NETGEAR, Inc. (NTGR) Q1 2014 Earnings Report, Transcript and Summary

Greetings, ladies and gentlemen, and welcome to the NETGEAR Incorporated First Quarter 2014 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 Incorporated. Thank you. Mr. Genualdi, please begin.

Thank you, operator. Good afternoon, and welcome to NETGEAR's First Quarter 2014 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 details on the financials and other information. We will then have time for any questions. If you have not received the 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, 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 made -- 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, 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 these forward-looking statements. Potential risks are detailed in the company's periodic filings with the SEC, including 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 a reconciliation of the non-GAAP measures and GAAP measures can be found in our press release or 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 for the first quarter of 2014 was $349.4 million, which is up 19.1% on a year-over-year basis, and down 2% on a sequential basis. Just as a reminder, the sequential result comparatives presented today include full quarters of the AirCard acquisition, which closed in April, 2013. But the year-over-year results comparisons do not. Non-GAAP diluted EPS for the first quarter of 2014 was $0.59, up 18% year-over-year. Please see the first quarter of 2014 earnings press release for a full reconciliation of GAAP to non-GAAP financial results. During the first quarter, net revenue for the Americas was $194.8 million, up 24.3% year-over-year, and down 7.8% quarter-over-quarter. As we indicated in our prior guidance, we experienced de-stocking in absolute dollar terms, among our North American retailers in anticipation of a seasonally slower Q2. Europe, the Middle East and Africa or the EMEA, net revenue was $106.8 million, which is flat year-over-year, and up 6.8% quarter-over-quarter. As we anticipated, we are seeing a meaningful uptick in service-provider purchases after the new year in Europe. Our Asia Pacific or APAC net revenue was $47.8 million, which is up 61.6% from the prior year's comparable quarter, and up 5.5% quarter-over-quarter. We are very pleased with our continued share gains in all Asia Pacific markets, particularly in Japan, China, India and Australia. In Q1, we maintained a high level of shipments with 6.8 million units shipped. We also introduced 16 new products during the quarter. As always, sales channel development is the key focus for the company as our sales channel remains a critical strategic asset. By the end of the first quarter of 2014, our products were sold in approximately 49,000 retail outlets around the world and our number of…

Thank you, Patrick. I will now provide you with the summary of the financials for the first quarter of 2014. As Patrick noted, net revenue for the first quarter ended March 30, 2014, was $349.4 million as compared to $293.4 million for the first quarter ended March 31, 2013, and $356.6 million in the fourth quarter ended December 31, 2013. We shipped a total of about 6.8 million units in the first quarter, including 5.3 million nodes of wireless products. Shipments of our wired and wireless routers and gateways combined were about 3.3 million units for the first quarter of 2014. Moving to the product category basis, first quarter net revenue splits between wireless and wired was about 71% and 29%, respectively. The first quarter net revenue split between home and business products was about 77% and 23%, respectively. Products introduced in the last 15 months constituted about 56% of our first quarter shipment, while products introduced in the last 12 months constituted about 42% of our first 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 for the first quarter of 2014 was 28.9% compared to 30.5% in a year ago comparable quarter and 29.2% in the fourth quarter of 2013. The year-over-year margin decrease is primarily due to the higher mix of Service Provider revenue for the quarter. Total non-GAAP operating expenses came in at $67 million for the first quarter of 2014. We continue to invest in R&D to drive innovation for all 3 business units. Our non-GAAP R&D expense for the first quarter was 5.9% of net revenue as compared to 5% in the year-ago comparable period and 6%…

[Operator Instructions] Our first question comes from the line of Tavis McCourt with Raymond James. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: Yes. Housekeeping item first. Did you say that cash flow from operations was $5.6 million?

Yes. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: And what was CapEx?

CapEx was about $3 million, approximately rounded. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: All right. I was wondering if you could give us a little more background on the progress of LTE gateways. Any developments you could talk about.

As we mentioned, in Q1, we added 2 customers on the LTE Gateway side. Sprint introduced -- they announced the LTE Gateway based on our LTE 6100D in CES, and they're starting to deploy them now. U.S. Cellular, also, started deploying our LTE Gateway, both alive and introducing to their customer base nationwide in the U.S. We certainly continue to enhance our offerings, and we intend to take these products to more operators around the world, as well as to other channels, for example, the LTE Gateway that we had been able to make -- work in the Verizon open band. We definitely will introduce those LTE gateways in the commercial as well as in the retail channel, and we expect a similar channel introduction in Europe as well as in Asia Pacific. So certainly, you're seeing accelerated activities in all 3 channels for the LTE gateways going forward for the rest of the year. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: Okay. And if I could ask a follow-up. Do you expect any more channel inventory declines in the Retail business in the current quarter?

We do believe that the channel inventory from an absolute dollar basis in Retail actually is going to go up at the end of Q2 because it's in preparation for back-to-school. But then, in terms of number of weeks, it'd probably stay the same. So that's how we see the Retail inventories now. That's -- there is normal same thing. But as -- if you take a longer-term perspective, as more and more sales are shifted towards online, then you should see a gradual decline of channel inventory for Retail, overall.

Our next question comes from the line of Hamed Khorsand.

Just a quick question here on the -- you said that you introduced 16 new products. In the past, the amount of new products you've been introducing has been more in the 20s last couple of years. So why the decline? And does that foreshadow maybe revenue growth slowing down?

Well as a matter of fact, I mean, the product introduction is focused both on quantity as well as quality. I think the products that we're introducing are more impactful and contains a lot more sophistication in terms of software, as well as the hardware. And you will guess, the revenue generated from new products introduced in the last 12 and 15 months, we are at all-time high. So I think, the 15 months were up to 56% of our revenue, so that indicates that the R&D is paying off in more impactful product and we continue to really focus both on the quantity as well as the quality of new product introduction. And clearly, I mean, the LTE Gateway and the Nighthawk router, the ReadyDATA high-end enterprise cloud, SMB storage, these are not the trivial 5-port managed switch or 8-port managed switch; they're not of the same plans.

And why hasn't it that these new products, since they're becoming more and more of your revenue base, has not trickling down to the profit margin line?

Well, again, I mean, if you look at the profit margin, it's very much impacted by the mix of the business. In Q1 as a matter of fact, the Service Provider mix is at all-time high. So needless to say, I mean, the Service Provider business is a lower-margin business. When that portion of the business is going up, all right, it kind of impacts the overall margin. But the important thing is that, as we continue to beef up the new products, our aim is to increase the margin of all 3 business units going forward. No doubt about it. But it is very much affected by the mix.

Yes, but if Service Provider is going up, doesn't that just mean that overall operating margins should be going up as well? And we're still not seeing any leverage on that line.

No, actually the operating margin is affected by the mix. I think the most important thing is how much overall operating margin dollar that we are generating, and then from that perspective, we see a pretty good uptake on a year-over-year basis when you compare of the same quarter. So I think that's the direction that we can focus on. Because if the percentage is pretty much affected by the mix of the 3 businesses, I think the most important thing is what is the absolute dollars of profit that we're generating, and we absolutely have very laser focus in making sure that is growing.

And last question is on the Service Provider side specifically in Europe. Do you think this is just purely restocking because inventory has been dragged down to lows because of the whole M&A activity over there? Or is this going to be sustainable purchasing activity for you?

I mean, we don't have the crystal ball. I mean, as we mentioned many of times, we really do not have the insight into their warehouse unlike Retail and Commercial that they report inventory as well as sales through to us. The Service Providers do not. But we certainly see that into the new year, they are actually more active in promoting their services. And as we said many of times, that we have visibility of 13 weeks, one quarter a time, and we do see that in Q2, the Service Provider business will be of similar magnitude to Q1.

Our next question comes from the line of Jeff Kvaal with Northland.

I have a couple of questions. I think, first, I would like to follow-up on the prior question about the margin outlook. Should we be expecting them, the margins, to hold in this 9% to 10% range? Are there reasons to think that things will be better in the second half of the year, that could be storage, or what have you driving that? And then I have a few follow-up as well.

Yes. So I would like to answer that questions again from the 2 angles. The first one is, what we would like to do? If you look at individual business unit bases to improve the margin of each one of them individually, that means all the new products, we are going -- all the leverage that we are going to use. So we would like to see, for example, Retail Business Unit margin going up, Commercial Business Unit margin going up, and Service Provider Business Unit margin, I mean, that's our objective quarter-after-quarter. But then the overall margin, it really depends on the mix, all right. Let's say the SPBU grows faster than the other 2 BUs then clearly that margin will be ranged down to 9% to 10%. But then, if we see that the RBU and CBU growing faster than the SPBU, then we will see a faster path of getting back into a higher margin range. But clearly, I mean, our objective is to increase profitability of every single business unit. And, we are very laser focused in improving the absolute profit dollars that we are generating, overall business life. And that's, that the ultimate aim is to really improve on the growth of EPS.

Okay. So I guess that then begs a question of what you see happening in the various business units over the course of the year. I mean, do you think that the mix should shift back towards commercial as storage recovers? Should we think that the AC -- ASP uplift you were talking about will shift the mix back towards Retail? What should we be thinking within those units?

Well, we don't have a crystal ball of how things I don't -- We're going to review profitable business from any business unit. Our ultimate objective is to really grow the profit dollars and EPS as fast as we can for the overall company. If we could achieve it through all 3 business units equally, that's fine. If we could achieve it through all 3 business units, but with the skew towards one of the 2 of the business, that's fine. The most important thing for us is to grow as much as possible in the overall profit margin dollars. And clearly, there is a more predictability in terms of the RBU and CBU because we have all the channels covered, it's kind of run rate business. We have all the product pipelines that we had planned for the rest of the year. We do expect those 2 businesses -- units to grow steadily in terms of top line and bottom line. SPBU is very big account, and big project-oriented. So if we have a big project, a big account coming in, we're not going to refuse it. We are going to take it, all right, so. But if that's the case, even though our overall profit margin dollars will increase because of the skewed of the heavy on to SPBU, you could see that the profit margin percentage is going to be in the same range of 9% to 10%, all right, but ultimately we're not going to refuse any good business, and our objective is to grow as fast as possible, the EPS as well as the overall absolute profit margin dollars for the business.

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

Patrick, the flattest trends in Europe is actually encouraging since we've been in a low in that region for quite some time. Is it a specific project or is it a broad range of customers that's driving the rebound in Europe? And recognizing that when it's, when it's working well, you could see strong growth in the region? And that cycle is maybe 3 or 4 years ago. Are we now at a point where we could actually start seeing good growth coming out of Europe?

Yes. You put it this way. We were negatively impact last year, especially in the second half of all the M&A activities on the Service Provider side of the business in Europe. I think that has quieted down a little bit. A lot of the dust have been settled. And pretty much all the merger target had been announced and had been consummated. Europe is now pretty much concentrating into 3 new big players, which is Liberty Global, Vodafone and [indiscernible]. And so I think that is going to offer a more stable environment for the rest of the year. So we hope this is the basis for us to grow our Service Provider business over there. And looking at Commercial Business Unit, there are pockets of increased commercial confidence, especially in Germany, as well as in the U.K. Clearly, we're seeing business confidence returning, and we're seeing more CapEx in buying hardware, networking and all that, so we are encouraged with those. On the Retail side, we're still not seeing the trend that we saw in the U.S. as well as in Asia, which is moving into 11ac. I mean, the movement of 11ac in Europe is still been pretty slow compared to the other 2 regions. We just don't -- I think that it might be because the broadband speed in Europe is just not as fast as in Asia as well as in the U.S. So there is a less of a desire to really move up in the WiFi speed. However, I understand based on our customer's talking in the certain markets such as in the U.K., there's a movement of the telcos moving into media cell. And also in Benelux, and in France, and to a certainly less extent in Germany, the cable companies are also moving into what we call 16 x 4, 24 x 8 cable DOCSIS 3, which is approaching 100 megabit plus, and all these speeds kick in for the second half of this year, and hopefully, that would kind of spur the retail channel for customers to upgrade from 11m to 11ac. So overall, we think the climate in Europe is definitely better for SPBU and CBU, especially in the 2 major economies of the U.K. and Germany. However, on the retail front, I think we're still seeing a lag of people moving onto 11ac as compared to Asia and North America.

Okay, got it. Within the Service Provider side, what do you think [ph] with the clustering around the 3 major service providers in Europe. Patrick, can you give us a sense of the Europe market share within these big 3 accounts, now that's what kind of consolidated, and what their approach is to dual source or even multisource and just kind of how you feel about your position in these 3 accounts?

Well, unfortunately, there is no public data that we could access to really gauge our market share for those accounts that we're not in. I mean, they are pretty confidential, we won't be able to get those data. But clearly, I could tell you where we are. I mean, we are in Virgin Media, which is the only cable operator in the U.K. We have 100% of the share over there. And, we -- in Spain, within ONO, and we have about 30% to 50% share over there. And in France, I mean [indiscernible] bubble, and then in Benelux, we are in Telenet, and in Nordic, we are in [indiscernible], we are in UC. So, in all these accounts, we are anywhere between 30% to 50% share, but then of course, we are not in UPC. We're not in Kabel Deutschland. And we're not in any of the major national telco such as BT, such as Orange, such as SwissCom. So that's the landscape we have in Europe.

Okay, that sounds cool. Patrick, if I look at the wireless cycles that we saw from the n to ac, but along the way, the number of devices had actually multiplied per individual, are we at a point where we might be actually seeing a residential router Gateway upgrade cycle from your residential, from your customers because of the number of devices, not just the speed that are increasing, maybe your kind of qualitative thoughts of what you're seeing from a customer point of view?

Absolutely. I mean, if you noticed that we made a joint press releases with the 2 leading WiFi technology providers, QUALCOMM, and Broadcom, in the last month, introducing a brand-new technology, what we call, multiuser MIMO WiFi. It's a mouthful. What it is, is today, WiFi is a round robin technology that means the router could only talk to one device at a time. And the slowest device is just basically going to hold down the network to hostage, and then we're trying to alleviate that by adding our proprietary technology called airtime fairness , which is trying to make it into a TDD, Time Division Multiplexing. However, a better deal is because the number of devices in the house that wants to talk to WiFi is proliferating from 2, 3 devices into 6 to 10, and we anticipate next year, it will be up to 15 to 20 devices, that we're working with all these technology providers to welcome multiuser WiFi. That means that any one point in time, we can talk to multiple groups of devices rather than one device at a time of the technology that we just announced to get with Broadcom and with QUALCOMM is that to be able to do simultaneously talk to 3 groups of devices. So instead of waiting for your turn forever, I mean, you will get your turn coming back rather quickly. So that's pretty much we expect the next wave of upgrade. So today, people are just upgrading to fast and faster brute force speed, the next wave of upgrade is to get into multiuser environment, multidevice environment. And we expect that upgrade cycle to start middle of next year.

Middle of next year, okay. That's helpful. Lastly, Christine, just the increase in inventory, is anything to look at on your balance sheet?

No, in fact, inventory in total has decreased, quarter-on-quarter, in total, on our balance sheet. No, I think, our turns improve slightly. So obviously, that we always balance the need for air freight with the inventory we take on, but we feel that we are in a good position.

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

This is Justin Jordan, filling in for Kent. Can you talk about the network attached towards business and how that is doing? Has the competitive landscape changed? Are you still seeing pricing pressures at the low end?

Yes. I mean, clearly, this is a very dynamic market. As we mentioned just now, we were very pleased that we see both sequential and year-over-year increase in the revenue of our storage solutions, so we would like to make that steady progress every quarter. Clearly, the high end of the spectrum is pretty stable. Our high-end rack mount storage has been primarily competing against the established storage vendors such as the low end of VMC, the low end of net apps, and the high-end of the servers from HP and also certain low end from Dell. But then, the low end of the market, which is very, what they call, prosumer focus, we have traditionally being competing primarily against timely vendors such as Synology and TuneUp. And prior to that, it's primarily against a Japanese vendor called Buffalo. But over the last 6 months, Western Digital has been coming on very strong with a new low price point in the U.S., and so, I would say, I mean, they are taking the place clearly of some of the Taiwanese vendors. But then, so there is a change in dynamic over there. Our focus is still on the high end of the market. It doesn't matter whether it is the pure SMB or the pure prosumer, our differentiation is purely cloud capability as well as data protection. So, we have 2 very unique capabilities that allow us to command premium against our competitors, primarily from the Tyranno from Japan or from Western Digital, one is our ReadyCLOUD technology that enables a Dropbox-like of user experience but in a private setting from your own nest. The second one is the data protection that we're the only one offering what we call unlimited snapshot of data production so that you could make unlimited number of copies at any 1 snapshot in time, and you can restore back to that particular snapshot. So those are 2 very unique technologies appreciated by the higher end of the market segment. And we'll continue to enhance our capabilities in those 2 regards.

Yes, that was helpful. And just one more follow-up question. You mentioned that you expect the Service Provider Business Unit to be up a similar magnitude in Q2 as it was in Q1. I just wanted to get a little clarity, is that similar Q-on-Q growth?

No, we're just seeing that the absolute dollar wise, if you look at our press release, we have the segment reporting. The Service Provider revenue in Q1 is roughly about $152 million. So we expect that, it's going to be roughly the same, up and down a little bit, hopefully up in the Q2.

[Operator Instructions] There are no further questions at this time. I'd like to turn the floor back over to management for closing comments.

Sure. Thank you, everyone, for joining our call. So I would like to specifically highlight a point that I made about the increase in ASP. Even though it's -- when I talked about it, it was related primarily to the Retail area, actually we are very encouraged not only in Retail. As we mentioned in Retail, when people move up to 11ac, when people move from pure router to gateway, which is a combination of a modem and a router and when people move from standard definition cameras to high-definition cameras. And in next year, when people move from, what we call the single-user mode WiFi to multiuser MIMO WiFi, all these are forces to drive the increase in ASP. What's encouraging to us is that, as a matter of fact, the proportion of a high ASP products are actually bigger than the low ASP products as we see it. So that clearly is encouraging trend that helps us to continue to expand the market from a Dollar market size standpoint. The same thing we're seeing also in Commercial Business Unit because, like in switching, we've seen the trend of people buying up some pure 100 megabit or gigabit switches into 10 gig switches with power of an ethernet capability again and reaching the ASP. Same thing on the network storage side, we're seeing more and more of our customers buying, not just the rack mount ReadyNAS, they're actually moving up to buy the rack mount of what we call the high-end line called ReadyDATA, which offer higher capacity, more data protection. So all those are encouraging sign that our strategy over the last 2 years, which we have cultivated so far to really push up the ASP of every single business unit, is starting to materialize, and getting the buy-in from our channel partners, as well as our end customers. So that's a very encouraging sign, and we will love to continue to see that progressing, that will certainly help our growth of our business on dollar terms, as well as our margins going forward. And, we would definitely continue to report on the progress of this effort in the next few quarters, and I look forward to talking to you all again in 3 months’ time. Thank you very much, once again, for joining us today. Have a great day.

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