NETGEAR, Inc. — Q2 2019 Form 10-Q
Reporting period: Three and six months ended June 30, 2019; comparisons are to the periods ended July 1, 2018. NETGEAR sells networking and connected products through Connected Home and Small and Medium Business (SMB) segments. Arlo was spun off on December 31, 2018, and its prior-period results are reported as discontinued operations, affecting year-over-year comparisons.
Financial performance and liquidity
| Metric | Q2 2019 | Q2 2018 | First half 2019 | First half 2018 |
|---|---|---|---|---|
| Revenue | $230.9 million | $255.3 million | $479.9 million | $500.5 million |
| Gross profit / margin | $65.4 million / 28.3% | $80.3 million / 31.4% | $147.5 million / 30.7% | $156.6 million / 31.3% |
| Operating income (loss) | $0.3 million | $(0.1) million | $14.3 million | $1.4 million |
| Net income from continuing operations | $0.8 million | $0.5 million | $13.7 million | $1.6 million |
| Net income (loss), including discontinued operations | $0.8 million | $(5.2) million | $13.7 million | $0.4 million |
| Diluted EPS | $0.03 | $(0.16) | $0.42 | $0.01 |
Cash flow: First-half operating cash flow was $(9.9) million, versus $20.9 million provided in the prior-year period. Investing activities provided $55.9 million, largely reflecting maturities of short-term investments; financing activities used $32.4 million, primarily for share repurchases. Cash and cash equivalents were $214.6 million at June 30, 2019, with short-term investments of $3.7 million, for combined cash and short-term investments of $218.3 million.
Balance sheet: Current assets were $771.9 million and current liabilities $315.0 million; total assets were $992.5 million and total liabilities $370.4 million. No conventional borrowings are listed on the balance sheet. Operating lease liabilities totaled $39.5 million. Inventory was $276.3 million, up from $243.9 million at year-end; accounts receivable fell to $238.6 million from $303.7 million.
Material changes and management commentary
- Q2 revenue declined 9.6% year over year. Management attributed the decrease mainly to $19.2 million lower service-provider sales, particularly mobile products in the Americas. Connected Home revenue fell 10.2%; SMB revenue fell 8.0%.
- Q2 gross margin decreased to 28.3% from 31.4%, primarily due to higher sales-return provisions and channel promotions, plus foreign-exchange headwinds; lower warranty provisions partly offset the decline.
- Operating expenses fell $15.2 million in Q2, mainly from lower personnel, IT and facilities costs following headcount reductions and the Arlo separation. This offset much of the gross-profit decline.
- For the first half, Connected Home revenue decreased 6.6% to $336.9 million; SMB revenue increased 2.4% to $143.1 million. SMB contribution income increased, while Connected Home contribution income declined.
- First-half operating cash outflow reflected working-capital needs, including inventory purchases to support moving supply outside China in response to Section 301 tariffs. Inventory turns were 2.4, down from 3.3 in Q4 2018.
Outlook, risks and unusual items
- Management expected gross margin for the remainder of 2019 to be in line with or slightly above first-half levels. It expected R&D expense to increase in absolute dollars, sales and marketing expense as a percentage of revenue to decrease, and G&A as a percentage of revenue to remain in line with the first half.
- Management cited growth opportunities in Connected Home through WiFi 6 (802.11ax), 5G and subscription services, and in SMB through 10Gig, PoE, managed and ProAV switches. It expected service-provider revenue of approximately $35 million per quarter for the remainder of 2019; Q1 and Q2 were $38.3 million and $27.8 million, respectively.
- Liquidity: management believed existing cash, investments and operating cash generation would meet anticipated needs for at least 12 months. Approximately 42% of cash and short-term investments were held outside the U.S.; repatriation may incur state and foreign withholding taxes.
- Commitments included $119.3 million of non-cancelable supplier purchase commitments and $17.4 million of long-term non-trade commitments. The company also disclosed $14.2 million of gross unrecognized tax benefits and related interest and penalties.
- Key risks include tariffs and supply-chain relocation, component availability and inventory exposure, dependence on a limited number of customers and manufacturers, competitive pricing and margin pressure, cybersecurity and product security, foreign exchange, and numerous patent, consumer and securities lawsuits. Management said it could not reasonably estimate potential financial impacts for the described litigation matters and did not believe any existing claim was likely to materially affect financial position within 12 months.
- Unusual items: the first-half effective tax rate included a one-time benefit from closing a French tax audit. NETGEAR repurchased approximately $32.0 million of shares in the first half; on July 19, 2019, the board authorized an additional 4.5 million shares for repurchase.
Important facts for investors to verify
- Whether service-provider demand and the approximately $35 million quarterly revenue expectation for the rest of 2019 were achieved.
- Whether gross margin stabilized after Q2’s decline and how tariffs, product mix, promotions and foreign exchange affected subsequent results.
- Whether inventory growth and lower inventory turns translated into excess or obsolete inventory, and whether operating cash flow recovered.
- Progress and costs associated with shifting manufacturing outside China, including any effect on supply, quality and product costs.
- Developments in the disclosed litigation and tax matters, including potential exposure that the filing says cannot currently be estimated.
- The effect of the enlarged share-repurchase authorization on cash, liquidity and share count.