NETGEAR, Inc. (NTGR) Q4 2013 Earnings Report, Transcript and Summary

Greetings, and welcome to the NETGEAR Fourth Quarter and Full Year 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Christopher Genualdi, Investor Relations Manager for NETGEAR. Thank you, Mr. Genualdi, you may begin.

Thank you, operator. Good afternoon, and welcome to NETGEAR's Fourth Quarter and Full Year 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 detail on the financials and other information. We will then have time for any questions. If you have not received a copy of today's release, please call NETGEAR Investor Relations or go to NETGEAR's corporate website at www.netgear.com. Before we begin the formal remarks, the company advises that today's conference call contains forward-looking statements. Forward-looking statements include statements regarding expected revenue, operating margins, tax rates, cash generation and other projected financial results, expected market share gains, market trends and opportunities, competition, research and development efforts, sales and marketing efforts, new product introductions and our growth strategy. Forward-looking statements made during the call are being made as of today. If this call is replayed or reviewed after today, the information presented in the call may not contain current or accurate information. Further, certain forward-looking statements are subject to certain risks and uncertainties and are based on assumptions as to future events that may not prove to be accurate. Therefore, actual outcomes and results may differ materially from what is expected or forecast in such forward-looking statements. Information on potential risk factors are detailed in the company's periodic filings with the SEC, including, but not limited to, those risks and uncertainties listed in the company's most recent Form 10-Q filed with the SEC. NETGEAR undertakes no obligation to release publicly any revisions to any forward-looking statements contained herein to reflect events or circumstances after the date hereof, or to reflect the accuracy of unanticipated events. In addition, several non-GAAP financial measures will be mentioned on this call. Information relating to the corresponding GAAP measures, as well as a 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. NETGEAR net revenue were $1.37 billion for the full year of 2013, which is up 7.7% compared to full year 2012 revenues. For the fourth quarter of 2013, NETGEAR net revenues were $356.6 million, which is up 14.9% on a year-over-year basis and slightly about the high end of our guidance. Non-GAAP EPS for the full year 2013 was $2.29. Non-GAAP diluted EPS for the fourth quarter came in at $0.59 per diluted share. Please see the fourth quarter and full year 2013 earnings press release for a full reconciliation of GAAP to non-GAAP financial results. As a reminder, the sequential results presented today include full quarters of the AirCard acquisition, which closed in April 2013, but the year-over-year results do not. During the fourth quarter, net revenue for the Americas was $211.3 million, up 24.3% year-over-year and down 4.2% quarter-over-quarter. The sequential decline is primarily driven by fewer purchases from our service provider customers. Due in large part to our Nighthawk 11ac router, we experienced a successful holiday season in retail in the Americas. Europe, the Middle East and Africa, or EMEA, net revenue was $100 million, down 9.5% year-over-year and up 2.8% quarter-over-quarter. While we were pleased to see year-over-year and sequential uptick for our retail and commercial businesses in Europe, our major service provider customers reduced their purchasing in Q4. We believe this was specific to Q4 and expect they will resume normal purchasing in the coming quarters. Our Asia Pacific, or APAC, net revenue was $45.3 million ,which is up 51.1% from the prior year's comparable quarter and up 2.6% quarter-over-quarter. Service provider of business aside, we continue to see year-over-year growth in Asia Pacific, driven by both the retail and commercial businesses in China and India. In Q4, we have maintained a high level of shipments with 7.1 million units shipped. We also introduced 20 new products during the quarter. As always, sales channel development is a key focus for the company as our sales channel remains a critical strategic asset. By the end of the fourth quarter of 2013, our products were sold in approximately 50,000 retail outlets around the world and our number of value-added resellers stands at approximately 39,000. Now let's turn to our review of the fourth quarter results for our 3 business units: Retail, Commercial and Service Provider. For the Retail Business Unit, or RBU, net revenue came in at $135.9 million, down 1.9% year-over-year and up 4.3% sequentially. The year-over-year decline was primarily driven by channel destocking in both North America and Europe, as sales increasingly shift from brick-and-mortar to the online channel. We're also seeing steady conscious actions being taken by physical store chains to reduce their overall store inventories. We have not been reporting inventories held by our online retail resellers, but starting this year, we'll report them as part of the entire retail channel. We expect the overall retail channel inventory, including both physical and online stores, will continue to decline in terms of number of weeks of stock. Short term, this will reduce our reported retail revenue since we account for revenue on a sell-in basis. Long term, however, this will reduce our price protection liabilities and improve the efficiency of our new product introductions. The Nighthawk AC1900 Smart WiFi router was a hit with consumers during the holiday season. At a price point of $199 retail, it is the most expensive consumer router ever sold by NETGEAR, and it was a major driver of RBU sales in North America during the fourth quarter. We're extremely pleased with the launch of this product. We look forward to continued success as we expand its worldwide presence this quarter into both Europe and Asia. The Nighthawk was one of 3 NETGEAR products to be selected as honorees' this year in the CES Innovation Design and Engineering Awards. The other 2 NETGEAR products to be recognized were the AC1200 high-power WiFi range extender and the AC750 WiFi range extender. Both range extenders support older ABG and WiFi devices, while providing additional performance for the latest 802.11 AC WiFi devices. Both range extenders will be introduced worldwide in the first quarter. The Commercial Business Unit, or CBU, generated net revenue of $75 million for the fourth quarter of 2013. That's up 2.1% on a year-over-year basis and down 2.5% sequentially. We are pleased to see the year-over-year growth despite the continued economic difficulties among small businesses in Europe. The shortened selling time in Q4 for the commercial channel is evident in the seasonal quarter-over-quarter decline, but the decline this year was the smallest it has been in the past 3 years. With the stabilization of economic situation in Europe, we believe growth can continue for the commercial business in 2014. We're entering the year with product momentum in 10 gigabit and POE switches, as well as in high-end storage, and we will continue to capitalize on this worldwide. Our high end switches and enterprise grade ReadyDATA storage line showed the most sequential growth of any of our commercial product categories during the fourth quarter. ReadyNAS sales across the entire product line also grew sequentially as the improvements we made to our mobile app features and channel promotions during the quarter have made ReadyNAS more competitive in the marketplace. While there is still work to be done, we believe our strategy of focusing on higher end, differentiated, premium-priced products for SMBs will allow us to gain market share and grow our commercial revenue in 2014. For our Service Provider Business Unit, or SPBU, net revenue came in at $145.7 million for the fourth quarter of 2013, up 48% year-over-year and down 5.8% on a sequential basis. As mentioned on the prior earnings call, we experienced a slowdown in orders caused by the consolidation of some of our European service provider customers last year. We also saw a reduction in purchasing from our North America service providers during the fourth quarter, which we believe is subject to our customers' year-end CapEx budgets. AirCard performed as expected, and we continue to be pleased with the acquisition that we made nearly a year ago. We're especially excited about Sprint, pending deployment of our LTE Gateways nationwide in the U.S. The NETGEAR LTE Gateway 6100D delivers Sprint's spot 4G LTE speed and improved in-building coverage. This LTE gateway is designed with enterprises in mind. It comes with features such as Power-over-Ethernet, WAN to wireless, WAN failover, advanced WiFi encryption and VPN capability. With support for up to 80 WiFi users, it's perfect as a primary Internet connection or as a dependable backup for small businesses. We made 2 exciting announcements for the Service Provider Business Unit at CES this year. First, we announced and showcased our new Ocuity Wireless IP Cameras for home security providers. Our Ocuity Wireless IP Camera line features the Ocuity 100, which has 720p resolution, high definition video and selectable dual band 802.11 and WiFi; and the Ocuity 500, which supports the same capabilities but with the added benefit of multifunction sensing and monitoring algorithms. Our second service provider announcement made at CES was the introduction of the NETGEAR NeoMediacast HDMI dongle. Our service provider customers can now give subscribers this dongle to replace their costly set-top boxes. For a home with multiple televisions, instead of having a set-top box for each TV, a NeoMediacast can be plugged into the HDMI input of each television, acting as a thin client that receives content from our headless media gateway. This significantly cuts CPU cost for service providers and enhances video streaming to IP devices. The NeoMediacast features a customizable, full Android support and Mirrorcast-enabled platform that enables service providers to use the latest Android applications to offer subscribers unique premium and over the top content. I will now turn the call over to Christine for further details on our financials for the past quarter and year.

Thank you, Patrick. I will now provide you with a summary of the financials for the fourth quarter of 2013. As Patrick noted, net revenue for the fourth quarter ended December 31, 2013, was $356.6 million as compared to $310.4 million for the fourth quarter ended December 31, 2012, and $361.9 million in the third quarter ended September 29, 2013. We shipped a total of about 7.1 million units in the fourth quarter, including 5.4 million nodes of wireless products. Shipments of our wired and wireless routers and gateways combined were about 3.2 million units for the fourth quarter of 2013. Moving to the product category basis, fourth quarter net revenue split between wireless and wired was about 69% and 31%, respectively. The fourth quarter net revenue split between home and business products was about 77% and 23%, respectively. Products introduced in the last 15 months constituted about 48% of our fourth quarter shipment, while products introduced in the last 12 months constituted about 41% of our fourth quarter shipment. 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 fourth quarter of 2013 was 29.2% compared to 30% in the year ago comparable quarter and 28.9% in the third quarter of 2013. The year-over-year margin decrease is due to a higher mix of service provider revenue in the fourth quarter. Total non-GAAP operating expenses came in at $66.2 million for the fourth quarter of 2013. We continue to invest in research and development in order to drive innovation in all 3 business units. Our non-GAAP R&D expense for the fourth quarter was 6% of net revenue as compared to 4.5% in the year ago comparable period and 6.2% of net revenue during Q3. We continue to spend R&D dollars strategically in the key areas that we expect will drive future growth for the company. Our headcount decreased by net 71 people to 1,029 during the quarter. The reduction was due to the previously announced realignment of resources across functions and geographies. We expect to add additional headcount in the appropriate functions and locations in the current and future quarters. The non-GAAP tax rate was 39.6% in the fourth quarter 2013 as compared to 39.4% in the fourth quarter of 2012 and 37.2% in the third quarter of 2013. Looking at the bottom line for Q4, we reported non-GAAP net income of $22.6 million and non-GAAP EPS at $0.59 per diluted share. Looking at the balance sheet, we ended the fourth quarter of 2013 with $248.2 million in cash, cash equivalents and short-term investments compared to $301.4 million at the end of the third quarter 2013. Our balance sheet and our ability to generate cash remains strong. During the fourth quarter of 2013, we generated approximately $14.1 million in cash flow from operations. During fiscal year 2013, we generated $86.9 million in cash flow from operations. In Q4, we spent 63 -- $63.1 million to repurchase approximately 2 million shares of NETGEAR common stock on the open market at an average price of $31.47 per share, which resulted in a $0.02 per share benefit to non-GAAP diluted earnings per share in Q4. This leaves approximately 2.8 million shares remaining in our open buyback program, under which we are continuing to repurchase NETGEAR common stock in a disciplined manner. We believe it is appropriate to return cash to our shareholders in excess of our operating and strategic needs and stock repurchase programs are an effective means to accomplish this. Furthermore, we believe in our long-term growth prospects and our cash flow generation capability. DSOs for the fourth quarter of 2013 were 69 days as compared to 76 days in the fourth quarter of 2012 and 68 days in the third quarter of 2013. As always, we closely manage our collections and try to effectively mitigate collection risk. Our fourth quarter net inventory ended at $224.5 million compared to $174.9 million in the fourth quarter of 2012 and $211.3 million at the end of the third quarter 2013. Fourth quarter ending inventory turns were 4.6 as compared to 5 turns in Q4 2012 and 4.9 turns in the third quarter of 2013. Let's turn to our channel inventory. Our channel partners report inventory to us on a weekly basis, and we use a 6-week trailing average to estimate weeks of stock. Our U.S. retail inventory came in at 10.4 weeks of stock. Current distribution inventory levels are 11.2 weeks in the U.S., 4.6 weeks of stock for distribution in EMEA and 8.5 in APAC. We expect our distribution and retail channel partners will destock in Q1. We expect the destocking will be partially offset by an increase in service provider shipments during Q1 '14. For the first quarter of 2014, we anticipate revenue will be in the range of approximately $335 million to $350 million. First quarter non-GAAP operating margin is expected to be in the range of 9% to 10% as we expect operating expenses will be slightly up quarter-over-quarter. Our non-GAAP tax rate is expected to be approximately 39% for the first quarter of 2014. Operator, that concludes our comments, and we can now take questions.

[Operator Instructions] Our first question comes from the line of Mark Sue from RBC Capital Markets.

Patrick, if I look at 2014 and if I look at the different segments, and I'd also look at the -- what we saw experienced in Europe with the service provider consolidation, any thoughts on how we should be bracketing the top line growth prospects for NETGEAR? You have a lot of new products, you want to gain share in commercial, so what does that all kind of lead into in terms of top line growth, please?

Yes, a lot of new products will be introduced at CES. And there is still the opti [ph] effect of the consolidation, because it's not done yet. I mean, as you probably saw, Ziggo was just acquired just last week and there is another one in play right now. I mean, there is news report on ONO being in play. And so I think things will have to settle down a little bit in the first half. And generally, if you look at the RBU and CBU business, we generally are more active in the second half because of the back-to-school as well as Christmas. So our overall objective for the year is still try to use all our new products in all 3 BUs to achieve double-digit growth. But certainly, it will be skewed more towards the second half of the year.

Okay. That's helpful. And then just conceptually, Patrick, if I look at -- so if I take a big picture view of NETGEAR, right now, it's the cheapest stock we cover and despite that hedge fund's law of shorting NETGEAR because your revenue growth has slowed, we've seen little margin improvement and you've actually done some controversial M&A. Now the flip side is our value investors, and is there anything that we could point to for value investors, who are looking for -- at NETGEAR as an investment vehicle for the longer term? What might be different this year? I ask because we haven't seen any OpEx improve -- margin improvements. There's no dividend. The company's repurchased 2 million shares, but the share count actually went up, and the share count actually has gone up for the past 18 quarters. So trying to see what, aside from better new products and better execution, value investors can look for in NETGEAR this year?

Well, I mean, there's no doubt, I mean, the only way to drive the success of the company is revenue growth, assuming, at least, on a constant margin basis, and of course, we'll do both. I mean, our intention is continue to drive revenue growth, as well as to drive margin growth. Margin growth will be achieved through multiple means. One is the new products that we introduced. Second one is the mix of the 3 BUs. Clearly, I mean, if we could achieve higher growth on CBU versus the other 2 BUs that will help us to grow the margin more. So I think those are the avenues that we're seeking to drive our revenue, as well as our EPS. And I think if we could achieve both of them the stock price will react appropriately according to the market sentiment, which we can not control.

Would there -- I mean, but it's also fundamentally driven and also capital return driven. Would there be any further thoughts to increase the buyback or potentially pay a dividend, buybacks should actually shrink the share count, it's actually been going up. So trying to see what we can relate to value investors because the stocks are at a depressed level to make a compelling investment case.

Sure, Mark, this is Christie. When you look at our share count or the fully diluted share count for Q4, there is -- that's only partially affected on the buyback, so we would expect approximately another $1 million-- 1 million shares to come off of that number as we go into Q1. We also announced, basically, we are continuing to buy on -- in a disciplined manner. So the board, we look at our capital allocation plan, what we need for operating the business in strategic, and we are very confident we're going to generate cash, and then be able to return in a buyback format most likely to the shareholders.

Okay, so it sounds like there's an openness to buy back the stock, particularly, at these levels?

Yes, I mean, we don't so much look at the levels, but we do -- you will see some benefit just effective from the Q4 purchase when you get the full quarter effect, and we did state we are continuing to buy.

Our next question comes from the line of Tavis McCourt from Raymond James.

This is Dan Toomey on for Tavis. One housekeeping question, in case I missed it. Did you guys -- or could you give us a CapEx number for the quarter?

Yes, I would tell you we didn't give that. CapEx is approximately $6 million for the quarter.

All right. And from our view, it looks like the service provider unit outperformed our expectations in the quarter. Was there a particular deal you can point to that occurred to drive that?

No, it's really just multiple customers and what they bought and took delivery of during the quarter.

And do you expect that to carry into this current quarter?

Yes, I believe it will.

All right. And as far as your outlook for the retail and the commercial units to piggyback on the last question about service provider, what do you see for the -- for 2014 in retail and commercial?

We believe that commercial and the retail businesses will continue to grow. However, as we talked about it just now, we do believe because of the channel shift we will see reduction in channel inventory over the next 2 quarters or so, and that would, of course, I mean, suppress the revenue because our revenue is counted on a sell-in basis. So on a sell-out basis, we believe that we'll continue to grow. On a sell-in basis, the growth will be a little bit suppressed because of the channel stock reduction.

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

Just want to start off with your past commentary as far as the impact from service providers in Europe. Are we past that? Are you seeing traction again?

Hamed, as I mentioned, right, just about 2 weeks ago, news coming out that one of our customers ONO is in play. So I think there is a news report that both Liberty Global and Vodafone are looking at buying ONO. ONO is going through an IPO process, so it's difficult to predict what that's going to happen. And also -- but on the other hand, Liberty Global just bought Ziggo, which is not our customer, but now, because we are a supplier to Liberty Global, so we stand a chance of getting in. So the M&A activity is still in flux in Europe.

What are you seeing on the retail front in Europe as far as the consumer traction and your retail product line?

Yes, we've seen in the European market finally, we're seeing growth in market demand both on the retail and the commercial side. And we're pretty happy with that. And what is even better is that it's less driven by the introduction of 11ac because it really hasn't hit Europe as much yet because, for example, our Nighthawk router hasn't hit Europe until just a few weeks ago in the New Year. So it's all encouraging in Europe. So we do believe that Europe will be a positive contributor to growth this year on RBU and CBU.

Okay, and then any commentary as far on the retail front, specifically in U.S., as far as the new competition pricing pressure?

No, the thing is, in U.S., you will constantly have some newcomers coming into the market. For example, like Linksys and Belkin have been declining, then you see some new Taiwanese and Chinese vendors coming in. We got ASUS coming in at the high end from Taiwan. You get TP-Link coming in from the low end in China. But then you also see some other really low-end players, such as D-Link, completely disappear from the market. So we expect, constantly, there will be churns in our competitors, but from a market share point of view, we're still, by far, the #1 market shareholder in the North America market with over 35% share in router. Now -- but the more exciting thing is other than just in the standard WiFi market, we are already playing in both routers, gateways and WiFi extenders. There are some really exciting new markets that we're going into, which is growing very fast such as the camera, the home monitoring camera market. With our patented technology of wire-free, battery-operated camera, we think that we can make a play, and that will be a growth for the next few years. And we do believe that as home automation becomes more and more prevalent, then, as they're all predicated on WiFi, more and more homes will buy WiFi extenders that will help us to continue to expand that WiFi market. Especially right now, we have over 60% market share in the WiFi extender market growing very nicely. And also storage, and home storage is starting to be a really significant market in retail as well. And we will continue to capitalize on that. So -- and then you talked about these 3 new markets of WiFi cameras, home monitoring and WiFi extenders, as well as -- and the last piece of the home storage, those competitors are different from the traditional competitors, those are new. Cameras are very fragmented in the market. You have startups, such as Dropcam, but you also have some really old competitors, such as Logitech, in that area. And then same thing for the storage. Of course, you have some traditional competitors such as Western Digital. But you also have startups such as Google. So they're different.

Okay, and then the last question is, on the guidance that you provided, you're saying operating margin of 9% to 10%. What's driving that? Because I would have thought even though there will be some improvements, especially with the headcount shrinking and you realigning operations, there will be some efficiencies here.

I think, Hamed, when you look at the headcount, we're down 71 headcount in Q4. And what we really want to do is realign that across geographies, and then the different business units to where we think we'll make more money. So we believe that we are going to add headcounts to that. And in addition to that the Q4 OpEx was pretty low compared to Q2 and Q3 of last year. So we're going to be doing some hiring, some accruals restart such as taxes and that as we go into a new fiscal year, and really, Q1 is trade show season, it's really kicked off by CES and then Mobile World Congress.

Our next question comes from the line of Kent Schofield.

Patrick, you mentioned -- you talked a little bit about the commercial mass side, you talked about some marketing programs there that helped out during the quarter. Could you talk a little bit about any other structural changes that you made there that you're looking to help you to gain some share in that category in 2014? And also, I believe switching is your biggest category in commercial. Can you update us as to whether or not you believe you took share in 2013 and how you believe you're set-up to do so in 2014?

We don't think there is any significant structural change that we need to make on a commercial business unit. The model hasn't changed much and the split of the revenue through 3 geographies has not changed much. Commercial Business Unit over the last few years has all been driven by products. When we have great products, better than our competitors, we'll grab share. And when we fumble in some product transitions such as ReadyNAS, we kind of ceded some share. So going forward, it's still a product story and I think we now have momentum behind both switching, especially in the high end, the 10 gig switches the layer 3 switches, the POE switches are really, really star performers. Even in the what we call this low-end of the spectrum, the high end of the low end, for example, our plus switches, which is in the high end of the unmanaged switch category is doing extremely well. And then on the storage side, the same thing. We try -- we compete mostly on the high end. You don't see as much selling a lot of those storage in Newegg or in Amazon, but we are selling them through varied other resellers. Our ReadyDATA, I mean, we just released a new operating system version of ReadyDATA, which provides almost instant realtime fail back. So a lot of times, in an enterprise, you can do a failover to a disaster recovery site, easy. But then when the official site's down, you want to recover from the recovery site, it takes days. But with this new operating system released on our ReadyDATA, you could actually recover from your recovery site back to your normal site almost instantly. So that's some special features that's liked by our high-end customers. So we're seeing tremendous momentum on the high end of the switching, high end of the storage. We will capitalize on that to grow our revenue. And if you look at it, of course, our #1 primary competitors in both areas is HP. We do believe that we are able to take share away from them.

And so kind of the bottom line is, is that to maybe accelerate revenue growth this year in that unit, you're really looking for EMEA to kind of kick back in, in terms of the demand environment?

Yes. We do agree because -- especially in the high-end, right, these are high end products, need a little bit of time in the market to get the acceptance, to get the word of mouth through the IT managers. So we do believe that the second half would be a faster growth half of the year.

Okay, great. And Christine, in the past you talked about needing about $150 million on the balance sheet to run the business. But I think that was prior to the AirCard acquisition. So I was wondering if there was any impact to that number from the acquisition? And can you just remind us as well, as far as where your cash is domiciled, is it all in the U.S. is there any that's trapped outside the U.S.?

Sure, so I would still say, even with AirCard, about $150 million is what we would say is still to operate in 32 countries on a global basis. So as far as cash trapped offshore, there's very little at this point, because our tax structure went into play really into 2011 so there's very little cash trapped offshore at this point.

[Operator Instructions] There are no further questions in the queue. I'd like to hand the call back over to management for closing comments.

Thank you, everyone, and we're excited about the new products coming in to the new year. As I mentioned in CES, we have a lot of channel customers, both retail and service provider, getting very excited with our offerings of the 11ac, both on the router, gateway and the extender side. The new cameras that we introduced would certainly help us to continue to gain share in that fast-growing market, both through the retail as well as the service provider channel. And then the new ReadyDATA, as well as the revamp to ReadyNAS especially with the new mobile apps, we feel that we have a strong product lineup to really continue our momentum with growth of the Commercial Business Unit in the new year. So 2014 is going to be very exciting for us for new technology introduction, as well as expansion of share in all 3 business units. And I look forward to report back to you in the next earnings call, because by then, the most exciting piece of news will be that our first LTE gateway, 4G LTE gateway, will be in true deployment nationwide in the United States through the Sprint Spark's 4G network. And that deployment was announced at CES, and it will happen in this quarter. Thank you so much. Talk to you, all, in the next earnings call.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.