Q2 2023 NETGEAR Inc Earnings Call
Participants
Bryan D. Murray; CFO; NETGEAR, Inc.
C. S. Lo; Co-Founder, Chairman & CEO; NETGEAR, Inc.
Hamed Khorsand; Principal & Research Analyst; BWS Financial Inc.
Unidentified Analyst
Erik Bylin; Principal; NMN Advisors
Presentation
Operator
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.
Erik Bylin
Thank you, David. Good afternoon, and welcome to NETGEAR's Second 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 second quarter provided by Bryan, followed by a detailed commentary on the business provided by Patrick, and finish with third quarter of 2023 guidance provided by Bryan. We'll then have time for any questions. If you have not received a copy of today's 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 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 assumptions as of today, and NETGEAR undertakes no obligation to update these 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. We are pleased by the execution of our team this quarter as we delivered net revenue above the high end of our guidance range. For the quarter ended July 2, 2023, revenue was $173.4 million, down 22.3% year-over-year and down 4.1% on a sequential basis. Enabled by increased demand, our largest service provider partner outperformed our original expectations. In the retail portion of our CHP business, our premium products, which consist of our Orbi 8 and 9 Tri- and Quad-band WiFi mesh products and 5G mobile hotspots once again outperformed the broader market, with worldwide sales to end users growing year-over-year and sequentially.
Also, we're beginning to see positive signs in the retail networking market and its channel inventory are stabilizing. Momentum behind our ProAV line of managed switches delivered another strong quarter in end user sales, up 44% year-over-year, more than offsetting some of the weakness in the traditional SMB market, which has been negatively impacted by the uncertain macroeconomic environment, particularly in Asia and Europe. While we outperformed our Q2 expectations on the top line, we continue to experience meaningful headwinds in the form of $29 million of channel inventory reductions across both our CHP and SMB businesses during the quarter.
Additionally, a higher mix of service provider revenue and seasonality in our CHP retail channel business affected our gross margins. Accordingly, we delivered non-GAAP operating loss of $10.7 million and non-GAAP operating margin of negative 6.2%, with the margin coming in at the high end of our guidance range. This was down 430 basis points compared to the year ago period and a decline of 230 basis points compared to the prior quarter.
For the second quarter of 2023, net revenue for the Americas was $116.6 million, a decline of 19% year-over-year and down 4.4% on a sequential basis. EMEA net revenue was $36.2 million, a decrease of 19.6% year-over-year and down 7.7% quarter-over-quarter. Our APAC net revenue was $20.6 million, which is down 39.7% from the prior year comparable period and up 4.2% sequentially. Our APAC revenue saw outsized declines due to a significant market slowdown in Greater China and Korea.
For the second quarter of 2023, we shipped a total of approximately 1.6 million units, including 830,000 nodes of wireless products. Shipments of our wired and wireless routers and gateways combined were about 426,000 units for the second 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 55% and 45%, respectively.
Products introduced in the last 15 months constituted about 20% of our second quarter shipments while products introduced in the last 12 months contributed about 12% of our second 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 second quarter of 2023 was 31.6%, which is up 390 basis points as compared to 27.7% in the prior year comparable period and down 200 basis points compared to 33.6% in the first quarter of 2023. As compared to the prior year period, improved supply for our premium, higher-margin CHP products and considerably lower total freight costs drove the improvement. As compared to the prior quarter, Q2 experienced a higher mix of service provider revenue and seasonal impact to our CHP retail channel business.
Total Q2 non-GAAP operating expenses came in at $65.5 million, which is down 0.9% year-over-year and down 3.6% sequentially. Our headcount was 653 as of the end of the quarter, down from 702 in Q1. We will continue to strategically invest in our business and hire in key areas we believe will deliver future growth and profitability, such as ProAV-managed switches, premium Orbi WiFi mesh systems, 5G mobile hotspots and subscription services. However, we continue to evaluate other areas of the business on a regular basis, driving further cost efficiencies.
Our non-GAAP R&D expense for the second quarter was 11.4% of net revenue as compared to 9.5% of net revenue in the prior year comparable period and 11.6% of net revenue in the first quarter of 2023. 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 $4 million in the second quarter of 2023. Looking at the bottom line for Q2, we reported non-GAAP net loss of $4.7 million and non-GAAP diluted net loss per share of $0.16.
Turning to the balance sheet. We ended the second quarter of 2023 with $202.8 million in cash and short-term investments, down $36.4 million from the prior quarter. During the quarter, $34.6 million of cash was used by operations, which brings our total cash used by operations over the trailing 12 months to $45.6 million. We used approximately $700,000 in purchase of property and equipment during the quarter, which brings our total cash used for capital expenditures over the trailing 12 months to $5.3 million. We expect to return to positive free cash flow in the second half of the year as we make further progress in reducing our inventory and our bottom line improves.
Now turning to the second quarter results of 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 $98.4 million during the quarter, down 23.6% on a year-over-year basis and down 4.2% sequentially. We experienced a year-over-year decline in both the retail and service provider channels, as the year ago period was still experiencing relatively elevated demand and higher inventory carrying levels at our channel partners.
Despite a year-over-year double-digit decline in the consumer retail networking market overall in Q2, our premium Orbi 8 and 9 WiFi mesh to 5G mobile hotspots once again materially outperformed the market, with worldwide sales to end users growing over the same period. Importantly, these higher-margin, high-end products with higher ASPs allowed us to deliver revenue above the high end of our guidance. This is clear validation of the long-term growth and profitability potential of our core strategy.
On the SMB side, net revenue came in at $75 million in the second quarter, led by continued strong demand for our ProAV-managed switch products. While we continue to be challenged by channel inventory compression to historically low levels as partners navigate through the uncertain macroeconomic environment, SMB end user sales were up high single digits year-on-year, demonstrating strong market momentum of our ProAV line of products.
Despite these near-term headwinds, it's clear that the strategic investments we've made in the rapidly expanding ProAV market continued to pay off, with end user sales in this category growing 44% as compared to the prior year. While we materially lowered channel inventory in the first half of the year across both businesses, elevated interest rates and macroeconomic uncertainty remain top of mind for our partners. We continue to expect top line headwinds throughout the second half of the year as our channel partners constrain both CHP and SMB products to historically low inventory carrying levels. However, we expect the revenue impact in the second half of the year to be smaller than the first half.
Encouragingly, we are starting to see indicators that the broader consumer retail networking market is beginning to stabilize. And the market should remain steady as we move through the remainder of the year. Despite our top line remaining challenged due to the inventory reduction in the near term, customer appetite for our premium CHP products and our SMB ProAV products remained strong, a positive indicator of the product that's underlying our business. I'll touch on this more when covering our guidance for the third quarter of 2023.
I'll now turn the call over to Patrick for his commentary.
C. S. Lo
Thank you, Bryan. I'm pleased that our results in Q2 came in above our guidance. it's clear that the growth areas that we have based our strategy on, namely premium WiFi mesh systems, 5G mobile hotspots and paid service subscriptions as well as ProAV-managed switches saw continued momentum even in the face of macroeconomic headwinds. We remain confident that these strategic investments will help lead NETGEAR to long-term growth and profitability expansion. Despite the headwinds of our channel partners optimizing the inventory levels to historically low levels, our higher margin, higher ASP premium products are selling well together with a rising paid subscriber base.
Accordingly, we delivered strong non-GAAP gross margin of 31.6%, an increase of 390 basis points year-over-year and a testament to the improving transition to the high end of our product portfolio. As the market continues to stabilize, we have begun to see signs of normal seasonality, which gives us hope that we will experience improved predictability in our business once channel inventory reduction abates.
In our CHP business, the demand for our high-speed, high-performance WiFi mesh systems is strong. For our best-selling Orbi 8 and Orbi 9 mesh WiFi products, end user sales grew year-over-year, solidifying confidence in our road map for the second half of the year as the imminent WiFi 7 upgrade cycle begins with our rollout of WiFi 7 Orbi mesh. We expect ASP's margin and service attach rates to expand in tandem and are confident in our ability to deliver long-term growth and profitability. Other than our recently announced WiFi 7 routers, the Nighthawk RS700, we will start shipping our WiFi 7 Orbi mesh, [Orbi 97x] during Q3. Together, they will form our initial push into WiFi 7, with additional new WiFi 7 products to follow in the coming quarters. We look forward to the new WiFi 7 upgrade cycle beginning in 2024.
Demand for our Nighthawk M6 and M6 Pro, 5G mobile hotspots also remained strong. And these products saw end-user sales in the retail channel grow both year-over-year and quarter-over-quarter. The flexibility that an unlocked mobile spots offers is unmatched. And NETGEAR solutions are truly best-in-class. Traction behind the unlocked category of hotspots remains solid and end-user demand grew double digits sequentially. In Q3, we are refreshing our lineup with a new upgraded international version of our M6 Pro. We plan to add support of all 3 major domestic carriers along with the international roaming in 125 countries, which would greatly expand our addressable market. At an MSRP of $999, it will further improve 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 as the retail channel inventory reduction abates. With more new products on the way, and further expansion of our direct-to-consumer web store sales worldwide, we're excited with the prospects of renewed top and bottom line growth of our CHP business in the back half of 2023 and into 2024.
Outside of our hardware offerings, we are experiencing growing demand of our NETGEAR Armor service, which is the only protection built directly into the router and can protect every connected device in your home. More and more connected devices becoming integral parts of a smart home setup, and as our research together with Bitdefender has shown, smart TVs and smart power blocks are the most hacked devices. Customers who refuse to compromise on cybersecurity and privacy are trusting NETGEAR Armor as the first line of defense. Given that NETGEAR Armor is the most comprehensive security solution available today, in the second quarter, we grew our paid subscribers by 22.9% year-over-year, ending the first quarter -- the second quarter with 804,000 subscribers.
Service revenue grew to $10.3 million, up 29.6% year-over-year and up 7.2% sequentially. Our messaging around the cyber protection services that only NETGEAR Armor can offer is clearly resonating with customers, and we are steadily working towards our goal of 875,000 paid subscribers by the end of this year.
We're also seeing strong growth in sales via our online direct-to-consumer stores worldwide, which remains a key element of our premium strategy. Our direct store provides the best platform to cater to premium, performance-conscious, less price-sensitive customers with improved customer satisfaction and maximization of the wallet share and higher service attach rate. As our footprint with this highly profitable channel grows larger, we anticipate growing our subscriber base in tandem with the building momentum behind the premium segment of the market. We will continue to invest and grow this channel across the globe to drive our premium and subscription strategy.
Turning to our SMB business. NETGEAR's ProAV-managed Ethernet switch products once again saw strong end customer growth, up 44% year-over-year. It is clear that the technological differentiation inherent in our ProAV-managed Ethernet switch products is resonating with customers. With a solid presence around the globe, NETGEAR is a leader in the ProAV market, and we made progress in growing our manufacturer and integrated partnerships worldwide.
As the industry transition from cumbersome unlocked solutions to ultrahigh resolution, intelligent digital AV over IP, we are proactively expanding into new verticals to unlock even greater available market opportunities such as the custom residential integration and broadcast markets. It's not only our customers and partners who are excited about our robust portfolio, industry experts are also recognizing the innovation of our ProAV line, which was designed with products specifically tailored to the unique needs of the AV industry. We are honored that our recently introduced M4350 ProAV managed switch won the InfoComm AV Technology Award for Best of Show last month in Orlando, Florida. This powerful AV over IP managed switch enables even more PoE power budget and more 25 gigabits per second ports all with low latency, low jitter and losses transport of AV signals.
Furthermore, on the software side, we were at support of the video broadcast protocol, of [70 2110] later this year. As such, we expect our highly profitable SMB business to resume its trajectory in becoming a greater part of our revenue mix and improve overall margins heading into 2024.
And with that, I'll turn it back over to Bryan to comment on our opportunities and challenges in the coming quarters 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 our CHP product portfolio, even in the face of ongoing broad-based inflationary pressures and an uncertain macroeconomic environment. We are starting to see indicators that the broader consumer retail networking market is beginning to stabilize.
However, as interest rates remain high, we will continue to work with our channel partners across both businesses to optimize their inventory carrying levels, but expect a revenue impact from these efforts to be at a lesser level than experienced in the second quarter. Accordingly, we expect our third quarter net revenue to be in the range of $175 million to $190 million. We expect third quarter GAAP operating margin to be in the range of negative 7% and to negative 4%, and non-GAAP operating margin to be in the range of negative 4% to negative 1%. Our GAAP tax rate is expected to be approximately 15% and our non-GAAP tax rate is expected to be 25% for the third quarter of 2023.
We would now like to answer any questions from the audience.
Question and Answer Session
Operator
(Operator Instructions) We'll take our first question from Hamed Khorsand with BWS Financial.
Hamed Khorsand
So my first question was, could you just talk a little bit more about the service provider order? How much was it for you as far as total revenue is concerned? And does this change your outlook as what service provider revenue would look like for the full year?
Bryan D. Murray
Yes. On the quarter, we unlocked the upside of about $10 million from service provider, largely coming from our biggest partner there. And I'd say the majority of that was coming from upside demand in the quarter. There was some, I guess, more rational thought put into inventory carrying levels.
You may recall that we discussed last quarter that they were working inventory down to a -- the extremely low level never seen before. They softened that a little bit, but most of that $10 million upside is coming from incremental demand pull-through. In terms of going forward and outlook, I would say that the $25 million per quarter level is probably the outlook that we would guide people to at this point.
Hamed Khorsand
Okay. And then as far as the home is concerned in retail, usually, Q3 has been a strong spot for you seasonality-wise. What are you not seeing that you would like to see?
C. S. Lo
No. Actually, we are actually going to see a seasonality returning. So the normal seasonality uplift of 10%, we expect that to happen this Q3.
Hamed Khorsand
Okay. And then as far as just pricing and discounts are concerned, what is it that's preventing you from reaching a breakeven or positive operating margin?
C. S. Lo
Well, there's still some channel destocking. And we believe that the channel destocking will last another 2 quarters. We're definitely shipping a lot less than what we actually sold through in the end-user market. That's basically hurting us from a bottom line perspective.
Bryan D. Murray
Yes. And if I might add there, the Q2 destocking level that Patrick was referring to was quite sizable, about $29 million. You may recall that Q1 was about $37 million. So it's been pretty meaningful in the first half of the year. It's going to continue in the back half, but we think it's probably at a level of about half of what we saw in the first half and probably a little more front loaded towards Q3. And for that reason, we would likely expect a step-up in Q4, probably in the neighborhood of about 10%, which we do think takes us to that non-GAAP level of profitability in the low single-digit margin level.
Operator
Next, we'll go to [Jake Norrison] with Raymond James.
Unidentified Analyst
Perfect. So just talking about that again. So you've said you're seeing signs that the broader retail network market could be stabilizing and you had confidence that inventory levels in the channel are going to stabilize, could you just provide more color on what you're seeing from both fronts there? There's going to be a lot of investors asking about the back half load with the operating margin expectation in 4Q, if you could just unpack that, that would be perfect.
C. S. Lo
Well, what we're seeing is every quarter relative to pre-pandemic level, the decline is stabilizing. For example, for the last 3 quarters, each quarter's market size in U.S. retail is roughly about 15% below the pre-pandemic level. It hasn't deteriorated. So that's what we mean by stabilizing because of that, then the market is following the normal seasonality. That means based on using Q1 as a base and Q2 is down roughly about 5%. And Q2 to Q3, we expect it to be up 10%, and then Q3 to Q4, we expect it to be flat or slightly up. So that's the normal seasonality returning because the entire market shrinkage is stabilizing relatively to the pre-pandemic level. So that's what we mean.
In terms of channel inventory stabilizing, which means that because, think about this, they used to carry 12 weeks of inventory of a bigger market. Now when the market shrinks, not only that they would shrink to 12 weeks of the smaller market, they actually would like to shrink to 8 to 10 weeks of the smaller markets, I think we're getting there. right? We're getting there. I think it will take us 2 more quarters to get there to about 9 weeks of the smaller market. Yes.
Unidentified Analyst
Okay. Perfect. And then last one for me, a little more high level. Just talk about the WiFi 7 refresh opportunity in '24 and if we'll see any ASP degradation for the WiFi 6 devices.
C. S. Lo
We don't believe so because of the technology of WiFi 7, which is significantly better in terms of speed and latency. Initially, the ASP will be significantly higher than the WiFi 6. And because -- and there aren't many WiFi 7 clients yet, so we don't see any erosion in ASP of the WiFi 6 in 2024. But of course, when you go into 2025, yes, we do expect that. But then there will be more WiFi 7 products, and there will be more weight towards WiFi 7 sales, which is a higher ASP. So we do see, because of that mix effect, ASP will continue to go up in the years to come.
Operator
And I show that there are no further questions at this time. I'll now turn the call back over to Patrick Lo for any additional or closing remarks.
C. S. Lo
Great. Thanks for everybody joining the call. We're really pleased we are making continuous year-over-year quarter-over-quarter progress in the 4 pillars of our strategy. On the CHP side, it's basically the 3 things: premium products, subscription and direct-to-consumer sales. And on the SMB side, it's really focusing on a tremendous growth opportunity of ProAV. And we're very excited about going into 2024. And we clearly will share more of those elements and how we could capitalize them more in 2024 in our Analyst Day, which is going to be somewhere at the end of November, early December, and we'll update you more on those aspects in the next earnings call. So look forward to talking to you all again.
Operator
This concludes today's conference call. You may now disconnect.
