Netgear's Promising Cordless Skype Phone (NTGR)

 |  Includes: EBAY, NTGR
by: ClearFish Research

Story: NetGear, a manufacturer of networking equipment, announced at CES 2006 that they would be coming out with a Skype WiFi phone, with the unique feature that it would provide cordless phone functionality without the need for a computer. This is basically what I described earlier as the holy-grail for Skype to go mainstream. At the time, I didn't think it would make too much of a difference for NetGear overall. I want to examine that a bit more closely here. The main point is that most analysts are considering the Skype WiFi phone as a cell-phone replacement limited to mobile WiFi hotspots - a model we (and they) do not find particularly compelling. What they are missing is that we consider it rather as a home or business phone landline replacement, with the side benefit of usability outside the home. There is a 911 emergency calling issue, but that can be overcome easily. That is a much bigger market, and a compelling and unique product in that market.

Skype background is here. They have something like 250M downloads, and something like 5M SkypeIn/SkypeOut users. That subscriber base has been growing very quickly, and we find the NetGear WiFi phone compelling, so let's assume that they sell ca. 5M of them. They are a pretty basic phone other than the Skype functionality, so we figure they can make about $50 on each phone ($30-$50 manufacturing cost, sell it for ca. $100). That gives $250M in profits over the next couple of years, with an upside estimate factor of 2, and a downside estimate factor of 10. Their latest gross profit is on the order of $150M/year, so the contribution from this device could be significant, even at the low end of those very wide error bars ($25M-500M). How is the rest of NetGear?

Company: Latest numbers are for 2 Oct 2005 (we'll call that Q3 2005). We'll use the 9-month figures, which give Y/Y revenue growth of 18% ($327M/$278M), operating revenue growth of 29% ($113.694M/$88.455M), operating expense growth of 16% ($73.552M/$63.399M), and operating income growth of 60% ($40.142M/$25.056). So operating revenue is growing faster than revenue, which means gross margins are going up and cost of goods is coming down, operating expense is growing more slowly than revenue, and as a result operating income is growing faster than any other term. Plus, these are not small numbers, just the type of model we like to see. Their OP margin (operating earnings/revenue) has gone from 9% to 12%, and their OOP margin (operating earnings/operating revenue) has gone from 28% to 35%. Share dilution is about 12% though, so the operating earnings increase has to overcome that, which is does nicely. Their operations are Solid already, so the Skype WiFi phone is just a bonus on a good company.

NTGR has traded from about $14 to about $26 over the last year, and currently sits around $18. With annualized operating earnings of $53M ($40Mx4/3) and ca. 34M shares, that gives an operating P/E of 11.5 ($18x34M/$53M), which is absurdly low for a growing tech company.

NetGear releases their Q4 2005 numbers today, and the announcement may provide some froth for buying at even better prices. The WiFi phone has not been released yet, so it will not enter into current numbers. The risk is that they will mis-price the phone, causing it to have zero market penetration. Since they are a good buy anyhow, that seems an acceptable risk.

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