NETGEAR, Inc. — Q3 2018 Form 10-Q
Reporting period: Fiscal quarter ended September 30, 2018; comparisons are with the quarter ended October 1, 2017. Financial amounts below are in U.S. dollars. Results are unaudited.
Business context
NETGEAR sells networking and connected-home products and services through three segments: Arlo, Connected Home, and Small and Medium Business (SMB). Arlo completed its IPO on August 7, 2018. NETGEAR retained approximately 84.2% ownership and intended to distribute its Arlo shares to NETGEAR stockholders before the end of Q1 2019, subject to approvals and market, tax, and legal considerations.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Net revenue | $400.6m | $355.5m | $1,112.4m | $1,009.9m |
| Gross profit / margin | $124.2m / 31.0% | $103.1m / 29.0% | $337.9m / 30.4% | $292.0m / 28.9% |
| Operating income / margin | $9.6m / 2.4% | $25.4m / 7.1% | $15.1m / 1.4% | $67.3m / 6.7% |
| Net income attributable to NETGEAR | $9.9m | $20.8m | $10.3m | $51.4m |
| Diluted EPS | $0.30 | $0.64 | $0.31 | $1.54 |
| Operating cash flow | Not stated for quarter | Not stated for quarter | $73.9m | $101.4m |
Q3 revenue rose 12.7%, with growth in all segments, while operating income fell $15.8m. Higher research and development, sales and marketing, general and administrative, and Arlo separation costs more than offset revenue growth and improved gross margin. Q3 net income attributable to NETGEAR also reflects a $0.8m loss attributable to Arlo’s outside shareholders.
- Arlo: Q3 revenue $131.2m, up 18.8%; contribution margin fell to 6.5% from 13.8%, mainly reflecting increased investment, including research and development.
- Connected Home: Q3 revenue $194.7m, up 6.3%; contribution margin improved to 16.1% from 13.4%.
- SMB: Q3 revenue $74.7m, up 20.7%; contribution margin improved to 28.4% from 20.3%.
Revenue growth was strongest in the Americas; EMEA also grew, while APAC declined. SMB growth was driven principally by switches. Connected Home gains in home wireless and broadband modem/gateway products were partly offset by lower mobile and service-provider sales.
Financial position and liquidity
- At September 30, 2018, cash and cash equivalents were $393.6m and short-term investments were $136.2m, totaling $529.8m. Arlo held $187.8m of cash, cash equivalents, and short-term investments.
- Total assets were $1,533.3m; total liabilities were $598.8m; total stockholders’ equity was $934.5m. The balance sheet presents no borrowings or debt balance.
- Nine-month cash flows: operating activities provided $73.9m; investing activities used $41.5m; financing activities provided $158.4m. The financing inflow included $170.2m of net Arlo IPO proceeds.
- Inventory rose to $330.5m from $245.9m at year-end, with management citing tariff mitigation and supply continuity. Inventory turns were 3.3 in Q3, down from 4.8 in Q4 2017. Non-cancelable supplier purchase commitments were $169.1m.
- Management believed existing liquidity and operating cash generation would cover anticipated cash needs for at least 12 months.
Outlook, unusual items, and risks
- Management expected strong Arlo growth, mid-single-digit Connected Home growth, and SMB growth. It cited Arlo cameras and services, WiFi systems, modems and gateways, Meural canvases, and SMB switches as growth drivers.
- Service-provider revenue was forecast at $40m–$50m in Q4 2018. Following the anticipated Arlo separation, Connected Home and SMB service-provider revenue was expected to be approximately $35m–$40m per quarter in 2019.
- Management expected Q4 gross margin percentage to decline due to holiday channel and promotional spending. It also estimated Q4 Arlo separation expense of approximately $7.5m and separation-related dis-synergies of approximately $21.0m; these estimates were subject to assumptions and uncertainty. Q3 dis-synergies were $15.5m.
- Arlo separation expense was $7.1m in Q3 and $25.8m for the first nine months; total expense since the separation effort began was $27.3m. The filing also cites $22.4m of separation-related dis-synergies for the first nine months.
- The U.S. had imposed a 10% tariff on certain China-origin imports from September 24, 2018, scheduled to rise to 25% on January 1, 2019. NETGEAR said some products were affected and mitigation efforts, including shifting production, might disrupt operations or prove costly.
- Other key risks include dependence on a limited number of retailers, distributors, service providers, and third-party manufacturers; component shortages; inventory and demand forecasting; foreign-exchange exposure; cybersecurity and privacy; competition and pricing pressure; and execution costs and uncertainty around the Arlo separation. The filing describes multiple patent, tax, and consumer cases; management said it could not reasonably estimate the potential financial impact of several matters. It expected the Be Labs settlement amount to be immaterial.
- NETGEAR adopted ASC 606 in 2018 using the modified retrospective method; prior-year results were not restated. The company reported that the adoption did not significantly affect the nature or timing of revenue, but it changed reserve and revenue presentation and affected reported 2018 amounts.
Most important facts for investors to verify
- Whether the planned Arlo distribution was completed on the expected timetable and on tax-efficient terms, and how it affected NETGEAR’s ownership, costs, and reported results.
- Whether Q4 and subsequent gross margins, separation costs, and dis-synergies tracked management’s estimates.
- Whether elevated inventory, lower inventory turns, tariffs, and supplier commitments resulted in excess inventory, higher costs, or supply disruption.
- Whether segment growth and contribution margins—particularly Arlo’s—improved as planned, and whether service-provider revenue matched the stated outlook.
- Developments in material litigation and tax examinations, as well as the potential impact of the announced and prospective privacy and trade requirements.