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NETGEAR, INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Forward-looking Statements This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements are based upon current expectations that involve risks and uncertainties. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. For example, the words "believes," "anticipates," "plans," "expects," "intends," "could," "may," "will," and similar expressions are intended to identify forward-looking statements. Our actual results and the timing of certain events may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a discrepancy include, but are not limited to, those discussed in "Part II-Item 1A-Risk Factors" and "Liquidity and Capital Resources" below. All forward-looking statements in this document are based on information available to us as of the date hereof and we assume no obligation to update any such forward-looking statements. The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and the accompanying notes contained in this quarterly report. Unless expressly stated or the context otherwise requires, the terms "we," "our," "us" and "NETGEAR" refer to NETGEAR, Inc. and our subsidiaries. Business and Executive Overview We are a global networking company that delivers innovative products to consumers, businesses and service providers. Our products are built on a variety of proven technologies such as wireless, Ethernet and powerline, with a focus on reliability and ease-of-use. Our product line consists of wired and wireless devices that enable networking, broadband access and network connectivity. These products are available in multiple configurations to address the needs of our end-users in each geographic region in which our products are sold. We operate in three specific business segments: retail, commercial, and service provider. Each business unit is managed by a Senior Vice President/General Manager. We believe this structure enables us to better focus our efforts on our core customer segments and allows us to be more nimble and opportunistic as a company overall. In March 2014, the CEO began temporarily serving as interim General Manager of the retail business unit due to the previous general manager's departure from the Company. 34-------------------------------------------------------------------------------- Table of Contents The CEO will continue to serve as interim general manager until a replacement is established. The retail business unit is focused on individual consumers and consists of high performance, dependable and easy-to-use home networking, home video monitoring, storage and digital media products. The commercial business unit is focused on small and medium size businesses and consists of business networking, storage and security solutions that bring enterprise class functionality at an affordable price. The service provider business unit is focused on the service provider market and consists of made-to-order and retail proven, whole home networking hardware and software solutions, as well as 4G LTE hotspots sold to service providers for sale to their subscribers. We conduct business across three geographic regions: Americas, Europe, Middle-East and Africa ("EMEA") and Asia Pacific ("APAC"). Our service provider business has grown substantially over the years, particularly as a result of acquisitions, and it is difficult to ascertain a seasonal pattern given that the business is less predictable than our other core businesses. The commercial business, consumer, and broadband service provider markets are intensely competitive and subject to rapid technological change. We believe that the principal competitive factors in the retail, commercial, and service provider markets for networking products include product breadth, size and scope of the sales channel, brand name, timeliness of new product introductions, product availability, performance, features, functionality and reliability, ease-of-installation, maintenance and use, and customer service and support. To remain competitive, we believe we must continue to aggressively invest resources in developing new products and enhancing our current products while continuing to expand our channels and maintaining customer satisfaction worldwide. We sell our networking products through multiple sales channels worldwide, including traditional retailers, online retailers, wholesale distributors, direct market resellers ("DMRs"), value-added resellers ("VARs"), and broadband service providers. Our retail channel includes traditional retail locations domestically and internationally, such as Best Buy, Costco, Fry's Electronics, K-mart, Radio Shack, Sears, Staples, Target, Wal-Mart, Argos (U.K.), Dixons (U.K.), PC World (U.K.), MediaMarkt (Germany, Austria), Dick Smith (Australia), JB HiFi (Australia) and Elkjop (Norway). Online retailers include Amazon.com, Dell, Newegg.com and Buy.com. Our DMRs include CDW Corporation, Insight Corporation and PC Connection in domestic markets and Misco throughout Europe. In addition, we also sell our products through broadband service providers, such as multiple system operators ("MSOs"), DSL, and other broadband technology operators domestically and internationally. Some of these retailers and broadband service providers purchase directly from us, while others are fulfilled through wholesale distributors around the world. A substantial portion of our net revenue to date has been derived from a limited number of wholesale distributors and retailers, including Ingram Micro and Best Buy. We expect that these wholesale distributors and retailers will continue to contribute a significant percentage of our net revenue for the foreseeable future. During the second quarter of 2014, we experienced a 5.6% decrease in net revenue compared to the second quarter of 2013 due to continued difficulty in Europe. On a geographic basis, net revenue increased in the APAC region, primarily driven by sales of our mobile and broadband products. Net revenue decreased in the Americas region, primarily attributable to the decrease in sales of our network storage, home security monitoring and automation, and multimedia products. Net revenue decreased in the EMEA region, primarily attributable to the decrease in sales of our broadband gateways and mobile products. On a segment basis, service provider net revenue was relatively flat with the increased sales of our mobile products offset by the decrease in sales of our home security monitoring and automation products and broadband gateways. Net revenue decreased in the retail business unit, primarily attributable to the decrease in sales of our multimedia products and broadband gateways. Net revenue in the commercial business unit decreased, primarily attributable to the decrease in sales of our network storage products and switches. Looking forward, we expect to see continued success in our commercial business unit driven by sales of our 10Gig switches, PoE switches, storage and wireless products among small and medium size businesses, end users and resellers. We expect to see future revenue growth in the service provider business unit driven by the LTE gateway and home monitoring and automation devices. In addition, we believe the moves to 11ac routers, WiFi extenders and cable modem routers in the US and DSL modem routers in international markets, as well as moves to high end products in home networking, will help us expand the market size in our retail business unit. 35-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth the unaudited condensed consolidated statements of operations and the percentage change for the three and six months ended June 29, 2014, with the comparable reporting periods in the preceding year. Three Months Ended Six Months Ended June 29, June 30, June 29, June 30, 2014 % Change 2013 2014 % Change 2013 (In thousands, except percentage data) Net revenue $ 337,604 (5.6 )% $ 357,719 $ 686,995 5.5 % $ 651,118 Cost of revenue 240,418 (5.5 )% 254,289 491,884 6.9 % 459,951 Gross profit 97,186 (6.0 )% 103,430 195,111 2.1 % 191,167 Operating expenses: Research and development 22,476 (6.3 )% 23,981 44,657 13.6 % 39,319 Sales and marketing 38,179 (5.5 )% 40,406 78,090 1.7 % 76,795 General and administrative 11,894 (3.4 )% 12,319 23,269 (5.6 )% 24,646 Restructuring and other charges (12 ) ** 1,587 830 (46.7 )% 1,557 Litigation reserves, net 68 (98.1 )% 3,555 185 (94.9 )% 3,603 Total operating expenses 72,605 (11.3 )% 81,848 147,031 0.8 % 145,920 Income from operations 24,581 13.9 % 21,582 48,080 6.3 % 45,247 Interest income 49 (48.4 )% 95 106 (56.6 )% 244 Other expense, net (227 ) 58.6 % (548 ) (335 ) 29.3 % (474 ) Income before income taxes 24,403 15.5 % 21,129 47,851 6.3 % 45,017 Provision for income taxes 9,698 35.8 % 7,144 18,735 19.4 % 15,689 Net income $ 14,705 5.1 % $ 13,985 $ 29,116 (0.7 )% $ 29,328 ** Percentage change not meaningful. The following table sets forth the unaudited condensed consolidated statements of operations, expressed as a percentage of net revenue, for the periods indicated: Three Months Ended Six Months Ended June 29, June 30, June 29, June 30, 2014 2013 2014 2013 Net revenue 100 % 100 % 100 % 100 % Cost of revenue 71.2 % 71.1 % 71.6 % 70.6 % Gross margin 28.8 % 28.9 % 28.4 % 29.4 % Operating expenses: Research and development 6.7 % 6.7 % 6.5 % 6.0 % Sales and marketing 11.3 % 11.4 % 11.4 % 11.9 % General and administrative 3.5 % 3.4 % 3.4 % 3.8 % Restructuring and other charges (0.0 )% 0.4 % 0.1 % 0.2 % Litigation reserves, net 0.0 % 1.0 % 0.0 % 0.6 % Total operating expenses 21.5 % 22.9 % 21.4 % 22.5 % Income from operations 7.3 % 6.0 % 7.0 % 6.9 % Interest income 0.0 % 0.1 % 0.0 % 0.1 % Other expense, net (0.1 )% (0.2 )% (0.0 )% (0.1 )% Income before income taxes 7.2 % 5.9 % 7.0 % 6.9 % Provision for income taxes 2.8 % 2.0 % 2.8 % 2.4 % Net income 4.4 % 3.9 % 4.2 % 4.5 % 36-------------------------------------------------------------------------------- Table of Contents Three Months Ended June 29, 2014 Compared to Three Months Ended June 30, 2013 Net Revenue Our net revenue consists of gross product shipments, less allowances for estimated returns for stock rotation and warranty, price protection, end-user customer rebates and other sales incentives deemed to be a reduction of net revenue per the authoritative guidance for revenue recognition, and net changes in deferred revenue. Net revenue decreased $20.1 million, or 5.6%, to $337.6 million for the three months ended June 29, 2014, from $357.7 million for the three months ended June 30, 2013, primarily attributable to the decrease in the sales of our network storage, home security monitoring and automation and broadband gateways products. On a geographic basis, we experienced an increase in revenue in the APAC region, and a decrease in revenues in the Americas and EMEA regions. On an operating segment basis, we experienced a decrease in revenues in the retail and commercial business units, while the service provider business unit was relatively flat. For discussion of net revenue by geographic region see the section entitled "Net Revenue by Geographic Region." For discussion of net revenue by segment see the section entitled "Segment Information." Net Revenue by Geographic Region Three Months Ended June 29, June 30, 2014 % Change 2013 (In thousands, except percentage data) Americas $ 187,534 (6.6 )% $ 200,848 Percentage of net revenue 55.6 % 56.1 % EMEA $ 100,436 (7.3 )% $ 108,367 Percentage of net revenue 29.7 % 30.3 % APAC $ 49,634 2.3 % $ 48,504 Percentage of net revenue 14.7 % 13.6 % Total net revenue $ 337,604 (5.6 )% $ 357,719 The decrease in Americas net revenue was primarily attributable to the decrease in the sales of our network storage, home security monitoring and automation and multimedia products. The decrease in EMEA was primarily attributable to the decrease in the sales of our broadband gateways and mobile products. The increase in APAC net revenue was primarily driven by sales of our mobile products and broadband gateways. Americas continues to represent the largest percentage of our net revenue, and APAC increased as a percentage of revenue. EMEA net revenue as a percentage of our revenue was relatively flat. 37-------------------------------------------------------------------------------- Table of Contents Cost of Revenue and Gross Margin Cost of revenue consists primarily of the following: the cost of finished products from our third party contract manufacturers; overhead costs, including purchasing, product planning, inventory control, warehousing and distribution logistics; third-party software licensing fees; inbound freight; warranty costs associated with returned goods; write-downs for excess and obsolete inventory, amortization expense of certain acquired intangibles and acquisition accounting adjustments to inventory. We outsource our manufacturing, warehousing and distribution logistics. We believe this outsourcing strategy allows us to better manage our product costs and gross margin. Our gross margin can be affected by a number of factors, including fluctuation in foreign exchange rates, sales returns, changes in average selling prices, end-user customer rebates and other sales incentives, changes in our cost of goods sold due to fluctuations in prices paid for components, net of vendor rebates, warranty and overhead costs, inbound freight, conversion costs, charges for excess or obsolete inventory and amortization of acquired intangible assets. The following table presents costs of revenue and gross margin, for the periods indicated: Three Months Ended June 29, June 30, 2014 % Change 2013 (In thousands, except percentage data) Cost of revenue $ 240,418 (5.5 )% $ 254,289 Gross margin percentage 28.8 % 28.9 % Cost of revenue decreased $13.9 million, or 5.5%, to $240.4 million for the three months ended June 29, 2014, from $254.3 million for the three months ended June 30, 2013. The decrease was primarily attributable to the decrease in net revenue. Our gross margin was 28.8% for the three months ended June 29, 2014, which was consistent with 28.9% for the three months ended June 30, 2013. The impact on gross margin resulting from the relatively faster growth in revenue from service providers, which generally carries lower gross margins than our other products, was offset by $1.6 million decrease in warranty costs. Sales to service providers increased as a percentage of net revenue to 44.9% in the three months ended June 29, 2014, compared to 42.5% in the three months ended June 30, 2013. Operating Expenses Research and Development Research and development expenses consist primarily of personnel expenses, payments to suppliers for design services, safety and regulatory testing, product certification expenditures to qualify our products for sale into specific markets, prototypes and other consulting fees. Research and development expenses are recognized as they are incurred. We have invested in building our research and development organization to enhance our ability to introduce innovative and easy-to-use products. In the future, we expect research and development expenses will remain relatively consistent with the prior year as a percentage of revenue. The following table presents research and development expense, for the periods indicated: Three Months Ended June 29, June 30, 2014 % Change 2013 (In thousands, except percentage data) Research and development expense $ 22,476 (6.3 )% $ 23,981 Percentage of net revenue 6.7 % 6.7 % Research and development expenses decreased $1.5 million, or 6.3%, to $22.5 million for the three months ended June 29, 2014, from $24.0 million for the three months ended June 30, 2013. Research and development as a percentage of net revenue was 6.7% for the three months ended June 29, 2014, consistent with the three months ended June 30, 2013. The decrease in research and development expenses was primarily due to a $1.2 million decrease in personnel and facility-related expenses driven by the decrease in headcount. The headcount decreased by 58 employees to 350 employees at June 29, 2014 compared to 408 employees at June 30, 2013, due primarily to our restructuring efforts implemented in the fourth quarter of 2013. 38-------------------------------------------------------------------------------- Table of Contents Sales and Marketing Sales and marketing expenses consist primarily of advertising, trade shows, corporate communications and other marketing expenses, product marketing expenses, outbound freight costs, amortization expenses, personnel expenses for sales and marketing staff and technical support expenses. The following table presents sales and marketing expense, for the periods indicated: Three Months Ended June 29, June 30, 2014 % Change 2013 (In thousands, except percentage data) Sales and marketing expense $ 38,179 (5.5 )% $ 40,406 Percentage of net revenue 11.3 % 11.4 % Sales and marketing expense decreased $2.2 million, or 5.5%, to $38.2 million for the three months ended June 29, 2014, from $40.4 million for the three months ended June 30, 2013. The decrease was due to decreases of $0.8 million in amortization of intangible assets, largely related to intangible assets acquired from AirCard as part of the assets were fully amortized in 2013, $0.8 million in freight costs and $0.6 million in projects and outside professional services. Sales and marketing expense as a percentage of net revenue was 11.3% for the three months ended June 29, 2014, which was consistent with 11.4% for the three months ended June 30, 2013. Sales and marketing headcount decreased by 24 employees to 377 employees at June 29, 2014 compared to 401 employees at June 30, 2013. General and Administrative General and administrative expenses consist of salaries and related expenses for executives, finance and accounting, human resources, information technology, professional fees, allowance for doubtful accounts and other general corporate expenses. The following table presents general and administrative expense, for the periods indicated: Three Months Ended June 29, June 30, 2014 % Change 2013 (In thousands, except percentage data) General and administrative expense $ 11,894 (3.4 )% $ 12,319 Percentage of net revenue 3.5 % 3.4 % General and administrative expenses decreased $0.4 million, or 3.4%, to $11.9 million for the three months ended June 29, 2014, from $12.3 million for the three months ended June 30, 2013. The decrease was primarily due to a decrease of $1.6 million in outside services, mainly related to acquisition and litigation related expenses, partially offset by a $1.3 million increase in personnel-related expenses driven by additional headcount, and an increase of $0.3 million in variable compensation. General and administrative expense as a percentage of net revenue was 3.5% for the three months ended June 29, 2014, which was consistent with 3.4% for the three months ended June 30, 2013. General and administrative headcount increased by 15 employees to 154 employees at June 29, 2014 compared to 139 employees at June 30, 2013. Restructuring and Other Charges We incurred a credit of $12,000 in restructuring and other charges during the three months ended June 29, 2014, resulting from the adjustments made to restructuring cost estimates, as compared to an expense of $1.6 million in the three months ended June 30, 2013. The charges incurred in the three months ended June 30, 2013 were due to $1.4 million in transition costs related to the AirCard acquisition and $0.2 million in restructuring charges related to an office lease exit liability related to the AVAAK acquisition. For further discussion of restructuring and other charges, refer to Note 15, Restructuring and Other Charges, of the notes to unaudited condensed consolidated financial statements. Litigation Reserves, net We recorded a litigation reserve charge of $68,000 during the three months ended June 29, 2014 for estimated costs related to the settlement of lawsuits, as compared to reserve charges of $3.6 million in the three months ended June 30, 2013 for estimated costs related to the Ericsson judgment. For a detailed discussion of our litigation matters, refer to Note 9, Commitments and 39-------------------------------------------------------------------------------- Table of Contents Contingencies, in the notes to unaudited condensed consolidated financial statements in Item 1 of Part I of this Quarterly Report on Form 10-Q. Interest Income and Other Expense, Net Interest income represents amounts earned on our cash, cash equivalents and short-term investments. Other expense, net, primarily represents gains and losses on transactions denominated in foreign currencies and other miscellaneous income and expenses. The following table presents interest income and other expense, net, for the periods indicated: Three Months Ended June 29, June 30, 2014 % Change 2013 (In thousands, except percentage data) Interest income $ 49 (48.4 )% $ 95 Other expense, net (227 ) 58.6 % (548 )Total interest income and other expense, net $ (178 ) (60.7 )% $ (453 ) Interest income decreased $46,000 to $49,000 for the three months ended June 29, 2014 from $95,000 for the three months ended June 30, 2013. The decrease in interest income was primarily attributable to the decrease in our cash, cash equivalents and short term investment balance mainly due to the repurchase of common stocks in the fourth quarter of 2013 and the first and second quarter of 2014. Other expense, net, decreased $0.3 million, to $0.2 million for the three months ended June 29, 2014, as compared to $0.5 million for the three months ended June 30, 2013. Our foreign currency hedging program effectively reduced volatility associated with hedged currency exchange rate movements during the three months ended June 29, 2014. For details of our hedging program and related foreign currency contracts, refer to Note 6, Derivative Financial Instruments, in the notes to unaudited condensed consolidated financial statements in Item 1 of Part I of this Quarterly Report on Form 10-Q. Provision for Income Taxes The income tax provision for the three months ended June 29, 2014 was $9.7 million or an effective tax rate of 39.7%, compared to the tax provision for the three months ended June 30, 2013 of $7.1 million or an effective tax rate of 33.8%. The increase in the effective tax rate for the three months ended June 29, 2014, compared to the same period in the prior year was primarily caused by changes in US tax law related to the research tax credit. On December 31, 2011 provisions allowing for the research tax credit expired. On January 2, 2013 the American Taxpayer Relief Act of 2012 reinstated the research credit, retroactive to January 1, 2012 through December 31, 2013. Accordingly, we recorded credits related to 2013 in its tax provision for the three months ended June 30, 2013. As of June 29, 2014, the research credit has not been reinstated. Accordingly, no tax benefit has been recorded during the three months ended June 29, 2014. Additionally, during the three months ended June 29, 2014 and June 30, 2013, we have incurred losses in a jurisdiction where no tax benefit could be recorded. Because tax benefit could not be recorded, the forecasted earnings from this jurisdiction were excluded from the determination of the effective tax rate which results in an increase in the tax rate from foreign earnings. The loss in the three months ended June 29, 2014 is relatively higher than the loss incurred during the same period in the prior year. We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Our future foreign tax rate could be affected by changes in the composition in earnings in countries with tax rates differing from the U.S. federal rate. The Company is under examination in various US and foreign jurisdictions. Net Income Net income increased $0.7 million, or 5.1%, to $14.7 million for the three months ended June 29, 2014, from $14.0 million for the three months ended June 30, 2013. This increase was primarily due to decreases of $9.2 million in operating expenses, primarily attributable to decreases in litigation charges, outside professional services and restructuring charges. These changes were partially offset by a decrease in gross profit of $6.2 million, which was largely attributable to revenue reduction, and an increase of $2.6 million in the provision for income taxes. 40-------------------------------------------------------------------------------- Table of Contents Segment Information A description of our products and services, as well as segment financial data, for each segment and a reconciliation of segment contribution income to income before income taxes can be found in Note 12, Segment Information, Operations by Geographic Area and Significant Customers, in the notes to unaudited condensed consolidated financial statements in Item 1 of Part I of this Quarterly Report on Form 10-Q. Future changes to our organizational structure or business may result in changes to the reportable segments disclosed. The discussions below include the results of each of our segments for the three months ended June 29, 2014 with the comparable reporting periods in the preceding year. Retail Three Months Ended June 29, June 30, 2014 % Change 2013 ( in thousands, except percentage data) Net revenue $ 110,663 (5.7 )% $ 117,395 Percentage of net revenue 32.8 % 32.8 % Contribution income $ 14,726 (6.6 )% $ 15,761 Contribution margin 13.3 % 13.4 % Net revenue decreased $6.7 million, or 5.7%, to $110.7 million for the three months ended June 29, 2014, from $117.4 million for the three months ended June 30, 2013. The decrease was primarily due to the decreased sales of our multimedia products and broadband gateways. Contribution income decreased $1.0 million, or 6.6%, to $14.7 million for the three months ended June 29, 2014, from $15.8 million for the three months ended June 30, 2013. The decrease was primarily attributable to decreased gross profit, mainly due to decrease in net revenue, partially offset by a decrease in sales and marketing costs. Commercial Three Months Ended June 29, June 30, 2014 % Change 2013 (in thousands, except percentage data) Net revenue $ 75,447 (14.7 )% $ 88,446 Percentage of net revenue 22.3 % 24.7 % Contribution income $ 17,129 (16.3 )% $ 20,476 Contribution margin 22.7 % 23.2 % Net revenue decreased $13.0 million, or 14.7%, to $75.4 million for the three months ended June 29, 2014, from $88.4 million for the three months ended June 30, 2013. The decrease was primarily attributable to the decreased sales of our network storage products and switches. Contribution income decreased $3.3 million, or 16.3%, to $17.1 million for the three months ended June 29, 2014, from $20.5 million for the three months ended June 30, 2013. This decrease was primarily attributable to a decrease in gross profit, largely driven by the decrease in net revenue while the operating expenses were relatively flat. 41-------------------------------------------------------------------------------- Table of Contents Service Provider Three Months Ended June 29, June 30, 2014 % Change 2013 ( in thousands, except percentage data) Net revenue $ 151,494 (0.3 )% $ 151,878 Percentage of net revenue 44.9 % 42.5 % Contribution income $ 15,235 8.1 % $ 14,090 Contribution margin 10.1 % 9.3 % Net revenue in the service provider business unit decreased $0.4 million, or 0.3%, to $151.5 million for the three months ended June 29, 2014, from $151.9 million for the three months ended June 30, 2013. The increased sales of our mobile products was offset by the decrease in sales of our home security monitoring and automation products and broadband gateways. Contribution income increased $1.1 million, or 8.1%, to $15.2 million for the three months ended June 29, 2014, from $14.1 million for the three months ended June 30, 2013, primarily due to a decrease in research and development costs. Six Months Ended June 29, 2014 Compared to Six Months Ended June 30, 2013 Net Revenue Net revenue increased $35.9 million, or 5.5%, to $687.0 million for the six months ended June 29, 2014, from $651.1 million for the six months ended June 30, 2013. The increase in net revenue was primarily driven by increased sales of our mobile products as a result of the AirCard acquisition, partially offset by a decrease in sales of our broadband gateways, network storage, and home security monitoring and automation products. We experienced an increase in revenues in the Americas and APAC regions, and a decrease in EMEA. In addition, our service provider business unit increased year-over-year, while the retail and commercial business units decreased . For discussion of net revenue by geographic region, see the section entitled "Net Revenue by Geographic Region." For discussion of net revenue by segment, see the section entitled "Segment Information." Net Revenue by Geographic Region Six Months Ended June 29, June 30, 2014 % Change 2013 (In thousands, except percentage data) Americas $ 382,313 6.9 % $ 357,524 Percentage of net revenue 55.6 % 54.9 % EMEA $ 207,229 (3.8 )% $ 215,492 Percentage of net revenue 30.2 % 33.1 % APAC $ 97,453 24.8 % $ 78,102 Percentage of net revenue 14.2 % 12.0 % Total net revenue $ 686,995 5.5 % $ 651,118 The increase in Americas net revenue was primarily driven by the increase in sales of our mobile products, partially offset by the decrease in the sales of our home wireless, multimedia, network storage, and home security monitoring and automation products. The decrease in EMEA net revenue was primarily attributable to a decrease in sales of our broadband gateways and mobile products. The increase in APAC was primarily driven by an increase in sales of our mobile and home wireless products. Americas continues to represent the largest percentage of our net revenue, and APAC increased as a percentage of revenue. EMEA decreased slightly as a percentage of revenue as we continued to see macroeconomic weakness in the European market. 42-------------------------------------------------------------------------------- Table of Contents Cost of Revenue and Gross Margin Six Months Ended June 29, June 30, 2014 % Change 2013 (In thousands, except percentage data) Cost of revenue $ 491,884 6.9 % $ 459,951 Gross margin percentage 28.4 % 29.4 % Cost of revenue increased $31.9 million, or 6.9%, to $491.9 million for the six months ended June 29, 2014, from $460.0 million for the six months ended June 30, 2013. The increase was primarily attributable to the increase in net revenue. Our gross margin decreased to 28.4% for the six months ended June 29, 2014, from 29.4% for the six months ended June 30, 2013. The decrease in gross margin percentage was primarily attributable to relatively faster growth in revenue from service providers, which generally carries lower gross margins than our other products. Sales to service providers increased as a percentage of net revenue to 44.2% in the six months ended June 29, 2014, compared to 38.1% in the six months ended June 30, 2013, which was primarily attributable to our acquisition of AirCard. Also contributing to the decrease in gross margin was an increase of $3.7 million in excess and obsolete inventory charges. Operating Expenses Research and Development Six Months Ended June 29, June 30, 2014 % Change 2013 (In thousands, except percentage data) Research and development expense $ 44,657 13.6 % $ 39,319 Percentage of net revenue 6.5 % 6.0 % Research and development expenses increased $5.3 million, or 13.6%, to $44.7 million for the six months ended June 29, 2014, from $39.3 million for the six months ended June 30, 2013. Additionally, research and development expenses increased as a percentage of net revenue to 6.5% for the six months ended June 29, 2014, from 6.0% for the six months ended June 30, 2013. These increases were primarily due to a $4.7 million increase in personnel and facility-related expenses driven by the growth in research and development headcount as a result of our acquisitions of AirCard and Arada in the second quarter of 2013. The headcount increased by 96 employees to 349 employees at March 30, 2014 compared to 253 employees at March 31, 2013 and decreased by 58 employees to 350 employees at June 29, 2014 compared to 408 employees at June 30, 2013. Sales and Marketing Six Months Ended June 29, June 30, 2014 % Change 2013 (In thousands, except percentage data) Sales and marketing expense $ 78,090 1.7 % $ 76,795 Percentage of net revenue 11.4 % 11.9 % Sales and marketing expense increased $1.3 million, or 1.7%, to $78.1 million for the six months ended June 29, 2014, from $76.8 million for the six months ended June 30, 2013. Sales and marketing expense decreased as a percentage of net revenue to 11.4% for the six months ended June 29, 2014, from 11.9% for the six months ended June 30, 2013. The change in sales and marketing expense was primarily due to increases of $0.9 million in amortization of intangible assets acquired from the AirCard acquisition in the second quarter of 2013, $1.0 million in personnel-related expenses, and $0.6 million in variable compensation expenses. These increases were offset by decreases of $0.7 million in projects and outside professional services and $0.7 million in freight. 43-------------------------------------------------------------------------------- Table of Contents General and Administrative Six Months Ended June 29, June 30, 2014 % Change 2013 (In thousands, except percentage data) General and administrative expense $ 23,269 (5.6 )% $ 24,646 Percentage of net revenue 3.4 % 3.8 % General and administrative expenses decreased $1.4 million, or 5.6%, to $23.3 million for the six months ended June 29, 2014, from $24.6 million for the six months ended June 30, 2013. The decrease was primarily attributable to a $2.5 million decrease in outside professional services, mainly related to acquisition and litigation related expenses, partially offset by a $1.5 million increase in personnel related expenses driven by additional headcount. Restructuring and Other Charges We incurred restructuring and other charges of $0.8 million during the six months ended June 29, 2014, mainly attributable to one-time separation costs related to the departure of the general manager of the retail business unit. We incurred $1.6 million restructuring and other charges in the six months ended June 30, 2013, $1.4 million of which were transition costs related to the AirCard acquisition and $0.2 million are restructuring charges related to an office lease exit liability related to the AVAAK acquisition. For a further discussion of our restructuring expenses, please see Note 15, Restructuring and Other Charges, of the notes to unaudited condensed consolidated financial statements. Litigation Reserves, net We recorded litigation reserve charges of $0.2 million during the six months ended June 29, 2014 for estimated costs related to the settlement of lawsuits, as compared to charges of $3.6 million in the six months ended June 30, 2013 for estimated costs related to the Ericsson judgment. For a detailed discussion of our litigation matters, refer to Note 9, Commitments and Contingencies, in the notes to unaudited condensed consolidated financial statements in Item 1 of Part I of this Quarterly Report on Form 10-Q. Interest Income and Other Expense, Net Six Months Ended June 29, June 30, 2014 % Change 2013 (In thousands, except percentage data) Interest income $ 106 (56.6 )% $ 244 Other expense, net (335 ) 29.3 % (474 )Total interest income and other expense, net $ (229 ) 0.4 % $ (230 ) Interest income decreased $0.1 million to $0.1 million for the six months ended June 29, 2014, from $0.2 million for the six months ended June 30, 2013. The decrease in interest income was primarily attributable to the decrease in our cash, cash equivalents and short term investment balance mainly due to the AirCard and Arada acquisitions in the second quarter of 2013 and the repurchase of common stocks in the fourth quarter of 2013 and the first and second quarter of 2014. Other expense, net, decreased $0.1 million, to $0.3 million for the six months ended June 29, 2014, from $0.5 million for the six months ended June 30, 2013. Our foreign currency hedging program effectively reduced volatility associated with hedged currency exchange rate movements during the three months ended June 29, 2014. For details of our hedging program and related foreign currency contracts, refer to Note 6, Derivative Financial Instruments, in the notes to unaudited condensed consolidated financial statements in Item 1 of Part I of this Quarterly Report on Form 10-Q. Provision for Income Taxes The income tax provision for the six months ended June 29, 2014 was $18.7 million or an effective tax rate of 39.2%, compared to the tax provision for the six months ended June 30, 2013 of $15.7 million or an effective tax rate of 34.9%. The increase in the effective tax rate for the six months ended June 29, 2014, compared to the same period in the prior year was primarily caused by changes in US tax law related to the research tax credit. On December 31, 2011 provisions in the tax law allowing for 44-------------------------------------------------------------------------------- Table of Contents the research tax credit expired. On January 2, 2013 the American Taxpayer Relief Act of 2012 reinstated the research credit, retroactive to January 1, 2012 through December 31, 2013. Accordingly, the entire benefit for the 2012 research credit of approximately $0.7 million was recognized during the six months ended June30, 2013. Additionally,we recorded credits related to 2013 in its tax provision for the six months ended June 29, 2013. As of June 29, 2014, the research credit has not been reinstated. Accordingly, no tax benefit has been recorded during the six months ended June 29, 2014. Additionally, during the six months ended June 29, 2014 and June 30, 2013, we have incurred losses in a jurisdiction where no tax benefit could be recorded. Because tax benefit could not be recorded, the forecasted earnings from this jurisdiction were excluded from the determination of the effective tax rate which results in an increase in the tax rate from foreign earnings. The loss in the six months ended June 29, 2014 is relatively higher than the loss incurred during the same period in the prior year. We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Our future foreign tax rate could be affected by changes in the composition in earnings in countries with tax rates differing from the U.S. federal rate. The Company is under examination in various US and foreign jurisdictions. Net Income Net income decreased $0.2 million, or 0.7%, to $29.1 million for the six months ended June 29, 2014, from $29.3 million for the six months ended June 30, 2013. This decrease was primarily due to increases of $3.0 million in the provision for income taxes, and $1.1 million in operating expenses. These changes were partially offset by an increase of $3.9 million in gross profit, largely driven by revenue growth. Segment Information Retail Six Months Ended June 29, June 30, 2014 % Change 2013 ( in thousands, except percentage data) Net revenue $ 228,895 (6.1 )% $ 243,717 Percentage of net revenue 33.3 % 38.4 % Contribution income $ 29,409 (14.5 )% $ 34,379 Contribution margin 12.8 % 14.1 % Net revenue in the retail business unit decreased $14.8 million, or 6.1%, to $228.9 million for the six months ended June 29, 2014, from $243.7 million for the six months ended June 30, 2013. The decrease was primarily due to decreased sales of our multimedia, home wireless, and home security monitoring and automation products. Contribution income decreased $5.0 million, or 14.5%, to $29.4 million for the six months ended June 29, 2014, from $34.4 million for the six months ended June 30, 2013. The decrease is primarily due to a decrease in gross profit, largely attributable to revenue reduction and higher excess and obsolete inventory charges, partially offset by a decrease in sales and marketing costs. Commercial Six Months Ended June 29, June 30, 2014 % Change 2013 (in thousands, except percentage data) Net revenue $ 154,310 (3.1 )% $ 159,297 Percentage of net revenue 22.5 % 24.5 % Contribution income $ 36,669 6.9 % $ 34,287 Contribution margin 23.8 % 21.5 % Net revenue in the commercial business unit decreased $5.0 million, or 3.1%, to $154.3 million for the six months ended June 29, 2014, from $159.3 million for the six months ended June 30, 2013. The decrease is primarily attributable to decreased sales of our network storage products and switches. Contribution income increased $2.4 million, or 6.9%, to $36.7 million for the six months ended June 29, 2014, from $34.3 million for the six months ended June 30, 2013. The increase in contribution income was primarily attributable to decreased freight costs in cost of revenues and a decrease in research and development costs. 45-------------------------------------------------------------------------------- Table of Contents Service Provider Six Months Ended June 29, June 30, 2014 % Change 2013 ( in thousands, except percentage data) Net revenue $ 303,790 22.4 % $ 248,104 Percentage of net revenue 44.2 % 38.1 % Contribution income $ 28,754 21.9 % $ 23,581 Contribution margin 9.5 % 9.5 % Net revenue in the service provider business unit increased $55.7 million, to $303.8 million for the six months ended June 29, 2014, from $248.1 million for the six months ended June 30, 2013. The increase is primarily attributable increased sales of our mobile products as a result of the AirCard acquisition, partially offset by a decrease in sales of our broadband gateways. Contribution income increased $5.2 million, or 21.9%, to $28.8 million for the six months ended June 29, 2014, from $23.6 million for the six months ended June 30, 2013. The increase is primarily due to an increase in gross profit, largely attributable to revenue growth, partially offset by increases in research and development costs and sales and marketing costs. Liquidity and Capital Resources Our cash and cash equivalents balance increased from $143.0 million as of December 31, 2013 to $147.0 million as of June 29, 2014. Our short-term investments, which represent the investment of funds available for current operations, decreased from $105.1 million as of December 31, 2013 to $95.7 million as of June 29, 2014, resulting from sale of treasuries. Operating activities during the six months ended June 29, 2014 provided cash of $42.7 million, compared to $56.2 million provided in the six months ended June 30, 2013. Investing activities during the six months ended June 29, 2014 used cash of $0.9 million, resulting primarily from final payment of $1.1 million relating to the Arada acquisition and purchases of property and equipment of $9.4 million, partially offset by $9.6 million in proceeds from the sale and maturity of short-term investments. During the six months ended June 29, 2014, financing activities used cash of $37.8 million, primarily due to the repurchase of common stock, partially offset by proceeds from the issuance of common stock upon exercise of stock options and our employee stock purchase program. Our days sales outstanding ("DSO") increased from 69 days as of December 31, 2013 to 76 days as of June 29, 2014. DSO of 76 days is in the normal range for the second quarter of the year. Our accounts payable decreased from $114.5 million at December 31, 2013 to $101.4 million at June 29, 2014. The decrease was primarily attributable to timing of payments. Inventory decreased by $29.9 million from $224.5 million at December 31, 2013 to $194.5 million at June 29, 2014. In the three months ended June 29, 2014 we experienced annualized ending inventory turns of approximately 4.9, slightly up from approximately 4.6 in the three months ended December 31, 2013. We enter into foreign currency forward-exchange contracts, which typically mature in three to five months, to hedge a portion of our exposure to foreign currency fluctuations of foreign currency-denominated revenue, costs of revenue, certain operating expenses, receivables, payables, and cash balances. We record in the consolidated balance sheet at each reporting period the fair value of our forward-exchange contracts and record any fair value adjustments in our unaudited condensed consolidated statements of operations and in our unaudited condensed consolidated balance sheet. Gains and losses associated with currency rate changes on hedge contracts that are non-designated under the authoritative guidance for derivatives and hedging are recorded within other expense, net, offsetting foreign exchange gains and losses on our monetary assets and liabilities. Gains and losses associated with currency rate changes on hedge contracts that are cash flow hedges under the authoritative guidance for derivatives and hedging are recorded within cumulative other comprehensive income until the related revenue, costs of revenue, or expenses are recognized. In October 2008, the Board of Directors authorized management to repurchase up to 6.0 million shares of our common stock in the open market. The stock repurchase authorization does not have an expiration date and the pace of repurchase activity is at the discretion of management and contingent on a number of factors, including levels of cash generation from operations, cash requirements for acquisitions and the price of our common stock. During the six months ended June 29, 2014, we repurchased and retired approximately 1.3 million shares of common stock at a cost of $43.1 million under this authorization. This leaves approximately 1.5 million shares remaining in our buyback program and we expect to continue to repurchase opportunistically. We did not repurchase any shares during the six months ended June 30, 2013. 46-------------------------------------------------------------------------------- Table of Contents In the six months ended June 29, 2014, we repurchased approximately 47,000 shares of common stock at a cost of $1.5 million under a repurchase program to help administratively facilitate the withholding and subsequent remittance of personal income and payroll taxes for individuals receiving RSUs. Similarly, during the six months ended June 30, 2013, we repurchased approximately 13,000 shares of common stock at a cost of $0.5 million under the same program to help facilitate tax withholding for RSUs. These shares were retired upon repurchase. Based on our current plans and market conditions, we believe that our existing cash, cash equivalents and short-term investments will be sufficient to satisfy our anticipated cash requirements for at least the next twelve months. However, we may require or desire additional funds to support our operating expenses and capital requirements or for other purposes, such as acquisitions, and may seek to raise such additional funds through public or private equity financing or from other sources. We cannot assure you that additional financing will be available at all or that, if available, such financing would be obtainable on terms favorable to us and would not be dilutive. Our future liquidity and cash requirements will depend on numerous factors, including the introduction of new products and potential acquisitions of related businesses or technology. Contractual Obligations There have been no material changes during the six months ended June 29, 2014 to the contractual obligations disclosed in Part II, Item 7, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. We lease office space, cars and equipment under non-cancelable operating leases with various expiration dates through December 2026. The terms of certain of our facility leases provide for rental payments on a graduated scale. We recognize rent expense on a straight-line basis over the lease period and have accrued for rent expense incurred but not paid. We enter into various inventory-related purchase agreements with suppliers. Generally, under these agreements, 50% of the orders are cancelable by giving notice 46 to 60 days prior to the expected shipment date and 25% of orders are cancelable by giving notice 31 to 45 days prior to the expected shipment date. Orders are non-cancelable within 30 days prior to the expected shipment date. At June 29, 2014, we had approximately $188 million in non-cancelable purchase commitments with suppliers. We establish a loss liability for all products we do not expect to sell for which we have committed purchases from suppliers. Such losses have not been material to date. From time to time the Company's suppliers procure unique complex components on the Company's behalf. If these components do not meet specified technical criteria or are defective, the Company should not be obligated to purchase the materials. However, disputes may arise as a result and significant resources may be spent resolving such disputes. As of June 29, 2014, we had $14.4 of total gross unrecognized tax benefits and related interest. The timing of any payments that could result from these unrecognized tax benefits will depend upon a number of factors. The possible reduction in liabilities for uncertain tax positions in multiple jurisdictions that may impact the statement of operations in the next 12 months is approximately $2.8 million, excluding the interest, penalties and the effect of any related deferred tax assets or liabilities. Off-Balance Sheet Arrangements As of June 29, 2014, we did not have any off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K. Critical Accounting Policies and Estimates Our critical accounting policies are disclosed in our Annual Report on Form 10-K for the year ended December 31, 2013. Our critical accounting policies have not materially changed during the six months ended June 29, 2014. Recent Accounting Announcement See Note 2, Summary of Significant Accounting Policies, in notes to unaudited condensed consolidated financial statements in Item 1 of Part I of this Report on Form 10-Q, for a full description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on financial condition and results of operations, which are hereby incorporated by reference. |