Control4's CEO Discusses Q4 2013 Results - Earnings Call Transcript

Feb.12.14 | About: Control4 Corporation (CTRL)

Control4 Corporation (NASDAQ:CTRL)

Q4 2013 Earnings Conference Call

February 11, 2013 5:00 p.m. ET

Executives

Dan Strong – CFO

Martin Plaehn – President and CEO

Analysts

Tal Liani – Bank of America

Tavis McCourt – Raymond James

Scott Zeller – Needham & Co.

Rob Stone – Cowen & Co.

Jed Dorsheimer – Canaccord Genuity

Steven Frankel – Dougherty & Company

Saliq Khan – Imperial Capital

Operator

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the Control4 Fourth Quarter 2013 Financial Results Conference Call.

[Operator Instructions]

I'd now like to turn the conference over to Dan Strong, CFO. Please go ahead.

Dan Strong

Thank you, operator, and good afternoon everyone, and thank you for joining Control4’s earnings conference call for the fourth quarter of 2013. My name is Dan Strong and I am the Chief Financial Officer for Control4, and with me on the call this afternoon is Martin Plaehn, our President and Chief Executive Officer.

Prior to this call we distributed our Q4 2013 earnings release over the wire services and we have posted it on our website at investor.control4.com as well as furnished it to the SEC on Form 8-K. This call is also being webcast and a replay will be available on the Investor Relations section of our website for 30 days.

Before we begin, I would like to remind you that during today’s call we will be making forward-looking statements regarding future events and financial performance, including our outlook for the first quarter and full year of 2014. We caution you that such statements reflect our best judgment as of today, February 11th, based on factors that are currently known to us and that actual future events or results may differ materially due to a number of factors, many of which are beyond our control.

For a more detailed discussion of the risks and uncertainties affecting our future results, we refer you to our filings with the SEC and our Q4 earnings release. Control4 disclaims any obligation to update or revise these forward-looking statements to reflect future events or circumstances.

During the call we will also discuss non-GAAP financial measures. Unless we specifically state otherwise, none of the non-revenue financial measures we will discuss today were prepared in accordance with generally accepted accounting principles. A reconciliation of the GAAP and non-GAAP results is provided in today’s press release and is posted on the Investor Relations section of our website.

With that, I will turn the call over to Martin.

Martin Plaehn

Thanks, Dan. Welcome everyone and thank you for joining us on the Control4 earnings call for the fourth quarter of 2013. This is a very exciting time for the home automation industry and Control4 is uniquely positioned to drive and build our business with the expanding opportunity. We are the leading provider of the most comprehensive, interoperable, easy-to-use and affordable home automation solution available.

Today we are reporting record revenues for both Q4 and 2013. Revenues for the fourth quarter was $35.8 million and our non-GAAP earnings were $0.14 per share. For the full year 2013, revenue was $128.5 million and non-GAAP earnings were $0.38 per share.

We continue to aggressively build upon our business and market momentum and we are well-positioned for 2014. I'm exciting to report that our North America core revenue for Q4 grew 27% year over year and 24% for the second half. This accelerating growth is an increase over the 17% growth experienced in Q2 and the 18% growth in the first half. The year-over-year increase in our total core revenue was 21% in Q4 compared to 18% in Q3.

Our international core revenue increased by 7% in Q4 compared to 11% in Q3. Although our international business is still working through specific near-term headwinds, we expect our international growth rate to begin to rebound during 2014. And our confident in the global opportunity for home automation solutions remains very strong.

I would like to highlight five themes that are driving our business. First, the internet of things is happening now. Second, new home construction is recovering. Third, our dealer base is expanding and its productivity is increasing. Fourth, our newest products are gaining traction. And fifth, our SDDP technology is being embraced by the industry.

To drill into each of these a bit, first, most of us can't avoid reading, seeing or hearing about the emergence of the internet of things at least several times a week. It's all around us and it's really happening. Home automation is an important subset of this broader macro trend where connected devices are unified by intelligent software to make home smarter and to improve people's lives.

Google's recently announced acquisition of Nest Labs is one very visible point of validation on how valuable and large these opportunities could be. As many of you know, in September of 2013, Nest selected Control4 as its home automation launch partner for its open API program. And our technical work with Nest continues today as they formalize their interfaces for interoperability.

Although the internet of things is now attracting broad attention, Control4 has been singularly focused on the connective home for over a decade, and we continue to take an urgent, albeit long-term view, at the market and the business opportunity. We see the internet of things, and specifically home automation, as a secular growth trend for many, many years to come. We are in the early stages of a generational shift to smarter homes and Control4 is very well-positioned as a growing market leader.

Our team and I spent this last week at Innovative Systems Europe conference in Amsterdam, the largest international gathering of AB and system integrations specialists. The bustling [ph] attention we received at our booth for the entire three-day trade show as well as the enlistment [ph] interest and feedback we gathered gives me greater confidence that the awareness and adoption of home automation is accelerating and that Control4 is well-positioned on the mainstream adoption curve.

Second, we are pleased to see a continued recovery in residential new construction, primarily single-family homes in North America and multi-dwelling projects internationally. During the 2008 to 2012 downturn in new housing, we were able to continue growing by successfully shifting our focus to the existing home retrofit market. With new constructions now showing real signs of resurgence, we are taking programmatic steps to help ensure that we participate in those opportunities while continuing to grow our business within the existing home retrofit market.

Last week we announced that Toll Brothers selected Control4 as its preferred provider of home automation solutions. Toll Brothers is the leading builder of luxury homes in the United States and prides itself on offering the latest technology in household amenities to make life more entertaining, more comfortable and more convenient.

Beginning this quarter, Toll Brothers and Control4 will be offering several automation solutions to new home buyers at select Toll Brothers communities throughout the United States. We will be jointly marketing the benefits of home automation to prospective home buyers through product demonstrations and marketing materials that will be available at Toll Brother model homes and design centers.

We are very pleased to be selected by and to be working with Toll Brothers. And we are equally excited about the broader resurgence in new housing and the continued growing awareness of connected, smart and automated homes.

Third, now turning to our dealer network, over the past several quarters we have taken a number of steps to not only expand our dealer network but to increase dealer productivity. We had added a staff of technical field specialists to provide our dealers with higher levels of in-field technical support and we have added staff to our customer advocacy department who work with end-customers and their dealers to address product questions and installation refinements.

We also remain focused on improving penetration rates of our newest products across our channel and on implementing programs to increase new product awareness and knowledge to accelerate dealer adoption, promotion and end-customer sell-through metrics. During the fourth quarter we recruited 70 new dealers in North America while simultaneously weeding out less productive dealers. As a result, we ended the quarter with a healthy base of 2,465 active dealers and our 2013 dealer productivity metrics have increased significantly over 2012.

Internationally we're recruited 44 new dealers and ended the fourth quarter with 578 active dealers. As we discussed in our Q3 earnings call, we are in the midst of a transition from a two-tier distribution model to a direct dealer model in China, and I am pleased to report that we are making good progress and returned to sequential quarterly revenue growth in Q4 over Q3. We also added 13 direct dealers in China who are now trained and will be generating revenue in 2014. Our sales support and training centers in Shanghai and Bangalore are both fully open and we are on track to continue new dealer recruiting and training.

In Europe and in Latin America we experienced continued by softer growth in several countries. We firmly believe this softness is not a macro demand issue but rather issue of sales and installation execution. We are therefore adding sales and technical support resources in those regions to help our distributors and their dealers more efficiently execute on the opportunities in front of them. We expect to see the benefits of these investments during the latter quarters of 2014.

Fourth, we are seeing solid acceptance by our dealers and end-customers of our new lighting and music products. And we are pleased with the broadening channel adoption and accelerating sales in both product categories. Our new panelized lighting and award-winning next-generation wireless lighting solutions are delivering new levels of sophistication, reliability and elegance to residential and commercial installations. And they are fully compatible not only with traditional lighting sources but also with emerging LED and digital lighting solutions and products.

Our Wireless Music Bridge introduced in the middle of 2013 enables family members and friends to stream their personal music to the home audio system, whether just in one room or throughout the whole home right from their smartphones, tablets and personal computers using AirPlay, DLNA and Bluetooth technologies.

Given the dynamic nature of the connected home market, we continue to invest aggressively in new product development. We have a very full pipeline of exciting software and new product introductions that will broaden the control for home automation platform and bring greater value to both our dealers and end-customers. I look forward to sharing those details with you as those developments become available.

Lastly, I'd like to highlight our success with our SDDP initiative. As a reminder, SDDP stands for Simple Device Discovery Protocol. Our SDDP technology enables automatic device discovery, pairing and interoperability between network-aware devices and Control4 automation systems. The adoption of SDDP by numerous consumer electronic manufacturers builds on our strategy to make the installation of our automation solutions with numerous devices more efficient for our dealers as well as more reliable, deeply functional and less expensive for our end-customers.

Throughout 2013 and particularly in the second half, we made significant progress in the adoption of our SDDP technology, with 59 product companies signing our SDDP license agreement and 22 of them already shipping products with SDDP enable. Today more than 180 third-party devices are available with SDDP and hundreds more are expected from new and existing licensees in 2014.

In January we announced that Harmon International, TiVo and Epson signed on as new SDDP licensees, building upon our established traction with other category leaders such as Denon, Dish Network, Integra, Lilin, Marantz, Onkyo, Pioneer, Sharp, Sony, Toshiba and Yamaha. Our SDDP technology is central to our long-term strategy to expand home automation into the mainstream by simplifying device discovery and integrating connected devices into personalized Control4 home automation system.

As a whole 2013 was a solid year for Control4 and we intend to continue building our momentum in 2014. Among our top priorities this year are the following. First, to increase the investment in sales presence, coverage and effectiveness in our channels in North America, Europe, China, India and Latin America. Second, to increase our investment in marketing solutions across our product lines in key regions and to prudently begin to more overtly build Control4 brand awareness with end-customers.

Third, to form additional commercial partnerships, to increase international, national and regional awareness and the delivery of home automation solutions. Fourth, to continue improving the ease of use and capability of our software and physical products for both our end-users and our dealer network. And fifth, to continue to enhance our team, our technology investments and our logistical infrastructure to enable us to keep scaling in 2015 and 2016.

With that, I would like to turn the call back over to Dan.

Dan Strong

Thanks, Martin. Two brief reminders before I turn to our financial results. First, unless I specifically note otherwise, I'll be discussing all numbers except revenue on a non-GAAP basis, which as I noted earlier, excludes gains and losses on inventory purchase commitments and expenses related to stock-based compensation, litigation settlement, executive severance and stock warrants.

Second, we refer to revenue attributable to sales through our dealers located in the United States and Canada as our North America core revenue. And we refer to revenue attributable to sales through dealers and distributors located throughout the rest of the world as international core revenue. Core revenue does not include lumpy or business from hotels which we qualify as other revenue.

Turning now to our results for the fourth quarter, total revenue was $35.8 million, representing a 17% increase year over year and a 6% sequential increase over the prior quarter. Our fourth quarter revenue was the highest revenue quarter in the company's history. Excluding other revenue, our Q4 revenue grew 21% year over year. Our fourth quarter non-GAAP net income was $3.5 million or $0.14 per diluted share, compared to non-GAAP net income of $3.3 million or $0.17 per diluted share in the fourth quarter of 2012.

For the full year 2013, total revenue was a record $128.5 million, representing a 17% increase over 2012. Excluding other revenue, 2013 revenues grew 20% year over year. Our non-GAAP net income for 2013 was $8.4 million or $0.38 per diluted share, compared to $4.1 million or $0.22 per diluted share in 2012. The $8.4 million in 2013 non-GAAP net income represents an increase of 104% over 2012, demonstrating the operating leverage in our model.

In the fourth quarter of 2013, North America core revenue was $27.3 million or 76% of our total revenue and our international core revenue was $8.3 million or 23% of our total revenue. Other revenue accounted for the remaining 1%.

In the fourth quarter of 2013 we sold 17,554 controllers worldwide. This represents a sequential increase of 8.7% compared to the 16,154 controllers we sold in Q3 of 2013. As a reminder, direct comparisons to controller unit sales rates [ph] between periods in 2013 and 2012 are not meaningful due to the introduction and ramp of our more powerful HC-800 and HC-250 controllers during 2012 which were fully deployed in 2013 and which had the effect of reducing our average number of controller units per home, but increasing our average revenue per controller. Our average price per controller was up 29% in 2013 compared to 2012.

On a non-GAAP basis, our gross margin in the fourth quarter of 2013 was 49.4% compared to 49.5% in the fourth quarter of 2012 and 50.7% in the third quarter of 2013. Compared to Q3 of 2013, our gross margin percentage declined slightly, primarily due to increased inventory reserves associated with some legacy products. If not for this increase in inventory reserves, our gross margin in Q4 2013 would have been approximately equal to that of Q3. The negative impact on our gross margin associated with the increased inventory reserves in the fourth quarter of 2013 is expected to be a one-time event as we have fully reserved against those legacy products. Our non-GAAP gross margin percentage for the total year 2013 was 50.1% compared to 47.8% in 2012.

Total operating expenses excluding stock-based compensation and executive severance in the fourth quarter of 2013 were $13.9 million, compared to $11.6 million for the fourth quarter of 2012 and $14.1 million in the third quarter of 2013. On a percent of revenue basis, operating expenses were 39% of revenue in Q4 of 2013 compared to 42% in Q3 and 38% in the fourth quarter of 2012.

For 2013, operating expenses excluding stock-based compensation, executive severance and litigation expenses were $55.2 million or 43% of revenue compared to $47.8 million or 44% of revenue in 2012. R&D expenses were 18% of revenue in both 2013 and 2012, while sales and marketing expenses declined from 18% in 2012 to 17% in 2013, and G&A expenses were flat at 8% in both years.

Our non-GAAP operating margin was 8% for 2013 and 10% for the fourth quarter of 2013. We are making steady progress toward achieving our targeted operating model margin of between 14% and 17%. During 2013, our non-GAAP income from operations increased by 106% year over year, again reflecting the significant operating leverage in our model.

Our cash balance at the end of the year was $84.5 million and we generated $2.0 million of free cash flow during the fourth quarter. Our rolling worldwide six-month DSO or days sales outstanding as of December 31, 2013 stood at 39.2 days compared to 40 days for the same period in 2012.

Now I'd like to turn to our outlook for 2014. For the first quarter of 2014, which historically is our seasonally lowest quarter, we expect revenue to be between $30 million and $32 million, and we expect our non-GAAP net income to be approximately breakeven. For the full year 2014, we expect revenue to increase between 16% and 22% over 2013.

With that, we'd now like to open the call for your questions.

Question-and-Answer Session

Operator

Thank you, sir. And our first question comes from the line of Kira Kiralowski [ph] with Bank of America. Please go ahead.

Tal Liani – Bank of America

Hi. This is actually Tal Liani calling for Kira [ph]. I'm joking.

I have a question -- hello. I have a question about the growth in North America. You mentioned that the growth accelerated from 16%, 17% to 22%. And at the beginning of the call you went over the five points that drive kind of your business in the long run. So when you look back and you analyze the delta, kind of the acceleration, and without even getting into the specifics, but can you kind of tell us what was the biggest impact of the five things you mentioned, what had the biggest impact on the revenue growth acceleration? And that will help us to understand kind of 2014. So was it the addition of distributors and the increasing the efficiency of distribution or was it new products or was it -- I'm just trying to understand kind of the acceleration. Thanks.

Martin Plaehn

Hi, it's Martin. Hi, Tal. Within the framework of the five themes, I would say the strongest driver was our new products being accepted easily by our channel, mostly in the lighting and music category, as I talked about in my remarks. The second driver is the internet of things is happening, consumers are much more broadly aware of the possibilities of home automation. And number three is our dealer base is expanding and the efficiency of our existing dealers are contributing nicely to our growth.

Tal Liani – Bank of America

Got it. So when you look at the next year and the long term trying to kind of hit more specific guidance on the year, but when you look at the next year 2014, how do you think will the geographic breakdown will play out? Meaning, we've seen this quarter that North America volume faster than the other region, and when you look at all these drivers that you mentioned, do you think they'll continue to impact North America more than the other regions, or do you have plans specific to the other regions that may cause some acceleration?

Dan Strong

Tal, this is Dan. We said in the call, and we said it for the last couple of earnings calls that we've had, that we do think that the situation that we've gone through in China is starting to turn around. We had -- our revenue in China was higher in Q4 than it was in Q3, and we've put things in place that we think will cause that region to rebound in 2014. We also think a little bit of slowness that Martin talked about in his remarks in Europe and in Latin America will also rebound in 2014. So we expect our international growth rate in 2014 to be higher than it was in the third and fourth quarter of 2013. So that'll be nice. That'll be a nice addition to our revenue.

The 27% growth that we experienced in the fourth quarter in North America we're really encouraged by. As Martin said, it's a combination of a lot of factors that we've been working on hard to get that accelerated growth. It's a little bit too early I think for us to project that level of growth in North America for the total year of 2014. And so in our guidance we've been -- we've monitored what we think North America growth will be in 2014 and reflected that.

So we're, again, we're encouraged a lot by North America. We're confident that it will continue to grow. And we've reflected what -- our best estimate in our guidance.

Tal Liani – Bank of America

Got it. My last question is probably the most common question we're getting from investors recently, which is, what do you think is the impact of Google buying Nest on your company? Do you think is risk or opportunity or it represents risks or opportunities? Thanks.

Martin Plaehn

Hi, this is Martin. I think it represents opportunity. As I pointed out in my remarks, I think it's a point of validation on how large the opportunity is and how global it is. We believe the connected home, home automation, the internet of things is not a winner-take-all phenomenon. It will take many companies to participate and provide solutions. And our business, we're less than half-a-percent penetrated for our demographic. I think our estimate is about 0.1% penetrated for homeowners. And we're going after that opportunity to move from one in a thousand homes to five in a thousand homes, to ten in a thousand homes, and keep driving. And we think that there's good growth in front of us. And we'll partner with Nest, we'll partner with hundreds of other companies that make exciting point products. That's our role, to deliver the automated home for those homeowners that have connected devices and want them to work together.

Tal Liani – Bank of America

Got it. Thank you.

Operator

And our next question comes from the line of Tavis McCourt. Please go ahead.

Tavis McCourt – Raymond James

Thanks for taking my question. Dan, I've got a couple for you and then two for Martin as well.

On the accounting question, the DSOs were down quite a bit. What was driving that and what should we think about in terms of kind of a run rate DSO business going forward? And then secondly, you gave top line guidance for the full year and obviously you probably want to keep some flexibility for expenses in the year. But in general, should we think about anything radically different in terms of the way you intend to expand margins with this year relative to last year?

Dan Strong

Hey, Tavis. Let me answer the first one first. So our DSO for the period, December 31, 2013, was 39 days, and it was 40 days for the same period last year. So we've made some progress. It's not significantly different, but we're happy with the collection and the transition that we have from revenue to cash, and I think that will continue. It may tick up a little bit as international increases, and international terms are a little bit different, but in general we don't think that it will change a lot, and we're happy with where we are.

In terms of the full year 2014, I think you're right in terms of your statement that we're early into the year, and we've provided guidance in terms of our expectations of between 16% and 20% growth based on best information we have today. There isn't anything radical that from a gross margin or an operating expense standpoint that you should expect in 2014, other than we expect to continue to make progress toward our long-term operating model that we have laid out and we made progress in 2013 versus 2012 and we expect to make progress in 2014.

Tavis McCourt – Raymond James

Right. And just to clarify your comment earlier, Dan, on the gross margin, you said the -- ex the inventory write-down, it was the same -- I think gross margin would have been the same as Q3. Is that correct?

Dan Strong

Yes, would have been very close to the Q3 percentage.

Tavis McCourt – Raymond James

Right. And Martin, a couple for you, more strategic. A couple of media reports have suggested that Verizon has kind of stopped selling their home automation service or security service bundled with home automation to new customers. And just kind of big picture, is the service provider channel something that you guys find intriguing or interesting? Or is there so much kind of meat on the bone with this dealer channel now that you got your head down just with this one channel strategy?

And then secondly, not to delve into the Toll Brothers relationship specifically, but maybe talk more generally about the home building industry. You know, what kind of opportunities are out there and expectations from home builders in terms of take rates for home automation? Thanks.

Martin Plaehn

Hi, Tavis. We at Control4 are very focused on the homeowner and their family with their -- in their connected home and their connected lives. And it's very early days in the evolution of this expanding market opportunity. And we believe that having a clear line of sight with a transparent channel to be able to address consumers, understand them and build products and services, to improve their lives, is the best strategy for innovation and responsiveness to the market.

I think that there is an enormous opportunity in front of us to continue building our professional channel and expanding it as lighting becomes more digital, as security becomes more digital. And it's a global opportunity. I think that that will yield the best results, the best products, the best referrals from customers. And when we nail that opportunity, we might look at service providers. But right now we're keeping our eye directly on homeowners, their families and the fastest path to serve them with fantastic products and great responsiveness and service.

With regard to builder opportunities, we've been working with builders for many, many years through our channel. Our channel is very broad in the United States, we have more than 2,400. Outside U.S. we have another almost 700. Many of these dealers have local relationships with custom home builders and community home, you know, community builders.

If you look at the building industry, and these are approximate numbers, about 45% of new home construction, sort of mid-tier and high-end new home construction, is from national and large regional builders, and 55% is from local builders within a state, within a county. So we are looking at the builder community from both the top-down and the grassroots basis. We empower our dealers to strike relationships with local builders and we help them with programs to educate builders and to deploy our solutions through specific dealers with specific builders locally. And now with Toll Brothers we're taking a top-down national approach with broad-based programs that can be replicated in the West Coast, the South, the Southeast and the Northeast as the first priorities.

We think the connected home is on the right side of history. People are going to build homes with more connected awareness going forward. There's no reason to build them otherwise. The systems that we're putting into our homes are becoming smarter and smarter and interoperable and rely on each other. And Control4 is really great at doing that and we continue to look at that and figure out ways to participate in that opportunity.

Tavis McCourt – Raymond James

Thanks, Martin. And congratulations on a good finish to the year.

Martin Plaehn

Thank you.

Operator

And our next question comes from the line of Scott Zeller with Needham & Company. Please go ahead.

Scott Zeller – Needham & Co.

Hi, thanks. First question is regarding the goal of increasing the profile of the company. Could you give us a sense as you look forward where will those investments be made? Will it be -- you mentioned sales heads I think increasing, I believe you've talked about marketing programs, there's partnership opportunities. How do you envision the balance amongst those efforts?

Martin Plaehn

I think -- this is Martin -- they're interwoven and creates a business fabric on promoting Control4 automation solutions and delivering them locally in a high-quality fashion. With regard to our sales organization, we have room to grow the management of our channel in North America and we're very early days in Europe, Chine and India and Latin America. And so we're putting the resources on the ground to make those channels as strong as proportionally with the opportunity as what we've done in the U.S.

That includes channel management, direct employees that manage the relationships with our dealers and distributors. That includes technical field managers in other industries. They would call those sales engineers or technical evangelists. And then also customer advocacy to ensure that our end-customers are receiving the quality of service and fulfillment of the product that they envisioned when they bought a Control4 solution. So that's step one.

The fuel that needs to be injected into that organization are the marketing programs. We have, with the products we introduced in 2013, an extremely strong digital lighting product family and solution offering, both for new construction in the panelized lighting category as well as for the retrofit market and wireless solution. And we've strengthened our audio and video distribution products significantly in 2013. And all of those are shipping now. And being able to push those as solutions through our channel, drive that awareness, is important for our channel and for our customers to become aware of our solutions.

The third piece that I mentioned as a priority is building go-to market partnerships with where the best example or the clearest to understand example are national and regional builders. New construction these days should be envisioned with the connected home and the connected consumer in mind. We believe that we are the leader in delivering those kinds of solutions. These builders do their homework. They check around. And they've started to select Control4 in increasing velocity. And that will make a difference long term to our market position and to our awareness to end-consumers.

Dan Strong

And so just to put some numbers behind that, and I think we've talked about this publicly in some of the presentations we've made, when we look at our long-term operating model, as a percent of revenue, we expect to get good leverage from R&D and from G&A and we expect the gross margin to continue to gradually improve. We don't expect to get a lot of leverage with the next couple of years in sales and marketing because we are going to make both absolute dollar investments in -- in both sales and marketing, such that we don't expect the percentage of revenue represented by sales and marketing to decrease very much over the next couple of years. And we think that's a prudent way to grow the business and we will make that investment in order to continue to increase the top line.

Scott Zeller – Needham & Co.

Okay. And wanted to ask about the comments on Europe. Martin, you'd mentioned I think that it's company-specific and you're looking for better execution in Europe and Latin America. Could you talk about what it is that's changed in Europe perhaps? Because I think our understanding is that it's a pretty robust market for home automation. Is it a channel challenge or is it interfacing with partners challenge? Could you offer more color on that?

Martin Plaehn

Yes, I can. In Europe and in Latin America, our channel, our market presence is relatively young or adolescent compared to where we are in the U.S. In many of these regions we have a two-tier distribution model where the initial growth is on a zero base rising through several hundred thousand dollars per annual -- per year. And that early revenue growth is quite straightforward to achieve. And then as you get to numbers that cross the million-dollar mark, real programmatic effort needs to be installed, discipline, metrics, more support needs to be applied to continue the percentage growth rate on a larger and larger basis. And we see the opportunity there and we now need to layer in this first tier of direct support for our distributors in region, whereas before we could do it remotely.

Scott Zeller – Needham & Co.

Okay. And one quick one for Dan. Could you help us understand what's going to be happening with share count as we look forward? The lockup has expired. What should we be thinking about for share count maybe for yearend calendar 2014?

Dan Strong

So let me -- thanks, Scott -- let me -- we've done some work on that, and obviously it depends on what happens with option exercises and new grants and so forth. But just to give everybody the same information, we've done it by quarter. We expect the fully diluted shares outstanding in Q1 to be about 26.3 million, increasing to about 26.6 million in Q2, 26.8 million in Q3, and just over 27, 27.1 million in Q4.

Scott Zeller – Needham & Co.

Okay. Thank you.

Operator

And our next question comes from the line of Rob Stone with Cowen & Company. Please go ahead.

Rob Stone – Cowen & Co.

Hi guys. Lots of good information. Thanks for that.

Dan, a couple of housekeeping items for you. So operating expenses were down sequentially a little bit. You know, Q1 is kind of a seasonally low quarter. You gave some big-picture guidance on where you'd see leverage versus now. How should we think about the sequential trends for OpEx into Q1 and through the year?

Dan Strong

So Q1 will be, you know, we ended Q4 at a run rate that -- based on hires and investments and so forth that we've made throughout the quarter. So Q1 operating expense will be a little bit above Q4 in total, not significantly but a little bit above Q4, primarily because of again the run rate that we ended the quarter with.

And then in terms of operating expenses for the year, we expect that our, you know, we're not going to give exact specifics, but we expect that we'll continue to get some leverage on our operating expenses as a percentage of revenue, for the total year 2014 will be less than 2013. And the leverage again will primarily be in R&D and G&A.

Rob Stone – Cowen & Co.

Great. And can you comment on the tax rate you expect for this year?

Dan Strong

Yeah. It -- we continue to have an NOL that, from U.S. NOL, that chills our revenue from taxes in the U.S., so about a $77 million NOL that we carried forward into 2014. We are a taxpayer outside of the U.S. and we think our tax rate going forward will be around 5%.

Rob Stone – Cowen & Co.

A couple of questions for Mart. As you think about the international opportunity, I'm guessing that China and India are small proportionally out of all of your non-North American sales today. How do you see the size of the opportunity eventually when you get your correct channels up in those two very large population centers?

Martin Plaehn

Right now --

Rob Stone – Cowen & Co.

Relative to international overall.

Martin Plaehn

Yeah. Relative to the international overall, China is slightly above 10% today. We think that that's very, very small relative to the opportunity, in just two cities, like Shanghai and Beijing, and then if you add in Hong Kong on top of that, between those three cities we should be able to do a significant amount of more revenue than what we're taking down today. Once we get the recipe and the coverage right in those three large populous areas with growing middle class and growing homeownership, we can pick off the next two or three large cities. So I see it as a very large multiyear growth opportunity.

And I think the same holds true for major cities in Europe. There's, if we look in Germany, Hamburg, Frankfurt and Berlin, there is a lot of opportunity, several multiples of what we've got today. Likewise with France, you know, Paris, Nice and Marseille. You can take every country, pick the top two or three cities and there are thousands of customers in each of them that we should go get.

Rob Stone – Cowen & Co.

Great. My next question is on subscription-related services. You've gotten broader SDDP support among suppliers of equipment for security. How significant is the opportunity through the dealer base for security as part of the home automation package? And is that something where you see an opportunity for Control4 corporate to grow subscription revenue, or was that something where dealers might then be providing monitoring services for instance?

Martin Plaehn

I think first of all, security and safety is an application domain that is important to homeowners and relevant -- highly relevant to the emerging connected home. We are certainly strengthening our platform and our product offerings in those categories. I think -- I'm certainly going to provide more color on that in subsequent earnings calls when we release products. I think that our Foresight subscription which is currently remote access is growing nicely. However, our installed base is statistically small when compared to other broad-based internet subscription services.

Once we have much stronger offerings in security cameras and network, video recorders and interfaces and interoperability with security panels, I think that it is not beyond reason to think about layers of offerings for Foresight that step into that demand. But I think that's out in the future. It's not an unreasonable leap of faith, but we got to get the platform and the offerings right first and the subscription services follow.

Rob Stone – Cowen & Co.

Great. Thanks very much.

Operator

And our next question comes from the line of Jed Dorsheimer with Canaccord. Please go ahead.

Jed Dorsheimer – Canaccord Genuity

Hey. Thanks guys. Congratulations on the quarter. And just going back to the Toll Brothers -- by the way, congratulations, great win, leading name there -- I'm wondering, is there a level of minimum commitments that they have accepted as part of this deal? And is there a margin impact in terms of the products that will be going to Toll Brothers versus the rest of the dealer network?

Martin Plaehn

So first of all, with regard to Toll Brothers, we're not going to comment on the contractual content between our two companies. We are both committed to bringing home automation directly to Toll Brothers homes and future homeowners. We will be deploying this quarter in projects in the Western United States and Southern United States. We're going to be moving quickly to put our software into design centers and model homes. And then we will begin the process of explaining to prospective homeowners the benefits through joint materials and walk-throughs in these model homes.

We're bringing to Toll Brothers the leading home automation platform as well as a large ecosystem of dealers that can -- from which Toll Brothers can select local dealers to provide the installation services for model homes, design centers as well as purchase homes. And Toll Brothers brings to our dealers and to Control4 a premium brand, high quality construction, and great clientele, prospective clientele. So it's a very good synergy and we're both bringing our strengths to the party and we're going to go make them work together.

Jed Dorsheimer – Canaccord Genuity

That's great.

Dan Strong

Just to answer --

Jed Dorsheimer – Canaccord Genuity

Yup.

Dan Strong

Sorry. To answer your question on gross margin, you asked about gross margin impact of Toll Brothers.

Jed Dorsheimer – Canaccord Genuity

Yes.

Dan Strong

There is some, you know, as you can imagine, there's some pricing concessions that we've made and that our dealers are sharing with us, but we don't think the impact on margin will be significant. It's not a material impact. And we've reflected that in the numbers that we've projected.

Jed Dorsheimer – Canaccord Genuity

Okay. Thanks, Dan, I appreciate that.

Martin, just, you know, in the past we saw -- so you're dealing with, you know, you've expanded in the sort of new channel or opportunity with going direct to the builder with Toll Brothers. You're going direct from an international perspective in terms of distribution. In the past we saw the relationship with Sony which really hasn't seen a big impact from a licensing perspective in terms of embedded. Should we expect to see more of these type of, you know, for lack of a better name, Toll Brothers type direct deals both domestically and internationally, or is there exclusivity domestically and maybe we would see more of this internationally? Could you just help in terms of thought process there?

Martin Plaehn

Yeah. First of all, let me clarify that our go-to market is not direct to Toll Brothers. Fulfillment still occurs through Control4 dealers. We have -- it is a buying program, a purchasing program, a marketing program by which Toll Brothers and Control4 make end-customers aware of the possibilities of home automation within the Toll Brothers home.

When an end-customer buys a Toll Brother home, Toll Brothers becomes the purchasing agent on behalf of that customer until closing, contracts with the various subcontractors to fulfill the customization of that, including home automation, and that customization of home automation is through a Control4 dealer, our existing channel. And then when the house closes, then the consumer and their bank probably pays Toll Brothers and they're done. So just to clarify that.

Right. That's the mechanics. There are -- we as a company don't sign exclusivities often, if hardly ever. So there aren't any exclusivities in this range [ph]. We think the model that we've put in place for Toll Brothers can be replicated with other large multi-state developers. We would do that prudently, to make sure that everybody's interest and ability to execute on those interests are really there.

And we see internationally a lot of new construction in multi-dwelling units where we're doing similar things, working with a distributor and a large multi-dwelling or community builder, or a set of dealers.

Jed Dorsheimer – Canaccord Genuity

That's helpful. You had alluded to sort of expansion in security in terms of peripherals of additional products. Do you feel at this point that on the lighting, with the panelized lighting, that you've gotten the lighting platform in terms of offering to where you want, and that we should expect to see new offerings in perhaps the security? Is that how I should read into those comments?

Martin Plaehn

I think what I would -- what I would embellish or amplify in my remarks is that the first thing we will do is make sure that our interoperability in the area of cameras, network video recorders and security panels and the integration of leading third-party products in those categories are really spectacular and compelling in the Control4 environment. That includes SDDP integration in those kinds of devices, so they can be easily identified on a home network and integrated into a Control4 solution, and that our tools for our dealer network enable home automation to be programmed in the context of both lighting and security, heating and air-conditioning, and security, video monitoring and lighting and other attributes of the home. That's the first piece that needs to be done, versus a whole sequence of physical products from Control4 in the security and camera area. You'll see software from us first.

Jed Dorsheimer – Canaccord Genuity

Okay. And in terms of -- I actually have your product -- and in terms of -- just from a personal perspective, I'm actually curious with the app that was on the iPad. You know, in my system I have a VPN tunnel back in, I'm in Asia right now, so if I wanted to operate my house, I have to tunnel back in. Are you streamlining that process through your application where you can securely get back into your home to operate the functionality of home automation?

Martin Plaehn

Yes, that's part of our Foresight service. We are aware that when people travel in certain countries and their home is in the U.S., that there is some latency with regard to connection time to go through the various security layers. And we're looking at how to optimize that on a global basis for our customers.

Jed Dorsheimer – Canaccord Genuity

Okay. Yeah, that'd be welcomed.

Martin Plaehn

Yeah, we're aware.

Jed Dorsheimer – Canaccord Genuity

And then, Dan, just last question, you mentioned that -- I just want to make sure that I understand it correctly, with respect to the breakeven, is that on an operating level, a non-GAAP operating level for Q1?

Dan Strong

Yes.

Jed Dorsheimer – Canaccord Genuity

Okay.

Dan Strong

Non-GAAP operating breakeven.

Jed Dorsheimer – Canaccord Genuity

Okay. Great. Thanks. I'll jump back in the queue. Congrats again. Thank you.

Dan Strong

Thanks, Jed.

Operator

And our next question comes from the line of Steven Frankel with Dougherty & Company. Please go ahead.

Steven Frankel – Dougherty & Company

Dan, was there any material impact on the gross margin from third-party products like you had in prior quarters?

Dan Strong

Our third-party revenue in the fourth quarter was fairly consistent with what we have achieved in the prior quarters. And for those of you that don't know, we recognize in a third-party revenue, we recognize the revenue based on the commission or the incremental that we get from the third-party revenue. So it's a really high level of margin percentage revenue for us. So it did have a nice impact on our Q4 margin, but not materially different than prior quarters because of revenue as a percentage of the total was fairly consistent.

Steven Frankel – Dougherty & Company

Okay. Would you be willing to give us any more detail on the uptake of the new lighting products among the dealer channel?

Dan Strong

Yeah. We can tell you that we don't have -- we have the numbers but we don't talk specifically about it, but we can tell you that we track very closely the penetration rates that we get across both the international and the U.S. channel on our new lighting products. And especially in the U.S. channel we're very pleased with the percentages of our dealers. They're now selling the new lighting products. And our lighting revenue both as a percentage and in total absolute dollars has increased quarter over quarter since we introduced the new products.

Steven Frankel – Dougherty & Company

Okay. And then last one, the weeding out of the less productive dealers, is that more of a yearend house cleaning or is that kind of the magnitude that happens on a regular basis?

Martin Plaehn

This is Martin. With regard to the house cleaning, internationally it was more on the back end and we'd prefer -- back end of the year. We prefer it to be much more uniform and be swifter with non-performing dealers. On the U.S. side where we're more mature, we prune as we go.

Steven Frankel – Dougherty & Company

Okay, great. Thank you.

Operator

And our last question comes from the line of Saliq Khan with Imperial Capital. Please go ahead.

Saliq Khan – Imperial Capital

Hi, this is Saliq speaking on behalf of Jeff Kessler. A couple of questions. First one, regarding the inventories. This actually increased a little bit faster than revenue. Was the segment of the revenue -- was this the prime cause of the days of inventories increase, or was it due to the faster expansion of your partners?

Dan Strong

Sorry, can you -- you cut out for just a minute. Did -- ask your question one more time.

Saliq Khan – Imperial Capital

Sure. This is regarding the inventories and the increase of that being faster than the increase in revenue. What segment of the inventory was the prime cause of the days of inventories increase? Was it primarily due to the faster expansion of your partners?

Dan Strong

No, it wasn't related to partner revenue or partner product. It primarily as a result of the product transitions that we've gone through in terms of our new lighting products where we ordered additional Gen-3 lighting products and we're still phasing out the Gen-2 lighting products. So that was part of the end-of-year inventory increase. But it's not related to partner inventory.

Saliq Khan – Imperial Capital

Got it. Second and last question will be, you had mentioned earlier that you were adding aggressively in new product development. As you look over further out, we're talking maybe possibly two quarters or three quarters out. What is your next step in home automation?

Martin Plaehn

Word dropped out. You must be using an IP phone. Can you just -- right before you said in two or three quarters out, what's the next, and then that word dropped out, for home automation.

Saliq Khan – Imperial Capital

Sorry about that. You had mentioned previously that you're adding aggressively in new product development. What will be your next step in home automation and the penetration rate as well?

Martin Plaehn

So in my remarks I mentioned that we have a strong pipeline of new development. Our additional R&D spend will be proportional to our revenue, as Dan mentioned, where we get continuing leverage. We don't comment hard core on our future products. I did mention that security and camera support is a big area of interest for us. I think you will see software coming from the company quite promptly in that category.

We continue to invest in the user experience for homeowners and making personalization, something that the family can be involved in, so they can make their home the way they wanted. And we're continuing to make sure that our platform is the most competitive and forward-leaning of the automation platforms available.

Saliq Khan – Imperial Capital

Right. And my last question is, I'll spin [ph] my second question a little bit as well, is you mentioned also that you try to improve the ease of use, A, both for the end-users, along with the dealer network. From the feedback that you're getting from the end-users and the dealers and the different partners that you have, what could be done to make the ease of use even better? I've had the opportunity to play around with some of the products as well and I think it's pretty well put together. What further could be done on your end to make it easier to use?

Martin Plaehn

I think there are many areas. One is the speed -- the simplification and streamlining of our user interface, so that actions intended by the consumer are at their fingertips, because a sequence of drill-down menus. That's one area. There are other areas in our product line where we see significant areas of strengthening, as we've done in lighting over the past year, we strengthened our lighting offering substantially. We think we can do a similar level of strengthening in our multi-room audio and multi-room video experiences. We think that there's room in the comfort category which is heating, air-conditioning, pools and spas. And I mentioned the whole area of security and cameras.

So there's a lot to do here. It's a multiyear voyage. And once we get to great, then we'll get to greater.

Saliq Khan – Imperial Capital

Great. Thank you both of you.

Operator

And that does conclude our question-and-answer session for today. I would like to turn the call back over to management. Please go ahead.

Martin Plaehn

Hi, this is Martin Plaehn. Thank you very much for joining our Q4 2013 conference call.

We're excited about getting started on 2014. As I made in my remarks, we just came back from ISE in Amsterdam which confirmed the European portion of the opportunity to us. We're excited about moving forward in the U.S. and in Asia. And we're going to work and to continue delivering on what we communicate to you each quarter, and we'll see you next quarter. Thank you.

Operator

Thank you, ladies and gentlemen. This does conclude the Control4 fourth quarter conference call. You may now disconnect.

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