Netgear, Inc. Q3 FY2023 Earnings Call

Hello and welcome to NETGEAR's Third Quarter 2023 Results Conference Call. Thank you for being here. I would now like to turn the conference over to Erik Bylin. Please proceed.

Thank you, Erik, and thank you, everyone, for joining today's call. We are pleased with the continued strong execution of our team this quarter in delivering both revenue and operating margin comfortably above the high end of our guidance range. For the quarter ended October 1, 2023, revenue was $197.8 million, up 14.1% on a sequential basis but down 20.7% year-over-year. Increased demand in both the CHP retail market and service provider channels, along with retail channel partners maintaining rather than depleting their inventories, enabled us to outperform our top line relative to our original expectations. As the WiFi 7 upgrade cycle begins to ramp and we approach the holiday season, we continue to see positive signs that the retail networking market is stabilizing. Notably, in Q3, the U.S. retail market grew double digits sequentially, in line with historical seasonality. In the retail portion of our CHP business, our premium solutions which consist of Orbi 8 and 9 tri- and quad-band WiFi mesh products and 5G Nighthawk mobile hotspots are continuing to perform well. Sales to end users of these premium products grew double digits year-over-year, dramatically outperforming the total market which compressed double digits over the same timeframe. On the other hand, our SMB business fell short of our top line expectation in the third quarter. The uncertain macroeconomic environment continued to pressure our channel partners, and we saw them reduce their inventory carrying levels, which constrained the top line of our SMB business and will continue to limit its top line potential in the quarters to come. This second consecutive quarter of top line outperformance is an encouraging sign that the CHP retail market is stabilizing and the WiFi 7 transition is gaining traction. The strong mix of our premium higher-margin products, combined with the progress we continue to make in growing our service revenue business in CHP, helped improve our gross margins. Additionally, we gained top line leverage from the seasonal lift of the back-to-school season and, coupled with disciplined expense management, we returned to profitability, delivering non-GAAP operating income of $5.3 million and non-GAAP operating margin of 2.7%, with the margin coming in well above the high end of our guidance range. Our non-GAAP operating margin was up 200 basis points compared to the year-ago period and up 890 basis points compared to the prior quarter. For the third quarter of 2023, net revenue for the Americas was $141 million, a decline of 16.7% year-over-year and up 20.9% on a sequential basis. EMEA net revenue was $35.7 million, a decrease of 20.4% year-over-year and down 1.3% quarter-over-quarter. Our APAC net revenue was $21.1 million, which is down 40.3% from the prior year comparable period and up 2.4% sequentially. For the third quarter of 2023, we shipped a total of approximately 1.8 million units, including 991,000 nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 520,000 units for the third quarter of 2023. The net revenue split between home and business products was about 64% and 36%, respectively. The net revenue split between wireless and wired products was about 61% and 39%, respectively. Products introduced in the last 15 months constituted about 16% of our third quarter shipments, while products introduced in the last 12 months contributed about 11% 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. Non-GAAP gross margin in the third quarter of 2023 was 35%, which is up 740 basis points as compared to 27.6% in the prior year comparable period and up 340 basis points compared to 31.6% in the second quarter of 2023. As compared to the prior year period, increased shipments of our premium higher-margin CHP products and considerably lower total freight costs drove the improvement. As compared to the prior quarter, Q3 experienced a higher mix of premium, higher-margin products. Overall, we were more efficient with our marketing spend. Total Q3 non-GAAP operating expenses came in at $64 million, which is down 4.7% year-over-year and down 2.2% sequentially. Our headcount was 644 as of the end of this quarter, down from 653 in Q2. We will continue to strategically invest in our business and hire in key areas we believe will deliver future growth and profitability, such as Pro AV managed switches, premium Orbi WiFi mesh systems, 5G mobile hotspots, and subscription services. However, we continue to evaluate other areas of the business on a regular basis, driving further cost efficiencies. Our non-GAAP R&D expense for the third quarter was 10.1% of net revenue as compared to 8.5% of net revenue in the prior year comparable period and 11.4% of net revenue in the second quarter of 2023. To continue our technology and subscription service leadership, we are committed to continued investment in R&D. Our non-GAAP tax expense was $0.7 million in the third quarter of 2023. Looking at the bottom line for Q3, we reported non-GAAP net income of $6.9 million and non-GAAP diluted earnings per share of $0.23. Turning to the balance sheet, we ended the third quarter of 2023 with $228 million in cash and short-term investments, up $25.2 million from the prior quarter. As we projected in July, we were able to return to positive free cash flow in the third quarter as we made meaningful progress in reducing our inventory and improving our bottom line. During the quarter, $26.1 million of cash was provided by operations, which reduced our total cash used by operations over the trailing 12 months to $4.4 million. We used $2 million in purchases of property and equipment during the quarter, which brings our total cash used for capital expenditures over the trailing 12 months to $5.2 million. We expect to continue generating positive free cash flow as we believe we will further reduce our inventory levels over the next couple of quarters and drive to our pre-pandemic carrying levels of 3 to 4 months.

Thank you, Bryan. I want to acknowledge our NETGEAR team for their significant achievements in the third quarter. We had the most successful launch of new WiFi technology in our history with the WiFi 7 quad-band Orbi 97x and Nighthawk RS700 router. Our overall gross margin reached 35% by focusing on high-margin products in CHP and SMB along with minimizing promotional discounts. The number of value-added service subscribers grew to 844,000, resulting in a 25% increase in service revenue to $10.6 million for the quarter. We collaborated with our retail partners to optimize inventory levels, which we believe have now stabilized. We also see increased market demand for our Pro AV line of SMB products. Our team worked hard to reduce inventory levels and generate cash for our balance sheet. We began shipping our first two WiFi 7 products exclusively through our U.S. direct-to-consumer web store in the second-to-last week of Q3, and the market response exceeded our expectations. The Orbi 97x, our WiFi 7 quad-band mesh, achieved sales in the first two weeks that were double those of our previous quad-band WiFi 6E mesh, the Orbi 96x. The Nighthawk WiFi 7 router, RS700, quickly became our top-selling premium router, surpassing our previous WiFi 6E flagship, the RAXE500. Although WiFi 7 clients aren't widely available yet, early tech adopters have shown strong support. We anticipate that as WiFi 7 clients become more available starting in April or May of next year, both the retail market and our CHP revenue will benefit from the upgrade cycle. We are preparing an impressive lineup of WiFi 7 introductions in 2024 across all major product categories: Orbi mesh, Nighthawk routers, Nighthawk mobile hotspots, and SMB Insight access points. We are enthusiastic about the potential for growth in both our top and bottom lines in 2024 on a year-over-year basis in every quarter. During Q3, our CHP sales and marketing teams globally worked diligently to promote our high-margin products across all categories: mesh, routers, mobile hotspots, cable gateways, and laptop WiFi adapters, resulting in an excellent mix of high-margin products. Our SMB team has applied the same approach to our Pro AV products. These efforts helped us achieve a 35% gross margin overall, and we expect that with more WiFi 7 products launching in 2024, there will be opportunities to further enhance our gross margin in the new year. We added 40,000 paid service subscribers in Q3, bringing the total to 844,000 and increasing our paid service revenue to $10.6 million. We are on track to reach our goal of 875,000 paid service subscribers by the end of the year, which would significantly boost our service revenue and contribute to gross margin growth for years ahead. We plan to enhance our Armor services with more features to safeguard our customers' connected devices at home, including additional privacy protection features in 2024 to broaden the appeal of our Armor service. With the positive reception of our WiFi 7 launch and the stabilization of the retail addressable market, our retail channel partners are more assured that the retail network market will remain stable or possibly even grow. They have shown this confidence by maintaining their inventory levels, and we will continue to introduce new products to support their confidence. This quarter, we will launch two new versions of our premium Nighthawk mobile hotspots, the M6 Pro: one for the U.S. compatible with the Verizon network and another for Japan compatible with all major carriers there. We plan to introduce more WiFi 7 mesh routers and mobile hotspots throughout 2024. On the SMB front, our Pro AV managed switches have seen year-on-year growth, with more commercial AV integrators and manufacturers opting for our user-friendly switches for diverse applications such as video conferencing, control room displays, digital signage, concert tours, sporting events, esports arenas, lecture halls, churches, and performance centers. We recently showcased our new M4350 switch, compatible with the SMPTE 2110 broadcast protocol, for the first time at IBC in Amsterdam, where we generated considerable interest from potential partners and integrators. We are excited about these prospects in 2024. Additionally, we've launched our first residential wired router, the PR60X, which has been well-received by high-end residential Pro AV integrators, and we expect further expansion in this market in 2024. We are progressively achieving inventory turns between 3 and 4. In Q3, we significantly reduced our inventory and generated substantial cash. We are confident that our inventory levels will normalize by mid-2024, although we anticipate some challenges in the next three quarters due to rising inventory costs resulting from prior period timing. We will persist in improving our product mix, managing costs, and introducing new products to alleviate some of these challenges. Our team is dedicated to these efforts. Turning to our SMB business, we recognize that some of our major markets, including Greater China, Germany, and Japan, are encountering macroeconomic uncertainty due to geopolitical tensions, high interest rates, and sluggish economic growth, which is impacting our SMB business in these regions and prompting our channel partners to reduce their inventory, potentially limiting SMB top-line growth in the upcoming quarters. Despite this inventory compression, we believe that these are merely short-term headwinds, and the long-term growth potential driven by our Pro AV solutions remains strong. With that, I will hand it back to Bryan to discuss our opportunities and challenges for the coming quarter and year.

Thank you, Patrick. We expect to continue to experience strong underlying demand in the premium portion of our CHP product portfolio, riding on the success of our WiFi 7 launch well into 2024. We are also encouraged that our retail channel partners are now maintaining rather than depleting their inventories. However, we will continue to work with our SMB channel partners to optimize their inventory carrying levels during the next few quarters. Accordingly, we expect CHP to be approximately flat sequentially, in line with market seasonality, and SMB to be down sequentially which will result in overall fourth quarter net revenue being in the range of $175 million to $190 million. As we continue to make meaningful progress in reducing our own inventory levels, we will be consuming older, higher cost inventory. We expect we'll move back to normal inventory levels and normal inventory costs by the middle of next year. Accordingly, we expect fourth quarter GAAP operating margin to be in the range of negative 4.4% to negative 1.4% and non-GAAP operating margin to be in the range of negative 2% to positive 1%. Our GAAP tax expense is expected to be in the range of $1 million to $2 million. And our non-GAAP tax expense is expected to be in the range of 0 to $1 million for the fourth quarter of 2023. We expect we will continue to generate meaningful cash in Q4 and beyond. We would now like to answer any questions from the audience.

My first question is about the inventory you plan to reduce and the timing of margins. What is the typical gross margin you are targeting right now? What impact do you anticipate this will have in the next two to three quarters?

In Q4, we anticipate a headwind of approximately 150 basis points compared to Q3, which is reflected in our guidance. This impact will peak in Q1 and then gradually decrease into Q2 and the latter half of 2024. As we actively reduce our inventory levels, we have already seen a sequential drop of about $42 million. We are halting the inflow and operational costs associated with procuring that inventory, which contributes more significantly to the overall cost. As mentioned, we expect about a 150 basis point headwind in Q4, which will rise slightly in Q1 before tapering off as we move forward.

Yes. Our aim is using 35% as the base of our standard. And after burning off these higher-cost inventory, we believe that we can continue to improve on that gross margin beyond 35%.

Okay. Given your comments about inventory, I assume your goal is to convert around $80 million to $90 million into cash. What is the timing for that inventory to convert from accounts receivable to cash, considering your days sales outstanding are still relatively high?

Yes. DSOs tend to go up in the fourth quarter. I expect that trend to continue. You may recall in the past and we continue to do this, we support a couple of retailers with extended payment terms leading into the holiday season. So I think DSOs will go up but that's in line with what our normal experience would be. In terms of the impact in reducing inventory, I would say that we're probably going to move in a similar direction to what you saw in Q3 in each of Q4 and Q1. I think the heaviest lift will happen in those two quarters. And I would expect that the free cash flow implications are slightly ahead of what we delivered in Q3 as a result of those efforts.

I believe that by Q3 of next year, we will be back to normal in generating cash equivalent to net earnings or close to net earnings, yes.

So what I'm trying to get to is your cash balance is going to increase quite a bit, why hasn't the company come out and started buying back stock at $10?

So we're opportunistic buyers of our stock. We continue to have those conversations. As you saw this Q3 was the first period we returned to positive free cash flow, that's obviously a consideration point. But repurchasing stock is still a conversation we continue to have.

What's a better opportunity than $10? I mean how much further down are you expecting your stock to go?

Well, I mean we definitely are looking at all these. I mean we believe that yes, we will always be the opportunistic buyer in the market, especially now we are confident in generating cash.

Firstly, can you guys touch on your early indications from the holiday season? How is this similar or different from years past? And have there been any changes to your sort of promotional philosophy for this holiday season?

As a matter of fact, I think a good indication from the Prime Day 2 that Amazon put together, it seems like the holiday season in networking is pretty much like the rest of the retail market, galvanizing into the high-end as well as the lower end. So that's why we're seeing really positive reception to our high-end products, such as the WiFi 7 products or even the existing Orbi 8 and Orbi 9 and the high-end routers such as what we mentioned, the RS700, the new one and the RAXE500 all on high end. But also there's quite a bit of demand on the lower cost WiFi products such as the adapters, such as the extenders which are really cheap quick fixes to better WiFi at home. We're also seeing the popularity of our lowest-cost cable gateway for $1.99 because a lot of customers will realize that by paying $15 a month of rent WiFi from cable operators, it's much cheaper to buy a cable gateway at $200 and after 12 months, it's all gravy. So I think the holiday season will be the same in those two areas. Now certainly, we're not promoting the Orbi 9, right? That's a premium product but yes, we will strategically promote some of these lower-end, higher-demand customer products where we have a unique position, we have less competition so that we could generate more margin dollars.

And then last one for me. Can you just speak to the performance of the cybersecurity Armor service and then funnel of activations this quarter?

The Armor cybersecurity service is still our number one service by our subscribers. And overall, we're seeing very strong uptake and strong renewal rate among these customers. So as we say, our intention is to expand the feature set so that we have the opportunity to further expand the subscriber base and also potentially increase the ARPU. That's the strategy going forward. And we did a lot of user surveys through our app that customers' number one request is to have privacy features such as removing cookies, hiding your identity, things like that. We would definitely add that in 2024.

Are you guys internally thinking about ever providing more disclosures around the service?

Such as?

A quarterly ARPU number, churn, retention metrics every quarter, things like that.

Okay. All right. Yes. Certainly, we'll look into that. I think we have said quite during the Analyst Day that our ARPU is pretty consistent around $50. It hasn't changed since 2 years ago. So we expect that during this phase of user acquisition, our ARPU would stay the same. And from a churn rate perspective, as we said, for those customers who have renewed after the first year, the churn rate is actually lower than the industry average. Our churn rate for those who have renewed for the first year, getting to the second year then from here on out, the churn rate is less than 15%. I think we talked about that last time on the Analyst Day. Thank you for joining us today. I'm very pleased by our execution this quarter where our results have demonstrated our high-end premium products and services are resilient and holding up against the broader retail market and inventory compression headwind. It's clear, our commitment to innovation and investments in building a market-leading portfolio of products are paying off. While we are still facing SMB channel inventory compression and a high interest rate environment in the short term, the top and bottom line expansion potential of our premium CHP products, Armor security service, and Pro AV switches is clear. NETGEAR is well positioned ahead of the imminent WiFi 7 upgrade cycle with two WiFi 7 products already shipping and many more to come, giving us confidence in our ability to deliver even greater revenue and margin expansion and improved predictability in our business as we close out 2023 and enter 2024. I look forward to sharing an update on our progress at our Analyst Day on December 7. We look forward to seeing you all. Thank you.

This concludes today's conference call. Thank you for your participation and you may now disconnect.