Netgear, Inc. Q3 FY2021 Earnings Call

Ladies and gentlemen, thank you for standing by. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. I would now like to turn the conference over to Erik Bylin. Please go ahead, sir. Thank you, Glen. Good afternoon. And welcome to NETGEAR’s third 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 we will start with a review of the financials for the third quarter provided by Bryan, followed by details and commentary on the business provided by Patrick, and finish with fourth quarter of 2021 guidance provided by Bryan. We will 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-Q. 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. Net revenue for the quarter ended October 3, 2021, was $290.2 million, down 23.3% year-over-year and within our guidance range despite greater than anticipated worldwide supply chain challenges. We’re also able to achieve non-GAAP operating margin of 6.7% or 70 basis points above the top end of our guidance range, helped by continued strong performance in our higher margin SMB business. We remain confident in our long-term strategy of providing premium WiFi products to lead innovation in the consumer networking markets and expand our paid service subscriber base. The hybrid and remote work models are becoming the norm for employees worldwide, whose home office requirements continue to increase the complexity, connection speed and coverage needs. We retained our leadership position in the U.S. consumer WiFi market share, which remained at roughly 46%. Meanwhile, the wave of businesses reopening and new startups worldwide continues to propel our SMB business forward, with double-digit growth of 33% year-over-year. Even with our top line being held back by the aforementioned supply disruptions, we experienced our third quarter in a row of double-digit year-over-year growth and our highest quarterly SMB revenue in nearly seven years. This was spearheaded by strong demand from distribution channels worldwide, where the team did a great job in securing demand towards available products. SMB wireless products and our managed switches propelled by ProAV applications were the driving forces behind this solid result. In the third quarter, we generated non-GAAP operating income of $19.5 million. This translated into a non-GAAP operating margin of 6.7%, which is 420 basis points below the prior year period, primarily as a result of significant top line leverage in the prior year period, aided by opportunistic demand in the service provider channel tied to the pandemic. Our supply constraints hindered our higher margin SMB business from reaching its full top line potential in the quarter, but strong SMB demand, in combination with slightly lower than expected investments in marketing and promotional activities, combined to deliver stronger operating income performance than originally anticipated. For the third quarter of 2021, net revenue for the Americas was $195.1 million, a decline of 29.8% year-over-year and down 8.2% on a sequential basis. EMEA net revenue was $56.9 million, which is down 10.6% year-over-year and down 7.8% quarter-over-quarter. Our APAC net revenue was $38.1 million, which is a 4.3% increase from the prior year comparable period and up 10.7% sequentially. For the third quarter of 2021, we shipped a total of approximately 3.4 million units, including 2.3 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 1.2 million units for the third quarter of 2021. The net revenue split between home and business products was about 72% and 28%, 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 33% of our third quarter shipments. While products introduced in the last 12 months contributed about 24% of our third 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 release distributed earlier today. The non-GAAP gross margin in the third quarter of 2021 was 30.1%, which is down 20 basis points as compared to 30.3% in the prior year comparable period and down 30 basis points compared to 30.4% in the second quarter of 2021. Total Q3 non-GAAP operating expenses came in at $67.9 million, which is down 7.2% year-over-year and up 0.125% sequentially. Our headcount was 780 as of the end of the quarter, up from 769 in Q2. We continue to manage our headcount, but we will add resources and invest in areas that we believe will deliver future growth. Our non-GAAP R&D expense for the third quarter was 7.6% of net revenue, as compared to 6.2% of net revenue in the prior year comparable period and 6.9% of net revenue in the second quarter of 2021. To continue our technology and subscription service leadership, we’re committed to continue investment in R&D. Our non-GAAP tax rate was 21.6% in the third quarter of 2021. Looking at the bottom line for Q3, we reported non-GAAP net income of $15.3 million and non-GAAP diluted EPS of $0.50. Turning to the balance sheet, we ended the third quarter of 2021 with $292.2 million in cash and short-term investments, down $43.1 million from the prior quarter. While we saw an increase in inventory carrying levels sequentially, continued elongation of transit times meant much of this supply was in transit at the end of the quarter. During the quarter, $17 million of cash was used by operations, which brings our total cash provided from operations over the trailing 12 months to $37.6 million. We used $2.4 million in purchases of property and equipment during the quarter, which brings our total cash used for capital expenditures for the trailing 12 months to $11.1 million. In Q3, we spent $32.5 million to repurchase approximately 953,000 shares of NETGEAR common stock at an average price of $34.07 per share. Since the start of our repurchase activity in Q4 2013, we have spent $610 million to repurchase 17.3 million shares. Further demonstrating our commitment to returning value to our shareholders, our Board of Directors has authorized the repurchase of up to an incremental 3 million shares of the company’s common stock or approximately 10% of outstanding shares. Our fully diluted share count is approximately 30.8 million shares as of the end of the quarter. Now turning to the third 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 $208.5 million during the quarter, which was down 34.2% on a year-over-year basis, and down 9.3% sequentially. Year-over-year decline was experienced in both retail and service provider channels, with Q3 2020, being boosted by heightened demand in response to the pandemic. In the third quarter, we saw a slowdown in the growth of the U.S. consumer networking market, which landed about 15% higher relative to the same period in 2019. This adjusts for Prime Day timing and falls short of our expectations for 20% growth for the back half of the year that we shared in July. Although we have made meaningful progress in stocking the U.S. retail channel in dollar terms, we expect these efforts to continue in the fourth quarter, adjusting for market size that we expect to remain at approximately 15% above the comparable period in 2019. The SMB segment continues to execute well against a supply constrained environment and generate net revenue of $81.6 million for the third quarter of 2021, which is up 33% on a year-over-year basis and up 3.4% sequentially. The growth was once again driven by exceptionally strong demand, buoyed by new business formations and demand for flexible working environments. We continue to see strong demand for our SMB wireless solutions and POE switches. But we were most excited about our ProAV business, which experienced exceptional year-over-year growth. Our market share in switches sold through the U.S. retail remained strong at 60% in Q3. Notably, in the face of the component and chip shortages and other supply constraints, our SMB business achieved its highest quarterly revenue in almost seven years. I’ll now turn the call over to Patrick for his commentary, after which I will provide guidance for the fourth quarter of 2021.

Thank you, Bryan. As we have shared for the last several quarters, work-from-home is here to stay and along with it, the need for household networking devices capable of distributing greater bandwidth continues. With hybrid and work-from-everywhere models becoming more pervasive, the consumer's need for greater bandwidth, improved coverage and faster connection speeds persists at homes. NETGEAR, as the leader of the premium WiFi retail market, continues to lead the industry in bringing cutting-edge high-performance products to market. I’m excited to announce that in the fourth quarter, just in time for the holidays, NETGEAR is introducing the next generation of smartphone WiFi mesh systems. The most powerful Orbi to date. The Orbi quad-band mesh WiFi 6E system makes the newly available 6 gigahertz WiFi band accessible to homeowners. This unique first-of-its-kind mesh system utilizes quad-band technology to deliver up to 10 gigabit internet speeds to more devices simultaneously and with less interference and lag. This remarkable improvement is thanks to the fourth 6 gigahertz band along with upgraded 5 gigahertz WiFi radio and antenna designs. NETGEAR is the first company to bring the quad-band solution to market to enable unprecedented WiFi performance for consumers. Furthermore, this new system supports up to 10 gigabit internet speed input, offers additional 2.5 gigabit Ethernet output ports for wired connections and supports the new, more secure WPA3 encryption standards. Finally, the quad-band Orbi WiFi 6E includes a free 30-day trial of the newly enhanced NETGEAR Armor service, which we expect will further add to our paid subscriber base. This exclusive product is available for pre-order in the U.S. and soon will be in the U.K. as well for roughly $1,500. In colors of gold, white and limited edition bucket, it will add to the portfolio of our products at the super premium portion of the market where systems exceed the $1,000 mark, which is experiencing tremendous year-over-year and quarter-over-quarter growth. Without a doubt, we are continuing the trend of innovation in the premium WiFi systems market, anchored by tri-band WiFi 6 mesh. The premium segment continued its growth within the market and was up sequentially to 36% of the total market, which is significant growth from a year ago. We continue to believe that the super premium portion of the market demands an uncompromised experience and that this higher average selling price will expand the market. Moreover, buyers in this segment of the market are much more likely to subscribe to one of our value-added services, such as Armor network security, especially when purchasing directly from our netgear.com store where we can create a premium experience. Our netgear.com stores worldwide are growing rapidly and we intend to make it 10% of our worldwide 6E retail sales channel sometime next year, focusing on the new products at the super premium end of the market. Additionally, I’m excited about the strong reception to the unlocked version of the Nighthawk M5 5G WiFi 6 mobile router. This compact device is capable of delivering gigabit internet speeds similar to that of the home WiFi network, but in a mobile environment. With the remote work and mobile lifestyle becoming more prevalent than ever, the Nighthawk M5 enables users to ditch mobile phone hotspots for a significant improvement in speed, coverage and security. Furthermore, the M5 enables those in areas with unreliable broadband options to remain connected, as it is the only device in its class to offer a 1 gigabit per second Ethernet port for connection to a home WiFi mesh system. This device is available exclusively in North America on netgear.com for about $700. Our focus on innovation is a key driver in the acquisition of our paid subscribers. The value proposition of our offerings continues to resonate with customers, especially with our highest end products. In the quarter, we added new capabilities to our enhanced NETGEAR Armor offering, which provides a protective shield for connected devices in the home network. This upgrade adds new protection to our already award-winning feature sets. For ease of use, the enhanced NETGEAR Armor is built into most Orbi and Nighthawk routers to protect the entire network, including IoT devices such as IP cameras, IP light switches and Wi-Fi lights. This is in stark contrast to traditional endpoint antivirus products that can only be installed on computing devices and charge a security subscription fee for each device, while still not protecting IoT devices. NETGEAR Armor is complimentary for a 30-day trial period, and upon expiration, the yearly subscriptions start at $99.99. Although we are currently projecting to end the year at 575,000 subscribers, below our original goal set at the start of the year, we remain positive about the long-term profitability impact on our business and our ability to achieve 1 million subscribers in the next three years. Turning to our SMB business, I’m proud of our team’s execution this quarter and once again delivering strong double-digit year-over-year growth for the third consecutive quarter. Undeniably, the momentum in SMB remains strong. As businesses continue to reopen and new businesses form, we saw further adoption of our WiFi 6 wireless offerings, and with WiFi 6E and WiFi 7 to follow, we expect this to continue to be a growth pillar. Additionally, we saw continued momentum in our ProAV business, which has been a key area of our focus and will continue to serve as a strategic growth area in the future. The industry's transition from analog to digital AV over IP is clearly accelerating, with disruptive new applications, such as digital hearing, digital AV studios, wireless digital speaker systems for large venues, remote classrooms and church services, green or blue screens replaced with ultra-high definition LED screens, digital theater backdrops and remote robotic surgeries. New applications are being adopted all the time, as traditional AV infrastructure via HDMI cables gets replaced with Ethernet. Our ProAV switches are uniquely embedded with many industry IP/AV protocols to enable these applications to be deployed easily by AV integrators. We sit at the heart of this transition along with our expanding worldwide network of VARs, AV integrators and AV equipment vendors. We’re also making progress in expanding our service offerings for the SMB sector. In the fourth quarter, we are introducing Insight business VPN, a new add-on service offering for our Orbi Pro Series business mesh systems. An integral part of every company’s IT needs is managing the security and integrity of the business network, and this service enables expansion of corporate networks to branch offices and home offices of employees, while ensuring each node on the network is secured and centrally managed with minimal administrative complexity. Before I turn it back over to Bryan, I’d like to take a moment to welcome Shravan Goli to the NETGEAR Board of Directors. Currently serving as Coursera’s Chief Product Officer and Head of Consumer Revenue, Shravan brings to NETGEAR an over 20-year track record of developing and scaling SaaS and subscription-based companies and offerings, with experience in executive leadership roles at companies including Coursera, Dictionary.com, Yahoo! and Microsoft. I’m excited to collaborate with Shravan as we continue to build out NETGEAR’s software and value-added services business to complement our industry-leading hardware. And with that, I’ll turn it back over to Bryan to comment on our opportunities and obstacles in the coming quarter.

Thank you, Patrick. It’s widely publicized that the rapidly changing macroeconomic environment is causing disruption in global supply chains for companies of all sizes and industries. NETGEAR is not immune to this. Despite the progress and the reopening of economies worldwide, the third quarter of 2021 saw the continuation of numerous headwinds, including component shortages, associated price increases and even longer transit times with dramatically increased costs, all exacerbated by flare-ups of the Delta variant. These worldwide supply chain constraints combined with lower than expected end-user demand of our retail consumer business presents a significant challenge to meeting our previous top line growth projections for the fourth quarter. We expect SMB to continue seeing strong demand in WiFi 6 access points and ProAV switches, only to be limited by supply in the fourth quarter and into 2022. On the consumer side, looking ahead to the fourth quarter of 2021, we see market growth moderating to approximately 15% above the same period in 2019. Our previous destocking efforts to optimize inventory levels in the third quarter made progress, but we plan for these efforts to continue into the fourth quarter. We also expect our service provider revenue to decline sequentially due to supply constraints. Accordingly, our expectations for net revenue in the fourth quarter is in the range of $250 million to $265 million. As a result of loss of leverage from our top line and in combination with the significant freight and component cost increases that we will see in the next quarter and beyond, we expect fourth quarter GAAP operating margin to be in the range of negative 0.5% to 0.5%. The non-GAAP operating margin is expected to be in the range of 2% to 3%. Our GAAP tax rate is expected to be approximately 80%, and our non-GAAP tax rate is expected to be 26.5% for the fourth 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 deteriorating supply chain conditions. Should unforeseen events occur, particularly challenges related to the closure of our manufacturing partners' operations, increased transportation delays into any of our regional distribution centers or greater than expected freight or component costs, our actual results could differ from the foregoing guidance. We would now like to answer any questions from the audience.

Your first question comes from Adam Tindle with Raymond James. Your line is open.

Okay. Thanks. Good afternoon. I just wanted to start, maybe Bryan and Patrick could potentially comment a little bit, but obviously understand a very difficult supply environment with supply constraints going on right now. But at the same time, you’re talking about the need to destock, meaning you have excess supply or excess inventory. And I’m trying to square those two dynamics of a supply constrained environment but the need to destock. Why is that the case, where is it concentrated and how much destocking is left?

Well, let me talk about the shortages primarily on the SMB side, while the destock is mostly on the consumer side, and Bryan, you could add more color to it.

Yeah. Just building on what Patrick was saying there, SMB is certainly facing shortages across a number of product categories for that business and we expect that to continue on until at least the second half of next year. At this point, we’re hopeful that we will start to see improvement in the back half of 2022. On the consumer side, the one area we are facing supply constraints would be for those products that we’re selling to our service provider customers. Certainly in the LTE and 5G mobile hotspots, we are facing challenges there and expect for Q4 that they will probably be in that $30 million to $35 million range, which is below what we were expecting coming into the second half of this year. From a channel inventory standpoint on the consumer side, you may recall back in July we had set out to reduce channel inventory levels given the market was at that time steering towards a 20% growth over 2019. We’re really just right sizing the channel footprint based on the levels that we’ve stocked in in the first half of the year to that level. But as I said earlier, with the market actually delivering about 15% growth, so that's below our expectation. There’s further room to deliver in terms of destocking the channel; we expect to deliver most of that in the fourth quarter.

Okay. That’s helpful color. I appreciate it. And maybe just a higher level one for Patrick, I am talking about competitive dynamics. Recently, some of the cybersecurity firms have been partnering with WiFi companies or creating their own products and I kind of think of this as an opportunity or a potential threat. From an opportunity standpoint, for example, Fortinet invested, I think, just under $100 million in Linksys. From a threat standpoint, Palo Alto was organically pursuing this market, that consumer WiFi market via their own organic product. So maybe you could bucket both the opportunity, would you consider partnering, the way that Linksys did, for example, and what would the terms you’d be looking for, and then the threat how to defend against new incumbents, like Palo Alto?

Yes. I think our target customers are different. As I mentioned in the discussion, we’re introducing our own version of similar services on our Orbi Pro Series for the SMB side. So we would be able to let IT managers centrally manage one of the SSIDs in home offices, with our Insight central management, as well as the new Insight VPN services. So we are ahead of them because they just announced they didn’t ship, and we’re already shipping. But of course, our target customers are different. Theirs are primarily Fortune 5000. Ours are primarily what we call micro businesses. The other thing is, I have stressed for many quarters as well as just now in our discussion, we are focusing more and more on the premium or the super-premium WiFi segment where people would not tolerate any lag and would not tolerate any uncovered areas in their houses. So we find a lot of our customers, as a matter of fact, dissatisfied with the WiFi provided by their own company or by the service providers that plug our high-end mesh systems into that particular provided piece of equipment. Looking at the specs of what Palo Alto Networks or Fortinet offer, they are at least two generations behind what we are going to offer. With more and more offerings of 1.4, 2, and 10 gigabits coming into the house, I think for very uncompromised customers, we can continue to sell this super high-end. So, all in all, we believe that it’s not really in the same space that we’re competing. From a cooperation standpoint, I am open -- we’re always open for partnerships. For example, the partners that we use to provide our VPN, Insight VPN services have been providing similar services to Fortune 5000 companies for really big businesses, and the software and services they provide are really rock solid. Now we’re partnering with them to provide similar services to IT departments of small and micro businesses.

Understood. That’s helpful. Thank you very much.

Yeah.

Your next question comes from Hamed Khorsand with BWS Financial. Your line is open.

Hi. First off, did I hear you right? You said unit shipped was 3.4 million.

That’s right.

And that unit count is quite low compared to Q3 2019. I’m just wondering if you’re missing the market or exiting the market since then where it was 3.8 million that quarter, now you’re at 3.4 million units shipped?

Well, I just like to point out that back in 2019, in the same quarter we were at 52% of market share, and right now we are at 46%. I think that is the major difference.

Okay. You just…

And furthermore in that time, we have more minutes towards the low end; right now we have more dollars towards the higher ASP products.

Okay. That was where I was going my follow-up. Okay. And then as far as the super premium you’re looking at, what trends have you seen so far this quarter, especially through the destocking that gives you confidence that you could continue to expand this market?

Well, I mean, as I discussed previously, we are only selling this super premium on our own netgear.com stores direct, so we can see the orders coming in every day.

Okay. But will super premium customers also be more inclined to use a middle person or someone to install it rather than do it themselves?

We provide that service as well.

Okay. All right. That’s it for me. Thank you.

Okay. Great. Thanks.

Your next question comes from the line of Paul Silverstein with Cowen. Your line is open.

Thanks, guys. I appreciate you taking the questions. Patrick and Bryan, with respect to this roughly 75% of revenue derived from Connected Home from consumer, it sounds like it -- and that risk of asking an argument in question, it sounds like you’re both attacking opportunity in the high end but it’s -- well, let me ask the question in a different way. How much of your pursuit of premium and super premium is a function of seeing a robust market opportunity measured by revenue and by margins and attending bottom line? And how much of it is really driven out of necessity that your 75% revenue is coming from consumers? It sounds like that market is already disappointing with relatively low prospect of meaningful improvement anytime soon independent of supply chain constraints, independent of COVID economic impact? And the related question would be, when you talk about 15% down from 20% growth outlook relative to 2019, which I assume you’re trying to get to normalized bits? Is that the right bits? What is the growth outlook for consumer WiFi? Maybe 2019 is not the right place to look; maybe it’s far lower than that, but let me let you respond.

No. I mean, we can only look at what the market is as of today in dollar terms, right? And let me be clear about that compared to 2019. As a matter of fact, most of the growth of 15% is from ASP increase. The ASP increase is primarily driven by us moving more into the super premium segment. And as Bryan mentioned in the discussion, the premium segment of tri-band and quad-band has grown doubled year-over-year. Remember, Q3 last year was a crazy quarter; the demand has gone through the roof. Everybody rushed out to buy WiFi, and even against a huge quarter, we still doubled the premium segment of the market. But that clearly is a greenfield, a new segment that we occur to be in. You said right, it’s a more profitable segment, both from a percentage and a dollar standpoint. As much as we could win 52% market share in the low $100 routers, you guys have 15 of them to rival one of this super premium, and so that in of itself is very lucrative from the dollar profit span. More importantly is that there is very little of our competitors do in chasing us in the technology required to offer quad-band; they are on tri-band. We believe that we will continue to enjoy a much higher market share in that particular segment. So when you sum it up, it's more profitable, an absolutely growth segment irrespective of what the rest of the market demand is, and we have a technological leadership that our competitors would take years to just to chase us, but by then we’ll move on to tri-band on WiFi 7. So we believe that we’ll continue to maintain a leadership position and that’s why we’re going after this.

Patrick, to those comments, can I ask you -- could you remind us, the super premium in the market or the premium and super premium? What -- how -- what percentage of revenue is that for you today? What is its growth rate for you? What can it be? At what point can it -- where can it be in the next two years to three years as a percentage of the total revenue?

No. We do not -- we traditionally do not break down product line revenues. But the only thing we can say is, as I just mentioned, that premium segment in the market that is tri-band and quad-band is 36% of the total mesh market is doubling, more than doubling year-over-year. So that’s how fast the market is growing. So we believe our growth on that will mimic in the next couple of years, and we’ll try to push it as big as possible, and our target is to make that premium end more than 50% to 60% of our revenue total plus 60% by when? Probably in two years to no later than three years.

Patrick, while you’re enjoying 100% plus growth, assuming you’re growing with the market or better than market given your dominant position, while you’re enjoying that growth in the premium in the market, what type of decline are you seeing in the rest of the market for you?

No. It’s just like Tesla is going like crazy, while the rest of the gasoline car industry is shrinking. It’s a new field. It’s a completely new field.

All right. I’ll take it offline. I understand what you’re saying, but there’s still math involved over the next several years as the premium, super premium grows dramatically before you get that portion of the market being the dominant portion of your revenue. But I’ll take it offline. That’s fine. I appreciate the responses.

Sure.

There are no further questions at this time. I will turn the call back over to the presenters.

Thank you for joining us today. The current macroeconomic environment is definitely challenging from the logistics and supply and component standpoint. But I’m confident in our team’s ability to navigate through these happenings and continue to march towards our goal of dominating in the premium end of the consumer market and in the ProAV side of the SMB. Our commitment to innovation and brands set us apart in the market and we remain poised to enable the work from everywhere environment, and I’m excited at the forefront of this transition. To explain further our product portfolio, technology and strategy, we plan to have our Analyst Day -- Annual Analyst Day early December and we’re going to send invitations out shortly and look forward to seeing you all then over Zoom. Thank you.

Ladies and gentlemen, this concludes today’s conference call. You may now disconnect.