Q3 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.
Jake Norrison
Erik Bylin; Principal; NMN Advisors
Presentation
Operator
Hello and welcome to NETGEAR's Third Quarter 2023 Results Conference Call. 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. Good afternoon, and welcome to NETGEAR's Third 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 third quarter provided by Bryan, followed by details and commentary on the business provided by Patrick, and finish with the fourth 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 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.
We are pleased by the continued strong execution of our team this quarter in delivering both revenue and operating margin comfortably above the high end of our guidance range. For the quarter ended October 1, 2023, revenue was $197.8 million, up 14.1% on a sequential basis, but down 20.7% year-over-year.
Increased demand in both the CHP retail market and service provider channels, along with retail channel partners maintaining rather than depleting their inventories, enabled us to outperform our top line relative to our original expectations. As the WiFi 7 upgrade cycle begins to ramp and we approach the holiday season, we continue to see positive signs that the retail networking market is stabilizing. Notably, in Q3, the U.S. retail market grew double digits sequentially, in line with historical seasonality.
In the retail portion of our CHP business, our premium solutions, which consist of Orbi 8 and 9 tri- and quad-band WiFi mesh products and 5G Nighthawk mobile hotspots are continuing to perform well. Sales to end users of these premium products grew double digits year-over-year, dramatically outperforming the total market which compressed double digits over the same time frame.
On the other hand, our SMB business fell short of our top line expectation in the third quarter. The uncertain macroeconomic environment continued to pressure our channel partners, and we saw them continue to reduce their inventory carrying levels, which constrained the top line of our SMB business and will continue to limit its top line potential in the quarters to come.
This second consecutive quarter of top line outperformance is an encouraging sign that the CHP retail market is stabilizing and the WiFi 7 transition is gaining traction. The strong mix of our premium higher-margin products, combined with the progress we continue to make in growing our service revenue business in CHP, helped improve our gross margins.
Additionally, we gained top line leverage from the seasonal lift of the back-to-school season and, coupled with the disciplined expense management, we returned to profitability, delivering non-GAAP operating income of $5.3 million and non-GAAP operating margin of 2.7%, with the margin coming in well above the high end of our guidance range. Our non-GAAP operating margin was up 200 basis points compared to the year ago period and up 890 basis points compared to the prior quarter.
For the quarter ended -- for the third quarter of 2023, net revenue for the Americas was $141 million, a decline of 16.7% year-over-year and up 20.9% on a sequential basis. EMEA net revenue was $35.7 million, a decrease of 20.4% year-over-year and down 1.3% quarter-over-quarter. Our APAC net revenue was $21.1 million, which is down 40.3% from the prior year comparable period and up 2.4% sequentially.
For the third quarter of 2023, we shipped a total of approximately 1.8 million units, including 991,000 [nodes] of wireless products. Shipments of all wired and wireless routers and gateways combined were about 520,000 units for the third quarter of 2023.
The net revenue split between home and business products was about 64% and 36%, respectively. The net revenue split between wireless and wired products was about 61% and 39%, respectively. Products introduced in the last 15 months constituted about 16% of our third quarter shipments, while products introduced in the last 12 months contributed about 11% of our third 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 third quarter of 2023 was 35%, which is up 740 basis points as compared to 27.6% in the prior year comparable period and up 340 basis points compared to 31.6% in the second quarter of 2023.
As compared to the prior year period, increased shipments of our premium higher-margin CHP products and considerably lower total freight costs drove the improvement. As compared to the prior quarter, Q3 experienced a higher mix of premium, higher-margin products. And overall, we were more efficient with our marketing spend.
Total Q3 non-GAAP operating expenses came in at $64 million, which is down 4.7% year-over-year and down 2.2% sequentially. Our head count was 644 as of the end of this quarter, down from 653 in Q2.
We will continue to strategically invest in our business and hire in key areas we believe will deliver future growth and profitability, such as Pro AV 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 third quarter was 10.1% of net revenue as compared to 8.5% of net revenue in the prior year comparable period and 11.4% of net revenue in the second 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 $0.7 million in the third quarter of 2023. Looking at the bottom line for Q3, we reported non-GAAP net income of $6.9 million and non-GAAP diluted earnings per share of $0.23.
Turning to the balance sheet. We ended the third quarter of 2023 with $228 million in cash and short-term investments, up $25.2 million from the prior quarter. As we projected in July, we were able to return to positive free cash flow in the third quarter as we made meaningful progress in reducing our inventory and improving our bottom line.
During the quarter, $26.1 million of cash was provided by operations, which reduced our total cash used by operations over the trailing 12 months to $4.4 million. We used $2 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 $5.2 million.
We expect to continue generating positive free cash flow as we believe we will further reduce our inventory levels over the next couple of quarters and drive to our pre-pandemic carrying levels of 3 to 4 months.
Now turning to the third 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 strong revenue of $127.3 million during the quarter, down 15.4% on a year-over-year basis and up 29.4% sequentially.
The year-over-year decline in both the retail and service provider channels is a result of a larger total addressable market and higher inventory carrying levels at our channel partners in the prior year period. Despite the year-over-year overall retail market contraction, demand for our premium Orbi 8 and 9 WiFi mesh and 5G mobile hotspots continue to grow, up double digits.
Bolstered by the addition of our recently released WiFi 7 products, namely the Orbi 97x mesh system and the Nighthawk RS700 router, these higher-margin, high-end products with high ASPs were an important contributor to delivering revenue and operating margin well above the high end of our guidance, serving as another proof point of the long-term growth and profitability potential of our core strategy.
On the SMB side, net revenue came in at $70.5 million in the third quarter, below our expectations. The softness in SMB was due to the uncertain macroeconomic environment weighing on the SMB market, especially in geographies with stagnant or even negative GDP growth, such as Germany, Greater China and Japan, which are our biggest markets outside of North America.
Our SMB channel partners continue to compress inventory levels in the quarter and are expected to continue doing so in the quarters ahead. Despite this, we continue to see growth in our Pro AV suite of products and remain confident they will be a long-term growth driver of our SMB business.
I'll now turn the call over to Patrick for his commentary.
C. S. Lo
Thank you, Bryan. I would like to thank our NETGEAR team for delivering many great achievements in the third quarter. We have the most successful launch of new WiFi technology in our history with our WiFi 7 quad-band Orbi 97x and Nighthawk RS700 router. We attained an overall gross margin of 35% by driving an ideal combination of high-margin products in CHP and SMB with fewer promotional discounts.
We continue to grow the number of value-added service subscribers to 844,000, achieving 25% growth in service revenue to $10.6 million for the quarter. We worked together with our retail channel partners to rightsize the inventory levels and believe they have reached the level they would like to maintain. We continue to see growth in market demand for our Pro AV line of SMB products. And finally, our team worked tirelessly to reduce our own inventory and generate meaningful cash for our balance sheet.
We started shipping our first 2 WiFi 7 products exclusively on our U.S. direct-to-consumer web store in the second to last week of Q3. And market reception well exceeded our expectations. The Orbi 97x, our WiFi 7 quad-band mesh delivered sales in the first 2 weeks double that of our prior launch of the quad-band WiFi 6E mesh, the Orbi 96x.
The Nighthawk WiFi 7 router, RS700, instantly became our #1 selling premium router, overtaking our previous top-of-the-line WiFi 6E router, the RAXE500.
While Wi-F7 clients are not widely available yet, the early technology adopters have clearly given us the stamp of approval. As WiFi 7 clients become widely available starting April or May of next year, we believe the retail market and our CHP revenue will ride the upgrade cycle. And we believe this will return our CHP business back to growth.
We are readying a strong pipeline of WiFi 7 introductions in 2024 across all our major product lines: Orbi mesh, Nighthawk routers, Nighthawk mobile hotspots and SMB Insight access point. We are excited about these opportunities to expand our top and bottom lines in 2024 on a year-over-year basis for every quarter.
During Q3, our CHP sales and marketing teams worldwide were hard at work in showcasing and marketing our high-margin products across all categories, mesh, routers, mobile hotspots, cable gateways and laptop WiFi adapters, to achieve the best mix of high-margin products in recent years. Our SMB team is doing the same with our Pro AV products. As a result of these efforts, we were able to achieve 35% gross margin overall. We believe, as more WiFi 7 products launch in 2024, we would have room to further improve our overall gross margin in the new year.
We added 40,000 paid service subscribers in Q3, reaching account of 844,000. We grew our paid service revenue to 10.6 million. We are on pace to reach our goal of 875,000 paid service subscribers by the end of the year, further growing our service revenue, which would be a major contributor to our gross margin expansion for years to come.
We will continue to add compelling features to our Armor services to protect our customers' connected devices throughout their homes. We intend to add more privacy protection features in 2024, thus increasing the appeal of our Armor service to even wider audiences.
With the strong reception of our WiFi 7 launch and the stabilization of the size of the retail addressable market, our retail channel partners are more confident that the retail network market will stay at current levels or potentially even increase. They have demonstrated this by no longer depleting their inventory and we will continue to bring new products to market to add to their confidence.
This quarter, we will bring out 2 new versions of our premium Nighthawk mobile hotspots, the M6 Pro. The first one is for the U.S. market with compatibility on the Verizon network. The second one is for the Japanese market with compatibility to all major carriers in Japan. There are more WiFi 7 mesh routers and mobile hotspots to be introduced in each quarter in 2024.
On the SMB side, our Pro AV managed switches continued their year-on-year growth with more commercial AV integrators and manufacturers adopting our easy to configure switches for various applications, video conferencing, control room displays, digital signage, concert tours, sporting events, esports arenas, lecture halls, churches and performance centers.
We recently participated for the first time in the biggest European broadcast equipment trade show, IBC in Amsterdam, showcasing our new M4350 switch with imminent support of the SMPTE 2110 broadcast protocol. We have seen lots of enthusiasm from potential partners, equipment manufacturers and integrators alike. We are excited about this opportunity in 2024.
We also recently introduced our first residential wired router PR60X. It is well received by the high-end residential Pro AV integrators. We believe we will be able to expand further into this market in 2024.
We are making good progress in returning our inventory turns to between 3 and 4. We significantly reduced our inventory and generated meaningful cash in Q3. We are confident that our inventory levels will return to normal by mid-2024. We will have headwinds in the next 3 quarters as inventory costs go up due to the timing of the arrival in prior periods. We will continue to work on better product mix, cost containment and new product introductions to mitigate some of the negative effects. Our team is committed to such efforts.
Turning to our SMB business. We have seen some of our large markets like Greater China, Germany and Japan face macro uncertainty from geopolitical tensions, high interest rates and sluggish economic growth. This is impacting our SMB business in these markets and causing our channel partners to lower their inventory carrying levels, which will limit the top line potential of SMB in the coming quarters.
Despite the inventory compression, we believe there are ample near-term headwinds -- these are simple near-term headwinds and the underlying long-term growth opportunity of the business driven by our Pro AV solutions remained intact.
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 premium portion of our CHP product portfolio, riding on the success of our WiFi 7 launch well into 2024. We are also encouraged that our retail channel partners are now maintaining rather than depleting their inventories.
However, we will continue to work with our SMB channel partners to optimize their inventory carrying levels during the next few quarters. Accordingly, we expect CHP to be approximately flat sequentially, in line with market seasonality, and SMB to be down sequentially, which will result in overall fourth quarter net revenue being in the range of $175 million to $190 million.
As we continue to make meaningful progress in reducing our own inventory levels, we will be consuming older, higher cost inventory. We expect we'll move back to normal inventory levels and normal inventory costs by the middle of next year. Accordingly, we expect fourth quarter GAAP operating margin to be in the range of negative 4.4% to negative 1.4% and non-GAAP operating margin to be in the range of negative 2% to positive 1%.
Our GAAP tax expense is expected to be in the range of $1 million to $2 million. And our non-GAAP tax expense is expected to be in the range of 0 to $1 million for the fourth quarter of 2023. We expect we will continue to generate meaningful cash in Q4 and beyond.
We would now like to answer any questions from the audience.
Question and Answer Session
Operator
(Operator Instructions) Your first question comes from the line of Hamed Khorsand from BWS Financial.
Hamed Khorsand
So first question I had was about this inventory that you're intending to burn off and the timing of margins. How much -- what is the normal gross margin that you're aiming for right now? What kind of impact are you thinking that this will have in the next 2, 3 quarters?
Bryan D. Murray
Yes. So in terms of Q4, we think there's probably about 150 basis points headwind relative to Q3, which is pretty much reflected in the guidance that we provided. It will reach its peak in the Q1 period and then taper off from there going into Q2 and the second half of 2024. And really, it's about -- as we're aggressively working down our inventory levels, you would have seen about a $42 million sequential decrease. We're stopping the inflow, and the operational cost supporting the procurement of that inventory as a percentage weigh a little bit heavier on the overall cost of the inventory. But as I said it's about 150 basis point headwind in Q4, it ticks up a little bit from there into Q1 and then will taper off as we progress.
C. S. Lo
Yes. Our aim is using 35% as the base of our standard. And after burning off these higher cost inventory, we believe that we can continue to improve on that gross margin beyond 35%.
Hamed Khorsand
Okay. And then given your commentary around inventory, I'm assuming that your aim is something around $80 million to $90 million of conversion to cash or -- what is the timing of that inventory converting from accounts receivable to cash because your DSOs still are pretty elevated?
Bryan D. Murray
Yes. DSOs tend to go up in the fourth quarter. I expect that trend to continue. You may recall in the past, and we continue to do this, we support a couple of retailers with extended payment terms leading into the holiday season. So I think DSOs will go up, but that's in line with what our normal experience would be.
In terms of the impact in reducing inventory, I would say that we're probably going to move in a similar direction to what you saw in Q3 in each of Q4 and Q1. I think the heaviest lift will happen in those 2 quarters. And I would expect that the free cash flow implications are slightly ahead of what we delivered in Q3 as a result of those efforts.
C. S. Lo
I believe that by Q3 of next year, we will be back to normal in generating cash equivalent to net earnings or close to net earnings, yes.
Hamed Khorsand
So what I'm trying to get to is your cash balance is going to increase quite a bit, why hasn't the company come out and start buying back stock at $10?
Bryan D. Murray
So we're opportunistic buyers of our stock. We continue to have those conversations. As you saw this Q3 was the first period we returned to positive free cash flow, that's obviously a consideration point. But repurchasing stock is still a conversation we continue to have.
Hamed Khorsand
What's a better opportunity than $10? I mean how much further down are you expecting your stock to go?
C. S. Lo
Well, I mean we definitely are looking at all these. I mean we believe that, yes, we will always be the opportunistic buyer in the market, especially now we are confident in generating cash.
Operator
Your next question comes from the line of Jake Norrison from Raymond James.
Jake Norrison
Firstly, can you guys touch on your early indications from holiday season? How is this similar or different from years past? And have there been any changes to your sort of promotional philosophy for this holiday season?
C. S. Lo
As a matter of fact, I think a good indication from the Prime Day 2 that Amazon put together, it seems like the holiday season in networking is pretty much like the rest of the retail market, is galvanizing into the high-end as well as the lower end. So that's why we're seeing really positive reception to our high-end products, such as the WiFi 7 products or even the existing Orbi 8 and Orbi 9 and the high-end routers such as what we mentioned, the RS700, the new one and the RAXE500 all on high end. But also there's quite a bit of demand on the lower cost WiFi products such as the adapters, such as the extenders, which are really cheap quick fix to better WiFi at home. We're also seeing the popularity of our lowest-cost cable gateway for $1.99 because a lot of customers will realize that by paying $15 a month of rent WiFi from cable operators, it's much cheaper to buy a cable gateway at $200, and after 12 months, it's all [gravy].
So I think the holiday season will be the same in those 2 areas. Now certainly, we're not promoting the Orbi 9, right? That's a premium product, but yes, we will strategically promote some of these lower end, higher demand customer products where we have a unique position, we have less competition so that we could generate more margin dollars.
Jake Norrison
And then last one for me. Can you just speak to the performance of the cybersecurity Armor service and then funnel of activations this quarter?
C. S. Lo
The Armor cybersecurity service still our #1 service by our subscribers. And overall, we're seeing very strong uptake and strong renewal rate among these customers. So as we say, our intention is to expand the feature set so that we have opportunity to further expand the subscriber base and also potentially increase the ARPU. That's the strategy going forward. And we did a lot of user surveys through our app that customers' #1 request is to have privacy features such as shooting away cookies, hiding your identity, things like that. We would definitely add that in 2024.
Jake Norrison
Are you guys internally thinking about ever providing more disclosures around the service?
C. S. Lo
Such as?
Jake Norrison
A quarterly ARPU number, churn, retention metrics every quarter, things like that.
C. S. Lo
Okay. All right. Yes. Certainly, we'll look into that. I think we have said quite -- during the Analyst Day that our ARPU is pretty consistent around $50. Hasn't changed since 2 years ago. So we expect that during this phase of user acquisition, our ARPU would stay the same. And from a churn rate perspective, as we said, for those customers who have renewed after the first year, the churn rate is actually lower than industry average.
Our churn rate for those who have renewed for the first year, getting to second year then from here on out, the churn rate is less than 15%. I think we talked about that last time on the Analyst Day.
Operator
We have no further questions in the queue at this time. Patrick, I'll turn the conference over to you for closing remarks.
C. S. Lo
Thank you for joining us today. I'm very pleased by our execution this quarter where our results have demonstrated our high-end premium products and services are resilient and holding up against the broader retail market and inventory compression headwind. It's clear, our commitment to innovation and investments in building a market-leading portfolio of products are paying off. While we are still facing SMB channel inventory compression and a high interest rate environment in the short term, the top and bottom line expansion potential of our premium CHP products, Armor security service and Pro AV switches is clear.
NETGEAR is well positioned ahead of the imminent WiFi 7 upgrade cycle with 2 WiFi 7 products already shipping and many more to come, giving us confidence in our ability to deliver even greater revenue and margin expansion and improved predictability in our business as we close out 2023 and enter 2024.
I look forward to sharing an update on our progress at our Analyst Day on December 7. We look forward to seeing you all. Thank you.
Operator
This concludes today's conference call. Thank you for your participation, and you may now disconnect.
