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Netgear Inc. (NASDAQ:NTGR)

Q1 2009 Earnings Call

April 22, 2009 5:00 pm ET

Executives

Joseph Vitalta – Investor Relations, The Ruth Group

Patrick Lo – Chairman, Chief Executive Officer

Christine Gorjanc – Chief Financial Officer.

Analysts

Samuel Wilson – JMP Securities

Maynard Um – UBS

Hamed Khorsand – BWS Financial

Jeff Kvaal – Barclays Capital

Tom Lee – Goldman Sachs

Jonathan Goldberg – Deutsche Bank Securities

Operator

Welcome to the Netgear Inc. first quarter 2009 conference call. (Operator Instructions) It is now my pleasure to introduce your host, Mr. Joseph Vitalta of the Ruth Group.

Joseph Vitalta

Good afternoon and welcome to Netgear's first quarter 2009 results call. Joining us from the company are Mr. Patrick Lo, Chairman and CEO and Mrs. Christine Gorjanc, CFO. The format of the call will be a brief business review by Patrick, followed by Christine providing details on the financials. We'll then have time for any questions.

If you have not yet received a copy of today's earning release, please call the Roots Group at 646-536-7026 or your can go to Netgear's web site at www.netgear.com.

Before we begin the formal remarks, the company's attorney's advise 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, estimate, project, outlook, forecast or other similar words to identify such forward-looking statements. However the absence of these words do not mean the statements are not forward-looking.

Forward-looking statements represent Netgear Inc's expectations and belief concerning future events based on information available at the time such statements were made and include statements among other regarding Netgear's expected revenue, earnings, growth and 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 competitive position in the SMB, our ability to innovate anticipate new product offerings, current and future demand for the company's existing and anticipated new products, willingness of the consumers to purchase and use any of the company's products and an 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 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 offering or adapt competing products, product performance may be adversely affected by real world operating conditions, the company may be unsuccessful or experience delays in manufacturing and distributing 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 fully collect receivables as they become due, the company may fail to manage costs including the cost of developing a new product, and manufacturing and distribution of existing offerings, channel inventory 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, development 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 the results may differ materially from what is expressed 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 1, Item A, risk factors, pages 11 through 26 in the company's annual report on Form 10-K for the fiscal year ended December 31, 2008 filed with the SEC on March 4, 2009.

Netgear undertakes no obligation to release publicly any revision to any forward-looking statements herein to reflect events or circumstances after the date hereof or due to 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 IR site at www.netgear.com.

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

Patrick Lo

Thank you everyone for joining today's call. As expected, Q1 was a challenging quarter characterized by continued declines in market demand, destocking in the channels and a higher average exchange rate of the U.S. dollar compared to previous quarters.

In light of the economic slow down we achieved net revenue of $152 million, a decline from fourth quarter of last year, but above our initial guidance of $135 billion to $145 million. We announced on last quarter's call the implementation of a cost reduction initiative with the aim of reducing operating expenses by $10 million in 2009 as compared to the annualized fourth quarter 2008 run rate.

We have already seen significant cost saving result from our efforts, about $2.6 million in the first quarter of 2009 and we expect to meet our goal of $10 million savings by the end of the year.

Our North American net revenue was $65.2 million in Q1 while Europe, the Middle East and Africa or India, net revenue was $74.2 million and our Asia Pacific net revenue was $12.6 million. Compared to Q1 of 2008, our North America decreased approximately 18%, EMIR net revenue decreased 24% and APEC revenue was down about 39%.

Our EMIR and APEC revenues were particularly hit hard by the appreciation of the U.S. dollar in the later half of 2008 and into Q1 of 2009. For example, in Q1, typically Australia based revenue accounts for the majority of our APEC revenue due to the celebration of the Chinese New Year holidays and the rest of the Asia Pacific region.

In this past quarter, the Australian dollar experienced depreciation of 25% against the U.S. dollar year over year resulting in an APEC revenue decline greater than other geographic regions on a year over year basis.

In the first quarter of 2009 we saw stabilization in our consumer retail sales but an incremental decline in global SMB product sales. We saw a significant reduction in channel inventory in absolute dollars in the first quarter. We expect this reduction to continue in the second quarter.

We introduced an additional 14 new products in the first quarter. Notable introductions include pro secure web email security appliance model 2FT N150 the highest performance desktop network storage for ready net extra. High power hot spots active points service providers and the 50 port 1100 stackable switch.

We are pleased with the results of our continued emphasis on new product R&D. Our leadership in home and small/medium business products continues to be recognized by the industry and our customers. We expect to continue this trend and accelerate our new product introductions in the coming quarters.

In the near terms we're picking up the pace, anticipating 15 or more new product launches by the end of June. With these new product offering, we expect to gain further market share in the second half of 2009 relative to our competitors.

Despite the current challenging macro economic environment, we believe our cost control measures coupled with our ongoing strategy of leading and differentiating product introduction will continue to keep us ahead of our competition.

In the first quarter, our net revenue from service providers accounted for approximately 27% of total net revenue compared to 18% of total net revenue in the fourth quarter of 2008 and 28% in the first quarter of 2008. We were pleased to add Telecom South Africa to our service provider customer list in the first quarter.

Our [inaudible] to accelerate has continued to grow with new ones joining our storage and security appliances. Recently we added over 100 certified pro secured resellers for a web email security appliance world wide. We currently have about 40 certified resellers globally.

We have evidence that market growth will resume in the not too distant future due to the low penetration of broad band in developing countries and the continuous proliferation broad band applications such as voice video communication and entertainment in the world.

I'm convinced that with our product pipeline and world wide channel coverage, and global brand recognition and strong balance sheet, we will continue to gain on our competitors and increase our market share under difficult market conditions.

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

Christine Gorjanc

Let me now provide with an overview of the financials for Q1. As Patrick noted, net revenue for the first quarter ended March 30, 2009 was $152 million compared to $198.2 million for the fiscal quarter ended March 30, 2008 and $161.4 million in the fourth quarter ended December 30, 2008.

On a constant currency basis, relative to Q1 last year, net revenue for the first quarter of 2009 would have increased to $161.2 million and non-GAAP operating profit would have been $6.8 million to $12.5 million.

In addition to the negative currency impact, our first quarter 2009 net revenue was hurt by further declines in SMB product shipment. We shipped about 1.4 million units in the first quarter, including 3.1 million nodes of wireless products. Shipments of wired and wireless routers and gateway combined in the first quarter were about 2.3 million units.

Moving to product category base, first quarter revenue split between wireless and wired was about 64% and 36% respectively. The first quarter net revenue input between home and small business products was about 65% and 35% respectively.

Products introduced in the last 15 months constituted about 37% of our first quarter shipments while products introduced in the last 12 months constituted about 36% of our first quarter shipments.

Gross quarter for first quarter of 2009 was 29.2% compared to 32.9% in the year ago comparable quarter and 13.2% in the fourth quarter of 2008. As expected, this decline was in part due to a strong average exchange rate of the U.S. dollar against foreign currencies compared to prior quarters.

Another main factor is the decline the SMB product shipments compared to Q4, 2008. To better predict margins we are expanding our programs to include the forecast of our quarterly forward currency revenue. We do expect to see an improved gross margin in the second quarter through our product cost reductions and a slight improvement in foreign currency pricing.

Non-GAAP operating expenses, total non-GAAP operating expenses declined by 15% compared to the prior year same quarter reflecting the impact of cost saving actions we have taken in this challenging environment and revenue levels.

Total non-GAAP operating expenses came in at $38.8 million in the first quarter of 2009. This compares to non-GAAP operating expense of $46.4 million in the first quarter of 2008, $41.4 million in the fourth quarter of 2008.

First quarter 2009 operating expenses represented 25.5% of net revenue as compared to 23.4% of revenue in Q1 of 2008. The percentage increase is compared to the first quarter of 2008, is prime due to lower revenue levels.

We continue to target $10 million reduction in operating expenses on an annualized basis in 2009. We saved $6 million in operating expenses in the first quarter of 2009 compared to the quarterly run rate of the previous quarters.

On a GAAP basis, the company had net income of $42,000 or $0.0 per diluted share for the first quarter of 2009 compared to net income of $11.2 million or $0.31 per diluted share for the first quarter of 2008 and a net loss of $7.3 million or $0.21 per diluted share in the fourth quarter of 2008.

On a non-GAAP basis, the company experienced net income of $1.8 million for the first quarter of 2009 as compared to non-GAAP net income of $14.1 million for the first quarter of 2008 and a net loss of $2.5 million for the fourth quarter of 2008.

Non-GAAP net profit was $0.05 per diluted share in the first quarter of 2009 compared to net income of $0.39 per diluted share in the first quarter of 2008 and a net loss of $0.07 per diluted share for the fourth quarter of 2008.

In the first quarter 2009, we recorded a net foreign currency gain of $1 million compared to a gain of $2.8 million in the first quarter of 2008 and a loss of about $6.6 million in the prior quarter.

Net tax expense was $5.1 million in the first quarter of 2009 compared to $9.1 million in the first quarter of 2008 and $5.8 million in the fourth quarter of 2008.

The reconciliation of GAAP to non-GAAP is detailed in our financial statements released earlier today. Specifically excluded from non-GAAP income from operations in the first quarter of 2009 is $5 million in charges related to three patent litigation settlements recently entered into by the company.

We continued to maintain a strong balance sheet in the first quarter with $200.3 million in cash, cash equivalents and term investments. Our account receivable collections remain strong. DSO's for the first quarter decreased to 74 days compared to 81 days in fourth quarter of 2008.

Due to our concentrated effort to reduce inventory, they were down $22 million sequentially and inventory turns increased from 4 to 4.7. We expect our own on hand inventory to continue to trend downward.

We saw a reduction in channel inventory in absolute dollars. In terms of weeks of sales, reduction is less apparent primarily because the weekly sales volume in U.S. dollars is much less in March than in December which is the respective basis for our calculation of weeks for each period.

Please note that while the strongest sales month in Q4 is December, in Q1 the only sales month is January.

We believe our successful strategy of continuous innovative global presence, focused channel programs, maintaining a healthy balance sheet and cost saving initiatives will allow us to weather this downturn. We will continue to bring new technology to the market place winning over more channel partners, customers and successfully expand our market share.

We anticipate seasonal weakness in consumer demand, a further slight decline in SMB shipments in the second quarter. While we see continued reduction in distributor channel inventory, we anticipate U.S. retail will increase inventory in June in preparation for the back to school sales season beginning in mid July.

Also, we foresee improvement in our gross margin in the second quarter 2009 through consistent efforts in product cost reductions and slight improvement in foreign currency pricing. For the second quarter 2009, we expect net revenue in the range of approximately $135 million to $145 million and non-GAAP operating revenue to be in the range of 3% to 5%.

That concludes our comments and we can now take questions.

Question-and-Answer Session

Operator

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

Samuel Wilson – JMP Securities

It sounds like in the retail side of the business you think inventory destocking ends in April/May and in June actually starts to build for back to school. And that's only the U.S. right, because back to school is really only a U.S. phenomenon.

Patrick Lo

True

Samuel Wilson – JMP Securities

What do you think is going on with channel inventories are destocking in the international markets?

Patrick Lo

The retail side is doing very well. I think we're done with that. But on the distribution side I think we still have some work to do in international distributors as well as the U.S. distributors.

Samuel Wilson – JMP Securities

Can you talk a little bit about the service provider business? I know that Charter was a customer in the past. They because of bankruptcy stopped ordering. How does that work, and just the service provider business in general.

Patrick Lo

The service provider as you see is a pretty good portion of our business of course is also affected by the economy as well. So we said service provider revenue in Q1 basically mimics the same percentage of Q1 2008. Charter is still a customer as you probably know. They actually do what they call a bankruptcy that the judge has agreed that they will continue to pay their trade creditors so we continue to ship to them and continue to be a good customer of ours.

Samuel Wilson – JMP Securities

Cash from operations, CapEx and head count.

Christine Gorjanc

Head count is 568. CapEx was very low this quarter, about $229,000 and we anticipate a much lower CapEx in 2009 than in 2008 because we did have an ERP implementation and a building move last year. And then cash flow from operations for the current quarter is about $2.8 million negative and if you look on our balance sheet you'll see how accounts payable is down significantly.

Samuel Wilson – JMP Securities

Any guess what you expect the tax rate to be or the tax provision to be?

Christine Gorjanc

I think we'll stick with the guidance that we've given really, is about $6 million to $8 million a quarter and I would tell you that that is somewhat back end loaded as you go through the quarters. The tax provision is on an annualized basis so its a percentage of an annual number so we still believe around $6 million to $8 million is the right number for each quarter but more back end loaded.

Samuel Wilson – JMP Securities

What went better than expected from many days ago when you gave guidance for Q1, what actually happened?

Patrick Lo

I would say that the consumer demand is a bit better than we expected and channel destocking is not as severe. We thought that it was going to do it in all one quarter. It looks like they do probably 75% of that in Q1 and then the other 25% in Q2. So those are the two that were better than we expected.

A little bit worse than we expected was the bigger, what we planned a decline in SMB shipments.

Operator

Your next question comes from Maynard Um – UBS.

Maynard Um – UBS

Can you talk about how much of a gross impact was from marking activity in the quarter?

Patrick Lo

The gross margin impact we think was primarily due to currency. There's very little movement on pricing at all and the pricing affected by the normal pricing movement was very, very little. Marketing activity, actually Q1 is not typically very high promotion quarter other than in January, but compared to Q4 the promotion is less severe, because in Q4 we do both the Thanksgiving promotion as well as the Christmas promotion. So the gross margin decline is primarily due to the currency pricing.

Maynard Um – UBS

Any color on how we should think about interest income for next quarter?

Christine Gorjanc

All I can really say right now is interest income as you saw from the financial statements is about $300,000 for the quarter and we're not earning a lot on our money. It's very safe, but we're earning very little, about 100 basis points right now.

Maynard Um – UBS

And the $2.6 million reduction operating expenses, could you provide a breakdown of some line items?

Patrick Lo

Primarily it's the cost savings is the bulk of it, and of course we got some concessions from our outside service providers, but those are the two major areas.

Operator

Your next question comes from Hamed Khorsand – BWS Financial.

Hamed Khorsand – BWS Financial

On the B&B comments, what's making the drag bigger than you thought or is it just a continuing along with the economy?

Patrick Lo

What we heard from channel is even the small/medium businesses started to freeze up in January so the market shrank pretty significantly.

Hamed Khorsand – BWS Financial

On the new products that you're developing to produce by June, when do you that coming, is that going to hit the market in June and also what kind of inter space do you have that can gain new market share with these new products?

Patrick Lo

I think most of the new products are already fixed. Some of the new products are already out on our web site. We made quite a few introductions in the past few days. For example, lo kits, those are some of the products that have already been announced. They will be spread across consumer, SMB as well as service providers.

Hamed Khorsand – BWS Financial

Any 10% customers this quarter?

Christine Gorjanc

Our typical 10% customers would be Ingram and Techdata.

Hamed Khorsand – BWS Financial

Any standouts for you?

Patrick Lo

No, as usual the big guys, Best Buy, Wal Mart, those are the big ones.

Operator

Your next question comes of Jeff Kvaal – Barclays Capital.

Jeff Kvaal – Barclays Capital

I was wondering if you could spend a little more time talking about the SMB. You suggested it got pretty weak in January. Has it turned up again or is the visibility there still pretty limited.

Patrick Lo

We don't really; it seems to be moving again in the last few weeks. Some of the purchases are starting to come unfrozen.

Jeff Kvaal – Barclays Capital

So talking to your channel partners, that's the feedback that you get?

Patrick Lo

Correct. It's world wide. It's global. SMB, they all behave pretty much the same because they're running their own business, using their own dollars. We find that they're easing up in the last few weeks.

Jeff Kvaal – Barclays Capital

On Asia, how much of what's going on there is a function of FX?

Patrick Lo

In Q1 there was a difference because as we mentioned, in Asia the bulk of our business is concentrated between Australia and by now Korea and Southeast Asia and India. So other than India, we're affected by Chinese media. Everybody else in Southeast Asia outside of Australia is affected by Chinese media. They've pretty much closed shop.

So in Q1 our revenue is pretty much Australia, and then when Australian dollars depreciated 25% year over year, it really whacked us pretty hard.

Jeff Kvaal – Barclays Capital

Anything in particular going on in India that we should be aware of?

Patrick Lo

No. Everybody knows that India is actually after those incidents and of course with the global slow down also. We do see the Indian market slow down just like the rest of the world. However, our position over there is pretty strong. We have a pretty good distribution network, the brand. We believe that will continue to do well.

Operator

Your next question comes from Tom Lee – Goldman Sachs.

Tom Lee – Goldman Sachs

You touched a little bit about this on the prepared remarks. In terms of linear for the quarter, you mentioned that Q1, typically January is the strongest month but in this quarter as well given the effect of Australia?

Patrick Lo

Even in this year, Q1 is usually the strongest quarter because it doesn't matter whether it's Australia, or in the U.S. most of the retail customers actually do quite significant after Christmas sales promotions, and we participated in that too so that's why Q1 is generally, and also the service providers, Q1 are usually the beginning of the financial year and all the CapEx budget, the expense budgets open up in January and that's when they typically put in as many purchases and ask us to ship the most.

Tom Lee – Goldman Sachs

As we went through January through March was there anything unusual that you saw outside of normal seasonal trends?

Patrick Lo

No not really, other than the whole market shrank.

Tom Lee – Goldman Sachs

It sounds like you're more constructive on the U.S. market and you expect channel inventories to come back. What gives you the confidence that you're going to see that replenishment in Q2 given what we know in terms of the macro outlook? A lot of companies and a lot of retailers are still limited, and just curious to get your thoughts in terms of your confidence level and demand coming back to some level of normalcy.

Patrick Lo

Basically in the U.S. we have the most solid consolation not only that we have weekly feed, sometimes daily feed from our retailers on the cash register ring. We also have weekly feed from market data from my survey companies that give us what's the size of the market.

So as the rate of slowing down flattens out, that means the decline of the market becomes zero, then the market is pretty much bottomed for the consumer demand and it's now following the normal, it's not declining faster.

I thing for us as well as the retailers that get the same data, we'll probably go back into normalcy now and that's why they feel like they need to stock back up in June for the back to school season.

Tom Lee – Goldman Sachs

Do you feel pretty confident that Q1 from an absolute level is a bottom from a revenue perspective?

Patrick Lo

As we see that the rate of decline of the market actually becomes much, much less in Q1 so if you say it probably is consumer demand is asking for financial data.

Tom Lee – Goldman Sachs

Was there anything from a marketer position that may have caused additional pressure and I just wanted to clarify when you said you expect this improve slightly, that's quarter on quarter?

Patrick Lo

From the market share perspective we look at it, I think we generally hold market share. We're not gaining market share, we don't intend to because in this shrinking market some of our competitors will opt for lower prices, try to grab some more market share so it would be difficult for us to gain further market share until we get some really products ramping and we believe when we have that done in the coming quarters. The primary weakness of our SMB shipment is driven by the market decline.

Tom Lee – Goldman Sachs

When you made your comments on SMB improving slightly that was sequentially, was that right?

Patrick Lo

Yes.

Operator

Your next question comes from Jonathan Goldberg – Deutsche Bank Securities.

Jonathan Goldberg – Deutsche Bank Securities

Christine, could you just repeat the data on units?

Christine Gorjanc

For the quarter we shipped 4.1 million units. Wireless and wired was 64 and 36% respectively and then home and SMB was 65% and 35% respectively.

Patrick Lo

There was 3.1 million units of wireless shipped.

Operator

There are no other questions at this time. I'd like to hand it back over to management for closing comments.

Patrick Lo

We see the market slowing so the second quarter is getting more [inaudible]. However, Q2 is still a seasonally weaker quarter. We believe that we will continue to be very diligent in terms of cost control and on the other hand we will still continue to focus more of our expenses into R&D and generate more new products that we believe will do us very good in the second half of the year when we believe the market will come back.

With all the products that we have in the pipeline plus the 14 products that we introduced in Q1, we feel very good about the year in terms of gaining on our competitors. So if the mark turns to even a slight lift in the second half, we believe that we're positioned very well at that time.

So we look forward to talk to everybody again and we'll have a little bit more color for the second half. Thank you.

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