NETGEAR, Inc. (NTGR) Q1 2013 Earnings Report, Transcript and Summary

Greetings, and welcome to the NETGEAR, Inc. First Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Christopher Genualdi, Investor Relations Specialist. Thank you. Mr. Genualdi, you may now begin.

Thank you, operator. Good afternoon, and welcome to NETGEAR's First Quarter 2013 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 the detail on 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 NETGEAR Investor Relations or go to the NETGEAR 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 expectation for the 802.11ac product market, the TV connectivity market and the range extender market, growth in emerging markets for our retail products, expectations for our commercial business unit products, including cloud-based features and wireless controllers, expectations regarding the AirCard business integration, LTE, WiFi and gateway business developments, our focus on growth, investment in research and development, expected revenue, earnings, operating income and margins, tax rates and other projected financial results. 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-K 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 measures, as well as reconciliation of the non-GAAP measures 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, Christopher, and thank you, everyone, for joining today's call. For the first quarter of 2013, NETGEAR net revenues were $293.4 million, which is down 9.9% on a year-over-year basis, and down 5.5% sequentially. Non-GAAP diluted EPS came in at $0.50 per diluted share. Please see the first quarter 2013 earnings press release for a full reconciliation of GAAP to non-GAAP financial results. Net revenue for the first quarter of 2013 came in at the lower end of our original guidance range of $290 million to $305 million. We are very disappointed with the non-GAAP operating margin of 10% for the quarter, which is lower than our original guidance of 11% to 12%. This lower-than-expected non-GAAP operating margin was driven by product mix, primarily due to difficulties in the transition to our new ReadyNAS line of products. The new ReadyNAS product transition occurred late in the quarter and we experienced difficulty securing components coupled with some last-minute bug fixes, which led to unanticipated delays. This marked the first time we completely replaced an entire line of products, which involved obsoleting 10 models and replacing them with 7 brand-new models. The execution was much harder than anticipated and we learned a valuable lesson in engineering and manufacturing planning. The good news is that our supply is now in full swing and customer feedback on the new product line has been very positive thus far. In addition to the ReadyNAS transition delay, our total revenue had a slightly stronger weighting than anticipated towards Service Provider. The combination of these 2 factors caused our operating margin to be lower than planned. During the first quarter, the Americas net revenue was $156.7 million, down 6.9% year-over-year and down 7.8% quarter-over-quarter. The year-over-year decline is primarily driven by lower revenue from the Service Provider…

Thank you, Patrick. I will now provide you with a summary of the financials for the first quarter of 2013. As Patrick noted, net revenue for the first quarter ended March 31, 2013, was $293.4 million, compared to $325.6 million for the first quarter ended April 1, 2012, and $310.4 million in the fourth quarter ended December 31, 2012. We shipped a total of about 6.6 million units in the first quarter, including 5.2 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 3.5 million units in the first quarter of 2013. Moving to the product category basis. First quarter net revenue split between wireless and wired was about 68% and 32%, respectively. The first quarter net revenue split between home and business products was about 75% and 25%, respectively. Products introduced in the last 15 months constituted about 30% of our first quarter shipments, while products introduced in the last 12 months constituted about 26% of our first quarter shipments. From this point on, my discussion points will focus on non-GAAP numbers. As mentioned previously, the reconciliation from GAAP to non-GAAP is detailed in our preliminary financial statements released earlier today. Non-GAAP gross margin in the first quarter of 2013 was 30.5% compared to 31% in the year-ago comparable quarter and 30% in the fourth quarter of 2012. Total non-GAAP operating expenses came in at $59.9 million for the first quarter of 2013, which is 3.8% higher than the prior quarter, primarily driven by people costs. We continue to invest in research and development in order to drive innovation in all 3 business units. Our non-GAAP R&D expense in Q1 was 5% of net revenue and compares to the 4.1% in the year-ago period and 4.5% of net revenue during Q4.…

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

A couple follow-ups on the NAS product lineup. First off, so is that fully in the channel globally? Are you still rolling it out? And then is there any legacy inventory that needs to be worked through during the quarter?

We were too good in working the legacy inventory out of the quarter and -- but we were late in shipping the new inventory into the channel. So the channel today is pretty depleted, and they are stocking our new products. We started shipping our products in the last 2 weeks of the quarter in Q1, and now they're making their way into the channel.

Okay, great. And then on the AirCard side of things, I was wondering if you could talk a little bit about the LTE gateway competitive landscape. Is it different than the competitors you normally see in the SPBU? And what are some of the advantages that AirCard brings to that business?

Yes. I mean, it's a very brand-new product, combining the LTE wide-area access to the WiFi local-area access. So you're right, and we have yet to see significant competitors emerging from it because of traditional WiFi router competitors such as Linksys, D-Link and Belkin. They don't participate in the LTE well. But then the traditional AirCard competitors such as Novatel and Huawei and ZTE have not come up with those mobile gateway. So we say, we are first to market and we've seen a lot of RFPs on it. And I do believe that, going forward, all those competitors from the WiFi side or from the AirCard side, probably, half of them would jump into this particular new category. By being first to the market, clearly, we have the first-move advantage, and by also being the #1 WiFi market share leader, we certainly know more about in-home distribution than any of these competitors. And also by being a leader in LTE technology such as LTE-Advanced, we feel very good going forward. But we certainly see the traditional competitors from both, well, would jump into the fray later on.

Our next question comes from Hamed Khorsand from BWS Financial.

First off, do you think that there is a time shift in a revenue related to your NAS product line?

Well, unfortunately, a lot of the ReadyNAS that we sell in volume for the low-end small business and what we call prosumers, and when you are out of stock, I mean, they just buy competitors. So we clearly lost quite a bit of share towards the last few weeks of the quarter of Q1. But we committed to make it up in Q2, and we're working very feverishly to try to push our product into the channel as quickly as possible. We're shipping in high-volume right now, we just have to get the logistics, get them into the hands of our channel partners worldwide.

Okay, is that going to increase any costs associated with this?

No, we don't believe so. I mean, we certainly are planning every quarter for new product introductions that will involve airfreights. That's part of the plan, and it's baked into our guidance in Q2.

Okay. And is there any kind of timeline as far as the full integration of the AirCard business, and just getting operating margins to be at least a little bit higher, because the margins of that business are quite low, compared to the rest of the business?

Well, the Service Provider Business Unit margin will always be lower than the other 2 business units. From an integration standpoint, I'm pretty happy to say that the 2 teams are pretty well-integrated, and we are all working as a team right now. And most of the systems are integrated. There is only a few systems that had yet to be integrated. But we expect that to be done within 6 months. So I would say, comfortably, by the end of the year, latest, in Q4, we should be fully integrated from systems, from people, locations, facility standpoint. And from a margin standpoint, as we mentioned before, the AirCard business margin from a contribution standpoint is pretty similar to the rest of the Service Provider Business Unit. There is a slight variation that they are little bit higher in R&D, but then they're a little bit less in sales and marketing. But then, overall, the contribution margin's pretty much the same as the rest of the Service Provider Business Unit. So the key for us to get back into the overall 11% to 12% operating margin for the company is for RBU and CBU to grow, so that the proportion of the Service Provider Business Unit revenue is back to the more normal range of 35% or below. Once that happens, then we'll see the overall company operating margin to be in the 11%, 12% range.

Okay, and my last question is associated with the guidance you provided. If I just back out the AirCard business, would you have expected that your -- the old NETGEAR revenue to be higher sequentially?

Well, I mean, so basically what we believe that, is the Retail Business Unit will continue to be following the seasonal trend, which is Q2 is usually a down quarter from Q1 because there is just nothing to celebrate in Q2, while in Q1, you have New Year. So that's definitely going to be down. But the Commercial Business Unit, because -- I mean, in Q1, we're exceptionally bad because of the delay in shipment of ReadyNAS. So we do believe the Commercial Business Unit will be up quarter-on-quarter. The Service Provider Business Unit on the -- if you back out AirCard, all right, we do believe that it will continue to be in the usual range that we talked about, anywhere between $95 million to $105 million. Within that range, it depends whether we get the new orders, whether we get extra inventory to ship, and so on and so forth. So that's pretty much where the overall business is going to be. And just for reference, and in Q4 of last year, the AirCard business was reported by Sierra Wireless to be roughly around $54 million.

Our next question comes from the line of Mark Sue from RBC Capital Markets.

Patrick, the sharp decline in the Service Provider segment down almost 22% year-over-year. We understand that the business is lumpy and the comps are tough because of the big growth you had last year. But there's also some thought that a lot of your key customers have purchased and the penetration is quite high. And if that's the case, any thoughts on how we should be thinking about the business? Should we see a return to growth this year? What's kind of a normalized rate of growth do you think for the Service Provider business?

Sure. I mean, if you -- you're talking about backing out the AirCard side, right?

Yes, your -- just your key traditional NETGEAR Service Provider business.

Right. The traditional NETGEAR Service Provider business, last year in Q1 as we talked about, was benefited by one of our competitors, just failed to ship. So one of our specific customers turned to us, instead of 50%, you get 100% of the revenue, would you be able to deliver? And our operations department rose up heroically to actually deliver, actually both in Q1 and Q2. And that really is an anomaly. And -- but since then, I mean -- unfortunately, our competitors came back. So anyway -- so we believe that, as we talked previously, that we're going to continue to stay in that tight range of $95 million to $105 million for our traditional Service Provider Business Unit, until we win a new customer or a new extra new project. Now the DOCSIS 3 penetration is still actually relatively low, especially given the fact that the DOCSIS 3 is like WiFi. It is not a single standard, it goes through multiple iterations. The first generation DOCSIS 3 is only 4X4, as we call it, 4-channel bonding upstream, 4-channel bonding downstream. But then it will go up to 8X4, it will go to 16X4, it will go to 16X8. So the upgrade cycle will just continue to move forward, so we do not see that there is any "saturation", as long as people are being enticed to go up to higher and higher speed. Also, there is a -- there is also a movement in the marketplace, as you probably know, is to make these gateways to be more intelligent. That is distributing channel to video into IP devices. And the industry's name is called the headless gateway or the media gateway. So the key for us is to go forward, all right, to win new projects on these new higher-speed DOCSIS 3 cable, DOCSIS gateway such as 16X8, 16X4, or to win some of these new media gateway projects. So those are the things that we're focusing, yes.

Okay, so it does sound, for that business, the Service Providers to grow, you need a new cable customer which is the likely candidate. When you move into this realm, Patrick, a lot of entrenched incumbents out there, which offer similar products, what price stimulation do you require to win market share there?

Yes. But every time there is a new technology disruption, then there is a new project, then we will be able to win over any entrenched incumbent. For example, if an incumbent has been supplying a DOCSIS 8X4 data gateway and the customers want to go to a media gateway, that opens up an opportunity for us to go and snap that project away from our competitors. Similarly, on the telco side, if a customer wants to move from a traditional DSL infrastructure into a vDSL or into a fiber-to-the-home infrastructure, those new projects open up an opportunity for us to go in and displace the incumbent. So every new technology disruption is an opportunity for us to gain share. And as I just said, that these technology disruption continues to come around.

Okay, helpful. Patrick, if I switch to the potential synergies and the combination of that, and also the higher RFPs you're seeing in LTE and WiFi, operationally, longer-term, as you combine these assets, will there be potentially better margins? Or is it just putting 2 separate technologies together, but you don't really charge a premium or get margin improvements? I'm just thinking much longer-term, as you respond to the higher RFPs, what it means for your business as you combine the assets together?

Yes. The -- as a matter of fact, I mean, we are acquiring a very minimal team. A lot of the infrastructure that's required to support that business did not come over. We actually have to build it up. So from a synergy standpoint, there is very little over there. As we mentioned, that right now we're modeling our business, that the entire Service Provider Business Unit's contribution margin is not going to improve with the acquisition of the AirCard. But certainly, I mean, it is not that we are not continuing to work on it, all right? As an overall business, we will continue to work on overall improvement in margin in individual business units, as well as in the overall. But we would like to point out the most immediate impact that we could have is by growing the additive business unit faster, so that the mix is more balanced. And that's what in fact the fastest way to get into a higher-margin, get back into an 11% to 12% range.

Okay. This year, we shouldn't really think about 11% to 12%?

We're not modeling that, but we're trying to work very hard.

Our next question comes from Ryan Hutchinson from Lazard Capital Markets.

So clarification on a couple of questions. On the AirCard contribution for the June quarter, can you just provide what were -- what was your model with respect to revenues? And then -- yes, go ahead.

Well, as we mentioned, specifically, they reported $54 million of revenue in Q4 of last year, and that will be the basis for our -- taking on the business. And clearly, I mean, we'll work very hard to grow that base as we move forward.

Okay. So at a minimum, you're thinking flattish revenues for the next couple of quarters based on the commentary from the fourth quarter?

Yes, you can safely say that. But we -- as we said that, we will continue to try and improve on it.

Okay. And then, maybe just diving a little bit deeper into the revenue shortfall, I'm just having a tough time reconciling the operating margin shortfall as well. So you referred to 2 drivers to ReadyNAS transition and the increase in Service Provider revenue mix. So perhaps, if you can quantify the impact each had to both revenues and gross margins? And then I just -- based on my calculation, I assume ReadyNAS shortfall of roughly $5 million at -- we'll call it better-than-corporate-gross-margins, implies roughly at 20 basis-point in positive impact to gross margin. So is the difference the increased Service Provider mix? And then along that same line of questioning, did operating expenses come in higher than you expected, and if so, why?

Well, yes, I think -- let me go on. The ReadyNAS, as of today, is a very software-intensive product. If you look at the features that we are touting for our ReadyNAS line, it provides unlimited snapshots, it provides thin provisioning, it provides cloud replicating -- I mean, all these are really, really software-intensive. So you can always -- almost imagine this is a piece of software product rather than hardware product. So the gross margin or the standup margin is significantly higher than a corporate average. And when the quarter is towards the end, all the cost is sunk -- every single piece cost is sunk. So that's why the standard margin dollar shortfall is -- almost impacts our final operating margin on a dollar-by-dollar basis. So I mean, if you can imagine a $3 million difference in operating margin dollar is separating us from what it is today and what will be in the range, then you could imagine a very high gross margin products impact.

So that was the vast majority?

Correct. It's the vast majority of that. I mean, just take it to an extreme case. I'm not going to disclose in specific. You take the extreme case. Let's say, if our shortfall is actually $10 million and at 50% gross margin, that's a $5 million difference. I'm not saying that's the exact number, but I'm just giving you some example.

Okay, that's helpful. And then in -- any update on the VueZone product line would be helpful, and inroads you're making with the service providers and then the expectations for potential wins there as they roll out some of their home security initiatives.

Yes. Right now, the VueZone camera is continuing expansion into distribution. We just expanded its distribution in the Best Buy, and we're seeing good positive results, and we're continuing to see of the trending up of the VueZone acceptance. Now on the Service Provider side, they have shown quite a bit of interest. But we still have some R&D to work. As today, the VueZone camera is very handy, it's wire-free, it's battery-operated. That's the plus side, it's very tiny. The downside is, because of that, the resolution is really not that high, and the frame rate is also not that high. So we're working very feverishly for the next generation of the cameras to improve on that before we believe we have a serious run on the Service Provider channel.

Our next question comes from Rohit Chopra from Wedbush Securities.

A couple of questions, Patrick and Christine. Patrick, you mentioned last quarter, and you mentioned in a response to Mark Sue's question, that you didn't -- it doesn't sound as if you got everything you needed when AirCard came over. So as far as resources, is there the potential that you need to hire a lot of resources as you go through the next 2 or 3 quarters and could the operating margin go below the range that you are after?

Sure, Rohit. Yes, Rohit, this is Christine. So we do need to backfill some ops positions and some of the mainly ops, IT a little bit. We'll take care of that this quarter, and we have factored that into our guidance and we actually factored it into the modeling we even did for the purchase. So the business will still run within the Service Provider range, so I don't expect anything below that, just because of that.

Okay. So nothing below that range. And then I just wanted to ask you, Patrick, about the RFPs you talked about, since you did mention them. Are these for fulfillment -- are these carriers looking for fulfillment in '13? Or are they looking for their fulfillment in '14?

Yes, the RFPs, of course, is pretty long range. You know, Service Providers, I mean, from RFP to actual deployment, it's multi-quarters. We're encouraged by all the opportunities, but we're not counting on any one of them immediately helping us. But before the close, I mean, they have worked on RFPs as well, and before the close, we jointly have worked on some RFP as well. And if we win anyone of those in the next few quarters, then it will benefit us.

Thank you. I'll now turn the floor back over to our speakers for any closing comments.

Yes. And we are very excited about this new team that we put together with the AirCard joining us, and which opens up an entirely new technology front. We have, traditionally, in all 3 business units depending on the Internet wide-area net access on either cable or a telco's DSL line, but now we opened it up for a third one. So not only does technology will enable our Service Provider Business Unit to get into new opportunity, it will also provide new product capabilities for both our Retail products, as well as for our Commercial products. And that's why we believe that we have rounded out all the technology needed, that we would be able to implement our vision of connecting everyone to the high-speed broadband Internet, both wired and wirelessly. And the -- we believe the secular strong demand from everyone around the world to connect to ever-highest speed of Internet is not going to fade anytime soon. So as long as we continue to keep up with the technology and produce products ahead of our competition, we will continue to be able to benefit from this secular trend in order to grow the company. So we are very confident for the growth potential, and right now, we have all the plans in place. It's just about execution. And if we could execute our plans according to what we designed as flawlessly as possible, we would be able to grow our revenue in the coming quarters. So that's why execution is key and we understand that and we will -- the entire management team focus on that, and I look forward to report back to you on our progress in the next earnings call. Thank you, everybody, for joining us today.

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