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Netgear Inc. (NASDAQ:NTGR)

Q3 2008 Earnings Call

October 23, 2008 5:00 pm ET

Executives

Patrick Lo – Chairman, CEO

Christine Gorjanc - CFO

Analysts

Samuel Wilson – JMP Securities

Maynard Um – UBS

Rohit Chopra – Wedbush Morgan

Hamed Khorsand – BWS Financial

Mark Sue – RBC Capital Markets

Stanley Kovler – Merrill Lynch

Operator

Welcome to the Netgear Inc. third quarter 2008 results conference call. (Operator Instructions)

It is now my pleasure to introduce your host, Joseph Fialto of the Roof Group.

Joseph Fialto

Welcome to Netgear's third quarter 2008 results call. Joining us from the company are Patrick Lo, Chairman and CEO and Christine Gorjanc, CFO. The format of the call will be a brief business review by Patrick, followed by Christine providing detail on the financials. We'll then have time for any questions. If you have not yet received a copy of today's earnings release, please call the Roof Group at 646-536-7026 or go to Netgear's corporate website at www.netgear.com.

Before we begin the formal remarks, the company's attorneys advised us that today's conference call contains forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. The words anticipate, expect, believe, will, may, should, estimates, project, outlook, forecasts or other similar words are used to identify such forward-looking statements.

However, the absence of these words does not mean the statements are not forward-looking. The forward-looking statements represent Netgear Inc.'s expectations or beliefs concerning future events based on information available at the time such events were made and include statements among others about Netgear's expected revenue, earnings, operating income and tax rate on both a GAAP and non-GAAP basis.

The effect of the global economic environment on the company's business, a possibility that Netgear may repurchase its shares under the repurchase program, the belief that the company's stock represents an attractive investment opportunity at current market prices, the long term future of Netgear's business, our controlled success in the S&B market, our ability to innovate and anticipated new product offerings, current and future demand for the company's existing and anticipated new products, willingness of the consumers to purchase and use the company's products and ability to increase distribution and market share for the company's products domestically and world wide.

These statements are based on management's current expectations and are subject to certain risks and uncertainties, including without limitation the following; future demand for the company's products may be lower than anticipated, consumers may choose not to adopt the company's new product offerings or adopt the competing products, product performance may be adversely affected by real world operating conditions, the company may be unsuccessful or experience delays in manufacturing or distributing its new and existing products, telecommunication service providers may choose to slow their deployment of the company's products or utilize competing products, the company may be unable to collect receivables as they become due, the company may fail to manage costs including the cost of developing new products and manufacturing and distribution of its existing offerings, channel information reported is estimated based on the average number of weeks of inventory on hand on the last Saturday of the quarter as reported by certain of Netgear's customers, changes in the level of Netgear's cash resources and the company's planned usage of such resources, changes in the company's stock price and developments in the business that could increase the company's cash needs.

Further, certain forward-looking statements are based on assumptions as to future events that may not prove to be accurate. Therefore, actual outcomes and results may differ materially from what is expected or forecast in such forward-looking statements. Further information on potential risk factors that could affect Netgear and its business are detailed in the company's periodic filings with the SEC including but not limited to those risks and uncertainties listed in the section entitled, "Part Two, Item One A, Risk Factors", pages 28 through 39 in the company's quarterly report on Form 10-Q for the quarterly period ended June 29, 2008 filed with the SEC on August 8, 2008.

Netgear undertakes no obligation to release publicly any revisions to any forward-looking statements contained herein to reflect events or circumstances after the date hereof or to reflect the current events of unanticipated events. In addition, several non-GAAP financial measures will be mentioned on the call. Information relating to the corresponding GAAP measures and reconciliation of the non-GAAP and GAAP measures can be found in our press release and the investor relations site at www.netgear.com.

At this time, I would now like to turn the call over to Patrick Lo.

Patrick Lo

Thank you everyone for joining today's call. This was a challenging quarter for us due to current global economic slow down. Net revenue in Q3 decreased 6% to $179.4 million compared to the year ago period and decreased 12% compared to Q2 this year. The September quarter showed an overall weakness in consumer demand led by the softening of the global economy and tightening in the credit markets.

In light of the recent economic environment, we experienced decline in sales for our consumer products across both retail and service provider channels and in all geographies. The performance of our emerging markets including China, Eastern Europe, the Middle East and Brazil, continues to be strong in Q3.

Specifically our Asian Pacific revenue was about $24 million in Q3, a growth of 22% year over year. Despite the lower than expected revenue, our operating margin remained stable in Q3 due to our continuous efforts in both product and operating cost reductions, healthy sales in smart switches and the reduction in air freight cost requirements as a result of our increased on hand inventory.

Looking forward, we foresee the current market weakness in global financial uncertainties lasting through 2008 and into 2009. In the interim, as we have previously shared with you, we continue to execute our core growth strategy of launching innovative products, expanding upon our current customer base and penetrating new emerging markets.

We also intend to put more resources behind our R&D efforts in order to accelerate new product introductions. Our S&B demand in Q3 held well despite the slowing of the greater macro economic environment. In late September we were very pleased to enter the high growth SMB security appliance market with the signing of a definitive agreement to purchase certain assets of CP Secure, a leading provider of integrated security solutions that protect organizations and businesses from internet originated web and email based malware threats.

With this acquisition we can further strengthen our share in this market by ensuring that our SMB customers are provided with the most innovative solutions to safeguard their networks from internet threats and ensure that overall business continuity.

From the product perspective, our ready network storage and gigabyte switches continues to enjoy strong appeal around the world in Q3. Among the 14 new products introduced in the third quarter, we have launched the superfast Six-Bay Ready/NAS Pro which has seen great success in the market place.

Moreover, we have been pleased to bring our new energy efficient high performance wireless end router and Wireless-N to the market. We foresee a continued transition in the market to high speed, energy efficient products and we believe our complete line of wireless end technology will position us for revenue growth and share gain going forward in this area.

We will continue to introduce additional models of smart switches and Ready/NAS, further consolidating our technology and market share leadership in these two fast growing areas of SMB booking and storage. For Q3, our service revenue was approximately $31.4 million, about 18% of our total revenue as compared to 22% in the year ago quarter, and 27% of the second of 2008.

In Q3, we have over 29,000 retail outlets worldwide. We continue to maintain and extend a reseller base of about 41,000 globally. In the upcoming fourth quarter, we expect continued weakness in retail demand due to the overall softness in the economic environment. We also see further slow down among our service providers customers due to the tight credit market leading to reduction in the CapEx expenses.

However, we are following our successful strategy that we employed last time when the market froze on September 11, 2001. We will continue to invest in innovation, improve operational efficiency, reduce our inventory exposure and focus on generating cash.

We are confident that we will emerge even stronger once economic growth and consumer confidence returns to the global market. At the same time, we remain confident in the company's prospect and we reaffirm that confidence today by announcing that our Board of Directors has authorized a share repurchase program of up to 6 million shares of the company's outstanding common stock, representing approximately 16.9% of our outstanding shares.

After reviewing our current cash needs against our current projected financial performance, the Board has determined that this is an appropriate use of a portion of our net cash balance, but one which will have no effect of the company's core growth strategy which we and the Board remain fully committed to.

I will now turn the call over to Christine for details on our financials.

Christine Gorjanc

Now let me provide you with a summary of the financials for Q3. As Patrick just noted, net revenues for the third quarter ended September 28, 2008 was $179.4 million, a 6% decrease as compared to $191.7 million in the comparable prior quarter and 12% decrease as compared to $204.5 million in the previous quarter.

Net revenue in the third quarter of 2008 by geography was $73.7 million for North America, $81.6 million for the Europe, Middle East and Africa regions and $24 million for the Asia Pacific region. We shipped about $4.3 million units in the third quarter, including $3.2 million of wireless products. Shipments for the wired and wireless routers and gateway combined were about 2.1 million units.

Moving the product category basis, the third quarter net revenues split between wireless and wired was about 55% and 45% respectively. The third quarter net revenue split between homes and small business products was about 56% and 44%. Products introduced in the last 15 months constituted about 34% of our third quarter shipments while products introduced in the last 12 months constituted about 26% of our third quarter shipments.

Non-GAAP growth margins for the third quarter of 2008 was 35.5% as compared to 34% in the year ago comparable quarter and 33.2% in the second quarter of 2008.

Moving to non-GAAP operating expenses, total non-GAAP operating expenses which excludes a facility restructuring charge related to vacating our headquarters facility, litigation reserves and acquisition related retention compensation that was non stock based compensation costs, came in at $33.7 million for the third quarter of 2008. This compares to non-GAAP operating expense of $42.8 million in the third quarter of 2007 and $44.4 million in the second quarter of 2008.

Q3 2008 operating expenses represented 24.4% of net revenue. This represents an increase that's compared with 22.3% in the third quarter of 2007, and 21.7% in the second quarter of 2008.

Non-GAAP sales and marketing expenses were $29.4 million. As a percentage of net revenue, sales and marketing expenses were 16.4% in Q3 of 2008 as compared to 15.5% in Q3 of 2007 and 13.8% in Q2 of 2008.

Non-GAAP R&D expenses were $7.3 million. This represents 4.1% of net revenue in Q3 in 2008 as compared to 3.6% in Q3 of 2007 and 3.5% in Q2 of 2008.

Non-GAAP G&A expenses in the third quarter were $7 million, or 3.9% of net revenue compared to 3.2% in the year ago period and 3.4% in the second quarter of 2008.

Non-GAAP operating profit for the September quarter came in at $19.9 million or 11.1%. Operating income on a GAAP basis, was $14.7 million which includes $1.3 million in charges for amortization of purchased intangibles and acquisition related retention compensation as well as non taxed stock based compensation of $2.9 million, $964,000 in facility restructuring charges and $85,000 in litigation reserves.

This compares to GAAP operating income of $18.5 million in the year ago third quarter and $18.8 million in the second quarter of 2008.

On a GAAP basis, the company recorded net income of $3.1 million or $0.09 per diluted share for the third quarter of 2008 compared to net income of $13.3 million or $0.37 per diluted share in the third quarter of 2007 and $11.1 million or $0.31 per diluted share in the second quarter of 2008.

Net income on a non-GAAP basis for the third quarter of 2008 was $6.9 million as compared to non-GAAP income of $16 million for the third quarter of 2007 and non-GAAP income of $14.5 million for the second quarter of 2008.

Non-GAAP net income was $0.19 per diluted share in the third quarter of 2008 compared to $0.44 per diluted share in the third quarter of 2007 and $0.41 for the second quarter of 2008.

For calculating the earnings per share, we have a fully diluted stock count of 35.7 million shares in Q3 versus 35.8 million shares for the prior quarter and 36 million shares for Q3 2007.

In Q3 of 2008 there was a currency loss of $4.7 million as compared to a gain of $1.7 million in Q3 of 2007 and no currency impact in Q2 of 2008.

The non-GAAP tax rate was 57.7% in the third quarter of 2008 compared to 38.4% in the prior year third quarter and 40.6% in the second quarter of 2008. We had an exceedingly high tax rate in the September quarter due to two reasons; the share of U.S. profits increased in Q3, at the same time we experienced a low than planned share of international profits which was negatively impacted by the strengthening of the U.S. dollar.

This caused a shift in profits to higher tax regions and raised our effective tax rate. Also, the absolute tax expense for the quarter including catch up adjustment for prior quarters is spread over an unexpected lower overall profit amount, thus pushing the tax rate higher.

The reconciliation of GAAP to non-GAAP is detailed within our financial statement released earlier today.

Moving on to the balance sheet, we ended the third quarter with $202.2 million or approximately $5.66 per diluted share in cash, cash equivalents and short term investments compared to a total of $177.2 million at the end of the third quarter of 2007 or approximately $4.93 per diluted share and $186.8 million at the end of the second quarter of 2008 or approximately $5.22 per diluted share.

In terms of inventory trends, we ended the third quarter 2008 with inventory at $125.7 million with ending inventory turns at 3.7 million compared to 6.5 million turns at the end of the third quarter of 2007, and 5.2 turns at the end of the second quarter of 2008. We increased our inventory levels in order to minimize the need for air freight. However, we intend to lower the inventory level in Q4 and bring the inventory turns closer to our normal five to six turns range.

Days sales outstanding were 76 in the third quarter of 2008 compared to 66 days in the third quarter of 2007 and 71 days ended second quarter 2008. This was slightly higher than our historical range of 65 to 75 days.

Total assets were approximately $602.4 million at the end of the third quarter of 2008 compared to $500 million at the end of the third quarter of 2007 and $569.3 million at the end of the second quarter 2008.

Deferred revenue increased to $13.3 million as compared to $4.3 million at the end of the prior quarter and $7.8 million at the end of the third quarter of 2007. We deferred revenue to adhere to customer contractual terms including title passage, delivery and payment terms.

The weakness in consumer demand and the global economic slowdown will continue to test growth in the coming quarters. Despite such market challenges, we are focused on the opportunities in the S&B market which will help us partially offset weaker demand for our consumer products.

The impending closing of the assets of CP Secure will provide us with differentiated technology in the form our new Pro Secure line of security appliances for S&B. We will continue to drive innovation in the S&B market with our smart switches and Ready/NAS products.

For the fourth quarter of 2008, we expect lower than normal consumer demand due to the current global economic slowdown. Specifically, we expect our fourth quarter net revenue to be approximately $155 million to $165 million. We expect non-GAAP operating margins to be in the range of 9.5% to 10.5%.

We can now take any questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Samuel Wilson – JMP Securities.

Samuel Wilson – JMP Securities

I missed head count, cash from operations and CapEx please.

Christine Gorjanc

Head count at the end of the quarter was 568. CapEx $2.2 million, and cash flow from operations $16.8 million.

Samuel Wilson – JMP Securities

You made some comments about inventory. Is that inventory up a little bit because you're air freighting less but you're going to bring it back down? Are you bringing the inventory down because the end customers are ordering less or you're just preparing for them to potentially less in the future? Are there any changes to logistics involved with air freighting now that oil prices have come down or is the plan still more to boat more than you air?

Patrick Lo

We're just trying to bring the inventory turn back to a traditional five to six times, so it's our forecast revenue in that $155 million to $160 million range, then we certainly do not need $127 million of inventory levels. We will bring down the inventory value in order to get our turns back to between five to six, which is a reasonable turn.

Samuel Wilson – JMP Securities

The last time you witnessed this type of poor seasonality was around 2001. On the guidance, is part of it on the $155 million to $160 million down sequential that you're letting the channel or the end customer's burn through channel inventory to bring those levels down? You ship less and therefore do you recognize revenue on selling, that's part of the problem, you need to get channeling inventories down.

Patrick Lo

That's exactly it. When the market is going up then you tend to ship a little bit more than you actually sell to, but when the market demand is going the other way, then you are going to sell a little bit less than what they sell to.

Samuel Wilson – JMP Securities

At some point if it turns, you actually have to rebuild channel inventories.

Patrick Lo

That's correct.

Operator

Your next question comes from Maynard Um – UBS.

Maynard Um – UBS

In this kind of subdued environment, what do you think the overall market which is typically growing at about 15% to 20%, how should we think about or how do you view the overall market growing as we enter next year?

Patrick Lo

All we can say is that this type of trend grand global economic environment which is basically doom and gloom, there's practically no growth in the consumer market. There is still a little bit of growth on the S&B side but if the economic slowdown persists, then we expect that would be pretty much the same. Hopefully we'll see the economic slowdown end pretty soon, within the next quarter or two.

Maynard Um – UBS

As we look into the fourth quarter if your revenue guidance assumes some burning through of inventory, is there any way to look at a normalized revenue run rate just to help us think about in terms of looking into the March quarter?

Patrick Lo

As we mentioned, we forecasted $155 million to $165 million of sell in. That will be slightly below the sell out so we would assume that probably the sell out would be probably $5 million to $10 million above that. That would be the way to look at it. So if you take that into account, then you could probably argue that Q4 is flat from Q3 from the sale through perspective.

Maynard Um – UBS

I'm a little surprised that the S&B market is holding up fairly well. Can you talk about why that market is holding up and whether your guidance assumes that continues into the next quarter?

Patrick Lo

For two reasons, I think we are competing in a few product categories that are still growing. One is network storage which is still growing albeit not as fast as before, and the fact that we are the newcomer and we have been grabbing market share from all the incumbents that help us. The other is smart switches.

Smart switches is a relatively new category that we invented about four years ago so we're still the leader, and that market is growing. That market is actually eating into the market of layer to layer three managed switch which we don't quite compete. So the strengthening of that piece of the market doesn't really hurt us. While the growth of these smart switches really benefits us. That's why we see the S&B side still holding up.

Maynard Um – UBS

Margin guidance against your top line implies some fairly large OpEx savings as the gross margin expansion. Can you talk about where in particular between those lines most of those savings are going to come from?

Patrick Lo

We're going to work on both. We'll work on the gross margin line by further reducing costs of our product as well as our services and we're going to negotiate big time with our freight orders. At the same time we are also holding our own expenses down so we're tackling it from both places.

Operator

Your next question comes from Rohit Chopra – Wedbush Morgan.

Rohit Chopra – Wedbush Morgan

Did Wal-Mart perform to your expectations this quarter?

Patrick Lo

Yes, they continue to perform at a level that is very satisfying.

Rohit Chopra – Wedbush Morgan

Can you talk a little bit about price moves of competitors and do you anticipate another round of price cuts to stimulate any demand as you head into a weaker fourth quarter?

Patrick Lo

We do not believe that under this environment any price move would stimulate any further demand. The fact of the matter is, you only have a group of people with surplus money to either upgrade or lock into a home network and we have been holding our price pretty steady and we have been navigating that in the industry. I think everybody right now believes that we were right. The pricing environment has stabilized.

Rohit Chopra – Wedbush Morgan

On the 11N end adoption, any changes there that you see?

Patrick Lo

No, I think the 11N is right on the path that we predicted. Right now by Christmas as we predicted, the N should be 50% of the market. I think it's heading that way on the retail side and on the source provider side it's still primarily 11G but we expect that by Christmas the same thing will happen, more than 50%, maybe even higher on the service provider side will be on 11N.

Operator

Your next question comes from Hamed Khorsand – BWS Financial.

Hamed Khorsand – BWS Financial

Are service providers reducing inventory on hand or has there been a material slowdown in subscriber additions?

Patrick Lo

It's the same like the retail channels. They're doing both. Actually they have seen a slowing down of subscribers, net new subscriber additions, and because of that, they also want to reduce their inventory as well. Both hit us.

Hamed Khorsand – BWS Financial

Were there any 10% customers in the quarter?

Patrick Lo

Yes, definitely.

Christine Gorjanc

Typically Tech Data and Ingram's and we expect that's still the same.

Operator

Your next question comes from Mark Sue – RBC Capital Markets.

Mark Sue – RBC Capital Markets

Can you help me bridge the gap a little on gross margins? All things considered they were obviously pretty good this quarter, up sequentially and if I look at number of units you said you sold, it was sort of flat from last quarter, so S&P's are down so how do I get to the 200 basis point plus improvement?

Patrick Lo

The gross margin is affected by multiple areas. One is the marketing dollars that we spend in the channel, so that is a reduction of sales. That means the less we spend in the channel for rebates, for promos that would help to boost gross margin. And certainly given the fact that we're not seeing the kind of demand stimulation that is effective in a normal year, we actually cut back on those in channel marketing activities. That's boosting the gross margin.

Secondly, if you notice that there is the shift of the mix towards the S&B side and as we mentioned the last two quarters, that because of the pricing environment on the retail side, the S&B business is getting more profitable compared to the retail side.

When the shift is more towards the S&B, then naturally that will boost up the gross margin as well. So even though the ASB has declined, the gross margin has gone up because of those two reasons, plus we mentioned that we used a lot less air freight, and the overall freight charges actually come down when the price of oil continues to come down.

Mark Sue – RBC Capital Markets

Looking at 4Q guidance and operating margins, is it fair to assume that most lays in sales and marketing?

Patrick Lo

In the fourth quarter there is still a lot of uncertainties that we could not see. For example, the currency move will have a significant impact on our operating margin from the cost perspective as well as from the selling price perspective because we are selling to service providers world wide in local currencies. So if the U.S. dollar continues to strengthen, then margins for those sales will be lower. They will affect our overall operating margin. So that's one area that would change.

Our forecast is still to be aggressive. If we come in at the low end of our range, then because if our fixed cost for people is already there, certainly any improvement we can make on the operating margin. The reverse is true. If the U.S. dollar softens a little bit and if we come in at revenue at the higher end, then our operating margin will be at the high end.

Operator

Your next question comes from Stanley Kovler – Merrill Lynch.

Stanley Kovler – Merrill Lynch

Can you go over some of the logic you started to discuss with the channel inventory. If we're at about $170 million sell through and you're selling in lower amounts, should we assume that the market overall based on the sell through is going to stay flattish or that we might potentially see some growth into Q1 as far as the sell through.

Patrick Lo

Q1 is too early to tell. We do not know how this thing is going to pan out. We're not going to go that far. As far as Q4 is concerned, we believe that as we mentioned, the sell through will be pretty flat from Q3, however, we will see our channel partners across the world reduce their channel inventory. That means that we'll be selling less. That's just the natural behavior of our channel.

Stanley Kovler – Merrill Lynch

Going over the geographic trends, we see Europe was on a dollar basis declined more than any other region. When you think about Q4, should be again assume that Europe declines further? Is that where the weakness is going to be concentrated or is it going to shift over more toward other geographies?

Patrick Lo

I think you're right. The weakness will continue to be concentrated in Europe. The reason being, in Europe that's our number one region and also the proportion of our service provider is selling in local currency. It's also in Europe as well. In local currency, if they decline as much as the U.S., but if the U.S. dollar strengthens that means on the dollar basis it will decline even more.

None of us can predict how the currency is going to go. As we've seen since the last week, the U.S. dollar has been going crazy, so it's hard to predict. I think the general observation is right, that we will see the weakness continue to be in Europe.

Stanley Kovler – Merrill Lynch

On the operating expenses, I missed the point about the mix between the operating expenses, R&D and G&A look like they continue to go up and then you get the savings in sales and marketing?

Patrick Lo

No, if you compare that we have been growing in all three areas in absolute dollars both on a year on year basis. But from a quarter on quarter basis, then you will see that primary growth is in R&D, and that will continue to be the case. We will continue to work on a quarter on quarter decline in the G&A and sales and marketing expenses, but we'll continue to invest on a quarter on quarter growth in R&D.

Operator

Your next question comes from Maynard Um – UBS.

Maynard Um – UBS

Do you think your assets are now appropriately re-measured, or should we expect further losses in the quarter with the U.S. dollar strengthening?

Christine Gorjanc

I can give you what the U.S. dollar has done in October. We don't know how it's all going to end up, but it's definitely gotten stronger.

Maynard Um – UBS

On the tax rate, how should be think about the tax rate in the fourth quarter?

Christine Gorjanc

We're not really going to give guidance on the fourth quarter. The Forex rate has a lot to do with the tax rate and exactly which jurisdiction we earn our money in. I would look on the income statement to the nine month year to date rate.

Operator

There are no further questions. I would like to turn the floor back to management for closing remarks.

Patrick Lo

Thank you very much. Certainly we all know that the market is very challenging to say the least. However, it's not the first time we saw this. We've seen it before and we had a very successful strategy last time, and we believe the same strategy will apply, which is no different that the core of Netgear is being innovative so we will continue to win with innovation. That's why will we continue to invest in R&D, to come out with innovative products that will give us gain in market share as well as in gross margin.

On the other hand, we will also focus on cash generation which will be brought on by our continued control of expenses and well as continuing to work down our inventory exposure. So coupled with innovative products that drive margin up, we believe that when the economic growth returns, we will be stronger and competitive, and will continue to win share from our weaker competitors in the market just like last time.

I will come back and report to you in the next earnings call how our progress is towards those goals.

Thank you very much for joining us today.

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