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Netgear (NASDAQ:NTGR)

Q2 2012 Earnings Call

July 26, 2012 5:00 pm ET

Executives

Christopher Genualdi

Patrick C. S. Lo - Co-Founder, Chairman, Chief Executive Officer and Acting General Manager of Commercial Business Unit

Christine M. Gorjanc - Chief Financial Officer

Analysts

Mark Sue - RBC Capital Markets, LLC, Research Division

Lynn Um - Barclays Capital, Research Division

Kent Schofield - Goldman Sachs Group Inc., Research Division

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

Hamed Khorsand - BWS Financial Inc.

Jonathan Goldberg - Deutsche Bank AG, Research Division

Jonathan Kees - Capstone Investments, Research Division

Rohit N. Chopra - Wedbush Securities Inc., Research Division

Operator

Greetings, and welcome to the NETGEAR Second Quarter 2012 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Christopher Genualdi with The Ruth Group. Thank you Mr. You may begin.

Christopher Genualdi

Thank you, operator. Good afternoon, and welcome to NETGEAR's Second Quarter Financial Results Conference Call. Joining us from the company are Mr. Patrick Lo, Chairman and CEO; and Ms. Christine Gorjanc, CFO. The format of the call will be a brief business review by Patrick followed by Christine providing detail on the financials and other information. We'll then have time for any questions. If you have not received a copy of today's release, please call The Ruth Group or go to NETGEAR's corporate website at www.netgear.com.

Before we begin the formal remarks, the company advises that today's conference call contains forward-looking statements. Forward-looking statements include statements, among others, regarding expected revenue; earnings; growth; operating income and margins; tax rates and other projected financial results; share gain expectations; the market for our products; business prospects, including back-to-school expectations, effects and expectations regarding 2012 Olympics coverage; competition; research and development efforts, including software development; sales and marketing efforts; hiring efforts; market trends and opportunities; our growth strategy; expectations regarding our recent acquisitions; and pace of new product introductions. Forward-looking statements made during the call are being made as of today.

If this call is replayed or reviewed after today, the information presented during the call may not contain current or accurate information. Further, certain forward-looking statements are subject to certain risks and uncertainties and are based on assumptions as to future events that may not prove to be accurate. Therefore, actual outcomes and results may differ materially from what is expected or forecast in such forward-looking statements.

Information on potential risk factors are detailed in the company's periodic filings with the SEC, including, but not limited to, those risks and uncertainties listed in the company's most recent Form 10-Q filed with the SEC. NETGEAR undertakes no obligation to release publicly any revisions to any forward-looking statements contained herein to reflect events or circumstances after the date hereof or to reflect the 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 on the Investor Relations website at www.netgear.com.

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

Patrick C. S. Lo

Thank you, Christopher, and thank you, everyone, for joining today's call.

During the second quarter of 2012, NETGEAR achieved year-over-year revenue growth across all 3 business units, as well as year-over-year revenue growth in all 3 geographic regions, despite the tough economic environment in Europe. The company has delivered 10% year-over-year growth in net revenue.

Non-GAAP diluted EPS was $0.64 per share. During the second quarter, we again demonstrated our leadership in home networking technology by being first to market with the latest in WiFi networking solutions. On April 26, we announced the industry's first 802.11ac dual band gigabit WiFi router, enabling third-generation WiFi at gigabit speeds. The release of NETGEAR's 802.11ac WiFi router marks the next generation of WiFi connectivity that is revolutionizing the way we consume multimedia content wirelessly by delivering Internet speeds up to 3x faster than its predecessors.

On the commercial side, we also launched the NETGEAR ReadyDATA 5200, the first of the new series of business-class storage solutions, complementing our existing ReadyNAS line of storage products for small businesses and professional users.

The ReadyDATA 5200 is our first product that carries an average selling price over $10,000, which features enterprise-class capabilities such as 180 terabytes of storage, deduplication and snapshots for a cost of ownership that is hard to beat in the industry. We will continue to achieve the industry's first by exercising our strength in new product innovation and second-to-none worldwide distribution.

For Q2, our Americas net revenue was $163.4 million; Europe, Middle East and Africa or EMEA net revenue was $117.8 million; and our Asia Pacific or APAC net revenue was $39.4 million. In the Americas, we generated 9% year-over-year net revenue growth. In EMEA, we achieved 7% year-over-year net revenue growth despite the economic recession in most of the region. We achieved an impressive 25% year-over-year net revenue growth and 22% sequential net revenue growth in Asia Pacific, reflective of our increasing penetration into this market, where demand for wireless Internet connectivity is rapidly growing.

In Q2, we maintained a high level of shipments with 6.5 million units shipped. We also introduced 26 new products during the quarter. Among the new products are the NeoTV Pro HD streaming player and the NETGEAR ReadyNAS surveillance products suite, as well as the previously mentioned industry's first 802.11ac dual band gigabit WiFi router and the previously mentioned ReadyDATA family of enterprise-class storage products. We are starting to see results from our focused R&D plan in the expanding product pipeline.

Sales channel investment continues to be a key focus for the company as our sales channel remains a critical strategic asset. By the end of the second quarter of 2012, our products were sold in approximately 32,000 retail outlets around the world, which is a record, and our number of value-added resellers stands at around 42,000.

Now let's turn to a review of the second quarter results for our 3 business units: Retail, Commercial and Service Provider. In our Retail Business Unit, or RBU, net revenue came in at $113.8 million, down 12% quarter-on-quarter and up 5% year-over-year. The sequential decline in revenue for Retail is typical of Q2 seasonality. However, with the tough macroeconomic environment, it was slightly more than we had planned. With the introduction of the 11ac WiFi product at the end of Q2, however, we have seen worldwide market share gain and ASP growth heading into Q3.

Based on third-party market share data, we believe NETGEAR gained further market share in North America, Europe and Asia Pacific in the retail channels, both online and in stores. Looking forward, we have a lot of exciting new products planned for the Retail segment over the next 12 months. With the recent introduction of our 11ac routers into our exceptional sales channel, we are confident that we will gain share in North America and Europe during the back-to-school season.

Net revenue for our Commercial Business Unit, or CBU, came in at $80.6 million for the second quarter of 2012. That's up 8% on a sequential basis and up 5% year-over-year. We're seeing healthy growth in switching, particularly around new technologies such as 10 gigabit Power-over-Ethernet Plus and remote stacking.

Our ReadyDATA 5200 introduction garnered the most attention among our resellers and installed base in the history of our storage business. The market situation in Europe has been challenging, and we see continuing uncertainty. However, with our strong, new product lineup, we are confident we will achieve sequential revenue growth in Q3 and gain share.

In our Service Provider Business Unit, or SPBU, net revenue came in at $126.2 million for the second quarter of 2012, up 3% sequentially and up an impressive 19% on a year-over-year basis. We continue to execute on the DOCSIS 3.0 gateway front, and we're able to deliver the volume and service our cable customers expect of us.

Service Provider has done exceptionally well during the first half of 2012, driven by our ability to deliver on short notice, and we believe that service providers were readying the networks for the 2012 London Olympics. We think this Olympics will mark a sea change in the delivery of online live and delayed content. For example, in the United States, NBCOlympics.com has announced it will stream 3,500 hours of live coverage, with a peak of 40 simultaneous streams. In the not-too-distant future, we envision homes with 4 or more devices simultaneously receiving HD content, driving a continued need to upgrade home networks. Post the Olympics, we expect that volumes in Service Provider will drop as our Service Provider customers take a breather in their drive for new subscribers. As a result, we're anticipating a decline in Service Provider revenue in Q3.

We have recently completed 2 acquisitions. In June, we acquired select assets of a small engineering operation in India to enhance our wireless product offerings in our Commercial Business Unit. The technology and engineering capabilities acquired will be instrumental in enabling us to take the leadership position in the small- to medium-size campus wireless LAN market using the latest dual band 3x3 11n and 11ac WiFi standards. Secondly, on July 2, we closed the acquisition of privately held AVAAK, Inc., creators of the VueZone home video monitoring system, expanding our presence into the smart home markets. The VueZone cameras are unique in that they are completely wire-free, operating on batteries alone and communicating with home routers wirelessly over 2.4 gigahertz. The cameras are elegant, unobtrusive and feature-rich. Images can be streamed or recorded over the track via Android and iOS-based mobile devices or browser-based laptops and PCs. VueZone products and services are currently sold online in the United States, and we plan to roll them out both in stores and online worldwide over the next 6 to 12 months.

We expect the acquisition to be accretive in the second half of 2013. This product line will be sold in our Retail Business Unit. Both of these acquisitions have been factored into our Q3 '12 guidance. We remain confident about our continued leadership in technology and product introductions, share gain around the world and higher penetration into emerging markets. We believe the demand for broadband Internet connectivity will be stronger over the next few years, and we believe our leadership in channel presence and technology will enable us to grow faster than our competitors.

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

Christine M. Gorjanc

Thank you, Patrick. I will now provide you with a summary of the financials for the second quarter of 2012. As Patrick noted, net revenue for the second quarter ended July 1, 2012, was $320.7 million compared to $291.2 million for the second quarter ended July 3, 2011, and $325.6 million in the first quarter ended April 1, 2012.

We shipped a total of about 6.5 million units in the second quarter, including 5.5 million nodes of wireless products. Shipments of our wired and wireless routers and gateways combined were about 3.8 million units in the second quarter of 2012.

Moving to the product category basis, second quarter net revenue split between wireless and wired was about 69% and 31%, respectively. The second quarter net revenue split between home and business products was about 75% and 25%, respectively.

Product introduced in the last 15 months constituted about 34% of our second quarter shipments, while products introduced in the last 12 months constituted about 28% of our second quarter shipments. From this point on, my discussion points will focus on non-GAAP numbers. The reconciliation of GAAP to non-GAAP is detailed in our preliminary financial statements released earlier today.

Non-GAAP gross margin in the second quarter of 2012 was 29.9% compared to 31.7% in the year-ago comparable quarter and 31% in the first quarter of 2012. Gross margin was down both year-over-year and quarter-over-quarter, due to the heavier proportion of Service Provider business as a percentage of the total revenue. Total non-GAAP operating expenses came in at $60.5 million for the second quarter of 2012.

As noted during our last 2 earnings calls, we are continuing to invest more in R&D on an absolute dollar basis and as a percentage of net revenues. Our R&D expense in Q2 increased to 4.4% of net revenues, in comparison to 4.1% of net revenues during Q1. With our recent technology acquisitions, we expect our R&D expense to be approximately 5% of net revenues in the upcoming quarters. We continue to invest these dollars in all 3 business units, and almost all of the incremental investment will be in software development, which enabled us to provide powerful differentiation against our competition and also provides us possible entries into new product categories in the future.

We increased headcount by 8 people during the quarter, bringing our total headcount to 818 at the end of Q2, and we expect to continue our hiring efforts in Q3 and for the rest of the year, both in R&D and new market channel expansion.

The non-GAAP tax rate was 31.4% in the second quarter of 2012 compared to 28.6% in the second quarter of 2011 and 30.1% in the first quarter of 2012. Our tax rate was slightly higher due to proportionally lower European profit.

Looking at the bottom line for Q2, we reported non-GAAP net income of $24.6 million and non-GAAP EPS of $0.64 per diluted share. Our balance sheet remains very strong, ending the second quarter with $360.4 million in cash, cash equivalents and short-term investments, which was driven by approximately $2.4 million in cash flow from operations. In aggregate, we invested $31 million in cash for the 2 acquisitions, 1 of which closed in Q2 and the other in early Q3.

DSOs for the second quarter 2012 were 77 days as compared to 66 days in the second quarter of 2011 and 70 days in the first quarter of 2012. Our 10% customer in Q2 was Virgin Media in the U.K. Our second quarter net inventory ended at $152.8 million compared to $137.8 million at the end of the second quarter 2011 and $134.3 million at the end of the first quarter 2012.

Second quarter ending inventory turns were 5.9 as compared to 5.8 turns in the second quarter of 2011 and 6.7 turns in the first quarter of 2012. Channel inventory remained at healthy levels. Our channel reports inventory to us on a weekly basis, and we use a 6-week trailing sell-through average to estimate weeks of stock. Our U.S. retail inventory came in at 12.3 weeks of stock. Current distribution inventory levels are 8.6 weeks in the U.S., 4.1 weeks of stock in distribution in EMEA and 5.7 weeks in APAC.

In summary, our growth strategy of aggressively expanding into new product categories, new geographic regions and new channels continues to produce positive results. With industry-leading new product introductions, global brand recognition and extensive distribution, we feel confident in our ability to stay ahead of our competition as we move into the third quarter of 2012.

Looking forward to the third quarter, we intend to roll out approximately 25 new products, and we look forward to the integration of our newly acquired businesses. Specifically, we expect third quarter net revenue in the range of approximately $310 million to $325 million, which accounts for a reduction in our Service Provider revenue, offset by expected increases in market demand in our Retail and Commercial Business Units resulting from the back-to-school season. Additionally, non-GAAP operating margin is expected to be in the range of 11% to 12%, and our non-GAAP tax rate is expected to be approximately 33%. This increased non-GAAP tax rate reflects the tax effect of our newest acquisitions.

Operator, that concludes our comments, and we can now take questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets, LLC, Research Division

If we look at the guidance, $310 million, $325 million, it's almost $34 million from the consensus estimate for the upcoming quarter. When you say the reduced marketing, some from service providers, what does that really mean? And do you actually recover that in the subsequent quarters?

Patrick C. S. Lo

Basically, we have visibility into 13 weeks of our service providers' order, and that's why we know pretty much how much we're going to ship to them. And the consumption of the gateway is based on the amount of marketing activities they do among the installed base, as well as their competitors' installed base. So the drop in volume from our service provider customers indicate to us that the possibility of a slow down in volume is a reduction in the marketing activities. And as we explained just now, that because they did quite a bit of promotion before the Olympics arrive, so we believe that is an effect of the post-Olympic. Now we don't have visibility into Q4 yet, but as the quarter progresses, we'll see whether they would do the usual Christmas promotions in Q4. And certainly, we'll keep you updated, as well everybody updated, in our next earnings call.

Mark Sue - RBC Capital Markets, LLC, Research Division

Okay. So Patrick, this is a broad thing because, I mean, we recognize a lot of the things are on hold, and it was front-end loaded because of the Olympics and now things are pausing. When it does resume, this should be your opportunity, and it shouldn't go to a competitor or anything else. Is that a fair assumption?

Patrick C. S. Lo

Yes. I mean, certainly, we're keeping the relationship with all our existing customers, and we -- as we always maintained that, that will try to get our -- more than a fair share of their purchase.

Mark Sue - RBC Capital Markets, LLC, Research Division

Okay. And then x the U.K. and your Virgin concentration, broadly speaking, impact to the macro, does that factor in your reduced guidance as well? And what sort of rebound or uptick in back-to-school are you're planning, vis-à-vis last year, considering that there are more macro headlines this year?

Patrick C. S. Lo

Well, certainly, it's still too early in the quarter to expect how the back-to-school magnitude is comparable to last year. Clearly, with the uncertainty in Europe, we expect that the European rebound probably will be smaller than last year. But on the other hand, this year, we have the 11ac launch in Retail worldwide, which we believe would be positive. But overall, we still feel pretty good about the sequential growth in both Retail, as well as in Commercial. However, as Christine just mentioned, that was just about to offset the drop off in the Service Provider revenue, which always, as we said, is very lumpy from quarter-to-quarter.

Mark Sue - RBC Capital Markets, LLC, Research Division

Okay. And then likewise, should we expect a bump in gross margins because of the mix of higher Commercial and Retail versus Service Provider in the near term and then that reverts subsequently in the December quarter?

Patrick C. S. Lo

Well, as we say, as long as the proportion of Service Provider revenue is less than what we are today, which is 39%, yes, the gross margin will go up.

Operator

Our next question comes from the line of Lynn Um with Barclays Capital.

Lynn Um - Barclays Capital, Research Division

I was wondering if you could just maybe walk us through the Retail business in a little bit more detail? Was it just kind of broader macro weakness? Or were there certain geographies that were particularly weaker than others?

Patrick C. S. Lo

Well, the Retail business actually -- certainly is affected by the macro environment, and the demand -- the overall market demand in the Western world, basically in Europe, Western Europe, as well as the United States in Q2 actually was not growing compared to Q1, which grew year-over-year. So that certainly provides -- I mean, more headwind for us. And fortunately, towards the end of Q2, we introduced the 11ac products, which is very exciting to the channel, as well as to the end-user customers. So we do believe that will rejuvenate the market and will set the market back onto a growth trend again, albeit at still single-digits for the overall market in Q3 on a year-on-year basis. And certainly, that's assuming that the situation in the Europe macro environment does not deteriorate any further. So we feel relatively confident given the current scenario that the retail market will grow in Q3, and we will grow much faster than the market because we are the leader in 11ac. And we will have our usual sequential bump in our Retail Business Unit revenue from Q2 going to Q3, both in Europe as well as in the United States.

Operator

Our next question comes from the line of Kent Schofield with Goldman Sachs.

Kent Schofield - Goldman Sachs Group Inc., Research Division

I was wondering if you could talk a little bit about the Commercial business, in particular, your NAS products and how HDD pricing is trending there from your perspective and what sort of impact that had during 2Q and how we should think about it going forward?

Patrick C. S. Lo

Sure. The NAS business continued to be weaker than what we would have liked, due to the high disk price. As we mentioned a few quarters ago, we continue to pass on the high disk prices to our customers. And those are some of our competitors, especially some of our Asian competitors who are -- actually, even U.S. competitors who are absorbing some of the price increases. So clearly, we are seeing that we are commanding a significant premium in price over quite a bit of our competitors. Now -- but the disk prices is continuing coming down. We expect that by the end of this year, then the disk prices will be back to way it was before, the normal level. So then we will be priced very competitive. But in the meantime, we continue to keep our position in the market by just offering superior features and capabilities. Clearly, the introduction of the ReadyDATA is a clear example of our superior technology. Even though the ASP is $10,000, we supply the features that nobody in that price range will be able to supply, such as deduplication, snapshot and restore and that support of expansion boxes up to 180 terabyte of storage, that kind of capability. And with the cost of ownership that we combine it with the product, it's very competitive in the market and it would take the Asian competitors quite a while to catch up. So we feel confident in the second half about our NAS business. And certainly, by the end of this year, when the hard disk drive price come back down to normal, it would be very, very good for us for next year.

Kent Schofield - Goldman Sachs Group Inc., Research Division

And then with the R&D going to 5%, 5% as a percentage of sales, can you help us think about beyond the third quarter? Because obviously, revenue growth is maybe not quite what we would have thought. Is that a new baseline level upon which you expect to grow? Or can we think about that staying relatively flat going forward from there? How should we think about that level?

Patrick C. S. Lo

What we are seeing is that this is the time, as what we did last time in the -- during the 2007, 2008, is when the market is tough, we actually would double down in our investment in R&D so that we'll be able to outpace our competitors in terms of technology and product introduction. And when the headwind eases, then we will be able to accelerate our growth. So for example, last time, when it was in the recession, we actually doubled down by doing the M&A on our NAS business and put a lot more R&D behind it. So when the economy picked back up again, actually in 2008, then we saw 2 great years of growth in 2009, all the way to 2011. We expect the same thing is going to be true. We're putting a lot of R&D. We believe that the 5% is where we're going to be, and we might even uptick a little bit into some quarters and which enable us to continue to outpace our competitors such as 11ac. We're ahead of our competitors by 3 to 4 months and with features much better. And with this acquisition of VueZone, which opens up a completely new market for us, we'll continue to pour R&D into it. We believe that this complete, wire-free, home monitoring system is the first entry into our smart home application, which has a lot of potential. We believe that we could actually create a market that could be as big as a few hundreds of millions of dollars. So we are putting R&D not only to outpace our competitors but also to try to create new markets that will further fuel our growth in the future.

Operator

Our next question comes from the line of Ryan Hutchinson with Lazard Capital Markets.

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

Really, a couple of questions. First, more of a clarification. Patrick, I know you have visibility into the third quarter, but if we go back, I don't know, a number of quarters, we talked about these rollouts potentially at some point coming to an end. So I wanted to just better understand where we are with respect to these rollouts, if in fact you're not worried about a second source in the fourth quarter. And I guess one way to look at that is what do we expect as the new revenue run rate for Service Providers at least in the back half of the year? And then I have a follow-up.

Patrick C. S. Lo

Well, I mean, we have been running the Service Provider at about $130 million-ish. I mean, in between $120 million to $130 million. So certainly, with the decline, I mean, we'll be at a lower level for the next quarter. As we said, I mean, we don't have the visibility in the second -- in the fourth quarter as yet. But if you look at some history in the past, usually, the first half is bigger than the second half. I mean, that's when service providers have more CapEx expenses, and they tend to run more promotions. But there is a possibility that they would run some Christmas promotions that would be able to help us. Now in terms of penetration of DOCSIS 3, which is still in the early innings, I don't think many of us in U.S. actually have subscribed to these super 30 megabit or 100 megabit level as yet. So that's why you're seeing all these TV commercials everyday, bombarding everybody to upgrade to these super speeds. Same is true in overseas markets such as in Europe and in Asia as well. So we don't think that the saturation is near, anywhere near. It's just depending on the CapEx budget of our competitors -- I mean, of our customers, when they're going to spend it. And as we said -- I mean, our customers always want to have 2 source of supply. And in most accounts, we actually have a competitor, which is getting our more than fair share of our supply to our customers. So that will be continuing the business model, is to assume that there's always a second source, and we're always going to provide better product, better service so that we have better share of the supply.

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

Okay. And then as a percent, it was right on 10% Virgin Media? Or was it 11% or 12%.

Christine M. Gorjanc

It was still, say, around 10%.

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

Okay. And the second question is really based on this new revenue run rate. It looks like the business x Service Provider has actually declined for the last couple of quarters, and I'm just trying to get my arms around that and really, the long-term goal, right? Because we've outlined a goal to hit $2 billion. I can't remember which year, but in the out year, which essentially implied 20% CAGR. So how do we think about that goal now that we look like we're not going to hit that goal here in 2012?

Patrick C. S. Lo

Well, the beauty of our business is that we have 3 legs to our business. In some years, such as year 2009, 2010, or actually even in 2011, in the first half, our Retail Business Unit has grown crazy. I mean, it's like 30%, 40% year-over-year. And then the Service Provider Business took over. They have been running a 30% growth year-over-year for many quarters. I mean, that's the beauty that we have one business versus the other that would be able to take the baton of growth. And clearly, right now, we are running through a patch of slow growth because of this macroeconomic environment and because of the service provider slowing down. We still think that with all these investment in R&D, I mean, just like this 11ac introduction, we'll see significant growth. As a matter of fact, I mean, we feel pretty good even with this tough economic environment that, in Q3, the sequential growth of both our Retail Business Unit and Commercial Business Unit will be very healthy.

Operator

Our next question comes from the line of Hamed Khorsand with BWS Financial.

Hamed Khorsand - BWS Financial Inc.

A couple of questions for you. I'll ask the simple one first. Are the acquisitions included in your new product estimate for Q3?

Patrick C. S. Lo

The new products -- actually, for the VueZone cameras, we are already selling them but in a very low volume online in the United States. And under the NETGEAR brand, we expect to roll it out, probably early Q4. So it will be 3 months or about 2, 3 months before we roll that out. The other acquisition is just a pure technology acquisition. It's a team of engineers that we like in India who would be able to do a wireless LAN, centralized management of access points, controller and so on and so forth so. So that is going to be added into our existing lineup of technology. We expect to use the technology to continue to roll out new products in probably 2013.

Hamed Khorsand - BWS Financial Inc.

Okay. And would this be a good going forward rate of 22, 25, 26 kind of number for new products going forward?

Patrick C. S. Lo

Well, certainly in the next few quarters. Yes.

Hamed Khorsand - BWS Financial Inc.

Okay. My other question there is that -- I usually stay away from gross margin topic, but I really want to address this here, given your guidance for 11% to 12% operating margin. If I look back over the past year of how you've spent money on SG&A and R&D, difference really comes out to about $5 million or $6 million a quarter. And if I tack that on to Q3 and compare what you guys did last year in Q3 to tack on the additional expenses, I mean, the biggest differential becomes what gross margin will be. So what's the predictability that operating margin could actually be higher than 12% if Retail is a bigger mix? Or has your Retail gross margin declined over the past year?

Patrick C. S. Lo

No. I mean, basically, generally speaking, as I mentioned in many a time if I have extra money, let's say if we know that we're going to hit 13%, let's say, then we will spend more, all right, in R&D, in channel expansion so that we could lay the groundwork to grow faster later on. But of course, if we see that, hey, we're not hitting 11%, all right, because we are seeing revenue slowdown, then we definitely -- we slow down our investment so that we would be able to hit between 11% and 12%. So I mean, that's what we do on a week-by-week basis, looking -- see how our trend is in terms of revenue but overall speaking, if you look at gross margin, if there is a higher mix of service provider revenue, let's say there is upside of service provider revenue, then gross margin will go down. But if you look at our operating margin basis, if we tend to hit at the high end of our guidance of revenue, then it would tend to be at the high end of the operating margin. But if we hit at the low end of our revenue guidance, then it would tend to be at the low end of our operating margin.

Hamed Khorsand - BWS Financial Inc.

No, I understand that. But it seems as though -- even if I expect you to increase spending by $12 million or $15 million for the quarter compared to Q2, I mean, the only way to avoid an excess of 12% operating margin would be that your gross margin mix would be down. Right? And that's what I'm trying to get to, is did your -- does Retail and Commercial gross margin have a decline over the past that we haven't seen any numbers before?

Patrick C. S. Lo

I would love to see -- we could spend $12 million or more quarter-on-quarter. I don't think we have ever done that in the past. It's very difficult to envisage that. For example, if you look at 2011 from Q2 to Q3, we raised our OpEx just by a little bit over $2 million. The only time that we had even close to $5.5 million of OpEx increase was in 2010, all right? But other than that, we generally would not jump that much in operating expenses quarter-on-quarter.

Operator

Our next question comes from the line of Jay Goldberg with Deutsche Bank.

Jonathan Goldberg - Deutsche Bank AG, Research Division

I wanted to dig in a little bit on Commercial. You got back to year-on-year growth this quarter. How is that market shaping up? What do you -- I guess, 2 parts: one is how is the market shaping up; and how do you feel about your product mix going the second half of the year?

Patrick C. S. Lo

Yes, the market is actually doing quite well in the U.S. Certainly, in Europe, it's pretty tough. The demand in Europe is actually pretty severe, but we are doing extremely well in both markets on the switching side. As I discussed previously in the call, we have been pushing aggressively into the new technologies such as 10 gig, such as PoE Plus, such as remote stacking that resonates very well with our customers. We're doing extremely well on the switching side. As I mentioned in the script also, because we refused to absorb the increase in prices of the hard disk drives to dilute our margin, our pricing on the NAS side becomes more expensive than our competitors such as HP, such as Buffalo and Asian competitors. So we are seeing such -- a tougher environment on the NAS side and -- but with the introduction of this new technology of ReadyDATA, we believe that we are turning the tide. And with the hard disk drives coming down to -- back to normal by the end of this year, next year, I think we will have a banner year for our NAS products.

Jonathan Goldberg - Deutsche Bank AG, Research Division

And in that category, do you -- you have all sorts of new products, you mentioned 10 gig. Do you find that those are expanding your footprint with existing customers? Or are you able to move into larger or another -- expanding your overall pool of customers, moving up into number of seats and whatnot?

Patrick C. S. Lo

Both. I mean, I have to say -- I mean, they're buying a lot of the 10-gig switches. I would say a good number of them are from our installed base who are upgrading. But we're also getting into a lot of new accounts, with a combination usually of our ReadyNAS, high-end ReadyNAS, which has a 10-gig back lane, together with our 10-gig switches. Certainly, there are customers -- there are new customers who are buying their solution either for virtualization or for backup of the disk volumes. So we have been able to see both. But of course -- and a bulk of it is from our installed base, but we are also attracting new customers as well with the 10-gig switches.

Operator

Our next question comes from the line of Jonathan Kees with Capstone Investments.

Jonathan Kees - Capstone Investments, Research Division

I wanted to ask for a better clarification here. The macro headwinds that you experienced in Europe was mainly in Retail and Commercial, right? Service Provider was up and that you expect Retail and Commercial to pick back up in the third quarter, and Service Provider should be down. And that's again from Europe post-Olympics. But you expect retail commercial to be up in Europe?

Patrick C. S. Lo

Yes. It's not because of the better economic environment. We expect the economic environment continue to be challenging. We expect that we'll be up in Europe, both in Retail and Commercial, simply on the strength of our products. On the Retail front is the 11ac. On the Commercial front is the introduction of the 10-gig switches or introduction of the ReadyDATA 5200. So that's why we anticipate sequential growth in Europe as well on Retail and Commercial.

Jonathan Kees - Capstone Investments, Research Division

So for small enterprises, you're not seeing a hesitation on purchases, a pause on new technology orders and more of a hesitancy in terms of sending you the P.O.

Patrick C. S. Lo

The beauty of it is that. I mean, there are still some small/medium businesses who must upgrade because their technology is old. And those will still buy. On the other hand, we see some large enterprises which has been seeing shrinking budgets. Then, instead of buying Cisco and HP, they buy us.

Jonathan Kees - Capstone Investments, Research Division

Okay. So it sounds like you're benefiting from -- even if there is a hesitancy, because it's -- in IT spending, you're still benefiting there.

Patrick C. S. Lo

Yes, as long as we have the unique products that our customer wants.

Jonathan Kees - Capstone Investments, Research Division

And for Service Provider, for CapEx, you talked about waiting on that, and there's a pause -- like you're talking about the September quarter. Overall, are you seeing any change in the direction of CapEx? You talked about the early innings of 3.0. Is there more of a delay there, especially post-Olympics, especially with Virgin Media? Or are you -- are they still communicating to you they're on track with their previous deployment plans?

Patrick C. S. Lo

Well, generally speaking, we don't comment on specific customers. But we will say that amount -- most of our Service Provider customers, we're seeing a slowdown in the CapEx expense in the second half, especially in Europe. Not so much in the U.S. So as a result, they are reducing their marketing activities to try to push more of the equipment into their subscriber base. So that's why we're seeing -- in Q3, there is a lesser demand from our Service Provider customers for our gateways.

Jonathan Goldberg - Deutsche Bank AG, Research Division

Okay. All right, that's helpful. Well, just one last question. The DSOs are up pretty high there. It's from Q1. And in fact, inventory days are also up from Q1. I noticed that Retail inventory for the U.S. is also pretty high, too. Just some more color behind that, please?

Patrick C. S. Lo

Yes. I mean, basically, when you have a higher proportion of Service Provider customers and revenue, they carry longer credit terms than the Retail and the Commercial customers. So that basically pushes up the DSO. In terms of inventory, it's pretty clear that we are ready for this big push of 11ac, so are our general partners. So they are really putting together quite a bit of inventory and especially when we're the only one that is providing the 11ac technology in the market. So we're seeing our channel partners around the world putting on inventory on 11ac and ready for the back-to-school sales.

Jonathan Kees - Capstone Investments, Research Division

Okay. So with the back-to-school sales and with service providers being a lesser percentage of revenue, we should expect those items to come down a little bit then?

Patrick C. S. Lo

Yes. Definitely. Yes.

Operator

Our next question comes from the line of Rohit Chopra with Wedbush Securities.

Rohit N. Chopra - Wedbush Securities Inc., Research Division

Christie, I had a question for you on currency. I know you guys hedge, but I just wanted to get a sense if there is any currency issues in the quarter?

Christine M. Gorjanc

During Q2? No. Again, we hedged, so we locked in our rates as we walked into that. And I think the only thing you can see -- where the currencies are today, and we'll hedge for the quarter. And again, I'd remind everyone we have both revenue and expenses in local currency. So we'll continue along with the hedging program, which has been -- made everything work very smoothly for us.

Rohit N. Chopra - Wedbush Securities Inc., Research Division

Yes, that's great. And then I just wanted to ask you about Target. You added Target last quarter, a fairly large chain. U.S. Retail still down, it looks like. Can you give us a sense, is Target operating above or below plan one quarter in? Is there any -- are there any issues?

Christine M. Gorjanc

Yes. Actually, we're quite happy with Target. Q2 is seasonally down for all retail. There's no big promotions in that. So what we saw was seasonally down, but we're quite happy with the relationship with Target.

Rohit N. Chopra - Wedbush Securities Inc., Research Division

Okay. And then lastly, I just want to ask about Shane when he left. I didn't see anybody get replaced in CBU. Is there other plans? Or is there something that needs to be done there?

Christine M. Gorjanc

No, we're actually -- we have a search going to look for a new general manager of the Commercial Business Unit. And in the short run, Patrick is stepping in.

Operator

There are no further questions at this time. I would like to turn the floor back over to management for closing comments.

Patrick C. S. Lo

Yes. We are really excited about all the new product lineups that we have, which are unique to us, and we're in a very leading leadership position. The 11ac routers, the ReadyDATA 5200, the 10-gig switch at unheard of cost of ownership. And now, with the addition of the 2 acquisitions, which enable us to go into the smart home market with the total wire-free cameras and the corresponding patented technology, as well as the capability that we acquired in India for rolling out of wireless controller for small/medium-sized campus LAN, we feel very good that we will continue to gain share. We'll continue to grow our revenue faster than our competition. So as I mentioned, we feel very good in the second half about our Commercial and Retail Business Units, and we would look forward to continue to be successful in the market. And we'll update everybody on all these new product fronts in the next earnings call. Thank you.

Operator

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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