NETGEAR, Inc.

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. At that time, if you have a question, you will need to press the star 1 on your push-button phone. I would now like to turn the conference over to Eric Weiland. Please go ahead, sir. Thank you, Christine. Good afternoon, and welcome to next year's third quarter of 2020 Financial Results Conference Call.

Joining us from the company are Mr. Patrick Lowe, Chairman and CEO, and Mr. Brian Murray, CFO. The format of the call will start with a review of the financials for the third quarter provided by Brian, followed by details and commentary on the business provided by Patrick. We then have time for any questions. If you have not received a copy of today's press release, please visit Netgear's investor relation website at www.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 concentrated by these forward-looking statements. For more information, please refer to the risk factors discussed in Netgear's Periodic Findings with the SEC, including the most recent Form 10-Q, 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 the call. The 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. Brian Murray Thank you, Eric. and thank you everyone for joining today's call. I'm very pleased to share with you our third quarter 2020 results. With continuing robust demand for our leading edge products, our team once again delivered a strong quarter with exceptional growth in revenue and profit. We were again constrained on the supply side for our CHP business, saw modest recovery in our SMB business, yet still delivered strong revenue growth and record non-GAAP operating profit. Net revenue for the third quarter ended September 27, 2020, was $378.1 million, up 42.2% year-over-year and up 35% on a sequential basis. This strong increase in revenue was primarily due to remarkably robust demand for our CHP products, powered by unprecedented bandwidth consumption in the home where people have transitioned to conduct the majority of their daily lives. This included products sold to service providers with associated revenue reaching $74.1 million, our highest level since the first quarter of 2016. We continue to win with our leading edge Wi-Fi 6 offerings and strong presence in both online and retail. Our supply chain team did an outstanding job in the quarter, giving product to our retail and service provider partners, outperforming our expectations. The team managed raw materials, manufacturing schedules, and transportation, optimizing with air freight in particular to meet more consumer demand than we had previously forecasted. With that said, We expect to remain supply constrained through the first quarter of 2021, primarily due to a worldwide shortage of advanced chips such as Wi-Fi 6. Our non-GAF operating income at $41.4 million was a quarterly record, with a reported non-GAF operating margin of 10.9%, as NECIR showed our ability to leverage our strong revenue growth. For the third quarter of 2020, net revenue for the Americas was $277.9 million, which is up 55.5% year-over-year and up 37.4% on a sequential basis. The Americas continued to benefit from increased demand for CHP products in both the retail and service provider channels generated by the shift to work-from-home environment. The median net revenue was $63.7 million, which is up 28.6% year-over-year and up 31.7% quarter-over-quarter, also driven by demand for CHP products in response to work from home and seen across both the retail and service provider channels. Our APAC net revenue was $36.5 million, which is down 2.9% from the prior year comparable quarter and up 24% sequentially. both largely driven by our service provider business in the region. For the third quarter of 2020, we shipped a total of approximately 4.7 million units, including 3.5 million loads of wireless products. Shipments of all wired and wireless routers and gateways combined were about 2 million units in the third quarter of 2020. The net revenue split between home and business products was about 84% and 16% respectively. The net revenue split between wireless and wired products was about 75% and 25% respectively. Products introduced in the last 15 months constituted about 27% of our third quarter shipments, while products introduced in the last 12 months contributed about 25% of our third quarter shipments. From this point on, my discussion points will focus on non-GAAP members. The reconciliation from GAAP to non-GAAP is detailed in our earnings release distributed earlier today. The non-GAAP gross margin in the third quarter of 2020 was 30.3%, which is up 90 basis points as compared to 29.4% in the prior year comparable quarter. and up 70 basis points compared to 29.6% in the second quarter of 2020. While the mix of our SMB business, which historically carries a relatively higher gross margin, declined year over year, and although we spent dramatically more on air freight in Q3, we were more than able to offset these gross margin headwinds through lower promotional activity on our CHP products. Total Q3 non-GAAP operating expenses came in at $73.2 million, which is up 27.8% year-over-year and up 18.1% sequentially. The team did a great job with revenue growth far outstripping OpEx growth to deliver strong leverage on our top line and produce record quarterly operating profit. As always, we will continue to manage our expenses prudently, while also ensuring that we are investing sufficiently in the growth portions of our business for future success. Our headcount was 803 as of the end of the quarter, up by 15 from the previous quarter. We continue to manage our headcount, but we'll add resources to invest in areas that we believe will deliver future growth. Our non-GAAP R&D expense for the third quarter was 6.2% of net revenue as compared to 6.8% of net revenue in the prior year comparable period and 6.9% of net revenue in the second quarter of 2020. To continue our technology and subscription service leadership, we are committed to continued investment in R&D. Our non-GAAP tax rate was 17% in the third quarter of 2020. In the quarter, we benefited from favorable one-time adjustments to domestic tax liability. This contributed about $0.08 to our non-GAAP diluted EPS. Looking at the bottom line for Q3, we reported non-GAAP net income of $34.7 million and record non-GAAP diluted EPS of $1.13. Turning to the balance sheet, We ended the third quarter of 2020 with $306.8 million in cash and short-term investments, up $48.3 million from the prior quarter. Additionally, our inventory decreased by $6.3 million in the quarter as we continued to deliver on strong demand in the Americas and EMEA, while remaining supply constrained, which left us unable to increase our own inventory holdings. We hope to reverse this trend in the first half of 2021 and move our inventory position closer to historical norms. In Q3, we generated $42.9 million in cash flow from operations, which brings our total cash provided from operations over the trailing 12 months to $184.6 million. We used $2.5 million in purchases of property and equipment during the quarter This brings our total cash use from capital expenditures over the trailing 12 months to $8.5 million. We remain confident in our ability to continue to generate cash and expect to further increase our cash position again in the fourth quarter. In Q3, we chose not to repurchase any shares under our open buyback program, and our fully diluted share count is approximately 30.7 million shares. especially in times of uncertainty like these, we recognize the importance of maintaining a strong cash position and will balance our practice of repurchasing shares with our desire to maintain a strong balance sheet. As I previously mentioned, we will need to replenish our own inventory levels. Thus, we would expect to consume some of our cash in the first half of 2021 as a result. Now, turning to the results of our product segments. The connected home, which includes the industry-leading Nighthawk, Orbi, Nighthawk Pro Gaming, and Mural Brands, generated net revenue of $316.7 million during the quarter, which is up 66.1% on a year-over-year basis and up 37.7% sequentially. The year-over-year and sequential increase was attributable to heightened demand across both service provider and retail channels. In the third quarter of 2020, service provider revenue was the highest it has been since the first quarter of 2016, while non-service provider revenue grew an impressive 56.8% as compared to the comparable prior year period. In the third quarter, despite supply headwinds in our Wi-Fi fixed products, we again held a strong leadership position in U.S. market share in consumer Wi-Fi, coming in at 44%. and we fully expect we can grow our share once again, once we overcome the Wi-Fi 6 supply constraints in the second quarter of next year. The SMB segment generated net revenue of $61.4 million for the third quarter of 2020, which is down 18.4% on a year-over-year basis, but up 22.7% sequentially. As we expected, our SMB business recovered slightly, as evidenced by the strong sequential growth. The year-over-year decline stems from the pandemic and corresponding business closures. On the product front, our wireless LAN and PoE Plus and PoEV switching lines continue to perform well in the market. Our market share in switches sold through the U.S. retail channel came in at 49% in Q3. I'll now turn the call over to Patrick for his commentary. Thank you, Brian. With the pandemic continuing around the world, many adjustments that seem temporary are cementing their place in our lives. People and companies have been forced to adapt. At work, some companies are embracing work from home on a permanent basis. Others are moving to a hybrid model of working from home and at the office in roughly equivalent amounts. In addition, the flexibility to work from anywhere has led to a massive migration away from crowded, high-cost areas to zoom towns in more isolated, less urban areas, leading to an increase in new or upgraded network connections. Regardless of when the pandemic ends, what's clear is that the future work has forever changed, and that means working from home at least part of the time is here to stay. And what counts as home may be defined by multiple occasions. At home, people are adapting to the new environment by learning how to pursue all of their daily activities virtually from home. Eight months in the making, There's more from home. Transition goes well beyond work and school. Families are pursuing a myriad of activities virtually. Everything from watching movie premieres and live music concerts, to shopping for groceries, to virtual gators, to doctor's visits, to fitness classes, and checking in on family and friends across the country or even across documents. These activities are taking place through their laptops, tablets, and phones. And families are recognizing the need for a fast and reliable Wi-Fi connection that spans their entire home to support the increased bandwidth consumption and multitude of connected devices utilized across their home. Whereas previously, these activities might have been optional, people have been forced to try them virtually and are now discovering they actually enjoy and even sometimes prefer them to the traditional way of doing things accelerating adoption and making these virtual activities an increasingly permanent part of our lifestyle the nagia team is working around the clock across the globe to serve this need as you can see from our results The aforementioned changes continue to drive strong growth in demand for our CHP products as people upgrade their Wi-Fi networks and discover new uses for mobile hotspots. In Q3, we made dramatic adjustments within our supply chain and worked closely with our channel partners to ramp production and delivery. I'm proud to say that the team at Netgear continued to execute at the highest level and exceeded my expectations on what we could deliver for our CHP business. Yet, even with these efforts, we remained supply constrained on CHP products as we are more dependent on advanced chips to power Wi-Fi 6 and our competitors who remain stuck on Wi-Fi 5. Similarly, in our SMB product portfolio, we were caught off guard by the surprisingly strong demand for low-end PoE switches and Wi-Fi 6 wireless mesh access points for home office and home-based business uses. We expect supply constraints to continue to limit the non-carrier side of CHP in Q4, But if our supply chain team can repeat their Q3 performance, we believe we can deliver to roughly the same revenue level we saw in Q3. On the service provider side in Q3, we were able to set aside the demand for mobile hot stops needed to fight the pandemic in the U.S. for the start of the new school year and for our first responders. we expect our 24 service provider revenues to return to roughly q2 level much has been made of the technology transitions that have been accelerated by more from home with these transitions we believe many of the activities that are now virtual will remain virtual and as such this represents a significant change in the way people conduct their lives The need for robust and pervasive Wi-Fi connectivity constitutes a fundamental need, and we believe this has recast our total addressable market on an upward basis going forward. Nigeria has a unique set of attributes that give us a defensible advantage. A longstanding, trusted brand with loyal followers, A well-deserved reputation for high-performance Wi-Fi products that are based on our leading-edge tri-band technology. Best-in-class channel relationships and a growing portfolio of value-added subscription services. This is why we are confident that Netgear will remain the Wi-Fi and networking vendor of choice. for both consumers and small businesses as more of our lives transition to virtual for the long term, and why we will continue to grow with the market. And it is more evident now than ever that our early investment to be a leader in next-generation technologies, namely tri-band Wi-Fi systems and minimum-wave 5G hotspots, we continue to pay dividends. In Q3, we saw a strong demand for our tri-band Wi-Fi 6 Orbi and Orbi Pro. While our three-pack configuration starts at $499 and can exceed $1,000 with Orbi Pro, we cannot keep them in stock across all the markets that we participate. From Tokyo to Hong Kong to Paris to Munich to Toronto, and especially right here in the U.S. Customers are telling us, even with their older Wi-Fi 5 smartphones and devices, that they are seeing a significant performance boost from our Wi-Fi 6 Orbi systems due to our innovative radio circuits and antenna designs. We are ramping production of our Wi-Fi 6 Orbi as quickly as we can, But at this point, we don't believe we will catch up to demand until Q2 next year at the earliest due to the Wi-Fi 6 chip supply shortage. Moving to the SMB business, the team continued to drive forward with a focus on products geared towards home offices and home businesses and delivered a sequential growth of 23% quarter-over-quarter. We faced the same headwinds as last quarter with channels that rely on personal interaction, like our VAR partners who do IT installations. During the quarter, we introduced the world's first Wi-Fi 6 mesh access points with app-based remote management. Just like its CHP-OB counterpart, we could not keep them in stock. We are seeing strong demand for our low-end power over Ethernet switches for home office setups, as remote workforces use them to connect to IP phones, desktops, printers, and access points. We believe this demand will persist as workforces increasingly become more distributed post-pandemic. We are making progress with our pro-AV business as well, The team also delivered marquee wins, such as with the PGA Tour in the US and the 2021 America's Cup in New Zealand. In Q3, we announced a brand new line of AV switches that support the audio over Ethernet protocol, AVB. This new M4250 line of AV switches was well received by AV integrators around the world. We expect a shutdown in volume in Q4. We look forward to continued improvement in our SMB revenue in Q4, with the year-over-year decline continuing to reduce from what was experienced in Q3. The increased importance of Wi-Fi in people's homes And the need to connect, manage, and secure more devices to that Wi-Fi is also translating into more subscribers to our premium paid services. We again delivered record progress in growing our recurring revenue stream. Beginning the quarter with 293,000 paid subscribers, we increased our new paid subscribers by 26% sequentially. adding 76,000 in the quarter to end with 369,000 paid subscribers. In only three quarters, we have exceeded our goal for all of 2020 of doubling our subscribers, a notable achievement and positive sign for our profitability growth in the years to come. I would also like to take a moment to welcome Sarah Belafast to the next year board, having led product development at Top Software First, consumer-facing brands such as Groupon and Orbis, and now Chief Product Officer at FanDuel. Sarah will add valuable apps and services product strategy and consumer engagement expertise to our board. I look forward to working with her as we grow our subscription business. And with that, I'll turn it over to Brian Murray to comment on our opportunities and obstacles in the coming quarter. Thank you, Patrick. While we are confident in the ongoing strength of in-market demand for home networks, there is still considerable uncertainty around the effects of COVID-19 on the global economy and our supply chain. This makes our outlook difficult to forecast. As such, We are not in a comfortable enough position to provide financial guidance for the fourth quarter. We would now like to answer any questions from the audience.

Thank you. As a reminder, to ask a question, you will need to press star 1 on your telephone. To withdraw your question, please press the pound or hash key. Please stand by as we compile the Q&A roster. Your first question comes from the line of Adam Tindall from Raymond James. Your line is open.