Apr 26, 2008
NetGear, Inc. (NASDAQ:NTGR) Q1 2008 Earnings Call Transcript April 24, 2008 5:00 pm ET
Executives
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Analysts
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Operator
Greetings and welcome to the NetGear, Inc. first quarter 2008 results conference call.
At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation.
(Operator instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Joseph Villalta of The Ruth Group.
Thank you. Mr.
Villalta, you may begin.
Joseph Villalta
Thank you. Good afternoon and welcome to NetGear's first quarter 2008 results call.
Joining us from the company are Patrick Lo, Chairman and CEO, and Christine Gorjanc, CFO. The format of the call will be a brief business review by Patrick followed by Christine providing detail on the financials.
We will then have time for any questions. If you have not received a copy of today's earnings release, please call The Ruth Group at 646-536-7026 or go to NetGear's corporate web site at www.netgear.com.
Before we begin the formal remarks, the company's attorneys advise us that today's conference call contains forward-looking statements within the meaning of the US Private Securities Litigation Reform Act of 1995. The forward-looking statements represent NetGear Inc.'
s expectations or beliefs concerning future events and include statements, among others, regarding NetGear's expected revenue, earnings, operating income, and tax rate on both a GAAP and non-GAAP basis, anticipated new product offerings, current and future demand for the company's existing and anticipated new products, willingness of consumers to purchase and use the company's products, and ability to increase distribution and market share for the company's products domestically and worldwide. These statements are based on management's current expectations and are subject to certain risks and uncertainties, including without limitation the following: future demand for the company's products may be lower than anticipated, consumers may choose not to adopt the company's new product offerings or adopt competing products, the company may be unsuccessful or experience delays in manufacturing and distributing its new and existing products, telecommunication service providers may choose to slow their deployment of the company's products or utilize competing products, the company may be unable to collect receivables as they become due, the company may fail to manage costs, including the cost of developing new products and manufacturing and distribution of its existing offerings.
Channel inventory information reported is estimated based on average number of weeks of inventory on hand on the last Saturday of the quarter as reported by certain of NetGear's customers. Further information on the potential risk factors that could affect NetGear and its business are detailed in the company's periodic filings with the SEC, including but not limited to those risks and uncertainties listed in the section entitled Part 1, Item 1A, Risk Factors, pages 12 through 24 in the company's annual report on Form 10-K for the fiscal year ended December 31, 2007 filed with the SEC on February 29, 2009.
NetGear undertakes no obligation to release publicly any revisions to any forward-looking statements contained herein to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. In addition, several non-GAAP financial measures will be mentioned on this call.
Information related to the corresponding GAAP measures and reconciliation of the non-GAAP and GAAP measures can be found in our press release in the Investor Relations site at www.netgear.com. At this time, I would now like to turn the call over to Patrick Lo.
Please go ahead, sir.
Patrick Lo
Thank you, Joseph. Thank you for everyone for joining today's call.
Net revenue in Q1 increased 14% to $198.2 million compared to the year ago period and flat as compared to Q4 2007. We enjoyed very healthy growth in Q1 in both Asia Pacific and North America regions, as well as in service provider channels worldwide.
We grew our revenue in North America 20% year-on-year and 14% quarter-on-quarter. The performance of our emerging markets, including China, India, Eastern Europe, the Middle East, and Brazil, continued to be strong in Q1.
The growth of this group on a percentage basis continues to be significantly higher than our corporate average, specifically our Asia Pacific revenue was $20.8 million in Q1, a growth of 39% year-over-year. We believe we'll continue to gain share in Asia Pacific and other emerging markets.
However, we were challenged in Q1 to meet our revenue and operating margin targets, mainly due to two factors: the abrupt weakening of the UK market in March, leading to a big shortfall of revenue there; and the unusual, aggressive price moves of our number one competitor in the US in March. We believe both occurrences are due to weakening consumer market demand caused by economic weakness in both countries.
However, we do believe that the economy will turn around eventually and we will be strongly positioned to improve our performance during the economic recovery. Despite the slowdown in the US market and the pricing pressures, we were able to capitalize on our RangeMAX wireless technology leadership, to hold a price premium over our number one competitor and continued to gain share in Q1.
We believe our proven strategy of innovation, technology, and usability differentiation will continue enabling us to gain share while staying at parity or premium relative to the prices of our primary competitors. In Europe, outside of the UK market, we were maintaining our strong momentum growth in revenue and in market share.
We grew our EMEA revenue outside of the UK 29% year-over-year. The EMEA revenue, excluding the UK, was $59.8 million in Q1 compared to $46.3 million in Q1 of 2007.
In the UK, our revenue actually declined to $38.4 million as compared to $46.3 million a year ago. The decline was across all channels in the UK.
However, market reports confirmed that we continued to gain share in the UK. While we fully recognize that weakness in consumer demand and pricing pressure in our top-two retail markets, the US and the UK, has and will continue to adversely affect our operating results, we firmly believe our core strategy of continuously driving growth through expansion in product lineup, channel penetration, new geographic regions, and profitably expanding our global market share remains sound.
From the product perspective, we see strong growth in market demand for our SMB product, especially our ReadyNAS and Smart Switches. We are preparing to introduce additional models on these two product lines for the rest of the year.
We are especially encouraged by the ramp of our ReadyNAS line of products, which has experienced fast sequential revenue growth since initial launch. Due to its leading-edge technologies, such as non-stop data access even during disk repairs or upgrades, we are able to command significant price premium over our primary competitors.
We intend to increase our investment in new products in our ReadyNAS line. We are especially excited about the introduction of the ReadyNAS Duo Home Media Server at the end of Q1, with three models ranging from 500 gigabyte to 1 terabyte.
This expands the reach of ReadyNAS beyond SMB and into the consumer market, providing a safe and secure way to store and serve family multimedia content, such as photos, songs, and home videos, within the home or over the Internet. In three quarters, we have achieved a number two market share position in the US SMB network attached storage, and we are closing in on the number one position.
In Q1, we also added another new member to our Advanced Smart Switch lineup, the 24-port gigabit Advanced Smart Switch with a smart switch price and ease of use of a web browser, it delivers the full features of a fully managed switch such as enhanced security of ACL and 802.1x and voice QoS. There are now five offerings in the Advance Gigabit Smart Switch line, including Stackables and Power-over-Ethernet versions.
We will continue to introduce additional models in Q2 and throughout the rest of the year, further consolidating our technology and market share leadership in this fast-growing segment of SMB switches. In the competitive retail consumer market, the market reception of our new RangeMAX wireless and Dual-Band and Gigabit routers has been very encouraging.
These products were introduced with great success in partnership with Best Buy and Dell in the United States in Q1. We are expanding the distribution of these successful products to other channels in the US, as well as in EMEA in Q2.
Our focus going forward is to continue to introduce RangeMAX N products, which utilize patent-pending metro-material multi-antenna technology. We are confident that the extra range and throughput of our RangeMAX N products will allow us to continue to command a price premium over our competitors and gain share.
On the service provider side, our Channel Bonding Voice Cable Gateway was very well received in Q1 in Europe. Together with other DOCSIS 2.0 cable gateway, it has been a major driver of our service provider revenue growth in Q2.
We intend to expand its distribution in other regions as well in the next few quarters. We will continue to capitalize on the industry's move to gateways with multiple functions such 11n Wi-Fi, Voice-over-IP, Quality of Service, DECT, and mobile phone convergence.
We introduced 11 new products in Q1. In the upcoming Network Interop Show next week in Las Vegas, we will introduce yet another new set of breakthrough SMB products, which will give us additional technology and product edge over our competitors.
We intend to introduce about 12 new products in Q2. On the channel front, we continued our strategy of expanding our presence and penetration.
Our service provider revenue in Q1 reached new heights to approximately $55 million, which is about 28% of our total revenue. This compares to 23% of total net revenue in the fourth quarter of 2007 and 21% in the first quarter of 2007.
We also concluded our agreement with a major US mass retailer and we will start selling a set of Wi-Fi products in over 3,000 of its stores in mid-May. As Wi-Fi penetration increases in US homes, more and more families are reaching out to this mass retailer to buy them.
Over the last three years, this mass retailer has achieved a significant market share in Wi-Fi home network product sales in the US and we believe this is the perfect time for us to enter this relationship. Surely, at the beginning of an engagement with any large new customer, we are always prudently conservative in projecting the level of business that we believe we can achieve given the lack of historical run rate data.
We are cautiously optimistic that if the channel partnership with this US mass retailer is successful, there could be upside to our revenue projections. Our operating margin was below our expectation in the first quarter and we do not expect it to increase in the next few quarters, given the pricing pressure we observed in the US retail market.
However, we intend to invest in speeding up the introduction of differentiated new offerings in ReadyNAS, Smart Switches, RangeMAX N, and multifunction DSL and cable gateway product families. We will also continue our upgrade of our global IT system.
We believe our new IT system will enhance our operational efficiency going forward. In summary, in the next few quarters, in spite of the sluggish US and UK retail markets, we are confident in maintaining our growth momentum worldwide with our planned new product introductions, expanded retail distribution, emerging market growth, and strength in the SMB and service provider channels.
By continuing to invest in innovation and operational efficiency, we are confident that we will emerge even stronger once economic growth resumes in the US and UK. Let me now turn the call over to Christine for details on our financials.
Christine Gorjanc
Thank you, Patrick. Let me now provide you with a summary of the financials for Q1.
As Patrick just noted, net revenue for the first quarter ended March 30, 2008 was $198.2 million, a 14% increase as compared to $173.6 million for the first quarter ended April 1, 2007 and flat as compared to $198.3 million in the fourth quarter ended December 31, 2007. Net revenue in the first quarter of 2008 by geography was $79.2 million for North America, $98.1 million for the Europe, Middle East, and Africa region, and $20.8 million for the Asia Pacific region.
We shipped about 4.2 million units in the first quarter, including 3.6 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 2.3 million units.
Moving to the product category basis, the first quarter net revenue split between wireless and wired was about 61% and 39%, respectively, relatively unchanged from the first quarter of 2007. The first quarter net revenue split between home and small business products was about 62% and 38% compared to a 65/35 split in the fourth quarter of 2007.
Products introduced in the last 15 months constituted about 31% of our first quarter shipments, while products introduced in the last 12 months constituted about 30% of our first quarter shipments. Non-GAAP gross margin in the first quarter of 2008 was 32.9% as compared to 34.7% in the year ago comparable quarter and 32.4% in the fourth quarter of 2007.
Moving to non-GAAP operating expenses, total non-GAAP operating expenses, which excludes litigation reserves and acquisition-related retention bonuses, as well as non-cash stock-based compensation costs, came in at $46.4 million for the first quarter of 2008. This compares to non-GAAP operating expense of $38.9 million in the first quarter of 2007 and $42.8 million in the fourth quarter of 2007.
Q1 2008 operating expenses represented 23.4% of net revenue. This is an increase of 100 basis points compared to the first quarter of 2007 and an increase of 180 basis points compared to the fourth quarter of 2007, both primarily due to our incremental investment in R&D and in emerging markets.
Non-GAAP sales and marketing expenses were $32.2 million. As a percentage of net revenue, sales and marketing expenses were 16.2% in Q1 of 2008 as compared to 15.7% in Q1 of 2007 and 15.4% in Q4 of 2007.
The increase year-over-year in sales and marketing expenses is due to additional payroll-related costs driven by our sales force expansion. Non-GAAP R&D expenses were $7.9 million.
This represents 4% of net revenue in Q1 of 2008 as compared to 3.1% in Q1 of 2007 and 3.2% in Q4 of 2007. The increase in R&D year-over-year includes the addition of the ReadyNAS team and the quarter-over-quarter increase is due to ramping up the introduction of differentiated new products in Q2 and beyond.
Non-GAAP G&A expenses for the first quarter were $6.4 million or 3.2% of net revenue compared to 3.6% in the year ago period and 2.9% in the fourth quarter of 2007. The increase compared to Q4 is due to payroll-related costs as well as professional fees.
Operating income on a GAAP basis was $14.7 million, which includes $1.2 million in charges for amortization of purchased intangibles and acquisition-related retention bonuses, a $51,000 charge for litigation reserves, as well as non-cash stock-based compensation of $2.8 million. This compares to GAAP operating income of $19.1 million in the year ago first quarter and $17.9 million in the fourth quarter of 2007.
On a GAAP basis, the company reported net income of $11.2 million or $0.31 per diluted share for the first quarter 2008 compared to net income of $14 million or $0.40 per diluted share for the first quarter of 2007 and $12.5 million or $0.35 per diluted share in the fourth quarter of 2007. Net income on a non-GAAP basis for the first quarter of 2008 was $14.1 million as compared to non-GAAP net income of $15.6 million for the first quarter of 2007 and non-GAAP net income of $14.8 million for the fourth quarter of 2007.
Non-GAAP net income was $0.39 per diluted share in the first quarter of 2008 compared to $0.44 per diluted share in the first quarter of 2007 and $0.41 for the fourth quarter of 2007. For calculating the EPS, we used a fully diluted stock count of 35.9 million shares for Q1 versus 36.1 million shares for the prior quarter and 35.4 million shares for Q1 of 2007.
In Q1 of 2008, there was a currency gain of $2.8 million compared to a gain of $272,000 in Q1 of '07 and a gain of about $146,000 in Q4 of '07. This represents roughly $0.05 a share in EPS for Q1 '08.
The non-GAAP tax rate was 39.2% in the first quarter of 2008 compared to 34.9% in the prior first quarter and 37.4% in the fourth quarter of 2007. The reconciliation of GAAP to non-GAAP is detailed in our financial statements released earlier today.
Moving on to the balance sheet, we ended the first quarter with $200.8 million or approximately $5.59 per diluted share in cash, cash equivalents, and short-term investments compared to a total of $216.2 million at the end of the first quarter of 2007 or approximately $6.11 per diluted share and $205.3 million at the end of the fourth quarter 2007 or approximately $5.69 per diluted share. Please note that during 2007, we paid $60 million cash for the acquisition of Infrant Technologies and its ReadyNAS line of network-attached storage products.
In terms of inventory trend, we ended the first quarter 2008 with inventory at $97.6 million with ending inventory turns of 5.5 compared to 6.6 turns at the end of the first quarter of 2007 and 6.5 turns at the end of the fourth quarter of 2007. The increase in inventory is due to the preparation for entry into the stores of our new mass retailer customer, as well as to drive reductions in air freight costs.
Days sales outstanding were 71 in the first quarter of 2008 compared to 65 days in the first quarter of 2007 and 73 days ended the fourth quarter of 2007. This remains within our historical range of 65 to 75 days.
Total assets were approximately $562.7 million at the end of the first quarter 2008 compared to $451.2 million at the end of the first quarter of 2007 and $551.1 million at the end of Q4 2007. Deferred revenue decreased slightly to $7.5 million as compared to $7.6 million at the end of the prior quarter and an increase as compared to $7.6 million at the end of the prior quarter and an increase as compared to $5.8 million at the end of the first quarter of 2007.
We expect normal seasonality in the historically weaker Q2, specifically, we expect second quarter net revenue to be approximately $195 million to $200 million, with non-GAAP operating margin in the range of 9% to 10%. Finally, we expect the non-GAAP effective tax rate to be approximately 39.5%.
Operator, that concludes our comments and we can now take any questions.
Operator
Thank you. (Operator instructions) Our first question comes from Samuel Wilson with JMP Securities.
Please proceed with your question.
Samuel Wilson – JMP Securities
A few small questions for you. First, I'm sorry if I missed this, but can you give me what headcount was and the number of retail locations and the number of VARs?
Patrick Lo
The number of retail locations has increased to over 24,000. The number of VARs also have increased to over 42,000.
And the number of headcount is total exactly 565 at the end of Q1 versus 514 at the end of Q4.
Samuel Wilson – JMP Securities
Can you give me a sense of what your hiring plans are, what you're thinking for the next couple of quarters?
Patrick Lo
We believe that we will continue to do some strategic hiring in Q2, but not very big since it's usually a flat-to-down quarter. But then we will resume our hiring in Q3 and Q4 again.
But, certainly, our hiring will still be pegged around normal $1.5 million per revenue per employee kind of level.
Samuel Wilson – JMP Securities
Got it. And then, Patrick, can you talk a little bit about pricing pressure or pricing action that you saw in North America?
It sounds like Linksys was the main culprit here. Did you match pricing?
Did you try to keep premium pricing and give up a few sales? Were you doing a lot of rebating?
Can you just give us a lot more color there on what you were seeing there at the end of the quarter?
Patrick Lo
Certainly, I mean normally, we price at parity with them on the high end such as RangeMAX, MIMO and N. And then we price below them10%, 15% in the 11g range.
And we saw them in March, all through March, first, price their g routers to our level, at parity. And then, they moved the N and the MIMO pricing actually $10 to $20 below us, which is really an act that we have never seen before.
We are taking this opportunity, of course, to take a premium price position. But, certainly, we could not let the gap to be more than $10.
So, we did move our price to close the gap a little bit. But, right now, we believe that because of our RangeMAX N, which is based on a patent-pending metro-material antenna technology, we should be able to price at a slight premium.
And as the indications from the market reports, we have been able to continue to gain share.
Samuel Wilson – JMP Securities
And do you think, I mean, it's now, I don't know, three weeks into April? Was it a March-only phenomenon or have they been all the way through, starting in the April being really aggressive with pricing also?
Patrick Lo
According to our observation and market intelligence, I think they are going to continue.
Samuel Wilson – JMP Securities
Patrick Lo
Well, actually as a matter of fact, all the emerging markets are generally referred as BRIC for Brazil, Russia, India, and China. Other than Russia, we are doing very well in all the other three countries.
We are progressing very well in terms of brand awareness, market share gain, as well as revenue growth.
Samuel Wilson – JMP Securities
Terrific. Thank you very much.
Patrick Lo
Thank you.
Operator
Our next question comes from Maynard Um with UBS. Please proceed with your question.
Maynard Um – UBS
Hi, thanks. Can you just talk about your revenue guidance and the makeup of that in the second quarter between service provider and non-service provider?
What I'm trying to understand is just how much visibility you have to the revenue, given kind of this environment?
Patrick Lo
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Maynard Um – UBS
Okay. And then secondly, in terms of currency, so you told us on the bottom line what the impact is.
How much did it help the revenue line?
Christine Gorjanc
It helped the revenue line a little bit, and then also had the same effect on the expenses. So the net effect is not a material number.
Maynard Um – UBS
Okay. And then lastly, just on the major US retailer that you're entering into, I guess, are you waiting for the customer to make that announcement?
Or I guess, if you can give a little more detail there, who the incumbent vendors there are today, if there are any. Thanks.
Patrick Lo
Yes, there are incumbent vendors over there. As a matter of fact, this retail customer as you said will make the announcement later on, so we are not supposed to get ahead of that.
The reason that we are going into this retailer is because they have already been carrying other competitors' products and have achieved a number two market share position in selling Wi-Fi home network products in the United States. They have over 3,000 retail outlets.
Certainly, they are carrying our number one competitor. So we think this is the perfect time going in there, given the fact that they have built a very, very big business and we believe that the inventory turn for our products on the shelves over there will be justifiable for us to be able to be there to be profitable.
Maynard Um – UBS
Great. Thank you.
Operator
Our next question is from Thomas Lee with Goldman Sachs. Please proceed with your question.
Thomas Lee – Goldman Sachs
Hi, thank you for taking my call.
Patrick Lo
Sure, my pleasure.
Thomas Lee – Goldman Sachs
I had a question on the cost side. I was wondering, are you guys seeing a more challenging environment I guess either from component costs?
You indicated higher freight costs, but how much of that is kind of baked into your lower operating margin guidance?
Patrick Lo
Thomas Lee – Goldman Sachs
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Patrick Lo
We [ph] analyzed it pretty carefully and it's pretty much primarily based on the pricing pressure.
Thomas Lee – Goldman Sachs
It is? Okay.
Patrick Lo
And as I just mentioned that we do not believe that this is the end of it. We anticipate they will be moving prices further and that's why we take that into account as well.
Thomas Lee – Goldman Sachs
Got it. And then, just looking for a little bit of color on your weakness in Europe.
So, it looked like it was pretty much contained in the UK. Have you seen any weakness in the non-UK regions, countries in Europe?
Why couldn't that spill over?
Patrick Lo
Interesting. It's really, really well contained in the UK market.
We try to kind of ask our country managers why that is the case, the only theory we could come up with is the UK housing market is very similar to the US. While in the other markets, for example, like in Germany, there are more renters than homeowners, and the mortgage is structured totally differently.
So, that might be the reason.
Thomas Lee – Goldman Sachs
Got it. Okay, thank you.
Operator
(Operator instructions) Our next question is from Stanley Kovler with Merrill Lynch. Please proceed with your question.
Stanley Kovler – Merrill Lynch
Thanks very much. Patrick, I was wondering if you can add some color to trends in the US.
I'm looking at your revenue growth, it seems like you've still managed to post some nice revenue growth in the US, both sequentially and year-over-year. And you did very well in the SMB market, but obviously it was a smaller dollar growth.
So, there must've been some benefit there from the service provider market and you mentioned that the retailers were weak. Just wondering if you can frame that for us a little bit better to see where that (inaudible) came from?
Patrick Lo
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Stanley Kovler – Merrill Lynch
Got it. And if I may, a question on Asia, Asia-Pac was down quarter-over-quarter in dollar terms and you mentioned that emerging markets were very strong.
Obviously, China's in there. Was that really seasonality from more of mature region such as Australia, or what was the cause of that lack of growth?
Patrick Lo
It's just the reverse. As more and more our revenue is derived from China, then the Chinese New Year effect [ph] will have more on us.
Stanley Kovler – Merrill Lynch
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Patrick Lo
As a matter of fact, because we have no historical run rate of this particular retailer, so even though it has quite a significant number of stores, there is no way for us to model how much incremental revenue it's going to bring to us, so that we would just use the most conservative approach of a similar retailer with similar number of stores and reduce it by a certain percent. But, how it's going to perform, we will know after the finish of Q2, when we have actual run rate data for about six to eight weeks.
Stanley Kovler – Merrill Lynch
Great. Thank you very much.
Operator
(Operator instructions) Our next question is from Alex Dannin with Morningstar. Please proceed with your question.
Alex Dannin – Morningstar
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Patrick Lo
Sure. We could divide the world into three portions.
We could first look at what we call the typical Western markets. We entered into new Western markets such as Spain, Italy, Benelux, just in the last two, three years.
The market structures are pretty similar to the US or the UK or Australia. So the channel structure, the technology reception are pretty similar.
For those markets, we expect to gain profitability on par with other mature markets in a very rapid rate, usually within three years. And then we have the second area, which is primarily the really, really emerging markets like Brazil, China, India that generally have a lower cost of entry, however, has a much different infrastructure, as well as reception of technology and a different set of competitors and a different set of products requirement.
For those, we expect that it will take longer, maybe five or maybe even seven years to get to the comparable profit contribution to our more mature markets. Then we have a third piece is somewhere in between there we have absolutely no clue and we still have no clue, which is Russia.
We still haven't found a way to get there yet. But, we just hired a good country manager and we hope that we'll be able to find a model there.
Operator
Mr. Lo, there are currently no further questions.
Would you like to make any closing comments?
Patrick Lo
Yes. Certainly, we were surprised by the reaction of some of our competitors in terms of how they handled the slowing down of the market.
We believe that we have always been competing on technology and products. It looks like that the game has changed, but we welcome the challenge.
We are always up to the challenge. And now, even the last weapon is used, so we know how to deal with it.
We think that we're going to live through a few quarters of rough time, but we still believe that our strategy is sound, which is basically diversifying into new product lineups with differentiated patented technology, as well as to diversify into new distribution channel such as new service providers and new retailers and, of course, running as fast as we can, better than our competitors in the emerging markets. I think it will pay off for us.
It has paid off for us for the last ten years. It will pay off for us in the next few quarters, especially when the economy of the US and the UK comes back.
We are very confident on our strategy and certainly, the whole NetGear team is very committed to continue executing to its fullest and continue to be the winner in the market. So, thank you very much and we will update you in the next quarter on how successful we are in competing in this new environment.
But, we have every confidence that we will prevail.
Operator
Thank you. Ladies and gentlemen, this concludes today's teleconference.
You may disconnect your lines at this time. Thank you for your participation.