Q1 2023 NETGEAR Inc Earnings Call

Participants

Bryan D. Murray; CFO; NETGEAR, Inc.

C. S. Lo; Co-Founder, Chairman & CEO; NETGEAR, Inc.

Erik Bylin; Former IR Executive; NETGEAR, Inc.

Hamed Khorsand; Principal & Research Analyst; BWS Financial Inc.

Jake Norrison

Presentation

Operator

Good afternoon, ladies and gentlemen, and welcome to the NETGEAR First Quarter 2023 Results Conference Call. At this time, all participants are in a listen-only mode, and please be advised that this call is being recorded. After the speaker's prepared remarks, there will be a question-and-answer session. (Operator Instructions). And now, at this time, I'll turn things over to Mr. Erik Bylin. Mr. Bylin, you may begin.

Erik Bylin

Thank you, Bob. Good afternoon, and welcome to NETGEAR's First Quarter of 2023 Financial Results Conference Call. Joining us from the company are Mr. Patrick Lo, Chairman and CEO; and Mr. Bryan Murray, CFO. The format of the call will start with a review of the financials for the first quarter provided by Bryan, followed by details and commentary on the business provided by Patrick, and finish with the second quarter of 2023 guidance provided by Bryan. We'll then have time for any questions. If you've not received a copy of today's release, please visit NETGEAR's Investor Relations website at www.netgear.com.Â

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-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. 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.

Bryan D. Murray

Thank you, Erik, and thank you, everyone, for joining today's call. While we came into the quarter forecasting approximately $28 million in channel inventory reductions of both CHP and SMB products, our actual experience was a reduction of $37 million or $9 million higher than anticipated. This increase was due to an unprecedented inventory reduction by our largest service provider partner as well as a meaningful reduction in SMB inventory by our largest e-commerce partner. This resulted in an unexpected challenge to our top line. Accordingly, our net revenue for the quarter ended April 2, 2023, was $180.9 million, which came in below the low end of our guidance range, down 14.1% year-over-year and down 27.4% on a sequential basis.Â

However, our end-user sales of SMB products remained strong, growing double digits year-on-year, driven by our ProAV line of managed switches, and our premium CHP products consisting of our Orbitz and 9 Tri and quad-band WiFi mesh products and 5G mobile hotspots, again outperformed the broader market, growing sequentially despite normal seasonal patterns. While our gross margin improved dramatically during the quarter, it was not enough to offset the reduced leverage from our top line. As a result, we delivered non-GAAP operating loss of $7.1 million, and non-GAAP operating margin came in at negative 3.9%, below the low end of our guidance range, which was up 50 basis points compared to the year ago period and a decline of 230 basis points compared to the prior quarter. 

For the first quarter of 2023, net revenue for the Americas was $121.9 million, a decline of 15.7% year-over-year and down 23.4% on a sequential basis. EMEA net revenue was $39.2 million, an increase of 6.3% year-over-year and down 25.7% quarter-over-quarter. Our APAC net revenue was $19.8 million, which is down 31.8% from the prior year comparable period and down 46.8% sequentially. Our APAC revenue saw outsized declines due to the Southern COVID surge in China at the end of last year and into Q1 of this year, which caused a significant market slowdown in China, Hong Kong and Korea. For the first quarter of 2023, we shipped a total of approximately 1.8 million units, including 860,000 nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 485,000 units for the first quarter of 2023. The net revenue split between home and business products was about 57% and 43%, respectively. The net revenue split between wireless and wired products was about 44% and 56%, respectively. Products introduced in the last 15 months constituted about 18% of our first quarter shipments, while products introduced in the last 12 months contributed about 12% 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. Non-GAAP gross margin in the first quarter of 2023 was 33.6%, which is up 540 basis points as compared to 28.2% in the prior year comparable period and up 870 basis points compared to 24.9% in the fourth quarter of 2022. This represents our second highest gross margin since the beginning of 2019. As compared to both the prior year period and Q4 2022, we experienced an improved mix of our premium CHP products as well as the higher mix of F&B revenue, both of which carry higher margins. Additionally, we experienced lower sea freight costs as determined when the inventory was purchased and decreased our use of higher-cost airfreight due to an improved supply picture. 

Total Q1 non-GAAP operating expenses came in at $67.9 million, which is down 1.1% year-over-year and up 2.8% sequentially. Our headcount was 702 as of the end of the quarter, up slightly to 691 in Q4. We will continue to strategically invest in our business and hire in key areas where we believe we will deliver future growth and profitability, such as ProAV-managed switches, premium Orbitz WiFi mesh systems, 5G mobile hotspots and subscription services. However, we continue to evaluate other areas of the business on a regular basis and plan to drive further cost efficiencies. Our non-GAAP R&D expense for the first quarter was 11.6% of net revenue as compared to 10.8% of net revenue in the prior year comparable period and 7.7% of net revenue in the fourth quarter of 2022. 

To continue our technology and subscription service leadership, we are committed to continued investment in R&D. Our non-GAAP tax expense was a benefit of $19,000 in the first quarter of 2023. Looking at the bottom line for Q1, we reported non-GAAP net loss of $5.6 million and non-GAAP diluted net loss per share of $0.19. Turning to the balance sheet. We ended the first quarter of 2023 with $239.2 million in cash and short-term investments, up $11.8 million from the prior quarter. During the quarter, $9.1 million of cash was provided by operations, which brings our total cash used by operations over the trailing 12 months to $5.9 million. We used $870,000 in purchase of property and equipment during the quarter, which brings our total cash used for capital expenditures over the trailing 12 months to $5.7 million. Now turning to the first quarter results for our product segments. The Connected Home segment, which includes our industry-leading Orbi, Nighthawk, Nighthawk Pro Gaming, Armor and Meural brands, generated net revenue of $102.7 million during the quarter, down 21.2% on a year-over-year basis and down 31.1% sequentially. 

We experienced a year-over-year decline in both the retail and service private channels. As the year ago period, we're still experiencing relatively elevated demand and higher inventory carrying levels at our channel quarters. Despite a year-over-year double-digit decline in the consumer networking market overall in Q1, our premium Orbi 8 and 9 WiFi mesh and 5G mobile hotspots materially outperformed the market in that same period. Importantly, these higher-margin, high-end products helped offset the lost top line leverage and resulted in an improved contribution profit in the CHC business as compared to the year ago period and Q4 2022 despite lower revenue. This is a clear validation of the long-term growth and profitability potential of our core strategy. 

On the SMB side, our products continue to gain a strong reception in the market, and initial sales grew by double digits year-on-year. However, while we had anticipated some channel inventory reductions of our SMB products, we also experienced a drastic and unanticipated reduction in inventory carrying levels at our largest e-commerce channel partner, which constrained our top line. Accordingly, SMB net revenue came in at $78.2 million in the first quarter, a decline of 2.6% on a year-over-year basis and 21.9% sequentially. Demand remains exceptionally strong for our ProAV managed switch products with end-user sales in this category growing over 50% as compared to the prior year quarter, and our investments in this area continue to pay off. 

As we continue to look to the remainder of the year, broad-based inflationary pressures and the uncertain macroeconomic environment still remain top of mind for our partners across all channels. Consequently, while we materially lower channel inventory in the first quarter, we continue to expect top line headwinds as our channel partners continue to constrain inventory levels of both CHP and SMB products to unprecedented carrying levels with an impact of a similar magnitude to Q1 on our top line projections. Despite our top line remaining challenges due to the inventory reductions in the near term, we expect end market sales of our premium CHP products and our SMB products to continue to deliver growth, a positive indicator for the underlying business. I'll touch on this more when covering our guidance for the second quarter of 2023. I'll now turn the call over to Patrick for his commentary.

C. S. Lo

Thank you, Brian. After 3 years of the pandemic, broad-based inflationary pressures amid an uncertain macroeconomic environment are affecting consumers and industries around the world. In the first quarter, channel partners in all parts of our business sharply constrained their order to reduce inventory carrying levels more aggressively than our original estimates, impacting our top line and resulting in lost operating leverage. However, the overarching market trends that we have based our strategy on delivering leading-edge technologically differentiated products to consumers and businesses that will pay for high performance features are clearly evident in the behavior of our end users.Â

Importantly, in the first quarter, NETGEAR delivered non-GAAP gross margin of 33.6%, up 540 basis points year-over-year and 870 basis points sequentially. As we achieved our second-highest gross margin since the beginning of 2019, we believe this serves as strong validation of our strategy to move away from the less profitable lower end of the market and focus on premium products where profitability has been consistently stronger. The impressive gross margin result of this quarter gives us renewed confidence in the sustainability and longevity of the margin expansion potential, unlocked by our core long-term growth strategy, even through periods of macroeconomic uncertainty, especially when channel inventory levels stabilize. Now, turning to an update on our CHP business. Demand for our best-selling premium Orbi8 and Orbi9 mesh WiFi products remained strong, and end-user sales actually grew sequentially even in the face of a normal seasonal decline from the Q4 holiday period. 

The solid performance of these higher-margin products enabled CHP to contribute to our significant gross margin improvement in the quarter. The WiFi 7 upgrade cycle is coming later this year, and we are poised to capitalize on another technological inflection point. As the transition of our portfolio mix from low end to high end progresses, ASPs, margins and service attach rates should improve in tandem and deliver long-term growth and profitability. Innovation is the key to next year's success, and I'm excited to share that we are again at the forefront of the next technology inflexion as we recently launched our first WiFi 7 router, the Nighthawk RS700. This high-performance triband router is spearheading the WiFi 7 revolution and introduces a powerful new antenna design, capable of delivering WiFi speeds of up to 19 gigabits per second, more than double that of the previous generations, optimized for the requirements of modern hyperconnected homes. 

The Nighthawk RS700 also features a 10 gigabit Internet port and 4 gigabit LAN ports for fast, flexible wired connections. As the first mover in the WiFi 7 space, we expect this product to expand our addressable market even further as consumers future-proof their networks. The Nighthawk RS700, retailing at $699, is already available for preorder and will begin shipping this quarter. Our WiFi 7 Nighthawk offering will be followed by our WiFi 7 4B introduction in Q3, putting further distance between us and our competitors. Demand for our Nighthawk M6 Pro 5G mobile hotspots also remained strong. And these products saw end-user sales in the retail channel grow year-over-year and quarter-over-quarter. The flexibility of the unlocked version of the M6 Pro 5G mobile hotspots launched just recently in the fourth quarter in Europe and is extremely appealing to customers, and the unlocked category grew double digits sequentially. Capable of delivering speeds of up to 3.6 gigabits per second and connecting up to 32 devices simultaneously, the unlocked diversion of the M6 Pro offers unparalleled affordability, security, reliability and customization for the customer to accommodate their unique location in carrier. We expect to launch the U.S. version of the unlocked Nighthawk M6 Pro 5G mobile hotspot next month, and we expect it will greatly expand our addressable market with support for all 3 major domestic carriers, along with international roaming. 

At an MSRP of $999, it will further improve our ASPs unit growth and uplift margins over time. These exciting new products will be key contributors to top and bottom line growth for CHP in the seasonally stronger second half of the year when retail channel inventory levels stabilize. We have seen improved demand for our NETGEAR Armor service as cybersecurity and privacy are top of mind for consumers these days. And Armor is the only protection billed directly into the router. With the most comprehensive security solution available to date, in the first quarter, we grew our paid subscribers by 23.1% year-over-year, ending the first quarter with $772,000. Service revenue grew to $9.6 million, up 26.3% year-over-year and up 7.9% sequentially. Our messaging around the services that only NETGEAR can offer is clearly resonating with customers, and we are steadily working towards our goal of 875,000 paid subscribers by the end of 2023. 

A key element of our premium strategy is to create online experience to deliver to guide our value-added customers through the shopping experience. This approach has helped grow netgear.com as a channel and with the expansion of these services to the U.K., France, Germany, Benelux and Australia, we have a great opportunity to accelerate our traction. Increased traction in the premium segment of the market through this highly profitable channel helps our subscriber base grow in tandem. Together, these can drive further improvement in our CHP profitability and ongoing growth and operating margin expansion. Turning to our SMB business. The technological differentiation inherent in NETGEAR's ProAV-managed ethernet switch products has fueled substantial end-customer growth, up over 50% year-over-year, and that drove end-customer sales growth of 18% year-over-year for the entire SMB business. 

In conjunction, we have also made great inroads in increasing our ProAV manufacturer and integrated partnerships, nearly doubling the number of our ProAV manufacturing partnerships year-over-year to over 200. We are poised to expand our opportunity by building on the success of our M4250 AV IP switches, with the introduction of the M4350 this quarter, which will enable more power over the ethernet budget and more 25 gigabits per second ports. As the industry transitions from cumbersome analog solutions to ultrahigh resolution, intelligent digital AV IP, we continue to make progress in expanding our routes to new markets to fully capitalize on this momentum and unlock even greater available market opportunities across new verticals. We will support this SMPTE protocol on our new M4350 ProAV switches for the broadcast and studio industry by year's end, and that will only accelerate this industry's move from analog to all digital IP. 

As channel inventory stabilizes in the second half and we expand the addressable market, we expect our highly profitable SMB business to resume its traditory and become a greater part of our revenue mix and thereby expand our growth and operating margin as well. A relentless focus on innovation has been integral to NETGEAR becoming the market leader in our high-end growth categories and also positions us well to fully capitalize on the trends we discussed at our recent Analyst Day. Growing the premium segment of the CHP market continued the momentum behind our paid subscriber additions and a rapidly accelerating transition from analog to digital IP-based AV over ethernet connections. And with that, I'll turn it back over to Bryan to comment on our opportunities and obstacles in the coming quarter and year.

Bryan D. Murray

Thank you, Patrick. We expect to continue to experience strong underlying demand in the SMB business and the premium portion of the CHP product portfolio, even in the face of ongoing broad-based inflationary pressures and an uncertain macroeconomic environment. We will continue to work with our channel partners across both businesses to optimize their inventory carrying levels and expect a revenue impact from these efforts to be at a similar level as experienced in the first quarter. Accordingly, we expect our second-quarter net revenue to be in the range of $150 million to $165 million. We expect the second quarter GAAP operating margin to be in the range of negative 13.4% to negative 10.4%. And non-GAAP operating margin is expected to be in the range of negative 9% to negative 6%. Our GAAP tax rate is expected to be approximately 11%, and our non-GAAP tax rate is expected to be 6% for the second quarter of 2023. We would now like to answer any questions from the audience.

Question and Answer Session

Operator

Thank you, Mr. Murray. (Operator Instructions). I can start one for questions, and we'll go first this afternoon to Hamed Khorsand BWS Financial.

Hamed Khorsand

So my first question is, what's been the biggest challenge for you as far as handling this inventory demand and balance? It seems like every quarter, there's been an issue that comes about.

Bryan D. Murray

Yes. I think, as I noted earlier, I think this quarter, in particular, it was the surprise factor. And I think you're seeing from a number of different companies the impact that they're feeling from the environment, the service provider account I mentioned earlier publicly noted some of the challenges they've seen on the free cash flow side. And they're in extreme circumstances, and they're responding accordingly. So I think it's the surprise factor to that. As I noted, we expected about $28 million of destocking to happen in the quarter. And just to remind everybody, what that really means is that as our channel partners sell through, they just won't replenish at the same rate. So we expected a sizable amount, and we expected it to be across both businesses. But as we said earlier, the surprise factor being the service provider account and, on the SMB side, the largest e-commerce partner we have, really implementing some very tight strict inventory management guidelines is unprecedented, is levels we haven't seen before. And so we're now preparing for that and expect it to continue into Q2.

Hamed Khorsand

And then, how are you balancing the premium CHP business? Are you spending more time advertising direct to the consumer? How are you going about that so you can at least try to offset what's going on at the retail front?

C. S. Lo

You're right. I mean, we are focusing on increasing the mix of our CP premium products. And we're seeing a positive response from the market as we see continued sequential growth of those products despite the market decline. And you're right, we're focusing on direct marketing to consumers who are looking for high-performance premium products. Generally, we do most of our marketing online using all kinds of aligned marketing capabilities. We're also using our own website, netgear.com, to direct them into our web stores and provide concise service to give them the best shopping experience. So we're also working with a lot of channel partners or media channel partners that we believe our customers would go to such as some of the technical sides like Tom hardware and others, and also in lifestyle types of outlets, such as the Rock Report. So yes, we're doing a lot of non-marketing targeting them. The one thing we don't do is discount and promotions on these high-end products because we have a very unique offering and we're way about any of our competitors' offerings. And if the customers want the absolute best WiFi experience either at home or on the go, then the only solution is our Orbi Mesh and our Nighthawk mobile routers.

Hamed Khorsand

My last question is, how are you managing inventory, just given where revenue is and what's the plan there?

C. S. Lo

Well, absolutely, we cannot control what the channel wants to do. So we are putting in a very conservative channel inventory estimate given all these surprises. And in return, we also are slowing down the production rate in our factories to slow the inventory coming in. So that's how we manage it. Now certainly, in Q1, the surprise is higher than what we estimated. And that's why we're taking a very conservative viewpoint in Q2, and we believe that we would be able to get ahead of the curve in Q2 from an inventory balance standpoint in our own warehouse.

Operator

Thank you. We'll go next now to Jake Norrison at Raymond James.

Jake Norrison

I'm just hoping you could touch on a few points here. One, have you made any changes to the sort of fiscal year '23 non-GAAP operating margin target and the service provider revenue targets? And then, beyond that, can you just let us know what is underpinning your confidence in the back half load this year?

Bryan D. Murray

Yes. I'll start here with kind of the outlook for the year. I mean, certainly, the surprise to Q1 and our guidance to Q2 were off pace from the guidance that we put out there back in December at our Analyst Day. At this point, as Patrick has said a couple of times here, we're being cautious, right? We're dealing with an environment where we're seeing unprecedented responses from channel partners in terms of their willingness to hold inventory. So at this point, we expect the second half of the year that 2 things will be driving factors. One is the CHP retail business gets the typical seasonal lift. And then secondarily, we think that the level of destocking will moderate in the second half. And based on both of those factors, we would likely expect the second half of the year, the total revenues in the back half of the year to over-index the first half by 15% to 20%. So that certainly is different than the annual guidance that we put out there before. And with that lower revenue level, operating margins have been suppressed. But with that revenue outlook in the back half, I think you'd likely be seeing non-GAAP operating margins in that low to mid-single-digit level.

Jake Norrison

Okay. Perfect. And then the last one from me. Has there been any thinking or any changes on the thinking in sort of share repurchases and capital allocation going forward here?

Bryan D. Murray

Yes. As we said before, we're always looking at it. We're opportunistic buyers of our stock. We're obviously looking at our cash balances, our planned cash outlay for operational purposes. And so all those things are factored into ongoing conversations with regards to capital allocation.

Operator

Thank you, ladies and gentlemen. It appears we have no further questions this afternoon. Mr. Well, I'll hand things back to you for any closing comments.

C. S. Lo

Okay. So thank you, everybody, for joining us today. I mean, while we're certainly disappointed by the impact of the inventory reduction of our channel partners, we and India remain confident in our long-term growth strategy, and I'm proud that the team has made progress in shifting our product mix to the high-end premium segment. Although the uncertain microeconomic environment and related inventory compression will continue as a headwind to achieve the full top-line potential of our business in the short term, we are seeing these premium products consistently outperform the broader market, armed with the reduced portfolio of high-margin products and services and with more on the way, our confidence in income's long-term growth trajectory is unwavering. I look forward to sharing an update on our progress at our next earnings call.

Operator

Thank you, Mr. Well. Ladies and gentlemen, that will conclude the NETGEAR First Quarter 2023 Results Conference Call. We'd like to thank you all so much for joining us and wish you all a great remainder of your day. Goodbye.