NETGEAR Inc (NTGR) 2016 Q2 法說會逐字稿

Greetings and welcome to the NETGEAR Inc. second quarter 2016 earnings conference call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded. I would now like to turn the conference over to your host today, Mr. Christopher Genualdi, Manager of Investor Relations. Thank you, sir. You may begin.

Thank you, operator. Good afternoon and welcome to NETGEAR's second quarter 2016 financial results conference call. Joining us from the Company are Mr. Patrick Lo, Chairman and CEO, and Miss Christine Gorjanc, CFO.

The format of the call will start with a review of the financials for the second quarter provided by Christine, followed by details and commentary on the business provided by Patrick. And finish with third-quarter guidance provided by Christine. We will then have time for any questions. If you have not received a copy of today's release, please call NETGEAR Investor Relations or go to NETGEAR's corporate website at www.netgear.com.

Before we begin the formal remarks, we advise you that today's conference call contains forward-looking statements. Forward-looking statements include, among other things, statements regarding expected revenue, operating margins, tax rates, expenses, and future business outlook. Actual results or trends could differ materially from those contemplated by these forward-looking statements. For more information, please refer to the risk factors discussed in NETGEAR's periodic filings with the SEC, including the most recent Form 10-Q.

Any forward-looking statements that we make on this call are based on assumptions as of today, and NETGEAR undertakes no obligation to update these statements as a result of new information or future events. In addition, several non-GAAP financial measures will be mentioned on this call. A reconciliation of the non-GAAP to GAAP measures 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 Miss Christine Gorjanc.

Thank you, Chris. Results for the second quarter of 2016 came in above the high end of our guidance, driven by the performance of both our retail business unit and our commercial business unit.

For the second quarter ended July 3, 2016, net revenue was $311.7 million, which is up 7.9% on a year-over-year basis and slightly up on a sequential basis.

NETGEAR net revenue by geography continues to emphasize our strength in North America. Net revenue for the Americas was $210.9 million, which is up an impressive 22.3% year-over-year and up 8.8% on a sequential basis.

EMEA net revenue was $51.7 million, which is down 24% year-over-year, and down 19.9% quarter-over-quarter.

Our APAC net revenue was $49.1 million for the second quarter of 2016, which is up 1.6% from the prior year's comparable quarter and down 5.4% quarter-over-quarter.

For the second quarter of 2016, we shipped a total of approximately 5.2 million units, including 4 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 2.1 million units for the second quarter of 2016.

The net revenue split between home and business products was about 76% and 24% respectively. Products introduced in the last 15 months constituted about 36% of our second quarter shipments, while products introduced in the last 12 months constituted about 28% of our second quarter shipments.

From this point on, my discussion points will focus on non-GAAP numbers. The reconciliation from GAAP to non-GAAP is detailed in our earnings release distributed earlier today.

The non-GAAP gross margin in the second quarter of 2016 was 32.3%, compared to 27.9% in the prior year comparable quarter, and 33.3% in the first quarter of 2016. The year-over-year gross margin improvement reflects the reduction in service provider revenue which typically carries a lower gross margin.

Total non-GAAP operating expenses came it at $64.6 million, which is up 7.6% year-over-year and down 2.9% sequentially. While we always manage our operating expense carefully, we will look to continue to invest in research and development as we add new product offerings to our portfolio.

Our head count decreased by net 9 people to 928, in part due to a realignment of sales and marketing resources, to take advantage of the (inaudible) and changing buying behaviors that we have seen in the SMB market recently. As a result, we took a restructuring charge during Q2 of $1.3 million. We expect to add headcount in the key areas of the business during the third quarter in order to drive further growth.

Our non-GAAP R&D expense for the second quarter was 6.6% of net revenue, as compared to 7% in the year ago comparable period, and 6.9% of net revenue during Q1 2016. We continue to believe that our investment in R&D is key to our business, and we expect this expense to grow in absolute dollars.

Our non-GAAP tax rate was 34% in the second quarter of 2016. Looking at the bottom line for Q2, we reported non-GAAP net income of $24.1 million and non-GAAP diluted earnings per share of $0.72 per diluted share.

Turning to the balance sheet, we ended the second quarter of 2016 with $352.7 million in cash, cash equivalents and short-term investments. For the second quarter of 2016, we generated approximately $23.8 million in free cash flow, which is calculated from cash flows from operating activities, as presented in the statement of cash flows under GAAP less capital expenditures.. We continue to remain very confident in NETGEAR's ability to generate meaningful levels of cash.

During the trailing four quarters, we generated approximately $149.7 million in free cash flow. We continue to be focused on optimizing the business and generating cash, which gives us flexibility with our operational needs as well as the ability to strategically deploy cash to enhance shareholder value.

In Q2, we spent $13.2 million to repurchase approximately 314,000 shares of NETGEAR common stock at an average price of $42.13 per share, which resulted in no benefit to non-GAAP diluted earnings per share for the quarter.

Despite our buyback activities over the last year, our fully diluted share count has trended upward slightly over each of the last three quarters. Nevertheless, since the start of our repurchase activity in Q4 2013, we have repurchased approximately 9.2 million shares and our diluted share count is lower by 14.6% as compared to the beginning of that period.

Now turning to the results of our three business units, the retail business unit, or RBU, generated net revenue of $170.6 million during the quarter, which is up 29.5% on a year-over-year basis, and up 8.3% sequentially.

The commercial business unit, or CBU, generated net revenue of $73.7 million for the second quarter of 2016, which is up 16.9% on a year-over-year basis, and up 7.7% sequentially.

For our service provider business unit, or SPBU, net revenue came in at $67.3 million for the second quarter of 2016. This is down 28.3% year-over-year, and down 20.1% on a sequential basis.

Our service provider results during the first half of 2016 reflect typical service provider lumpiness, as our Q1 service provider revenue was greater than expected and Q2 was less than expected. Overall, we are pleased with our ability to manage this business's revenue downward while maintaining a healthy contribution margin and believe that the lower revenue contribution per service provider is not a major concern for our business.

Looking forward to the second half of 2016, we expect service providers to deliver approximately $65 million in revenue per quarter.

I'll now turn the call over to Patrick for his commentary on the results of the three business units as well as the overall business, after which I will then provide guidance for the third quarter of 2016.

Thank you, Christine. And thank you everyone for joining today's call.

We are very pleased with our second quarter results, which reinforce our belief that we're managing our business effectively and take advantage of the opportunities in the market.

Our retail business unit clearly had a stellar Q2, bucking the trend of what is typically slower second quarter seasonality. Our premium Nighthawk Routers, cable gateway, and Arlo lines all performed especially well during the quarter.

On our prior earnings call, I discussed how consumer Wi-Fi is evolving given the proliferation of connected devices and streaming media in the home. Our retail results for the second quarter are not only a reflection of this ongoing trend, but also a reflection of how NETGEAR is the leader in home connectivity in IoT.

For most of our 20-year history, we have been building superior Wi-Fi solutions with innovative features and designs to meet the ever-changing needs of technology consumers, and this is what sets us apart from our competition.

Our Nighthawk line of home routers continue to be the gold standard for home Wi-Fi worldwide. As such, our Nighthawk X6, which supports Tri-Band 802.11ac connectivity, was just named the best router by the EHA in the 2016 European Hardware Awards competition. This honor is testament to the industry-leading R&D effort that our team puts into every Nighthawk router that is brought to market.

Additionally, another member of the Nighthawk family of routers, the Nighthawk X4S, was recently recognized by PC Gamer Magazine as the best Wi-Fi gaming router on the market. This recognition is a significant achievement because the gaming audience is very scrutinizing in the selection of technologies that they choose to adopt. You can expect further innovation and expansion for our Premium Nighthawk line in the months to come.

Turning to the Arlo side of the business, our line of IP security cameras continued to be the industry leader during Q2. Over one year after the original Arlo Wire-Free cameras were launched, there are two new software features that I would like to highlight at this time.

First, during the quarter, we rolled out new automation capabilities such as geofencing, which enables users to set up a virtual fence or perimeter around their home and automatically arm or disarm their Arlo system when their mobile device is inside or outside of the virtual fence.

Second, we rolled out IFTTT integration during Q2, which enables users to create If This Then That recipes that connect to other smartphones, apps, and products. This has been a highly requested feature from our users, and as of July 20th, over 350,000 unique IFTTT recipes have been recorded only two months after launching the integration. One example of an IFTTT recipe is if my front door Arlo camera senses motion at night, turn on my smart lights and have all my Arlo cameras start recording.

Also during Q2, Tom's Guide named the NETGEAR Arlo Q as the best wireless security camera overall for 2016, highlighting its superior hardware, flexible options, and affordable cloud storage subscription plan. In the fairly crowded, competitive space of home security cameras, we believe that we have the expertise to make great products that both provide peace of mind and delight our customers.

Looking forward for RBU, you can expect us to release more products in the near future that address the ever-increasing number of Wi-Fi-enabled devices in the home, the need to have high speed Wi-Fi connectivity in every corner of the house, and the need for reliable security in and around consumers' properties.

Next, I'd like to provide a few words on the commercial business unit. We are very pleased with the year-over-year and sequential growth generated by CBU during Q2. Last quarter, we saw the US distribution channel inventory stabilize, and we have been able to capitalize on that stabilization since then.

Looking at the market, SMBs are continuing to upgrade to multi-gig and 10-gig switching. A 2016 study of the US, UK, and German IT managers conducted by Palmer Research found that while only a third of surveyed businesses currently have 10-gig switching, the expectation is that 75% will have it deployed by the end of 2017.

To continue to address this need and tackle the bandwidth bottlenecks created by IoT, video streaming, and cloud services, we expanded our switching line during the second quarter with the release of three new 10-gig switches that provide powerful network performance in capacity. These switches are available now and retail at prices between $1,500 and $8,500.

Our service provider business unit stepped down in revenue during Q2, yet we maintained a healthy contribution margin despite this. We are pleased with the effective pricing and cost management that our SPBU team has shown through this revenue volatility, which has resulted in profitability levels that are expected of our service provider business unit.

As Christine alluded to, our service provider business always had a lumpy revenue profile, but as our other two business units grow, we have been able to mitigate the impact of that lumpiness. We will continue to focus on maximizing profitability for this business unit and expect the service provider business unit to have a run rate of approximately $65 million per quarter in the second half.

To summarize, the second quarter exceeded our expectations, and we continue to gain share in home Wi-Fi, home security cameras, and switching. I will now turn the call back over to Christine for our Q3 guidance.

For the third quarter of 2016, we anticipate revenue will be in the range of approximately $315 million to $330 million. Third quarter non-GAAP operating margin is expected to be in the range of 10.5% to 11.5%. Our non-GAAP tax rate is expected to be approximately 35% for the third quarter of 2016.

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

Thank you. At this time, we will conduct a question and answer session. (Operator Instructions) One moment, please, while we poll for questions. Ryan Hutchinson, Guggenheim.

And good afternoon. I guess the one question that I have is, is the service provider, now that it's expected to step down again, and I recognize you do guide to operating margins, but just want to get a sense, should we anticipate gross margins to stay at or above the levels that we've seen over the last couple of quarters?

Yeah, we really don't guide to the gross margin, again. It's something that can go into the back half of the year with our more highly promotional quarters for retail in that, and we're not sure where our marketing expenses will be, whether they'll be in OPEX or above the line. So we would just, again, guide to the 10.5% to 11.5% operating margin. I mean, this quarter, it was also around $65 million.

Okay. Yeah, I guess the reason for the question is just to try and understand where the investments will be made within the operating expenses, but it sounds like it'll be somewhat of a mix between the two, and R&D in absolute dollars will continue to move higher? Is that kind of a way to think about it?

Yes, absolutely.

Okay. And then on, let's see. You talked about Nighthawk, and maybe just an update on Arlo. What are the expectations for the back half of the year?

We certainly continue Arlo to continue to do very well in multiple ways. First is in the expansion of distribution. We just entered the Chinese market, and we would also expand into new retail. We just entered in the Verizon stores. So we certainly expect that Arlo continue to grow pretty rapidly.

On the second half, we would continue to roll out new Arlo products in the second half, and clearly we alluded to that will we introduce new category before the end of the year.

Okay, great. I'll pass it along. Thanks.

Great. Thank you.

Tavis McCourt, Raymond James.

Hey, you guys. Thanks for taking my question. First, a housekeeping item. Christine, I wonder if you could break out the components of free cash flow in the quarter between cash flow from Ops and CapEX.

Sure. Cash flow from operations is $26.8 million, CapEX is about $3 million, and then free cash flow, $23.8 million.

Got you. And then a couple for you, Patrick. In the commercial business, especially if you kind of look at the work you did on channel distribution in this quarter, it looks like (inaudible) was actually quite strong year-over-year, and I'm wondering is that in the core switch business or are some of the ancillary products starting to sell better?

Well, clearly, switch is the strongest of them all, and we also initial momentum on the new wireless LAN products that we introduced.

Okay. And in terms of what you see for commercial in Q3, I guess what I'm trying to get at, was there anything kind of artificial in terms of channel fill in Q2 that we should expect any kind of big movement as we look sequentially into Q3, or would it be normal seasonality?

No. Okay, no. I think really, if you look, we saw that US distribution channel inventory be right around in the fives. It looks good, so we're not expecting anything unusual as far as (inaudible).

Thanks. And then Patrick, in your prepared remarks you talked a little bit about kind of what to expect for new products within the retail business unit, and I caught the part on security around the house. What else were you referring to in those comments?

Unfortunately, I won't be able to give you a little bit more detail, I mean, because I think many of our competitors are on this call. So, stay tuned.

All right. But you're still holding to a new product category this holiday season?

Correct, correct.

Okay. Thanks.

Matt Robinson, Wunderlich.

Thanks. First my housekeeping question is depreciation, what that was in the quarter. I'd like to, despite what you just said about competition, Patrick, I'd like to get your views on the need that you see in offering a mesh solution for whole-home networking, and if you guys are offering unified management between your switches and your commercial Wi-Fi products, and when we might be able to see that. And then lastly, I'd be interested to know how the growth of the LTE was as part of the service provider (inaudible).

Yes, one answer at a time. So, regarding the home mesh network, and clearly, different people have different needs and we believe that most of the market today really would like to have really, really fast Wi-Fi connectivity or devices close to the routers and even at the edge of the homes. And needless to say, our Nighthawk serves that exact purpose I would say for 90% of the houses.

But of course, there are many people who live in a 6,000-square-foot house that a single router might not be suffice, and we applaud the validation of our (inaudible) you do need good home Wi-Fi coverage, including the one-percenter. So we do believe that the recent attraction from home mesh Wi-Fi networks satisfy that niche market, however, it does validate our stance that whole-home Wi-Fi coverage is important.

Now, traditionally, NETGEAR has been servicing the masses, which is the 99%, but it doesn't mean that we ignore that 1%. And clearly, we have our solution for the 1% as well.

On the second question about unified switch management, clearly, we believe that the world is moving towards cloud (inaudible) management, and we certainly are working on that front. And you've already seen some of it coming out from our wireless LAN solution that is offering cloud management. And clearly, our direction is to provide that type of management across our SMB line and at the end of it, we'll unify it all into one platform.

But this is not a small feat. I mean, this is a pretty significant development, so it would take us a few years to get there, but we're clearly on that path.

And on the depreciation, we actually don't normally give that number until we filed a Q, but what I would tell you is I think if you just look back over the past couple of quarters, it'll be in that ballpark.

Thanks. Any comment on LTE?

Oh, the LTE growth, I mean, clearly, we have been seeing very strong demand on our LTE Advanced products. That's where we're focusing in. And clearly, the non-advanced products, we call it Cat 3, Cat 4, those are clearly very commoditized and we're seeing a lot of Chinese competition, so purposely are not participating in that particular market.

We are focusing our effort on the LTE Advanced, and we're seeing significant interest and demand over our products both in North America, as well as in Australia and in Europe for that class of products. And you would expect us to continue to push the envelope forward. As a matter of fact, at Mobile World Congress, we, actually jointly with Ericsson and Telstra, demonstrated (inaudible) 15 and 16 LTE Advanced, which could do a gigabit download speed, and which we will introduce pretty soon. And that's a very exciting breakthrough.

(Inaudible) that service provider business for profitability, should we expect LTE to rise to be some number maybe in kind of in line with an 80/20 rule, or how big of a mix do you think it could get to be?

Oh, well, clearly, we are technology agnostics, as we mentioned. We are focusing on the leading edge, high software content, proprietary technology area of the service provider unit. So that's why you see us moving away from the ordinary LTE, moving away from DOCSIS 3.0, moving away from ADSL, while pushing forward into LTE Advanced, Cat 9 and (inaudible), and moving into media (inaudible). Moving into (inaudible), moving into Arlo. Those are the areas we believe that we have an edge. And surely, DOCSIS 3.1, and we'll be the first to begin certified DOCSIS 3.1 for retail.

And so I think those are the areas that we believe that will win, and those are what we don't -- and we're not going to really shoot for a certain mix. I mean, we will basically supply our leading edge technology to any customers who value our contribution.

Thanks for letting me have so much time on the call.

Sure.

Hamed Khorsand, BSW Financial.

Hi. Just a couple questions here. Can you talk about the weakness in EMEA? It almost feels like NETGEAR's being squeezed out, and what you're trying to do to rectify that?

Well, I mean, EMEA clearly, as we have observed, naturally, there was a recent article coming out on the internet making the comment that European operators, generally very price conscious due to the fact that all of them actually pay a hefty amount of money to get bandwidth spectrum, and that's why they are much backwards in terms of technology deployment. I mean, they are laggard in LTE Advanced deployment, they're laggard in DOCSIS 3.1 development, they're laggard in media (inaudible) deployment.

So the market has become very commoditized, and that's why not only us, but if you look at even their local, Nokia, Alcatel-Lucent, and Ericsson as being basically squeezed out by really cheap Chinese competitors. So we do not believe that we could make any decent profit among the service provider market in Europe, and that's why over the last 18, 24 months, we've been gradually exiting that market once the contract is finished. Of course, we have to deliver what we promised, but once the contract is done, we're just not in a position to (inaudible) the next contract, which is another commodity (inaudible) with lower margin, lower price.

So what you see in the decrease in our European revenue is basically our continued refocus, pivoting primarily to CBU and RBU, which is growing very nicely for us. While on the other hand, in North America and in APAC, the operators are a lot more advanced in terms of technology and deployment. For example, like in North America, both Verizon and AT&T are really app and LTE Advanced adopters, and Telstra has always been at the forefront of pushing the envelope of LTE Advanced.

So we have been able to maintain more of the service provider revenue in North America, as well as in Asia, and that's why you see this change. We believe that this condition will continue to go forward, and that's why you see this apparent weakness of the EMEA, but if you look deeper, actually, the non (inaudible) apart, obviously, Europe is actually doing pretty nicely for us.

Okay, and can you say how much is left in EMEA as far as the service provider goes?

We don't (inaudible), but you can pretty much look at year-over-year the same quarter.

Okay. And the other question I had is given the demand you saw in Q2 and the guidance you're providing for Q3 as far as RBU, do you think this seasonal demand in Q4 is going to be there and do you think that the business is still seasonal?

Yes. Clearly, is a combination of two. Is both seasonal, which is kind of demand driven, but there's also supply driven as well. I mean, the fact that we have been able to buck the trend in Q2 is because of the supply of new products. I mean, our Arlo and the new Arlo, like Arlo Q, Arlo Q Plus, like the new switches that we introduced, I mean we introduced three really good 10-gig switches, very unique in the market. The most compact in form factor with the highest concentration of 10-gig managed ports. I mean, all those are generating demands. These are new supplies. So there's a combination.

So we are very confident about the demand, the market demand during Q4, the coming Christmas season. But then whether we can do better than that, it really depend on the new products that we're going to introduce before then.

Okay. Thank you.

(Operator Instructions) Rohit Chopra, Buckingham Research.

Thanks very much. Christine, I just wanted to ask my housekeeping question. Wired versus wireless, do you have a split there? The other question I had as you look for that is were there any FX issues as you came towards the end of the quarter?

I would say FX issues are pretty minimal, so nothing to speak about. And wired versus wireless is 73% and 27%.

And then the other question I had was related to Arlo. At the end of last year, I think it was the big release, and it was a big push into the holiday season. Can you maintain those kind of comps? Is that the kind of growth you're seeing right now, or are the comps that difficult as you go into the back half of this year for Arlo?

Well, I just made a comment if we look at the market of IP security camera is growing 45% year-over-year, both in the North America market as well as the German market. So from a demand perspective, we see very strong. And clearly, we're going to introduce new products. So, again, I mean, as I just made a comment to, we're very confident about market demand. Whether we can do better than that depends on the success of the new products we will be introducing in the next two quarters.

Okay. And then my last question is related to what Hamed was asking on the non-SP business in Europe. Are you seeing any type of slowdown related to the macro in the UK or anything like that? It is one of your larger territories.

Well, what I'd like to point out is that UK is an important market for us, for sure. But in the overall scheme of Europe, they're not over-dominating. In Europe right now, we have a very balanced distribution of revenue across the, now, the European Union, ex-UK, and especially in Germany is really big, clearly, and so is France, so is Italy, so is Norway. So we do believe that with the new products that we introduced, we should be able to offset any (inaudible) Brexit.

Thanks, Patrick. Thanks, Christine.

Sure.

Thank you. At this time, I would like to turn the call back over to management for closing comments.

Thank you, everybody, for joining the call today. We're certainly very excited by the performance of our new products in the marketplace. So we clearly have invested quite a bit in R&D to the tune of about 6.5% to 7% every quarter for the last six to eight quarters, and it's starting to bear fruit. However, there will be more new products to come in the second half of this year. Some of them are into new product categories that nobody ever has ventured into, so we're very excited about it and certainly would like to share more of that in the next earnings call and would like to talk to you all in October. Thank you.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time, and have a great day.