NETGEAR Inc (NTGR) 2018 Q1 法說會逐字稿

Good evening. My name is Chris, and I'll be your conference operator today. At this time, I would like to welcome everyone to the NETGEAR First Quarter 2018 Results Conference Call. (Operator Instructions) Christopher Genualdi, Director of Investor Relations, you may begin the conference.

Thank you, operator. Good afternoon, and welcome to NETGEAR's First Quarter 2018 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 start with a review of the financials for the first quarter provided by Christine, followed by details and commentary on the business provided by Patrick, and finish with second quarter of 2018 guidance provided by Christine. We will then have time for any questions. If you have not received a copy of today's release, please visit NETGEAR's Investor Relations 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 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-K. 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 today's press release on our Investor Relations website.

At this time, I would now like to turn the call over to Ms. Christine Gorjanc.

Thank you, Chris, and thank you, everyone, for joining today's call. Results for the first quarter of 2018 came in at the high end of our guidance, driven by the success of our Orbi line, the new Nighthawk Pro Gaming Router, Arlo Pro 2 and our SMB switching line. Overall, NETGEAR net revenue for the first quarter ended April 1, 2018, was $345 million, which is up 6.6% on a year-over-year basis and down 13.1% on a sequential basis. The sequential decline is the result of Q1 seasonality as consumer spending slows following the holiday season.

NETGEAR net revenue by geography once again reflects continued strength in North America and the EMEA region. Net revenue for the Americas was $233.6 million, which is up 10.4% year-over-year and down 15.1% on a sequential basis. EMEA net revenue was $66.6 million, which is up 14% year-over-year and down 14.7% quarter-over-quarter. Our APAC net revenue was $44.7 million for the first quarter of 2018, which is down 16.5% from the prior year comparable quarter and up 1.9% quarter-over-quarter.

For the first quarter of 2018, we shipped approximately 5 million units, including 4 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 1.6 million units for the first quarter of 2018. The net revenue split between home and business products was about 79% and 21%, respectively. The net revenue split between wireless and wired products was about 76% and 24%, respectively. Products introduced in the last 15 months constituted about 43% of our first quarter shipments, while products introduced in the last 12 months constituted about 35% of our first 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 first quarter of 2018 was 30.7% compared to 30.9% in the prior year comparable quarter and 26.5% in the fourth quarter of 2017. The quarter-over-quarter improvement in non-GAAP gross margin was primarily due to reduced investments in channel marketing as we exited the holiday season as well as reduced air freight costs. As mentioned on the prior calls, the majority of our channel marketing spend hits our P&L as contra revenue, therefore affecting our gross margin level.

Total non-GAAP operating expenses came in at $80.2 million, which is up 18.5% year-over-year and up 5.1% sequentially. This included $879,000 of costs associated with the separation of Arlo and the corresponding dis-synergies created as we hired talent to duplicate certain roles to prepare that business to stand up on its own. As always, we manage our expenses prudently while also ensuring that all portions of our business have the resources necessary to succeed.

Our headcount increased by a net of 39 people to 1,047 heads during the quarter. We are adding resources as we continue down the path to separate the Arlo business as well as continuing to invest in the key growth areas of our business. We expect to continue to add additional headcount during the second quarter of 2018.

Our non-GAAP R&D expense for the first quarter was 7.9% of net revenue as compared to 6.6% of net revenue in the prior year comparable period and 6.1% of net revenue in Q4 of last year. R&D is critical to our business, and therefore, we expect this expense to continue to grow in absolute dollars as well as in percentage in Q2 as we continue to ramp the R&D spend in Arlo. We are actively investing in R&D for software, cloud, apps and services across all 3 business segments. As for Arlo, Q2 is a heavy R&D investment quarter as we invest in premium paid services and new products for the second half of the year. Our non-GAAP tax rate was 23.8% in the first quarter of 2018.

Looking at the bottom line for Q1, we reported non-GAAP net income of $20.4 million and non-GAAP diluted earnings per share of $0.62 per diluted share.

Turning to the balance sheet. We ended the first quarter of 2018 with $386.2 million in cash or cash equivalents. During the quarter, we generated a healthy $53.8 million in free cash flow, which is calculated in cash flows from operating activities, as presented in the statement of cash flows under GAAP, less capital expenditures. Free cash flow for the trailing 12 months was an impressive $121.8 million. We continue to remain very confident in our ability to generate meaningful levels of cash.

Now turning to the results for our 3 product segments. The Arlo segment's net revenue came in at $96.2 million for the first quarter of 2018. This is up 58.5% year-over-year or about $35.5 million from the prior year and down 25.1% on a sequential basis. The seasonality of IP cameras is particularly pronounced going from the holiday season to Q1, more so than the Q1 seasonality of consumer networking.

The Connected Home segment, which includes the industry-leading Nighthawk and Orbi brands, generated net revenue of $177.8 million during the quarter, which is down 8.5% on a year-over-year basis and down 10.5% sequentially. The year-over-year decline is primarily due to reduced service provider revenue for the Connected Home, which is down $11.4 million from Q1 2017. We also continued to see headwinds for cable products in North America retail. However, we expect these declines to slow in the coming quarters.

The SMB segment generated net revenue of $71 million for the first quarter of 2018, which is up 3.5% on a year-over-year basis and up 1.6% sequentially. We are seeing strength in our switching line, especially in the areas of 10Gig, Power-over-Ethernet and ProAV, where we lead in both product portfolio and in brand.

We are continuing to move forward with our previously announced separation of our Arlo business from NETGEAR, as contemplated, and have recently submitted a confidential draft registration statement on Form S-1 to the SEC relating to the proposed initial public offering of common stock of Arlo Technologies, Inc.

I'll now turn the call over to Patrick for his commentary, after which I will provide guidance for the second quarter of 2018.

Thank you, Christine, and hello, everyone. We're pleased with our results for the first quarter of 2018, which came in at the high end of our guidance range for both the top and the bottom lines.

The Arlo segment posted $96.2 million in revenue for the quarter, representing an impressive 58.5% year-over-year growth. Arlo's growth during the quarter was largely driven by the success of Arlo Pro 2, which was launched in the fourth quarter of 2017. PC Magazine recently named Arlo Pro 2 their favorite camera for outdoor surveillance. Meanwhile, Digital Trends, an online millennial-focused publication, wrote that, "It's not cheap, but this is the best home security cam we've ever tested." Pro 2 improves on the original Arlo Pro with crisp 1080p video, optional plug-in power for 24/7 monitoring, supports activity zones and a wider viewing angle.

We're also excited to be approaching the 2 million registered user mark, with over 1.9 million registered users as of April 1, 2018, as we continue to expand our installed base to which we will promote our paid subscription services. We are in the final beta trial of our AI-based Arlo Smart paid service, and we intend to roll it out in the next 60 days. We believe that it will significantly enhance our ability to expand our premium service subscription attach rate, thus ramping our recurring revenue stream.

Looking forward, as we've already shared publicly, we expect to launch the Arlo Security Light during the spring of 2018. This will be our first noncamera product added to the Arlo family. I look forward to updating you on this during our next earnings call in July.

Turning to the Connected Home segment. Q1 was a strong quarter on the bottom line as CHP's contribution margin improved meaningfully on a sequential basis. Q1 marked CHP's highest contribution margin in the last 4 quarters. We expect this trend to continue into Q2. Additionally, we gained 1 point of market share in the U.S. during the quarter from the competition, thanks for our industry-leading WiFi products. CHP's success in the first quarter was driven by both the Orbi line and the new Nighthawk Pro Gaming Router.

As many of you know, Orbi is our industry-leading consumer mesh WiFi solution that will blanket every corner of your home in high-speed WiFi. While our competitors currently offer 1 or maybe 2 models of mesh WiFi products, we currently have 6 different models on the market, and more are on the way. This enables consumers to choose the perfect mesh configuration for their specific connectivity needs. Tom's Guide, a well-respected tech review publication, recently evaluated all of the mesh systems available in the market and determined that, "The NETGEAR Orbi is the best mesh router that we tested." We continue to stay ahead of the competition by delivering the best WiFi performance on the market, engineered by our world-class WiFi engineering team.

Meanwhile, the Nighthawk Pro Gaming Router took the market by storm with its industry-leading WiFi performance and, more importantly, its cutting edge software that optimizes one's gaming experience. By providing geo-filtering, ping stabilization, lag spike reduction, bandwidth allocation and a host of other unique features, the Nighthawk Pro Gaming Router is the undisputed, best home networking solution for gamers worldwide. A review by PC Gamer of the gaming routers available on the market recently named the Nighthawk Pro Gaming Router the best gaming router for most users. The Nighthawk Pro Gaming Router has been a hit straight out of the gate, and it marks just the beginning of our push into the gaming space.

Additionally, during the first quarter, we continued rolling out Circle parental control subscription services to some of our existing router customers. We believe service revenue would gradually become a meaningful contributor to CHP's bottom line in the coming years.

Our SMB segment had a strong first quarter, posting year-over-year and sequential revenue growth, which was primarily driven by our switching line. We gained 5 points of market share in the U.S. retail channel switching market. Additionally, SMB experienced strength in the international markets, particularly in Germany and Japan.

From a product category perspective, our Power-over-Ethernet and 10Gig switches continued to be strong performers during Q1. Like CHP, SMB delivered a strong quarter on the bottom line, posting its highest contribution margin of the last 4 quarters. Again, we expect this uptrend to continue into Q2 for SMB. Looking forward, we expect that our app-managed Insight switches, ProAV and Multi-Gig switches will be ramping up in revenue throughout the rest of the year.

In summary, we are very encouraged by the continuous top line growth for both Arlo and SMB as well as the improvement in contribution margin and market share gains for both the CHP and SMB segments. For Arlo, we're excited by the continuous growth in the number of the registered users, pending introduction of Arlo Smart, the launch of Light in Q2, and more new premium paid services and products coming in the second half of the year.

I will now turn the call back to Christine for the Q2 guidance.

Thank you, Patrick. For the second quarter of 2018, we anticipate revenue will be in the range of approximately $340 million to $355 million. First quarter GAAP operating margin is expected to be in the range of negative 1.2% to negative 0.2%, which includes approximately $10 million of onetime costs associated with the separation, which includes professional service fees for various advisory and audit-related costs. Non-GAAP operating margin is expected to be in the range of 5.5% to 6.5%, which includes approximately $4 million of costs associated with the separation of Arlo and the corresponding dis-synergies created as we hire talent to duplicate certain roles to prepare that business to stand up on its own. Furthermore, we expect to increase our R&D spend as a percentage of overall revenue due to investment across all 3 product segments and Arlo in particular. Our GAAP tax rate is expected to be approximately 30%, and the non-GAAP tax rate is expected to be approximately 25% for the second quarter of 2018.

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

(Operator Instructions) Your first question comes from Rob Cihra from Guggenheim.

A few questions, if that's okay. One, just you called out the improved profitability in Connected Home. Any chance you would give us actual numbers for segment profits or do we have to wait for the Q? And then the $4 million in -- on -- reducing the non-GAAP operating margin with that $4 million, not the $10 million. So I mean, are those -- that sort of dis-synergies, I mean, is that $4 million sort of a $4 million per quarter ahead of the separation? Or is that $4 million going to go higher? Or just curious sort of how the balance of the year plays out even though I recognize the balance of the year, at one point, it will be 2 companies. And then I had one follow up, if that's okay.

Okay. So we will file the Q shortly, and we'll have all the segment contribution results in the Q. And related to the $4 million, that again is headcount. It's license fees and again duplicate expenses that we are incurring. I would expect that to go up in Q3 as we continue to add headcount for Arlo as a stand-alone company. And at some point, you're right, it will be totally separate companies and you'll see the structures we're in both. But we are standing up complete operations and IT organizations and finance. And I believe you had one more question.

Yes, just on the promotional spending or discounting, you said actually, seasonally, it was a little better, as shown in the gross margins. Is that -- if I go back sort of a year ago when you guys started getting more ambitious with your promotions to drive market share up in, particularly, I think Arlo and Orbi, I mean, where are you now kind of a year later? I mean, you have been gaining share. Do you sort of feel like you still have to be aggressive with that? Or is there sort of some areas where you're still being aggressive and others where you feel like you've kind of gotten to where you wanted to be? I'm just curious sort of from a strategic standpoint how you feel about that sort of aggressive spending.

From an overall perspective, I mean, we're pleased with the market share gain that we have. From a competitive consideration, we are not going to pre-tell our competitors when we're going to be hard on promotion, when we're not going to be. But generically speaking, I mean, in Christmas season, it's probably with Black Friday, with November 11 in China, that would be the most promotional quarter. I could just only stop at that.

Your next question comes from Woo Jin Ho with Bloomberg.

A couple of things in terms of the full year guidance. And I know that the full year guidance is probably taking off primarily because of the pending Arlo spin, but are you still -- if there was one business year end, are you still sticking to the 10% growth for the year?

Yes. That's our intent, and we're working very hard to get to that objective. I think we're still on track.

Okay. And then -- but given your second quarter guidance, you'll need a fairly strong second half to achieve roughly the $500 million in Arlo revenue that you intended. And then if we're still looking at flattish Connected Home and SMB, how are you thinking about that Arlo business in the second half? And how should we start thinking about the Connected Home in the second half as well given that they'll be 2 separate businesses?

As Christie just pointed out, the Arlo business is more seasonal than our traditional home networking business. So that means the Arlo business will have a much bigger second half than the first half. And as Arlo's base gets bigger, then that seasonal pop in the second half will have a much -- made -- more dramatic effect on the overall revenue. So we're still pretty confident on that 10%. And as I just mentioned, our CHP business, the headwind of the CHP business, both from the service provider decline as well as the cable side decline, is moderating as we go forward. So -- and then we're really happy to see that our switching line is powering the growth of the SMB both on a sequential and annual basis. When you add all that together, we believe that if we continue to execute, we should be able to get to our annual guidance on the top line.

Got it. Just a couple more, if I may. One of the drivers for the NETGEAR growth in 2015 and 2016 were ASPs. How should we start thinking about the product ASPs going forward? It looks like it's tailing off a little bit, especially as Orbi starts to anniversary and then we're starting to get some anniversary of the Arlo products.

Yes. I mean, we will continue to introduce product of higher ASP. A good example is the gaming router. The gaming router is almost like a 35% increase in the comparable range of routers. And then Pro 2 that we introduced in Q4 last year is another 25% jump from Pro. You will expect us to continue to do the same thing in the second half.

Okay. And then one strategic question from me. Given all the M&A activity that's happening in the smart home segment, Patrick, I mean, is the IPO the only route for the Arlo business? Or would you be open to a third-party M&A if the price is right?

I'm clearly, I mean, responsible for our shareholders. We look at all options, and we're not going to preclude one from the other. For now, I mean, we're all focused on executing on the IPO of Arlo, which we believe is this tremendous path.

Your next question comes from Trip Chowdhry with Global Equities Research.

I was wondering, if we think about Arlo and you did mention that the next 60 days, we are going to get Arlo Smart, the beta version -- the beta that you launched had object classification to include people, [vehicles] and animal. Do you think you will still have all the 3 object classification when it starts or we may only get a subset of it and the other objects later?

Well, we just finished our second round of beta. For this second round of beta, we focused on 3 functionalities: One is person identification. The other one is rich notification. The third one is E911. And so when I talked about rolling out the Arlo Smart service in the next 60 days, it will be surrounding those 3 functionalities. We're not precluding what we're going to roll out in the second half. I just mentioned I'm not going to pre-tell my competitors what I'm going to do. But as you probably heard from me saying that -- or actually from Christie that Q2 is a heavy R&D quarter for Arlo because there will be more Arlo Smart Services in the second half and there will be more new products from Arlo in the second half. So I mean, I will stop at that.

I was wondering, do we have any sense on the subscription service fees at this moment or we'll have to wait for 60 days to come out later?

You'll have to wait within that 60 days, and we think that it will be very attractive.

Now other question I had is regarding Arlo Pro 2. Do you think the sales of Arlo Pro 2 have exceeded the sales of Arlo Pro yet or there's still a lot of gap between the 2?

We don't break down product by product revenue, I mean, for obvious reasons. So we're not going to comment on that.

No worries, no worries. Last question I had is, we know that Arlo Light is coming. Do you think there are some other devices we may expect in the second half from Arlo, I mean device like a hardware device versus a subscription service?

The only thing I could say is in just the discussion, we're investing heavily in Q2 for Arlo because of new Arlo Smart Services and new products in the second half. And I think that's more than enough for our investment community. If I talk more, then our competitors will know exactly what we're going to do.

(Operator Instructions) Your next question comes from Rob Cihra with Guggenheim.

Great, back in. Two more questions since I'm given the chance. Service provider, I'm assuming looking at the quarter that still you're thinking sort of $50 million to $55 million a quarter. Is that now do you feel kind of a stable run rate for that business?

Yes. With the combination of Arlo, CHP and a tiny little bit of SMB, yes, that's about right.

Okay. And then looking at Connected Home and your expectations for the declines there to moderate and perhaps grow for the year, how much of that is kind of anniversary-ing the mix impact throughout last year of the growth in Orbi Mesh versus sort of traditional or legacy WiFi versus kind of getting past the weakness in U.S. carrier cable -- or sorry, retail cable modems that you had called out? Is one bigger than the other?

No, I mean, basically, the mix for the service provider products for any one of our product segments will be changing over time. So right now, for CHP products into the service providers, it's primarily composed of the mobile hotspots and then the traditional in-home WiFi products and -- as well as the new mesh WiFi products. We expect to see more of the in-home WiFi mesh products to be increasing and the traditional WiFi single routers, gateways to be decreasing and the mobile hotspots to be stable. So that's why we see this dynamic is pretty moderate going forward from a decline standpoint. But again, I mean, next year, we see tremendous opportunity that 5G could bring to us. And because of 5G, then WiFi mesh is more important than ever. So that might play into our hands. We don't know but we're not going to forecast that long. All we can say is for the rest of this year, this decline compared to last year, it will be moderating. But you're right, you said last year, we declined quite a bit already. So it's easier comps.

Your next question comes from Hamed Khorsand with BWS Financial.

First question I have for you is, Patrick, do you feel any competitive pressures increasing on you with Foxconn buying Belkin earlier this quarter?

No. I mean, because Foxconn is a huge conglomerate, as you probably know. I think they're over $100 billion in sales. And as a matter of fact, it's a very complicated group with many subsidiaries doing business with different people. The group that is supplying to us is actually a subsidiary listed in Singapore. And the primary facilities as well as engineering capabilities and manufacturing capabilities are based in Vietnam. And the group that's buying Belkin is actually listed in Hong Kong, which is primarily involved in providing Apple peripherals, cables, Ethernet, USB cables and so on and so forth. That's why they bought Belkin. But their capabilities are primarily in the U.S. as well as in China. So they are 2 very distant. So I don't think there's a lot of crossover. And of course, we get assurances and we're pretty confident that the firewall, pretty solid and distant between these 2 subsidiaries of Foxconn.

Okay. Another question. Now that you have 1.9 million registered users and I guess -- and inching closer to 2 million with -- how much are you willing to put more focus on doing the recurring revenue subscription model versus discounting and selling products more? What are you putting more focus on?

Well, I mean, we prioritize what we do, right. I mean, as of -- right now, I think our #1 priority, as described in our previous Analyst Day as well as our January separation presentation, our #1 priority right now is to increase the installed base, the number of registered users of Arlo. So I mean, you could term it as in a user acquisition mode. So that's what we do. And that's why -- I mean, we have been providing semi-free basic service to our customers to get more customers to be our registered Arlo users. Our second priority is to ramp up our premium paid services beyond the basic service that the customers actually prepaid when they bought the hardware. It's not really free but it's prepaid, all right. But anyway -- so that's our second priority. So I hope that I made it clear enough, yes.

Yes. And then lastly, just following up on other people's questions here. Can you just describe how you can get to the operating margin guidance that you gave being similar to last year if we're in the low single digits for first half of the year?

Well, the operating margin guidance we made in the Analyst Day last year was without the Arlo separation. So I don't think it is of any reference anymore. I think the best way to look at is follow our quarterly guidance in terms of operating margin because seriously, I mean, we have no clue on how much of these advisory fees, audit fees is going to be for the separation. So it's very difficult. But on the other hand, every quarter we tell you what those fees are and what are the dis-synergies and duplicate costs. And then we're pretty confident when you take that into account, we're pretty much on track on what we do.

Your last question comes from Woo Jin Ho with Bloomberg.

So I understand that the service provider was a headwind for the Connected Home business. But even if you exclude the Connected Home business, Patrick, the Connected Home business was down 4% on a year-on-year basis. I mean, it is an improvement from last quarter. But how should we start thinking about the revenues for Connected Home? When should we start thinking about a return to growth, number one? And then in terms of the year-over-year declines, ex service provider, is that mix driven? Or is that volume driven?

I thought that I explained it already, that other than the service provider headwind, we also have the cable headwind in North America retail because as we explained in previous 3 conference call, that Charter took over the Time Warner territories. And once they took it over, they kind of bundled the cable modem fees into the Internet subscription fees. So people do not have the option to go to retail and buy their own cable modem. So that really hurts us and because it took them 1.5 years to roll over all that policy to all the Time Warner territories that they acquired, so we suffered that headwind. However, they are towards the tail end of that taking over so that -- and of course, I mean, we have easier comp from a year ago. And that's why we see that headwind is going to be subsiding. So we believe that once that is completely gone away -- well, of course, if Comcast or the other are going to follow the same thing, [this will be a] problem. But assuming that Comcast and the other cable operators are not doing the same thing, I think that will be behind us. So our growth in Orbi, growth in Pro Gaming will be able to more than cover and generate growth for the service provider declines. As I just mentioned, looking into 2019, we see opportunities even on the service provider side if 5G does deliver the promise of the speed of -- into the house.

Okay. And then sticking on the Connected Home theme, you mentioned Circle and then ramping that up. But also at the Analyst Day, you did talk about advanced services for the Connected Home. Where are you on that? And how should we start thinking about that going forward?

Yes. I mean, putting the other -- well, actually, the gaming services is already rolled out -- I forgot to mention, but in a very, very small scale in China. And we're going to roll it out to the rest of the world later on. And for the cybersecurity service, the NETGEAR Armor, it's a little bit more difficult than we originally thought. So we are not in a position to even roll it for beta as yet. So I would say for this year, we're pretty confident that we'll have the parental control and the gaming services out, and then the cybersecurity services should be out in the second half of this year.

This concludes the Q&A session for the conference. I'd now like to turn it back to Patrick Lo for closing remarks.

Thank you, everyone, for joining today's call. We're really excited about the progress that we've made in terms of profitability as well as market share gain in the SMB and CHP segments and also the continued improvement in terms of our registered number of users and the rolling out of -- our pending roll-out of our Arlo Smart Services on the Arlo line. Clearly, on top of that, we are working very diligently in preparation for the separation of the Arlo Technologies into an independently listed company. A lot of things are going on. We're very excited about it, and I look forward to updating all of you on all those fronts in the next earnings call. Look forward to it. Thank you.

This concludes today's conference call. You may now disconnect.