10-Q 1 ntgr20130331-10q.htm FORM 10-Q NTGR 2013.03.31 - 10Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
 
þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended March 31, 2013.

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the transition period from                     to                    
Commission file number: 000-50350
NETGEAR, Inc.
(Exact name of registrant as specified in its charter)
 
Delaware
 
77-0419172
(State or other jurisdiction of
incorporation or organization)
 
(IRS Employer
Identification No.)
 
 
 
350 East Plumeria Drive,
San Jose, California
 
95134
(Address of principal executive offices)
 
(Zip Code)
(408) 907-8000
(Registrant’s telephone number including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  þ    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large Accelerated filer
 
þ
  
Accelerated filer
 
¨
Non-Accelerated filer
 
¨
  
Smaller reporting company
 
¨
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).    Yes  o    No  þ
The number of outstanding shares of the registrant’s Common Stock, $0.001 par value, was 38,524,049 as of April 30, 2013.


1



 
 
 
 
 
 
 



2


PART I: FINANCIAL INFORMATION

Item 1.
Financial Statements

NETGEAR, INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
 
 
March 31,
2013
 
December 31,
2012
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
279,098

 
$
149,032

Short-term investments
143,314

 
227,845

Accounts receivable, net
237,896

 
256,014

Inventories
158,555

 
174,903

Deferred income taxes
24,052

 
22,691

Prepaid expenses and other current assets
34,773

 
33,724

Total current assets
877,688

 
864,209

Property and equipment, net
18,387

 
19,025

Intangibles, net
26,079

 
27,621

Goodwill
100,880

 
100,880

Other non-current assets
22,282

 
22,834

Total assets
$
1,045,316

 
$
1,034,569

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
82,410

 
$
87,310

Accrued employee compensation
14,103

 
18,338

Other accrued liabilities
119,587

 
126,255

Deferred revenue
26,998

 
27,645

Income taxes payable
4,667

 
1,382

Total current liabilities
247,765

 
260,930

Non-current income taxes payable
13,187

 
13,735

Other non-current liabilities
6,987

 
5,293

Total liabilities
267,939

 
279,958

Commitments and contingencies (Note 9)


 


Stockholders’ equity:
 
 
 
Common stock
39

 
38

Additional paid-in capital
402,050

 
394,427

Cumulative other comprehensive income
139

 
4

Retained earnings
375,149

 
360,142

Total stockholders’ equity
777,377

 
754,611

Total liabilities and stockholders’ equity
$
1,045,316

 
$
1,034,569

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.



3


NETGEAR, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
 
 
Three Months Ended
 
 
March 31,
2013
 
April 1,
2012
 
Net revenue
$
293,399

 
$
325,620

 
Cost of revenue
205,662

 
225,771

 
Gross profit
87,737

 
99,849

 
Operating expenses:
 
 
 
 
Research and development
15,338

 
14,121

 
Sales and marketing
36,389

 
38,970

 
General and administrative
12,327

 
10,413

 
Restructuring and other charges
(30
)
 

 
Litigation reserves, net
48

 
151

 
Total operating expenses
64,072

 
63,655

 
Income from operations
23,665

 
36,194

 
Interest income
149

 
119

 
Other income (expense), net
74

 
(601
)
 
Income before income taxes
23,888

 
35,712

 
Provision for income taxes
8,545

 
10,565

 
Net income
$
15,343

 
$
25,147

 
Net income per share:
 
 
 
 
Basic
$
0.40

 
$
0.67

 
Diluted
$
0.39

 
$
0.65

 
Weighted average shares outstanding used to compute net income per share:
 
 
 
 
Basic
38,433

 
37,796

 
Diluted
39,050

 
38,576

 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.



4



NETGEAR, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)

 
Three Months Ended
 
 
March 31,
2013
 
April 1,
2012
 
Net income
$
15,343

 
$
25,147

 
Other comprehensive income (loss), before tax:
 
 
 
 
Unrealized gain (loss) on derivative instruments
151

 
(56
)
 
Unrealized loss on available-for-sale securities
(26
)
 
(34
)
 
Other comprehensive income (loss), before tax
125

 
(90
)
 
Tax benefit related to items of other comprehensive income
10

 
12

 
Other comprehensive income (loss), net of tax
135

 
(78
)
 
Comprehensive income
$
15,478

 
$
25,069

 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.


5


NETGEAR, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
 
 
Three Months Ended
 
March 31,
2013
 
April 1,
2012
Cash flows from operating activities:
 
 
 
Net income
$
15,343

 
$
25,147

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
4,942

 
3,609

Purchase premium amortization on investments
373

 
718

Non-cash stock-based compensation
3,590

 
3,392

Income tax benefit associated with stock option exercises
354

 
937

Excess tax benefit from stock-based compensation
(354
)
 
(910
)
Deferred income taxes
(1,015
)
 
(477
)
Changes in assets and liabilities:
 
 
 
Accounts receivable
18,118

 
12,099

Inventories
16,348

 
29,410

Prepaid expenses and other assets
(671
)
 
3,273

Accounts payable
(4,901
)
 
(37,751
)
Accrued employee compensation
(4,235
)
 
(9,121
)
Other accrued liabilities
(6,869
)
 
(4,079
)
Deferred revenue
1,317

 
(14,937
)
Income taxes payable
2,737

 
1,482

Net cash provided by operating activities
45,077

 
12,792

Cash flows from investing activities:
 
 
 
Purchases of short-term investments
(20,022
)
 
(108,517
)
Proceeds from sales and maturities of short-term investments
104,154

 
32,400

Purchase of property and equipment
(2,761
)
 
(1,462
)
Payments made in connection with business acquisitions, net of cash acquired

 
(500
)
Net cash provided by (used in) investing activities
81,371

 
(78,079
)
Cash flows from financing activities:
 
 
 
Purchase and retirement of common stock
(336
)
 
(596
)
Proceeds from exercise of stock options
2,547

 
4,378

Proceeds from issuance of common stock under employee stock purchase plan
1,053

 
955

Excess tax benefit from stock-based compensation
354

 
910

Net cash provided by financing activities
3,618

 
5,647

Net increase (decrease) in cash and cash equivalents
130,066

 
(59,640
)
Cash and cash equivalents, at beginning of period
149,032

 
208,898

Cash and cash equivalents, at end of period
$
279,098

 
$
149,258

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.



6


NETGEAR, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


Note 1.
The Company and Basis of Presentation
NETGEAR, Inc. (“NETGEAR” or the “Company”) was incorporated in Delaware in January 1996. The Company is a global networking company that delivers innovative products to consumers, businesses and service providers. For consumers, the Company makes high performance, dependable and easy-to-use home networking, storage and digital media products to connect people with the Internet and their content and devices. For businesses, the Company provides networking, storage and security solutions without the cost and complexity of Big IT. The Company also supplies leading service providers with made-to-order and retail proven, whole home networking solutions for sale to their customers. The Company’s products are built on a variety of proven technologies such as wireless, Ethernet and powerline, with a focus on reliability and ease-of-use. The Company sells products primarily through a global sales channel network, which includes traditional retailers, online retailers, wholesale distributors, direct market resellers ("DMRs"), value added resellers ("VARs"), and broadband service providers.
The accompanying unaudited condensed consolidated financial statements include the accounts of NETGEAR, Inc., and its wholly owned subsidiaries. They have been prepared in accordance with established guidelines for interim financial reporting and with the instructions of Form 10-Q and Article 10 of Regulation S-X. All significant intercompany balances and transactions have been eliminated in consolidation. The balance sheet dated December 31, 2012, has been derived from audited financial statements at such date. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments considered necessary (consisting only of normal recurring adjustments) to fairly state the Company’s financial position, results of operations, comprehensive income and cash flows for the periods indicated. These unaudited condensed consolidated financial statements should be read in conjunction with the notes to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012.
The Company’s fiscal year begins on January 1 of the year stated and ends on December 31 of the same year. The Company reports its interim results on a fiscal quarter basis rather than on a calendar quarter basis. Under the fiscal quarter basis, each of the first three fiscal quarters ends on the Sunday closest to the calendar quarter end, with the fourth quarter ending on December 31.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect (i) the reported amounts of assets and liabilities, (ii) the disclosure of contingent assets and liabilities at the date of the financial statements, and (iii) the reported amounts of revenues and expenses during the reported period. Actual results could differ materially from those estimates and operating results for the three months ended March 31, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013.

2.
Summary of Significant Accounting Policies
The Company’s significant accounting policies are disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012. The Company’s significant accounting policies have not materially changed during the three months ended March 31, 2013.

Recent Accounting Pronouncements

In December 2011, the Financial Accounting Standards Board (the "FASB") issued Accounting Standards Update ("ASU") 2011-11 ("ASU 2011-01") , "Balance Sheet," which requires the disclosure of the effect or potential effect of offsetting arrangements on a company's financial position as well as enhanced disclosure of the rights of setoff associated with a company's recognized assets and liabilities. In January 2013, the FASB ASU 2013-01, which provides clarification on the scope of ASU 2011-11. ASU 2011-11 and ASU 2013-01 are effective for fiscal years beginning on or after January 1, 2013 and interim periods within those annual periods. Since the adoption of the authoritative guidance only required additional disclosures, it did not have an impact on the Company's financial position, results of operations or cash flows.

In February 2013, the FASB issued ASU 2013-02 "Comprehensive Income," which amends Topic 220 to improve the reporting of reclassifications out of accumulated other comprehensive income. ASU 2013-02 is effective for reporting periods beginning after December 15, 2012. Since the adoption of the authoritative guidance only required additional disclosures, it did not have an impact on the Company's financial position, results of operations or cash flows.

In February 2013, the FASB issued ASU 2013-04, “Liabilities,” which provides guidance for the recognition, measurement, and disclosure of obligations resulting from joint and several liability arrangements for which the total amount of the obligation

7


NETGEAR, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


is fixed at the reporting date, with the exception of obligations already addressed within existing US GAAP guidance. ASU 2013-04 is effective for reporting periods beginning after December 15, 2013. The Company will adopt this standard in the first quarter of 2014 and it does not expect the adoption to have a significant impact on its financial position, results of operations or cash flows.

In March 2013, the FASB issued ASU 2013-05, "Foreign Currency Matters," which provides the standards for parent's accounting for the cumulative translation adjustment upon derecognition of certain subsidiaries or groups of assets within a foreign entity or of an investment in a foreign entity. ASU 2013-05 is effective for reporting periods beginning after December 15, 2013. The Company will adopt this standard in the first quarter of 2014 and it does not expect the adoption to have a significant impact on its financial position, results of operations or cash flows.

3.
Business Acquisitions
AVAAK, Inc.
On July 2, 2012, the Company acquired 100% of the voting equity interests of AVAAK, Inc. (“AVAAK”), a privately-held company that developed wire-free video networking products for a total purchase consideration of $24.0 million in cash. The Company believes the acquisition will bolster its retail business unit product offerings and expand its presence into the smart home market. The Company paid $21.6 million of the aggregate purchase price in the third quarter of 2012, and expects to pay the remaining $2.4 million, less amounts used to satisfy certain claims, twelve months after the closing of the acquisition.
The acquisition qualified as a business combination and was accounted for using the acquisition method of accounting. The results of AVAAK have been included in the consolidated financial statements since the date of acquisition. Pro forma results of operations for the acquisition are not presented as the financial impact to the Company's consolidated results of operations is not material.
The allocation of the purchase price was as follows (in thousands):
Net tangible assets acquired (liabilities assumed)
$
172

Deferred tax assets, net
5,937

Intangible assets, net
6,000

Goodwill
11,895

Total consideration
$
24,004

The estimation of fair values for tangible assets and intangible assets acquired and liabilities assumed was subject to estimates, assumptions and other uncertainties, and it is possible that the allocation of the purchase consideration reflected in the foregoing table may change.
None of the goodwill recognized related to AVAAK is deductible for income tax purposes. The goodwill recognized, which was assigned to the Company's retail business unit, is primarily attributable to expected synergies resulting from the acquisition.
In connection with the acquisition, the Company recorded $5.9 million of deferred tax assets net of deferred tax liabilities. The deferred tax assets arise from the tax benefit of the estimated net operating losses as of the date of the acquisition after consideration of limitations on the use under U.S. Internal Revenue Code section 382. The deferred tax assets are reduced by deferred tax liabilities recorded for the book basis in intangible assets and in-process research and development ("IPR&D") for which the Company has no tax basis.
The Company designated $2.3 million of the acquired intangible assets as technology. The value was calculated based on the present value of the future estimated cash flows derived from estimated savings attributable to the existing technology and discounted at 14.0%. The acquired existing technology is being amortized over its estimated useful life of five years.
The Company designated $0.3 million of the acquired intangible assets as customer relationships. The value was calculated based on the present value of the future estimated cash flows derived from projections of future operations attributable to existing customer relationships and discounted at 14.0%. The acquired customer relationships are being amortized over an estimated useful life of five years.

8


NETGEAR, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


The Company designated $1.4 million of the acquired intangible assets as trade name and trademarks. The value was calculated based on the present value of the future estimated cash flows derived from projections of future operations attributable to existing trade name and trademarks and discounted at 16.0%. The acquired trade name and trademarks are being amortized over an estimated useful life of five years.
In addition, $2.0 million of the consideration paid represents the fair value of acquired IPR&D projects. The IPR&D acquired is considered indefinite lived intangible assets until research and development efforts associated with the projects are completed or abandoned. The most significant of the acquired IPR&D projects relate to camera technology and applications. As of March 31, 2013, all the acquired IPR&D has been reclassified to definite intangibles and they are being amortized over an estimated useful life of four years.
Firetide, Inc.
On June 4, 2012, the Company acquired certain intellectual property of Firetide, Inc. (“Firetide”) for an aggregate purchase price of $7.2 million in cash. The acquisition included intangible assets that existed at the closing date, including IP contracts, technology assets, business technology, and goodwill. The Company believes the acquisition will bolster its wireless product offerings in its commercial business unit and strengthen its market position in the small to medium size campus wireless LAN market. The acquisition qualified as a business combination and was accounted for using the acquisition method of accounting.
The Company paid $6.6 million of the aggregate purchase price in the second quarter of 2012, and expects to pay the remaining $0.6 million, less amounts used to satisfy certain claims, twelve months after the closing of the acquisition. The ongoing costs of developing these assets subsequent to the date of acquisition have been included in the consolidated financial statements since the date of acquisition. The historical results of operations related to the acquired assets prior to the acquisition were not material to the Company’s results of operations.
The allocation of the purchase price was as follows (in thousands):
 
Intangible assets, net
$
4,159

Goodwill
3,041

Total consideration
$
7,200

The estimation of fair values for intangible assets acquired was subject to estimates, assumptions and other uncertainties, and it is possible that the allocation of the purchase consideration reflected in the foregoing table may change.

Of the $3.0 million of goodwill recorded on the acquisition of Firetide, approximately $1.6 million and $3.0 million are deductible for U.S. federal and state income tax purposes, respectively. The goodwill recognized, which was assigned to the Company's commercial business unit, is primarily attributable to expected synergies of Firetide.
The Company designated the 4.2 million in acquired intangible assets as technology. The value was calculated based on the present value of the future estimated cash flows derived from estimated savings attributable to the existing technology and discounted at 22.0%. The acquired existing technology is being amortized over its estimated useful life of five years.


9


NETGEAR, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


4.
Balance Sheet Components (in thousands)

Short-Term Investments

 
As of
 
March 31, 2013
 
December 31, 2012
 
Cost
 
Unrealized Gain
 
Unrealized Loss
 
Estimated Fair Value
 
 Cost
 
Unrealized Gain
 
Unrealized Loss
 
Estimated Fair Value
U.S. Treasuries
$
140,508

 
$
19

 
$

 
$
140,527

 
$
225,016

 
$
48

 
$
(2
)
 
$
225,062

Certificates of Deposits
2,787

 

 

 
2,787

 
2,783

 

 

 
2,783

Total
$
143,295

 
$
19

 
$

 
$
143,314

 
$
227,799

 
$
48

 
$
(2
)
 
$
227,845


All of the Company’s marketable securities are classified as available-for-sale and consist of government securities with an original maturity or remaining maturity at the time of purchase of greater than three months and no more than 12 months. Accordingly, none of the short-term investments have unrealized losses greater than 12 months.

Cost Method Investments

As of March 31, 2013 and December 31, 2012, the carrying value of the Company's cost method investments was $1.3 million. These investments are included in other non-current assets in the consolidated balance sheets and are carried at cost, adjusted for any impairment, because the Company does not have a controlling interest and does not have the ability to exercise significant influence over these companies. The Company monitors these investments for impairment on a quarterly basis, and adjusts carrying value for any impairment charges recognized. There were no impairments recognized in the three months ended March 31, 2013 and April 1, 2012. Realized gains and losses on these investments are reported in other income (expense), net in the consolidated statements of operations.

Accounts receivable, net
 
 
As of
 
March 31,
2013
 
December 31,
2012
Gross accounts receivable
$
259,070

 
$
276,084

Allowance for doubtful accounts
(1,256
)
 
(1,256
)
Allowance for sales returns
(17,532
)
 
(17,031
)
Allowance for price protection
(2,386
)
 
(1,783
)
Total allowances
(21,174
)
 
(20,070
)
Total accounts receivable, net
$
237,896

 
$
256,014


Inventories
 
 
As of
 
March 31,
2013
 
December 31,
2012
Raw materials
$
7,295

 
$
4,447

Finished goods
151,260

 
170,456

Total inventories
$
158,555

 
$
174,903


The Company records provisions for excess and obsolete inventory based on forecasts of future demand. While management believes the estimates and assumptions underlying its current forecasts are reasonable, there is risk that additional charges may be necessary if current forecasts are greater than actual demand.


10


NETGEAR, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


Property and equipment, net
 
 
As of
 
March 31,
2013
 
December 31,
2012
Computer equipment
$
7,422

 
$
7,290

Furniture, fixtures and leasehold improvements
12,789

 
12,761

Software
22,233

 
21,521

Machinery and equipment
33,669

 
31,694

Construction in progress
232

 
385

Total property and equipment, gross
76,345

 
73,651

Accumulated depreciation and amortization
(57,958
)
 
(54,626
)
Total property and equipment, net
$
18,387

 
$
19,025


Depreciation expense was $3.4 million and $2.6 million for the three months ended March 31, 2013 and April 1, 2012, respectively.

Intangibles, net
 
The following tables present details of the Company’s purchased intangible assets:

 
Gross
 
Accumulated Amortization
 
Net
March 31, 2013
 
 
 
 
 
Technology
$
33,259

 
$
(22,852
)
 
$
10,407

Customer contracts and relationships
16,000

 
(3,806
)
 
12,194

Other
6,870

 
(3,392
)
 
3,478

Finite-lived intangibles, net
$
56,129

 
$
(30,050
)
 
$
26,079


 
Gross
 
Accumulated Amortization
 
Net
December 31, 2012
 
 
 
 
 
Technology
$
32,259

 
$
(22,065
)
 
$
10,194

Customer contracts and relationships
16,000

 
(3,301
)
 
12,699

Other
6,870

 
(3,142
)
 
3,728

Finite-lived intangibles, net
55,129

 
(28,508
)
 
26,621

Indefinite-lived intangible assets
1,000

 

 
1,000

Total purchased intangible assets, net
$
56,129

 
$
(28,508
)
 
$
27,621


All of the IPR&D assets as of December 31, 2012 were acquired in connection with the Company's acquisition of AVAAK. IPR&D assets represent IPR&D projects that have not reached technical feasibility and are required to be classified as indefinite-lived assets until the successful completion or abandonment of the associated research and development efforts. Accordingly, during the development period after the date of acquisition, these assets will not be amortized. When the asset reaches technical feasibility, the Company will determine the useful life of the asset, reclassify the asset out of IPR&D, and begin amortization. Development costs incurred after acquisition on acquired IPR&D projects are expensed as incurred. As of March 31, 2013, the remaining $1.0 million of the IPR&D at December 31, 2012 had reached technical feasibility and as a result, was reclassified from IPR&D to technology.


11


NETGEAR, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


Amortization of purchased intangible assets was $1.5 million and $1.0 million for the three months ended March 31, 2013 and April 1, 2012, respectively. No impairment charges were recorded in the three months ended March 31, 2013, and April 1, 2012.

Estimated amortization expense related to intangibles for each of the next five years and thereafter is as follows:

Year Ending December 31
Amount
2013 (remaining nine months)
$
4,363

2014
5,589

2015
4,972

2016
4,610

2017
3,025

Thereafter
3,520

Total expected amortization expense
$
26,079


Goodwill
 
 
As of
 
March 31,
2013
 
December 31,
2012
Retail
$
45,441

 
$
45,441

Commercial
35,084

 
35,084

Service Provider
20,355

 
20,355

Total
$
100,880

 
$
100,880


There were no impairments to goodwill during the three months ended March 31, 2013 and April 1, 2012.

Other non-current assets

 
As of
 
March 31,
2013
 
December 31, 2012
Non-current deferred income taxes
$
16,510

 
$
16,856

Cost method investment
1,322

 
1,322

Other
4,450

 
4,656

Total other non-current assets
$
22,282

 
$
22,834


Other accrued liabilities
 
 
As of
 
March 31,
2013
 
December 31,
2012
Sales and marketing programs
$
40,257

 
$
43,652

Warranty obligation
45,876

 
46,659

Freight
4,601

 
4,457

Other
28,853

 
31,487

Total other accrued liabilities
$
119,587

 
$
126,255



12


5.
Product Warranties
The Company provides for estimated future warranty obligations at the time revenue is recognized. The Company’s standard warranty obligation to its direct customers generally provides for a right of return of any product for a full refund in the event that such product is not merchantable or is found to be damaged or defective. At the time revenue is recognized, an estimate of future warranty returns is recorded to reduce revenue in the amount of the expected credit or refund to be provided to its direct customers. At the time the Company records the reduction to revenue related to warranty returns, the Company includes within cost of revenue a write-down to reduce the carrying value of such products to net realizable value.
The Company’s standard warranty obligation to its end-users provides for replacement of a defective product for one or more years. Factors that affect the warranty obligation include product failure rates, material usage and service delivery costs incurred in correcting product failures. The estimated cost associated with fulfilling the Company’s warranty obligation to end-users is recorded in cost of revenue. Because the Company’s products are manufactured by third party manufacturers, in certain cases the Company has recourse to the third party manufacturer for replacement or credit for the defective products. The Company gives consideration to amounts recoverable from its third party manufacturers in determining its warranty liability.
Changes in the Company’s warranty liability, which is included in other accrued liabilities in the unaudited condensed consolidated balance sheets, are as follows (in thousands):
 
 
Three Months Ended
 
March 31,
2013
 
April 1,
2012
Balance as of beginning of the period
$
46,659

 
$
44,846

Provision for warranty liability made during the period
16,375

 
12,956

Settlements made during the period
(17,158
)
 
(15,773
)
Balance at end of period
$
45,876

 
$
42,029


6.
Derivative Financial Instruments

The Company’s subsidiaries have had, and will continue to have material future cash flows, including revenue and expenses, which are denominated in currencies other than the Company’s functional currency. The Company and all its subsidiaries designate the U.S. dollar as the functional currency. Changes in exchange rates between the Company’s functional currency and other currencies in which the Company transacts business will cause fluctuations in cash flow expectations and cash flow realized or settled. Accordingly, the Company uses derivatives to mitigate its business exposure to foreign exchange risk. The Company enters into foreign currency forward contracts in Australian dollars, British pounds, Euros, and Japanese yen to manage the exposures to foreign exchange risk related to expected future cash flows on certain forecasted revenue, costs of revenue, operating expenses and existing assets and liabilities. The Company does not enter into derivatives transactions for trading or speculative purposes.

The Company’s foreign currency forward contracts do not contain any credit-risk-related contingent features. The Company is exposed to credit losses in the event of nonperformance by the counter-parties of its forward contracts. The Company enters into derivative contracts with high-quality financial institutions and limits the amount of credit exposure to any one counter-party. In addition, the derivative contracts typically mature in less than six months and the Company continuously evaluates the credit standing of its counter-party financial institutions. The counter-parties to these arrangements are large highly rated financial institutions and the Company does not consider non-performance a material risk.

The Company may choose not to hedge certain foreign exchange exposures for a variety of reasons, including, but not limited to, immateriality, accounting considerations and the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign exchange rates. The Company’s accounting policies for these instruments are based on whether the instruments are designated as hedge or non-hedge instruments in accordance with the authoritative guidance for derivatives and hedging. The Company records all derivatives on the balance sheet at fair value. The effective portions of cash flow hedges are recorded in other comprehensive income until the hedged item is recognized in earnings. Derivatives that are not designated as hedging instruments and the ineffective portions of its designated hedges are adjusted to fair value through earnings in other income (expense), net in the unaudited condensed consolidated statement of operations.


13


NETGEAR, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


The fair values of the Company’s derivative instruments and the line items on the unaudited condensed consolidated balance sheet to which they were recorded as of March 31, 2013, and December 31, 2012, are summarized as follows (in thousands):
 
Derivative Assets
 
Balance Sheet
Location
 
Fair Value at
March 31, 2013
 
Balance Sheet
Location
 
Fair Value at
December 31, 2012
Derivative assets not designated as hedging instruments
 
Prepaid expenses and other current assets
 
$
967

 
Prepaid expenses and other current assets
 
$
1,142

Derivative assets designated as hedging
instruments
 
Prepaid expenses and other current assets
 
149

 
Prepaid expenses and other current assets
 
2

Total
 
 
 
$
1,116

 
 
 
$
1,144


 
Derivative Liabilities
 
Balance Sheet
Location
 
Fair Value at
March 31, 2013

 
Balance Sheet
Location
 
Fair Value at
December 31, 2012

Derivative liabilities not designated as hedging instruments
 
Other accrued liabilities
 
$
(449
)
 
Other accrued liabilities
 
$
(1,616
)
Derivative liabilities designated as hedging instruments
 
Other accrued liabilities
 
(54
)
 
Other accrued liabilities
 
(3
)
Total
 
 
 
$
(503
)
 
 
 
$
(1,619
)

For details of the Company’s fair value measurements, see Note 13, Fair Value of Financial Instruments.

Offsetting Derivative Assets and Liabilities

The Company has entered into master netting arrangements which allow net settlements under certain conditions. Although netting is permitted, it is currently the Company's policy and practice to record all derivative assets and liabilities on a gross basis in the condensed consolidated balance sheets.

The following tables set forth the offsetting of derivative assets as of March 31, 2013 and December 31, 2012 (in thousands):

As of March 31, 2013
 
 
 
 
 
 
 
Gross Amounts Not Offset in the Condensed Consolidated Balance Sheets
 
 
 
Gross Amounts of Recognized Assets
 
Gross Amounts Offset in the Condensed Consolidated Balance Sheets
 
Net Amounts Of Assets Presented in the Condensed Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral Pledged
 
Net Amount
Barclays        
 
$
1,009

 
$

 
$
1,009

 
$
(503
)
 
$

 
$
506

Wells Fargo Bank
 
107

 

 
107

 

 

 
107

Total
 
$
1,116

 
$

 
$
1,116

 
$
(503
)
 
$

 
$
613


As of December 31, 2012
 
 
 
 
 
 
 
Gross Amounts Not Offset in the Condensed Consolidated Balance Sheets
 
 
 
Gross Amounts of Recognized Assets
 
Gross Amounts Offset in the Condensed Consolidated Balance Sheets
 
Net Amounts Of Assets Presented in the Condensed Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral Pledged
 
Net Amount
Barclays        
 
$
1,107

 
$

 
$
1,107

 
$
(1,107
)
 
$

 
$

Wells Fargo Bank
 
37

 

 
37

 
(37
)
 

 

Total
 
$
1,144

 
$

 
$
1,144

 
$
(1,144
)
 
$

 
$



14


NETGEAR, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


The following tables set forth the offsetting of derivative liabilities as of March 31, 2013 and December 31, 2012 (in thousands):

As of March 31, 2013
 
 
 
 
 
 
 
Gross Amounts Not Offset in the Condensed Consolidated Balance Sheets
 
 
 
Gross Amounts of Recognized Liabilities
 
Gross Amounts Offset in the Condensed Consolidated Balance Sheets
 
Net Amounts Of Liabilities Presented in the Condensed Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral Pledged
 
Net Amount
Barclays        
 
$
503

 
$

 
$
503

 
$
(503
)
 
$

 
$

Wells Fargo Bank
 

 

 

 

 

 

Total
 
$
503

 
$

 
$
503

 
$
(503
)
 
$

 
$


As of December 31, 2012
 
 
 
 
 
 
 
Gross Amounts Not Offset in the Condensed Consolidated Balance Sheets
 
 
 
Gross Amounts of Recognized Liabilities
 
Gross Amounts Offset in the Condensed Consolidated Balance Sheets
 
Net Amounts Of Liabilities Presented in the Condensed Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral Pledged
 
Net Amount
Barclays        
 
$
1,401

 
$

 
$
1,401

 
$
(1,107
)
 
$

 
$
294

Wells Fargo Bank
 
218

 

 
218

 
(37
)
 

 
181

Total
 
$
1,619

 
$

 
$
1,619

 
$
(1,144
)
 
$

 
$
475


Cash flow hedges

To help manage the exposure of operating margins to fluctuations in foreign currency exchange rates, the Company hedges a portion of its anticipated foreign currency revenue, costs of revenue and certain operating expenses. These hedges are designated at the inception of the hedge relationship as cash flow hedges under the authoritative guidance for derivatives and hedging. Effectiveness is tested at least quarterly both prospectively and retrospectively using regression analysis to ensure that the hedge relationship has been effective and is likely to remain effective in the future. The Company typically hedges portions of its anticipated foreign currency exposure for three to five months. The Company enters into about five forward contracts per quarter with an average size of about $7 million USD equivalent related to its cash flow hedging program.

The Company expects to reclassify to earnings all of the amounts recorded in other comprehensive income ("OCI") associated with its cash flow hedges over the next 12 months. OCI associated with cash flow hedges of foreign currency revenue is recognized as a component of net revenue in the same period as the related revenue is recognized. OCI associated with cash flow hedges of foreign currency costs of revenue and operating expenses are recognized as a component of cost of revenue and operating expense in the same period as the related costs of revenue and operating expenses are recognized.

Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur within the designated hedge period or if not recognized within 60 days following the end of the hedge period. Deferred gains and losses in other comprehensive income associated with such derivative instruments are reclassified immediately into earnings through other income and expense. Any subsequent changes in fair value of such derivative instruments also are reflected in current earnings unless they are re-designated as hedges of other transactions. The Company did not recognize any material net gains or losses related to the loss of hedge designation on discontinued cash flow hedges during the three months ended March 31, 2013, and April 1, 2012.


15


NETGEAR, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


The effects of the Company’s derivative instruments on OCI and the unaudited condensed consolidated statement of operations for the three months ended March 31, 2013, and April 1, 2012, are summarized as follows (in thousands):

Derivatives Designated as Hedging Instruments
 
Three Months Ended March 31, 2013
 
Gain or (Loss)
Recognized in
OCI -
Effective
Portion (a)
 
Location of
Gain or (Loss)
Reclassified from OCI
into Income - Effective
Portion
 
Gain or (Loss)
Reclassified
from
OCI into
Income -
Effective
Portion (a)
 
Location of
Gain or (Loss)
Recognized in
Income and
Excluded from
Effectiveness  Testing
 
Amount of Gain or (Loss) Recognized in
Income and
Excluded from
Effectiveness  Testing
Cash flow hedges:
 
 
 
 
 
 
 
 
 
 
Foreign currency forward contracts
 
$
178

 
Net revenue
 
$
75

 
Other income (expense), net
 
$
(22
)
Foreign currency forward contracts
 

 
Cost of revenue
 
(2
)
 
Other income (expense), net
 

Foreign currency forward contracts
 

 
Operating expenses
 
(46
)
 
Other income (expense), net
 

Total
 
$
178

 
 
 
$
27

 
 
 
$
(22
)
 
Derivatives Designated as
Hedging Instruments
 
Three Months Ended April 1, 2012
 
Gain or (Loss)
Recognized in
OCI -
Effective
Portion (a)
 
Location of
Gain or (Loss)
Reclassified from OCI
into Income - Effective
Portion
 
Gain or (Loss)
Reclassified
from
OCI into
Income -
Effective
Portion (a)
 
Location of
Gain or (Loss)
Recognized in
Income and
Excluded from
Effectiveness  Testing
 
Amount of Gain  or (Loss)  Recognized in
Income and
Excluded from
Effectiveness  Testing
Cash flow hedges:
 
 
 
 
 
 
 
 
 
 
Foreign currency forward contracts
 
$
(106
)
 
Net revenue
 
$
2

 
Other income (expense), net
 
$
(45
)
Foreign currency forward contracts
 

 
Cost of revenue
 
(2
)
 
Other income (expense), net
 

Foreign currency forward contracts
 

 
Operating expenses
 
(50
)
 
Other income (expense), net
 

Total
 
$
(106
)
 
 
 
$
(50
)
 
 
 
$
(45
)

(a)
Refer to Note 10, Stockholders' Equity, which summarizes the cumulative other comprehensive income activity related to derivatives.

The Company did not recognize any net gain or loss related to the ineffective portion of cash flow hedges during the three months ended March 31, 2013, and April 1, 2012.

Non-designated hedges

The Company enters into non-designated hedges under the authoritative guidance for derivatives and hedging to manage the exposure of non-functional currency monetary assets and liabilities held on its financial statements to fluctuations in foreign currency exchange rates, as well as to reduce volatility in other income and expense. The non-designated hedges are generally expected to offset the changes in value of its net non-functional currency asset and liability position resulting from foreign exchange rate fluctuations. Foreign currency denominated accounts receivable and payable are hedged with non-designated hedges when the related anticipated foreign revenue and expenses are recognized in the Company’s financial statements. The Company also hedges certain non-functional currency monetary assets and liabilities that may not be incorporated into the cash flow hedge program. The Company adjusts its non-designated hedges monthly and enters into about 13 non-designated derivatives per quarter. The average size of its non-designated hedges is about $2 million USD equivalent and these hedges range from one to five months in duration.


16


NETGEAR, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


The effects of the Company’s derivatives not designated as hedging instruments in other income (expense), net in the unaudited condensed consolidated statements of operations for the three months ended March 31, 2013 and April 1, 2012, are as follows (in thousands):
 
Derivatives Not Designated as Hedging Instruments
 
Location of Gains or (Losses)
Recognized in Income on  Derivative
 
Amount of Gains or (Losses)
Recognized in Income on Derivative
 
Three Months  Ended
March 31, 2013

 
Three Months  Ended
April 1, 2012

Foreign currency forward contracts
 
Other income (expense), net
 
$
268

 
$
(744
)

7.
Net Income Per Share
Basic net income per share is computed by dividing the net income for the period by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing the net income for the period by the weighted average number of shares of common stock and potentially dilutive common stock outstanding during the period. Potentially dilutive common shares include outstanding stock options and unvested restricted stock awards, which are reflected in diluted net income per share by application of the treasury stock method. Under the treasury stock method, the amount that the employee must pay for exercising stock options, the amount of stock-based compensation cost for future services that the Company has not yet recognized, and the estimated tax benefit that would be recorded in additional paid-in capital upon exercise are assumed to be used to repurchase shares.
Net income per share for the three months ended March 31, 2013, and April 1, 2012, are as follows (in thousands, except per share data):
 
 
Three Months Ended
 
 
March 31,
2013
 
April 1,
2012
 
Net income
$
15,343

 
$
25,147

 
Weighted average shares outstanding:
 
 
 
 
Basic
38,433

 
37,796

 
Dilutive potential common shares
617

 
780

 
Total diluted
39,050

 
38,576

 
 
 
 
 
 
Basic net income per share
$
0.40

 
$
0.67

 
Diluted net income per share
$
0.39

 
$
0.65

 

Weighted average stock options and unvested restricted stock awards to purchase 2.4 million shares and 1.8 million shares of the Company’s stock for the three months ended March 31, 2013, and April 1, 2012, respectively, were excluded from the computation of diluted net income per share because their effect would have been anti-dilutive.

8.
Income Taxes

The income tax provision for the three months ended March 31, 2013 was $8.5 million or an effective tax rate of 35.8%. The income tax provision for the three months ended April 1, 2012 was $10.6 million or an effective tax rate of 29.6%. The decrease in income tax expense for the three months ended March 31, 2013 compared to the same period in the prior year was predominantly due to lower pre-tax earnings for the three months ended March 31, 2013. The increase in the effective tax rate for the three month period ended March 31, 2013, compared to the same period in the prior year was primarily caused by a loss incurred during the period ended March 31, 2013 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 to the tax rate from foreign earnings. This increase is partially offset by recognition of the tax benefit for the 2012 U.S. federal research credit. On January 2, 2013 the American Taxpayer Relief Act of 2012 reinstated the research credit, retroactive to January 1, 2012. Accordingly, the entire benefit for the 2012 research credit of approximately $734,000 was recognized in the three months ended March 31, 2013.


17


The Company files income tax returns in the U.S. federal jurisdiction as well as various state, local, and foreign jurisdictions. Due to the uncertain nature of ongoing tax audits, the Company has recorded its liability for uncertain tax positions as part of its long-term liability as payments cannot be anticipated over the next 12 months. The existing tax positions of the Company continue to generate an increase in the liability for uncertain tax positions. The liability for uncertain tax positions may be reduced for liabilities that are settled with taxing authorities or on which the statute of limitations could expire without assessment from tax authorities. The possible reduction in liabilities for uncertain tax positions resulting from the expiration of statutes of limitation in multiple jurisdictions in the next 12 months is approximately $2.2 million excluding the interest, penalties and the effect of any related deferred tax assets or liabilities.

9.
Commitments and Contingencies

Leases

The Company leases office space, cars and equipment under operating leases, some of which are non-cancelable, with various expiration dates through December 2026. The terms of some of the Company’s office leases provide for rental payments on a graduated scale. The Company recognizes rent expense on a straight-line basis over the lease period, and has accrued for rent expense incurred but not paid.

Purchase Obligations

The Company has entered into various inventory-related purchase agreements with suppliers. Generally, under these agreements, 50% of 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 March 31, 2013, the Company had $153.2 million in non-cancelable purchase commitments with suppliers. The Company establishes a loss liability for all products it does not expect to sell for which it has committed purchases from suppliers. Such losses have not been material to date.

Guarantees and Indemnifications

The Company, as permitted under Delaware law and in accordance with its Bylaws, indemnifies its officers and directors for certain events or occurrences, subject to certain limits, while the officer or director is or was serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum amount of potential future indemnification is unlimited; however, the Company has a Director and Officer Insurance Policy that enables it to recover a portion of any future amounts paid. As a result of its insurance policy coverage, the Company believes the fair value of these indemnification agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of March 31, 2013.

In its sales agreements, the Company typically agrees to indemnify its direct customers, distributors and resellers for any expenses or liability resulting from claimed infringements by the Company's products of patents, trademarks or copyrights of third parties, subject to customary carve outs. The terms of these indemnification agreements are generally perpetual any time after execution date of the respective agreement. The maximum amount of potential future infringement indemnification is generally unlimited. The Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of March 31, 2013.

Employment Agreements

The Company has signed various employment agreements with key executives pursuant to which, if their employment is terminated without cause, such employees are entitled to receive their base salary (and commission or bonus, as applicable) for 52 weeks (for the Chief Executive Officer), 39 weeks (for the Senior Vice President of Worldwide Operations and Support) and up to 26 weeks (for other key executives). Such employees will also continue to have stock options vest for up to a one-year period following such termination without cause. If a termination without cause or resignation for good reason occurs within one year of a change in control, such employees are entitled to full acceleration (for the Chief Executive Officer) and up to two years acceleration (for other key executives) of any unvested portion of his or her stock options.

Litigation and Other Legal Matters

The Company is involved in disputes, litigation, and other legal actions, including, but not limited to, the matters described below. In all cases, at each reporting period, the Company evaluates whether or not a potential loss amount or a potential range of loss is probable and reasonably estimable under the provisions of the authoritative guidance that addresses accounting for

18


contingencies. In such cases, the Company accrues for the amount, or if a range, the Company accrues the low end of the range as a component of legal expense. The Company monitors developments in these legal matters that could affect the estimate the Company had previously accrued. In relation to such matters, the Company currently believes that there are no existing claims or proceedings that are likely to have a material adverse effect on its financial position within the next 12 months, or the outcome of these matters is currently not determinable. There are many uncertainties associated with any litigation, and these actions or other third-party claims against the Company may cause the Company to incur costly litigation and/or substantial settlement charges. In addition, the resolution of any intellectual property litigation may require the Company to make royalty payments, which could have an adverse effect in future periods. If any of those events were to occur, the Company's business, financial condition, results of operations, and cash flows could be adversely affected. The actual liability in any such matters may be materially different from the Company's estimates, which could result in the need to adjust the liability and record additional expenses.

Ruckus Wireless v. NETGEAR

On May 5, 2008, a lawsuit was filed against the Company by Ruckus Wireless (“Ruckus”), a developer of Wi-Fi technology, in the U.S. District Court, Northern District of California (case number C08-2310-PJH (“NETGEAR I”)). Ruckus alleges that the Company infringes U.S. Patent Nos. 7,358,912 ("the '912 Patent") and 7,193,562 ("the '562 Patent") in the course of deploying Wi-Fi antenna array technology in its WPN824 RangeMax wireless router. Ruckus also sued Rayspan Corporation alleging similar claims of patent infringement. The Company filed its answer to the lawsuit in the third quarter of 2008. The Company and Rayspan Corporation jointly filed a request for inter partes reexamination of the Ruckus patents with the USPTO on September 4, 2008. The Court issued a stay of the litigation while the reexaminations proceeded in the USPTO. On November 28, 2008, a reexamination was ordered with respect to claims 11-17 of the '562 Patent, but denied with respect to claims 1-10 and 18-36. On December 17, 2008, the defendants jointly filed a petition to challenge the denial of reexamination of claims 1-10 and 18-36 of the '562 Patent. In July 2009, the petition was denied, and the remaining claims 11-17 were confirmed by the USPTO. On December 2, 2008, reexamination was granted with regard to the '912 Patent. In early October 2009, the Company received an Action Closing Prosecution in the reexamination of the '912 Patent. All the claims of the '912 Patent, with the exception of the unchallenged claims 7 and 8, were finally rejected by the USPTO. On October 30, 2009, Ruckus submitted an “after-final” amendment in the '912 Patent reexamination proceeding. The Company's comments to Ruckus' “after-final” amendment were submitted on November 30, 2009. On December 1, 2009, the Court found that bifurcating the '562 Patent from the '912 Patent and commencing litigation on the '562 Patent while the USPTO reexamination process and appeals are still pending would be an inefficient use of the Court's resources. Accordingly, the Court ruled that the litigation stay should remain in effect. On September 12, 2010, the Company filed the rebuttal brief in its appeals of the USPTO's rulings during the reexamination of the '562 Patent, and the Company requested an oral hearing with the Board of Appeals at the USPTO to discuss this brief. On September 13, 2010, Ruckus filed a notice of appeal of the '912 Patent to appeal the adverse rulings it received from the USPTO in the reexamination of this patent. The Company filed a respondent's brief in the '912 Patent case on January 24, 2011. An oral hearing in the '562 case was set for February 1, 2011, but the Company decided to cancel it and let the USPTO decide the '562 case based solely on the previously submitted papers. On May 13, 2011, the USPTO indicated that the Company was successful in its appeal of the examiner's previous decision to allow claims 11-17 in the '562 reexamination, and the USPTO Board of Appeals reversed the examiner's decision and declared those claims invalid. On June 13, 2011, Ruckus submitted a request for rehearing by the Board of Appeals of its decision to reject claims 11-17 of the '562 Patent. On September 28, 2011, the Board of Patent Appeals and Interferences denied Ruckus's request for a rehearing in the '562 Patent reexamination case. Ruckus did not timely file a notice of appeal to the Court of Appeals for the Federal Circuit appealing the USPTO's cancellation of claims 11-17 of the '562 patent. Therefore, a reexamination certificate will issue with claims 11-17 cancelled and claims 1-10 and 18-36 confirmed.

On November 4, 2009, Ruckus filed a complaint in the U.S. District Court, Northern District of California (case number C09-5271-PJH (“NETGEAR II”)), alleging the Company and Rayspan Corporation infringe a patent that is related to the patents previously asserted against the Company and Rayspan Corporation by Ruckus, as discussed above. This asserted patent in this second case is U.S. Patent No. 7,525,486 entitled “Increased wireless coverage patterns.” As with the previous Ruckus action, the WPN824 RangeMax wireless router is the alleged infringing device. The Company challenged the sufficiency of Ruckus's complaint in this new action and moved to dismiss the complaint. Ruckus opposed this motion. The Court partially agreed with the Company's motion and ordered Ruckus to submit a new complaint, which Ruckus did. The initial case management conference occurred on February 11, 2010. On March 25, 2010, the Court ordered a stay until the completion of the reexamination proceedings instigated on the patents in NETGEAR I.

Ruckus and the Company in December of 2012 requested that the stay of the California actions be lifted. This request to lift the stay was predicated on Ruckus's Withdrawal of Appeal and Cancellation of Claims ("Withdrawal") of the '912 Patent that was on appeal in re-examination at the USPTO and that was asserted by Ruckus in NETGEAR I. Through the filing of the Withdrawal, Ruckus announced its intent to withdraw and its actual withdrawal of its appeal of claims 1, 4-9-14, 18, 19, and 22-29 in re-examination (the "Appealed Claims"), and Ruckus further announced its intent to cancel and its actual cancellation of claims 30-31 in re-examination (the "Cancelled Claims"). Claims 2, 3, 15-17, 20, and 21 had previously been cancelled during re-examination

19


(the "Previously Cancelled Claims"). Because the Appealed Claims and the Cancelled Claims represented the entirety of the claims remaining for consideration in re-examination, and the Previously Cancelled Claims are no longer of record in the offensive case by Ruckus against the Company, there are no remaining claims for re-examination in the '912 Patent and the '912 Patent cannot be asserted against the Company. Thus, the Company and Ruckus requested that the Court lift the stay of this litigation and calendar a case management conference. The case management conference occurred on January 3, 2013. At that time, the Court scheduled a claim construction hearing for August of 2013. The parties to the lawsuit - the Company, Rayspan, and Ruckus - also agreed that Ruckus's two offensive cases against the Company and Rayspan should be consolidated because the cases involve similar complaints and common questions of law and fact and doing so will advance the interests of judicial economy.

Ruckus served its infringement contentions on the Company on January 17, 2013, and the Company's invalidity contentions were served on March 4, 2013. On March 5, 2013, Ruckus and Rayspan filed a stipulation with proposed order dismissing Rayspan from the case, and, on March 6, 2013, the Court dismissed with prejudice Rayspan. On March 14, 2013, Ruckus filed its Second Amended Complaint, as ordered by the Court. Ruckus did not add any patents, but is attempting to add claims of breach of contract and misappropriation of trade secrets by the Company. The Company believes that Ruckus contravened the Court's order that there should not be a “substantial change” in the Second Amended Complaint by adding the breach of contract and misappropriation of trade secrets claims to the lawsuit. Consequently, the Company filed a Motion to Strike the newly added claims.

In addition in the patent prong of the litigation, the parties have exchanged claim terms that they believe the Court needs to construe. Discovery is ongoing.

On November 19, 2010, the Company filed suit against Ruckus in the U.S. District Court, District of Delaware for infringement of four of the Company's patents. The Company alleges that Ruckus's manufacture, use, sale or offers for sale within the United States or importation into the United States of products, including wireless communication products, infringe United States Patent Nos. 5,812,531, 6,621,454, 7,263,143, and 5,507,035, all owned by the Company. The Company granted Ruckus an extension to file its answer to the Company's suit, and on January 11, 2011, Ruckus filed a motion to dismiss the Company's suit based on insufficient pleadings. The Company filed its response to Ruckus's motion on January 31, 2011. In addition, on May 6, 2011, Ruckus filed a motion to transfer venue to the Northern District of California. The Court denied Ruckus' motion to transfer the case to the Northern District of California and granted the Company leave to file an amended complaint rather than address the Ruckus motion to dismiss based on insufficient pleadings. The Company filed the proposed amended complaint. Nevertheless, Ruckus filed a second motion to dismiss based on insufficient pleadings by the Company. On March 28, 2012, the Delaware District Court in a memorandum opinion and order denied Ruckus's second motion to dismiss. A scheduling conference occurred April 18, 2012, and the Company submitted its initial disclosures in the case on May 15, 2012. On May 31, 2012, Ruckus filed its third motion to dismiss, asserting that the Company cannot sustain its indirect infringement and willfulness allegations without pleading pre-suit knowledge of the patents. The Company responded to Ruckus's motion to dismiss on June 18, 2012. The Court released the schedule for the case on June 8, 2012 with Claim Construction and Summary Judgment Hearings scheduled for August 9, 2013 and a ten day jury trial scheduled for October 21, 2013. On July 13, 2012, the Company added to its complaint against Ruckus an allegation of infringement of patent number 6,512,480 (“System and method for narrow beam antenna diversity in an RF data transmission system”) by Ruckus's ZoneFlex and MediaFlex products. The Company and Ruckus participated in a court-ordered mediation on September 13, 2012 in Delaware, and the parties did not come to an agreement to settle the litigation pending between the parties. Fact discovery closed on December 14, 2012. Expert discovery was completed in March, 2013, and all expert reports have been served, including the Company's expert report on infringement on all five patents-in-suit that was served on January 15, 2013. Claim construction briefing was completed by the parties on April 30, 2013.

It is too early to reasonably estimate the financial impact to the Company as a result of the Ruckus litigation matters.

Northpeak Wireless, LLC v. NETGEAR

In October 2008, a lawsuit was filed against the Company and 30 other companies by Northpeak Wireless, LLC (“Northpeak”) in the U.S. District Court, Northern District of Alabama. Northpeak alleges that the Company's 802.11b compatible products infringe certain claims of U.S. Patent Nos. 4,977,577 ("the '577 Patent") and 5,987,058 ("the '058 Patent"). The Company filed its answer to the lawsuit in the fourth quarter of 2008. On January 21, 2009, the District Court granted a motion to transfer the case to the U.S. District Court, Northern District of California. In August 2009, the parties stipulated to a litigation stay pending a reexamination request to the USPTO on the asserted patents. The reexaminations of the patents are proceeding. In March 2011, the USPTO confirmed the validity of the asserted claims of the '577 Patent over certain prior art references. In April 2011, the USPTO issued a final office action rejecting both asserted claims of the '058 Patent as being obvious in light of the prior art. In March of 2013, the Board of Patent Appeals and Interferences of the USPTO affirmed the rejection of both asserted claims of the '058 Patent. The case remains stayed by stipulation, and no trial date has been set. The Company does not expect there to be a material financial impact to the Company because of this litigation matter.


20


Ericsson v. NETGEAR

On September 14, 2010, Ericsson Inc. and Telefonaktiebolaget LM Ericsson (collectively “Ericsson”) filed a patent infringement lawsuit against the Company and defendants D-Link Corporation, D-Link Systems, Inc., Acer, Inc., Acer America Corporation, and Gateway, Inc. in the U.S. District Court, Eastern District of Texas alleging that the defendants infringe certain Ericsson patents. The Company has been accused of infringing eight U.S. patents: 5,790,516; 6,330,435; 6,424,625; 6,519,223; 6,772,215; 5,987,019; 6,466,568; and 5,771,468 ("the '468 Patent"). Ericsson generally alleges that the Company and the other defendants have infringed and continue to infringe the Ericsson patents through the defendants' IEEE 802.11-compliant products. In addition, Ericsson alleged that the Company infringed the claimed methods and apparatuses of the '468 Patent through the Company's PCMCIA routers. The Company filed its answer to the Ericsson complaint on December 17, 2010 where it asserted the affirmative defenses of noninfringement and invalidity of the asserted patents. On March 1, 2011, the defendants filed a motion to transfer venue to the District Court for the Northern District of California and their memorandum of law in support thereof. On March 21, 2011, Ericsson filed its opposition to the motion, and on April 1, 2011, defendants filed their reply to Ericsson's opposition to the motion to transfer. On June 8, 2011, Ericsson filed an amended complaint that added Dell, Toshiba and Belkin as defendants. At the status conference held on Jun 9, 2011, the Court set a Markman hearing for June 28, 2012 and trial for June 3, 2013. On June 14, 2011, Ericsson submitted its infringement contentions against the Company. On September 29, 2011, the Court denied the defendants motion to transfer venue to the Northern District of California. In advance of the Markman hearing, the parties on March 9, 2012 exchanged proposed constructions of claim terms and on April 9, 2012 filed the Joint Claim Construction Statement with the District Court. On May 8, 2012, Ericsson submitted its opening Markman brief and on June 1, 2012 the defendants submitted their responsive Markman brief. Ericsson's Reply Markman brief was submitted June 15, 2012, and on June 28, 2012 the Markman hearing was held in the Eastern District of Texas. On June 21, 2012, Ericsson dismissed the '468 Patent (“Multi-purpose base station”) with prejudice and gave the Company a covenant not to sue as to products in the marketplace now or in the past. On June 22, 2012, Intel filed its Complaint in Intervention, meaning that Intel is now an official defendant in the Ericsson case. The parties recently completed fact discovery and are exchanging expert reports. During the exchange of the expert reports, Ericsson dropped the '516 patent (the OFDM “pulse shaping” patent). In addition, Ericsson dropped the '223 Patent (packet discard patent) against all the defendants' products, except for those products that use Intel chips. Thus, Ericsson has now dropped the '468 Patent (wireless base station), the '516 Patent (OFDM pulse shaping), and the '223 Patent (packet discard patent) for all non-Intel products. The five remaining patents are all only asserted against 802.11-compliant products.

At a Court ordered mediation in Dallas on January 15, 2013, the parties did not come to an agreement to settle the litigation. On March 8, 2013, the parties received the Markman (claim construction) Order in response to the claim construction briefing and claim construction hearing. In addition, expert reports of the parties have been filed. The Court has set a hearing date for the permitted summary judgment and Daubert motions of May 9, 2013. It is too early to reasonably estimate any financial impact to the Company because of this litigation matter.

Fujitsu v. NETGEAR

On September 3, 2010, Fujitsu filed a complaint against the Company, Belkin International, Inc., Belkin, Inc., D−Link Corporation, D−Link Systems, Inc., ZyXEL Communications Corporation, and ZyXEL Communications, Inc. in the U.S. District Court, Northern District of California alleging that certain of the Company's products infringe upon Fujitsu's U.S. patent Re. 36,769 patent ("the '769 Patent") through various cards and interface devices within the Company's products. The Company answered the complaint denying the allegations of infringement and claiming that the asserted patent is invalid. In addition, the Company filed a motion to disqualify counsel for Fujitsu. The Company's disqualification motion was argued before the Court on December 16, 2010, and on December 22, 2010, the Court granted the Company's motion and disqualified counsel for Fujitsu. In response, Fujitsu requested a stipulation from all parties to reset the case management conference and scheduled hearing dates for the motions to dismiss. The initial case management conference was held on March 18, 2011. A claim construction hearing was held on October 14, 2011. On February 3, 2012, the Court issued its claim construction order based on the claim construction hearing. On March 3, 2012, the Fujitsu patent emerged from the latest ex-parte reexamination in the USPTO that was initiated by Belkin, Inc. The USPTO examiner rejected five of the “wired” claims in the patent, but found that the majority of claims of the patent were valid. Expert discovery opened May 4, 2012 with the exchange of initial expert reports. Rebuttal expert reports were exchanged on May 25, 2012, and expert discovery closed on June 8, 2012. A further case management conference was held on May 9, 2012 where the Court ordered that by June 12, 2012 Fujitsu must file a status report narrowing its asserted claims to no more than 10 claims, and narrowing the accused products accordingly, and Fujitsu filed the status report on the due date. By July 3, 2012, the Court ordered the Defendants to file a status report reducing its number of prior art references and obviousness combinations, and Defendants filed the status report on the due date. The Court also limited Fujitsu to one motion for summary judgment and allowed Defendants to jointly file two summary judgment motions. The Court further implemented the following dates: last day to file disposition motions of July 26, 2012; hearing on dispositive motions on September 6, 2012; final pretrial conference on November 1, 2012; and jury trial beginning November 26, 2012. The Court ordered the length of the trial to be 10 days. The Court also set a further case management conference for September 6, 2012, immediately following the hearing on any

21


dispositive motions filed. The parties submitted their summary judgment motions on July 26, 2012. Fujitsu submitted a summary judgment motion arguing that the defendants infringe the '769 Patent. The defendants submitted two summary judgment motions. The first argued that any infringement by the defendants was not willful, and the second argued that the '769 Patent is invalid.

On September 28, 2012, the Court issued its summary judgment ruling. The Court did not invalidate the '769 Patent and ruled that some of the Company's cards infringed the '769 Patent.

In addition, the Court rejected Fujitsu's narrowing arguments for the terms “card” and “slot” that are contained in the claims of the patent in suit, expressly holding that “card” should be given its plain and ordinary meaning and agreeing with Defendants that “slot” was a broad term meaning “an opening.”

After a 10-day trial in November and December of 2012,the eight-member jury sided with the remaining defendants - NETGEAR, Belkin, and D-Link - and found Fujitsu's claims under the '769 patent for a "card type input/output interface device" to be invalid. The jury also found the defendants had not caused infringement by selling routers and access points that were compatible with wireless interface cards. The parties then entered into a final settlement agreement ending the case on March 7, 2013. There was no material financial impact to the Company because of this settlement agreement.
 
NETGEAR v. Innovatio IP Ventures LLC.

On November 16, 2011, the Company filed a declaratory judgment action in the District of Delaware for non-infringement and invalidity of 17 WiFi-related patents brought in the approximately 15 actions throughout the United States by Innovatio IP Ventures LLC (“Innovatio”) against end user customers of the Company and other companies. Shortly after filing the declaratory judgment action, the Company filed a response supporting Cisco Systems, Inc.'s ("Cisco") and Motorola Solutions, Inc.'s ("Motorola") Motion to Transfer for Coordinated Pretrial Proceedings Pursuant to 28 U.S.C. § 1407 that was before the United States Judicial Panel on Multidistrict Litigation (“JPML”). The pending motion to transfer would serve to consolidate all of the Innovatio lawsuits - including the Company's pending declaratory judgment action in Delaware-and transfer them to a single court for coordinated pretrial proceedings. On December 28, 2011, the JPML issued an order transferring the Innovatio actions throughout the United States, including the Company's declaratory judgment action, to the United States District Court for the Northern District of Illinois. Thus, the Company's declaratory judgment action and approximately 15 other similar cases will now proceed in the Northern District of Illinois in a consolidated fashion. The status conference originally scheduled for March 27, 2012 was postponed by the District Court until April 10, 2012. At the conference, the District Court discussed two primary issues (1) case phasing (i.e., which subset of defendants should proceed after Markman Hearing through the remaining proceedings) and (2) the defendants' proposal on damages contentions. The District Court stated that it tentatively felt that the case should proceed with one or more WiFi hardware suppliers after the Markman Hearing, but was going to reserve a final ruling on the issue. The District Court also ordered that the parties prepare a joint pretrial order reflecting the court's decisions and the schedule for the case. On July 10, 2012, Innovatio answered the Declaratory Judgment Complaint filed by the Company with various counterclaims, cross claims, and affirmative defenses. In its answer, Innovatio accused the Company of infringing six WiFi-related patents in addition to the 17 WiFi-related patents on which the Company brought its declaratory judgment action of non-infringement and invalidity. The Company filed its answer to Innovatio's various counterclaims, cross claims, and affirmative defenses on August 3, 2012. In addition, on October 1, 2012, Cisco, Motorola and the Company filed an amended complaint alleging racketeering, fraud, interference with contract, unfair business practices, and conspiracy, among other things, against Innovatio. On February 4, 2013, the Court dismissed the offensive claims of Cisco, Motorola, and the Company that alleged Innovatio was engaging in racketeering, fraud, and unfair business practices by demanding licensing fees from hotels, cafes and other businesses but left intact claims against Innovatio that allege breach of contract with respect to Innovatio's RAND obligations. Discovery in the case is ongoing, and the parties have already exchanged their Final Infringement, Unenforceability and Invalidity Contentions and Damages contentions. The Court has indicated, and the parties have agreed, that the Court is going to implement a special damages-focused proceeding prior to proceeding to the liability phase of the case. In this damages-focused proceeding, the Court will have a bench trial on certain licensing and damages issues. This damages-focused proceeding should culminate with a bench trial in August, 2013, but the final schedule has not been determined. Also, the liability trial date has not been set. It is too early to reasonably estimate any financial impact to the Company because of this litigation matter.


22


U.S. Ethernet Innovation, LLC v. NETGEAR

On June 22, 2012, U.S. Ethernet Innovations, LLC (“USEI”) sued the Company in the District Court for the Eastern District of Texas, alleging infringement of certain of its Ethernet-related patents: U.S. Patent Numbers 5,732,094 (“Method for automatic initiation of data transmission”); 5,434,872 (“Apparatus for automatic initiation of data transmission”); 5,299,313 (“Network interface with host independent buffer management”) and 5,530,874 (“Network adapter with an indication signal mask and an interrupt signal mask”). USEI is a patent holding entity with a nominal office in the Eastern District of Texas. The accused products include products such as the “Netgear RT311 Internet Gateway Router.” The Company received an extension until August 17, 2012 to answer the complaint. USEI has sued, in addition to the Company, the following companies on the same and other of its Ethernet-related patents: Ricoh Americas Corporation, TRENDnet, Inc., Xerox Corporation, Konica Minolta Business Solutions U.S.A., Inc., Freescale Semiconductor, Inc., Sharp Electronics Corporation, Digi International Inc., NetSilicon, Inc., Epson America, Inc., Cirrus Logic, Inc., Yamaha Corporation of America, Control4 Corporation, Samsung Electronics Co., Ltd., Samsung Electronics America, Inc., Samsung Telecommunications America, LLC, Samsung Austin Semiconductor, LLC, Oki Data Americas, Inc., STMicroelectronics N.V., and STMicroelectronics, Inc. (collectively, “Defendants”).

The Company received a further extension to answer the complaint and answered on September 4, 2012 via a 12(b)(6) motion to dismiss the complaint for various reasons, including a lack of pleading specificity. USEI responded to the Company's motion to dismiss under Rule 12(b)(6) on September 21, 2012. The Company submitted its Reply in Support of its Motion to Dismiss on October 1, 2012.

USEI served its infringement contentions on the Company on October 10, 2012. The Company filed its transfer motion for a transfer to the Northern District of California and supporting declarations on November 16, 2012. On December 3, 2012, Defendants filed their joint invalidity contentions.

Because the Eastern District of Texas's preferred time for deciding motions to transfer is after the Markman Hearing, the defendants filed a motion to stay the litigation pending the result of the Eastern District of Texas's decisions on the motion to transfer on January 29, 2013.

The Court has consolidated for discovery purposes USEI's cases against the aforementioned defendants and scheduled a consolidated Markman hearing for April 4, 2013 for the asserted patents. The Court also indicated that the court would consider any of Defendants' transfer motions as soon as possible. The trial date has been set for April 14, 2014.

On March 27, 2013, the Court issued a Memorandum Opinion and Order granting the Company's motion to transfer to the United States District Court for the Northern District of California, effective on April 16, 2013. In response, on April, 12, 2013, USEI filed a motion for clarification and/or reconsideration of the venue order. Specifically, USEI seeks to delay the transfer until the Markman order in the Eastern District of Texas case becomes final under the guise that it is more efficient to allow the Texas court to construe the terms. The Company opposed USEI's motion. The mediation in this case that was scheduled for May 15, 2013 has been cancelled.

It is too early to reasonably estimate any financial impact to the Company because of this litigation matter.

ReefEdge Networks, LLC v. NETGEAR, Inc.

On September 17, 2012, the Company was sued by ReefEdge Networks, LLC, a non-practicing entity. The Company received an extension from the plaintiff until November 8, 2012 to answer the complaint and answered the complaint on that date.

The complaint alleges that NETGEAR infringes three related patents: 6,633,761 B1; 6,975,864 B2; 7,197,308 B2. In general terms, these asserted patents involve seamlessly handing-off portable wireless devices from one access point to another so as to provide roaming within a wireless network.

The complaint specifically accuses the Company's ProSafe wireless controller of infringing these three patents. On August 15, 2012, ReefEdge filed complaints in Delaware against Aruba Networks Inc., Cisco Systems Inc., Meru Networks Inc., and Ruckus Wireless Inc. alleging infringement of the same three patents. In the second tranche of lawsuits, ReefEdge sued--in addition to the Company-Brocade Communications Systems, Inc., Extreme Networks Inc., ADTRAN, Inc., Alcatel-Lucent Inc., D-Link Systems, Inc., Enterasys Networks, Inc., Motorola Solutions Inc., CDW Corporation, Avaya Inc., and ZyXEL Communications Corporation. The Company has hired defense counsel and is evaluating ReefEdge's allegations. It is too early to reasonably estimate any financial impact to the Company because of this litigation matter.


23


Pragmatus Telecom, LLC v. NETGEAR, Inc.

On December 6, 2012, Pragmatus Telecom, LLC (“Pragmatus”), filed a lawsuit against the Company asserting that the Company's use of a system “to provide live chat service over the Internet” infringes U.S. Patent Nos. 6,311,231, 6,668,286, and 7,159,043 ("'231 patent", "'286 patent", and "'043 patent", respectively).

The '231 patent is entitled "Method and System for Coordinating Data and Voice Communications via Customer Contact,” the '286 patent is entitled "Method and System for Coordinating Data and Voice Communications via Customer Contact Channel Changing System Over IP," and the '043 patent is entitled "Method and System for Coordinating Data and Voice Communications via Contact Channel Changing System," The patents very generally allegedly relate to “live chat" services of companies, which can give customers the ability to exchange text messages with a virtual or real customer support person. It appears that most companies named in the various lawsuits by Pragmatus license the “live chat” technology and software from a third-party supplier. A few of these third-party suppliers have been named in some of the over 100 lawsuits filed by Pragmatus in California, Delaware, and the Eastern District of Texas, and two third-party suppliers of text-chat (LivePerson and LogMeIn) have filed declaratory judgment actions on the patents in suit in Delaware. There is a pending reexamination on one of the three asserted patents.

Pragmatus and the Company agreed to extend the deadline for the Company to answer or otherwise respond to Pragmatus's complaint until February 11, 2013. The Company answered the complaint on that day by denying Pragmatus's infringement allegations and requesting a declaratory judgment by the Court that the patents in suit are not infringed and invalid. On February 20, 2013, the Company filed a motion to stay the case, and, on March 6, 2013, Pragmatus filed its opposition to the Company's motion to stay the case. The Company filed its reply on March 13, 2013. The Court has not yet ruled on the Company's motion. It is too early to reasonably estimate any financial impact to the Company because of this litigation matter.

Voice Integration Technologies, LLC v. NETGEAR, Inc.

On December 28, 2012, Voice Integration Technologies, LLC (“VIT”) sued the Company alleging direct, indirect, and willful infringement of U.S. Patent No. 7,127,048 (the "'048 Patent"), entitled "Systems and Methods for Integrating Analog Voice Service and Derived POTS Voice Service in a Digital Subscriber Line Environment." The '048 Accused Products include integrated access device ("IAD") products that allow users to place and receive both telephone and VoIP calls over the same telephone line, and VIT specifically named the Company's DG 834GV Integrated ADSL2+ Modem and Wireless Router with Voice in the complaint.

The Company was served with the complaint on February 6, 2013, and on February 25, 2013 received an extension to answer the complaint until April 12, 2013. In parallel, the Company reached out to VIT requesting that the case against the Company be voluntarily dismissed by VIT since the Company has sold no products in the U.S. that could in good faith be argued to infringe the '048 Patent. Accordingly, VIT agreed to dismiss its suit without prejudice, and, on March 13, 2013, VIT filed with the Court its Notice of Voluntary Dismissal as to the Company. There was no financial impact to the Company because of this litigation matter.

IP Indemnification Claims

In its sales agreements, the Company typically agrees to indemnify its direct customers, distributors and resellers (the “Indemnified Parties”) for any expenses or liability resulting from claimed infringements by the Company's products of patents, trademarks or copyrights of third parties that are asserted against the Indemnified Parties, subject to customary carve outs. The terms of these indemnification agreements are generally perpetual after execution of the agreement. The maximum amount of potential future indemnification is generally unlimited. From time to time, the Company receives requests for indemnity and may choose to assume the defense of such litigation asserted against the Indemnified Parties.

Environmental Regulation

The European Union (“EU”) enacted the Waste Electrical and Electronic Equipment Directive, which makes producers of electrical goods, including home and commercial business networking products, financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. The deadline for the individual member states of the EU to transpose the directive into law in their respective countries was August 13, 2004 (such legislation, together with the directive, the “WEEE Legislation”). Producers participating in the market were financially responsible for implementing these responsibilities under the WEEE Legislation beginning in August 13, 2005. The Company adopted the authoritative guidance for asset retirement and environmental obligations in the third quarter of fiscal 2005 and has determined that its effect did not have a material impact on the Company's consolidated results of operations and financial position for the three months ended March 31, 2013 and April 1, 2012, The WEEE Directive was recast on July 24, 2012, published on August 13, 2012, and will be implemented by all member states on February 14, 2014. The Company expects no material impact on its consolidated results of operations and financial

24


positions due to this recasting. Similar WEEE Legislation has been or may be enacted in other jurisdictions, including in the United States, Canada, Mexico, China, India, Australia and Japan. The Company continues to monitor WEEE Legislation and similar legislation in other jurisdictions as individual countries issue their implementation guidance. The Company believes it has met the applicable requirements of current WEEE Legislation and similar legislation in other jurisdictions, to the extent implementation requirements has been published.

Additionally, the EU enacted the Restriction of Hazardous Substances Directive (“RoHS Legislation”), the REACH Regulation, Packaging Directive and the Battery Directive. EU RoHS Legislation, along with similar legislation in China, requires manufacturers to ensure certain substances, including polybrominated biphenyls (“PBD”), polybrominated diphenyl ethers (“PBDE”), mercury, cadmium, hexavalent chromium and lead (except for allowed exempted materials and applications), are below specified maximum concentration values in certain products put on the market after July 1, 2006. The RoHS Directive was recast on July 21, 2011 and went into force on January 3, 2013. The Company expects no material impact on its consolidated results of operations and financial positions due to this recasting. The REACH Regulation requires manufacturers to ensure the published lists of substances of very high concern in certain products are below specified maximum concentration values. The Battery Directive controls use of certain types of battery technology in certain products and requires mandatory marking. The Company believes it has met the requirements of the RoHS Directive Legislation, the REACH Regulation and the Battery Directive Legislation.

Additionally, the EU enacted the Energy Using Product (“EuP”) Directive, which came into force in August of 2007. The EuP Directive required manufacturers of certain products to meet minimum energy efficiency performance requirements. These requirements were documented in EuP implementing measures issued for specific product categories. The implementing measures affecting the Company's products are minimum power supply efficiencies and may include required equipment standby modes, which also reduce energy consumption. The EuP Directive was repealed in November of 2009 and replaced by the Energy Related Products ("ErP") Directive, which includes the same implementing measures of the former EuP Directive and new implementing measures applicable to the Company's products. The Company is in compliance with applicable implementing measures of the ErP Directives since it came into force.

10.
Stockholders' Equity

Common Stock Repurchase Program

On October 21, 2008, the Company’s Board of Directors authorized management to repurchase up to 6,000,000 shares of the Company’s outstanding common stock. Under this authorization, the timing and actual number of shares subject to repurchase are at the discretion of management and are contingent on a number of factors, such as levels of cash generation from operations, cash requirements for acquisitions and the price of the Company’s common stock. The Company did not repurchase any shares under this authorization during the three months ended March 31, 2013.
The Company repurchased approximately 8,000 shares, or $0.3 million of common stock under a repurchase program to help administratively facilitate the withholding and subsequent remittance of personal income and payroll taxes for individuals receiving RSUs during the three months ended March 31, 2013.
These shares were retired upon repurchase. The Company’s policy related to repurchases of its common stock is to charge the excess of cost over par value to retained earnings. All repurchases were made in compliance with Rule 10b-18 under the Securities Exchange Act of 1934, as amended.
Cumulative Other Comprehensive Income, Net

The following table sets forth the components of cumulative other comprehensive income, net of related taxes, as of March 31, 2013 and December 31, 2012 (in thousands):
 
 
As of
 
March 31,
2013
 
December 31,
2012
Net unrealized gain (loss) on derivative instruments
$
127

 
$
(24
)
Net unrealized gain on available-for-sale securities
12

 
28

Total cumulative other comprehensive income, net of taxes
$
139

 
$
4



25


11.
Employee Benefit Plans
The Company grants options and restricted stock units from the Amended and Restated 2006 Long-Term Incentive Plan, and 2003 Stock Plan under which awards may be granted to all employees. Award vesting periods for these plans are generally four years. As of March 31, 2013, a total of 2,670,789 shares were reserved for future grants under these plans.
Additionally, the Company sponsors an Employee Stock Purchase Plan (the “ESPP”), pursuant to which eligible employees may contribute up to 10% of base compensation, subject to certain income limits, to purchase shares of the Company’s common stock. Employees may purchase stock semi-annually at a price equal to 85% of the fair market value on the purchase date. As of March 31, 2013, a total of 350,274 shares were reserved for future grants under the ESPP.
Option Activity
Stock options activity during the three months ended March 31, 2013, was as follows:
 
 
Options Outstanding
 
Number of shares
 
Weighted Average Exercise Price Per Share
 
(in thousands)
 
(in dollars)
December 31, 2012
4,324

 
$
29.29

Granted
138

 
36.80

Exercised
(108
)
 
23.64

Cancelled and expired
(59
)
 
33.54

March 31, 2013
4,295

 
$
29.62


RSU Activity

RSU activity during the three months ended March 31, 2013, was as follows:

 
RSUs Outstanding
 
Number of shares
 
Weighted Average Grant Date Fair Value Per Share
 
(in thousands)
 
(in dollars)
December 31, 2012
112

 
$
28.36

RSUs granted
1

 
36.80

RSUs vested
(20
)
 
11.41

RSUs cancelled
(1
)
 
38.16

March 31, 2013
92

 
$
32.11


Valuation and Expense Information
The fair value of each option award is estimated on the date of grant using a Black-Scholes-Merton option valuation model that uses the assumptions noted in the following table. The estimated expected term of options granted is derived from historical data on employee exercise and post-vesting employment termination behavior. The risk free interest rate is based on the implied yield currently available on U.S. Treasury securities with a remaining term commensurate with the estimated expected term. Expected volatility is based on historical volatility over the most recent period commensurate with the estimated expected term.
The following table sets forth the weighted-average assumptions used to fair value option grants during the three months ended March 31, 2013 and April 1, 2012 based on its historical experience.
 

26


 
Three Months Ended
 
March 31,
2013
 
April 1,
2012
Expected life (in years)
4.4

 
4.3

Risk-free interest rate
0.74
%
 
0.65
%
Expected volatility
50.3
%
 
52.5
%
Dividend yield

 


The following table sets forth the total stock-based compensation expense resulting from stock options, RSUs and the ESPP included in the Company’s unaudited condensed consolidated statements of operations (in thousands):
 
 
Three Months Ended
 
March 31,
2013
 
April 1,
2012
Cost of revenue
$
189

 
$
270

Research and development
672

 
611

Sales and marketing
1,230

 
1,194

General and administrative
1,499

 
1,317

Total stock-based compensation
$
3,590

 
$
3,392


As of March 31, 2013, $22.8 million of total unrecognized compensation cost related to stock options, adjusted for estimated forfeitures, is expected to be recognized over a weighted-average period of 2.59 years. Additionally, $1.1 million of total unrecognized compensation cost related to non-vested RSUs, adjusted for estimated forfeitures, is expected to be recognized over a weighted-average period of 1.06 years.

12.
Segment Information, Operations by Geographic Area and Customer Concentration

Operating segments are components of an enterprise about which separate financial information is available and is regularly evaluated by management, namely the Chief Operating Decision Maker (“CODM”) of an organization, in order to determine operating and resource allocation decisions. By this definition, the Company operates in three specific business units: retail, commercial, and service provider. The retail business unit consists of high performance, dependable and easy-to-use home networking, storage and digital media products to connect people with the Internet and their content and devices. The commercial business unit consists of business networking, storage and security solutions without the cost and complexity of Big IT. The service provider business unit consists of made-to-order and retail proven, whole home networking solutions sold to service providers for sale to their customers. Each business unit is managed by a Senior Vice President/General Manager. The Company believes this structure enables it to better focus its efforts on the Company’s core customer segments and allows it to be more nimble and opportunistic as a company overall.

In the second quarter of 2012, the CEO began temporarily serving as interim General Manager of the commercial business unit due to the previous general manager's departure from the Company. As of March 31, 2013, the CEO continues to serve as interim general manager until a replacement is established.

The results of the reportable segments are derived directly from the Company’s management reporting system. The results are based on the Company’s method of internal reporting and are not necessarily in conformity with accounting principles generally accepted in the United States. Management measures the performance of each segment based on several metrics, including contribution income. Segment contribution income includes all product line segment revenues less the related cost of sales, research and development and sales and marketing costs. Contribution income is used, in part, to evaluate the performance of, and allocate resources to, each of the segments. Certain operating expenses are not allocated to segments because they are separately managed at the corporate level. These unallocated indirect costs include corporate costs, such as corporate research and development, general and administrative costs, stock-based compensation expenses, amortization of intangibles, acquisition-related integration costs, restructuring costs, litigation reserves and interest and other income (expense), net. The Company does not evaluate operating segments using discrete asset information.


27


Financial information for each reportable segment and a reconciliation of segment contribution income to income before income taxes is as follows (in thousands, except percentage data):

 
Three Months Ended
 
March 31,
2013
 
April 1,
2012
Net revenues:
 
 
 
Retail
$
126,322

 
$
128,977

Commercial
70,851

 
74,632

Service provider
96,226

 
122,011

Total net revenues
$
293,399

 
$
325,620

Contribution income:
 
 
 
Retail
$
18,618

 
$
26,272

Retail contribution margin
14.7
%
 
20.4
%
Commercial
13,811

 
12,845

Commercial contribution margin
19.5
%
 
17.2
%
Service Provider
9,491

 
12,930

Service Provider contribution margin
9.9
%
 
10.6
%
Total segment contribution income
41,920

 
52,047

Corporate and unallocated costs
(12,466
)
 
(11,363
)
Amortization of intangible assets (1)
(1,471
)
 
(947
)
Stock-based compensation expense
(3,590
)
 
(3,392
)
Restructuring and other charges
30

 

Acquisition related expense
(710
)
 

Litigation reserves, net
(48
)
 
(151
)
Interest income
149

 
119

Other income (expense), net
74

 
(601
)
Income before income taxes
$
23,888

 
$
35,712

________________________________
(1)
Amount excludes amortization expense related to patents within purchased intangible assets in costs of revenues.

The Company conducts business across three geographic regions: Americas, Europe, Middle-East and Africa (“EMEA”) and Asia Pacific ("APAC'). Net revenue by geography comprises gross revenue less such items as end-user customer rebates and other sales incentives deemed to be a reduction of net revenue per the authoritative guidance for revenue recognition, sales returns and price protection. For reporting purposes revenue is attributed to each geographic region based on the location of the customer. The following table shows net revenue by geography for the periods indicated (in thousands):
 
 
Three Months Ended
 
March 31,
2013
 
April 1,
2012
United States
$
153,713

 
$
164,745

Americas (excluding U.S.)
2,963

 
3,610

United Kingdom
40,858

 
49,394

EMEA (excluding U.K.)
66,267

 
75,687

APAC
29,598

 
32,184

Total net revenue
$
293,399

 
$
325,620


28



Long-lived assets, comprising fixed assets, are reported based on the location of the asset. Long-lived assets by geographic location are as follows (in thousands):

 
March 31,
2013
 
December 31,
2012
United States
$
8,876

 
$
9,898

Americas (excluding U.S.)
34

 
36

EMEA
1,072

 
1,173

China
7,173

 
6,763

APAC (excluding China)
1,232

 
1,155

 
$
18,387

 
$
19,025


Significant customers as a percentage of net revenues are as follows:
 
 
Three Months Ended
 
March 31,
2013
 
April 1,
2012
Virgin Media Limited and Affiliates (Service Provider)
9
%
 
11
%
All others
91
%
 
89
%
 
100
%
 
100
%

13.
Fair Value Measurements
The following tables summarize assets and liabilities measured at fair value on a recurring basis as of March 31, 2013 (in thousands):
 
 
As of March 31, 2013
 
Total
 
Quoted market
prices in active
markets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Cash equivalents—money-market funds
$
86,569

 
$
86,569

 
$

 
$

Available-for-sale securities—U.S. Treasuries (1)
140,527

 
140,527

 

 

Available-for-sale securities—Certificates of Deposit (1)
2,787

 
2,787

 

 

Foreign currency forward contracts (2)
1,116

 

 
1,116

 

Total assets measured at fair value
$
230,999

 
$
229,883

 
$
1,116

 
$

(1)
Included in short-term investments on the Company’s unaudited condensed consolidated balance sheet.
(2)
Included in prepaid expenses and other current assets on the Company’s unaudited condensed consolidated balance sheet.

 
As of March 31, 2013
 
Total    
 
Quoted market
prices in active
markets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Foreign currency forward contracts (3)
$
(503
)
 
$

 
$
(503
)
 
$

Total liabilities measured at fair value
$
(503
)
 
$

 
$
(503
)
 
$

(3)
Included in other accrued liabilities on the Company’s unaudited condensed consolidated balance sheet.

29


The following tables summarize assets and liabilities measured at fair value on a recurring basis as of December 31, 2012 (in thousands):
 
 
As of December 31, 2012
 
Total
 
Quoted market
prices in active
markets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Cash equivalents—money-market funds
$
3,061

 
$
3,061

 
$

 
$

Available-for-sale securities—Treasuries (1)
225,062

 
225,062

 

 

Available-for-sale securities-Certificates of Deposit (1)
2,783

 
2,783

 

 

Foreign currency forward contracts (2)
1,144

 

 
1,144

 

Total assets measured at fair value
$
232,050

 
$
230,906

 
$
1,144

 
$

 
(1)
Included in short-term investments on the Company’s unaudited condensed consolidated balance sheet.
(2)
Included in prepaid expenses and other current assets on the Company’s unaudited condensed consolidated balance sheet.

 
As of December 31, 2012
 
Total
 
Quoted market
prices in active
markets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Foreign currency forward contracts (3)
$
(1,619
)
 
$

 
$
(1,619
)
 
$

Total liabilities measured at fair value
$
(1,619
)
 
$

 
$
(1,619
)
 
$

(3)
Included in other accrued liabilities on the Company’s unaudited condensed consolidated balance sheet.
The Company’s investments in cash equivalents and available-for-sale securities are classified within Level 1 of the fair value hierarchy because they are valued based on quoted market prices in active markets. The Company enters into foreign currency forward contracts with only those counterparties that have long-term credit ratings of A+/A2 or higher. The Company’s foreign currency forward contracts are classified within Level 2 of the fair value hierarchy as they are valued using pricing models that take into account the contract terms as well as currency rates and counterparty credit rates. The Company verifies the reasonableness of these pricing models using observable market data for related inputs into such models. Additionally, the Company includes an adjustment for non-performance risk in the recognized measure of fair value of derivative instruments. At March 31, 2013 and December 31, 2012, the adjustment for non-performance risk did not have a material impact on the fair value of the Company’s foreign currency forward contracts. The carrying value of non-financial assets and liabilities measured at fair value in the financial statements on a recurring basis, including accounts receivable and accounts payable, approximate fair value due to their short maturities.

14.
Shipping and Handling Fees and Costs

The Company includes shipping and handling fees billed to customers in net revenue. Shipping and handling costs associated with inbound freight are included in cost of revenue and ending inventory. Shipping and handling costs associated with outbound freight are included in sales and marketing expenses and totaled $2.7 million for three months ended March 31, 2013, and $3.2 million for the three months ended April 1, 2012.

15.
Restructuring and Other Charges

The Company accounts for its restructuring plans under the authoritative guidance for exit or disposal activities. The Company presents expenses related to restructuring and other charges as a separate line item in its Consolidated Statements of Operations.

During the three months ended March 31, 2013, the Company recorded a restructuring adjustment to decrease the previously recorded severance liability related to the consolidation of product groups within the commercial business unit by $54,000. The Company expects to payout the remaining severance by the end of fiscal 2013. In addition, the Company incurred $24,000 in transition service costs in connection with the pending acquisition of the AirCard division of Sierra Wireless ("AirCard"). Refer to Note 16, Subsequent Events for additional information regarding the AirCard acquisition. There were no restructuring and other charges in the three months ended April 1, 2012.

30



The following tables provide a summary of accrued restructuring and other charges activity:

 
Accrued Restructuring and Other Charges at December 31, 2012
 
Additions
 
Cash Payments
 
Adjustments
 
Accrued Restructuring and Other Charges at March 31, 2013
 
(In thousands)
Restructuring
$
999

 
$

 
$
(692
)
 
$
(54
)
 
$
253

Acquisition transition costs

 
24

 

 

 
24

Restructuring and other charges
$
999

 
$
24

 
$
(692
)
 
$
(54
)
 
$
277


Note 16. Subsequent Event

Acquisition of AirCard Division of Sierra Wireless, Inc.

On April 2, 2013, the Company completed the acquisition of select assets and operations of the Sierra Wireless, Inc. AirCard business ("AirCard"), including several customer relationships, a world-class LTE engineering team, certain intellectual property, inventory and fixed assets. The acquisition qualifies as a business combination and will be accounted for using the acquisition method of accounting. The Company paid cash consideration of approximately $141 million on April 2, 2013, subject to further adjustments for inventory. The Company believes this acquisition will accelerate the mobile initiative of the service provider business unit to become a global leader in providing the latest in LTE data networking access devices. The initial accounting for the acquisition is incomplete as of the time of this filing, therefore the results of AirCard operations and unaudited pro forma results of operations for the acquisition will be included in the financial results of the quarter ending June 30, 2013.


31


Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

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. The retail business unit consists of high performance, dependable and easy-to-use home networking, home monitoring, storage and digital media products to connect consumers with the Internet and their content and devices. The commercial business unit consists of business networking, storage and security solutions without the cost and complexity of Big IT. The service provider business unit consists of made-to-order and retail proven, whole home networking solutions sold to service providers for sale to their customers. We conduct business across three geographic regions: Americas, Europe, Middle-East and Africa (“EMEA”) and Asia Pacific (“APAC”).

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 Apple Stores, Best Buy, Costco, Fry’s Electronics, K-mart, MicroSoft Stores, 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), Elkjop (Norway) and Lenovo (China). 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 first quarter of 2013, we experienced a 9.9% decrease in net revenue compared to the first quarter of 2012. This decrease was seen across all three geographic regions and reporting segments. On a geographic basis, the decrease was led by the Americas, largely attributable to a decrease in service provider sales. On a segment basis, the decrease was largely attributable to decreased sales of our broadband gateways and home wireless products to both retail and service provider customers and a decrease in network storage product sales to our commercial customers. The decrease in network storage product sales was driven by our inability to ship the backlog on our new line of ReadyNAS products. The new ReadyNAS product transition occurred late in the quarter and we experienced difficulty securing components, coupled with last minute bug fixes, which led to unanticipated delays. Operating expenses remained relatively flat year-over-year, as increased research and development expense was offset by a decrease in variable compensation expense.

Our service provider business has grown substantially over the years 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

32


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.

On April 2, 2013, we completed the acquisition of select assets and operations of the Sierra Wireless, Inc. AirCard business ("AirCard"), including several customer relationships, a world-class LTE engineering team, certain intellectual property, inventory and fixed assets. The acquisition qualifies as a business combination and will be accounted for using the acquisition method of accounting. We paid cash consideration of approximately $141 million on April 2, 2013, subject to further adjustments for inventory. We believe this acquisition will accelerate the mobile initiative of the service provider business unit to become a global leader in providing the latest in LTE data networking access devices. The results of AirCard operations and unaudited pro forma results of operations for the acquisition will be included in the financial results of the quarter ending June 30, 2013.


33


Results of Operations
The following table sets forth the unaudited condensed consolidated statements of operations and the percentage change for the three months ended March 31, 2013, with the comparable reporting periods in the preceding year.
 
 
Three Months Ended
 
March 31,
2013
 
% Change
 
April 1,
2012
 
(In thousands, except percentage data)
Net revenue
$
293,399

 
(9.9
)%
 
$
325,620

Cost of revenue
205,662

 
(8.9
)%
 
225,771

Gross profit
87,737

 
(12.1
)%
 
99,849

Operating expenses:
 
 
 
 
 
Research and development
15,338

 
8.6
 %
 
14,121

Sales and marketing
36,389

 
(6.6
)%
 
38,970

General and administrative
12,327

 
18.4
 %
 
10,413

Restructuring and other charges
(30
)
 
**

 

Litigation reserves, net
48

 
(68.2
)%
 
151

Total operating expenses
64,072

 
0.7
 %
 
63,655

Income from operations
23,665

 
(34.6
)%
 
36,194

Interest income
149

 
25.2
 %
 
119

Other income (expense), net
74

 
112.3
 %
 
(601
)
Income before income taxes
23,888

 
(33.1
)%
 
35,712

Provision for income taxes
8,545

 
(19.1
)%
 
10,565

Net income
$
15,343

 
(39.0
)%
 
$
25,147

 ** 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
 
March 31,
2013
 
April 1,
2012
Net revenue
100
 %
 
100
 %
Cost of revenue
70.1
 %
 
69.3
 %
Gross margin
29.9
 %
 
30.7
 %
Operating expenses:
 
 

Research and development
5.2
 %
 
4.3
 %
Sales and marketing
12.4
 %
 
12.1
 %
General and administrative
4.2
 %
 
3.2
 %
Restructuring and other charges
0.0
 %
 
 %
Litigation reserves, net
0.0
 %
 
0.0
 %
Total operating expenses
21.8
 %
 
19.6
 %
Income from operations
8.1
 %
 
11.1
 %
Interest income
0.0
 %
 
0.1
 %
Other income (expense), net
0.0
 %
 
(0.2
)%
Income before income taxes
8.1
 %
 
11.0
 %
Provision for income taxes
2.9
 %
 
3.3
 %
Net income
5.2
 %
 
7.7
 %


34



Three Months Ended March 31, 2013 Compared to Three Months Ended April 1, 2012

Net Revenue   

Our net revenue consists of gross product shipments, less allowance 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 $32.2 million, or 9.9%, to $293.4 million for the three months ended March 31, 2013, from $325.6 million for the three months ended April 1, 2012, primarily due to decreased sales of broadband gateways and home wireless products to our service provider customers. From a geographic perspective, this decrease was primarily driven by a decrease in EMEA and Americas revenue. For further discussion of net revenue by geographic region see the section entitled "Net Revenue by Geographic Region." For further discussion of net revenue by segment see the section entitled “Segment Information.”

Net Revenue by Geographic Region

 
Three Months Ended
 
March 31,
2013
 
% Change
 
April 1,
2012
 
(In thousands, except percentage data)
Americas
$
156,676

 
(6.9
)%
 
$
168,355

Percentage of net revenue
53.4
%
 
 
 
51.7
%
EMEA
$
107,125

 
(14.4
)%
 
$
125,081

Percentage of net revenue
36.5
%
 
 
 
38.4
%
APAC
$
29,598

 
(8.0
)%
 
$
32,184

Percentage of net revenue
10.1
%
 
 
 
9.9
%
Total net revenue
$
293,399

 
(9.9
)%
 
$
325,620



The decrease in Americas net revenue was primarily driven by a decrease in sales of our broadband gateways and home wireless products, partially offset by an increase in sales of our home security monitoring and automation products and switches. The decrease in EMEA and APAC net revenue was primarily driven by a decrease in sales of our broadband gateways, home wireless products, and network storage products. The decrease in network storage product sales was driven by our inability to ship the backlog on our new line of ReadyNAS products. The new ReadyNAS product transition occurred late in the quarter and we experienced difficulty securing components, coupled with some last minute bug fixes, which led to unanticipated delays.

Americas continues to represent the largest percentage of our net revenues, and APAC increased as a percentage of revenue. EMEA decreased as a percentage of revenues as we continued to see macroeconomic weakness in the European market.


35


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 and amortization expense of certain acquired intangibles. 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 and charges for excess or obsolete inventory. The following table presents costs of revenue and gross margin, for the periods indicated:

 
Three Months Ended
 
March 31,
2013
 
% Change
 
April 1,
2012
 
(In thousands, except percentage data)
Cost of revenue
$
205,662

 
(8.9
)%
 
$
225,771

Gross margin percentage
29.9
%
 
 
 
30.7
%

Cost of revenue decreased $20.1 million, or 8.9%, to $205.7 million for the three months ended March 31, 2013, from $225.8 million for the three months ended April 1, 2012. This decrease was commensurate with the decrease in net revenue. Our gross margin decreased to 29.9% for the three months ended March 31, 2013, from 30.7% for the three months ended April 1, 2012. The decrease was primarily due to additional warranty-related expenses incurred in the quarter, and an unfavorable mix of products shipped.

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 increase in absolute dollars and as a percentage of revenue as we broaden our core competencies and expand into new software and networking product technologies. The following table presents research and development expense, for the periods indicated:

 
Three Months Ended
 
March 31,
2013
 
% Change
 
April 1,
2012
 
(In thousands, except percentage data)
Research and development expense
$
15,338

 
8.6
%
 
$
14,121

Percentage of net revenue
5.2
%
 
 
 
4.3
%

Research and development expenses increased $1.2 million, or 8.6%, to $15.3 million for the three months ended March 31, 2013, from $14.1 million for the three months ended April 1, 2012. The increase was primarily attributable to facility-related expenses of $0.7 million and project and outside professional services costs of $0.5 million. Personnel-related expenses were relatively flat, as increases in headcount driven expenses were offset by a benefit of $1.0 million due to a decrease in variable compensation. Headcount grew by 21 employees to 253 employees at March 31, 2013 compared to 232 employees at April 1, 2012. The increase in research and development expenses was primarily related to our increased investment in research and development projects for software development, and acquisition-related research and development.

36



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, 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
 
March 31,
2013
 
% Change
 
April 1,
2012
 
(In thousands, except percentage data)
Sales and marketing expense
$
36,389

 
(6.6
)%
 
$
38,970

Percentage of net revenue
12.4
%
 
 
 
12.1
%

Sales and marketing expense decreased $2.6 million, or 6.6%, to $36.4 million for the three months ended March 31, 2013, from $39.0 million for the three months ended April 1, 2012. The decrease was primarily attributable to decreases of $1.9 million in personnel-related expenses primarily as a result of decreased sales compensation and variable compensation costs, $0.5 million in freight expense, and $0.4 million in outside professional service costs. This decrease was partially offset by an increase in marketing programs expense of $0.3 million. Sales and marketing headcount increased by 1 employee to 365 employees at March 31, 2013 compared to 364 employees at April 1, 2012.
   
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
 
March 31,
2013
 
% Change
 
April 1,
2012
 
(In thousands, except percentage data)
General and administrative expense
$