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Edited Transcript of NTGR earnings conference call or presentation 23-Oct-19 9:00pm GMT

Q3 2019 NETGEAR Inc Earnings Call

SAN JOSE Oct 25, 2019 (Thomson StreetEvents) -- Edited Transcript of NETGEAR Inc earnings conference call or presentation Wednesday, October 23, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Bryan D. Murray

NETGEAR, Inc. - CFO

* C. S. Lo

NETGEAR, Inc. - Co-Founder, Chairman & CEO

* Erik Bylin;Investor Relations

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Conference Call Participants

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* Adam Tyler Tindle

Raymond James & Associates, Inc., Research Division - Research Analyst

* Elizabeth Mary Pate

Cowen and Company, LLC, Research Division - Research Associate

* Hamed Khorsand

BWS Financial Inc. - Principal & Research Analyst

* Robert Ari Gutman

Guggenheim Securities, LLC, Research Division - Senior Analyst

* Woo Jin Ho

Bloomberg Intelligence - Senior Technology Analyst

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by. (Operator Instructions)

I would now like to turn the conference over to Erik Bylin. Please go ahead, sir.

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Erik Bylin;Investor Relations, [2]

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Thank you, Angela. Good afternoon, and welcome to NETGEAR's Third Quarter of 2019 Financial Results Conference Call.

Joining us from the company are Mr. Patrick Lo, Chairman and CEO; and Mr. Bryan Murray, CFO.

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 and finish with fourth quarter of 2019 guidance provided by Brian. We'll then have time for questions.

If you have not received a copy of today's press release, please visit NETGEAR's Investor Relations website at investor.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. Any forward-looking statements that we make on this call are based on the 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. Bryan Murray.

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Bryan D. Murray, NETGEAR, Inc. - CFO [3]

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

The third quarter presented us with some unexpected challenges. Entering September, when we typically see increased demand in Europe after the normal summer recess, we instead saw heightened uncertainty due to Brexit and the possible start of a German recession. Because of this, September sales in Europe came in below our expectations.

In addition, APAC was hampered by a sudden economic downturn in the China-Hong Kong region due to the escalating trade war and the unstable sociopolitical situation in Hong Kong. However, on the domestic front, the home WiFi market in North America appears to have stabilized, with indications that the market was down year-over-year about the same level we saw in Q2 or 4.5%.

At the same time, we continue to execute on our robust pipeline of new products to extend our market leadership introducing WiFi 6 technologies in Q3. Entering the quarter, we had 3 products containing WiFi 6 technology.

We ended the quarter with 7, including the all-important WiFi 6 Orbi Mesh, the world's only WiFi 6 mesh system.

Overall, NETGEAR net revenue for the third quarter ended September 29, 2019, was $265.9 million, which came in at the low end of our guidance range, and is down 1.3% on a year-over-year basis and up 15.2% on a sequential basis.

With revenue coming in at the low end of our guidance, our non-GAAP operating margins came in at 7.8%, below our guidance range. However, as a result of onetime beneficial revisions to prior period domestic and international tax liabilities, we were able to deliver non-GAAP net income of $0.65 per diluted share in earnings.

Net revenue for the Americas was $178.7 million, which is up 1.6% year-over-year and up 13.7% on a sequential basis.

EMEA net revenue was $49.6 million, which is down 6.8% year-over-year and up 15% quarter-over-quarter.

Our APAC net revenue was $37.6 million for the third quarter of 2019, which is down 6.7% from the prior year comparable quarter and up 23% sequentially.

For the third quarter of 2019, we shipped a total of approximately 3.8 million units, including 2.7 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 1.6 million units for the third quarter 2019.

The net revenue split between home and business products was up 72% and 28%, respectively. The net revenue split between wireless and wired products was about 68% and 32%, respectively.

Products introduced in the last 15 months constituted about 26% of our third quarter shipments, while products introduced in the last 12 months contributed about 23% of our third quarter shipments.

From this point on, my discussion points will focus on non-GAAP numbers. A 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 2019 was 29.4%, which is down 590 basis points as compared to 35.3% in the prior year comparable quarter and up 60 basis points compared to 28.8% in the second quarter of 2019.

Total non-GAAP operating expenses came in at $57.3 million, which is down 14.4% year-over-year and up 1.7% sequentially.

As always, we manage our expenses prudently, while also making sure that the growth portions of our business have the resources that they need to succeed.

Our headcount decreased by a net of 22 people to 802 heads as of end of the quarter.

Our non-GAAP R&D expense for the third quarter was 6.8% of net revenue as compared to 7.1% of net revenue in the prior year comparable period and 7.6% of net revenue from the second quarter of 2019.

R&D investment remains critical to the future success of our business, and we will continue to invest here in the quarters to come.

Our non-GAAP tax rate was 2.3% in the third quarter of 2019.

In the quarter, we benefited from favorable onetime adjustments to both domestic and foreign tax liabilities. This contributed approximately $0.13 to our non-GAAP diluted EPS.

Looking at the bottom line for Q3, we reported non-GAAP net income of $20.7 million and non-GAAP diluted EPS of $0.65 a share.

Turning to the balance sheet. We ended the third quarter of 2019 with $171.9 million in cash. During the quarter, we used $26.1 million in cash flow from continuing operations, which brings our total cash used in continuing operations over the trailing 12 months to $93.8 million. We used $2.4 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 $15.1 million.

Nevertheless, we remain confident in our ability to generate meaningful levels of cash. With the move of our manufacturing sites out of China behind us, we will be able to work down our buffered inventory levels, and we expect to generate positive cash flow going forward.

In Q3, we split $22 million in -- to repurchase approximately 679,000 shares of NETGEAR common stock at an average price of $32.34 per share. Since the start of our repurchase activity in Q4 2013, we have spent approximately $506.7 million to repurchase approximately 14 million shares.

Our fully diluted share count is approximately 31.8 million shares as of the end of the third quarter. We plan to continue to opportunistically repurchase our stock in the quarters to come.

Now turning to the results of our product segments. The Connected Home segment, which includes the industry-leading Nighthawk, Orbi, Nighthawk Pro Gaming and Meural brands, generated net revenue of $190.7 million during the quarter, which is down 2.1% on a year-over-year basis and up 13.8% sequentially.

The year-over-year decline is primarily due to reduced revenue in the EMEA and APAC regions as a result of the aforementioned factors.

We also continue to see the U.S. WiFi market declining year-over-year. However, we believe the decline has stabilized in part due to our introduction of WiFi 6 router products. Our U.S. market share in consumer WiFi remained strong at 51% for the third quarter.

The SMB segment generated net revenue of $75.2 million for the third quarter of 2019, which is up 0.6% on a year-over-year basis and up 18.7% sequentially.

Our PoE+ and ProAV switching lines continue to perform well. Our market share in switches sold through the retail channel was also strong at 53% for the third quarter.

I'll now turn the call over to Patrick for his commentary, after which, I will provide guidance for the fourth quarter of 2019.

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [4]

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Thank you, Bryan, and hello, everyone. While the third quarter of 2019 was challenging on both the top and bottom line, we are confident in our strategy of capitalizing on technology inflections, building recurring service revenue and expanding into new adjacent markets. We are also excited by the execution of our WiFi 6 program, where we have a substantial need over our competition.

During the quarter, we announced multiple new WiFi 6 products for the Connected Home, including the Orbi WiFi 6 Mesh system, the $600 Nighthawk 12 stream WiFi 6 AX11000 router and the Nighthawk WiFi 6 mesh extender.

We now have 7 products with WiFi 6 technology, while our top 3 competitors still have not released a single WiFi 6 product.

Additionally, we have the product introduction pipeline to more than double the count of our WiFi 6 products over the next 6 months.

While the year-over-year decline of North America retail WiFi market in Q3 remained constant relative to Q2 at about 4.5%, the product composition is very different. With our strong WiFi 6 router lineup, our router end-market sales actually grew strongly in Q3. However, we saw an overall decline in mesh WiFi sales in North America due to the absence of WiFi 6 mesh products.

However, we believe the September release of the iPhone 11 embedded with WiFi 6 will spur consumers to take advantage of this increased speed by connecting with WiFi 6 routers and mesh products.

We will aggressively introduce more WiFi 6 mesh products in the coming quarters, and we believe that will enable the North America WiFi retail market to return to growth in 2020.

As for adjacent markets, we believe with the introduction of Meural Canvas II, we're expanding the reach of our digital canvas market to a wider audience with a smaller form factor of 21.5 inches and a retail price starting at just $399.

We will also be adding exciting new content from HBO's incredibly popular Game of Thrones series to our Meural streaming subscription membership as well as for purchase through the marketplace, with more to come.

Turning to the SMB segment, during Q3, we announced the industry's first cloud-configurable commercial-grade mesh network. The latest updates to the NETGEAR Insight solution enabled the deployment of fully configurable mesh networks to support wireless port extenders, VLAN mapping across the mesh, instant discovery and many other feature enhancements.

The NETGEAR Insight cloud management solution, now in its third year, has proven to be a powerful tool for small businesses to manage their networks remotely offer managed service providers to better keep tabs on the health of the clients' networks.

The Insight platform offers support for 22 different switches, access points, mesh satellites and security devices, managed by way of a mobile application accessible on both iOS and Android as well as browser-based desktop solutions popular among IT network managers and managed service providers.

We believe we are at the forefront in the industry's technology pivot to mesh wireless LAN and cloud management via mobile devices.

As another example of expanding into adjacent markets, we are extremely excited about the inroads we are making into the ProAV switching market. We introduced 3 new groundbreaking models ideal for deployment of AV over IP solutions. The compact 16-port all copper with POE and the 24-port and 48-port fiber modules for the M4300 series of our modular switch.

Furthermore, we just announced a strategic 3-way joint marketing initiative with Broadata, a leading ProAV equipment manufacturer, and AVI, one of the top 5 ProAV integrators in North America.

With AVI Systems as the integrator, this partnership will provide next-generation ProAV systems based on IP technology with unprecedented levels of performance, scale and cost efficiency for customers looking to deploy IP-based audiovisual systems.

Finally, we continue to make progress with our initiative to build recurring revenue stream. This is especially important as we expect that it will have a significant impact on both our bottom line and the stability of NETGEAR's earnings in the future.

As of the end of the third quarter, we have approximately 12 million registered users. Our registered app user count has grown to 3.6 million, which represents approximately 29% sequential user growth over Q2 2019. We remain very excited about the transformative value-creation opportunity of this initiative.

At the start of October, we also started a very strategic service offering with Best Buy's Geek Squad. For about $400 a year, customers will receive an Orbi Mesh network with 2 nodes, full technical installation and support services from Geek Squad and a variety of value-added subscription services, including NETGEAR Armor and parental controls.

During Q3, we also experimented with a 30-day free trial for NETGEAR Armor services and are seeing up to a 9% conversion rate from free trials to paid subscription on some of our customer-engagement campaigns.

We are learning as we go and are confident we will continue to improve our ability to grow our service customer revenue.

Last, but not least, I would like to invite our investors and analysts to join us on November 20 at the Nasdaq MarketSite in New York for the 2019 NETGEAR Financial Analyst Day, during which, we will provide more detail around our WiFi 6 product rollout plans, ProAV market penetration progress, success in acquiring service subscribers and our margin improvement plan for 2020 and beyond.

I hope that all of you can join us. If you would like to attend, please reach out to NETGEAR Investor Relations at investors@netgear.com or visit our Investor Relations website for more details.

In summary, while geopolitical headwinds presented near-term setbacks to our progress towards double-digit operating margin and mid-single-digit annual revenue growth, we remain confident in our strategy heading into the fourth quarter and 2020.

I will not turn the call back to Bryan for fourth quarter guidance.

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Bryan D. Murray, NETGEAR, Inc. - CFO [5]

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Thank you, Patrick. Fourth quarter revenues will be impacted by the trends we have seen in core markets within EMEA and APAC.

While we expect to see softer end-user demand, there will be an additional effect on our revenue as the channel reduces inventories for these new conditions.

In North America, we are also taking proactive steps to reduce channel inventories to prepare for an accelerated shift towards WiFi 6 within the U.S. in 2020 after CES in early January.

In response to our lower top line expectations in Europe and China, we are taking actions to further resize our cost base in those regions to enable us to redeploy resources where we see greater opportunities, such as North America and Japan.

We are going to shrink sales headcount in China and Europe, where appropriate, and reduce our office footprint in those markets.

In consideration of the foregoing, our net revenue for the fourth quarter is expected to be in the range of $240 million to $255 million, GAAP operating margin is expected to be in the range of 0.1% to 1.1% and our non-GAAP operating margin is expected to be in the range of 4.5% to 5.5%. Our GAAP tax rate is expected to be approximately 33.5%, and our non-GAAP tax rate is expected to be 23% for the fourth quarter of 2019.

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

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Questions and Answers

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Operator [1]

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(Operator Instructions) And your first question comes from the line of Adam Tindle with Raymond James.

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Adam Tyler Tindle, Raymond James & Associates, Inc., Research Division - Research Analyst [2]

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I just wanted to start on the inventory. You talked about the initiative to reduce channel inventory, the weeks didn't look significantly out of line, I think you called it proactive. So kind of two-part here, I was just hoping that you could help us size the adjustment that's needed? How much of this is going to hit contra-revenue? And secondly, help us with the timing of this. Does this continue into 2020? Or is it all in Q4 guidance and then thereafter into 2020, we can look forward to WiFi 6 and the outlook with that?

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Bryan D. Murray, NETGEAR, Inc. - CFO [3]

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It's all implied in our guidance for Q4. In terms of the sizing, I would say if you've looked at normal seasonality, you would typically see us lift on the nonservice provider portion of CHP in the 12% range. So I would say probably 2/3 of this correction is coming from the Americas to anticipate the WiFi 6 rollout and the remaining 1/3 is really being weighed down by the international headwinds that we're facing.

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [4]

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And we don't expect further channel inventory reduction going forward.

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Bryan D. Murray, NETGEAR, Inc. - CFO [5]

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That's right.

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Adam Tyler Tindle, Raymond James & Associates, Inc., Research Division - Research Analyst [6]

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Okay. And then maybe just a big-picture operational question. At the Analyst Day last year, you made a point to show how margin fundamentals were intact, ex-Arlo double digits, you were targeting the 10% to 11% non-GAAP operating margin for 2019 based on the mid-single-digit revenue growth.

Now that we're looking at a full picture 2019, I understand revenue is going to be down mid-single digits instead of growing, but operating profit dollars are going to be down like more than 30% and you're going to be finishing the year at half of the original operating margin target based on what we learned today. I think we're just all surprised that the amount of negative leverage that we're seeing here. So can you maybe just touch on a little bit deeper what you're doing operationally in-house to start reversing this trend? And where do you think operating margins can sustain with just the internal initiatives and no assumption per market? Is the kind of 6% or 7% that we're looking at for the year, the right way to think about this business?

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Bryan D. Murray, NETGEAR, Inc. - CFO [7]

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Yes. I mean there's no doubt that we faced a number of challenges this year, starting with the U.S. WiFi market. We see it stabilized in Q3, but it's still down year-over-year 4.5% and started the year off down 8% in Q1. So certainly, that's provided some challenges. These factors I mentioned, both in EMEA and Asia-Pacific, specifically China, Hong Kong, really accelerated in the September time frame. So it certainly came late and not much time to course-correct there.

We don't see those things necessarily correcting themselves in the short term, but we do think that our strategies here, specifically on the WiFi 6 rollouts, were far ahead of our competition, our top 3 competitors do not have WiFi 6 products out there. In fact, in the U.S., we saw the routers for us, our end-user sales and routers grow there. So it's giving us the confidence that our strategy is working. So all these things combined are really kind of what's giving us the confidence as we head into 2020. Again, what's transpired in 2019 is behind us, we do think that we can get back to mid-single-digit growth in 2020.

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Adam Tyler Tindle, Raymond James & Associates, Inc., Research Division - Research Analyst [8]

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Is there a view on -- go ahead.

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [9]

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Yes. I think -- yes, just to add to what Bryan has said, I think in 2020, there are significant differences versus 2019. Number one, we reset our baseline, so we would not assume that China, Hong Kong or Europe will perform at all. So that's going to be resetting into our baseline. And as such, we are redeploying those resources into markets that have shown robustness such as in Japan and also in North America in the WiFi 6 segment.

What, also, we see is that we kept getting surprises on the tariff and trade war front in terms of the percentage of tariff so -- and the speed that the tariff is being assessed. Some of the products we believe that were not in the tariff territory that we were slow to move them out of China all of a sudden become tariffs. So that really put a lot of dent in it. And secondly, our productions in -- outside of China is in testing phase in the early of the year so that's why we had to buffer a lot of inventory, right? Just in case, the factory production did go well, we still have inventory.

Now those buffered inventory, even though, is produced long before the tariff was applied, it is generally higher cost because as time goes on, those -- I mean we are like in the seafood industry, right? When the inventory is older, it is relatively more expensive relative to the current selling price. And then the factories in -- outside of China would take time to get to the same efficiency as the factories in China.

Now we believe in 2020, all those negative factors will be gone, well, unless, of course, we cannot predict whether a tariff will be applied to other countries. But as long as, let's say, the tariff is not going to apply to the countries that we move into, number one, our higher-cost inventory will be worked down. Number two, the production in those new factories will be getting in line with the cost base of the old Chinese factories. So that's also the advantage of 2020.

Now one thing more importantly in that based on that assessment of what we saw of WiFi 6 in Q3 and what we saw in U.S., Japan versus China, Europe, we are doing adjustment. We are going to accelerate more of our mix of revenue into WiFi 6 as well as into Japan and the U.S. versus still keeping some 11ac at a higher proportion and still hoping that Europe and China will come back.

So those are the few factors where we are working on to ensure that we would be able to hit our single-digit revenue growth and double-digit operating margin growth versus this year.

Inherently, by looking at the margin profile of WiFi 6 and looking at the latest production cost from the factories in Vietnam, in Thailand and in Indonesia, we feel that we are absolutely on the right track. But in order to get into this new reality, we have to do some real adjustment in terms of channel inventories around the world in order to prepare for this.

And so yes, we are going to debut a lot of WiFi 6 products, which we -- unlike last year, we announced the products, we didn't ship until Q3. This year, what we would like to do, we -- is to announce the products and ship that the week after CES into the channel. That, we believe, will create the biggest momentum for us, not only to generate revenue but as well as to take market share. However, we do not know how fast that transition will be in 2019, so we would like to keep the channel inventory very lean so that we could adjust really rapidly accordingly. Because we only -- we sell not only routers, but we also sell mesh systems, we also sell cable gateways, we also sell mobile hotspots, we also sell extenders. We don't know how the WiFi 6 technology will shift in any one of these categories. We want to be able to be nimble. We want to be able to capitalize on the fastest move and ship the channel inventory accordingly. And that's why we are taking all of these actions in Q4. And we feel like that we at least have about 3 to 4 quarters lead of the WiFi 6 technology over all our major competitors and that gives us the confidence 2020 will be a year that we could really get ourselves into a really good position of our long-term deliverable. And of course, in 2021 and beyond, that would believe that our service revenue will start to kick in to have the positive impact. And for that, how are we going to do that, what we have done, we'll get some more granularity on the Analyst Day for that service revenue part.

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Adam Tyler Tindle, Raymond James & Associates, Inc., Research Division - Research Analyst [10]

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Okay. Maybe just one quick one for Bryan. You talked about you being confident in generating meaningful levels of cash, can you just help us quantify what that means? And then remind us how much is left on the buyback and whether M&A would make sense to help the business? Or is buyback still the right use of cash?

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Bryan D. Murray, NETGEAR, Inc. - CFO [11]

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Yes. I think going into Q4, we think things will turn around. You may recall that we typically have some seasonal dating programs with some key accounts of ours, which usually go the other direction from a cash standpoint. But we do believe that we're in a position to work down some of these inventory levels. My guess is it's probably north of 150% of non-GAAP net income that we'll generate in terms of free cash flow in Q4. It likely will take us 2 to 3 quarters to work the inventory completely down to the levels that we'd like to carry forward, and we'll try and do that as fast as we can, but that's my best estimate of what Q4 would be.

In terms of use of cash, yes, we still think that using cash for buyback is an appropriate use of our cash balance, that still carries in excess of what we think our operating cash needs are. And as I just said, we expect to generate additional cash in the quarter.

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [12]

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And also, I mean, we will not stop looking at some tuck-in technology acquisitions that will benefit our growth area, such as the ProAV space, such as the WiFi 6 space, such as the content space, service revenue space, yes.

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Operator [13]

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And your next question comes from the line of Robert Gutman with Guggenheim.

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Robert Ari Gutman, Guggenheim Securities, LLC, Research Division - Senior Analyst [14]

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Given all the uncertainties that you cited and sort of moving parts that we've seen now in the Sprint. I was just wondering the impact on promotional spending in contra-revenue. Is there a change in allocation there or overall dollar amount?

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Bryan D. Murray, NETGEAR, Inc. - CFO [15]

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Relative to the second quarter?

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Robert Ari Gutman, Guggenheim Securities, LLC, Research Division - Senior Analyst [16]

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Well, relative to your prior plan or how you're spending that money?

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Bryan D. Murray, NETGEAR, Inc. - CFO [17]

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Yes. I would say that maybe a slight tweak to our original plan. I mean coming into the quarter, there was certainly anticipation of Prime Day being extended to a 2-day event this year as opposed to 1 day in the past. And certainly, it was successful on one account, but that typically comes with some additional promotional dollars. So that certainly had some impact on the quarter. But I think going into Q4, we think it will be at normal Q4 promotional spending levels, certainly on the back of Black Friday and Cyber Monday.

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Robert Ari Gutman, Guggenheim Securities, LLC, Research Division - Senior Analyst [18]

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And do you see the need to spend more there in the coming quarters, given that -- I think we were looking for more of a flattish-type development for the broader U.S. WiFi market in the third quarter. And obviously, it's a little disappointing, but do you think you could move that? Or is that just sort of a wait-and-see type situation?

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Bryan D. Murray, NETGEAR, Inc. - CFO [19]

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Yes. I'm hoping that we'll get some momentum here. I think we mentioned that we launched the Orbi WiFi 6 Mesh late in the quarter. That's now getting out seeded into the market as we speak. And so we think that's a key component. As I said earlier, we saw the success on the router side because of our WiFi 6 product introductions. Now that we're touching on mesh, which is about 1/3 of the market, we think that will be a contributing factor. And we're hopeful that we'll get closer to a flat market in Q4 from an end-user standpoint.

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [20]

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From a contra-revenue marketing perspective, we don't see that we are going to spend more than what we traditionally spend in the Q4 in prior years.

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Operator [21]

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And your next question comes from the line of Liz Pate with Cowen and Company.

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Elizabeth Mary Pate, Cowen and Company, LLC, Research Division - Research Associate [22]

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You just had a comment that you think you get about closer to flat market growth in the fourth quarter. Just in terms of looking out into calendar '20, when do you think you'll get back to top line growth? You have a lot of channel reduction, inventory reductions to do. I'm just wondering in terms of timing of a return to top line growth.

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [23]

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If given all the factors constant, that means there's no more surprises, no more geopolitical headwinds. We expect that we should be able to get to top line revenue growth probably from second quarter onwards. So that's how we look at it, because we believe that the channel inventory adjustment should be done by Q4 and not be later than Q1.

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Elizabeth Mary Pate, Cowen and Company, LLC, Research Division - Research Associate [24]

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Okay. Great. And just -- so double-digit operating margin still a reasonable target on kind of low single-digit 3% revenue growth for '20, is that what you're saying?

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [25]

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Yes. In a normal economic situation, that is still the plan for 2020.

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Elizabeth Mary Pate, Cowen and Company, LLC, Research Division - Research Associate [26]

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Okay. And then lastly, service provider revenue, look like that held up or rebounded nicely in 3Q. Do you still see that kind of in that $35 million to $36 million range moving forward?

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [27]

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Yes. It's roughly in the $35 million range, yes, plus or minus. So Q3 was plus, Q1 was a big plus, yes, Q2 was a big minus.

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Elizabeth Mary Pate, Cowen and Company, LLC, Research Division - Research Associate [28]

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Right. Okay. I'm sorry, just one other question on operating expenses in 4Q. Do you have some levers to pull there? Do you expect OpEx to be flat, down a little bit?

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Bryan D. Murray, NETGEAR, Inc. - CFO [29]

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It's probably closer to flat. We did talk about some of the actions that we're taking to rightsize some of these markets that we see a bit challenged, but we will be reallocating those resources to the areas we see opportunity.

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [30]

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Yes, we're definitely ramping up our investment in headcounts and resources in North America for the ProAV market and in Japan overall.

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Operator [31]

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

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Hamed Khorsand, BWS Financial Inc. - Principal & Research Analyst [32]

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I just want to -- got a follow-up here on the commentary about WiFi 6. Beginning of the year, you were somewhat bewilder as to the decline in the market, I guess that it was WiFi 6-related. Now you're saying that WiFi 6 is just slow, but you have more products on the market. I mean is that really the case of what's going on in the home WiFi market? Or are you just losing share to the carriers?

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [33]

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No. We think, clearly, the WiFi 6 is the reason because it's pretty simple. In Q1, when there was absolutely no WiFi 6 products, the market declined by 8%. In Q2, when we had WiFi 6 products for about 1.5 SKUs, for the full quarter, we saw that the market improved to negative 4.5%. In Q3, where we have 3, we doubled the WiFi 6 router product, the market should have improved from 4.5% to whatever. Unfortunately, what we saw in the market is the mesh market, for the very first time in history, actually declined, all right, year-over-year, all right?

So that clearly tells you -- it's like in a drug test, one is a placebo and the other one is the drug, all right? So when there is WiFi 6 on the router side, the market demand kept holding up, but on the mesh side, well, there's absolutely no WiFi 6, the market actually declined for the very first time in history. So that tells us very likely WiFi 6 is going to be the key driver. And that's why Q4 is the very first time that we would have WiFi 6 both on the router side with 5 SKUs. And then with mesh also Wifi 6 and extended with 1 SKU in WiFi 6, we should see the improvement of the market might not be totally flat, but at least would improve from 4.5%.

Now come Q1, as we said, post-CES, we will have Wifi 6 products in all categories, cable, extenders and mesh and router, that when we see there's a high likelihood the market will be flat or even return to growth.

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Hamed Khorsand, BWS Financial Inc. - Principal & Research Analyst [34]

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Okay. And as far as inventory is concerned, how much of that inventory is not WiFi 6 that you're concerned that you need to liquidate it faster?

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [35]

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No. We don't believe that we would liquidate, because, as you can see, our inventory buffer is maximum, about 1 or 2 quarters, all right?

On 11ac, as much as we single-handedly pushed the market over to 11ax WiFi 6, it's probably still 2 to 3 years before the transition is completely over. So we are absolutely in no hurry to liquidate the 11ac inventory at all.

And as a matter of fact, I mean we hold a 51% market share, so we still have a lot of wherewithal to really move 11ac products.

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Hamed Khorsand, BWS Financial Inc. - Principal & Research Analyst [36]

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And if you think that's Wifi 6 that's providing the catalyst here for the year, why haven't your competitors made the move? Is it really just the cost-driven consumers not wanting to spend this much for Wifi 6 router?

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [37]

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No. It's multiple reasons. If you look at it, I mean, seriously, there are only 3 competitors in the market today, all right? One is, I mean, 2 are Amazon and Google. And for them, they have not had -- because their development process is a little bit different, all right? The hardware and software is completely developed in-house. They don't use the ODM model, all right? They ride their software from the stack all the way that they don't even use some of the driver software from the chip vendors. So it is very difficult for them to expand their WiFi 6 offerings.

And furthermore, I think their focus right now, as you just saw the recent introduction of their product is really focused on lowering cost and collecting more data, all right? So to them, WiFi 6 is not the priority.

And then for the other competitors such as Linksys, they just don't have the financial wherewithal to engage in WiFi 6 product development in all those many areas. So I think we are in a very unique position that we have enough financial as well as the ODM model to introduce that many WiFi 6 products, and we absolutely are going to capitalize on this advantage.

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Operator [38]

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And your final question comes from the line of Woo Jin Ho with Bloomberg Intelligence.

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Woo Jin Ho, Bloomberg Intelligence - Senior Technology Analyst [39]

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A couple of quick ones. How big is your Hong Kong and China exposure today? My understanding was that it has been small. So kind of scratching my head on why there would be such a big revenue impact going into the fourth quarter and possibly into 2020.

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [40]

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I mean clearly, as you can see, right, I mean, we usually would love to be at the high end of our guidance, right? And we hit the low end so that's a swing of about at least $10 million. And Europe and China, Hong Kong, you could easily do the calculation and see how big the impact is.

Now remember, Hong Kong, China is the #2 economy in the world, so they should be our #2 market, right? So it's pretty significant, all right? And clearly, if you look at the other economies as Japan, as Germany, which are also big for us, so that's why we've got to quickly shift as fast as possible from China into Japan, which is an absolute growth area for us, and we're under-indexing in Japan, which we feel good that we'll be able to make strides over there.

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Woo Jin Ho, Bloomberg Intelligence - Senior Technology Analyst [41]

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And just to be clear, you're not exiting the China, Hong Kong market? You're just reducing your exposure there and shifting over the resources to Japan, is that the right way thinking of it?

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [42]

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Correct. We're not exiting at all, but we are definitely shrinking the footprint. For example, I mean just to give you how important it is, we have 3 sales offices in China. We have Beijing, we have Shanghai, we have Guangzhou and we have plus Hong Kong, get 4. Clearly, with this new reality, we probably don't need 4 sales offices.

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Woo Jin Ho, Bloomberg Intelligence - Senior Technology Analyst [43]

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All right. And in your Q&A commentary, it sounds like you're targeting single-digit growth revenues in 2020, sounds like a preview to the Analyst Day. Given your focus on WiFi 6, is this going to be an ASP-driven growth? Or a unit-driven growth, given all the puts and takes on what you're doing with the inventory and on the product portfolio?

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [44]

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For our planning horizon, it would be mostly ASP growth. However, we'll take any unit growth, all right? I think the unit growth has to come from share gain. So -- but for now, our baseline planning is for ASP growth, but the growth is not only coming from the ASP side. We're very excited also on the SMB side on the ProAV space as well. I think we laid a pretty good foundation. As I just talked about, we just announced the first marketing alliance initiative with Broadata and AVI, and you will see more of that coming. And we are excited about that opportunity as we have described many times that this opportunity represents $150 million to $200 million TAM and even a 50% market share, which will be pretty lucrative as incremental business to the SMB side.

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Bryan D. Murray, NETGEAR, Inc. - CFO [45]

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And Woo Jin, just to refer back to something Patrick said earlier with respect to the growth, we see that as starting in Q2. You normally see seasonality in Q1 coming out of the holiday season where CHP, nonservice provider drops about 20%. That certainly will be muted with some of the actions that we're taking in the U.S. but I still think that we'll see that seasonal drop maybe in the 10% to low-teen percentage-wise.

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Woo Jin Ho, Bloomberg Intelligence - Senior Technology Analyst [46]

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Okay. And then one last product portfolio question for me. Patrick, you guys have done a great job in mastering the good, better, best strategy in the WiFi market, whereas Google and Amazon have focused on the good.

Given your focus on WiFi 6 and the higher end of the product spectrum, is there any risk that you might be giving up a large share of the base of that pyramid to Amazon and Google with the lower-priced mesh products?

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [47]

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Not really, all right? We are at the high end of the good, better, best. So we compete on every single level. So for example, if you look at WiFi 6 router, right, we just introduced a WiFi 6 router at $179, all right? So which is the high end of the good. And we also just introduced still a new dual-band Orbi, the 1x series, which is priced at around $249 so we continue to do that. So we compete in every single price level. But in every single price level, we're always the highest priced, which is basically our modus operandi, and it has been very successful because channel partners want that, all right? For every single price level, they want a higher-priced product. We just introduced a $249 extender, all right? But we'll continue to expand the line of WiFi 6, we're not going to leave any price point open and empty.

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Operator [48]

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And I will now turn the call back to Patrick Lo for closing remarks.

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C. S. Lo, NETGEAR, Inc. - Co-Founder, Chairman & CEO [49]

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Thank you, everybody, for joining today's call. Clearly, I mean we would like to have better financial results for Q3 and Q4, but with the political headwinds thrown at us, we are quickly readjusting, and we are very optimistic about our prospects across the business as we close out the year and enter 2020.

We have clear leadership in WiFi 6, in ProAV and listing partners in both areas. We are very encouraged by our progress in acquiring subscription service customers and making good initial steps towards our goal of 1 million paid subscribers in a few years.

I look forward to updating all of you at our Analyst Day on all those fronts in November and look forward to seeing all of you on November 20 in Europe at the Nasdaq site. Thank you.

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Operator [50]

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And this concludes today's conference call. You may now disconnect.