NETGEAR, Inc. — Q2 2018 Form 10-Q
Reporting period: Fiscal quarter ended July 1, 2018; comparative quarter ended July 2, 2017. Dollar amounts below are in millions unless otherwise indicated. Financial statements are unaudited.
Business context and reporting period
NETGEAR sells networking and connected-home products and services through three segments: Arlo, Connected Home, and Small and Medium Business (SMB). It announced a planned separation of Arlo in February 2018. The quarter’s results include substantial Arlo separation costs and emerging separation-related operating dis-synergies.
Financial performance and liquidity
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Revenue | $366.8 | $330.7 | $711.8 | $654.4 |
| Gross profit / margin | $109.2 / 29.8% | $91.9 / 27.8% | $213.7 / 30.0% | $188.9 / 28.9% |
| Operating income (loss) | $(3.0) | $19.1 | $5.5 | $41.9 |
| Net income (loss) | $(5.2) | $14.6 | $0.4 | $30.6 |
| Diluted EPS | $(0.17) | $0.44 | $0.01 | $0.91 |
- Q2 revenue grew 10.9% year over year; six-month revenue grew 8.8%. Q2 operating expenses rose $39.3 million to $112.2 million, including $12.0 million of separation expense. Gross margin improved, which partly offset the expense increase.
- Q2 segment revenue: Arlo $104.8 million, up 33.1%; Connected Home $191.2 million, up 2.8%; SMB $70.8 million, up 7.2%. Segment contribution income was near break-even for Arlo, $30.3 million for Connected Home, and $18.3 million for SMB.
- For the six months, operating cash flow was $40.1 million, versus $3.4 million in the prior-year period; capital expenditures were $13.4 million. Cash and cash equivalents were $227.4 million and short-term investments $128.2 million at July 1, totaling $355.6 million. Management said available funds and expected operating cash flow should cover anticipated needs for at least 12 months.
- Total assets were $1,256.6 million and total liabilities $500.9 million at July 1. The balance sheet presents no borrowings or debt balance. Inventory was $291.5 million, up from $245.9 million at year-end 2017.
Material changes and comparability
- Arlo revenue growth was strong, while Connected Home revenue was down 3.0% for the first six months; SMB revenue rose 5.3%. APAC revenue declined 21.1% in Q2, while Americas and EMEA grew.
- Operating results weakened despite higher revenue and gross margin, primarily because of higher research and development, sales and marketing, general and administrative, and separation expenses. Q2 included $5.1 million of separation-related dis-synergies.
- NETGEAR adopted ASC 606 on January 1, 2018 using the modified retrospective method; prior periods were not restated. The company said adoption did not significantly affect the nature or timing of revenue, but altered reserve and balance-sheet presentation. Reported Q2 revenue was $1.4 million lower and net loss $0.8 million greater than under the former standard; six-month revenue was $3.7 million lower and net income $2.5 million lower.
- The six-month effective tax rate was 94.9%, reflecting low pretax income and estimated nondeductibility of some Arlo separation costs, partly offset by the lower U.S. statutory tax rate.
Outlook, risks, contingencies, and unusual items
- Management expected strong Arlo growth, SMB growth in selected networking and storage products, and low-single-digit Connected Home growth year over year. It expected service-provider revenue of approximately $50 million per quarter and fiscal 2018 gross margin to be in line with or slightly above the prior year.
- For the three months ending September 30, 2018, management estimated approximately $11 million of additional separation costs and $19 million of separation-related dis-synergies, subject to assumptions and uncertainty. It expected further separation costs during 2018.
- Arlo’s IPO was priced at $16 per share in August 2018, after the reporting date. The offering was expected to provide Arlo net proceeds of approximately $144.6 million, or $167.4 million if the underwriters’ option were fully exercised. NETGEAR expected to retain about 86.0% of Arlo after closing and intended, subject to approvals and other conditions, to distribute its remaining Arlo shares to NETGEAR stockholders after the 145-day lock-up period. The separation could be changed or abandoned and carries market, tax, legal, execution, and cost risks.
- Other notable exposures include $164.2 million of non-cancelable supplier purchase commitments and $76.7 million of operating lease commitments. Management identified inventory forecasting, component supply, intense competition and pricing, customer concentration, foreign exchange, tariffs and trade policy, cybersecurity, and the planned Arlo separation as important risks.
- The filing describes multiple patent and other legal matters; several were stayed, dismissed, or subject to appeal. Management stated it did not believe existing claims were likely to materially adversely affect financial position within 12 months, while noting outcomes and potential costs remain uncertain. Italian tax litigation for 2004–2012 remained unresolved and its financial impact was not reasonably estimable.
- Disclosure controls were concluded effective at quarter-end. The filing reports no off-balance-sheet arrangements.
Important facts for investors to verify
- Whether Arlo’s IPO closed on the stated terms and whether the planned distribution was completed, and the resulting ownership, tax treatment, and separation costs.
- Whether Arlo’s rapid revenue growth can translate into sustained contribution profitability as research and marketing investment rises.
- Whether the increase in inventory and the decline in inventory turns signal demand, supply, or obsolescence risk; review subsequent inventory and cash-flow trends.
- How operating expenses and separation dis-synergies compare with management’s estimates, and whether gross-margin improvement is maintained.
- Developments in significant litigation and tax matters, supplier commitments, customer concentration, cybersecurity, and international trade or tariff exposure.