Earnings Call Transcript - NTGR Q1 2020

Operator, Operator

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.

Bryan Murray, CFO

Thank you, Erik. And thank you, everyone, for joining today's call. We are very pleased with our first quarter 2020 results. Our team executed well in a rapidly changing market while working from home for the final few weeks of the quarter. Despite the market demand and distribution logistics disruptions presented by the worldwide COVID-19 pandemic, our team adapted quickly and overachieved on the financial and operational targets we set at the beginning of the quarter for net revenue, operating margin, free cash flow, and channel inventory levels and product mix. Net revenue for the first quarter ended March 29, 2020, was $230 million, above the top end of our guidance range, but down 7.7% year-over-year and down 9.1% on a sequential basis. The decline in revenue year-over-year is primarily due to a reduction in service provider revenue of approximately $11 million. The Q1 '19 period benefited from a pull-forward from certain channel partners in the U.K., ahead of the originally planned Brexit deadline. Revenue came in above guidance, due to exceptionally strong market demand towards the end of the quarter, driven by the massive shift to work from home around the world. This increase in end user demand helped us to adjust our channel inventory level and product mix to become more WiFi 6 centric on the CHP side and Power-over-Ethernet centric on the SMB side. Our non-GAAP operating margin for the first quarter came in at 3.6%, also above the top end of our guidance range, driven largely by the leverage created by our revenue outperformance. For the first quarter of 2020, net revenue for the Americas was $158.2 million, which was up 6.9% year-over-year and down 6.5% on a sequential basis. The seasonal decline in the Americas lessened from the prior year, benefiting from the increased demand created by the work-from-home requirements. EMEA net revenue was $42.1 million, which was down 26% year-over-year and down 16.5% quarter-over-quarter. This was largely due to a difficult year-over-year comparison, as Q1 '19 benefited from increased shipments to our U.K. distribution partners in anticipation of the originally scheduled Brexit deadline. Additionally, service provider net revenue was lower on a year-over-year basis, as our partners awaited the launch of 5G products. Our APAC net revenue was $29.6 million, which is down 32.8% from the prior-year comparable quarter and down 11.2% sequentially. The decline on a year-over-year basis is largely driven by service provider revenue in Australia, as they also are awaiting the launch of 5G products, while sequentially, we faced challenges from COVID-19 in the Greater China region. For the first quarter of 2020, we shipped a total of approximately 3.4 million units, including 2.4 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 1.3 million units for the first quarter of 2020. 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 65% and 35% respectively. Products introduced in the last 15 months constituted about 23% of our first quarter shipments, while products introduced in the last 12 months contributed about 21% 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 release distributed earlier today. The non-GAAP gross margin in the first quarter of 2020 was 29.2%, which was down 410 basis points as compared to 33.3% in the prior-year comparable quarter, and up 130 basis points compared to 27.9% in the fourth quarter of 2019. Gross margin improved as expected in Q1 '20 compared to Q4 '19, as the drag from Section 301 tariffs was largely eliminated. The year-on-year decline in gross margin is partially due to significantly lower shipments of SMB products compared to Q1 '19 when we shipped high volumes into the U.K. market in anticipation of the previously expected Brexit deadline. Total Q1 non-GAAP operating expenses came in at $58.9 million, which is down 2.1% year-over-year and down 0.9% sequentially. As always, we manage our expenses prudently, while also ensuring that the growth portions of our business have the resources that they need to succeed. Our headcount was 797 as of the end of the quarter, down by 12 from the prior quarter. As always, we manage our headcount very tightly, especially in times of economic uncertainty. Our non-GAAP R&D expense for the first quarter was 8.1% of net revenue, as compared to 7.1% of net revenue in the prior-year comparable period and 7.2% of net revenue in the fourth quarter of 2019. R&D is one area where we will continue to commit resources because our leading-edge product introductions are the engine of our future growth and empower us to gain share. Our non-GAAP tax rate was 24.2% in the first quarter of 2020. Looking at the bottom line for Q1, we reported non-GAAP net income of $6.4 million and non-GAAP diluted EPS of $0.21. Turning to the balance sheet, we ended the first quarter of 2020 with $209.7 million in cash and short-term investments, up $14 million from the prior quarter. We successfully reduced our inventory by $54.9 million in the quarter, as we delivered on strong domestic demand and continued to shift the mix towards WiFi 6. In Q1, we generated $29 million in cash flow from operations, which brings our total cash provided from operations over the trailing 12 months to $79.7 million. We used $1.3 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 $9.5 million. We remain confident in our ability to continue to generate cash, and expect we will be able to further increase our cash position during the remainder of 2020. In Q1, we spent $15 million to repurchase approximately 584,000 shares of NETGEAR common stock at an average price of $25.71 per share. Since the start of our repurchase activity in Q4 2013, we have spent $543.7 million to repurchase 15.3 million shares. Our fully diluted share count is approximately 30 million shares as of the end of the first quarter. We recognize the importance of maintaining a strong cash position in a time of uncertainty, and we'll balance our practice of repurchasing shares with our desire to maintain a strong balance sheet. Now, turning to the results of our product segments. The connected home segment, which includes the industry-leading Nighthawk, Orbi, Nighthawk Pro Gaming, and Meural brands, generated net revenue of $164.7 million for the quarter, which is down 2.8% on a year-over-year basis, and down 10.4% sequentially. The year-over-year decline was attributable to lower service provider revenue, mainly in EPAC, which was down approximately $10 million as compared to Q1 '19. This decline offset strong growth in the Americas, where we saw increased demand in both service provider and retail channels compared to the prior year. We again held more than half of the U.S. market share in consumer WiFi, coming in at 51% for the first quarter. The SMB segment generated net revenue of $65.3 million for the first quarter of 2020, which is down 18.1% on a year-over-year basis, and down 5.5% sequentially. As previously mentioned, the European region benefited in Q1 '19 from increased demand in anticipation of the originally scheduled Brexit deadline, while in Q1 '20, the Americas experienced declines with the onset of the pandemic. On the product front, our PoE Plus and Pro AV switching lines continue to perform well in the market. Our market share in switches sold through the U.S. retail channel remained at 53% in Q1. As noted in the press release, given the uncertainty in the global economy brought about by the shutdowns due to the COVID-19 pandemic and its corresponding unpredictable effect on market demand, we feel it is prudent to suspend our practice of giving guidance. Consequently, we are withdrawing the prior revenue and operating margin targets for the full year of 2020 that we gave in November of last year at our Analyst Day.

Patrick Lo, CEO

Thank you, Bryan. First, I would like to start by saying that I'm very proud of and grateful to our team for the adjustment in a difficult environment and how we delivered in the first quarter. We faced considerable execution challenges, such as a shift in channel demand from retail e-commerce, our accelerated product demand, and slower SMB sales, and disruptions to inbound and outbound supply, all while pivoting our workforce to work from home starting in Asia in February, and then on a global basis since early March. Despite these hurdles, I am extremely pleased that the team navigated through this difficult environment to come through for our customers at this enormously disruptive moment. By pivoting our broad set of products to the right channels and mix in an uncertain environment, NETGEAR outperformed a number of key financial metrics, while strengthening our balance sheet. Our connected home business saw double-digit growth in end market demand worldwide towards the end of Q1, as people mobilized for work-from-home mandates. The work-from-home and school-from-home requirements put unprecedented demands on home networks. Families recognized that strong WiFi performance at home is now a necessity, and responded by upgrading their WiFi connections at various price points, according to their financial ability. Also, across both connected home and SMB segments, we saw strong e-commerce growth due to the shuttering of many physical retail stores. The March surge in home WiFi market demand drove performance on the connected home side of the business. However, given the shutdown of non-essential businesses in most markets from mid-March, SMB results came in line, but faced increased headwinds as we exited the quarter. Even in this significantly disrupted market, we saw further signs that each component of our strategy, from capitalizing on technology inflections, to expanding into adjacent markets, to building recurring revenue, helped to propel NETGEAR to advanced share gains, revenue growth, and double-digit operating margin in the long run. Currently, our early involvement in WiFi 6 product leadership is paying dividends; it propelled the North American retail networking market back to growth in January and February, and growth significantly accelerated in March. While we can't be confident how long the home WiFi demand surge will last, we're still seeing double-digit growth at this point in Q2. WiFi 6 accounts for about 25% of our North America router and mesh system market demand in Q1. With more new products and supply, we believe this proportion will increase in Q2 and beyond. We now have three different WiFi 6 Mesh products in the market, with two-pack pricing at $229, $449, and $699 to suit homes of different sizes. Our two major competitors in the market have yet to introduce a single competitive product. We now have six models of WiFi 6 routers, with pricing ranging from $149 to $599, spanning different performance levels. We're excited to ship our first batch of WiFi 6 5G mobile hotspots into the EMEA market towards the end of the quarter. We expect this category to ramp up in the quarters to come and be a meaningful component of our service provider revenue for the rest of the year. We anticipate our service provider revenue will grow 50% sequentially in Q2 due to increased mobile hotspot sales worldwide. Mobile hotspots are now being used by people working from home when they cannot access high-speed wired Internet. Hotspots are also now extensively used by first responders during this pandemic. In addition, the NETGEAR team is doing what they can to help the community by donating hundreds of mobile hotspots to various San Francisco Bay Area school districts for students' use. We are thankful for our partner, AT&T, for providing free data plans to those in need to help their school-from-home efforts. Furthermore, we have recorded progress on driving our recurring revenue stream. We began the quarter with 177,000 paid subscribers, and added a record 51,000 to end with 228,000 paid subscribers. We are off to a great start towards attaining our goal of more than doubling our subscriber base during 2020. In the SMB market, we continue to excel in Power over Ethernet switching, and saw strong growth in unmanaged and Pro AV switches. Clearly, with more home offices being set up by engineers, designers, architects, and other professionals, the demand for our unmanaged switches increases.

Bryan Murray, CFO

I think Patrick touched on a little bit of this. Certainly, the headwinds that we're seeing within the SMB business, we know that's a very profitable business for us. You can look at the differential and contribution margins between the two businesses, and it certainly highlights that. So with the headwinds there, and even though we're seeing upside on the CHP side, the mix is having a significant impact on our overall gross margin, at least as far as we can see today. In terms of the year-over-year gross margin improvement, we did deliver I think about 130 basis points improvements. We'd aimed to do that with the tariffs relenting, based on our manufacturing location move. It would have been stronger, but certainly, as we exited the quarter with the surge in demand and our need to airfreight, we were seeing airfreight rates that were about 2.5 times what we would normally see, given what Patrick said in terms of airspace capacity.

Patrick Lo, CEO

Overall, we expect our SMB revenue to decline 25% sequentially, if IT demand does not revive in Q2. The COVID-19 pandemic has brought about a considerable shift in our business in short order. We are seeing a surge in demand that bolsters the outlook for connected home in both the service provider and retail channels, countered by softness in SMB. The resulting mixed shift, coupled with higher freight costs as we quickly respond to the increased demand on the connected home side, will likely constrain operating margins to Q1 levels in the current quarter. Despite the airfreight rate increasing by 2.5 times recently, we are committed to helping our customers to upgrade their home WiFi performance by expediting the availability of our products across the whole lineup, from WiFi 5 to WiFi 6, from routers to expanders, from cable to 4G, and 5G. We believe by serving our customers well, they will reward us in the future by upgrading their home WiFi to WiFi 6 with us and be more likely to subscribe to our value-added services. We cannot predict how long the surge in demand for WiFi products will last for the work-from-home upgrades or what the demand will look like after it subsides. However, we remain hopeful that a higher bar will have been set. In the next few quarters, we have finite volumes we can deliver to the channels worldwide, as we are limited by supply capacity that is constrained by material availability, factory uptime, and freight capacity. With the shift in demand from retail to online, we expect channel inventory to decline, as channel partners move to more efficient operating structures. While we cannot predict how long the business shutdown will depress the IT demand of our SMB products in Q2, and possibly beyond, we are confident our leadership in WiFi 6, 5G, Power over Ethernet, and Pro AV will position us to be the biggest benefactor after the pandemic subsides, with so many customers experiencing the superior performance and availability of our products worldwide during these difficult times. And finally, on behalf of the entire NETGEAR team, I would like to show our deepest gratitude to all the medical, first responder, and essential business teams on the frontlines fighting for us and keeping us safe. And with that, I'll open the call up for Q&A.

Adam Tindle, Analyst

Okay, thanks. Good afternoon. I just wanted to maybe start on the connected home segment. Understand not providing guidance, but it does seem like you highlighted a lot of positives in the segment moving forward. Just a two-parter, first on channel inventory, and second on sell-through. In channel inventory, your biggest market in North America, retail, is showing essentially the lowest level in the past decade. I think it's four weeks below that normal 10 to 12-week range. I guess, maybe first, how are you thinking about channel inventory right now? Is there a certain number of weeks that you're targeting to get this up to? Is that 10 to 12 range permanently changed? Just comments on channel inventory. And then secondly, it also seems like demand indicators like search trends remain very favorable, and sell-through should be very strong in Q2. What do current sell-through indicators look like for you, and how have they trended? Do you think you’re past the peak?

Patrick Lo, CEO

We believe that the pandemic and the shift to remote work have permanently changed the channel landscape. More of our channel partners are moving online, which requires less inventory. Some physical stores are successfully transitioning to online markets and offering curbside pickup, allowing them to manage their inventory more efficiently. Therefore, we expect that overall retail channel inventory will decline. Specifically for Q2, we continue to see strong demand for consumer WiFi home networks worldwide, with double-digit sell-through rates, which further helps reduce channel inventory. However, we do have limitations on the volume we can produce and move in Q2.

Adam Tindle, Analyst

Thank you, Patrick, for the information. I would like to follow up and ask if you could provide an update on the variables related to operating margin improvement for the year. Previously, you mentioned a 240 basis point impact from the expected reduction in tariffs during the first half of the year, along with around 140 basis points from promotional activities. It seems that ASPs in the connected home segment are still strong, but we're now anticipating significant year-over-year declines for Q2. I suspect that the change is mainly due to the SMB segment. Could you please clarify the details regarding the operating margin so that we can better understand the potential upswing when SMB begins to recover? Thank you.

Bryan Murray, CFO

Sure. I think Patrick touched on a little bit of this. Certainly, the headwinds that we're seeing within the SMB business, we know that's a very profitable business for us. You can look at the differential and contribution margins between the two businesses, and it certainly highlights that. So with the headwinds there, and even though we're seeing upside on the CHP side, the mix is having a significant impact on our overall gross margin, at least as far as we can see today. In terms of the year-over-year gross margin improvement, we did deliver I think about 130 basis points improvements. We'd aimed to do that with the tariffs relenting, based on our manufacturing location move. It would have been stronger, but certainly, as we exited the quarter with the surge in demand and our need to airfreight, we were seeing airfreight rates that were about 2.5X what we would normally see.

Hamed Khorsand, Analyst

So first off, I just want to ask, how are you managing your receivables and the cash receipts? Are you on top of that as customers are extending payment terms right now?

Bryan Murray, CFO

Yes, we've always been very vigilant in monitoring the credit worthiness of our customers. We do business globally with very well established distribution partners, so we continuously monitor news and information, and right-size credit capacity. But historically speaking, we have not faced any material write-offs of any sorts, and we've dealt with these kind of downturns, starting in 2001, and then again in 2008. So we think we're well prepared to monitor the situation.

Hamed Khorsand, Analyst

Okay, and then as far as just the product categories go, are there any specific products that are seeing the growth, or is it across the spectrum?

Patrick Lo, CEO

Yes, as we just discussed, it's pretty much across the spectrum because it has become apparent to us upgrading WiFi performance at home is across the board in all strata of the economic spectrum. So for those with significant financial needs, clearly they're chasing after WiFi 6, Tri-Band, 12-Stream, Orbi, paying up to $999 for it. We know. But you also have families that, with limited financial headroom, would just opt for a simple upgrade, or for maybe a $20 extender so that they can expand the WiFi signals through the bedrooms. So it's across the spectrum. It's equal.

Hamed Khorsand, Analyst

Okay. And then, lastly, you were talking about not having enough product to meet demand. Is that purely from an airfreight standpoint? Or are you still facing component shortages?

Patrick Lo, CEO

Both. Number one, even if we're willing to pay for the airfreight, we just can't find a plane to fly sometimes. And secondly, the components availability is unpredictable because of the pandemic. For example, Mexico is just on the rising curve of the pandemic situation, and they're putting in shelter-in-place, shutting down some factories, which some of the RF components are manufactured. It just happened in the last few weeks. And then a few weeks back in Malaysia, which was doing the final packaging of some chips, memory chips, they also had this pandemic hit, and they shut down the factories that interrupted supply for a few weeks. So we're constantly fighting these supply challenges. Now, the good thing is our main final assembly factory in Vietnam, Indonesia, and Thailand has been operating at 100%, and then the factories that supply the components from China are back to 100%. So now, it's about the pandemic starting to hit all the other different places that we are still trying to navigate around, and we have no way to predict what's going to happen next.

Hamed Khorsand, Analyst

Are you able to track as far as the customer turnover is concerned with routers, as far as the refresh rate is concerned? Are you able to do that at all?

Patrick Lo, CEO

Not until they sign up to what we call the single sign-on registration service and download our apps. Today, we have increased that to about 25% of our install base. We believe we have a 25 million install base, and about 5.5 million of them have downloaded the apps. Other than that, we have very little exposure of that data for the rest.

Paul Silverstein, Analyst

Thanks, guys. Before I ask my real questions, Patrick, can you tell us what were the WiFi 6 unit shipments during Q1, and what are the total unit shipments to date? Because I recognize Q1 is going to be the big chunk of that, but what were the numbers?

Patrick Lo, CEO

Traditionally, we do not break out by specific shipment numbers. However, the share of WiFi 6 sell-out demand for our products in the end market has grown from 15% towards the later part of last year to 25% in Q1 for our routers and mesh systems. So we're very encouraged by that trend.

Paul Silverstein, Analyst

Okay, now for the questions. I have several to ask, so I hope you don't mind. First, looking at the long-term perspective, if we consider the business segment of small and medium-sized businesses, it’s clear that they have been severely affected globally. The impact of COVID has been especially harsh. As we move past the peak of the crisis, I believe that segment of the enterprise market will not recover quickly. While it will certainly improve from the current situation, it will continue to face challenges for some time, especially with limited resources available for IT spending. What are your expectations for SMB demand from a long-term perspective as businesses begin to resume operations and move beyond the worst effects of the crisis?

Patrick Lo, CEO

I mean, clearly, there is no way to estimate what that's going to look like. Typically, we saw in the small businesses that our major business customers are on the IT side, primarily manufacturing, schools, and local government. Those are our typical customers, as well as engineering departments of startups or major companies. So our experience is that when the activities resume, they should come back. Now, it may not be 100% at the previous level. It will still be pretty close. Schools have to be run. Engineering departments have to continue to develop products, and government still has to be run. Manufacturing is going to resume. And that's why I'm mentioning, on the other hand, we are also benefiting from two new trends that are completely new. One, we've developed it, which is the Pro AV trend, which is completely an adjacent market, which is completely incremental. Because the world is moving more and more to digital video, and the digital video is getting more and more high-res. And we are benefiting from the increase from 1080K to 4K and from 4K to 8K. All that requires AV to be done over IT. And now, as people get a taste of work from home, so even software developers, or UX designers, or architects, kind of figure out, you know what, I don't need to go to the office and all the time, and I could actually work from home. And for most of them, when they work from home, they use very sophisticated PCs, such as the Mac Pro, which is multi-gig. And so, they set up Ethernet networks at home to outfit their home offices. So we do believe that, as is indicated right now, the Pro AV and the home office setup is mitigating part of the IT demand decline. And I think when the pandemic is over, the IT demand will resume for our typical customers. Hopefully, they can return to the prior level. If not, and it will take a longer time to return to a prior level, we believe that our Pro AV, which is completely new and incremental, and the home office, which is not going to go away, is going to more than compensate for that scenario.

Paul Silverstein, Analyst

With respect to the 5G hotspot business, that sounds like a new, exciting opportunity. Can you provide some color? How big is the business at present? What do you expect to do to extend your visibility in that business this year? What did the ASPs look like to the service providers? What's the gross margin associated with it? Any other insight you'd care to provide? That'd be appreciated.

Patrick Lo, CEO

Well, clearly, 5G is the way to go. So the operators from around the world are quickly moving their subscriber base to 5G for a variety of reasons. I think the most important reason is 5G is a significantly more efficient way of delivering data over airwaves. Secondly, it's significantly cheaper to maintain and to upgrade because 5G is more software-oriented than hardware-oriented from the base station from the data routing perspective; so there is an inherent incentive for the operators to move over to 5G. For the end-user, the advantage of 5G clearly is about latency and speed. So the world is moving that way. There's no turning back. And from a data speed perspective, initially, 5G will be significantly more expensive from an ASP standpoint. However, over time, I think it would decline back to the 4G well so that it will become super popular and available to everybody. To give you an idea right now, if you go online to Amazon or our own store, you will see that the highest-performing 4G mobile hotspot is selling at about $329. But the new 5G WiFi 6 mobile hotspot is probably double that. So that's the ASPs. But over time, the two will converge. Our strategy, of course, is to continue to sell whatever the operators want. As I just mentioned during this work-from-home time, there are different people with different financial means, and there is basic demand for both the latest, greatest and most expensive, but there's also quite a good demand for the good value, older technology items. And we'll continue to capitalize on this trend. On the mobile hotspots perspective, nobody has a broad portfolio that we do. And that's why we talk about that our second quarter, we'll be seeing a 50% sequential growth in terms of our service provider revenue, which is now pretty much dominated by mobile hotspots and with a significant boost from the 5G shift. We are pretty confident that this sequential growth will continue in the third quarter as well.

Woo Jin Ho, Analyst

Yes, hi. It's Woo Jin and not Wuhan. Hey, Bryan. Could you give us that wireless node number again, please, if you don't mind?

Bryan Murray, CFO

Wireless nodes. I think it was about 2.4 million.

Woo Jin Ho, Analyst

Given the strength that you had in Q1, and given what you said about what you're thinking about the demand or the pent-up demand for wireless products, is there any concern that you may have frontloaded the year in terms of your wireless sales, and may have had a weakened second half as a result, if we do have a normalized second half?

Patrick Lo, CEO

I mean, it's very difficult to predict. The encouraging thing is that the demand we see has been across the board. That means there are people buying the latest technology, upgrading to WiFi 6. But there are also a lot of people buying the older technology or the 11 AC low-end expander and adapter as well. I think people are doing whatever they can afford to upgrade their WiFi performance at home, which leaves us with a really bigger space for us to upgrade them to WiFi 6 later on. With people getting a taste of what it is like to be at home, doing your movie watching, gaming, working, and getting your home school set up, I think people have realized that WiFi should not be an afterthought. WiFi should be as important as your cell phone. So people are upgrading their cell phones every year or every other year whenever there is a new iPhone out there. And for them, they tend to upgrade their WiFi three years, four years, sometimes even five years. I hope our WiFi upgrade frequency will be able to match their cell phones very quickly. And that's how I look at it. Currently, we finished the first quarter with roughly about $26 million of service provider revenue, which we expect a 50% sequential growth in Q2. We believe that the second half will see a double-digit growth over the first half. All right, thank you, everybody, for today and joining me. Once again, I would like to thank our employees and our partners for the hard work and flexibility during this time. We have delivered a strong start to 2020, and we remain confident that the components of our strategy will be strong contributors to our success this year and beyond. I look forward to updating more on the progress of our strategy with you in the next quarter and beyond. Talk to you soon. Bye-bye.

Operator, Operator

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