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NETGEAR, Inc. (NASDAQ:NTGR)

Q2 2008 Earnings Call Transcript

July 23, 2008 5:00 pm ET

Executives

Joseph Villalta – IR, The Ruth Group

Patrick Lo – Chairman and CEO

Christine Gorjanc – CFO

Analysts

Hamed Khorsand – BWS Financial

Lynn [ph] – Lehman Brothers

Samuel Wilson – JMP Securities

Tom Lee – Goldman Sachs

Mark Sue – RBC Capital Markets

Ryan Hutchinson – Lazard

Stanley Cobbler – Merrill Lynch & Co.

Um Maynard – UBS

Neil Gagnon – Gagnon securities

Rohit Chopra – Wedbush Morgan

Operator

Good evening, ladies and gentlemen, and welcome to the NETGEAR, Inc. second quarter 2008 results conference call. (Operator instructions) It is now my pleasure to introduce your host, Joseph Villalta of The Ruth Group.

Joseph Villalta

Thank you, good afternoon and welcome to NETGEAR’s second quarter 2008 results call. Joining us from the company are Patrick Lo, Chairman and CEO; and Christine Gorjanc, CFO. The format of the call will be a brief business review by Patrick followed by Christy providing detail on the financials. We will then have time for any questions. If you have not yet received a copy of today’s earnings release please call the Ruth Group at 646-536-7026 or go to NETGEAR’s corporate web site at

www.netgear.com.

Before we begin the formal remarks, the company’s attorneys advise us that today’s conference call contains forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. The forward-looking statements represent NETGEAR expectations or beliefs concerning future events and include statements among others regarding NETGEAR’s expected revenue, earnings, operating income and tax rate on both a GAAP and non-GAAP basis, anticipated new product offerings, current and future demand for the company's existing and anticipated new products, willingness of the consumers to purchase and use the company's products, and ability to increase distribution and market share for the company's products domestically and worldwide.

These statements are based on management's current expectations and are subject to certain risks and uncertainties, including, without limitation, the following future demand for the company's products may be lower than anticipated; consumers may choose not to adopt the company's new product offerings or adopt competing products; the company may be unsuccessful or experience delays in manufacturing and distributing its new and existing products; telecommunications service providers may choose to slow their deployment of the company's products or utilize competing products; the company may be unable to collect receivables as they become due; the company may fail to manage costs, including the cost of developing new products and manufacturing and distribution of its existing offerings; channel inventory information reported is estimated based on average number of weeks of inventory on hand on the last Saturday of the quarter, as reported by certain of NETGEAR's customers.

Further information on potential risk factors that could affect NETGEAR and its business are detailed in the company's periodic filings with the Securities and Exchange Commission, including, but not limited to, those risks and uncertainties listed in the section entitled "Part II – Item 1A. Risk Factors," pages 23 through 34, in the company's Quarterly Report on Form 10-Q for the quarterly period ended March 30, 2008, filed with the Securities and Exchange Commission on May 9, 2008. 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 in the investor relations site at www.netgear.com. At this time, I would now like to turn call over to Patrick Lo, please go ahead sir.

Patrick Lo

Thank you, Joseph, and thank you everyone for joining today’s call. This was a solid quarter for us despite a challenging market environment. Net revenue in Q2 increased 24% to $204.5 million compared to the year ago period and increased 3% as compared to Q1 of 2008. We enjoyed very healthy revenue growth in Q2 due to a strong performance in Asia-Pacific. Performance of our emerging markets including China, India, Eastern Europe, the Middle East, and Brazil continued to be strong in Q2, specifically our Asia-Pacific revenue was $31 million in Q2 a growth of 79% year-over-year and 49% quarter-on-quarter. Our operating margin saw much improvement in Q2 due to our successful efforts in both product and operating cost reductions. We also had increased sales of Smart Switches which carry a slighter higher margin. We increased our on hand inventory in order to better meet demands with less airfreight. With the introduction of newer and lower cost 802.11 WiFi products in the second quarter we are also better positioned to compete with the lower priced offerings from our primary competitors. Looking forward, we foresee the current market weakness and uncertainty in both the UK and the U.S. lasting into 2009.

In the interim, as we have previously shared with you, we continue to execute our core growth strategy of releasing innovative products, winning new customers, and penetrating emerging markets. We also intend to put more resources behind our R&D efforts in order to accelerate new product introduction. In addition, in Q3 of this year we will bring online our new ERP system, which will make our supply chain management more efficient in the intermediate and long term. From the product perspective, our ReadyNAS Network Attached Storage and Gigabit Smart Switches continued to enjoy strong reception worldwide in Q2. Among the 11 new products released in the second quarter, notable launches include

our low cost, high performance 11n router, an 11n upgrade kit for any installed 11g routers, and our two industry-first Layer 3 Smart Switches. We foresee a strong transition in the market to 11n in the second half of 2008 and would believe our complete line-up of 11n products with the differentiated RangeMax technology will position us for revenue growth and share gain. We will continue to introduce additional models of Smart Switches in ReadyNAS in the second half of the year, further consolidating our technology and market share leadership in these two fast growing areas of SMB networking and storage.

On the channel side, we are pleased to have added TV Cabo in Portugal and Cablemas in Mexico to our service provider customer list. For Q2, our service provider revenue was approximately $55 million, about 27% of our total revenue, as compared to 24% in the year ago quarter, and 28% in the first quarter of 2008.

We ended the second quarter with a significant increase in retail outlets due to our launch into the Wal-Mart stores in the U.S. Now, we have over 28,000 retail outlets worldwide. We continue to maintain an extensive value added reseller base of about 42,000. In the upcoming third quarter we expect lower than normal back to school demand due to the economic climate in the U.S. and the UK. In spite of the challenging environment, we have decided to increase our emphasis in R&D in the coming quarters to increase our pipeline of new differentiated products. We will also spend more in IT as we will bring up a new ERP system in Q3. This new ERP system will enable us to be more efficient in our supply chain management down the road as well as increasing the visibility of critical business metrics. By continuing to invest in innovation and operational efficiency enhancement we are confident that we will emerge even stronger once economic growth resumes in the U.S. and UK. Let me now turn the call over to Christine for details on our financials.

Christine Gorjanc

Thank you, Patrick. Let me now provide you with a summary of our financials for Q2. As Patrick just noted, net revenue for the second quarter ended June 29, 2008 was $204.5 million, a 24% increase as compared to $164.3 million for the second quarter ended July 1, 2007, and a 3% increase as compared to $198.2 million in the first quarter ended March 30, 2008.

Net revenues in the second quarter of 2008 by geography was $75.9 million for North America; $97.6 million for the Europe, Middle East, and Africa region; and $31 million for the Asia-Pacific region. We shipped about 4.3 million units in the second quarter including 3.5 nodes and wireless products. Shipments of our wired and wireless routers and gateways combined were about 2.3 million units.

Moving to the product category basis, the second quarter net revenue split between wireless and wired was about 62% and 38% respectively, relatively unchanged from the first quarter of 2008. The second quarter net revenue split between homes and small business products was about 62% and 38%, unchanged from Q1. 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 33% of our second quarter shipments. Non-GAAP gross margin in the second quarter of 2008 was 33.2%, as compared to 35.5% in the year ago comparable quarter, and 32.9% in the first quarter of 2008.

Moving to non-GAAP operating expenses, total non-GAAP operating expenses which exclude litigation reserves and acquisition related retention, compensation, as well as non cash stock based compensation costs came in about $44.4 million for the second quarter of 2008. This compares to non-GAAP operating expense of $39.8 million in the second quarter of 2007 and $46.4 million in the first quarter of 2008. Q2 2008 operating expenses represented 21.7% of net revenue. This is a decrease of 250 basis points compared to the second quarter of 2007 and a decrease of 170 basis points compared to the first quarter of 2008.

Non-GAAP sales and marketing expenses, were $30.3 million. As a percentage of net revenue, sales and marketing expenses were 14.8 in Q2 of 2008 as compared to 16.7% in Q2 of 2007, and 16.2 in Q1 of 2008. This decrease is reflective of the company’s cost saving efforts. Non-GAAP R&D expenses were $7.2 million. This represents 3.5% of net revenue in Q2 of 2008 as compared to 3.7% in Q2 of 2007 and 4% in Q1 of 2008. The decrease in R&D expense is due to the timing of product certification costs. Non-GAAP G&A expenses in the second quarter was $6.9 million, 3.4% of net revenue compared to 3.8% in the year ago period and 3.2% in the first quarter of 2008. The increase compared to Q1 is due to increased professional service fees in the areas of legal and finance.

Operating income on a GAAP basis was $18.8 million, which includes $1.7 million in charges of amortization of purchase intangibles and acquisition related retention compensation as well as non cash stock-based compensation of $2.9 million. This compares to GAAP operating income of $9.6 million in the year ago second quarter and $14.7 million in the first quarter of 2008. On a GAAP basis, the company recorded net income of $11.1 million or $0.31 per diluted share for the second quarter of 2008 compared to net income of $6.1 million or $0.17 per diluted share for the second quarter of 2007 and $11.2 million or $0.31 per diluted share in first quarter of 2008. Net income on a non-GAAP basis for the second quarter of 2008 was $14.5 million as compared to non-GAAP net income of $13.7 million for the second quarter of 2007 and non-GAAP net income of $14.1 million for the first quarter of 2008. Non-GAAP net income was $0.41 per diluted share in the second quarter of 2008 compared to $0.38 per diluted share in the second quarter of 2007 and $0.39 for the first quarter of 2008.

For calculating earnings per share we use a fully diluted stock count of 35.8 million shares for Q2 versus 35.9 million shares for the prior quarter and 35.8 million shares for Q2 of 2007. In Q2 of 2008, there was no currency gain as compared to a gain of $1.1 million in Q2 of 2007 and a gain of about $2.8 million in Q1 of 2008. The non-GAAP tax rate was 40.6% in the second quarter of 2008 compared to 37.3% in the prior year’s second quarter and 39.2% in the first quarter of 2008. The reconciliation of GAAP to non-GAAP is detailed in our financial statement released earlier today.

Moving on to the balance sheet, we ended the second quarter with $186.8 million or approximately $5.22 per diluted share in cash, cash equivalents and short-term investments compared to a total of $155.8 million at the end of the second quarter of 2007 or approximately of $4.35 per diluted share and $200.8 million at the end of first quarter of 2008 or approximately $5.59 per diluted share.

In terms of inventory trends, we ended the second quarter of 2008 with inventories at $106.4 million with ending inventory turns of 5.2 compared to 5.1 turns at the end of the second quarter 2007 and 5.5 turns at the end of the first quarter of 2008. We increased our inventory levels in order to better meet demand while minimizing the need for airfreight.

Days sales outstanding were 71 in the second quarter of 2008, compared to 75 days in the second quarter of 2007, and 71 days in the first quarter of 2008. This remains within our historical range of 65 to 75 days.

Our channel inventory is slightly higher than prior quarter due to the channels preparation for back to school, which begins in mid July.

Total assets were approximately $559.3 million at the end of second quarter 2008 compared to $481.6 million at the end of second quarter of 2007 and $562.7 million at the end of second quarter of 2008. Deferred revenues decreased to $4.3 million as compared to $7.5 million at the end of the prior quarter and $8.7 million at the end of the second quarter of 2007. For the third quarter of 2008, we expect lower than normal back to school consumer purchases in the U.S. and UK due to the challenging economic climate, specifically we expect third quarter net revenue to be approximately $208 million to $212 million. With additional investment in R&D and IT infrastructure we expect the non-GAAP operating margin in the range of 9.5% to 10.5%. Finally, we expect a non-GAAP effective tax rate to be approximately 39.5%.

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

Question and Answer Session

Operator

Thank you. Ladies and gentlemen, we will now be conducting a question-and answer-session. (Operator instructions) Our first question comes from the line of Tom Lee with Goldman Sachs. Please proceed with your questions.

Tom Lee Goldman Sachs

Hi, thanks for taking that call. A few questions. The first one is, can you talk with a little more granularity in terms of what is driving the strength in Asia Pac and then was it specifically – was it in small medium business or was in more kind of consumer markets that you are seeing that strength?

Patrick Lo

It is across the board.

Tom Lee Goldman Sachs

Across the board. And was it primarily APAC as opposed to like Eastern Europe or Middle East.

Tom Lee Goldman Sachs

We specifically said it was Asia-Pacific.

Tom Lee Goldman Sachs

Got it. And then can you talk a little bit about your visibility. Has that – has that changed at all since the last quarter or is that relatively the same?

Patrick Lo

We certainly are seeing the trend in the market and based on the trend, that is why we gave the guidance.

Tom Lee Goldman Sachs

And then can you – what was your operating cash flow in the quarter?

Christine Gorjanc

Operating cash flow for Q2 is a negative $6.6 million.

Tom Lee Goldman Sachs

Got it, and then last question is regarding your commentary around strong transition to 11n in the back half of the year. Can you give a little bit – a little more of color in terms of what gives you the confidence that you know – that we will see a strong pickup in 11n and is that likely more in the developed markets, you know, if you can just help kind of reconcile some of the comments about the slowing macro – the tough macro conditions in both the U.S. and Europe as well as expectations of strong 11n adoption?

Patrick Lo

Yes, we see definitely the overall unit purchase is slowing down because of the economic climate, but in the overall unit sales, the percentage of 11n sales is going to be bigger as compared to the first half.

Tom Lee Goldman Sachs

Got it. And then – so there is no – because I think I though you said previously that you though that the 11n was going to be more of a 2009 story because of what was going on with the standards being ratified. But is that not an issue anymore?

Patrick Lo

Basically, we were surprised by the price moves of our competitors on the 11n across the board and I think that really tilts the scale, especially in the consumer sector.

Tom Lee Goldman Sachs

Got it. Okay, thank you very much.

Operator

Thank you. Our next question comes from the line of Samuel Wilson with JMP Securities. Please proceed with your question.

Samuel Wilson JMP Securities

Good afternoon. A couple of small questions also. First, on last quarter’s conference call you mentioned you were a 100% sure how you were going to recognize revenue on Wal-Mart given the lack of experience with the customer, can you just talk about how you recognized this quarter for that?

Patrick Lo

We are recognizing the revenue of Wal-Mart just as we did with all the other retailers such as RadioShack as well as Best Buy, which is based on selling, and the reason we took that approach is because the sell through was very encouraging. So, we believe that it is prudent to do the selling as because they actually bought all the products.

Samuel Wilson JMP Securities

Perfect. Second, a couple of questions for Christine. Tell me your CapEx and I am sorry I missed headcount?

Christine Gorjanc

Headcount is 563 at the end of the quarter and CapEx is $7.2 million and there is about 3.6 of that that is a building that we are moving into that we capitalize, but we actually won’t really pay for. We will be reimbursed for that.

Samuel Wilson JMP Securities

Got it. And then Patrick, you certainly talked about this in the last question, but maybe you could just talk a little bit more, just sort of the status of the pricing pressure being put in the market place by Linksys in the U.S., any change throughout the quarter, any noticeable difference from last quarter?

Patrick Lo

No. As a matter of fact as we said that we predict that they would continue to put price pressure on the market and expect as the school season is about to start, they will lower the price one more time which we were expecting anyway because we (inaudible) at the beginning of last quarter. So, all our actions in terms of bringing our product cost down as well as preparing for the third quarter has that in mind.

Samuel Wilson JMP Securities

Great. And my last question for you Patrick. You had some products on exclusivity with Best Buy and others that came off over the summer. Can you just talk a little bit about how the uptake of those products, have you been able the distribution broader?

Patrick Lo

Yes, it is very well received around the world. Right now, we have our RangeMax in dual-band routers and double-band adapters sold in every single channel in every single country and the reception was very, very encouraging.

Samuel Wilson JMP Securities

Great, thank you very much.

Patrick Lo

My pleasure.

Operator

Thank you. Our next question is from the line of Lynn [ph] with Lehman Brothers. Please proceed with your question.

Lynn Lehman Brothers

Hi, thanks for taking my question. Just a quick question geographically speaking, I know, last quarter you said particularly with EMEA the weakness was contained to the UK retail. I was just wondering if you are seeing perhaps any spillover into any of the service provider segments either in UK or other parts of Europe.

Patrick Lo

As a matter of fact, you are right. The UK market continued to be very weak, and outside of the UK our growth is still very, very high. As a matter of fact, if we take the UK market out, EMEA revenue actually grew 70% year-over-year. Unfortunately, the weakness in the UK market has spread beyond the retail, actually into the service provider as well, but fortunately the rest of Europe has been able to more than make it up.

Lynn Lehman Brothers

Okay, great thanks, and just another quick question on the Wal-Mart piece, I know it is probably a little bit early on, but just generally speaking would you say it has been tracking in line with your expectations, maybe ahead, I know you had initially been guiding conservatively, any color there would be helpful?

Patrick Lo

It is definitely ahead of our very conservative estimation. We could say that we are really happy that we entered into Wal-Mart and immediately get our fair share of the market share over there as we did in the rest of the channel.

Lynn Lehman Brothers

Okay, great. Thanks then, good luck next quarter.

Patrick Lo

Thank you.

Operator

Thank you. Our next question comes from the line of Hamed Khorsand with BWS Financial. Please proceed with your question.

Hamed Khorsand BWS Financial

Good afternoon. Congratulations on the quarter. Just one question is – where in the APAC region were you strong. I mean, what execution did you see that worked for you this quarter that you haven’t been seeing in the past quarters?

Patrick Lo

No, I think our Asia-Pacific growth had been pretty strong in most of the quarters, the primary reason is that our base in countries such as China, such as India are still small relative to our competitors and because of our differentiated technologies such as ReadyNAS, such as RangeMax, and our approach to the channel help us to really significantly grow in those two markets. On top of that, our established base in Australia, which we have a pretty significant market share continued to do well for us.

Hamed Khorsand BWS Financial

Okay, any improvements in Russia?

Patrick Lo

No, Russia is not part of Asia-Pacific unfortunately and we are still not seeing any success over there yet?

Hamed Khorsand BWS Financial

Thank you.

Patrick Lo

Yes, sure.

Operator

Thank you. Our next question comes from the line of Mark Sue with RBC Capital Markets. Please proceed with your question.

Mark Sue RBC Capital Markets

Hi, Patrick. Hi, Christy. Just on the price cuts from Cisco as a clarification. So, it is 3 major cuts that we saw and it is still no worse in terms of deterioration?

Patrick Lo

What do you mean by deterioration, I am sorry?

Mark Sue RBC Capital Markets

I mean it is not getting any worse. (inaudible) on additional price cuts going forward?

Patrick Lo

As I just mentioned that they just cut another round. I heard it was successful.

Mark Sue RBC Capital Markets

So, it is 3 total that we have seen.

Patrick Lo

Yes, pretty much.

Mark Sue RBC Capital Markets

Okay, got it, and then

Patrick Lo

We don’t rule out that they would do another round before Christmas.

Mark Sue RBC Capital Markets

Okay, and then just on operating margin improvements, what components of that do you think are repeatable understanding that you can’t predict mix and you reduce cost a little bit more, better predict freight requirements, how should we model operating margins going forward?

Patrick Lo

I think we are not focused on one area only. The philosophy in NETGEAR is just like the Japanese manufacturing, it is basically every little bit helps, continuous improvement. So, we are looking at all areas, product costs for sure, and operating costs for sure, freight costs for sure. So, all those areas are areas that we could continue the focus on?

Mark Sue RBC Capital Markets

So, certainly [ph] we will get kind of back to the 11% to 12%?

Patrick Lo

We guided 9.5 to 10.5%.

Mark Sue RBC Capital Markets

And then just lastly, I am not sure why economic cycles were tempered back to school demand, I mean, still have to go to school when the penetration is still low, maybe are you just being extra conservative on the back to school season?

Patrick Lo

Well, as you probably know, having a router at home might not be 100% necessary. They might decide to just to have the kids share that broadband connection by Walkman [ph]. These days as you have probably heard that the customers are buying less product for back to school. So, we are seeing a trend and also there could be that instead of buying the dual band and router they could opt for buying the low cost end router. So, there are a lot of things at work and I think we do believe that for most people in the U.S. and the UK, basically bombarded with the higher oil prices, the high food prices, and you just have to make choices.

Mark Sue RBC Capital Markets

Sure, got it. It is helpful. Thank you Patrick. Thank you Christy.

Operator

Thank you. Our next question comes from the line of Ryan Hutchinson with Lazard. Please proceed with your question.

Ryan Hutchinson – Lazard

Yes, just a quick follow-up with Mark’s question on the guidance as it relates to OpEx, I know you are going to be prudent across the board here, but specifically as it relates to R&D, should we expect that that should be the largest quarter-over-quarter increase compared to the other line items there?

Patrick Lo

As we mentioned just now, we are going to put some more emphasis in R&D, as well as in the IT infrastructure. So, clearly the R&D line item will go up, both in absolute dollars as well as in percentage. So, is G&A. We believe that those are prudent investments because it will help us in the long term.

Ryan Hutchinson – Lazard

And should we expect that that would continue moving into Q4?

Patrick Lo

Yes, definitely those percentages will be higher for both R&D and G&A in Q4, but certainly we hope that those investments will help us improve our overall standard margin in Q4 for the products as well.

Ryan Hutchinson – Lazard

And then the upside here on the top line, did that surprise you, I guess, that question is this, what was your assumption in pricing, was it better or worse as we got towards the end of the quarter here?

Patrick Lo

Do you mean for Q2?

Ryan Hutchinson – Lazard

Yes.

Patrick Lo

Well, basically when we guided for Q2 we are unsure of a few things. First is what is the scenario of the launch into Wal-Mart, and we have no experience over there, and our products are the most expensive (inaudible). So, we don’t even know how our products will be received in that particular chain store. So that is something that we do not know until we get in there. So, certainly we have no surprise, happily surprised by the well-received sales in Wal-Mart. I think that is good. Second one is that the strength in Asia-Pacific. We understand that we will continue to grow in Asia-Pacific but we are little bit also surprised on the upside that our business in both India, China, and Australia are doing a little bit better than what we expected?

Ryan Hutchinson – Lazard

Okay, and then finally, one just for modeling purposes here, you obviously had a benefit on the other income line item in Q1 flat and in Q2, I am assuming that moving forward we expect that to essentially be at or near 0, it that fair?

Patrick Lo

That would be fair because in Q2 we really had 0.

Ryan Hutchinson – Lazard

All right. Thank you.

Operator

Thank you. (Operator instructions) Our next question comes from the line of Stanley Cobbler with Merrill Lynch & Co. Please proceed with your question.

Stanley Cobbler Merrill Lynch & Co.

Thank you very much. I have a question on the guidance. Just want to understand a little bit better how the growth both year-over-year and sequentially is constructed. When I look at the retail segment of the market, I am expecting the weaker back to school season. Even if we assume very low digit sequential growth for retail and we also assume a very slow growth in service provider business quarter-over-quarter, overall there is strong seasonality in your SMB business if I am correct. And so, that is in and itself should typically lead to strong growth. I am wondering if I am thinking about his correctly and I have another question on the guidance.

Patrick Lo

Well, basically we are looking at the trends as you rightly point out. The service provider not necessarily we have sequential growth of any significant magnitude and the retail side as a matter of fact the back to school in the U.S. will be muted and the UK decline has not stopped. So, even with the back to school and the UK is looking at best to be staying at the Q2 level if not lower. So, even though the SMB will continue to carry the day for us and remember in Q3 is the seasonally low quarter in Australia, which is our biggest country in Asia-Pacific because Q2 is the financial year-end and Q3 is the beginning of the new financial year, which is generally the slowest season. So, when you add all those factors together, I think our guidance is prudent.

Stanley Cobbler Merrill Lynch & Co.

So, essentially, it was my next question, the weakness in Australia, we expect the growth in areas like India and China of the small base to be pretty much offset and that is why you are seeing very limited growth overall when you put all the numbers together?

Patrick Lo

That is correct.

Stanley Cobbler Merrill Lynch & Co.

Great. Thanks a lot.

Operator

Thank you. Our next question comes from the line of Um Maynard with UBS. Please proceed with your question.

Um Maynard – UBS

Hi, thanks. You have historically leveraged best of breed technologies in the market for new products in terms of keeping your R&D dollar low, can you just talk about what changed now that requires you to spend more from an R&D standpoint, and I guess more to another question asked earlier, is the right level of – what is the right level of R&D as a percentage as we go forward?

Patrick Lo

Well, when we say more in R&D we don’t mean we are increasing R&D from 3.5% to 6%. We are talking about bringing it back to the level that in previous quarters like closer to 4%. We had been at that level since about a year ago with acquisition of Infrant Technologies of the ReadyNAS product line. So, we don’t think that we are out of line. We still believe in leveraging the best of breed technology from around the valley, and I think 4% is a reasonable level and we are still significantly lower than a lot of traditional networking companies in the valley.

Um Maynard – UBS

Okay. So does that presume that most of the R&D spend is going towards ReadyNAS or is it across your other product portfolios?

Patrick Lo

It is across all the other portfolios.

Um Maynard – UBS

And then secondly I am trying to reconcile your comments on you know, when you look at the higher channel inventories which you said was a result of balancing demand and also airfreight, how do I reconcile that against the weakening demand or the slower demand in back to school. Now, I understand Asia inventories potentially rising because the demand there seems to be pretty good, but can you help us understand the rise in the other regions.

Patrick Lo

Well, the two things are separate. On hand inventory has nothing to do with the channel inventory. So, the reason why we increased the on hand inventory level is because that would more on hand inventory we have a better chance of meeting the market demand, no matter what the mix is, so that we can minimize airfreight cost, and when we minimize airfreight cost our operating margin will go up. So that is the first part. The second part regarding the higher channel inventories in preparation for back to school. There were actually multiple elements that go into it. The number of weeks of channel inventory is calculated as the last 6 weeks average. So, if the overall market is weak that means the weekly POS is lower than the channel inventory goes up. So, that reflects one element. The other element is that we just (inaudible) stock up for the beginning for July. So, when all that – all that up it explains why our channel inventory is high relatively speaking.

Um Maynard – UBS

Okay. So, as we go in to the next quarter, would you expect that to come back down to normal levels across the regions?

Patrick Lo

And as far as the retail channel inventory is concerned it will gradually come down just like what we did with – when we entered in the RadioShack, it took us almost 2 years to gradually work to 13 weeks of channel inventory back down to about 8 or 10 weeks. We expect the process would take just as long.

Um Maynard – UBS

And then lastly, just in terms of your (inaudible) from your chipset perspective, have there been any changes there, and the reason why I ask is you know, some of your competitors have moved few companies like solutions from companies like Raylink to help lower their cost and then also essentially to lower than ASPs, have you made any of those shifts and if you have how long does it typically take to come to market commercially?

Patrick Lo

We haven’t, but of course, we thank our competitors moving to those chips which puts downward pressure on the price of their competitors and our suppliers chipset as well. So, we do enjoy the similar cost reductions. We believe that sticking to our existing supplier will give our products the stability and the superior performance that we are known for in the market.

Um Maynard – UBS

So, you are benefitting from a lower cost on your chipsets?

Patrick Lo

Well, definitely.

Um Maynard – UBS

Well great, thanks.

Patrick Lo

Thanks.

Operator

Thank you. Our next question comes from the line of Neil Gagnon with Gagnon Securities. Please proceed with your question.

Neil Gagnon Gagnon Securities

Good afternoon Patrick.

Patrick Lo

Hi, Neil.

Neil Gagnon Gagnon Securities

I am wondering on Wal-Mart. What percent of a normal business did you do in the quarter, because you were ramping up during the quarter, so there really wasn’t a full quarter’s of business?

Patrick Lo

Well, certainly for competitive reasons we are not disclosing what percentage of the revenue is and certainly Wal-Mart is in a pretty good scale. They are the number 2 retailer of such products in the U.S. after Best Buy. So, they are pretty significant for us.

Neil Gagnon Gagnon Securities

Okay. I wasn’t asking how much was Wal-Mart, I was saying if they were running normally, you really didn’t have a full quarter. What percent might that be?

Patrick Lo

Again, for competitive reasons that we will not like to disclose that. So, again with few in a ramp up mode it is very difficult to predict it. We are still going to see week by week improvement.

Neil Gagnon Gagnon Securities

Okay, thank you.

Operator

Thank you. Our next question comes from the line of Rohit Chopra from Wedbush Morgan. Please proceed with your question.

Rohit Chopra Wedbush Morgan

Hi, this is Sanjit Singh on behalf of Rohit Chopra. Just a couple of quick questions. First off, any ideas on how many new products you plan to release this quarter?

Patrick Lo

About 12 to 13.

Sanjit Singh Wedbush Morgan

12 to 13, got it. And then kind of related to fuel cost. Could you perhaps give us maybe some detail on the ratio of air versus land shipping by sea?

Patrick Lo

We don’t give that specific out, but certainly the cost of air freighting a unit by air is about 7 to 10 times that of by sea.

Sanjit Singh Wedbush Morgan

I wasn’t asking the relative cost, but maybe you know, how much – to what extent did you shift to air – or sorry, ground and sea shipping versus air?

Patrick Lo

Unfortunately, we would not be disclosing that. That is very important metrics that our competitors would like to note it.

Sanjit Singh Wedbush Morgan

Okay, and maybe you could provide us a little more detail on the relative price positioning versus Linksys maybe on the high-end versus the low end, maybe some detail on that?

Patrick Lo

We generally maintain a $10 price differential with them.

Sanjit Singh Wedbush Morgan

$10 on the high-end?

Patrick Lo

You know, across the board.

Sanjit Singh Wedbush Morgan

Across the board. Got it. Thank you.

Operator

Thank you. (Operator instructions) We do have a follow-up question from the line of Stanley Cobbler with Merrill Lynch & Co. Please proceed with your question.

Stanley Cobbler Merrill Lynch & Co.

Thanks for taking that follow-up. I just wanted to go back to the on hand inventory and look at the sequential increase in the amount that you have on hand versus the expected growth in the third quarter. So, in other words, you are expecting the back to school season to be pretty weak and you have grown inventory, which I assume was to help shipping cost. So, going into the third quarter how much risk is there that you will need to airfreight again or perhaps that you might have to build additional inventory given that you have already build up a lot in June and don’t expect a lot of sequential growth?

Patrick Lo

We certainly will see how the market reacts to the economic changes. If the market gives us a happy surprise that we need to airfreight them, we will have to make a decision, whether the additional revenue will bring us additional absolute bottom line. We will make those decisions as we go along. We will increase the inventory level because we have a financial plan that we believe that we need to execute.

Stanley Cobbler Merrill Lynch & Co.

Got it. And just on the gross margin. Is there any chance that because – going to increase the percentage of your shipments that there is sequential growth and gross margin percentage or will pricing just wash that out?

Patrick Lo

As we mentioned many a time gross margin is relatively irrelevant because in Q3 as you probably know it is back to school season, no matter what why we are going to run a lot of channel promotion programs and that will be a reduction of revenue and that will affect the gross margin, but on the other hand we will reduce our marketing expenses in advertising and TV ad or so on and so forth. So, really it is meaningless to look at the gross margin. We internally just look at standard margin and operating margins.

Stanley Cobbler Merrill Lynch & Co.

Great, thank you. Just in terms of the component cost savings. I think that was mainly – what I was asking about because that would fall through to the bottom margin as well.

Patrick Lo

Definitely, as you saw in Q2, so when we had product cost reduction, it was flow through into the bottom line. In Q3 we expect that we will continue to get the benefit of reduction in cost of the product that will increase our standard margin, however, as we mentioned, we are going to increase our operating expenses by putting more money behind our R&D and IT infrastructure. So, when you add that two together we guide 9.5 to 10.5% operating margin.

Stanley Cobbler Merrill Lynch & Co.

Thanks a lot, much clearer.

Patrick Lo

Good.

Operator

Thank you. Our final question comes from the line of Ben Atkinson with Gagnon Securities. Please proceed with your question.

Ben Atkinson Gagnon Securities

Thanks. Patrick you were guiding to 9 to 10% operating margins for Q2 and ended up at 11.5%. Was that all because of higher than expected revenue or were there any other factors?

Patrick Lo

I think that certainly has a big part to play and then there is another part as I think we have to thank our operation folks, which have been able to bring the product cost down, which increased our standard margin that helped, and thirdly we have the thank the entire staff that really hold down a lot of ordinary expenses and our OpEx has come down. So, all those contribute to it but certainly the increased revenues would help significantly.

Ben Atkinson Gagnon Securities

Okay. And on the service provider, in the past you told us what you thought revenue – what percentage of revenue would be in that category in coming quarters. Can you give us any sense from where you think service provider would be as a percentage of revenue in Q3?

Patrick Lo

It would be at the similar level.

Ben Atkinson Gagnon Securities

Okay, thank you.

Operator

Thank you. There are no further questions. Gentlemen, do you have any closing comments?

Patrick Lo

Yes. We are very excited by the fact that even though the market is challenging we are making the right moves and we are excited for the new products that are going to come out in the second half which will benefit us certainly probably later in the year or next year. We continue to see share gain across the board and we are looking forward to, you know, even more successful market share gain in the market once these new products are flowing through beginning in the fourth quarter. So, thank you very much for joining us today and look forward to talking to you again in our next earnings call in October. Thank you.

Operator

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

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Source: NETGEAR, Inc. Q2 2008 Earnings Call Transcript
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