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NETGEAR, Inc. (NASDAQ:NTGR)

Q4 2008 Earnings Call

February 12, 2009 5:00 pm ET

Executives

Joseph Villalta – Investor Relations, The Ruth Group

Patrick C. S. Lo – Chairman and Chief Executive Officer

Christine M. Gorjanc – Chief Financial Officer

Analysts

Maynard Um - UBS

Samuel Wilson - JMP Securities

[Jeff Scoval] – Barclays Capital

Hamed Khorsand - BWS Financial

Ryan Hutchinson - Lazard Capital Markets

Rohit Chopra - Wedbush Morgan Securities Inc.

[Stanley Coldler] – Bank of America Securities

Operator

Greeting and welcome to the NETGEAR, Inc. fourth quarter and full year 2008 conference call. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Joseph Villalta of The Ruth Group. Thank you, Mr. Villalta. You may now begin.

Joseph Villalta

Thank you. Good afternoon and welcome to NETGEAR’s fourth quarter and full year 2008 results call. Joining us from the company are Patrick Lo, Chairman and CEO and Christy Gorjanc, CFO.

The format of the call will be a brief business review by Patrick followed by Christy 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 Ruth Group at 646-536-7026 or you can go to NETGEAR’s corporate website at www.netgear.com.

Before we begin the formal remarks the company’s attorneys advise that today’s conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words anticipate, expect, believe, will, may, should, estimate, project, outlook, forecast or other similar words are used to identify such forward-looking statements. However, the absence of these words does not mean that 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 statements were made and include statements among others regarding 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; the possibility that NETGEAR may repurchase its shares under the repurchase program; our position in the market relative to our competition; the long term future of NETGEAR’s business; our continued success in the SMB market; our ability to innovate; anticipated new product offerings; current and future demand for the company’s existing and anticipated new products; willingness of consumers to purchase and use the company’s products; and ability to increase distribution and market share for the company’s products domestically and worldwide.

These statements are based on management’s current expectations and are subject to certain risks and uncertainties including without limitation the following, future and are subject to certain risks and uncertainties; future demand for the company’s products may be lower than anticipated; consumers may choose not to adapt the company’s new product offerings or adopt competing products; product performance may be adversely affected by real world operating conditions; the company may be unsuccessful or experience adversely [react] affected by real world operation conditions; delays in manufacturing; 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 costs of developing new products; and manufacturing and distribution of its existing offerings; channel inventory information reported is estimated based on an average number of weeks of inventory and on hand of 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; developments in the business that could increase the company’s cash needs; and fluctuations in foreign exchange rates.

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 forward-looking statements. Further information on the 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 2, Item 1A, Risk Factors”, pages 31 through 44 in the company’s quarterly report on Form 10-Q, quarterly period ended September 28, 2008 filed with the Securities and Exchange Commission on November 7, 2008.

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

At this time I would now like to turn the call over to Patrick Lo. Please go ahead sir.

Patrick C. S. Lo

Thank you Joseph and thank you everyone for joining today’s call. As we entered the global recession, Q4 became a challenging quarter characterized by declines in end market demand and negative foreign exchange trends. Fourth quarter profit and revenue were heavily weighted down by rapid declines in foreign currencies against the U.S. dollar; 13% in the British pound; 10% in the euro; and 17% in the Australian dollar.

During the quarter we experienced a foreign exchange loss of $6.6 million on the re-measurement of our net assets primarily related to accounts receivable and cash, denominated in foreign currencies. We achieved net revenue of $161.4 million in line with our initial guidance. Given the current economic environment we are embarking on a cost reduction effort with the aim of cutting $10 million of operating expenses in 2009 when compared to the Q4 2008 run rate.

Our North America net revenue was $68.8 million in Q4 2008 while Europe, the Middle East and Africa or EMEA net revenue was $76.7 million. And our Asia-Pacific net revenue was $15.8 million. Comparing to Q4 of 2007, our North America revenue was relatively flat, EMEA net revenue decreased by 28% while Asia-Pacific revenue was also down about 27%.

We saw slightly weaker consumer demand in Q4 versus Q3. We experienced a sharper decline in shipment of our SMB products with the exception of our ReadyNAS Network Storage. As anticipated, we saw some reduction in channel inventory and would believe such reduction would accelerate in the first quarter of 2009 in preparation for a seasonally weak Q2.

In late December we closed the $14 million asset acquisition of CP Secure, a leading provider of integrated security appliances that protect organizations and businesses from Internet oriented, originated web and email malware threats and viruses. With this acquisition not only are we entering a $800 million a year market, we are further solidifying our place in the SMB market by insuring that our customers business networks, which consist of our routers, switches, network storage and WiFi equipment, are protected from Internet threats of malware and viruses.

We believe our end-to-end networking solutions strategically position us as a top vendor with our target SMB customers and value added resale base. During the quarter we also made a $10 million earn out payment in connection with a 2007 acquisition of Infrant Technologies which provides the platform for our ReadyNAS Network Storage.

We introduced an additional 12 new products in the fourth quarter, making a total of 48 new products for 2008. Notable introductions include a 3G Mobile WiFi Router, DOCSIS 3.0 Cable Modem, ReadyNAS Pioneer Edition and a 48-port Advanced Smart Switch. Our leadership in home and small-medium business products continued to be recognized by the industry and our customers. Among accolades we received the January, 2009 CES Best Innovation Award in the Home Networking Category for our new Gigabit Dual Band 11n Router.

Computer Reseller News Magazine also awarded us the 2008 Storage Product of the Year for our ReadyNAS Pro. Also yesterday we learned that small-medium business customers selected our ReadyNAS as the storage product of the year in the Small Business Computing Magazine 2008 Survey.

In Q4 our net revenue from service providers accounted for approximately 18% of net revenue as compared to 18% of total net revenue in the first quarter of 2008 and 23% in the fourth quarter of 2007. Despite the current challenging macroeconomic environment we believe our cost control measures, coupled with our ongoing strategy of leading in differentiated product introductions combined with new channel and market expansion will continue to keep us ahead of our competition.

On the innovation front we are stepping up on our new product introduction pipeline especially on the WiFi Draft 11n products; DOCSIS 3.0 Cable Gateway; ProSecure Security Appliances; Advanced Smart Switches; and the ReadyNAS Pro Series.

Our products in these categories carry distinct technology differentiation such as the [method] material antenna for our routers and gateways for better wireless range; the Stream Scanning and Active Profiling technology for malware for our security appliances for faster detection of viruses and malware; the high-speed redundant True Stacking for our Advanced Smart Switches for easier and cheaper local area network expansion; and superior speed and x-rayed, too, for easier and more secure data expansion and protection for our ReadyNAS Pro.

Looking ahead we will continue to expand our retail footprint as we did in 2008 with the additional Wal-Mart stores in the U.S. By the end of 2008 our products were sold through close to 29,000 retail outlets around the world. Our value added reseller base continues to grow especially with new ones joining us for our ReadyNAS Network Storage and Pro Secure Security Appliances. We currently have about 40,000 [that] are value added reseller partners globally.

We added TV Cabo in Portugal, [DANTE] Telecom in France and Cablemas in Mexico as major new service provider customers in 2008. We believe we will continue to add new service provider customers in 2009. We believe we are making good progress in further penetrating China and India and have had a great initial push into Brazil in 2008. We expect to start making some inroads in Russia in 2009.

In the coming year we expect to forge ahead in the face of continued macroeconomic headwinds. We believe we are better positioned than our competitors given that we continued to gain market share in the past year despite weak market demand. We strongly believe that growth will resume, hopefully in the not too distant future, because of the low penetration rate of broadband in developing countries and the continuous proliferation of broadband applications such as [VoIP] video communications and entertainment over the Internet in the developed world.

Once growth resumes, we are confident that we will emerge even stronger thanks to our unrivaled product pipeline, global channel coverage, worldwide brand recognition and strong balance sheet. We are confident that we will continue to win against our competition and gain market share going forward.

Let me now turn the call over to Christine for details on our financials.

Christine M. Gorjanc

Thank you Patrick. Let me now provide you with a summary of the financials for Q4. As Patrick just noted net revenue for the fourth quarter ended December 31, 2008 was $161.4 million as compared to $198.3 million for the fourth quarter ended December 31, 2007 and $179.4 million in the third quarter ended September 28, 2008.

On a constant currency basis, revenue would have increased by $5 million and operating profits would have benefited by $3 million. In addition to foreign currency fluctuations, our operating margin was also negatively impacted by an unfavorable shift in product mix. We shipped about 4.25 million units in the fourth quarter including 3 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined in the fourth quarter were about 2.15 million units.

Moving to the product category basis, the fourth quarter net revenue split between wireless and wired was about 58% and 42% respectively. The fourth quarter net revenue split between home and small business products was about 59% and 41%. Products introduced in the last 15 months constituted about 36% of our fourth quarter shipments, while products introduced in the last 12 months constituted about 32% of our fourth quarter shipments.

Non-GAAP gross margin in the fourth quarter of 2008 was 31.2% as compared to 32.4% on the year ago comparable quarter and 35.5% in the third quarter of 2008. Moving to non-GAAP operating expenses, total non-GAAP operating expenses which exclude in process research and development, litigation reserves, restructuring charges, acquisition related compensation as well as non-cash stock-based compensation costs came in at $41.4 million for the fourth quarter of 2008. This compares to non-GAAP operating expenses of $42.8 million in the fourth quarter of 2007 and $43.7 million in the third quarter of 2008.

Q4 2008 operating expenses represented 25.6% of net revenue. This increase as compared to the fourth quarter of 2007 is primarily due to lower revenue levels. To counteract the negative effect of the rising U.S. dollar we are gradually raising retail and distribution local currency prices and lowering the U.S. dollar buying costs for products over the next few quarters. We are also renegotiating higher local currency pricing for service provider sales contracts once they expire in the coming quarters.

Non-GAAP sales and marketing expenses were $26.4 million. As a percentage of net revenue sales and marketing expenses were 16.4% in Q4 of ’08 as compared to 15.4% in Q4 of 2007 and 16.4% in Q3 of 2008. Non-GAAP R&D expenses were $7.4 million. This represents 4.6% of net revenue in Q4 of 2008 as compared to 3.2% in Q4 of 2007 and 4.1% in Q3 of 2008.

Non-GAAP G&A expenses in the fourth quarter were $7.6 million or 4.7% of net revenues compared to 2.9% in the year ago period and 3.9% in the third quarter of 2008.

Operating income on a GAAP basis was $1.2 million which includes $3 million in charges for in process research and development; amortization of purchased intangibles; and acquisition related compensation; $575 thousand in litigation reserves; restructuring costs related to certain reorganization activities of $964 thousand; impairment of certain long lived assets of $609 thousand; as well as non-cash stock-based compensation of $2.7 million. This compares to GAAP operating income of $17.9 million in the year ago fourth quarter and $14.7 million in the third quarter of 2008.

On a GAAP basis the company recorded a net loss of $7.7 million or $0.22 per diluted share for the fourth quarter of 2008 compared to net income of $12.5 million or $0.35 per diluted share for the fourth quarter of 2007 and $3.1 million or $0.09 per diluted share in the third quarter of 2008.

On a non-GAAP basis the company experienced a net loss of $2.9 million for the fourth quarter of 2008 as compared to non-GAAP net income of $14.8 million for the fourth quarter of 2007; a non-GAAP net income of $6.9 million for the third quarter of 2008. Non-GAAP net loss was $0.08 per diluted share in the fourth quarter 2008 compared to net income of $0.41 per diluted share in the fourth quarter of 2007 and $0.19 for the third quarter of 2008. For calculating earnings per share we used a fully diluted stock count of 35 million shares for Q4 versus 35.7 million shares for the prior quarter and 36.1 million shares for Q4 2007.

In Q4 2008 there was a currency loss of $6.6 million compared to a gain of $146 thousand in Q4 of 2007 and a loss of about $4.7 million in the prior quarter. Non-GAAP tax expense was $6.2 million in the fourth quarter of 2008 compared to $8.8 million in the prior year fourth quarter and $9.4 million in the third quarter of 2008.

I would like to make a comment on our Q4 tax expense. Because our tax expense is a function of the various taxing jurisdictions in which we operate, changes in local country profitability can significantly affect the tax expense. Our tax expense reflects the fact that international profits decreased significantly due to the strong U.S. dollar in the second half of 2008 and profits were weighted more towards the U.S. A reconciliation of GAAP to non-GAAP is detailed in our financial statement that was released earlier today.

Moving on to the balance sheet we ended the fourth quarter with $203 million in cash, cash equivalents and short term investments compared to a total of $202.2 million at the end of the third quarter and $205.3 million at the end of the fourth quarter 2007. Please note that this number reflects the $14 million we paid for the acquisition of CP Secure, the $10 million earn out payment for the Infrant Technology acquisition, and approximately $12 million for our stock repurchase program, all of which took place in the fourth quarter from a cash perspective.

In terms of inventory trends, we ended the fourth quarter 2008 with inventory of $112.2 million with inventory turns of 4 compared to 6.5 turns at the end of the fourth quarter 2007 and compared to 3.7 turns at the end of the third quarter 2008. We expect our ending inventory to improve further in Q1 and beyond.

Day sales outstanding were 81 in the fourth quarter of 2008 compared to 73 days in the fourth quarter of 2007 and 76 days ended third quarter 2008. Total assets were approximately $585.9 million at the end of the fourth quarter 2008 compared to $551.1 million at the end of the fourth quarter 2007 and $602.4 million at the end of the third quarter 2008.

Deferred revenue increased to $21.5 million as compared to $13.3 million at the end of the prior quarter and $7.6 million at the end of the fourth quarter 2007. Given the current economic environment, we have converted some customers to a cash basis revenue model which in turn increased our deferred revenue balance.

Now I would like to discuss the company’s common stock repurchase program. During the fourth quarter of 2008, the company repurchased approximately 1.2 million shares of our common stock at a total cost of approximately $12 million or at an average repurchase price of approximately $10.29 per share.

In light of the current economic challenges, we anticipate a slight decline in customer demand during Q1 with the SMB market remaining steady. Despite the slight decline in end user demands, we do anticipate an acceleration of reduction of channel inventories ahead of the seasonally weak second quarter, thus negatively affecting our net revenue.

In addition, we foresee further erosion of our gross and operating margins due to our foreign currency business exposure which will not begin to see a rebound until the second quarter of 2009 when both our local currency pricing and our lower product costs will catch up with the strengthening of the U.S. dollar. Additionally, we would expect our new products to have meaningful margin impact by then.

In order to counteract such significant economic fallout, we are taking immediate action to reduce our cost structure and improve our operating margins going forward. As such we will reduce the variable components of employee compensation; cut the base compensation of executives by 10%; forego bonuses for all executives and eligible employees; reduce IT and facilities costs; as well as reduce headcount through natural attrition. We are targeting a $10 million reduction in operating expenses on an annualized basis in 2009.

With these efforts in place, as well as a healthy balance sheet, we believe we will successfully weather the storm. We will continue to win over more channel partners, customers and market share during this downturn and will emerge stronger once economic growth returns.

Specifically, we expect our first quarter net revenue to be in the range of approximately $135 million to $145 million with non-GAAP operating margin in the range of 0% to 3%. Operator that concludes our comments. We can now take questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Maynard Um – UBS.

Maynard Um – UBS

Question on the reduction in inventory by distribution and retailers, in terms of impacting the revenue does that presume when we look at Q2 you should see a sequential increase in revenue as the inventories level out or do you think the market weakness will continue into the second quarter? And then just related to that can you just talk about what you think the new levels of appropriate weeks of inventory are by region and channel? Thanks.

Patrick C. S. Lo

We do believe that most of the channel inventory reduction will be accomplished in Q1 so in Q2 our net revenue will be a truer reflection of the real end market demand. So it’s hard to predict what Q2 is going to be, seasonally Q2 from a market demand perspective is slightly less than Q1. So we will update everybody in the next earnings call that what our Q2 net revenue will be, but certainly we intend to get most of the channel inventory reduction in Q1.

Maynard Um – UBS

And then just on the appropriate weeks of inventory levels by region and channel?

Patrick C. S. Lo

We always would like to drive to around between four to five weeks of distribution channel inventory and between eight to ten weeks in the retail channel inventory. However, we do see that our channel partners would like to drive below that.

Operator

Your next question comes from Samuel Wilson - JMP Securities.

Samuel Wilson - JMP Securities

I didn’t hear, what was cash from operations and CapEx for the quarter?

Christine M. Gorjanc

CapEx for the quarter was $1.6 million and cash flow for Q4 was $38.4 million.

Samuel Wilson - JMP Securities

Given your current sort of what’s going on, do you think you’ll be cash flow positive in the first quarter?

Christine M. Gorjanc

We’re typically cash flow positive in the first quarter. We definitely will be generating cash during the year. There’s a little dependency on that, but typically Q4 and Q1 are good cash flow quarters for us.

Samuel Wilson - JMP Securities

And did you say headcount?

Christine M. Gorjanc

Headcount was 579 at the end of the year and that did include our recent acquisition of CP Secure in late December.

Samuel Wilson - JMP Securities

Patrick, for the fourth quarter give us your gut feeling here on the delta between sell-in and sell through or sell-out from the channel as they’re taking down inventory. How big do you think the difference was?

Patrick C. S. Lo

Well, you know we believe that the difference is quite big. It’s to the tune of about in the mid-teen of millions. But it’s not done yet.

Samuel Wilson - JMP Securities

Can you give us a sense of what’s going on in Europe in general with your products and maybe if you have any update on the UK where you’ve traditionally been very strong?

Patrick C. S. Lo

UK is in a free fall even though that I mean we did not lose any market share over there and to any great extent, the UK market from a British pound basis and based on our market report has dropped 33% on a year-to-year basis. But then on a U.S. dollar basis it’s like almost like 60% so UK clearly is the driving factor for our European business. As a matter of fact if we take the UK market out, the rest of Europe was pretty much flat for us, year-over-year.

Samuel Wilson - JMP Securities

Your gut feeling, the free fall – is it going to stop in the next couple of quarters or do you think this is an ongoing thing or you just don’t know?

Patrick C. S. Lo

I just don’t know. I wish that I know but because it has fallen so much that the number’s getting so small that the impact to the rest of the European business is getting smaller.

Samuel Wilson - JMP Securities

Inventory levels on your balance sheet, the boat traffic and what you’re doing there and the fact that oil’s come down and airlines, just where does the company stand right now on how much inventory it wants to carry on its balance sheet? And how is it moving inventory around the world right now?

Patrick C. S. Lo

Well, basically, you know because of the accounting right all deferred revenue is carried as inventory as well. So if you take – those are actually not on our hands. They’re actually in customers hands. But we because we registered it as deferred revenue we always have to carry it as inventory as well. Now if you take that out, you know our ideal inventory turn will be in the between 6 to 7 turns. I mean that’s what we would like it to be. So we’re working on two fronts. First we would like to bring the deferred revenue down. And secondly we would also like to bring our own inventory down.

So combined with some deferred revenue because in the normal operation of a business we always carry something like between $10, $12 million deferred revenue, with that on the balance sheet anywhere between 5.5 to 6 turns of inventory will be satisfactory.

Samuel Wilson - JMP Securities

HP, Tech Data, Cisco, everybody’s announcing some sort of channel [bar] financing program, are you going to do anything there number one? And number two, just in general with 40 thousand bars in a lot of retailers, how are you dealing with the credit quality issues of your customers right now? I mean, how are you kind of keeping yourself from getting caught holding the bag?

Patrick C. S. Lo

Well, we are super conservative. I think you’ve brought up a good point. The lucky thing about our broad base is our bars are generally much smaller scale than the bars at HP and Cisco are facing with. So in a way we’re spreading our risk. Any particular bars you know the average purchase from our distribution is relatively small.

So our distributors have been able to shoulder off all that credit risk on our behalf because they know that our business is spread over so many number of bars. So as such we just do not see that there is significant impact because of the credit availability to our bars and the ability to buy our products, because you know the average purchase from our bars on a monthly basis we’re talking about a few hundred dollars. We’re not talking about even a few thousand dollars. They can finance it and actually most of our bars would finance it through credit cards.

So we’re not worried about that. In terms of those bigger customers such as our service provider customers as well as our retailers, you bet – I mean we’re watching very carefully on all the S&P, Moody’s report and we’re also watching the CDS market on the debt as well. And you know we will react almost in real time with the movement of the CDS. And sometimes you know we always have the conservative approach that we’d rather minimize our credit risk than try to stick our heads out and really try to get a few million dollars of revenue.

That strategy has proven to be working with the fact that we did not lose any money with Circuit City and we are not going to have any impact on Charters Communication which announced today that they are about to file Chapter 11. So I think the credit watch procedure that we have put in place has served us well and will continue to do so.

Operator

Your next question comes from [Jeff Scoval] – Barclays Capital.

Jeff Scoval – Barclays Capital

Patrick, I was wondering if you could spend a little more time talking about the effects of the foreign currency contracts. To what extent are they going to be fully rolled off in the second quarter? Will they linger into the third? And to what extent the next time around might you be able to insulate yourself should currencies move around a bit?

Christine M. Gorjanc

All right, let me answer that for you. At the moment what we’re doing is what we would call FAS 52 balance sheet hedging so we’re hedging our receivables and our cash and basically the balance sheet against the re-measurement every quarter. We are now looking into certain contracts to decide if we’re going to hedge what we call on the revenue side. And we – as on both sides on the balance sheet and that we would layer them out over the next anywhere from three to six months, based on when we expect to collect the money or invoice the customer.

So we’re working on – we’ve implemented the hedging program and then we will continually modify it as the need to the business demand that or you know given what we’re seeing out there.

Patrick C. S. Lo

Fair to say that you know for the next two quarters we hope, you know, we would be able to minimize all those foreign exchange gain and loss on the re-measurement of our accounts receivable and cash. So those $4.7 million, $6.6 million of exchange loss would be significantly smaller. But that’s outside of operational revenue. However, we have not started the hedging on the revenue side which to be fair to say for the next two quarters was too very exposed to currency fluctuation on the revenue side.

So any significant volatility either way will have significant impact on both our top and bottom line for the next two quarters.

Jeff Scoval – Barclays Capital

And then by the September quarter the revenue hedging will be in place then? Is that fair?

Patrick C. S. Lo

That’s what we hope so. Unless the whole world stabilizes, that makes it irrelevant.

Operator

Your next question comes from Hamed Khorsand - BWS Financial.

Hamed Khorsand - BWS Financial

I’m trying to understand what’s going on with the gross margin this past quarter where you guys had an unfavorable mix. Could you explain what that unfavorable mix was?

Patrick C. S. Lo

Well, if we dissect the numbers that we just sent out a little bit, you will find out that in the Q4 shipments the significant decline compared to Q3 was the SMB products. That was a little bit unexpected. We did not anticipate that. So the mix of less SMB and higher consumer was the one that really tipped us on the gross margin side.

And then overall because the currency was moving against us that also depressed our U.S. dollar revenue and that also hurt our gross margin. So those are the two major issues.

Hamed Khorsand - BWS Financial

It’s been now two consecutive quarters where service provider revenue was under 20%, do you have any insight as to where inventory levels stand in the channel as for the service providers?

Patrick C. S. Lo

No, actually unfortunately because the service provider revenue is mimicking the kind of split of the general business, which is more than – you know close to 60% or more of our revenue for service providers is international. However, that’s all in local currency. Unlike our international [nor] service provider revenue a lot of it is still in U.S. dollars, the service provider revenue outside of U.S. are all in local currency. And when you have a rate of decline of currency against the U.S. dollars to the tune of about 13% in a quarter that clearly hurts our service provider revenue overall.

Hamed Khorsand - BWS Financial

On the revenue guidance you provided for Q1 what is your assumption as to the mix? What are you expecting from the consumer SMB side of the business?

Patrick C. S. Lo

You know we believe that it will be pretty steady composition across all three areas; consumer, SMB and service providers.

Operator

Your next question comes from Ryan Hutchinson - Lazard Capital Markets.

Ryan Hutchinson - Lazard Capital Markets

So on the currency loss, what are the expectations specifically for Q1? You said significantly smaller but just for modeling purposes I know it’s not going to be 6.5 or 4.6 but to the tune of 1 to 2 or?

Christine M. Gorjanc

Well, I would say when we estimate it we estimate in for the quarter at 0 but that would mean we had perfect hedging. We think it will be much smaller than the normal range of what we used to have in the past. So we’re basically hedging our biggest currencies and we – you know, every month layering them out. So we don’t expect a big gain or loss. It might be a gain, it might be a loss.

Ryan Hutchinson - Lazard Capital Markets

And then as we think about margin improvements in the second half does that imply both gross margins as well as operating margins?

Patrick C. S. Lo

Yes. We expect that starting from second quarter we will have improvement both in gross margin and operating margin.

Ryan Hutchinson - Lazard Capital Markets

And then on the buyback roughly 4.8 million left, how aggressive should we think you’re going to be here in Q1 specifically as it relates to share count and as that ties into the model?

Christine M. Gorjanc

Well, you know we continue to meet with the board and get directions on that. So we will just be buying back according to what the company decides is good for the company at the time. So we won’t disclose that until the end of Q1.

Ryan Hutchinson - Lazard Capital Markets

And then finally tax rate for the full year?

Christine M. Gorjanc

For 2008?

Ryan Hutchinson - Lazard Capital Markets

No, for 2009.

Christine M. Gorjanc

Two-thousand-and-nine, we’re not guiding the tax rate for the full year because I would have to know what the revenue number is and what countries I was going to make it in for 2009. So we’re not guiding the tax rate.

Operator

Your next question comes from Rohit Chopra - Wedbush Morgan Securities Inc.

Rohit Chopra - Wedbush Morgan Securities Inc.

Christine I think you mentioned there were some actions you were going to take as far as raising prices, especially also as it relates to service providers when contracts are up. How realistic is to think you can increase prices?

Christine M. Gorjanc

Well, I would tell you right now that that’s in progress and that has actually happened in cases. It’s really a matter of when does it go into effect, you know, and at the beginning of what quarter and beginning on what product. So I think we’re having very good success on that and both in the local curren – you know in local jurisdictions where they’re raising their local prices and on our buy price from customers buying from us.

Rohit Chopra - Wedbush Morgan Securities Inc.

And then the other question was related to pricing and promotions. There seem to be a lot of people pushing a lot of product last quarter I guess due to inventory levels. Should we expect that some of that promotional activity declines as we move over the next couple of quarters? Or does it stay the same? What’s your thoughts there?

Patrick C. S. Lo

Yes, Q4 is usually a heavily promoted quarter and so is January so we really have not seen any significant deviations in Q4 and in January from prior years. So we do not expect that it will be anything different going forward. Q2 is usually a pretty quiet quarter from a promotion standpoint and then Q3 will be back to school. Then Q4 is Thanksgiving and Christmas. We do not anticipate any significant difference this year.

Rohit Chopra - Wedbush Morgan Securities Inc.

So let me just get this straight. Even though you see demand where it is now, I mean, is there any reason to even do the promotions? I mean if demand is there – if there’s no demand for example why would you even do that? Why bother?

Patrick C. S. Lo

There is demand. There is no doubt about it. I mean so as you see probably over this weekend there is a lot of President’s Day sales from all the automobile dealers, clearly, that promotions do incite people to go buy. And as a matter of fact if you do not do any promotions the retailers are not going to [enlist] you. So I think promotions is a normal way of life.

Operator

Your next question comes from [Stanley Coldler] – Bank of America Securities.

Stanley Coldler – Bank of America Securities

First of all I just wanted to confirm that the constant currency margin if you add the amounts that you gave on the call was somewhere around 7% of – if my math is right. And I was also hoping if you could walk us through maybe some of the assumptions that you have for the market in general and Q1 just kind of go back to the inventory a little bit. And just discuss what the sell out forecast might be, give us a sense of that.

Patrick C. S. Lo

I think your math is correct and there’s a little bit of about 7%. In terms of you know the market we believe that Q1 from the market demand standpoint is generally flat to slightly down from Q4 which is what our assumption is. That’s the market demand. However we do believe that there is another significant channel reduction of inventory that is going to be negatively impacting our revenue and that’s why we guide the range from $1.35 to $1.45.

Stanley Coldler – Bank of America Securities

So if we think about the true number going from Q4 to Q1 on the margins you’re really going from about 7% to at the mid-point about 1.5%, that much of a decline?

Patrick C. S. Lo

That’s correct. That’s correct.

Stanley Coldler – Bank of America Securities

So when your gross margins come back especially in the second half how much of that do you think will be attributed to volume? You mentioned some of the other factors.

Patrick C. S. Lo

Well, I mean, your 7% assuming the currency is going to stay at the September level, which of course is not a reality. Since September the currency not only has already gone through the real Q4 level, it actually has gone even further down. All right, imagine the British pound for example in December it was still trading at $1.58 and right now it’s trading at $1.42 and it was traded as low as $1.35. So I don’t think using the 7.2% it’s a fair starting point. So I think using the 5% it’s a fair starting point because that reflects the weighted average exchange rate in Q4. Unfortunately that exchange rate has already gone further worse than for us.

So that’s one area. The other area is that because of the further channel reductions the top line is going to go down from $1.61 to the range of $1.35 to $1.45 and our cost reduction effort will not be as speedy as that. So that also again would have impact on our operating margin. And remember the way that the U.S. tax system is working is that in Q1 we’re pretty much pay our FICA for our employees, so that’s expended – and the 401K as well, that’s an expenditure in Q1.

So all those factors add together. To summarize it for you again the foreign currency further deteriorate from the Q4 level, extra expenses in the employee compensation because of tax, and a further decline in the revenue because of the channel inventory reduction. When you add those three together and that’s why the operating margin would go 5%-ish down further.

Operator

There are no other questions in the queue. I’d like to hand it back over to management for closing comments.

Patrick C. S. Lo

Thank you. So the management team and with everybody in that gear is very confident that we will emerge from this economic recession as a winner because we are stepping up our R&D effort and we’re very confident with all this differentiated products that’s coming out this year. We also believe that our efforts in our cost control will help us to continue to be operationally profitable throughout the year.

Our balance sheet is strong and our customers have been with us knowing that we’re financially strong. And we have been winning customers and we believe that based on the market reports that we have seen we continue to gain share. So when the economic situation turns better, we believe that we will accelerate our growth and accelerate our market share gain. So I look forward to talking with all of you again in the next earnings call and we’ll give you more update on how the market performs at that time. Thank you.

Operator

Ladies and gentlemen this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines at this time.

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Source: NETGEAR, Inc. Q4 2008 Earnings Call Transcript
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