NETGEAR Q3 2023 Earnings Call Transcript

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Provided by Quartr
October 25, 2023

There are 6 speakers on the call.

Operator

Hello and welcome to NETGEAR's 3rd Quarter 2023 Results Conference Call. Ladies and gentlemen, thank you for standing by. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session. I would now like to turn the conference over to Eric Bylin.

Operator

Please go ahead, sir.

Speaker 1

Thank you. Good afternoon, and welcome to NETGEAR's Q3 of 2023 Financial Results Conference Call. Joining us from the company are Mr. Patrick Loew, Chairman and CEO and Mr. Brian Murray, CFO.

Speaker 1

The format of the call will start with a review of Thank you, Brian. We will now begin the Q4 of 2023 guidance

Operator

If you

Speaker 1

have not received a copy of today's release, please visit NETGEAR's Investor Relations website atwww.netgear.com. Before we begin the formal remarks, we advise you that today's conference call contains forward looking statements. Forward looking statements include statements regarding expected revenue, operating margins, tax rates, expenses and future business outlook. Actual results or trends could differ materially from those contemplated by these forward looking statements. For more information, Please refer to the risk factors discussed in NETGEAR's periodic filings with the SEC, including the most recent Form 10 Q.

Speaker 1

Any forward looking statements that we make on this call are based on assumptions as of today, and NETGEAR undertakes no obligation to update these statements as a result of new information or future events. In addition, several non GAAP financial measures will be mentioned on this call. A reconciliation of the non GAAP to GAAP measures can be found in today's press release on our Investor Relations website. At this time, I would now like to turn the call over to Mr. Brian Murray.

Speaker 2

Thank you, Eric, Thank you everyone for joining today's call. We are pleased by the continued strong execution of our team this quarter Revenue was $197,800,000 up 14.1% on a sequential basis, but down 20.7% year over year. Increased demand in both the CHP retail market and service provider channels, along with retail channel partners maintaining rather than depleting their inventories, enabled us to outperform our top line relative to our original expectations. As the WiFi 7 upgrade cycle begins to ramp As we approach the holiday season, we continue to see positive signs that the retail networking market is stabilizing. Notably, in Q3, the U.

Speaker 2

S. Retail market grew double digits sequentially, in line with historical seasonality. In the retail portion of our CHP business, our premium solutions, which consists of our Orbi 8 and 9 Tri and Quad Band WiFi Mesh Products and 5 gs Nighthawk Mobile Hotspots are continuing to perform well. Sales to end users of these premium products grew double digits year over year, dramatically outperforming the total market, which compressed double digits over the same timeframe. On the other hand, our SMB business fell short of our top line expectations in the 3rd quarter.

Speaker 2

The uncertain macroeconomic environment continued to pressure our channel partners and we saw them continue to reduce their inventory carrying levels, which constrained the top line of our SMB business and will continue to limit its top line potential in the quarters to come. This 2nd consecutive quarter of top line outperformance is an encouraging sign that the CHP retail market is stabilizing And the WiFi 7 transition is gaining traction. The strong mix of our premium, higher margin products, Additionally, we gained top line leverage from the seasonal lift of the back to school season and coupled with the disciplined expense management, We returned to profitability, delivering non GAAP operating income of $5,300,000 and non GAAP operating margin of 2.7 percent, with the margin coming in well above the high end of our guidance range. Our non GAAP operating margin was up 200 basis points compared to the year ago period and up 8 90 basis points compared to the prior quarter. For the Q3 of 2023, Net revenue for the Americas was $141,000,000 a decline of 16.7% year over year and up 20.9% on a sequential basis.

Speaker 2

EMEA net revenue was $35,700,000 a decrease of 20.4% year over year and down 1.3% quarter over quarter. Our APAC net revenue was $21,100,000 which is down 40.3% for the prior year comparable period and up 2.4% sequentially. For the Q3 of 2023, we shipped a total of approximately 1,800,000 units, including 991,000 nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 520,000 units for the Q3 of 2023. The net revenue split between Home and Business Products was about 64% 36%, respectively.

Speaker 2

The net revenue split between wireless and wired products was about 61% and 39% respectively. Products introduced in the last 15 months constituted about 16% of our 3rd quarter shipments, while products introduced in the last 12 months contributed about 11% for 3rd quarter shipments. From this point on, my discussion points will focus on non GAAP numbers. Non GAAP gross margin in the Q3 of 2023 was 35%, which is up 7 40 basis points as compared to 27.6% the prior year comparable period and up 3 40 basis points compared to 31.6% in the Q2 of 2023. As compared to the prior year period, increased shipments of our premium higher margin CHP products And considerably lower total freight costs drove the improvement.

Speaker 2

As compared to the prior quarter, Q3 experienced a higher mix of premium, higher margin products and overall we were more efficient with our marketing spend. Total Q3 non GAAP operating expenses came in at $64,000,000 which is down 4.7% year over year and down 2.2% sequentially. Our headcount was 644 as of the end of this quarter, down from 653 in Q2. We will continue to strategically invest in our business and hire in key areas we believe will deliver future growth and profitability, such as ProAV managed switches, premium Orbi WiFi mesh systems, 5 gs mobile hotspots and subscription services. However, we continue to evaluate other areas of the business on a regular basis, driving further cost efficiencies.

Speaker 2

Our non GAAP R and D expense for the Q3 was 10.1 percent of net revenue as compared to 8.5% of net revenue in the prior year comparable period and 11.4% of net revenue in the Q2 of 2023. To continue our technology and subscription service leadership, We are committed to continued investment in R and D. Our non GAAP tax expense was $700,000 in the Q3 of 2023. Looking at the bottom line for Q3, we reported non GAAP net income of $6,900,000 and non GAAP diluted earnings per share of $0.23 Turning to the balance sheet. We ended the Q3 of 2023 with $228,000,000 in cash Short term investments, up $25,200,000 from the prior quarter.

Speaker 2

As we projected in July, We were able to return to positive free cash flow in the 3rd quarter as we made meaningful progress in reducing our inventory and improving our bottom line. During the quarter, dollars 26,100,000 of cash was provided by operations, which reduced our Total cash used by operations over the trailing 12 months to $4,400,000 We used $2,000,000 in purchase of property equipment during the quarter, which brings our total cash used for capital expenditures over the trailing 12 months to $5,200,000 We expect to continue generating positive free cash flow as we believe we will further reduce our inventory levels over the next couple of quarters and drive to our pre pandemic carrying levels of 3 to 4 months. Now turning to the 3rd quarter results for our product segments. The Connected Home segment, which includes our industry leading Orbi, Nighthawk, Nighthawk Pro Gaming, Arbor and Muirubrands, Generated strong revenue of $127,300,000 during the quarter, down 15.4% on a year over year basis and up 29.4% sequentially. The year over year decline in both the retail and service provider channels is a result of a larger total addressable market and higher inventory carrying levels at our channel partners in the prior year period.

Speaker 2

Despite the year over year overall retail market contraction, Demand for our premium Orbi 8 and 9 WiFi Mesh and 5 gs Mobile Hotspots continued to grow, up double digits. Bolstered by the addition of our recently released Wi Fi 7 products, namely the Orbi 9 7X Mesh System and the Nighthawk RS700 Router, These higher margin, high end products with high ASPs were an important contributor to delivering revenue and operating margins well above the high end of our guidance. Serving as another proof point of the long term growth and profitability potential of our core strategy. On the SMB side, net revenue came in at $70,500,000 in the 3rd quarter, below our expectations. The softness in SMB was due to the uncertain macroeconomic environment weighing on the SMB market, especially in geographies with stagnant or even negative GDP growth, such as Germany, Greater China and Japan, which are our biggest markets outside of North America.

Speaker 2

Our SMB channel partners continue to compress inventory levels in the quarter and are expected to continue doing so in the quarters ahead. Despite this, we continue to see growth in our ProAV suite of products and remain confident they will be a long term growth driver of our SMB business. I'll now turn the call over to Patrick for his commentary.

Speaker 3

Thank you, Brian. I would like to thank our NETGEAR team For delivering many great achievements in the Q3, we had the most successful launch of new Wi Fi technology in our history. With our WiFi 7 quad van, OB97X and Nighthawk RS700 Router, We attained an overall gross margin of 35% by driving an ideal combination of high margin products In CHP and SME with fewer promotional discounts, we continue to grow the number of value added service subscribers to $844,000 achieving 25 percent growth in service revenue to $10,600,000 for the quarter. We worked together with our retail channel partners to right size the inventory levels and believe they have reached the level they would like to maintain. We continue to see growth in market demand for our ProAV line of SMB products.

Speaker 3

And finally, our team worked tirelessly to reduce our own inventory and generate And market reception well exceeded our expectations. The OB9 7x, our WiFi 7 quad band mesh, Delivered sales in the 1st 2 weeks doubled that of our prior launch of the Quad Band WiFi 6E Mesh, The OB966. The Nighthawk WiFi 7 Router, RS700, InstaNY became our number one selling premium router, overtaking our previous top of the line WiFi 6E The RAXE500. While WiFi 7 clients are not widely available yet, The early technology adopters have clearly given us the stand of approval. As Wi Fi 7 clients become widely available starting April or May of next year, we believe the retail market And our CHP revenue will ride the upgrade cycle and we believe this will return our CHP Business back

Speaker 4

to growth.

Speaker 3

We are readying a strong pipeline of Wi Fi 7 introductions in 2024 Across all our major product lines, Orbi Mesh, Nighthawk routers, Nighthawk Mobile Hotspots and SMB Insight Access Point. We are excited about these opportunities to expand our top and bottom lines in 2024 on a year over year basis for every quarter. During Q3, our HP sales and marketing teams worldwide were hard at work in showcasing and marketing our high margin products across all categories: To achieve the best mix of high margin products in recent years, our SMB team is doing the same With our ProAV products, as a result of these efforts, we were able to achieve 35% gross margin overall. We believe as more WiFi 7 products launch in 2024, we will have room to further improve Our overall gross margin in the New Year. We added 40,000 paid service subscribers in Q3, Reaching a count of $844,000 we grew our paid service revenue to $10,600,000 We are on pace to reach our goal of 875,000 paid service subscribers By the end of the year, further growing our service revenue, which would be a major contributor to our gross margin expansion for years to come.

Speaker 3

We will continue to add compelling features to our ARMOR services To protect our customers' connected devices throughout their homes, we intend to add more privacy protection features in 2024, thus increasing the appeal of our armor service to even wider audiences. With the strong reception of our Wi Fi 7 launch and the stabilization of the size of the retail addressable market, Our retail channel partners are more confident that the retail network market will stay at current levels or potentially even increase. They have demonstrated this by no longer depleting the inventory, and we will continue to bring new products to market To add to their confidence, this quarter, we will bring out 2 new versions of our premium Nighthawk mobile hotspot, the M6 Pro. The first one is for the U. S.

Speaker 3

Market with compatibility on the Verizon network. The second one is for the Japanese market With compatibility to all major carriers in Japan, there are more WiFi 7 mesh, Routers and mobile hotspots to be introduced in each quarter in 2024. On the SMB side, our ProAV managed switches continued their year on year growth with more commercial AV integrators and manufacturers Control room displays, digital signage, concert tours, sporting events, esports arenas, Lecture halls, churches and performance centers. We recently participated For the first time in the biggest European broadcast equipment trade show, IBC in Amsterdam, Showcasing our new M4350 switch with imminent support of the SMPTE 2,110 broadcast protocol. We are seeing lots of enthusiasm from potential partners, equipment and manufacturers and integrators alike.

Speaker 3

We are excited about this opportunity in 2024. We also recently introduced our first Residential wired router, PR-sixty X. It is well received by the high end residential ProAV integrators. We believe we will be able to expand further into this market in 2024. We are making good progress in returning our inventory turns to between 34.

Speaker 3

We significantly reduced our inventory and We are confident that our inventory levels will return to normal by mid-twenty 24. We will have headwinds in the next three quarters as inventory costs go up due to the timing of their arrival in prior periods. We will continue to work on better product mix, cost containment and new product introductions to mitigate some of the negative effects. Our team is committed to such efforts. Turning to our SMB business.

Speaker 3

We are seeing some of our large markets like Greater China, Germany and Japan face macro uncertainty from geopolitical tensions, high interest rates and sluggish economic growth. This is impacting our SMB business in these markets and causing our channel partners to lower the inventory carrying levels, which will limit the top line potential of SMB in the coming quarters. Despite the inventory compression, We believe there are ample near term headwinds. These are simple near term headwinds and the underlying long term growth The opportunity of the business, driven by our ProAV solutions remain intact. And with that, I'll turn it back over to Brian to comment on our opportunities and obstacles in the coming quarter year.

Speaker 2

Thank you, Patrick. We expect to continue to experience strong underlying demand in the premium portion of our CHP product portfolio. Writing on the success of our Wi Fi 7 launch well into 2024. We are also encouraged that our retail channel partners are now maintaining rather However, we will continue to work with our SMB channel partners to optimize their inventory carrying levels during the next few quarters. Accordingly, we expect CHP to be approximately flat sequentially, in line with market seasonality And SMB to be down sequentially, which will result in overall 4th quarter net revenue being in the range of $175,000,000 to 190,000,000 As we continue to make meaningful progress in reducing our own inventory levels, we will be consuming older higher cost inventory.

Speaker 2

We expect we will back to normal inventory levels and normal inventory costs by the middle of next year. Accordingly, we expect 4th quarter GAAP operating margin to be in the range of negative 4.4 percent to negative 1.4 percent and non GAAP operating margin to be in the range of negative 2% to positive 1%. Our GAAP tax expense is expected to be in the range of $1,000,000 to $2,000,000 and our non GAAP tax expense is expected to be in the range of $0 to $1,000,000 for the Q4 of 2023. We expect we will continue to generate meaningful cash in Q4 and beyond. We would now like to answer any questions from the

Operator

Your first question comes from the line of Hamed Khorsand from BWS Financial, please go ahead. Your line is open.

Speaker 4

Hi. So first question I had was About this inventory, it's been you're intending to burn off and the timing of margins. How much what is the normal gross margin that you're aiming for right now? What kind of Impact are you thinking that this will have in the next 2, 3 quarters?

Speaker 2

Yes. So in terms of Q4, we think there's Probably about 150 basis point headwind relative to Q3, which is pretty much reflected in the guidance that we provided. It will reach its peak in the Q1 period and then taper off from there going into Q2 in the second half of twenty twenty four. And really it's about as we're aggressively working down our inventory levels, you would have seen about a $42,000,000 sequential decrease. We're stopping the inflow and the operational cost supporting the procurement of that inventory As a percentage, weigh a little bit heavier on the overall cost of

Speaker 4

the inventory. But as I

Speaker 2

said, it's about 150 basis point headwind in Q4. It Takes up a little bit from there into Q1, and then we'll taper off as we progress.

Speaker 3

Yes. Our aim is using 35 And after burning all of these higher cost inventory, We believe that we can continue to improve on that gross margin beyond 35%.

Speaker 4

Okay. And then given your commentary around inventory, I'm assuming that your aim is something around $80,000,000 to $90,000,000 of conversion The cashier, what is the timing of that inventory converting from accounts receivable to cash because Your DSOs still are pretty elevated.

Speaker 2

Yes. DSOs tend to go up in the 4th quarter. I expect Trying to continue, you may recall in the past and we continue to do this, we support a couple of retailers with Extended payment terms leading into the holiday season. So I think DSOs will go up, but that's in line with what our normal experience would be. In terms of the impact in reducing inventory, I would say that we're probably going to move in a similar direction to what you saw in Q3 in each of Q4 and Q1, I think the heaviest lift will happen in those two quarters.

Speaker 2

And I would The free cash flow implications are slightly ahead of what we delivered in Q3 as a result of those efforts.

Speaker 3

I believe that by Q3 of next year, we'll be back to normal in generating cash equivalent to net earnings Close to net earnings, yes.

Speaker 4

So what I'm trying to get to is your cash balance is going to increase quite a bit. Why hasn't the company come out and start buying back stock at $10

Speaker 2

So we're opportunistic buyers of our stock. We continue to have those conversations. As you saw, this Q3 was the 1st period we returned to positive free cash flow. That's obviously a consideration point. But Repurchasing stock is still a conversation we continue to have.

Speaker 2

I

Speaker 4

mean, what's a better opportunity than $10 I mean, How much further down are you expecting your stock to go?

Speaker 3

Well, I mean, we definitely are looking at all these. I mean, We believe that, yes, we will always be the opportunistic buyer in the market, especially now we are confident in generating cash.

Speaker 4

Okay. Thank you.

Speaker 3

Sure.

Operator

Your next question comes from the line of Jake Norason from Raymond James. Please go ahead. Your line is open.

Speaker 5

Hey, thank you for taking my questions. Firstly, can you guys touch on your early indications from holiday season? How is this similar or different from years past? And have there been any changes to your sort of promotional

Speaker 1

As a matter

Speaker 3

of fact, I think a good indication From the Prime Day 2 that Amazon put together, it seems like the holiday season is In networking, it's pretty much like the rest of the retail market is galvanizing into the high end As well as the lower end. So that's why we're seeing really positive reception to our high end products, such as the WiFi 7 products or even the existing OV8 and OV9 and the high end routers such as what we mentioned, The RS700 is a new one and the RAP 500 is the 1 high end. But also there's quite a bit Of demand on the lower cost Wi Fi products such as the adapters, such as the Standards which are really cheap quick fix to better Wi Fi at home. We're also seeing the popularity of Our lowest cost cable gateway for $199 because a lot of customers will realize that By paying $15 a month to rent Wi Fi from cable operators, it's much cheaper to buy a cable gateway at $200 And after 12 months, it's all gravy. So I think the holiday season will be the same in those Now certainly, we're not promoting the RB9, all right?

Speaker 3

These are premium products. But yes, we'll Strategically, promote some of these lower end, higher demand customer products where we have a unique position. We have less competition so that we could generate more margin dollars.

Speaker 5

Perfect. Thank you. And then last one for me. Can you just speak to the performance of the cybersecurity ARMOUR service and then funnel of activations this quarter?

Speaker 3

The ARMOUR cybersecurity service is still our number one Service by our subscribers. And overall, we're seeing very strong uptake and Strong renewal rate among these customers. So as we say, our intention is to expand the feature set So that we have opportunity to further expand the subscriber base and also potentially increase the ARPU. That's the strategy going forward. And we did a lot of user survey through our app that customers' number one request Is to have privacy features such as shooting away cookies, hiding your identity, things like that.

Speaker 3

We would definitely add that in 20

Speaker 5

Are you guys internally thinking about ever providing more disclosures around the service?

Speaker 2

Such as?

Speaker 5

A quarterly ARPU number, churn,

Speaker 3

Okay. All right. Yes, certainly, we will look into that. I think we have said quite during the Analyst Days that our ARPU is pretty consistent around $50 hasn't changed since 2 years ago. So we expect that during this phase of user acquisition, our apple would stay the same.

Speaker 3

And from a churn rate perspective, as we said, for those customers who have renewed After the 1st year, the churn rate is actually lower than industry average. Our churn rate for those who have renewed For the 1st year, getting into the 2nd year, then from here on out, the churn rate is less than 15%. I think we talked about that last time on the M and A.

Speaker 5

Okay, that's very helpful. Thank you so much.

Speaker 2

Sure.

Operator

We have no further questions in the queue at this time. Patrick, I'll turn the conference over to you for closing remarks.

Speaker 3

Thank you for joining us today. I'm very pleased by our execution this quarter where our results have demonstrated Our high end premium products and services are resilient and holding up against the broader retail market And inventory compression headwind. It's clear our commitment to innovation and investments in building Our market leading portfolio of products are paying off. While we are still facing SMB channel inventory compression In a high interest rate environment in the short term, the top and bottom line expansion potential of our Premium CXP Products, ARMOUR Security Service and Pro AV Switches is clear. Netgear Well positioned ahead of the imminent Wi Fi 7 upgrade cycle with 2 Wi Fi 7 products already shipping and many more to come, giving us confidence in our ability to deliver even greater revenue and margin expansion and improved Predictability in our business as we close out 2023 and enter 2024.

Speaker 3

I look forward to sharing an update on our progress at our Analyst Day on December 7. Look forward to seeing you all. Thank you.

Operator

This concludes today's conference call. Thank you for your participation and you may now disconnect.

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