Netgear, Inc. Q1 FY2021 Earnings Call

Thank you, Mike. Good afternoon, and welcome to NETGEAR’s first quarter of 2021 financial results conference call. Joining us from the Company are Mr. Patrick Lo, Chairman and CEO; and Mr. Bryan Murray, CFO. The format of the call will start with a review of the financials for the first quarter provided by Bryan, followed by details and commentary on the business provided by Patrick, and finish off with second quarter 2021 guidance provided by Bryan. We’ll then have time for any questions. If you have not received a copy of today’s press release, please visit NETGEAR’s Investor Relations website at www.netgear.com. Before we begin the formal remarks, we advise you that today’s conference call contains forward-looking statements. Forward-looking statements include statements regarding expected revenue, operating margins, tax rates, expenses, and future business outlook. Actual results or trends could differ materially from those contemplated by these forward-looking statements. For more information, please refer to the risk factors discussed in NETGEAR’s periodic filings with the SEC, including the most recent Form 10-K. Any forward-looking statements that we make on this call are based on assumptions as of today, and NETGEAR undertakes no obligation to update these statements as a result of new information or future events. In addition, several non-GAAP financial measures will be mentioned on this call. A reconciliation of the non-GAAP to GAAP measures can be found in today’s press release on our Investor Relations website. At this time, I would now like to turn the call over to Mr. Bryan Murray.

Thank you, Erik, and thank you, everyone, for joining today’s call. We delivered a great start to the year, setting the pace to achieve the full year target we set out last December at our Analyst Day. We reported net revenue just above our guided range as both sides of the business performed well, and we saw supply constraints ease slightly. Our operations team navigated around chip constraints and the continuing elongated transportation times to bring products in from our suppliers while significantly lowering our freight spend from the fourth quarter levels. Net revenue for the first quarter ended March 28, 2021 was $317.9 million, up 38.3% year-over-year, driven primarily by strong CHP growth in the retail channel and better than expected SMB performance. Our leading WiFi 6 offerings continued their momentum in the first quarter across both businesses. Additionally, the work we continue to do to focus on the right products to support the work-from-home networking market, coupled with strong Pro AV growth, resulted in a continued upward trajectory for our SMB business, delivering 17.9% year-over-year growth. In the first quarter, we generated a record non-GAAP operating income of $42.3 million. This translated into a non-GAAP operating margin well above the top end of our guidance range at 13.3%, an improvement of 970 basis points over the first quarter of 2020 and 230 basis points over the fourth quarter of 2020. Relative to our guidance range, we experienced better than expected performance from our SMB business, which carries higher margins. Additionally, we saw an improved mix of business coming from the higher margin e-commerce channel. As mentioned previously, our operations team was able to lower spend on airfreight significantly below planned levels. All three factors contributed to non-GAAP operating margin coming in well above our initial expectations. While we spent less on airfreight than originally expected, much of the improved supply arrived later in the quarter. As a result, we could only replenish the channel inventory towards the end of the quarter. Thus, we didn’t have an opportunity to increase promotional efforts and capture even more market share from the modest gains we experienced in the quarter. We believe we are in a solid position heading into the second quarter to selectively increase promotional efforts, including participation in promotional activities planned with some key channel partners, which should allow for further gains in market share and assist with our goal of driving increased paid subscribers. The strength in our business is seen across the globe as we delivered solid double-digit year-over-year growth in all geographies, led by demand for our premium mesh products in our CHP business, as well as strength in our SMB business. For the first quarter of 2021, net revenue for the Americas was $219.2 million, which is up 38.5% year-over-year and down 15.6% on a sequential basis. EMEA net revenue was $61.1 million, which was up 44.9% year-over-year and down 9.4% quarter-over-quarter. Our APAC net revenue was $37.7 million, which was up 27.2% from the prior year comparable quarter and down 5.7% sequentially. For the first quarter of 2021, we shipped a total of approximately 4.1 million units, including 2.7 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 1.4 million units for the first quarter of 2021. The net revenue split between home and business products was about 76% and 24%, respectively. The net revenue split between wireless and wired products was about 69% and 31%, respectively. Products introduced in the last 15 months constituted about 35% of our first quarter shipments, while products introduced in the last 12 months contributed about 30% of our first quarter shipments. From this point on, my discussion points will focus on non-GAAP numbers. The reconciliation from GAAP to non-GAAP is detailed in our earnings released distributed earlier today. The non-GAAP gross margin in the first quarter of 2021 was 35.2%, which is up 600 basis points compared to 29.2% in the prior year comparable quarter and up 460 basis points compared to 30.6% in the fourth quarter of 2020. The year-over-year improvement was driven by improved product margins led by our premium mesh solutions. Sequentially, lower spend on airfreight, higher demand for SMB products, and a higher mix of revenue going through e-commerce channels contributed to improved gross margins. With improving supply, we plan to selectively increase promotional spending to accelerate market share gains, which should contribute to further growth in paid subscribers. In addition to higher promotional activities, we’ve seen an uptick in the cost of sea transportation by 2 to 3 times historical levels, and as a consequence, we believe the Q1 ‘21 gross margin performance is not likely to repeat in the near-term quarters ahead. Total Q1 non-GAAP operating expenses came in at $69.7 million, which is up 18.2% year-over-year and down 3.3% sequentially. Our team continues to navigate a challenging operating environment while adding proportionately less spend. As a result, we were able to unlock considerable leverage on a 38% year-over-year revenue growth. As always, we manage our expenses prudently while also ensuring we adequately fund the growth portions of our business so that they have the resources they need to succeed. Our headcount was 775 as of the end of the quarter, down from 818 in Q4 as we consolidated some of our offices in the APAC region to gain some cost efficiencies. This will fund further investment in other areas of the business, such as resources supporting our paid subscription business. We continue to manage our headcount, but we’ll add resources to invest in areas that we believe will deliver future growth. Our non-GAAP R&D expense for the first quarter was 7.1% of net revenue compared to 8.1% of net revenue in the prior year comparable period and 6% of net revenue in the fourth quarter of 2020. To continue our technology and subscription service leadership, we are committed to continued investment in R&D. Our non-GAAP tax was 24.5% in the first quarter of 2021. Looking at the bottom line for Q1, we reported non-GAAP net income of $31.6 million and non-GAAP diluted EPS of $0.99, each substantially higher than the prior year period. Turning to the balance sheet, we ended the first quarter of 2021 with $370.7 million in cash and short-term investments, up $17.3 million from the prior quarter. We were also able to strengthen our inventory position incrementally in the quarter, adding $43.6 million to our stock levels. We believe our supply position will continue to improve in the second quarter. During the quarter, we generated $13.7 million in cash flow from operations, which brings our total cash provided from operations over the trailing 12 months to $165.9 million. We used $1.6 million for the purchase of property and equipment during the quarter, which brings our total cash used for capital expenditures over the trailing 12 months to $10.6 million. As we previously highlighted, we plan to reestablish normal carrying levels of our inventory in 2021. As a result, we expect to be below our normal conversion ratio of 85% to 100% of non-GAAP net income by a fair amount as we saw in Q1, but we remain confident in our ability to continue to generate cash on a full-year basis. Now, turning to the first quarter results for our product segments. The Connected Home segment, which includes the industry-leading Nighthawk, Orbi, Nighthawk Pro Gaming, and Meural brands, generated net revenue of $240.9 million during the quarter, which is up 46.3% on a year-over-year basis and down 18.6% sequentially. The strong year-over-year growth was driven by heightened demand in the retail channel for our premium WiFi 6 solutions. In the first quarter, despite supply headwinds for our WiFi 6 products existing for much of the quarter, we were able to improve on our strong leadership position in U.S. market share in consumer WiFi, regaining 2 points to 43%, and we fully expect to continue to gain share in the second quarter, given the improved supply position in the channel entering the quarter. The SMB segment executed well and generated net revenue of $77 million for the first quarter of 2021, which is up 17.9% on a year-over-year basis and up 8.5% sequentially. This is the highest quarterly revenue for our SMB business in the past two years. The growth was driven primarily by exceptionally strong demand for work-from-home solutions, including low port count switches as well as our SMB wireless solution. We are also particularly pleased with the performance of our Pro AV business, which experienced meaningful year-over-year growth as we see signs of activities resuming at business offices and sports entertainment venues. Our market share in switches sold through the U.S. retail channel came in at 56% in Q1. I’ll now turn the call over to Patrick for his commentary, after which I will provide guidance for the second quarter of 2021.

Thank you, Bryan. As we progress through 2021, we are seeing the world’s slow recovery from the pandemic. New cases remain high, and variants from other continents are becoming prevalent in many states. However, unprecedented federal spending plans, accelerated vaccine rollout, and state reopening plans point to a light at the end of the tunnel. Businesses, small and large, are planning for growth off a difficult 2020 with signs of business offices and sports and entertainment venues steering towards reopening, albeit at adjusted capacity. The pandemic has accelerated multiple years of technological progress into one year, and people adjusted surprisingly quickly to more time and activities from home. However, to enable this transition, highly reliable, high-speed internet connectivity that covers the entire home and even patio or yard has become a necessity. This has spurred the rapid growth of the premium segment in home WiFi, spearheaded by WiFi 6 mesh with tri-band architecture, which NETGEAR pioneered and continues to lead in the market. These solutions fuel the work and enable everything from home for families that need to cover large houses and provide reliable internet to every corner of the home. Given the demands all these activities put on home WiFi, we see no slowdown in the demand for our products that help keep people and their devices connected. This premium tri-band WiFi 6 segment represented 30% of the WiFi mesh market in the U.S. in Q1, rising from 25% in Q4 and 7% in the prior year comparable period. This category continues to grow quickly, garners the highest prices, uses the healthiest margins, and has the highest prospect for attaching our value-added services, which we clearly see the benefits of in our Q1 performance. NETGEAR continues to deliver innovative, leading-edge products to meet the needs of these demanding consumers in the market. Last quarter, we announced the Nighthawk Tri-Band mesh WiFi system, model MK83, which we started shipping in Q1. This is our first Tri-Band Nighthawk mesh system and retails for $499 for the router and two satellite kits. The Nighthawk brand has a strong following among those who would like to have more real-time control of their WiFi setup, such as QoS settings and SSID controls with different bands. The MK83 satisfies a long-anticipated desire from our loyal Nighthawk base. We are also quite pleased with the demand and reception of the Nighthawk RAXE500 Tri-Band WiFi 6E router, which debuted in Q1 at a price of $599. With speeds of 2 gigabits now available from cable operators in the U.S., WiFi 6E products have the WiFi speeds to match, thus enabling multiple high-quality video downloads and uploads and 8K gaming. Equally important as the performance of the product is the strong attach rate of our subscription services that we are seeing from the ultra-premium customers purchasing this product. Last but not least, for product introduction on the CHP side, we launched our second DOCSIS 3.1 WiFi 6 cable gateway, the entry-level CAX30. The power of combining DOCSIS 3.1 speed with the benefits of WiFi 6 technology gives cable subscribing households an all-in-one option built to provide multi-gigabit internet speeds across various devices in a home while avoiding the monthly rental fees of cable modems and WiFi routers from the cable operators. The category constitutes about 20% of the total U.S. retail WiFi market, and we possess substantial market share. There is only one meaningful competitor in this category, and they have yet to introduce a WiFi 6 cable product today. As we enter the second quarter with an improving supply picture in the channel, we see the opportunity to build on our Q1 performance in regaining U.S. market share. This bodes well for us to continue to make progress in paid subscriber acquisition, building from the 481,000 paid subscribers that we ended with in Q1. We are on track to meet our goal of 650,000 subscribers by year-end, and we’re excited about the long-term profitability impact that has on our business. Additionally, we’ll improve our service offerings in the second quarter with the rollout of our Smart Parental Controls service that Gartner awarded at CES earlier this year. Following that, we plan to bring the features of our gaming router lineup to the market through a service offering in the second half of this year for those online gaming-loving customers of our premium WiFi 6 Tri-Band Orbi systems. I’m also very happy to share that we continue to make great progress with our SMB business. Our efforts to equip sophisticated home offices with best-in-class configurable WiFi fixed solutions in highly functional low port count PoE switches continue to meet with strong demand as businesses transition to flexible working environments. Additionally, with businesses better navigating COVID-related challenges and reopening, our more sophisticated switching business is accelerating. This includes our Pro AV switching line, which is also seeing the added benefit of sports and entertainment venues opening at entry levels of capacity. We intend to capitalize on this opportunity, and to do so, we are investing in these areas to continue to strengthen our differentiation. Our recent releases in the AV line expand our highly successful 4250 Pro AV switch product offerings and are tailored to make complex AV deployments easy to install and manage. These switches deliver higher overall wattage, provide AV-specific presets and user interfaces while seamlessly transporting the highest quality digital audio and video signals. We’re excited about what lies ahead, given the tailwinds across both businesses and an improving supply outlook, driving opportunities for further market share gain and a solid foundation for increasing our subscriber base. With that, I’ll turn it over to Bryan Murray to comment on our opportunities and obstacles in the coming quarter.

Thank you, Patrick. Our net revenue for the second quarter is expected to be in the range of $305 million to $320 million. GAAP operating margin is expected in the range of 6.5% to 7.5%. Non-GAAP operating margin is expected to be in the range of 9% to 10%. As our channel inventory progresses to healthy levels, we do expect Q2 will present an opportunity to selectively turn promotions back on, including participation in key sales events with some of our channel partners, allowing us to continue to grow market share and to drive paid subscriber acquisition. Additionally, while airfreight costs will stay at the Q1 level, we see sea transport costs rising to 2 to 3 times their normal rate. Our GAAP tax rate is expected to be approximately 27%, and our non-GAAP tax rate is expected to be 24.5% for the second quarter of 2021. While we are confident in our ability to provide guidance at this time, we do so with the caveat that considerable uncertainty remains in the market due to the COVID-19 pandemic and, should unforeseen events occur, in particular, related to transportation delays into any of our regional distribution centers, our actual results could differ from the foregoing guidance. We would now like to answer any questions from the audience.

Hi. Thanks for taking the question. You talked about participating in more promotional activities in the second quarter. With global chip supply still being relatively tight and demand remaining strong, can you just discuss the thought process for running more promotional activities?

Yes. As we have said, we would like to continue the momentum to regain share. We have to be in lockstep with our channel partners. So, our channel partners have planned some promotional activities in a seasonally weaker Q2, and we would like to continue to keep the momentum going. We believe this is the most opportune time for us to gain share. The importance of gaining shares is, of course, to try to continue to have a really good installed base to work with to increase our paid subscribers, which is a very long-term benefit for us. Over the last two years, we have found that the most opportune time to recruit service subscribers is at the point when they install a new product, and that’s the reason behind our decision.

And just as my follow-up, how are you thinking about the trajectory of your SMB business as the global economy continues to open? Will that partially be offset by fewer people setting up home offices as we approach a return to the more traditional office?

We don’t believe so. We’re actually seeing a three-legged stool in the SMB business that we find very encouraging. Many entrepreneurs have left the workforce and started businesses at home. Additionally, there are small business owners and professionals who split time between their home office and main office, such as accountants, architects, and interior designers. The activities of entrepreneurial home-based businesses purchasing our sophisticated home office solutions continue unabated. Secondly, we’ve also seen these small businesses, which are starting to reopen and get back into the office after being closed for over a year. They have upgraded their home offices to WiFi 6, while their offices are stuck with WiFi 5, providing us numerous upgrade opportunities in the actual office. So, that is also driving what we call the reopening trade. Our wireless business continues to grow tremendously. Lastly, the Pro AV business is benefiting from the reopening of sports and entertainment venues and video productions. The combination of these factors gives us confidence that our SMB momentum will continue in the upcoming few years.

Hi. I just want to first ask is -- how do you feel about the current market environment as far as comparing it to previous cycles regarding seasonality? How are you navigating the inventory that you built up? Is that being consumed in the channel or are you holding it off for particular promotions in Q2?

No. The channel inventory is 'just in time'. We ship to the channel in anticipation of the weekly run rate. We typically want to maintain it at the forward-looking run rate of anywhere between 8 to 10 weeks, which we consider optimal. There are some pockets where products are still below that level. When promotions happen, we shift our inventory maybe two to three weeks before the promotion starts. We do not preload channels for promotional activities to be done much later on. The market is encouraging because, for the first three weeks of this quarter and the last two weeks of the last quarter, we’re comparing against last year’s onset of COVID-19 lockdowns. The market remains at an elevated level. Of course, it will revert to the usual seasonality, where Q2 is slightly lower than Q1, then Q3 will see significant growth, and Q4 will be flat to Q3. We believe that seasonality will happen but at an elevated level, which is very encouraging. The reason we feel confident about this is that we observed the same phenomenon in Asia, which has not been hit hard by COVID in some markets, where they have always resumed back-to-office work without any gathering lockdowns. So, we're optimistic based on what we’ve seen so far.

Yes. I think it's actually what Patrick just touched on. We’ve gotten the channel into a healthier place a bit ahead of schedule. This bodes well for our ability to start to regain market share in the second quarter and build the subscriber base. But, as we said early on in the call, we expect the full year targets we set out back in December. We believe we’re on track for those. The back half of the year is probably steering more towards 10% growth over the first half, because we thought there would be more channels happening early on. We think it will be about 10% over the first half of the year. Some of that’s driven by the service provider business, which again is lumpy, and we believe will average about $30 million for Q2, still below the $35 million we believe we will hit for the full year. The strength in the SMB business also contributes to the overall profile for the rest of the year, but again, we expect the second half will see growth over the first half by about 10%.

Your next question comes from the line of Adam Tindle from Raymond James. Your line is open.

Hi. Thanks. This is Alex on for Adam. I’m just curious about how you’re thinking about kind of the margin impacts from promotional spend; how are you thinking about the return on investment for that? And then also, regarding margins, you mentioned that shipping costs were up about 2 to 3 times. So, I’m just curious about how that impacts the gross margins. Is shipping a large component of gross margin?

Yes. I would say, the Q2 guidance relative to Q1 performance indicates that about a third of the movement from the 13.3% operating margin to the 9% to 10% range is driven by the sea cost, the transportation cost for sea freight. So, it is significant. The other two-thirds is tied to the promotional activities. In terms of the return on investment, I think Patrick touched on that earlier. It is all about assisting us in gaining additional paid subscribers, which is our long-term goal. We are focused on pushing that up and achieving our long-term target of a 15% operating margin.

Different channels will have different focus. Generally speaking, it would be on the midrange WiFi 6 products. That would be the focus. We believe that this serves multiple purposes. One, it has a relatively high average selling price; secondly, we have a relatively high chance that those new installation users will attach to our paid subscription services. They generally have a little bit higher margin. So, I think those are the areas we will focus on.

A couple of questions for you, Patrick. I’m actually looking at gross margin differently. There are many things that could potentially pressure gross margin. You've got the higher freight costs; you’ve got a lower mix of SMB. Traditionally, when there are gross margin impacts, your operating margin really sinks because of low gross margin. However, the implied information seems to suggest that you’re holding the gross margin roughly around the 28% to 30% level. I’m curious if there are any other factors helping to prop up the gross margin going into your outlook.

In terms of the bridge from the peak levels we saw in Q1 of 35%, the freight cost and promotional activities will drive it downward. I would say the entirety of the bridge from Q1 to Q2 is going to be in the gross margin. I don't foresee any changes in operating leverage on the business, but those would be the driving forces there. But again, long term, we are trying to push that up by adding subscribers and continuing to grow the premium segment of the market.

Are you seeing any positive impacts from subscription revenue on gross margin?

Yes, definitely. Look at our Analyst Day deck put out in December; the average selling price was about $48 and we said it would contribute close to 80 basis points to this year’s margin. So it is starting to contribute, but again, we’re trying to grow that as quickly as possible, as you saw us increasing our target from $1 million to $2 million.

The cable gateway and cable modem segment of the retail WiFi market has always hovered around 20% of the total market. There's one major competitor, and it’s not an easy task to gain certification from all U.S. cable operators. We have a commanding market share, and theoretically, we could achieve 100% market share in this segment, meaning we’d have 20% of the U.S. WiFi market. Actually, when Bryan talked about returns, it’s not limited only to our own online stores, but also to our partner online stores. Online stores are very nimble in reacting to price fluctuations compared to brick-and-mortar. Ninety-nine percent of the returns show no trouble found; the most frequent reason for a return is that a customer bought from store A and later found a better price in store B. It’s less common online due to nimbleness in price matching. Therefore, online stores have a lower return rate.

As you normalize your inventory levels in the channel, I assume your revenue was mostly from selling. Can you provide any color on the delta between sell-in versus sell-through revenue for this year?

For the rest of this year, as we said, we think we’re pretty much there in terms of filling in the channel. From here forward, there shouldn’t be much delta.

I know you’ve maintained your guidance for this year, but any initial color you can provide on what your growth would look like into calendar ‘22?

We’ll get there eventually. But at this point, we’re focused on executing and navigating this operational environment for 2021, but we’ll get there.

As you look to reinvest your incremental growth into promotional expenses, how should we model incremental operating margins in your business, and what will the trajectory of the operating margins look like as we go through the year?

Yes. As we see the mix of SMB increase, it certainly bodes well for our margins. In a normal year, we typically see seasonality lift in the back half of the year when we get the most operating leverage. But as I said earlier, we’re maintaining the targets for full-year revenue and operating margins that we set out for 2021. To your earlier point regarding 2022, we believe the market has risen and will maintain elevated levels, and we will likely return to low single-digit increases driven by average selling price expansion.

Thank you. Thanks, everybody, for joining us today. As you can see from our results, the team at NETGEAR is operating at a high level in a difficult environment to produce excellent results. I remain confident that the tailwinds buoying our business will continue, and we will continue to execute well to deliver results for all of our stakeholders. I look forward to sharing more about that in the coming quarters with all of you. Thank you.

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