Netgear, Inc. Q3 FY2024 Earnings Call

Ladies and gentlemen, thank you for your patience. I would now like to hand the conference over to Erik Bylin. Please proceed, sir.

Good afternoon, and thanks for joining the call today. Today marks my 9-month anniversary with NETGEAR, and I'm thrilled with our progress and the speed at which we're executing on our transformation. Our focus remains on creating long-term shareholder value. I'm more confident than ever that we will transform NETGEAR into a growing and higher-margin business, generating increased cash flow that will reward our current shareholders and attract new investors along the way. Today, I will cover the following three topics: first, highlights from Q3; second, an update on our transformation on the heels of our recently completed strategic planning process; and third, our capital allocation plan. Q3 was an excellent quarter. We delivered above the revenue and operating income guidance that we increased in September. We were profitable, and we increased our cash balance by over $100 million through lowering our inventory and successfully defending our intellectual property. There are several factors that contributed to these strong results, and I'll highlight a few. First, we acted aggressively to rebalance the business. After identifying channel stocking issues earlier this year, we implemented a successful destocking plan. That is behind us, and we're now matching sell-in with sell-through, which also brings the benefit of more linearity of our top line. I'm very proud of how the team worked with suppliers and customers to aggressively get this behind us. Second, we're executing. We achieved a $27 million reduction in inventory in Q3 as we march towards our goal of reducing finished goods inventory to three months of supply by the end of the year. This more disciplined approach to inventory is driving improved demand and supply planning execution, and the team is stepping up to the challenge. Third, we are identifying exciting growth opportunities within NETGEAR. Our ProAV business had another record quarter, driven by strong growth in North America and APAC, enabling our overall NFB business to grow top line over 10% year-over-year and to return to historical levels on contribution margin. We increased the number of ProAV manufacturing partners to over 330, further improving the ease of use and reliability of our ProAV solutions. The deep integration we announced with HP Poly for their Poly Studio G62 system is a great example of our continued momentum with this vast and growing ecosystem. We strongly believe that this ProAV business is a gem that we can polish further and use as a driver of long-term revenue growth and cash flow generation. Fourth, we're innovating. We launched several exciting and market-leading products across both businesses this quarter. Our pull-forward launch of the M7 Pro, the industry's first mobile hotspot that combines 5G and WiFi 7 was a key highlight in Q3. We also launched several WiFi 7 home networking products that have been very well received by consumers and align with our strategy of expanding our addressable market. In fact, for most of the new product introductions, we're struggling to keep up with the demand. Fifth, we are growing recurring revenue. This priority continues to make progress as we implement our strategy of simplifying our subscription offerings across our consumer and B2B businesses. We ended the quarter with approximately 555,000 recurring revenue subscribers, and we saw our recurring revenue grow 22% year-over-year. Finally, we unlocked $100 million of additional cash. Our IP litigation resulted in a large settlement with TP-Link that will also lead to lower G&A expenses given the dismissal of several legal proceedings between us. So, overall, excellent work by our team to deliver such a great quarter. I'm truly enthusiastic about our direction going forward. I'll now shift to my second topic, an update on our longer-term transformation efforts. In the spring of this year, after my global listening tour where I met with employees, customers, partners, and investors from around the world, we kicked off several interconnected work streams to define the future direction of NETGEAR. This ongoing work hit a major milestone earlier in the month and culminated in a new purpose and mission, a new set of values, and three-year strategic plans for each of our businesses. I'll touch on each of these briefly, and we look forward to a more in-depth discussion at an Investor Day we're planning for the first half of next year. NETGEAR's prior purpose and mission was to be the innovative leader in connecting the world to the Internet. This served the company well in the early days of the Internet where new product launches wowed customers with new ways of connecting to the world. Fast forward to today, and this mission has largely been accomplished. Our new purpose that will serve us for the next 30 years is to power extraordinary experiences. We do this today through our role in enabling professional sporting events, rock concerts, powering connectivity for schools in India, and enabling the best-in-class home gaming and streaming experiences. Enabling the extraordinary is our new North Star. Our new mission, which more specifically defines what we will do to realize this purpose, is to unleash the full potential of connectivity with intelligent solutions that delight and protect. Every word in this mission statement was chosen with care, though I'll just elaborate on a couple of critical points. First, intelligent solutions is capturing the importance of the role that software and AI play in delivering delightful experiences to our customers. NETGEAR's legacy is in delivering incredible devices. And as part of our transformation, our focus will be on delivering customer value via software and AI innovations. Second, protect is a critical element of our mission. The cyber world is becoming increasingly unsafe, complex, and the battlefield upon which nation states are waging war, as is evidenced by the various typhoons launched by the PRC against the United States recently. As an independent, U.S.-based, publicly traded company, NETGEAR is incredibly well-positioned to be the trusted connectivity partner to consumers, service providers, and businesses. Delivering on this promise will require us to continue to innovate in the realm of security, so that a core part of our differentiation is the peace of mind we deliver to our customers. Moving on to our new values. We've defined the behaviors that will allow us to transform the business to deliver on our new purpose and mission. There are many great things about NETGEAR's culture that we will preserve, though this transformation will require us to think and act differently and our new values will enable that. We're integrating the new values into everything we do, for example, how we recruit, manage performance, innovate for our customers, and be responsible stewards of the business for our investors. I will save further details of the values for our upcoming Investor Day. On the development of our three-year strategic plans, this was a first-of-its-kind strategic planning process for NETGEAR. Our new VP of Strategy and our teams across the company did an incredible job analyzing the opportunity ahead, and we have clarity in the direction we are taking. I'll share three big takeaways for me coming out of this process. First, I'm more confident than ever that the opportunity I saw before officially stepping into my role is fully achievable. I see a clear path to long-term growth, stronger growth in operating margins, and improved cash flow generation. We have a great foothold to begin with because NETGEAR is a recognized market leader with a brand that is synonymous with high quality and technology innovation across both our consumer and B2B businesses. Second, our near-term plans to get there will involve directing our investments into the businesses that have the highest potential. Many of these opportunities lie on the NFB side, given this business is addressing large markets with significant potential to expand our market share and our recurring revenue businesses. NFB also has the added benefit of having stronger margins and greater profitability. Finally, as we stabilize our consumer business and further invigorate the growth of our NFB businesses, we see a path to growing overall NETGEAR revenue and expanding gross margins in 2025. We have work to do to finalize our 2025 plan. And as I mentioned earlier, we're excited to share more at an Investor Day we are planning for the first half of next year. My last point on our transformation is an update on our team. As I mentioned last quarter, we hired Pramod Badjate to lead our B2B business. Since then, we've hired Eric Law to lead our B2B sales team. Eric has an amazing pedigree with over 25 years of go-to-market experience, mostly at Cisco and Ruckus. We've also onboarded new B2B leaders in product management and user experience and are revamping our sales operations capabilities for our B2B business with the help of a long-time Palo Alto Networks executive. All these executives are joining NETGEAR because they too see the attractive opportunity in front of us. And from NETGEAR's perspective, we expect this investment in human capital to deliver stronger products, incremental market share, and better financial results and cash generation. I'll now turn to our capital allocation plan. Our plan covers three areas: return of capital to shareholders, organic investments in the business, and potentially acquisitions. I'll briefly cover each of these. Since I joined early this year, we completed repurchases of about $10 million of our shares in each of the first two quarters, but we were mostly out of the market in Q3 given the confidential settlement negotiations with TP-Link. With an expanded repurchase authorization and an even stronger cash balance, you can expect us to be active in the market for our stock in Q4 post earnings, including during the restricted period. From an organic investment perspective, as I noted previously, we do plan to invest in our NFB business to further invigorate growth and drive margin expansion via software differentiation and recurring revenue. Some of this investment will be incremental OpEx and some will be pulled from slower growing parts of the business. While our primary focus in 2025 will be on improving the performance of our core businesses, we will be investigating acquisition opportunities that could accelerate our transformation with a focus on our NFB business. The opportunities we could consider include software development capabilities that drive differentiation, margin expansion, and our recurring revenue; product adjacencies that are complementary to our current offering that would allow us to deliver a more integrated customer experience, leverage our brand or capitalize on our distribution footprint; or simply consolidation opportunities that are accretive to earnings. Having completed many acquisitions on both sides of the fence, my bar for M&A is very high, so we'll be extremely selective as we evaluate these opportunities. In closing, I want to thank the teams at NETGEAR for all the incredible work that is happening to delight our customers and deliver on the transformation. We had a great Q3. We've done much of the hard work to define the path forward. We have an amazing start to our transformation, and we're excited about delivering for shareholders as we power extraordinary experiences. I'll now hand it over to Bryan and look forward to your questions during Q&A.

Thank you, CJ, and thank you, everyone, for joining today's call. We are once again pleased with the execution by our team this quarter in delivering both revenue and profitability above our guidance range, including a return to profitability. These outstanding results were driven by higher-than-expected service provider revenue, buoyed by the early launch of our new Nighthawk M7 Pro 5G WiFi 7 mobile hotspot. As a reminder, we took decisive action in the prior quarter to accelerate destocking of the channel to better position both sides of the business for more predictable performance aligned to the market trends and reduce volatility. We have already begun to see the benefits of this plan as evidenced by this quarter's results. We also saw the additional benefit of reduced DSOs, which came in at 88 days, our lowest level in over three years, due to the improved linearity with channel partners needing to maintain their lean inventory positions throughout the quarter. Our more profitable NFB segment performed well against our expectations and once again delivered a record quarter in-market sales of our ProAV managed switch products. In CHP, we saw continued strength in premium products. We made further progress in expanding our product portfolio, addressing other segments of the market, and we were able to pull in the launch of our next-generation M7 Pro mobile hotspot. While the CHP retail market size declined in the third quarter, the decline continued to slow in Q3 compared to earlier in the year. However, we do see the U.S. retail market remaining quite promotional in part due to the holiday period. For the quarter ended September 29, 2024, revenue was $182.9 million, up 27.1% on a sequential basis and down 7.6% year-over-year, above the high end of our guidance. In addition, by continuing to drive down our own inventory by $27 million in Q3 and reaching a settlement with TP-Link, we generated approximately $106 million in free cash flow and ended the quarter with nearly $396 million in cash and short-term investments. After successfully putting the destocking behind us last quarter, we entered Q3 well positioned to match sell-in with sell-through with our channel partners. Consequently, the NFB segment delivered $78.5 million in revenue for the third quarter, up 31.2% sequentially and up 11.4% year-over-year. Led by our ProAV managed switch products, which once again saw end-user demand grow double digits year-over-year, momentum is clearly building behind NFB's growth trajectory, and we also continue to make progress with our strategic manufacturing partnerships. In Q3, the CHP business delivered net revenue of $104.3 million, down 18.1% on a year-over-year basis and up 24.1% sequentially, which benefited from the release of our latest M7 Pro mobile hotspots, which pulled into the quarter because of great execution by our team. Service provider revenue was $22.9 million, above our expectations and boosted by the earlier than originally anticipated launch. We saw our premium mesh products continue to outperform the broader market. Our recently introduced Nighthawk products that broaden our market reach are performing well and receiving warm customer reviews, a testament to the power of our brand and innovative technology. With our additional new product introductions planned for release through 2025, we expect the full benefits of this new strategy to build over time. We exited the third quarter with 555,000 recurring subscribers, and we generated $7.9 million in recurring service revenue in the quarter, a year-over-year increase of 22%. We continue to see increased emphasis placed by consumers on cybersecurity protection, privacy, and premium support. As we noted last quarter, we are confident that the optimal strategy is to grow recurring subscribers, and that is our focus going forward. For the third quarter of 2024, net revenue for the Americas was $127.8 million, a decline of 9.4% year-over-year and up 33.8% on a sequential basis. EMEA net revenue was $32.8 million, a decrease of 8.1% year-over-year and up 19.9% quarter-over-quarter. Our APAC net revenue was $22.3 million, which is up 5.5% from the prior year comparable period and up 6% sequentially. 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 2024 was 31.1%, down 390 basis points compared to 35% in the prior year comparable period and up 870 basis points compared to 22.4% in the second quarter of 2024. This marks the first time this year we have achieved gross margins above 30% as we begin to benefit from an improved mix of NFB products and the impact of aged inventory begins to lessen with our continued progress working down our old inventory. Compared to the prior year period, our profitability was impacted by higher costs of inventory and our use of air freight as we begin to operate at leaner inventory levels. Total Q3 non-GAAP operating expenses came in at $55.3 million, down 13.7% year-over-year and down 12.7% sequentially. Non-GAAP operating expenses were lowered in the quarter by the $10.9 million legal fee adjustment from the TP-Link settlement to offset actual legal expenses incurred in prior quarters. Our headcount was 638 as of the end of the quarter, up from 622 in Q2. We are currently refining our long-term strategy and looking to make investments, primarily in our NFB business. Some of this will be incremental, and some will come from other areas of the business as we shift costs to the areas that will deliver long-term growth and expand profitability. Our non-GAAP R&D expense for the third quarter was 11% of net revenue as compared to 10.1% of net revenue in the prior year comparable period and 13.2% of net revenue in the second quarter of 2024. To continue our technology and product leadership, we are committed to continued investment in R&D. The improved leverage from having the destocking of our channel partners behind us and our new product introductions in the third quarter, combined with the offset of historical legal costs as a result of the TP-Link settlement, enabled us to deliver third quarter non-GAAP operating profit of $1.6 million with an operating margin of 0.9%, above the high end of our guidance range. This was down 180 basis points compared to the year-ago period and up 2,250 basis points compared to the prior quarter. Our non-GAAP tax expense was $17,000 in the third quarter of 2024. Looking at the bottom line for Q3, we reported non-GAAP net income of $5.1 million and non-GAAP diluted earnings per share of $0.17. Turning to the balance sheet. We ended the third quarter of 2024 with $395.7 million in cash and short-term investments, up $101.4 million from the prior quarter and equating to $13.48 per share. The increase is largely due to the cash payment from the TP-Link litigation settlement. However, even excluding the settlement impact, we delivered our fifth consecutive quarter of positive cash generation. We continued to convert our working capital into cash and made significant progress lowering our inventory in the quarter, which declined $27 million sequentially. During the quarter, $107.7 million of cash was provided by operations, which brings our total cash provided by operations over the trailing 12 months to $199.6 million. We used $1.7 million in purchase of property and equipment during the quarter, which brings our total cash used for capital expenditures over the trailing 12 months to $8.7 million. With the better-than-expected reduction of inventory in the third quarter, combined with seasonal terms with certain of our channel partners, we expect that in Q4, we will be in the range of using $10 million of cash to neutral, but still generating cash in the second half of the year even without the benefit of the legal settlement. In Q3, due to trading restrictions, we spent $1.5 million to repurchase approximately 99,000 shares of NETGEAR common stock at an average price of $14.92 per share. We have approximately 3.8 million shares reserved under current authorization. Since the beginning of 2020, we have spent $146.1 million to repurchase 5.8 million shares. We will be resuming our share repurchase program in Q4 during an open window, and we plan to enable opportunistic repurchasing during the restricted period as well. Our fully diluted share count is approximately 29.4 million shares as of the end of the third quarter. Now I'll cover our Q4 2024 outlook. As we experienced in the third quarter, we expect to continue to see more predictable performance that is aligned with the market for both of our businesses. Within NFB, we expect to experience continued growth led by our ProAV line of managed switches. Within CHP, while we're seeing the signs of market recovery, we expect increased promotional activity within our retail business. After the launch of our M7 Pro mobile hotspot in Q3, we expect revenue from the service provider channel to be approximately $20 million in Q4, down slightly on a sequential basis. Accordingly, we expect fourth quarter net revenue to be in the range of $160 million to $175 million. We expect gross margins and operating margins to continue to be impacted by our inventory reduction efforts and higher-than-expected transportation costs due to a variety of factors, including the Red Sea shipping crisis. We also expect increased promotional activities within our CHP retail business due in part to the holiday period. Accordingly, we expect our fourth quarter GAAP operating margin to be in the range of negative 12.4% to negative 9.4%, and non-GAAP operating margin to be in the range of negative 8% to negative 5%. Our GAAP tax benefit is expected to be in the range of $2 million to $3 million, and our non-GAAP tax benefit is expected to be in the range of $0 to $1 million for the fourth quarter of 2024. And with that, we can now open up for questions.

CJ, I wanted to start by congratulating you on the TP-Link settlement and request an update on what might be expected from this. There are still some legislative matters and national security concerns in play. Could you remind investors of the potential impacts and any ongoing issues? Bryan, regarding the TP-Link settlement, could you provide a high-level overview related to the income statement for this quarter, specifically pointing out what are the one-time items we should not expect to recur versus those that are more permanent? I am particularly interested in the non-GAAP gross margin and operating margin. For instance, non-GAAP G&A decreased from 16% to 6%. Will that remain at that level? Please walk us through any one-time items from this quarter compared to those that are more stable.

Adam, I'll address the first part of your question. This is not related to our settlement, but as you mentioned, there is significant government activity concerning networking equipment from foreign adversarial countries. With the election approaching, there is increased focus on cyberattacks involving the People's Republic of China, particularly using botnets supported by home and small business networking equipment. A notable development since our last earnings call is that the Select Committee for China sent a strongly worded letter to the Department of Commerce highlighting what they described as a glaring security issue and a significant national security threat posed by TP-Link. This is concerning because the same group at the Department of Commerce previously banned Kaspersky, the Russian software security firm. We are monitoring this situation closely. There are also other developments concerning the ROUTERS Act, which is addressing similar issues and has passed through the House and is now in the Senate. As we approach the election, it’s likely that progress on these matters will slow down, so we are keen to see what unfolds after next week.

And Adam, to your question on the one-time items that are in the non-GAAP earnings for the quarter with regards to the TP-Link settlement, it's actually fairly straightforward and may be easy to see in the 8-K that we put out there. But effectively, it's really about $11 million as a contra expense item that would have offset G&A in the quarter. And that was a recovery for all the past legal fees. They're all prior period legal fees associated with pursuing those actions against TP-Link. And so, on a normalized basis, you could just add that $11 million back in and get to an established baseline of OpEx.

And I want to talk about the windfall of cash here and, CJ, the capital allocation priorities. I guess I want to pick on the organic investment piece of this first. As we see here based on the Q4 guidance, a more of a normalized quarter. We're not quite at sustainable breakeven on the non-GAAP operating line here in this model just yet. So I want to better understand how you're thinking about potential further investments in the model given the current operating structure of the business and what that would do in time to breakeven on the non-GAAP operating income line.

Yes, that’s a great question. I’d like to reiterate some points from the call, focusing on the overall picture. We experienced strong growth in NFB last quarter, which we’re thrilled about as it presents an opportunity to enhance the business's performance. Overall, we anticipate growth next year and see potential for increasing gross margins. This is partly due to the growing NFB mix and efforts to clear out legacy products, align finished goods inventory with demand, and we hope for some additional benefits if the freight situation improves. Regarding operational expenses, we are carefully examining our spending because we want our investments to largely come from reallocating current expenditures. We do expect to make some additional investments next year, but we don’t anticipate profitability in 2025. We believe we have a clear path to achieve profitability in the future, but we’re not ready to specify which quarter that will occur. I am confident that we will reach that goal, and part of our strategy focuses on positioning ourselves to capture significant growth opportunities, especially in the NFB area.

And on capital allocation, broadly, it was helpful that you outlined the buckets, and this might be a tough question to answer. But if I look at the balance sheet, I think you're at about $400 million of cash. I think you previously alluded to somewhere around $150 million needed to run the business, and wanted to confirm that's still the view. And if so, that leaves us with around $250 million of excess cash here. If we could just understand how you're thinking about the general weighting between those three categories, the share repurchase or returning cash to shareholders, organic investment, and M&A at this point, and just make sure that I'm understanding the excess cash correctly.

Yes, that's a good question. I want to clarify that the $150 million of working capital requirements could increase significantly if there were a substantial regulatory change related to the topics you mentioned earlier. We want to be prepared for that possibility. However, aside from that, our priorities include returning capital to shareholders. We plan to repurchase more shares this quarter compared to the previous few quarters, and this remains a key focus for us. We believe that returning capital to shareholders will be a more significant use of our cash than the organic investments we're considering. Regarding mergers and acquisitions, our top priority is to restore profitable growth and focus on our core businesses. We will review specific opportunities, but those are currently quite uncertain. Our main focus is on turning the business around, and I hope this provides a clearer context.

At this time, there are no further questions. I would now hand today's call back over to CJ Prober, CEO, for closing remarks.

Well, thanks for joining, and we really appreciate the support of our global team partners, customers, and our investors and look forward to continuing the open communication on our transformation. And on that note, Bryan and I we're planning to join Adam at the RJ Conference in New York in December. So whoever is there, we look forward to seeing you.

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