending from your perspective, and what sort of impact that had during 2Q and how we should think about it going forward?

Sure, the NAS business continued to be weaker than what we would have liked due to the high disk price. As way mentioned a few quarters ago, we continue to pass on the high disk prices to our customers. Some of our competitors, especially some of our Asian competitors -- actually even U.S. competitors who are absorbing some of the price increases, so clearly we are seeing that we are commanding a significant premium in price over our competitors.

Now, this price is continuing coming down. We expect that by the end of this year, the disk prices will be back to where it was before the normal level. So then we will be priced very competitive. But in the meantime we continue to keep our position in the market by just offering superior features and capabilities. Clearly the introduction of the ReadyDATA is a clear example of our superior technology.

Even though the ASP is $10,000, we supply the feature that nobody in that price range will be able to supply, such as the duplication, snap shot and restore. And support of expansion boxes up to 180 terabytes of storage. That kind of capability with the costs that we combine it with the product. It is very competitive in the market. It would take the Asian compete tor quite a while to catch up. We feel confident in the second half about our NAS business, and certainly by the end of this year when the hard disk drive price comes back to normal, it would be very, very good for us for next year.

Thank you for that detail. And then with the R&D going to 5%, 5% as a percentage of sales, can you help us think beyond the third quarter. Obviously revenue growth is maybe not quite what we would have thought. Is that a new baseline level upon which you expect to grow, or can we think about that staying relatively flat going forward from there? How should we think about that level?

What we are seeing is this is what we did last time during the 2007 and 2008 is when the market is tough, we actually would double down in our investment in R&D so that we would be able to out pace our competitors in terms of technology and product introduction. And when the head wind eases then we are able to accelerate our growth. For example, last time when it was in the recession, we actually double down by doing the M&A on our NAS business and put a lot more R&D behind it.

So when the economy picks back up again actually in 2008, then we saw two great years of growth from 2009 all the way to 2011. We expect the same things to be true. We are putting a lot of R&DWe believe that the 5% is where we will be. We may even uptick a little bit in some quarters, which enable us to continue out pace our competitors, such as 11acwe are ahead of our competitors by three to four months with features much better.

With this acquisition of VueZone, it opens a completely new market for us and we continue to put R&D into it. We believe that this complete wire-free home monitoring system is the first entry into our smart home application, which has a lot of potential. We believe that we could actually create a market that could be as big as a few hundreds of millions of dollars. We are putting R&D not only to out pace our competitors, but also to try to create new markets that will further fuel our growth in the future.

Thank you, Patrick.

Sure.

Our next question comes from the line of Ryan Hutchinson with Lazard Capital Markets.

Great. Thanks. Really a couple questions, first more of a clarification, Patrick I know you have visibility into the third quarter, but if we go back, I don't know, a number of quarters we talked about these rollouts potentially at some point coming to an end.

I wanted to just better understand where we are with respect to these rollouts if in fact you are not worried about a second source in the fourth quarter. And I guess one way to look at that what do we expect as the new revenue run rate for service providers at least in the back half of the year? And then I have a follow-up.

Well, I mean, we have been running the service provider at about 130 millionish. In between 120 to 130. So certainly with a decline we will be at a lower level for the next quarter. As we said,we don't have the visibility in the fourth quarter as yet. But if you look at some history in the past, usually the first half is bigger than the second half. That's when service providers have more CapEx expenses, and they tend to run more promotions.

But there is a possibility that they will run some Christmas promotions that will be able to help us. Now, in terms of penetration of [inaudible],we are in the early innings. I don't think many of us in the U.S. actually have subscribed to this 30 megabit or 100 megabit level yet. That's why you see all of these TV commercials bombarding everybody to upgrade to these super speeds. Same is true in overseas markets, such as in Europe and in Asia as well.

So we don't think it is anywhere near. It is just depending on the CapEx budget of our customers, when they are going to spend it. As we said, our customers always want to have two source of supply, and in most accounts, as a compete tor, we are just getting our more than fair share of our -- of our supply to our customers. That will be continuing the business model is to assume that there is always a second source, and we are always going to provide better product, better service so that we have better share of the supplies.

And as a percent, it was right around 10% Virgin Media or was it 11 or 12?

It is around 10%.

Okay. And the second question is really based on this new revenue run rate, it looks like the business exservice provider has actually declined for the last couple of quarters. And I am just trying to get my arms around that and really the long-term goal, right? Because we have outlined a goal to hit $2 billion. I can't remember which year, but in the out year, which essentially implied 20% keger. So how do we think about that goal now that we look like we are not going to hit that goal here in 2012?

The beauty of our business is that it is [a three-legged business] In some years, such as year 2009, 2010 or actually even in 2011 in the first half, our retail business unit has grown crazy. It is like 30, 40% year-over-year. And then the service provider business took over. They had been running a 30% growth year-over-year for many quarters.

That's the beauty that we have one business versus the other, that would be able to take up the tone of growth. Clearly right now we are running through a patch of slow growth because of the macroeconomic environment and because of the service provider slowing down. We still think that with all these investment in R&D, just like this 11ac introduction, we see significant growth. As a matter of fact, we feel pretty good even with this tough economic environment that in Q3 the sequential growth of both our retail business unit and commercial business unit will be very healthy.

Thanks, guys. Good luck.

Sure.

Our next question comes from the line of Hamed Khorsand with BWS Financial. Please proceed with your question.

A couple of questions for you. I will ask the simpler one first. Are the acquisitions included in your new product estimate for Q3?

The new products actually for the VueZone camera, they are already selling them, but in the very low volume online in the United States. Under the NETGEAR brand, we expect to roll it out probably early Q4, so it will be three months -- two, three months before we roll that out. The other acquisition is just pure technology acquisition. It is a team of engineers that we like in India who would be able to do a wireless land centralized management of access points controller and so on and so forth. So that is going to be added into our existing lineups technology. We expect to use the technology to continue to roll out new products in probably 2013.

Okay. And would this be a good going forward rate of 22, 25, 26 number for new products going forward?

Certainly in the next few quarters, yes.

Okay. My other question is, I usually stay away from gross margin topic, but really want to address this here given your guidance for 11% to 12% operating margin. If I look back over the past year of how you spent money on SG&A and R&D, difference really comes out to about $5 million, $6 million a quarter. If I tack that on to Q3 and compare what you guys did in Q3 and tack on the additional expenses, the biggest differential becomes what gross margin will be. So what is the predictability that the operating margin could be higher than 12% if retail is a bigger mix or has your retail gross margin declined over the past year?

No, I mean basically generally speaking, as I mentioned many times if I have extra money, let's say if we know we are going to hit 13% let's say, then we will spend more. in R&D, in channel extension so that we could lay the groundwork to grow faster later on. Of course if we see if we are not hitting 11% because we are seeing revenue slow down, then we definitely slow down our investment so that we would be able to hit between 11% and 12%.

So that's what we do on a week-by-week basis looking to see how our trend is in terms of revenue. Overall speaking, if you look at gross margin, if there is a higher mix of service provider revenue, let's say there is upside of service revenue, then gross margin will go down. But if you look at operating margin basis, if we tend to hit at the high end of our guidance of revenue, then it would tend to be at the high end of the operating margin, but if we hit at the low end of our revenue guidance, then it would tend to be at the low end of our operating margin.

No, I understand that, but it seems as though even if I expect you to increase spending by $12 or $15 million for the quarter compared to Q2, I mean the only way to avoid excess of 12% operating margin would be that your gross margin mix would be down, right? And that's what I'm trying to get to. Does retail and commercial gross margin as a decline over the past that we haven't seen in the numbers before.

I would love to see how we can spend $12 million more quarter-on-quarter. I don't think we have ever done that in the past. It is very difficult to envision that.

For example, if you look at 2011 from Q2 to Q3 we raised our OpEx by a little over $2 million. The only time that we had even close to 5.5 million of OpEx increase was in 2010, but other than that, we generally would not jump that much in operating expenses quarter-on-quarter.

Okay. All right, thank you.

Our next question comes from the line of Jay Goldberg with Deutsche Bank.

Hi, guys. Thanks for taking my question. I wanted to get a little bit on commercial.

You got back to year-on-year growth this quarter. How is that market shaping up? Two parts. One is how is the market shaping up, and how do you feel about your product mix going second half of the year?

The market is actually doing quite well in the U.S., certainly in Europe it is pretty tough. The demand in Europe is actually pretty severe, but we are doing extremely well in both markets on the switching side, as I discussed previously in the call. We have been pushing aggressively into the new technology such as 10 gig, such as POE plugs, such as remote stacking that resonate very well with our customers. They do extremely well on the switching side.

As I mentioned in the script, also because we refused to absorb the increase in prices [inaudible] to dilute our margin, our pricing on the NAS side becomes more expensive than our competitors such as HP, such as Buffalo and Asian competitors. So we are seeing a tougher environment on the NAS side. With this new technology of the ReadyDATA, we believe that we are turning the tide and with the hard disk drives coming down to back to normal by the end of this year, next year I think we will have a better year for our NAS products.

And in that category, do you -- you have all sorts of new products. You mentioned 10 gig. Do you find that those are expanding your footprint with existing customers, or are you able to move into larger -- expanding your overall pool of customers, moving up in the number of seats and what not?

Both. I have to say, buying a lot of the 10 gig switches, I would say a good number of them are from an install base we are upgrading. But we are also getting into a lot of new accounts with a combination usually of our ReadyNAS, high-end ReadyNAS, which has a 10 gig back plane together with our 10 gig switches. Certainly there are customers -- there are new customers who are buying the solution either for virtualization or for back up of the disk form. So we have been able to see both. But, of course, the bulk is from our install base, but we are also attracting new customers as well with the 10 gig switches.

All right. Thank you.

Sure.

Our next question comes from the line of Jonathan Kees with Capstone Investments. Please proceed with your question.

Great, thanks. Hi, guys. Thanks for taking my questions.

I wanted to ask for better clarification here. The macro head winds that you experienced in Europe was mainly in retail and commercial, right? Service provider was up, and you expect retail and commercial to pick back up in the third quarter and service provider should be down. That's again from Europe post-Olympics, but you expect retail and commercial to be up in Europe?

Yes. It is not because of the better economic environment. We expect the economic environment continue to be challenging. We expect that we will be up in Europe both in retail and commercial simply on the strength of our products. On the retail front is the 11ac. On the commercial front is the introduction of the 10 gig switches , introduction of the ReadyDATA 5200. So that's why we anticipate sequential growth in Europe as well on retail and commercial.

So for small enterprises, you are not seeing hesitation on purchases, a pause on new technology orders and more of hesitancy in terms of sending you to the P.O.

The beauty is thatthere are still some small-medium businesses who must upgrade because the technology is old. Those will still buy. On the other hand, we see some large enterprises which has been seeing shrinking the budget. Instead of buying CISCO and HP they buy us.

Okay, so it sounds like you are benefiting from even if there is a hesitancy because of in I.T. spending are you still benefiting there.

As long as we have the unique products that our customer wants.

And for service provider, for CapEx, you talked about waiting on that. There is a pause you are talking about for September quarter. Overall you seeing any change in CapEx? You talk about the early endings of 3.0. Is there more of a delay there especially post-Olympics especially Virgin Media, or are they still communicating to you they are on track with their previous deployment plans?

Generally speaking we don't comment on specific customers, but we would say that most of our service provider customers we are seeing a slow down in the CapEx expense in the second half, especially in Europe, not so much in the U.S. As a result, they are reducing the marketing activities to try and push more of the equipment into their subscriber base. That's why we are seeing in Q3 there is a lesser demand from our service provider customer for our Gateway.

That's helpful. One last question, the DSO's are up pretty high there. It is from Q1. And in fact inventory days are up from Q1. I notice inventory for the U.S. is high too. Some more color behind that, please.

Yes. Basically when you have a higher proportion of service provider customers and revenue they carry longer credit terms than the retail and the commercial customers. So that basically pushes up the DSO. In terms of inventory, it is pretty clear that we are ready for this big push of 11ac. So are our general partners , they are really putting together quite a bit of inventory, and especially when we are the only one that is providing the 11ac technology in the market . So we are seeing our channel partners around the world putting inventory on 11ac and ready for the back- to-school sales.

Okay, so with the back-to-school sales and the service providers being a lesser percent revenue we should expect guidance to come down a little bit?

Yes. That's what I'm thinking.

All right, thank you. Good luck, guys.

Thank you.

Our next question comes from the line of Rohit Chopra with Wedbush Securities.

Thanks very much. Christie, I have a question for you on currency. I know you guys hedge, but I want to get a sense if there was any currency issues in the quarter?

During Q2, no, again, we hedges so we locked in our rates as we locked in that. I think the only thing you can see where the currencies are today, and we will hedge for the quarter, and again I remind everyone that we have both revenue and expenses in local currency, so we will continue to, along with the hedging program which has been everything work smoothly for us.

That's great. And then I just want to ask you about Target. You added Target last quarter, fairly large chain. U.S. retail still down it looks like. Can you give us a sense is Target operating above or below plan one quarter in?

Actually we are quite happy with Target. Q2 is seasonally down for all retail. There is no big promotions in that. What we saw was seasonally down. We are quite happy with the relationship with Target.

And then lastly I just want to ask about Shane when he left, I didn't see anybody get replaced in CBU. Are there plans or is there something that needs to be done there?

No, we are actually -- we have a search going to look for a new general manager of the commercial business unit, and in the short run Patrick is stepping in.

I appreciate it. Thank you.

Sure, thank you.

There are no further questions at this time. I would like to turn the floor back over to management for closing comments.

We are really excited about all of the new product lineups that we have, which are unique to us. We are in a leadership position. The 11ac routers, the ReadyDATA 5200, the 10 gig switch and now with the addition of the two acquisitions, which enable us to go into the smart home market with a total wire-free camera and the corresponding patented technology, as well as the capability that we acquired in India for the rolling out of the wireless controller for small, medium-sized camera.

We feel very good that we will continue to gain shares and we will grow our revenue faster than our competition. As I mentioned we feel very good in the second half about our commercial and retail business units, and we would look forward to continue to be successful in the market, and we will update everybody on all of these new product finds in the next earnings call. Thank you.

This concludes today's conference. You may disconnect your line at this time and thank you for your participation.