NETGEAR, Inc.

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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 Palin. Please go ahead, sir.

Thank you, Mike. Good afternoon, and welcome to Netgear's first quarter of 2021 Financial Results Conference Call. Joining us from the company are Mr. Patrick Lowe, Chairman and CEO, Mr. Brian Murray, CFO. The format of the call will start with a review of the financials for the first quarter provided by Brian, followed by details and commentary on the business provided by Patrick, and finish off with the second quarter of 2021 guidance provided by Brian. We'll then have time for any questions. does not receive a copy of today's press release, please visit Netgear's investor relations 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 maturely from those contemplated by these forward-looking statements. For more information, please refer to the risk factors discussed in Netgear's periodic findings of the SEC, including the most recent Forum 10-K. 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. 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. Thank you, Eric, and thank you, everyone, for joining today's call. We delivered a great start of the year, setting the pace to achieve the full-year targets we put out at last December at our analyst day. We reported net revenue just above our guided range as both sides of the business performed well. And we saw supply constraints ease slightly. Our operations team navigated around chip constraints and the continuing elongated transportation times to bring product in from our suppliers, while significantly lowering our freight spend from the fourth quarter levels. Net revenue for the first quarter ended March 28, 2021, was $317.9 million, up 38.3% year-over-year, driven primarily by strong CHP growth in the retail channel and better-than-expected SMB performance. Our leading Y56 offerings continued their momentum in the first quarter across both businesses. Additionally, The work we continue to do to focus on the right products in support of the work-from-home networking market, coupled with strong ProAV growth, resulted in continued upward trajectory for our SMB business, delivering 17.9% year-over-year growth. In the first quarter, we generated a record non-GAAP operating income of $42.3 million. This translated into a non-GAAP operating margin well above the top end of our guidance range at 13.3%, an improvement of 970 basis points over the first quarter of 2020, and 230 basis points over the fourth quarter of 2020. Relative to our guidance range, we experienced better than expected performance from our SMB business, which carries higher margins. Additionally, we saw an improved mix of business coming from the higher margin e-commerce channel. As mentioned previously, our operations team was able to lower spend on air freight meaningfully below planned levels. All three factors contributed to non-GAAP property margin coming in well above our initial expectation. While we spent less in air freight than originally expected, much of the improved supply arrived later in the quarter. As a result, we could only replenish the channel inventory towards the end of the quarter. And thus, we didn't have an opportunity to increase promotional efforts and recoup even more market share than the modest gains we experienced in the quarter. We do believe we were in a solid position heading into the second quarter to selectively increase promotional efforts, including participation in promotional activities planned with some key channel partners. which should allow further gains in market share and assist with our goal of driving increased paid subscribers. The strength in our business was seen across the globe as we delivered solid double-digit year-over-year growth in all geographies. Led by the demand for our premium mesh products in our CHP business, as well as strength in our S&B business. For the first quarter of 2021, net revenue for the Americas was $219.2 million, which is up 38.5% year over year and down 15.6% on a sequential basis. The median net revenue was $61.1 million, which is up 44.9% year over year and down 9.4% quarter over quarter. Our APAC net revenue was $37.7 million, which is up 27.2% from the prior year comparable quarter and down 5.7% sequentially. For the first quarter of 2021, we shipped a total of approximately 4.1 million units, including 2.7 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 1.4 million units for the first quarter of 2021. The net revenue split between home and business products was about 76% and 24%, respectively. The net revenue split between wireless and wired products was about 59% and 31%, respectively. Products introduced in the last 15 months constituted about 35% of our first quarter shipments, while products introduced in the last 12 months contributed about 30% of our first quarter shipments. From this point on, my discussion points will focus on non-GAAP numbers. The reconciliation from GAAP to non-GAAP is detailed in our earnings release distributed earlier today. The non-GAAP gross margin in the first quarter of 2021 was 35.2%, which is up 600 basis points as compared to 29.2% in the prior year comparable quarter, and up 460 basis points compared to 30.6% in the fourth quarter of 2020. The year-over-year improvement was driven by improved product margins led by our premium mesh solutions. Sequentially, lower spend on air freight, higher demand for SMB products, and higher mix of revenue going through e-commerce channels, which brings the added benefit of lower costs associated with consumer returns, all contributed to improved gross margins. With improving supply, we plan to selectively increase promotional spending to accelerate market share gains, which should contribute to further growth in paid subscribers. In addition to higher promotional activities, we have seen an uptick in the cost of sea transportation by two to three times historical levels. And as a consequence, we believe the Q1 2021 gross margin performance is not likely to repeat in the near-term quarters ahead. Total Q1 non-GAAP operating expenses came in at $69.7 million, which is up 18.2% year-over-year and down 3.3% sequentially. Our team continues to navigate a challenging operating environment while adding proportionately less spend. As a result, we were able to unlock considerable leverage on a 38% year-over-year revenue growth. As always, we manage our expenses prudently while also ensuring we adequately fund the growth portions of our business so that they have the resources they need to succeed. Our headcount was 775 as of the end of the quarter, down from 818 in Q4, as we consolidated some of our offices in the APAC region to gain some cost efficiencies. This will fund further investment in other areas of the business, such as resources supporting our paid subscription business. 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 first quarter was 7.1% of net revenue, as compared to 8.1% of net revenue in the prior year comparable period, and 6% of net revenue in the fourth 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 24.5% in the first quarter of 2021. Looking at the bottom line for Q1, we reported non-GAAP net income of $31.6 million and non-GAAP deleted EPS of 99 cents, each substantially higher than the prior comparable period. Turning to the balance sheet, we ended the first quarter of 2021 with $370.7 million in cash and short-term investment, up $17.3 million from the prior quarter. We were also able to strengthen our inventory position intramutually in the quarter, adding $43.6 million to our stock levels. We believe our supply position will continue to improve in the second quarter. During the quarter, we generated $13.7 million in cash flow from operations, which brings our total cash provided from operations over the trailing 12 months to $165.9 million. We used $1.6 million in purchases of property and equipment during the quarter, which brings our total cash used for capital expenditures over the trailing 12 months to $10.6 million. As we previously highlighted, we plan to reestablish normal carrying levels of our own inventory in 2021. As a result, we expect to be below our normal conversion ratio of 85% to 100% of non-GAAP ad income by a fair amount, as we saw in Q1. But we remain confident in our ability to continue to generate cash on a full-year basis. Now, turning to the first quarter results for our product segments. The connected home segment, which includes the industry-leading Nighthawk, Orvi, Nighthawk Pro Gaming, and Nero brands, generated net revenue of $240.9 million during the quarter, which is up 46.3% on a year-over-year basis and down 19.6% sequentially. The strong year-over-year growth was driven by heightened demand in the retail channel for our premium Wi-Fi 6 solutions. In the first quarter, despite supply headwinds for our Wi-Fi 6 products existing for much of the quarter, we were able to improve on our strong leadership position in U.S. market share and consumer Wi-Fi, regaining two points to 43%. And we fully expect we will continue to gain share in the second quarter, given the improved supply position in the channel entering the quarter. The SMB segment executed well and generated net revenue of $77 million for the first quarter of 2021, which is up 17.9% on a year-over-year basis and up 8.5% sequentially. This is the highest quarterly revenue for our SMB business in the past two years. The growth was driven primarily by exceptionally strong demand for work-from-home solutions, including low port count switches as well as our SMB wireless solutions. We were also particularly pleased with the performance of our pro AB business, which experienced meaningful year over year growth as we see signs of activities resuming at business offices and sports entertainment venues. Our market share in switches sold through the US retail channel came in at 56% in Q1. I'll now turn the call over to Patrick for his commentary, after which I'll provide guidance for the second quarter of 2021.

Thank you, Brian. As we progress through 2021, we are seeing the progress of the world's slow recovery from the pandemic. New cases remain high and variants from other continents are becoming prevalent in many states. However, unprecedented federal spending plans and accelerated vaccine rollout and state reopening plans point to a light at the end of the tunnel. Businesses, small and large, are planning for growth off of a difficult 2020, with signs of business offices and sports and entertainment venues steering towards reopening, albeit at dialed-back capacity. It is clear that the pandemic has accelerated multiple years of technological progress into one year, and people adjusted surprisingly quickly to more time and activities from home. However, to enable this transition, highly reliable, high-speed internet connectivity that covers the entire home and even patio or yard has become a necessity. This spurred the rapid growth of the premium segment in home Wi-Fi, spearheaded by Wi-Fi 6 mesh with tri-band architecture, which Nokia pioneered and continues to be the leader in the market. These solutions fuel the work and do everything from home for families that need to cover large houses and supply reliable internet to every corner of the home. Given the demands all these activities put on home Wi-Fi, we see no slowdown in the demand for our products that help keep people and their devices connected. This premium tri-band Wi-Fi 6 segment represented 30% of the Wi-Fi mesh market in the U.S. in Q1, rising from 25% in Q4 and 7% in the prior year comparable period. This category continues to grow quickly, and regardless the highest prices, use the healthiest margins, and has the highest prospect for attaching our value-added services, which we clearly see the benefits are in our Q1 performance. Yankeer continues to deliver the last quarter we announced the nighthawk tri-band mesh wi-fi system model mk83 and we started shipping it in q1 this is our first tri-band nighthawk mesh system and it retails and has a strong following among those who would like to have more real time control of their Wi-Fi setup, such as QoS sets for different bands.

This provides a long-anticipated real Nighthawk base. We're also quite pleased with the demand and reception of the Nighthawk R8XE500 tri-band Wi-Fi 6E router.

which debuted at $299. With speeds of 2 gigabit now available from cable operators in the U.S., Wi-Fi 6E products have the Wi-Fi speeds to match, thus enabling multiple high-quality video downloads, not those, and 8K gaming. Equally important as the performance of the product is the strong attach rate of our subscription services that we are seeing from the ultra-premium customers purchasing this product. Last but not least, for product introduction on the CHP side, we launched our second DOCSIS 3.1 Wi-Fi 6 cable gateway, the entry-level CAX30. The power of combining DOCSIS 3.1 speed with the benefits of Wi-Fi 6 technology gives cable-subscribing households an all-in-one option built to provide multi-gigabit internet speeds across a multitude of devices in the home, while avoiding the monthly rental fees of cable modems and Wi-Fi routers from the cable operators. This category is about 20% of the total U.S. retail Wi-Fi market and one in which we possess substantial market share. There is only one meaningful competitor to us in this category and they have yet to introduce a Wi-Fi 6 cable product today.

As we enter the second quarter with an improving supply picture in the channel, we see the opportunity to build on our Q1 performance in regaining U.S.

market share. This bodes well for us to continue to make progress in paid subscriber acquisition, building from the 481,000 paid subscribers that we ended with in Q1. We're on track to meet our goal of 650,000 subscribers by year-end, and we're excited about the long-term profitability impact that we have on our business. Additionally, we will improve on our service offerings in the second quarter with the rollout of our smart parental control service. They garnered accolades at CES 30 this year. Following that, we plan to bring the features of our gaming router lineup to the market through a service offering in the second half of this year. for those online game-loving customers of our premium Wi-Fi 6 tri-band OBE systems. Our most advanced solutions and highly functional low-port count PoE switches continue to meet with strong demand as businesses transition to flexible working environments. Additionally, with businesses better navigating COVID-related challenges, and reopening, and economies beginning to improve, our more sophisticated switching business is accelerating. This includes our Pro AV switching line, which is also seeing the added benefit of sports and entertainment venues opening at entry levels of capacity. We intend to capitalize on this opportunity, and to do so, we are investing in these areas to continue to strengthen our differentiation. Our recent releases in the AV line expand our highly successful and are tailored to make complex AV deployments easy to install and manage.

These switches deliver higher overall wattage, provide AV-specific presets and user interfaces, and provide the best quality digital audio interface.

We're excited with what lines we have given the tailwinds across both businesses and improving supply outlook, driving the opportunity for further market share gains and a solid foundation for increasing our subscriber base.

And with that, I'd like to make a comment on our opportunities and our net revenue for the second quarter $5 million to 320.

Gap operating margin expected to be in the range of 6.5% to 7.5%, and non-gap operating margin is expected to be in the range of 9% to 10%. Inventory progresses to healthy levels. We do expect Q2 will present an opportunity to selectively turn promotions back on, including participation in key sales events with some of our channel partners. allowing us to continue to grow market share and to drive paid subscriber acquisition. Additionally, while air freight costs will stay at the Q1 level, we see sea transport costs rising to two to three times their normal rates. Our gap tax rate is expected to be approximately 27%, and our non-gap tax rate is expected to be 24.5% for the second quarter of 2021. While we are confident in our ability to provide guidance at this time, we do so with the caveat that considerable uncertainty remains in the market due to the COVID-19 pandemic, and should unforeseen events occur, in particular related to transportation delays into any of our regional distribution centers, our actual results could differ from the foregoing guidance. We would now like to answer any questions from the audience.

At this time, I would like to remind everyone, in order to ask a question, press star, then the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. Your first question comes from the line of Jeffrey Wren from Deutsche Bank. Please go ahead.

Hi, thanks for taking the question. You talk about participating in more promotional activities in the second quarter. With global chip supply still being relatively tight and demand remaining strong, can you just discuss the thought process for running more promotional activities?

Yeah, as we have said, that we would like to continue the momentum to regain share. And also, we actually have to be in lock steps with our channel partners. So our channel partners have plans for some promotional activities in the seasonally weaker Q2, and we would like to continue to keep the momentum going. And we believe that this is the most opportune time for us to regain share. And the importance of regaining shares, of course, is to continue to have a really good install base to work with to increase our paid subscribers, which is a very long-term benefit for us. We have found out over the last two years that the most opportune time to recruit service subscribers is at the point when they install a new product. And that's the reason why driving our position.

Great. Thank you. And just as my follow up, how are you thinking about the trajectory of your SMB business as the global economy continues to open? Will that partially be offset by less people setting up home offices as we approach a return to the more traditional office?

We don't believe so. We're actually seeing a three-leg stool on the SMB business we're very encouraged by. I think there are a lot of entrepreneurs who have left the workforce and started to become entrepreneurs to open businesses at home. And then also there are other small business owners and professionals who actually would split time between home office and their main office, such as accountants, architects, and interior designers, and so forth. So the activities of entrepreneurial home-based business buying our what we call sophisticated home office solution is unabated. Secondly, as we have seen also, these small businesses who are starting to reopen and get back into the office, which they have not been for over a year, found out, well, now they have just upgraded their home offices to Wi-Fi 6, but their office is stuck with Wi-Fi 5, and we're seeing quite a bit of upgrade opportunities happening in their actual office. So that's also driving what we call the reopening trade. And our wireless name business is still continuing to grow tremendously. And then third piece is the pro AV business. We're seeing a lot of sports events reopening, entertainment reopening, and a lot of video productions going on, all driving the demand of our pro AV businesses as AVs are aging towards more into ultra-high definition.

and things like that.

And so those three next years give us confidence that our SMB momentum will continue on in the upcoming few years.

Question comes from the line of Hamad Khorasan from BWS Financial. Your line is open.

Hi. Market environment as far as previous cycle,

How are you going about with the inventory that you've built up? Is that being considered off for particular promotion in Q2?

No. I mean, so the channel inventory is, quote, unquote, just in time.

So we ship to the channel in anticipation of the weekly run rate. We want to keep it at the forward-looking run rate of anywhere between 8 to 10 weeks, which we are thinking is in the optimal.

Of course, there are some pockets of products that are still below that level.

And then when promotions happen, we will shift to that maybe two, three weeks before the promotion starts.

So we will not preload the channel for a promotional activity to be done. done much later on.

The market is pretty encouraging because for the first three weeks of this quarter and the last two weeks of last quarter, we're actually comping last year's onset of the COVID-19 lockdowns. And as we have expected, Q2 is slightly lower than Q1, and then Q3 will be a big step up, and then Q4 will be flat to Q3. So we believe that seasonality will happen, but at an elevated level. So, which is very encouraging. The reason why we feel confident about this is because we saw that phenomenon in Asia, which, you know, really hasn't been hit hard by COVID in certain markets where they have always been, you know, zooming back to office work and, you know, without... having any gathering lockdowns. So we're pretty encouraged by what we have seen so far.

Brian, what's transpired in the business that your Q2 guidance is a little different than the qualitative guidance that you provided in past comments?

Yeah, I think it's actually what Patrick just touched on. We've gotten the channel into a healthier place, a bit ahead of schedule. It bodes well in terms of our ability to start to regain the market share in the second quarter, start to build the subscriber base. But as we said early on in the call, we expect the full year targets that we set out back in December, we think we're on track for those. And what that means is the back half of the year is probably steering more towards a 10% growth over the first half. As we had said back in December, we thought they'd be on the lower side because we thought there'd be more channels happening early on. But we think it'll be about 10% over the first half of the year. Some of that's driven by the service provider business, which, again, is lumpy. This quarter for Q2, we think it will be about $30 million. So still below the $35 million on average that we still believe will hit for the full year. But also the strength of the SMB business is also contributing to the overall profile for the rest of the year. But, again, we think the second half will be up on the first half about 10%. Okay. Great.

Thank you. Sure.

Your next question comes from the line of Liz Pate from Cowan & Company. Your line is open. Liz Pate, your line is open. Your next question comes from the line of Adam Tindall from Raymond James. Your line is open.

Hi, thanks. This is Alex on for Adam. I'm just curious about how you're thinking about kind of the margin impacts from promotional spend, how you're thinking about the return on investment for that. And then kind of just an aside on margins, you mentioned that shipping costs are up about two, three times. So just kind of curious about how that kind of flows through the gross margins. Is shipping a large component of gross margins?

Yeah, I would say the Q2 steer relative to the Q1 performance, I'd say about a third of the movement from the 13.3% operating margin to the 9% to 10% range is going to be driven by the sea cost, the transportation cost for sea freight. So it is significant, certainly. And then the other two-thirds, I would say, is tied to the promotional activities. Chairman... In terms of the return on investment, I think Patrick touched on that earlier. It's all about assisting us in gaining additional paid subscribers, which is the long-term goal that we have of pushing that up and getting to our long-term target of 15% operating margin. That is key to us getting there.

Okay, perfect. More on the gaming side, more on the SMB side, home office side, and just kind of the cadence of that.

Different channels would have different focus. Generally speaking, it would be on the mid-range Wi-Fi 6 products that would be the focus. That is the place. It serves multiple purposes. One, it's relatively high ASP. Secondly, relatively high chance of users to attach to our paid subscription services. And they generally have a little bit higher margin. So I think those are the areas that we'll focus on.

Perfect. Thank you so much.

Your next question comes from Woojin Ho from Bloomberg.

Oh, great. Thank you for taking my question. I'm actually looking at the – there's a lot of things that could potentially pressure gross margin.

You've got the higher freight costs. you've got a lower mix of SMB. And traditionally, when you have these gross margin impacts plus promotional activity, your operating margin really sinks because of gross margin, low gross margin. But impliedly, it almost seems as if you're kind of holding the gross margin roughly around the 28 to 30% level. I'm just curious if there are any other factors that's helping to prop up the gross margin going into your outlook. In terms of, I think we just went through kind of the bridge of the gross margin from the peak levels that we saw in Q1 at 35%. The sea freight costs and the commercial activities will steer it downwards. And I would say the entirety of the bridge from Q3, sorry, Q1 to Q2 is going to be in the gross margin. I don't think, obviously, with the revenue guide, that there's not going to be a change in operating leverage on the business, but that would be the driving forces there. But again, long-term, we're going to try and push that up by adding subscribers and keep pulling these premium segments to the market. Are you seeing any positive impacts from subscription revenue on gross margin? Yeah, yeah. I think if you look at our analyst day deck that we put out in December, I think if you looked at the ASP that we communicated, which was about $48, we said it would probably contribute close to 80 basis points on this year's margin. So it is starting to contribute. But, again, we're trying to grow that as quickly as possible, as we saw with us increasing our target from $1 million to $2 million. And secondly, Patrick, you kind of called out your cable gateway business. And given some of the recent industry dynamics, I mean, how much of an opportunity do you see in that cable gateway business going forward, given some of the, I guess, the investors that's going in the industry?

The cable gateway and cable modem segment of the retail Wi-Fi has always been pretty steady at somewhere around 20% of the total market. As you probably know, there's just only one other major competitor. And because it's not easy, you have to get certified by all the cable operators in the U.S. We have a commanding market share. And, I mean, theoretically, we could get 100% market share in this segment. That means then we'll have a base of 20% market share of U.S. Wi-Fi. So it's pretty lucrative, yeah.

Got it. And then lastly to me, you mentioned fairly briefly about getting a growing sales in your online store. I'm curious how large is that business and why is the return dynamic different than your online store versus your traditional retailers to help on the gross margin side?

Actually, when Brian talked about return, it's not limited only to our own online stores, but also to our partner online stores, such as Amazon, such as Newegg. So basically, as you probably know, the online stores are very, very nimble in reacting to price fluctuations, much more than breaking Malta. And actually, 99% of the returns are no trouble found. And the most frequent reason for people to return is they bought this at store A and then found in, you know, store B is having a promotion, it's cheaper. So they would return the one to store A and buy the one from store B to enjoy that price arbitrage. Such a situation would be much less online because the online stores are very nimble. They wouldn't match any lowest price already in the market today. So generically speaking, the online stores are low in return rate. It doesn't matter whether it is the Amazon or it's the Newegg or it's B&H or it's Netgear.com stores. It's the same story.

Good. Thank you.

Sure.

again if you would like to ask a question press star then the number one on your telephone keypad your next question comes from the line of Fajal Daghra from Cowan your line is open hi thank you for taking my question uh you know i wanted to ask you like as you normalize your inventory levels in the channel i assume like your revenue is mostly selling any color you can provide on the delta between sell-in versus sell-through revenue for this year that you expect?

For the rest of this year, as we said, we think we're pretty much there in terms of filling in the channel. So from here forward, there shouldn't be much delta.

So basically, your sell-through would be similar to your sell-in revenue growth. That's correct. Okay. And I know you've maintained your guidance for this year, but any initial color you can provide on what your group would look like into calendar 22.

We'll get there eventually. Um, but at this point we're focused on executing, you know, and navigating this operational environment for 2021, but we'll get there. Okay.

and you know as you look to reinvest your incremental growth into promotional uh you know expenses how should we look at incremental like anything you can provide on how do we model incremental operating margins in your business and what the trajectory on the operating margins would look like as we go through the year thank you yeah i think as we see the mix of smb increase it certainly bodes well for for our margins

But in a normal year, when we typically see seasonality lift the back half of the year, that's usually when we get the most operating leverage, just given the top line sphere there. But as I said earlier, we're maintaining that the targets we set out for the full year, both on the top line and operating margin standpoint, is what we're starting to for 2021. Thank you. And to your earlier question, the one bit I would remind you of in terms of 2022 is that we think the market has risen, it's been elevated, and we think it will maintain at these elevated levels. And then from here forward, we kind of get back into the business of increasing the market, probably in the low single digits, all driven by ASP expansion. That's what we do. We keep innovating and we keep bringing out products in the premium portion of the market that raises ASPs periodically

Appreciate that. Sure.

That was our last question at this time. I would like to turn the call back over to Patrick Lowe.

Thank you. Thanks, everybody, for joining us today. As you can see from our results, the team at Netgear is operating at a very high level in a difficult environment to produce excellent results. I remain confident on the tailwinds that have buoyed our business will continue. And we will continue to execute well to produce results for all of our stakeholders. And I look forward to sharing more of that in the coming quarters with all of you. Thank you.

This concludes today's conference call. You may now disconnect.