10-Q 1 ntgr20161002-10q.htm FORM 10-Q Document

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
 
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the quarterly period ended October 2, 2016.
¨ 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  x    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  x    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
 
¨
 
Accelerated filer
 
x
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  x
The number of outstanding shares of the registrant’s Common Stock, $0.001 par value, was 33,078,587 as of October 28, 2016.

1


TABLE OF CONTENTS
 
Item 1.
 
 
 
 
 
Item 2.
Item 3.
Item 4.
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 

2


PART I: FINANCIAL INFORMATION
Item 1.
Financial Statements
NETGEAR, INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
 
 
October 2,
2016
 
December 31,
2015
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
273,720

 
$
181,945

Short-term investments
129,296

 
96,321

Accounts receivable, net
233,911

 
290,642

Inventories
217,621

 
213,118

Prepaid expenses and other current assets
30,519

 
39,117

Total current assets
885,067

 
821,143

Property and equipment, net
19,476

 
22,384

Intangibles, net
36,216

 
48,947

Goodwill
81,721

 
81,721

Other non-current assets
74,268

 
76,374

Total assets
$
1,096,748

 
$
1,050,569

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
95,991

 
$
90,546

Accrued employee compensation
24,026

 
27,868

Other accrued liabilities
142,751

 
166,282

Deferred revenue
26,515

 
29,125

Income taxes payable
1,866

 
1,951

Total current liabilities
291,149

 
315,772

Non-current income taxes payable
15,610

 
14,444

Other non-current liabilities
12,793

 
11,643

Total liabilities
319,552

 
341,859

Commitments and contingencies (Note 7)


 


Stockholders’ equity:
 
 
 
Common stock
33

 
33

Additional paid-in capital
555,167

 
513,047

Accumulated other comprehensive income
242

 
3

Retained earnings
221,754

 
195,627

Total stockholders’ equity
777,196

 
708,710

Total liabilities and stockholders’ equity
$
1,096,748

 
$
1,050,569

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
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
Net revenue
$
338,458

 
$
341,893

 
$
960,369

 
$
939,832

Cost of revenue
235,336

 
245,566

 
658,894

 
677,569

Gross profit
103,122

 
96,327

 
301,475

 
262,263

Operating expenses:
 
 
 
 
 
 
 
Research and development
21,935

 
21,572

 
65,876

 
63,126

Sales and marketing
37,337

 
35,923

 
110,703

 
107,538

General and administrative
14,111

 
11,803

 
39,995

 
33,192

Restructuring and other charges
(130
)
 
1,016

 
3,859

 
6,384

Litigation reserves, net
13

 

 
58

 
(2,690
)
Total operating expenses
73,266

 
70,314

 
220,491

 
207,550

Income from operations
29,856

 
26,013

 
80,984

 
54,713

Interest income
291

 
65

 
804

 
184

Other income (expense), net
116

 
(199
)
 
(582
)
 
(67
)
Income before income taxes
30,263

 
25,879

 
81,206

 
54,830

Provision for income taxes
9,144

 
10,780

 
27,464

 
28,053

Net income
$
21,119

 
$
15,099

 
$
53,742

 
$
26,777

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.64

 
$
0.47

 
$
1.64

 
$
0.80

Diluted
$
0.62

 
$
0.47

 
$
1.60

 
$
0.79

Weighted average shares used to compute net income per share:
 
 
 
 
 
 
 
Basic
32,913

 
31,979

 
32,688

 
33,473

Diluted
33,913

 
32,335

 
33,624

 
34,002

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
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
Net income
$
21,119

 
$
15,099

 
$
53,742

 
$
26,777

Other comprehensive income (loss), before tax:
 
 
 
 
 
 
 
Unrealized gain (loss) on derivative instruments
240

 
10

 
204

 
(102
)
Unrealized gain (loss) on available-for-sale securities
(43
)
 
6

 
104

 
34

Other comprehensive income (loss), before tax
197

 
16

 
308

 
(68
)
Tax expense related to items of other comprehensive income
(14
)
 
(2
)
 
(69
)
 
(13
)
Other comprehensive income (loss), net of tax
183

 
14

 
239

 
(81
)
Comprehensive income
$
21,302

 
$
15,113

 
$
53,981

 
$
26,696

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)
 
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
Cash flows from operating activities:
 
 
 
Net income
$
53,742

 
$
26,777

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
24,601

 
27,336

Purchase premium amortization/discount accretion on investments, net
106

 
(73
)
Non-cash stock-based compensation
14,300

 
12,517

Income tax impact associated with stock option exercises
1,627

 
(1,049
)
Excess tax benefit from stock-based compensation
(2,290
)
 
(252
)
Deferred income taxes
1,327

 
(149
)
Changes in assets and liabilities:
 
 
 
Accounts receivable
56,731

 
1,516

Inventories
(4,503
)
 
52,870

Prepaid expenses and other assets
9,772

 
7,332

Accounts payable
5,428

 
(7,696
)
Accrued employee compensation
(3,842
)
 
(174
)
Other accrued liabilities
(24,444
)
 
(4,405
)
Deferred revenue
(2,610
)
 
(899
)
Income taxes payable
1,082

 
2,002

Net cash provided by operating activities
131,027

 
115,653

Cash flows from investing activities:
 
 
 
Purchases of short-term investments
(117,994
)
 
(50,301
)
Proceeds from sales and maturities of short-term investments
85,286

 
105,142

Purchase of property and equipment
(6,984
)
 
(11,142
)
Net cash provided by (used in) investing activities
(39,692
)
 
43,699

Cash flows from financing activities:
 
 
 
Purchase and retirement of common stock
(27,616
)
 
(107,531
)
Proceeds from exercise of stock options
21,874

 
6,137

Proceeds from issuance of common stock under employee stock purchase plan
3,892

 
2,985

Excess tax benefit from stock-based compensation
2,290

 
252

Net cash provided by (used in) financing activities
440

 
(98,157
)
Net increase in cash and cash equivalents
91,775

 
61,195

Cash and cash equivalents, at beginning of period
181,945

 
141,234

Cash and cash equivalents, at end of period
$
273,720

 
$
202,429

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. The Company's products are built on a variety of proven technologies such as wireless (WiFi and LTE), Ethernet and powerline, with a focus on reliability and ease-of-use. The 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 the end-users in each geographic region in which the Company's products are sold.
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, 2015 has been derived from audited financial statements at such date. Accordingly, these condensed consolidated financial statements do not include all of the information and footnotes typically found in the audited consolidated financial statements and footnotes thereto included in the Annual Report on Form 10-K. 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, 2015.
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 net revenue and expenses during the reported period. Actual results could differ materially from those estimates and operating results for the three and nine months ended October 2, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016 or any future period.

Note 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, 2015. The Company’s significant accounting policies have not materially changed during the nine months ended October 2, 2016.

Recent Accounting Pronouncements

Accounting Pronouncement Recently Adopted

In November 2015, the FASB issued ASU 2015-17, "Balance Sheet Classification of Deferred Taxes" (Topic 740), which simplifies the presentation of deferred income taxes. This ASU requires that deferred tax assets and liabilities be classified as non-current in a statement of financial position. ASU 2015-17 may be adopted either prospectively or retrospectively and is effective for reporting periods beginning after December 15, 2016, with early adoption permitted. The Company elected early adoption ASU 2015-17 effective December 31, 2015 on a prospective basis. Adoption of this ASU resulted in a reclassification of the Company's net current deferred tax asset to the net non-current deferred tax asset in its Consolidated Balance Sheet as of December 31, 2015. No prior periods were retrospectively adjusted.

Accounting Pronouncements Not Yet Effective

In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers" (Topic 606). The guidance in this update supersedes the revenue recognition requirements in Topic 605, Revenue Recognition. Under the new guidance, an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance also specifies the accounting for some costs to obtain or fulfill a contract with a customer. An entity should apply the amendments in the update either

7

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

retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying this update recognized at the date of initial application. On July 9, 2015, the FASB concluded to delay the effective date of the new revenue standard by one year. ASU 2014-09 is effective for the Company beginning in the first quarter fiscal 2018. Early adoption is permitted but may not occur earlier than January 1, 2017, the original effective date of the standard for the Company. In 2016, the FASB issued additional guidance to clarify the implementation guidance (ASU 2016-08, "Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations; ASU 2016-10, "Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing; and ASU 2016-12, "Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients). The Company is in the process of evaluating the available transition methods and the impact of the guidance on its financial position, results of operations and cash flows.

In July 2015, the FASB issued ASU 2015-11, "Simplifying the Measurement of Inventory" (Topic 330). The new guidance changes the subsequent measurement of inventory from lower of cost or market to lower of cost and net realizable value. ASU 2015-11 should be applied on a prospective basis and is effective for the Company beginning in the first fiscal quarter of 2017. Early adoption is permitted. The Company does not expect the adoption of this guidance to have a material impact on its financial position, results of operations and cash flows.

In January 2016, the FASB issued ASU 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities (Subtopic 825-10). The changes to the current US GAAP financial instruments model primarily affect the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. This standard is effective for annual and interim reporting periods beginning after December 15, 2017. The Company is currently evaluating what impact, if any, the adoption of this standard will have on its financial position, results of operations and cash flows.

In February 2016, FASB issued ASU No. 2016-02, "Leases" (Topic 842), which requires lessees to recognize on the balance sheet a right-of-use asset, representing its right to use the underlying asset for the lease term, and a corresponding lease liability for all leases with terms greater than twelve months. This ASU becomes effective for the Company in the first quarter fiscal 2019 and early adoption is permitted. This ASU is required to be applied with a modified retrospective approach and requires application of the new standard at the beginning of the earliest comparative period presented. The Company is currently evaluating what impact the adoption of this standard will have on its financial position, results of operations and cash flows.

In March 2016, the FASB issued ASU 2016-09, "Improvements to Employee Share-Based Payment Accounting" (Topic 718), which simplifies the accounting for share-based payment transactions, including the income tax consequences, forfeitures, and statutory tax withholding requirements, as well as classification on the statement of cash flows. ASU 2016-09 is effective for the Company beginning in the first quarter fiscal 2017, with early adoption permitted (an entity that elects early adoption must adopt all of the amendments in the same period). The Company is currently evaluating what impact the adoption of this standard will have on its financial position, results of operations and cash flows.

In August 2016, the FASB issued ASU 2016-15, "Statement of Cash Flows-Classification of Certain Cash Receipts and Cash Payments" (ASC Topic 230), which clarifies how certain cash receipts and cash payments are presented and classified in the statement of cash flows. This ASU is effective for annual periods beginning after December 15, 2017, and interim periods within those annual periods. Early adoption is permitted. The Company is in the process of assessing the impact, if any, of this ASU on its cash flows.



8

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

Note 3.
Balance Sheet Components

Available-for-sale short-term investments (in thousands)
 
As of
 
October 2, 2016
 
December 31, 2015
 
Cost
 
Unrealized Gain
 
Unrealized Loss
 
Estimated Fair Value
 
 Cost
 
Unrealized Gain
 
Unrealized Loss
 
Estimated Fair Value
U.S. treasuries
$
127,649

 
$
46

 
$
(6
)
 
$
127,689

 
$
95,057

 
$
1

 
$
(65
)
 
$
94,993

Certificates of deposit
156

 

 

 
156

 
147

 

 

 
147

Total
$
127,805

 
$
46

 
$
(6
)
 
$
127,845

 
$
95,204

 
$
1

 
$
(65
)
 
$
95,140


The Company’s short-term investments are primarily comprised of marketable securities that 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 available-for-sale securities have unrealized losses greater than 12 months.

Accounts receivable, net (in thousands)
 
As of
 
October 2,
2016
 
December 31,
2015
Gross accounts receivable
$
253,117

 
$
309,926

Allowance for doubtful accounts
(1,255
)
 
(1,255
)
Allowance for sales returns
(13,312
)
 
(15,904
)
Allowance for price protection
(4,639
)
 
(2,125
)
Total allowances
(19,206
)
 
(19,284
)
Total accounts receivable, net
$
233,911

 
$
290,642


Inventories (in thousands)
 
As of
 
October 2,
2016
 
December 31,
2015
Raw materials
$
6,588

 
$
4,292

Work in process
3


2

Finished goods
211,030

 
208,824

Total inventories
$
217,621

 
$
213,118


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.


9

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

Property and equipment, net (in thousands)
 
 
As of
 
October 2,
2016
 
December 31,
2015
Computer equipment
$
11,594

 
$
11,161

Furniture, fixtures and leasehold improvements
20,099

 
18,317

Software
30,741

 
30,396

Machinery and equipment
68,834

 
66,662

Total property and equipment, gross
131,268

 
126,536

Accumulated depreciation and amortization
(111,792
)
 
(104,152
)
Total property and equipment, net
$
19,476

 
$
22,384


Depreciation and amortization expense pertaining to property and equipment was $3.4 million and $11.5 million for the three and nine months ended October 2, 2016, respectively, and $4.4 million and $13.8 million for the three and nine months ended September 27, 2015, respectively.

Intangibles, net (in thousands)
 
Gross
 
Accumulated Amortization
 
Net
October 2, 2016
 
 
 
 
 
Technology
$
61,099

 
$
(55,111
)
 
$
5,988

Customer contracts and relationships
56,500

 
(28,604
)
 
27,896

Other
10,545

 
(8,213
)
 
2,332

Total intangibles, net
$
128,144

 
$
(91,928
)
 
$
36,216


 
Gross
 
Accumulated Amortization
 
Net
December 31, 2015
 
 
 
 
 
Technology
$
61,099

 
$
(48,485
)
 
$
12,614

Customer contracts and relationships
56,500

 
(23,290
)
 
33,210

Other
10,545

 
(7,422
)
 
3,123

Total intangibles, net
$
128,144

 
$
(79,197
)
 
$
48,947


Amortization of intangibles was $4.2 million and $12.7 million for the three and nine months ended October 2, 2016, respectively, and $4.2 million and $13.0 million for the three and nine months ended September 27, 2015, respectively.

Estimated amortization expense related to intangibles for each of the next five years and thereafter is as follows (in thousands):
Year Ending December 31
Amount
2016 (remaining three months)
$
4,190

2017
11,386

2018
7,871

2019
6,028

2020
5,316

Thereafter
1,425

Total estimated amortization expense
$
36,216



10

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

Other non-current assets (in thousands)
 
As of
 
October 2,
2016
 
December 31, 2015
Non-current deferred income taxes
$
67,118

 
$
68,445

Other
7,150

 
7,929

Total other non-current assets
$
74,268

 
$
76,374


Other accrued liabilities (in thousands)
 
As of
 
October 2,
2016
 
December 31,
2015
Sales and marketing programs
$
55,421

 
$
69,693

Warranty obligation
53,826

 
56,706

Freight
7,631

 
5,748

Other
25,873

 
34,135

Total other accrued liabilities
$
142,751

 
$
166,282

 
Note 4.
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, Canadian dollars, 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. In addition, the derivative contracts typically mature in two to nine 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, materiality, 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 ("OCI") 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.


11

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 sheets to which they were recorded as of October 2, 2016 and December 31, 2015 are summarized as follows (in thousands):
Derivative Assets
 
Balance Sheet
Location
 
Fair Value at
October 2, 2016
 
Balance Sheet
Location
 
Fair Value at
December 31, 2015
Derivative assets not designated as hedging instruments
 
Prepaid expenses and other current assets
 
$
431

 
Prepaid expenses and other current assets
 
$
3,203

Derivative assets designated as hedging
instruments
 
Prepaid expenses and other current assets
 
622

 
Prepaid expenses and other current assets
 
2

Total
 
 
 
$
1,053

 
 
 
$
3,205


Derivative Liabilities
 
Balance Sheet
Location
 
Fair Value at
October 2, 2016
 
Balance Sheet
Location
 
Fair Value at
December 31, 2015
Derivative liabilities not designated as hedging instruments
 
Other accrued liabilities
 
$
1,040

 
Other accrued liabilities
 
$
447

Derivative liabilities designated as hedging instruments
 
Other accrued liabilities
 
245

 
Other accrued liabilities
 
4

Total
 
 
 
$
1,285

 
 
 
$
451


For details of the Company’s fair value measurements, see Note 11, Fair Value Measurements.

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 unaudited condensed consolidated balance sheets.

The following tables set forth the offsetting of derivative assets as of October 2, 2016 and December 31, 2015 (in thousands):
As of October 2, 2016
 
 
 
 
 
 
 
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
J.P. Morgan Chase
 
92

 

 
92

 
(92
)
 

 

Wells Fargo
 
$
961

 
$

 
$
961

 
$
(961
)
 
$

 
$

Total
 
$
1,053

 
$

 
$
1,053

 
$
(1,053
)
 
$

 
$


As of December 31, 2015
 
 
 
 
 
 
 
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        
 
$
577

 
$

 
$
577

 
$
(56
)
 
$

 
$
521

Wells Fargo
 
2,628

 

 
2,628

 
(395
)
 

 
2,233

Total
 
$
3,205

 
$

 
$
3,205

 
$
(451
)
 
$

 
$
2,754



12

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

The following tables set forth the offsetting of derivative liabilities as of October 2, 2016 and December 31, 2015 (in thousands):
As of October 2, 2016
 
 
 
 
 
 
 
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
JP Morgan Chase
 
$
132

 
$

 
$
132

 
$
(92
)
 
$

 
$
40

Wells Fargo
 
1,153

 

 
1,153

 
(961
)
 

 
192

Total
 
$
1,285

 
$

 
$
1,285

 
$
(1,053
)
 
$

 
$
232


As of December 31, 2015
 
 
 
 
 
 
 
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        
 
$
56

 
$

 
$
56

 
$
(56
)
 
$

 
$

Wells Fargo
 
395

 

 
395

 
(395
)
 

 

Total
 
$
451

 
$

 
$
451

 
$
(451
)
 
$

 
$


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 eight months. The Company enters into about ten forward contracts per quarter with an average size of approximately $8.0 million USD equivalent related to its cash flow hedging program.

The Company expects to reclassify to earnings all of the amounts recorded in OCI associated with its cash flow hedges over the next twelve 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 OCI 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 as there were no discontinued cash flow hedges during the three and nine months ended October 2, 2016 and September 27, 2015.


13

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

The pre-tax effects of the Company’s derivative instruments on OCI and the unaudited condensed consolidated statement of operations for the three and nine months ended October 2, 2016 and September 27, 2015 are summarized as follows (in thousands):
Derivatives Designated as Hedging Instruments
 
Three Months Ended October 2, 2016
 
Gain (Loss)
Recognized in
OCI -
Effective
Portion
 
Location of
Gain (Loss)
Reclassified from OCI
into Income - Effective
Portion
 
Gain (Loss)
Reclassified
from
OCI into
Income -
Effective
Portion (1)
 
Location of
Gain (Loss)
Recognized in
Income and
Excluded from
Effectiveness Testing
 
Amount of Gain (Loss) Recognized in
Income and
Excluded from
Effectiveness Testing
Cash flow hedges:
 
 
 
 
 
 
 
 
 
 
Foreign currency forward contracts
 
$
(417
)
 
Net revenue
 
$
(824
)
 
Other income (expense), net
 
$
116

Foreign currency forward contracts
 

 
Cost of revenue
 
4

 
Other income (expense), net
 

Foreign currency forward contracts
 

 
Operating expenses
 
163

 
Other income (expense), net
 

Total
 
$
(417
)
 
 
 
$
(657
)
 
 
 
$
116

(1) Refer to Note 8, Stockholders' Equity, which summarizes the accumulated other comprehensive income activity related to derivatives.

Derivatives Designated as Hedging Instruments
 
Nine Months Ended October 2, 2016
 
Gain (Loss)
Recognized in
OCI -
Effective
Portion
 
Location of
Gain (Loss)
Reclassified from OCI
into Income - Effective
Portion
 
Gain (Loss)
Reclassified
from
OCI into
Income -
Effective
Portion (1)
 
Location of
Gain (Loss)
Recognized in
Income and
Excluded from
Effectiveness Testing
 
Amount of Gain (Loss) Recognized in
Income and
Excluded from
Effectiveness Testing
Cash flow hedges:
 
 
 
 
 
 
 
 
 
 
Foreign currency forward contracts
 
$
(1,116
)
 
Net revenue
 
$
(1,543
)
 
Other income (expense), net
 
$
169

Foreign currency forward contracts
 

 
Cost of revenue
 
4

 
Other income (expense), net
 

Foreign currency forward contracts
 

 
Operating expenses
 
219

 
Other income (expense), net
 

Total
 
$
(1,116
)
 
 
 
$
(1,320
)
 
 
 
$
169

(1) Refer to Note 8, Stockholders' Equity, which summarizes the accumulated other comprehensive income activity related to derivatives.

Derivatives Designated as Hedging Instruments
 
Three Months Ended September 27, 2015
 
Gain (Loss)
Recognized in
OCI -
Effective
Portion
 
Location of
Gain (Loss)
Reclassified from OCI
into Income - Effective
Portion
 
Gain (Loss)
Reclassified
from
OCI into
Income -
Effective
Portion (1)
 
Location of
Gain (Loss)
Recognized in
Income and
Excluded from
Effectiveness Testing
 
Amount of Gain (Loss) Recognized in
Income and
Excluded from
Effectiveness Testing
Cash flow hedges:
 
 
 
 
 
 
 
 
 
 
Foreign currency forward contracts
 
$
(416
)
 
Net revenue
 
$
(552
)
 
Other income (expense), net
 
$
(9
)
Foreign currency forward contracts
 

 
Cost of revenue
 
3

 
Other income (expense), net
 

Foreign currency forward contracts
 

 
Operating expenses
 
123

 
Other income (expense), net
 

Total
 
$
(416
)
 
 
 
$
(426
)
 
 
 
$
(9
)
(1) Refer to Note 8, Stockholders' Equity, which summarizes the accumulated other comprehensive income activity related to derivatives.







14

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

Derivatives Designated as Hedging Instruments
 
Nine Months Ended September 27, 2015
 
Gain (Loss)
Recognized in
OCI -
Effective
Portion
 
Location of
Gain (Loss)
Reclassified from OCI
into Income - Effective
Portion
 
Gain (Loss)
Reclassified
from
OCI into
Income -
Effective
Portion (1)
 
Location of
Gain (Loss)
Recognized in
Income and
Excluded from
Effectiveness Testing
 
Amount of Gain (Loss) Recognized in
Income and
Excluded from
Effectiveness Testing
Cash flow hedges:
 
 
 
 
 
 
 
 
 
 
Foreign currency forward contracts
 
$
(1,299
)
 
Net revenue
 
$
(1,474
)
 
Other income (expense), net
 
$
(43
)
Foreign currency forward contracts
 

 
Cost of revenue
 
7

 
Other income (expense), net
 

Foreign currency forward contracts
 

 
Operating expenses
 
270

 
Other income (expense), net
 

Total
 
$
(1,299
)
 
 
 
$
(1,197
)
 
 
 
$
(43
)
(1) Refer to Note 8, Stockholders' Equity, which summarizes the accumulated other comprehensive income activity related to derivatives.

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 18 non-designated derivatives per quarter. The average size of its non-designated hedges is approximately $3.0 million USD equivalent and these hedges range from one to three months in duration.

The effects of the Company’s non-designated hedge included in other income (expense), net in the unaudited condensed consolidated statements of operations for the three and nine months ended October 2, 2016 and September 27, 2015 are as follows (in thousands):
Derivatives Not Designated as Hedging Instruments
 
Location of Gains (Losses)
Recognized in Income on Derivative
 
Amount of Gains (Losses) Recognized in Income
 
Three Months Ended
 
Nine Months Ended
 
October 2, 2016
 
September 27, 2015
 
October 2, 2016
 
September 27, 2015
Foreign currency forward contracts
 
Other income (expense), net
 
$
(493
)
 
$
1,267

 
$
(1,252
)
 
$
3,278


Note 5.
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.

15

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

Net income per share for the three and nine months ended October 2, 2016 and September 27, 2015 are as follows (in thousands, except per share data):
 
Three Months Ended
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
Numerator:
 
 
 
 
 
 
 
Net income
$
21,119

 
$
15,099

 
$
53,742

 
$
26,777

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Weighted average common shares - basic
32,913

 
31,979

 
32,688

 
33,473

Potentially dilutive common share equivalent
1,000

 
356

 
936

 
529

Weighted average common shares - dilutive
33,913

 
32,335

 
33,624

 
34,002

 
 
 
 
 
 
 
 
Basic net income per share
$
0.64

 
$
0.47

 
$
1.64

 
$
0.80

Diluted net income per share
$
0.62

 
$
0.47

 
$
1.60

 
$
0.79

 
 
 
 
 
 
 
 
Anti-dilutive employee stock-based awards, excluded

 
2,768

 
235

 
2,486


Note 6.
Income Taxes

The income tax provision for the three and nine months ended October 2, 2016 was $9.1 million, or an effective tax rate of 30.2%, and $27.5 million, or an effective tax rate of 33.8% respectively. The income tax provision for the three and nine months ended September 27, 2015 was $10.8 million, or an effective tax rate of 41.7%, and $28.1 million, or an effective tax rate of 51.2%, respectively. The effective tax rate for the three and nine months ended October 2, 2016 compared to the three and nine months ended September 3, 2015 decreased partly due to changes in earnings incurred in a jurisdiction where a loss was not tax benefited for the three and nine months ended September 3, 2015. For the three and nine months ended September 3, 2015, the forecasted loss from this jurisdiction was excluded from the determination of tax expense. For the three and nine months ended October 2, 2016, the Company did not exclude any jurisdictions from the determination of tax expense. The decrease was also due to a $1.8 million non-recurring tax benefit related to a change in estimate during the three and nine months ended October 2, 2016. The Company is subject to income taxes in the U.S. and numerous foreign jurisdictions. The future foreign tax rate could be affected by changes in the composition in earnings in countries with tax rates differing from the U.S. federal rate. The Company is under examination in various U.S. and foreign jurisdictions.

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 twelve 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 twelve months is approximately $0.7 million, excluding the interest, penalties and the effect of any related deferred tax assets or liabilities.


Note 7.
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.


16

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

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 October 2, 2016, the Company had approximately $161 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. From time to time the Company’s suppliers procure unique complex components on the Company's behalf. If these components do not meet specified technical criteria or are defective, the Company should not be obligated to purchase the materials. However, disputes may arise as a result and significant resources may be spent resolving such disputes.

Warranty Obligation
Changes in the Company’s warranty obligation, which is included in other accrued liabilities in the unaudited condensed consolidated balance sheets, are as follows (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
Balance as of beginning of the period
$
50,393

 
$
40,967

 
$
56,706

 
$
44,888

Provision for warranty obligation made during the period
27,939

 
22,625

 
62,748

 
53,862

Settlements made during the period
(24,506
)
 
(15,664
)
 
(65,628
)
 
(50,822
)
Balance at end of period
$
53,826

 
$
47,928

 
$
53,826

 
$
47,928


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 each indemnification agreement is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of October 2, 2016.

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 October 2, 2016.

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 equity awards 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 equity awards. The Company has no liabilities recorded for these agreements as of October 2, 2016.


17

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

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 contingencies. In such cases, the Company accrues for the amount, or if a range, the Company accrues the low end of the range, only if there is not a better estimate than any other amount within the range, as a component of legal expense within litigation reserves, net. 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 twelve 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.

Ericsson v. NETGEAR, Inc.

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 (the “‘516 Patent”); 6,330,435 (the “‘435 Patent”); 6,424,625 (the “‘625 Patent”); 6,519,223 (the “‘223 Patent”); 6,772,215 (the “‘215 Patent”); 5,987,019 (the “‘019 Patent”); 6,466,568 (the “‘568 Patent”); and 5,771,468 (the “'468 Patent"). Ericsson generally alleged 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 June 8, 2011, Ericsson filed an amended complaint that added Dell, Toshiba and Belkin as defendants. At the status conference held on June 9, 2011, the Court set a Markman (claim construction) hearing for June 28, 2012 and trial for June 3, 2013. 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 became an official defendant in the Ericsson case. 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.

A jury trial in the Ericsson case occurred in the Eastern District of Texas from June 3 through June 13, 2013. After hearing the evidence, the jury found no infringement of the '435 and '223 Patents, and the jury found infringement of claim 1 of the '625 Patent, claims 1 and 5 of the '568 Patent, and claims 1 and 2 of the '215 Patent. The jury also found that there was no willful infringement by any defendant. Additionally, the jury found no invalidity of the asserted claims of the '435 and '625 Patents. The jury assessed the following damages against the defendants: D-Link: $435,000; NETGEAR: $3,555,000; Acer/Gateway: $1,170,000; Dell: $1,920,000; Toshiba: $2,445,000; Belkin: $600,000. The damages awards equated to 15 cents per unit for each accused 802.11 device sold by each defendant (5 cent per patent).

On December 16, 2013, the Company and defendants submitted their appeal brief to the Federal Circuit. Ericsson filed its response brief on February 20, 2014, and the defendants filed their reply brief before on March 24, 2014. The oral arguments before the Federal Circuit took place on June 5, 2014.

In December 4, 2014, the Federal Circuit issued its opinion and order in the Company’s Ericsson appeal. The Federal Circuit vacated the entirety of the $3.6 million jury verdict against the Company and the ongoing 15 cent per unit royalty verdict, and also vacated the entirety of the verdict against the other defendants and their ongoing royalties, finding that the District Court hadn’t properly instructed the jury on royalty rates and Ericsson’s licensing promises. The Federal Circuit held that the lower court had failed to adequately instruct the jury about Ericsson’s actual commitments to license the infringed patents on reasonable and nondiscriminatory (“RAND”) terms. Further, the Federal Circuit stated that the lower court had neglected to inform the jury that a royalty for a patented technology must be removed from the value of the entire standard, and that a RAND royalty rate should

18

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

be based on the invention’s value, rather than any added value from standardization. The jury’s damages awards were therefore completely vacated, and the case was remanded for further proceedings.

While the Federal Circuit found the district court had inadequate jury instructions, it held that there was enough evidence for the jury to find infringement of two claims of U.S. Patent Number 6,466,568 and two claims of U.S. Patent Number 6,772,215, but reversed the lower court’s decision not to grant a noninfringement judgment as a matter of law regarding the third patent, U.S. Patent Number 6,424,625, finding that no reasonable jury could find that the ‘625 Patent was infringed by the defendants.

In September of 2013, Broadcom filed petitions in the USPTO at the Patent Trial and Appeal Board (PTAB) seeking inter partes review (“IPR”) of Ericsson’s three patents that the jury found were infringed by the Company and other defendants. On March 6, 2015, the PTAB invalidated all the claims of these three patents that were asserted against the Company and other defendants at trial -- claim 1 of the '625 Patent, claims 1 and 5 of the '568 Patent, and claims 1 and 2 of the '215 Patent -- ruling these claims were anticipated or obvious in light of prior art. The PTAB also rejected two motions to amend by Ericsson, which sought to substitute certain proposed claims in the '625 and '568 patents, should they be found unpatentable by the PTAB. This PTAB decision comes on top of the Federal Circuit decision (a) vacating the jury verdict after finding that the district court had not properly instructed the jury on royalty rates and Ericsson’s licensing promises, and (b) ruling that no reasonable jury could have found the ‘625 Patent infringed. Ericsson appealed the PTAB decision to the Federal Circuit and also requested that the PTAB reconsider its decision, but the PTAB denied Ericsson’s request for reconsideration. Accordingly, the Company reversed the accruals related to this case in the first fiscal quarter of 2015. On September 16, 2016, the Federal Circuit upheld the invalidity of certain claims of the '625 Patent, the '568 Patent, and '215 Patent, as previously determined by the PTAB. The Federal Circuit only issued one precedential written opinion, on the 215 Patent; the PTAB invalidity rulings on the '625 and '568 Patents were upheld without a written decision. Ericsson petitioned the Federal Circuit for an en banc rehearing of the appeal decision, and the present status of the case continues to be that the Company does not infringe on any valid Ericsson patent.

Agenzia Entrate Provincial Revenue Office 1 of Milan v. NETGEAR International, Inc.

In November 2012, the Italian tax police began a comprehensive tax audit of NETGEAR International, Inc.’s Italian Branch. The scope of the audit initially was from 2004 through 2011 and was subsequently expanded to include 2012. The tax audit encompasses Corporate Income Tax (IRES), Regional Business Tax (IRAP) and Value-Added Tax (VAT). In December 2013, December 2014, August 2015, and December 2015 an assessment was issued by Inland Revenue Agency, Provincial Head Office No. 1 of Milan-Auditing Department (Milan Tax Office) for the 2004 tax year, the 2005 through 2007 tax years, the 2008 through 2010 tax years, and the 2011 through 2012 tax years, respectively.

In May 2014, the Company filed with the Provincial Tax Court of Milan an appeal brief, including a Request for Hearing in Open Court and Request for Suspension of the Tax Assessment for the 2004 year. The hearing was held and decision was issued on December 19, 2014. The Tax Court decided in favor of the Company and nullified the assessment by the Inland Revenue Agency for 2004. The Inland Revenue Agency appealed the decision of the Tax Court on June 12, 2015. The Company filed its counter appeal with respect to the 2004 year during September 2015. On February 26, 2016 the Regional Tax Court conducted the appeals hearing for the 2004 year, ruling in favor of the Company. On June 13, 2016, the Inland Revenue Agency appealed the decision to the Supreme Court. The Company has filed a counter appeal.

In June, 2015, the Company filed with the Provincial Tax Court of Milan an appeal brief including a Request for Hearing in Open Court and Request for Suspension of the Tax Assessment for the 2005 through 2007 tax years. The hearing for suspension was held and the Request for Suspension of payment was granted. The hearing for the validity of the tax assessment for 2005 and 2006 was held in December 2015 with the Provincial Tax Court issuing its decision in favor of the Company. The Inland Revenue Agency filed its appeal with the Regional Tax Court. The Company filed its counter brief on September 30, 2016.

The hearing for the validity of the tax assessment for 2007 was held on March 10, 2016 with the Provincial Tax Court who issued its decision in favor of the Company on April 7, 2016. The Inland Revenue Agency has until November 7, 2016 to file for an appeal to the Regional Tax Court with regard to the 2007 tax year.

With respect to 2008 through 2010, the Company filed its briefs with the Tax Court in October 2015 and the hearing for the validity of the tax assessments was held on April 21, 2016 and a decision favorable to the Company was issued on May 12, 2016. The Inland Revenue Agency has until December 9, 2016 to file an appeal to the Regional Tax Court.


19

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

With respect to 2011 through 2012, the Company has filed its appeal brief on February 26, 2016 with the Provincial Tax Court to contest this assessment. The hearing for suspension was held and the Request for Suspension of payment was granted. On October 13, 2016, the Company filed its brief with the Provincial Tax Court. The hearing was held on October 24, 2016. The Company is awaiting the decision of the Provincial Tax Court.

With regard to all tax years, it is too early to reasonably estimate any financial impact to the Company resulting from this litigation matter.

Via Vadis v. NETGEAR, Inc.

On August 22, 2014, the Company was sued by Via Vadis, LLC and AC Technologies, S.A. (“Via Vadis”), in the Western District of Texas. The complaint alleges that the Company’s ReadyNAS and Stora products “with built-in BitTorrent software" allegedly infringe three related patents of Via Vadis (U.S. Patent Nos. 7,904,680, RE40, 521, and 8,656,125). Via Vadis filed similar complaints against Belkin, Buffalo, Blizzard, D-Link, and Amazon.

By referring to “built-in BitTorrent software,” the Company believes that the complaint is referring to the BitTorrent Sync application, which was released by BitTorrent Inc. in spring of 2014. At a high-level, the application allows file synchronization across multiple devices by storing the underlying files on multiple local devices, rather than on a centralized server. The Company’s ReadyNAS products do not include BitTorrent software when sold. The BitTorrent application is provided as one of a multitude of potential download options, but the software itself is not included on the Company’s devices when shipped. Therefore, the only viable allegation at this point is an indirect infringement allegation.

On November 10, 2014, the Company answered the complaint denying that it infringes the patents in suit and also asserting the affirmative defenses that the patents in suit are invalid and barred by the equitable doctrines of laches, waiver, and/or estoppel.

On February 6, 2015, the Company filed its motion to transfer venue from the Western District of Texas to the Northern District of California with the Court; on February 13, 2015, Via Vadis filed its opposition to the Company’s motion to transfer; and on February 20, 2015, the Company filed its reply brief on its motion to transfer. In early April 2015, the Company received the plaintiff’s infringement contentions, and on June 12, 2015, the defendants served invalidity contentions. On July 30, 2015 the Court granted the Company’s motion to transfer venue to the Northern District of California. In addition, the Company learned that Amazon and Blizzard filed petitions for the inter partes reviews (“IPRs”) for the patents in suit. On October 30, 2015, the Company and Via Vadis filed a joint stipulation requesting that the Court vacate all deadlines and enter a stay of all proceedings in the case pending the Patent Trial and Appeal Board’s final non-appealable decision on the IPRs initiated by Amazon and Blizzard. On November 2, 2015 the Court granted the requested stay. On March 8, 2016, the Patent Trial and Appeal Board issued written decisions instituting the IPRs jointly filed by Amazon and Blizzard.

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

Chrimar Systems, Inc. v NETGEAR, Inc.

On July 1, 2015, the Company was sued by a non-practicing entity named Chrimar Systems, Inc., doing business as CMS Technologies and Chrimar Holding Company, LLC (collectively, “CMS”), in the Eastern District of Texas for allegedly infringing four patents-U.S. Patent Nos. 8,155,012 (the “'012 Patent”), entitled “System and method for adapting a piece of terminal equipment”; 8,942,107 (the “'107 Patent”), entitled “Piece of ethernet terminal equipment”; 8,902,760 (the “'760 Patent”), entitled “Network system and optional tethers”; and 9,019,838 (the “'838 Patent”), entitled “Central piece of network equipment” (collectively “patents-in-suit”). 

The patents-in-suit relate to using or embedding an electrical DC current or signal into an existing Ethernet communication link in order to transmit additional data about the devices on the communication link, and the specifications for the patents are identical. It appears that CMS has approximately 40 active cases in the Eastern District of Texas, as well as some cases in the Northern District of California on the patents-in-suit and the parent patent to the patents-in-suit.

The Company answered the complaint on September 15, 2015. On November 24, 2015, CMS served its infringement contentions on the Company, and CMS is generally attempting to assert that the patents in suit cover the Power over Ethernet standard (802.3af and 802.3at) used by certain of the Company's products.


20

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

On December 3, 2015, the Company filed with the Court a motion to transfer venue to the District Court for the Northern District of California and their memorandum of law in support thereof. On December 23, 2015, CMS filed its response to the Company’s motion to transfer, and, on January 8, 2016, the Company filed its reply brief in support of its motion to transfer venue. On January 15, 2016, the Court granted the Company’s motion to transfer venue to the District Court for the Northern District of California. The initial case management conference in the Northern District of California occurred on May 13, 2016, and on August 19, 2016, the parties exchanged preliminary claim constructions and extrinsic evidence. On August 26, 2016, the Company and three defendants in other Northern District of California CMS cases (Juniper Networks, Inc., Ruckus Wireless, Inc., and Fortinet, Inc.) submitted motions to stay their cases. The defendants in part argued that stays were appropriate pending the resolution of the currently-pending IPRs of the patents-in-suit before the Patent Trial and Appeal Board (PTAB), including four IPR Petitions filed by Juniper. On September 9, 2016, CMS submitted its opposition to the motions to stay the cases. On September 26, 2016, the Court ordered the cases stayed in their entirety, until the PTAB reaches institution decisions with respect to Juniper’s four pending IPR petitions. The Court ordered that the parties provide the Court with a written update on the status of all IPR and reexamination proceedings within ten days of the PTAB’s institution decisions on Juniper’s four IPR petitions, at which time the Court may either lift or continue the stay of the cases.

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

Wi3, INC. v. NETGEAR, Inc.

On November 12, 2015, a lawsuit was filed against the Company by a company called Wi3, INC. (“Wi3”) in the United States District Court, Western District of New York. The patent No. 6,108,331 (the “'331 Patent”) is entitled “Single Medium Wiring Scheme for Multiple Signal Distribution in Building and Access Port Therefor,” and was filed in 1998, and should expire in July 2018. The complaint alleges direct and indirect infringement, and accuses the Company's MoCA Network Adapters and/or Network Extenders (including at least model MCA1001 v2) of infringing at least claims 26, 27, 29, and 30. The complaint alleges no pre-suit knowledge of the patent, but seeks enhanced damages. The patent has been asserted in three prior cases, and all three cases were resolved in the early stages.

The Company filed its answer to the Wi3 complaint on March 11, 2016. In the answer, the Company denied the infringement allegations and put forth several counterclaims. Subsequent to the Company’s answer, the parties participated in some motion practice resulting in an amended answer and counterclaims being filed by the Company on April 1, 2016. Wi3 answered the Company’s amended answer and counterclaims on April 13, 2016. The initial case management conference occurred on August 17, 2016. Without admitting any wrongdoing or violation of law and to avoid the distraction and expense of continued litigation and the uncertainty of a jury verdict on the merits, on August 29, 2016, the Company and Wi3 settled the lawsuit for a one-time payment from the Company to Wi3 in return for a license to the Company to the Wi3 patents and applications that are currently owned by Wi3. As part of the settlement, Wi3 also agreed not to sue the Company’s customers or suppliers on the Wi3 patents and applications that are currently owned by Wi3. The Court subsequently dismissed the case. The settlement did not have a material financial impact to the Company.

Tessera v. NETGEAR, Inc.

On May 23, 2016, Tessera Technologies, Inc., Tessera, Inc., and Invensas Corp. (collectively, “Tessera”) filed a complaint requesting that the U.S. International Trade Commission (“Commission”) commence an investigation pursuant to Section 337 by reason of alleged infringement of certain patent claims by the Company and other respondents. On June 20, 2016, the Commission issued the related Notice of Investigation, and the Investigation was instituted on June 24, 2016.

The Tessera complaint alleges that the following “Proposed Respondents” unlawfully import into the U.S., sell for importation, and/or sell within the U.S. after importation certain semiconductor devices, semiconductor device packages, and products containing the same that infringe one or more claims of U.S. Patent Nos. 6,856,007 (the ‘007 patent), 6,849,946 (the ‘946 patent), and 6,133,136 (the ‘136 patent) (collectively, the “asserted patents”): Broadcom Limited of Singapore; Broadcom Corp. of Irvine, California; Avago Technologies Limited of Singapore; Avago Technologies U.S. Inc. of San Jose, California; Arista Networks, Inc. of Santa Clara, California; ARRIS International plc of Suwanee, Georgia; ARRIS Group, Inc. of Suwanee, Georgia; ARRIS Technology, Inc. of Horsham, Pennsylvania; ARRIS Enterprises LLC of Suwanee, Georgia; ARRIS Solutions, Inc. of Suwanee, Georgia; Pace Ltd. (formerly Pace plc) of England; Pace Americas, LLC of Boca Raton, Florida; Pace USA, LLC of Boca Raton, Florida; ASUSTeK Computer Inc. of Taiwan; ASUS Computer International of Fremont, California; Comcast Cable Communications, LLC of Philadelphia, Pennsylvania; Comcast Cable Communications Management, LLC of Philadelphia, Pennsylvania; Comcast Business Communications, LLC of Philadelphia, Pennsylvania; HTC Corp. of Taiwan; HTC America, Inc. of Bellevue, Washington;

21

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

Technicolor S.A. of France; Technicolor USA, Inc. of Indianapolis, Indiana; Technicolor Connected Home USA LLC of Indianapolis, Indiana; and the Company.

According to the complaint, the asserted patents generally relate to semiconductor packaging technology. In particular, the ‘007 patent relates to a compact and economical semiconductor chip assembly that includes a packaged semiconductor chip, a chip carrier with a metallic thermal conductor, and a circuit panel with a thermal conductor mounting. The ‘946 patent relates to a semiconductor layout configuration and method that results in a more efficient planarization process for a semiconductor chip. Lastly, the ‘136 patent relates to a structure for metal interconnects used in semiconductor packaging.

In the complaint, Tessera states that the Proposed Respondents import and sell products that infringe the asserted patents. In particular, the complaint refers to multiple categories of accused semiconductor products associated with Broadcom and asserts that the remaining Proposed Respondents import and sell products that contain these infringing Broadcom semiconductor products. Tessera requested that the Commission issue a permanent limited exclusion order and a permanent cease and desist order directed at the Proposed Respondents and related entities.

The claim construction hearing for the Investigation is scheduled for December 1, 2016; the evidentiary hearing is scheduled for March 27 - 31, 2017; and the target date for completion of the Investigation is October 24, 2017.

Concurrently with the filing of the instant ITC complaint, Tessera also filed a complaint against Broadcom Corp. in the U.S. District Court for the District of Delaware alleging infringement of the asserted patents. The Company has not been sued in Delaware or any other jurisdiction other than the ITC.

Discovery in the ITC case is ongoing. The Company is considering stipulating to certain facts regarding its importation and inventory of Broadcom-based products in return for various relief from discovery, such as reduced depositions and discovery responses.

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

Symbology v. NETGEAR, Inc.

On June 7, 2016, the Company and numerous other companies were sued in the Eastern District of Texas by a non-practicing entity named Symbology Innovations, LLC (“Symbology”). The lawsuit alleges infringement of three patents: U.S. Patent Nos. 8,424,752 (the ‘752 Patent); 8,651,369 (the ‘369 Patent); and 8,936,190 (the ‘190 Patent) (collectively “Patents in Suit”). The Patents in Suit are all entitled “System and method for presenting information about an object on a portable electronic device”, and the complaint targets the Company’s use of QR codes. In total, Symbology has filed approximately 50 lawsuits against 50 companies alleging infringement of the Patents in Suit.

The alleged infringers Symbology is targeting are advertisers using QR codes. The plaintiff generally is alleging that the Patents in Suit cover the use of QR codes to display content from a website, such as using a mobile phone to scan the QR code, whereby the phone gets the URL from the QR code and fetches the associated web page and then displays it on the mobile phone.

The Company was served with the complaint on July 8, 2016. On August 29, 2016, the Company received Symbology’s Preliminary Infringement Contentions and Disclosures. On September 12, 2016 the Company filed its Answer to the Complaint, denying the allegations of infringement and asserting numerous affirmative defenses.

On September 30, 2016, the Company received Symbology’s Initial Disclosures. On October 3, 2016, the Company filed a Motion to Transfer the case from the Eastern District of Texas to the Northern District of California, and on October 10, 2016, the Company filed its Initial Disclosures and initial technical document production. Without admitting any wrongdoing or violation of law and to avoid the distraction and expense of continued litigation and the uncertainty of a jury verdict on the merits, on October 20, 2016, the Company and Symbology reached a verbal agreement in principle to settle the lawsuit for a one-time payment from the Company to Symbology in return for a license to the Company to the Symbology patents and applications that are currently owned by Symbology. If the verbally-agreed settlement is finalized and case dismissed then this litigation matter will not have a material financial impact to the Company.



22

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

e.Digital v. NETGEAR, Inc.

On September 12, 2016, e.Digital Corporation (e.Digital) filed a lawsuit against the Company in the Northern District of California accusing the Company of infringing U.S. Patent Nos. 8,311,522 (“the ’522 patent”); 8,311,524 (“the ’524 patent”); 9,002,331 (“the ’331 patent”); and 9,178,983 (“the ’983 patent”) (collectively, the “patents-in-suit”), which purportedly cover systems and methods for the remote detection, classification, and communication of sensor data. In the Complaint, e.Digital broadly accuses the Company’s Arlo wireless camera systems, including the Arlo Wire-Free, Arlo Q, and Arlo Q Plus cameras (collectively, the “Accused Products”). The allegations are generally directed at the “remote monitoring and communication” functionality of the Accused Products. Specifically, the Complaint alleges that the Accused Products infringe the patents-in-suit by utilizing sensors-such as cameras and microphones-to collect data and perform various operations-such as send alerts, trigger video recording, or take a snapshot-in response to a classification of the collected sensor data.

Beginning with a lawsuit against Dropcam in July, 2014, e.Digital has litigated the patents-in-suit, and related portfolio, against a handful of other companies with products similar to the Arlo wireless camera systems. The previous litigation includes the lawsuit against Dropcam along with suits against ArcSoft, Inc., ShenZhen Gospell Smarthome Electronic Co., Ltd., iBaby Labs, Inc., iSmart Alarm, Inc., MivaTek International, Inc., MyFox, Inc., and Nest. Concurrent with the filing of the instant complaint against the Company, e.Digital also filed similar suits against Netatmo LLC and Y-Cam Solutions, LLC. The Company’s case is scheduled to have an initial case management conference on December, 28, 2016, with a case management statement due December 16, 2016. The Company’s Answer to the Complaint is due in early November, 2016.

It is too early to reasonably estimate any financial impact to the Company resulting from 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 Company is required to comply and is currently in compliance with the European Union ("EU") and other Directives on the Restrictions of the use of Certain Hazardous Substances in Electrical and Electronic Equipment (“RoHS”), Waste Electrical and Electronic Equipment ("WEEE") requirements, Energy Using Product (“EuP”) requirements, the REACH Regulation, Packaging Directive and the Battery Directive.

The Company is subject to various federal, state, local, and foreign environmental laws and regulations, including those governing the use, discharge, and disposal of hazardous substances in the ordinary course of our manufacturing process. The Company believes that its current manufacturing and other operations comply in all material respects with applicable environmental laws and regulations; however, it is possible that future environmental legislation may be enacted or current environmental legislation may be interpreted to create an environmental liability with respect to its facilities, operations, or products. See further discussion of the business risks associated with environmental legislation under the risk titled, "We are subject to, and must remain in compliance with, numerous laws and governmental regulations concerning the manufacturing, use, distribution and sale of our products, as well as any such future laws and regulations. Some of our customers also require that we comply with their own unique requirements relating to these matters. Any failure to comply with such laws, regulations and requirements, and any associated unanticipated costs, may adversely affect our business, financial condition and results of operations." within Item 1A Risk Factors of this Form 10-Q.

Note 8.
Stockholders' Equity

Common Stock Repurchase Program

From time to time, the Company’s Board of Directors has authorized programs under which the Company may repurchase shares of its common stock, depending on market conditions, in the open market or through privately negotiated transactions. Under the authorizations, the timing and actual number of shares subject to repurchase are at the discretion of management and

23

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

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. Repurchases made by the Company pursuant to Board-authorized programs during the nine months ended October 2, 2016 and September 27, 2015 are discussed below. As of October 2, 2016, 1.6 million shares remained authorized for repurchase under the repurchase program approved by the Board in July 2015. All shares authorized under previously approved programs were fully utilized.
The Company repurchased, reported based on trade date, 0.6 million shares of common stock at a cost of $23.3 million during the nine months ended October 2, 2016. The Company repurchased, reported based on trade date, 3.4 million shares of common stock at a cost of $105.2 million under the repurchase authorization during the nine months ended September 27, 2015.
The Company repurchased, as reported based on trade date, approximately 99,000 shares of common stock at a cost of $4.4 million under a repurchase program to help administratively facilitate the withholding and subsequent remittance of personal income and payroll taxes for individuals receiving restricted stock units ("RSUs") during the nine months ended October 2, 2016. Similarly, during the nine months ended September 27, 2015, the Company repurchased approximately 77,000 shares of common stock at a cost of $2.4 million under the same program to help facilitate tax withholding for RSUs.
These shares were retired upon repurchase. The purchase price for the shares of the Company’s stock repurchased is reflected as a reduction to stockholders’ equity. 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.

24

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

Accumulated Other Comprehensive Income, Net

The following table sets forth the changes in accumulated other comprehensive income ("AOCI") by component, net of taxes, for the nine months ended October 2, 2016 and September 27, 2015 (in thousands):
 
Gains and losses on available-for-sale securities
 
Gains and losses on derivatives
 
Total
Beginning balance as of December 31, 2015
$
(40
)
 
$
43

 
$
3

Other comprehensive income (loss) before reclassifications
65

 
(684
)
 
(619
)
Amounts reclassified from accumulated other comprehensive income

 
858

 
858

Net current period other comprehensive income (loss)
65

 
174

 
239

Ending balance as of October 2, 2016
$
25

 
$
217

 
$
242


 
Gains and losses on available for sale securities
 
Gains and losses on derivatives
 
Total
Beginning balance as of December 31, 2014
$
(5
)
 
$
43

 
$
38

Other comprehensive income (loss) before reclassifications
21

 
(1,299
)
 
(1,278
)
Amounts reclassified from accumulated other comprehensive income

 
1,197

 
1,197

Net current period other comprehensive income (loss)
21

 
(102
)
 
(81
)
Ending balance as of September 27, 2015
$
16

 
$
(59
)
 
$
(43
)

The following tables provide details about significant amounts reclassified out of each component of AOCI for the three and nine months ended October 2, 2016 and September 27, 2015 (in thousands):
Details about Accumulated Other Comprehensive Income Components
 
Three Months Ended October 2, 2016
 
Nine Months Ended October 2, 2016
 
Amount Reclassified from AOCI
 
Affected Line Item in the Statement of Operations
 
Amount Reclassified from AOCI
 
Affected Line Item in the Statement of Operations
Gains and losses on cash flow hedge:
 
 
 
 
 
 
 
 
Foreign currency forward contracts
 
$
(824
)
 
Net revenue
 
$
(1,543
)
 
Net revenue
Foreign currency forward contracts
 
$
4

 
Cost of revenue
 
$
4

 
Cost of revenue
Foreign currency forward contracts
 
163

 
Operating expenses
 
219

 
Operating expenses
 
 
$
(657
)
 
Total before tax
 
$
(1,320
)
 
Total before tax
 
 
230

 
Tax impact
 
462

 
Tax impact
 
 
$
(427
)
 
Total, net of tax
 
$
(858
)
 
Total, net of tax

Details about Accumulated Other Comprehensive Income Components
 
Three Months Ended September 27, 2015
 
Nine Months Ended September 27, 2015
 
Amount Reclassified from AOCI
 
Affected Line Item in the Statement of Operations
 
Amount Reclassified from AOCI
 
Affected Line Item in the Statement of Operations
Gains and losses on cash flow hedge:
 
 
 
 
 
 
 
 
Foreign currency forward contracts
 
$
(552
)
 
Net revenue
 
$
(1,474
)
 
Net revenue
Foreign currency forward contracts
 
3

 
Cost of revenue
 
7

 
Cost of revenue
Foreign currency forward contracts
 
123

 
Operating expenses
 
270

 
Operating expenses
 
 
(426
)
 
Total before tax
 
(1,197
)
 
Total before tax
 
 

 
Tax impact (1)
 

 
Tax impact (1)
 
 
$
(426
)
 
Total, net of tax
 
$
(1,197
)
 
Total, net of tax
(1)
Under the Company's 2015 tax structure, all hedging gains and losses from derivative contracts were ultimately borne by a legal entity in a jurisdiction with no income tax.


25

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

Note 9.
Employee Benefit Plans
 
2006 Long Term Incentive Plan
The Company's 2006 Long Term Incentive Plan (the "2006 Plan") expired on April 13, 2016 by its terms. No further equity awards can be granted under the 2006 Plan. The 2006 Plan will continue to govern awards previously granted under it.

2016 Equity Incentive Plan
In April 2016, the Company's Board of Directors adopted the 2016 Equity Incentive Plan (the "2016 Plan") which was approved by the Company's stockholders at the 2016 Annual Meeting of Stockholders on June 3, 2016. The 2016 Plan provides for the granting of stock options, stock appreciation rights, restricted stock, restricted stock units, performance shares and performance units to eligible directors, employees and consultants of the Company. Award vesting periods for this plan are generally four years. The maximum aggregate number of shares that may be issued under the 2016 Plan is 2.5 million Shares, plus (i) any shares that were available for grant under the Company’s 2006 Plan as of immediately prior to the 2006 Plan's expiration by its terms, which was 699,827 shares, plus (ii) any shares granted under the 2006 Plan that expire, are forfeited to or repurchased by the Company. As of October 2, 2016, approximately 3.1 million shares were reserved for future grants under the 2016 Plan.
Options granted under the 2016 Plan may be either incentive stock options or nonstatutory stock options. Incentive stock options (“ISO”) may be granted only to Company employees (including officers and directors who are also employees). Nonstatutory stock options (“NSO”) may be granted to Company employees, directors and consultants. Options may be granted for periods of up to ten years and at prices no less than the estimated fair value of the common stock on the date of grant. In addition, the exercise price of an ISO granted to a 10% shareholder shall not be less than 110% of the estimated fair value of the shares on the date of grant. Options granted under the 2016 Plan generally vest over four years, the first tranche at the end of twelve months and the remaining shares underlying the option vesting monthly over the remaining three years. 
Stock Appreciation Rights may be granted under the 2016 Plan subject to the terms specified by the plan administrator, provided that the term of any such right may not exceed ten (10) years from the date of grant. The exercise price may not be less than the fair market value of the Company’s common stock on the date of grant.    
Restricted stock awards may be granted under the 2016 Plan subject to the terms specified by the plan administrator. The period over which any restricted award may fully vest is generally no less than three (3) years. Restricted stock awards are nonvested stock awards that may include grants of restricted stock or grants of restricted stock units. Restricted stock awards are rights to acquire or purchase shares that generally are subject to transferability and forfeitability restrictions for a specified period. Restricted stock has the same voting rights as other common stock and is considered to be currently issued and outstanding. Restricted stock units do not have the voting rights of common stock, and the shares underlying the restricted stock units are not considered issued and outstanding. The Company expenses the cost of the restricted stock awards, which is determined to be the fair market value of the shares at the date of grant, ratably over the period during which the restrictions lapse.    

Performance units and performance shares are awards that result in a payment to a participant only if specified performance objectives or other vesting provisions are achieved during a specified performance period. Each performance unit will have an initial value established by the Administrator on or before the grant date. Each performance share will have an initial value equal to the fair market value of a share on the grant date. The plan administrator will determine the number of performance awards that will be granted and will establish the performance goals and other conditions for payment of such performance awards. The period of measuring the achievement of performance goals will be specified by an award agreement.

Other stock or cash awards may be granted under the 2016 Plan subject to the terms specified by the plan administrator.

Any shares subject to restricted stock, restricted stock units, performance units, or performance shares awarded under the 2016 Plan will be counted against the shares available for issuance under the 2016 Plan as one and fifty-eight hundredths (1.58) shares for every one share subject to such awards. Any shares of common stock subject to an award that is forfeited, settled in cash, expires or is otherwise settled without the issuance of shares shall again be available for awards under the 2016 Plan. Additionally, any shares that are tendered by a participant of the 2016 Plan or retained by the Company as full or partial payment to the Company for the purchase of an award or to satisfy tax withholding obligations in connection with an award shall no longer again be made available for issuance under the 2016 Plan.




26

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

Employee Stock Purchase Plan
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. Prior to February 16, 2016, employees could purchase stock semi-annually at a price equal to 85% of the fair market value on the purchase date. As the price of the shares was determined at the purchase date, the Company recognized expense based on the 15% discount at purchase. Beginning February 16, 2016, the terms of the plan include a look-back feature that enables employees to purchase stock semi-annually at a price equal to 85% of the lesser of the fair market value at the beginning of the offering period or the purchase date. The duration of each offering period is generally six-months. The fair value of the shares offered under the ESPP is estimated at grant using a Black-Scholes option valuation model. In April 2016, the Company approved an amendment to the 2003 Employee Stock Purchase plan to increase the number of shares of common stock authorized for sale under the Purchase Plan by 1.0 million shares to a total of 2.0 million shares. As of October 2, 2016, approximately 1.0 million shares were available for issuance under the ESPP.
Option Activity
Stock option activity during the nine months ended October 2, 2016 was as follows:
 
Number of shares
 
Weighted Average Exercise Price Per Share
 
(in thousands)
 
(in dollars)
Outstanding at December 31, 2015
2,461

 
$
30.08

Granted
328

 
39.53

Exercised
(707
)
 
31.23

Cancelled
(15
)
 
34.10

Expired
(2
)
 
34.37

Outstanding at October 2, 2016
2,065

 
$
31.16


RSU Activity

RSU activity during the nine months ended October 2, 2016 was as follows:
 
Number of shares
 
Weighted Average Grant Date Fair Value Per Share
 
(in thousands)
 
(in dollars)
Outstanding at December 31, 2015
964

 
$
31.63

RSUs granted
457

 
40.65

RSUs vested
(321
)
 
31.22

RSUs cancelled
(82
)
 
31.35

Outstanding at October 2, 2016
1,018

 
$
35.84


Valuation and Expense Information
The fair value of each option award and share granted under the ESPP commencing February 16, 2016 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 for options and ESPP shares 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 for options and ESPP shares is based on historical volatility over the most recent period commensurate with the estimated expected term.

27

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

The table below sets forth the weighted average assumptions used to estimate the fair value of option grants during the three and nine months ended October 2, 2016 and September 27, 2015 and purchase rights granted under the ESPP commencing February 16, 2016 during the three and nine months ended October 2, 2016.
 
Three Months Ended
 
Nine Months Ended
 
ESPP
 
Stock Options
 
ESPP
 
Stock Options
 
October 2,
2016
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
October 2,
2016
 
September 27,
2015
Expected life (in years)
0.5
 
N/A
 
N/A
 
0.5
 
4.4
 
4.5
Risk-free interest rate
0.45%
 
N/A
 
N/A
 
0.43%
 
1.28%
 
1.44%
Expected volatility
28.6%
 
N/A
 
N/A
 
38.3%
 
35.4%
 
39.3%
Dividend yield
 
N/A
 
N/A
 
 
 
The following table sets forth the 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
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
Cost of revenue
$
426

 
$
358

 
$
1,316

 
$
1,190

Research and development
1,087

 
877

 
3,071

 
2,495

Sales and marketing
1,300

 
1,173

 
3,835

 
3,838

General and administrative
2,057

 
1,703

 
6,078

 
4,994

Total stock-based compensation
$
4,870

 
$
4,111

 
$
14,300

 
$
12,517


As of October 2, 2016, $6.6 million of unrecognized compensation cost related to stock options, adjusted for estimated forfeitures, is expected to be recognized over a weighted-average period of 2.7 years. $24.8 million of unrecognized compensation cost related to unvested RSUs, adjusted for estimated forfeitures, is expected to be recognized over a weighted-average period of 2.6 years.

Note 10.
Segment Information and Operations by Geographic Area

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 has identified its CEO as the CODM and 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, home video security, storage and digital media products. The commercial business unit consists of business networking and storage solutions that bring enterprise class functionality down to the small and medium-sized business at an affordable price. The service provider business unit consists of made-to-order and retail proven, whole home networking hardware and software solutions as well as 4G LTE hotspots sold to service providers for sale to their subscribers. Each business unit contains leadership focused on the product development efforts, both from a product marketing and engineering standpoint, to service the unique needs of these customer segments. 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.

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, corporate marketing expense and general and administrative costs, amortization of intangibles, stock-based compensation expense, restructuring and other charges, losses on inventory commitments due to restructuring, litigation reserves, net, interest income and other income (expense), net. The Company does not evaluate operating segments using discrete asset information.


28

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

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
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
Net revenue:
 
 
 
 
 
 
 
Retail
$
194,203

 
$
164,081

 
$
522,392

 
$
416,847

Commercial
73,405

 
65,187

 
215,508

 
200,935

Service provider
70,850

 
112,625

 
222,469

 
322,050

Total net revenue
338,458

 
341,893

 
960,369

 
939,832

Contribution income:
 
 
 
 
 
 
 
Retail
$
23,218

 
$
21,149

 
$
73,177

 
$
53,715

Retail contribution margin
12.0
%
 
12.9
%
 
14.0
%
 
12.9
%
Commercial
20,216

 
13,700

 
53,604

 
42,507

Commercial contribution margin
27.5
%
 
21.0
%
 
24.9
%
 
21.2
%
Service Provider
12,872

 
14,819

 
35,582

 
27,472

Service Provider contribution margin
18.2
%
 
13.2
%
 
16.0
%
 
8.5
%
Total segment contribution income
56,306

 
49,668

 
162,363

 
123,694

Corporate and unallocated costs
(17,532
)
 
(14,363
)
 
(50,666
)
 
(39,559
)
Amortization of intangibles (1)
(4,165
)
 
(4,165
)
 
(12,496
)
 
(12,804
)
Stock-based compensation expense
(4,870
)
 
(4,111
)
 
(14,300
)
 
(12,517
)
Restructuring and other charges
130

 
(1,016
)
 
(3,859
)
 
(6,384
)
Losses on inventory commitments due to restructuring

 

 

 
(407
)
Litigation reserves, net
(13
)
 

 
(58
)
 
2,690

Interest income
291

 
65

 
804

 
184

Other income (expense), net
116

 
(199
)
 
(582
)
 
(67
)
Income before income taxes
$
30,263

 
$
25,879

 
$
81,206

 
$
54,830

(1)
Amount excludes amortization expense related to patents included in cost of revenue.

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
 
Nine Months Ended
 
October 2,
2016
 
September 27,
2015
 
October 2,
2016
 
September 27,
2015
United States (U.S.)
$
217,631

 
$
213,913

 
$
610,505

 
$
552,787

Americas (excluding U.S.)
7,604

 
5,823

 
19,488

 
13,194

EMEA
60,034

 
77,725

 
176,192

 
234,827

APAC
$
53,189

 
$
44,432

 
$
154,184

 
$
139,024

Total net revenue
$
338,458

 
$
341,893

 
$
960,369

 
$
939,832



29

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

Long-lived assets include purchased intangibles, goodwill and property and equipment. The Company's property and equipment are located in the following geographic locations (in thousands):
 
As of
 
October 2,
2016
 
December 31,
2015
United States
$
8,992

 
$
9,832

Canada
3,131

 
3,586

EMEA
602

 
468

China
4,725

 
6,562

APAC (excluding China)
2,026

 
1,936

 
$
19,476

 
$
22,384


Note 11.
Fair Value Measurements (in thousands)
The following tables summarize assets and liabilities measured at fair value on a recurring basis as of October 2, 2016:
 
As of October 2, 2016
 
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
$
10,325

 
$
10,325

 
$

 
$

Available-for-sale securities—U.S. treasuries (1)
127,689

 
127,689

 

 

Available-for-sale securities—certificates of deposit (1)
156

 
156

 

 

Trading securities—mutual funds (1)
1,451

 
1,451

 

 

Foreign currency forward contracts (2)
1,053

 

 
1,053

 

Total assets measured at fair value
$
140,674

 
$
139,621

 
$
1,053

 
$

 
(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 October 2, 2016
 
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)
$
1,285

 
$

 
$
1,285

 
$

Total liabilities measured at fair value
$
1,285

 
$

 
$
1,285

 
$

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

30