NETGEAR, Inc. (NTGR) Q4 2011 Earnings Report, Transcript and Summary

Greetings and welcome to the NETGEAR, Inc. Fourth Quarter and Full Year 2011 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Joseph Villalta of The Ruth Group. Thank you, Mr. Villalta, you may begin.

Thank you, operator. Good afternoon and welcome to NETGEAR's Fourth Quarter and Full Year 2011 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 Christie providing detail on the financials. We'll then have time for any questions. If you have not received a copy of today's release, please call The Ruth Group or you could go to NETGEAR's corporate website at netgear.com. Before we begin the formal remarks, the company's attorney advises that today's conference call contains forward-looking statements. Forward-looking statements include statements, among others, regarding NETGEAR's expected revenue, earnings, growth, operating income and margins, tax rates and other projected financial results, share gain expectations, the market for our products, business prospects and competition, research and development efforts, including software development, sales and marketing efforts, market trends and opportunities, our growth strategy, the company's commitment to research and development, 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 during the call may not contain current or accurate information. Further, certain forward-looking statements are subject to risks and uncertainties, and are based on assumptions as to future events that may not provide (sic) [prove] to be accurate. Therefore, actual outcomes and results may differ materially from what is expected or forecast in such forward-looking statements. Further, information on potential risk factors 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 occurrence of unanticipated events. In addition, several non-GAAP financial measures will be mentioned on this call. Information relating to the corresponding GAAP measures and reconciliation of the non-GAAP and GAAP measures can be found in our press release on the Investor Relations 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, Joseph and thank you, everyone for joining today's call. NETGEAR finished 2011 on a high note by posting record fourth quarter revenue and operating profit. Double-digit year-over-year revenue growth was achieved in all 3 geographic regions, as well as sequential growth in the Americas and Europe, Middle East and Africa, or EMEA. We also experienced outstanding year-over-year growth in all business segments: Retail, Commercial and Service Provider. We experienced over 21% year-over-year revenue growth in the EMEA and Asia Pacific regions and over 16% in the Americas, as positive momentum out of the strong third quarter continued into the fourth quarter. Our Americas net revenue was $156.6 million. EMEA net revenue was $125 million and our Asia Pacific, or APAC, net revenue was $27.6 million. APAC revenue was down sequentially due to seasonality in Australia, which is a major part of our revenue in the region. In summary, despite the global economic uncertainty, we were able to achieve worldwide record quarterly revenue, which grew 20% year-over-year. Our success continues to be based on our strength in new product innovation and second to none worldwide distribution. Looking at the bottom line for Q4, we recorded non-GAAP net income of $26.5 million, which represents an impressive 65% year-over-year growth and non-GAAP EPS of $0.69 per diluted share, which represents 57% year-over-year growth. Please see the press release for the reconciliation between GAAP and non-GAAP numbers. In Q4, end market demand for networking products industry-wide continued to grow globally and we were pleased to be maintaining above-[ph] market growth driven mainly by share gains. For the quarter, we continued a high level of shipments with 7.1 million units shipped and we also introduced 18 new products during the quarter. Sales channel investment continues to be a key focus for the company as our sales channel is a key strategic asset. By the end of the fourth quarter of 2011, our products were sold in over 29,000 retail outlets around the world, a 1,500 increase over the prior quarter. And our number of value-added retailers stands around 36,000. Now let's turn to a review of the fourth quarter results for our 3 business units: Retail, Commercial and Service Provider. In our Retail Business Unit, or RBU, we saw healthy growth with quarterly revenues of about $129.7 million, up 2% quarter-on-quarter and up 9% year-over-year. Holiday spending in the U.S. and Europe was strong as our 900 megabit Wi-Fi router and our Wi-Fi repeaters were standout winners. However, we did see our U.S. retail channel reducing the shelf inventory to maximize the inventory turns going forward, thus limiting our sequential growth in revenue for the RBU in Q4. However, our distributors serving the online channel picked up the slack in taking on more inventory to serve the traditional January upswing in online sales. Net revenues in our Commercial Business Unit, or CBU, came in at $83.6 million in the fourth quarter 2011. This is up 15% year-over-year. On a sequential basis, our Commercial Business Unit revenue decreased 8%, reflective of the shorter selling period in the quarter due to the holidays in December. On a year-over-year basis, we saw strong growth in switching, network storage, UTM and canvas wireless LAN. In our Service Provider Business Unit, or SPBU, net revenue came in at about $95.8 million for the fourth quarter of 2011, up 14% sequentially. This is up an impressive 43% on a year-over-year basis capping off a 102% growth for the full year. At 31% of NETGEAR's total revenue, the SPBU revenue was just about the high-end of our historical range, which is 20% to 30% of total NETGEAR revenue. There was the usual year-end CapEx budget spending amount of service provider customers and that sequential increase in spending benefited us in Q4. With respect to 2011, as a whole, revenue was a record $1.18 billion or an impressive 31% year-over-year growth and 2011 non-GAAP net income surpassed $100 million, up 67% year-over-year. We estimate that our markets grew in the range of 5% to 10% for the year and we believe that we grew considerably faster due to share gains in all key markets. New products and the company's ability to quickly meet customer demands were the keys to success in 2011. Looking at 2012, we believe the overall market in which NETGEAR participates in will once again grow in the range of 5% to 10%. On the positive side, more Internet enabled devices are being sold each day, increasing the need for NETGEAR products, which is offset by a difficult to forecast macroeconomic environment, particularly in Europe. For 2011, NETGEAR was able to grow at 3x to 4x the market rate. We believe that maintaining our 2011 growth rate in 2012 may not be likely, as we expect share gains to slow down. However, we still expect to grow well in excess of the market. Looking at our exciting new product introductions, in January, at the Consumer Electronics Show in Las Vegas, NETGEAR was again the recipient of Innovation Honorary Award. This year, the Media Storage Router, the Wi-Fi Dual Band Gigabit DSL Modem Router and the mobile version of the NETGEAR Genie home network configuration and management tool were all recognized. We remain focused in product development and intend to introduce approximately 20 new products in Q1. Looking into the future, 2012 will be a year of R&D investments for future growth for NETGEAR, as we see several meaningful market opportunities coming in 2013 and beyond, such as mobility, security, cloud computing, virtualization, IP video and home automation. We will increase our non-GAAP R&D spending rate from 4% of revenue in 2011 to over 4.5% in 2012. Almost all of the incremental investment 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. Also, we will continue to invest in sales and marketing, enabling us to continue to widen our distribution capabilities in the emerging markets, especially in China and Russia. We believe these investments will enable NETGEAR to continue growing faster than the market over the next 5 years. At the same time, we remain focused on the 5 key product growth areas we have identified to get us to $2 billion revenue per year. First, is the TV tablet video connectivity products with simple installation and high performance. And second, network storage with easy-to-use user interface, cloud capabilities, high capacity and resilience. Third, security appliances that carry superior ability to block unwanted Internet intrusion. And fourth, DOCSIS 3.0 gateways with more integrated functions. And finally, the 3G and 4G-LTE related repeaters and gateways. Stay tuned as you should expect to hear more about our investments throughout the year. Closing 2011 at nearly $1.2 billion in revenue, we are well on our way to our goal of $2 billion in revenue by 2014. I will now turn the call over to Christine for further details on our financials.

Thank you, Patrick. Let me now provide you with a summary of the financials for the fourth quarter of 2011. As Patrick noted, net revenue for the fourth quarter ended December 31, 2011, was $309.2 million compared to $258.5 million for the fourth quarter ended December 31, 2010, and $301.8 million in the third quarter ended October 2, 2011. We shipped a total of about 7.1 million units in the fourth quarter, including 5.9 million nodes of wireless products. Shipments of our wired and wireless routers and gateways combined were about 4.5 million units in the fourth quarter 2011. Moving to the product category basis, fourth quarter net revenue split between wireless and wired was about 68% and 32%, respectively. The fourth quarter net revenue split between home and business products was about 73% and 27%, respectively. Products introduced in the last 15 months constituted about 39% of our fourth quarter shipments while products introduced in the last 12 months constituted about 36% of our fourth quarter shipment. In Q4, our Americas net revenue was $156.6 million, while EMEA net revenue was $125 million and our APAC net revenue was $27.6 million. We are seeing solid growth quarter-over-quarter in North America and EMEA along with very impressive year-over-year growth in all 3 geographic regions. From this point on, my discussion points will focus on non-GAAP numbers. The reconciliation of GAAP to non-GAAP is detailed in our preliminary financial statements released earlier today. Non-GAAP gross margin in the fourth quarter of 2011 was 31.1% compared to 32% in the year-ago comparable quarter and 32.4% in the third quarter of 2011. 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 $58.1 million for the fourth quarter of 2011. Our G&A costs for Q4 '11 were unusually low due to a $1.4 million benefit in professional services expense. However, we do expect G&A to return to normal levels in Q1 '12 and forward. We hired an additional 35 people during the quarter, bringing our total headcount to 791 at the end of Q4. The non-GAAP tax rate was 30.5% in the fourth quarter of 2011 compared to 45.4% in the fourth quarter of 2010 and 20.2% in the third quarter of 2011. Non-GAAP net income was 69% -- $0.69 per diluted share in the fourth quarter of 2011 compared to net income of $0.44 per diluted share in the fourth quarter of 2010 and net income of $0.79 per diluted share in the third quarter of 2011. Our balance sheet remains very strong, ending the fourth quarter with $353.7 million in cash, cash equivalents and short-term investments which was driven by approximately $32.9 million in cash flow from operations. We also continue to maintain a solid inventory position. DSOs for the fourth quarter 2011 were 76 days as compared to 78 days in the fourth quarter 2010 and 66 days in the third quarter 2011. Note that we usually experience higher DSOs in our fourth quarter due to seasonal terms offered to some of our retail customers. Our 10% customers for Q4 and 2011 were Best Buy and Ingram Micro. Our fourth quarter net inventory ended at $163.7 million compared to $127.4 million at the end of the fourth quarter 2010 and $136 million at the end of the third quarter 2011. The increase in inventory quarter-on-quarter was driven by additional inventory procured so we could be assured of supply during factory shutdown in China due to Chinese New Year, which did come earlier than usual this year. There is also an increase in inventory remaining on the balance sheet, associated with increased deferred revenue. Fourth quarter ending inventory turns were 5.2, as compared to 5.6 turns in the fourth quarter of 2010 and 6 turns in the third quarter of 2011. Channel inventory remained at healthy levels. Our channel reports inventory to us on a weekly basis and we use a 6-week trailing sell-through average to estimate weeks of stock. Our U.S. retail inventory came in at 7.3 weeks of stock, a very low-level, which we believe is the result of our retail customer trying to improve their inventory turns. Current distribution inventory levels are 9 weeks in the U.S., reflecting our U.S. distributors' willingness to increase their inventory for the January upswing in online sales. We noted 5.4 weeks of stock and distribution in Europe and 6.7 weeks in APAC. In summary, our growth strategy of aggressively expanding into new product category, new geographic region and new channels continue to produce positive results. With industry-leading new product introduction, global brand recognition and extensive distribution, we feel confident in our ability to stay ahead of our competition as we move into the first quarter of 2012. Looking forward to the first quarter of 2012, we intend to roll out approximately 20 new products. Specifically for the first quarter of 2012, we expect net revenue in the range of approximately $310 million to $325 million, with non-GAAP operating margin to be in the range of 11% to 12%. Please also note that our R&D investment will raise our R&D expenses to approximately 4.5% of revenue. We expect our non-GAAP tax rate to be in the range of 30% to 31%. Operator, that concludes our comments and we can now take questions.

[Operator Instructions] Our first question comes from the line of Lynn Um with Barclays Capital.

I was just -- wanted to ask a quick question on the guidance. Historically, you've been -- or guided modest to down, we see that [indiscernible] came up as you mentioned. Could you just help us connect the dots a little bit in terms of -- I guess, what's the delta in terms of the guidance versus your traditional seasonality?

Yes. We certainly see 2 things. I mean, one, that a lot of sales are starting to move online and January is usually a good month for online sales. We see the trend going for the -- obviously, that way. Secondly, we actually introduced quite a few new products towards the mid-to late Q4, which we believe are doing very well. For example, we just introduced the dual band Wi-Fi repeater. We also introduced a new desktop NAS, the Duo and NV+ v2. On the commercial side, we also introduced right before Christmas, a very high-priced performance gigabit layer 2 switch, which we believe that will be very competitive in the market, redefines the price performance. All of these new products will have a full quarter effect in Q1. So we believe that all those will add up to help this Q1 to be better than Q4.

Okay. And then, I guess, historically your guidance range has been sort of $10 million. It was widened a bit this quarter to $15 million, could you maybe just comment a little bit more on your visibility and also perhaps, the assumption behind sequential growth for each of the business units next quarter?

Well, as far as the guidance goes, as the numbers keep getting larger and we hit $1 billion, we just want to guide within a normal range. The range was getting too much less percentage of the net revenue. And so we widened that range to approximately 5% of the net revenue. So we'll guide within the $15 million. And your second question?

Assumptions behind sequential growth for each of the 3 business units, next quarter?

We don't really guide as far as the business units grow, we believe they're all going to grow but we don't really guide specifically on the business units.

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

Talk a little bit about the quarter and looking at, by segment, which segments do you think did better than expected than what you had planned? Who did worse? What surprised you positively or negatively during the quarter?

Well, we're not going to give a range of prices to our GMs. I think they all did very well. All 3 BUs did as what we expect them to do and the only surprise is that the retail channel business, the physical brick and mortar stores actually were trying to reduce the inventory on the shelves, which we believe is probably their consensus view of upping the efficiency. I think the retailers are all under tremendous pressure to up their inventory turn efficiency so that they would be probably more profitable and less capital intensive. So that part, that our number of weeks dropped to 7.3 weeks is a little bit of surprise to us. But other than that, on the actual sell-through, we're very pleased with all 3 segments.

Okay, and then in terms of your guidance for OpEx with R&D going to 4.5% of revenue, it seems a pretty meaningful boost, do you think you're going to be able to offset that with cuts elsewhere. How should we think about the cost structure or margin structure going forward?

No, I don't think we're going to cut anything out. It's just that our chance of getting to 12.5% operating margin is going to be significantly lower. I think going forward, this year, we would stay pretty much within 11% to 12%.

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

Just a couple of questions here. How much impact the reduced shelf space have on the revenue?

Actually it's not reduced in shelf space, the facings are the same, it's less deep. So let's say, if usually they put 4 or 5 deep, they put 2 to 3 deep, so there's no lack of shelf space, there's no reduction in shelf space, as a matter of fact, we increased our shelf space measurably in both Best Buy and Staples and we added shelf space in OfficeMax, and we entered new shelf space in Costco. So there is no problem with the shelf space, it's just a matter of how many deep. So basically, they're more efficient right now in the end to end warehousing, from where we deliver to them, to get them onto the shelves and so they believe that they will be able to turn faster.

So going forward, we shouldn't see much of a deviation from the current inventory numbers?

Well for us, and we probably want them to get back up a little bit. I mean, of course, we would try to just make sure that we don't leave any money on the table, that we try to get them back up to 10 weeks, over time.

Okay and then what's the timeline? You say on the call that the -- your N900 did well this past quarter. What's your timeline as far as keeping pricing on that product unchanged so that you can maximize profit from it?

Well, basically our standard procedure is that if we reduce N900, something new has to replace it at that price point. So as you probably read our press releases in CES, there are 2 new high price point products that we are -- in the wings, one is the 11 AC and then the other one is the storage router.

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

Looking at 4Q and look at the Service Provider business, it did a little bit better than I think we were expecting and then maybe you were expecting going in and you mentioned the CapEx flush. Can you talk about what all was driving it, whether it was DOCSIS 3.0 or anything else?

Well, actually it's across-the-board. I mean, we sell DOCSIS 3.0 gateways, DOCSIS 2.0 gateways, as well as DSL gateways, even DSL modems, because we heard it from the acquisition back in April. All of them did more basic service provider [indiscernible] pull CapEx money to left over and they want us to spend them, they asked us whether we can ship them a little bit more and say, yes, why not? So we were able to supply the demands and that's why it's probably doing a little bit better than what we originally planned but not a lot. I mean, we plan most of it

And do you expect the service provider business to kind of stay towards that high-end of the range you were talking about throughout 2012 or should we think about it a different way?

Well, we have always been saying that it's pretty lumpy and until we win another big account, we've been saying that's in the next few quarters, we're going to stay in the range of anywhere between, I would say, $85 million to $105 million. That's the lumpiness. So you can see some quarters we would be up in $105 million, $110 million, probably see another quarter that would go down to $85 million to $90 million. But over the next few quarters until we announce a big win on a new account, that will probably be the range. But over the full year, you could expect that, I mean, it would be similar to what last year with a little bit of growth.

And then last question, deferred revenues grew really nice, I think almost 70% year-on-year. Can you talk a little bit about the drivers behind our growth?

Sure. That actually came in a little higher than we would expect but overall as our historical average is going to go up as our revenue goes up. So there's a significant portion of that is really just based on terms, delivery acceptance, et cetera and then some of that is our approach secured deferred and our services deferred. So we do expect that number to come slightly down in Q1.

[Operator Instructions] Our next question comes from the line of Jonathan Kees with Capstone Investments.

I wanted to ask you just a couple of questions, the -- talk about R&D going up just a bit. Are you still investing for the CBU and you talked about in the past increasing some money for sales and marketing because you're targeting firms greater than 75 but less than 250. Are you still going to be doing that in 2012?

Definitely. I mean we clearly are going to invest in all 3 BUs. Each one of them will have their own requirements of what we call differentiated software development.

Okay, all right. So that will be for the R&D, as well as for the sales and marketing, okay.

Yes.

Okay and then in regards to the distribution inventory. It's at 9 weeks. I know you said that's in preparation for some online sales in January? That seems kind of high compared to historical standards. Is it reflective of a promotion that's coming up? Some kind of program that you have or is it something else?

Yes, definitely [ph] in January, that is a heavily promotional month for audio [ph] online and as the online portion is getting bigger piece of the overall retail business, the distribution partners supplying them is actually stocking up. But certainly, after Q1 and we will certainly bring it back down because there's no online sales in April.

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

Just a few questions. Can you come back to APAC and the seasonality there? You said it was due to Australia but it looks like it's a little bit more seasonal than usual. Are you experiencing anything or any more aggression from let's say, TP-Link in the area?. I know they've been fairly aggressive in China and expanding beyond that. Or is that partially because of the weakness in APAC?

No, actually in China, we have been gaining share. It's purely Australia and Australia is basically at summer months and you probably also saw that the latest report, I think a day or 2 ago, that for some reason, in December, the Australian retail customer is actually holding back in spending. So I think it's this year's market condition as well as the usual seasonality.

Just want to come back in increase in R&D, we just had the analyst day so have a little bit of an increase in R&D post that and -- what I wanted to understand was, is there anything you're seeing in the environment, which is making you or forcing you to invest a little bit more than you originally anticipated? Because it's been hanging out at around 4% and you've been growing the business at, let's just say, well over 20% on the top line. So we've seen R&D increase, I mean, it's been increasing generally pretty quickly, so I'm just trying to figure out what you're seeing in the landscape that's forcing you to increase investment.

Well, the fact is that in 2 years, by 2014, we'll hit $2 billion. So we got to do something beyond that, right. So if you want to grow beyond $2 billion to get to the next milestone, say, $5 billion, we got to start investing in the R&D in preparation of that. Primarily in broadening our product categories, offering, entering into new product categories. That requires quite a bit of R&D investment of now and we can afford it. So we see that our current structure will be able to afford it as in the past year. Our operating margin has been over 12% and we have always been saying that let's do 11% to 12% and maximize our long-term growth and this is rain in the alley [ph]. So we're in preparation of growing beyond $2 billion.

Okay, so there's nothing unusual there and then the last question...

No.

Last question is just on service provider. I know it's a little bit different but we've been hearing all kinds of, I guess, the stories about service providers not spending, some are spending, some are spending in different areas, so are you seeing anything different in the service provider spending pattern as you moved into the new year? I know it was up in Q4 but is there anything different that you guys are seeing? Is there is some different ordering pattern are they holding back as they try to increase capacity on their networks, anything that you could see that's going on with SPs?

Our Service Provider revenue is spread over multiple accounts. So unlike some of our competitors, which are very concentrated in 2 or 3 accounts, we -- our Service Provider revenue is spread over 70 accounts or more. So we don't really see a general trend of behavior among all of them but on the other hand, though, we keep saying that it's a lumpy business. Sometimes we order more, sometimes we order less. We do not see a correlation between what the economy is, what the sentiment of the industry is versus what our aggregate orders that we see from these 70 service providers as customers. We still do believe that we will have sequential growth in Q1 for service provider revenue.

[Operator Instructions] We have a follow-up from Rohit Chopra..

Another quick question on gross margin, we talked about mix having an impact, but did the drive issue impact gross margin for the NAS products?

Yes, what we mainly did was just increase the price to cover the costs so I don't think there was a significant impact from that.

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

Just have quick follow-up. Just wanted to understand, Service Provider was up significantly in the quarter. Usually that's -- not usually -- that is a lower margin business and yet operating margin is above what you guided for. Is it -- just you didn't have discount much or I'm wondering what the dynamics was there in terms of why operating margin was above guidance?

Yes, I would say our OpEx was slightly lower than in Q4. And then in addition to -- the other businesses were healthy also so that's just due to mix on that margin, but then OpEx was a little bit, we expect a little bit less.

[Operator Instructions] Our next question comes from the line of Kent Schofield with Goldman Sachs.

Quick follow-up on the DOCSIS opportunity. Can you talk about where you think we're at in terms of penetration domestically versus internationally?

From a pass-through perspective, I think, DOCSIS is pretty much close to 70% to 80%. But in terms of people subscribing to it, we're still in the 20% to 30% range.

And obviously the 70% to 80% is what's more applicable to you or how do we think about the 70% to 80% versus the 20% to 30%?

Well certainly, the 70% to 80% is more applicable, that means we're still have a long way to go.

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

Great. Thank you, everyone, for joining us today. As we mentioned, this year is a different year from what we previously done primarily by our commitment to our incremental software R&D development for the future growth of NETGEAR beyond the $2 billion mark. And please stay tuned and we will continue to update everyone as the year progresses, and looking forward to talking to you all again in April. Thank you.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.