10-Q 1 ntgr20170402-10q.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 April 2, 2017.

¨ 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, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large Accelerated filer
 
x
 
Accelerated filer
 
¨
Non-Accelerated filer
 
¨
 
Smaller reporting company
 
¨
 
 
 
 
Emerging growth company
 
¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
 
¨


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 32,453,968 as of April 28, 2017.

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)
 
 
As of
 
April 2,
2017
 
December 31,
2016
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
235,668

 
$
240,468

Short-term investments
125,567

 
125,514

Accounts receivable, net
265,254

 
313,839

Inventories
267,826

 
247,862

Prepaid expenses and other current assets
29,959

 
35,102

Total current assets
924,274

 
962,785

Property and equipment, net
19,348

 
19,473

Intangibles, net
33,438

 
37,899

Goodwill
85,463

 
85,463

Other non-current assets
79,620

 
78,836

Total assets
$
1,142,143

 
$
1,184,456

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
89,765

 
$
112,436

Accrued employee compensation
20,514

 
33,096

Other accrued liabilities
149,282

 
170,674

Deferred revenue
32,507

 
35,301

Income taxes payable
9,855

 
5,146

Total current liabilities
301,923

 
356,653

Non-current income taxes payable
15,734

 
15,119

Other non-current liabilities
16,456

 
15,865

Total liabilities
334,113

 
387,637

Commitments and contingencies (Note 8)


 


Stockholders’ equity:
 
 
 
Common stock
33

 
33

Additional paid-in capital
576,862

 
566,307

Accumulated other comprehensive income
402

 
1,938

Retained earnings
230,733

 
228,541

Total stockholders’ equity
808,030

 
796,819

Total liabilities and stockholders’ equity
$
1,142,143

 
$
1,184,456

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
 
April 2,
2017
 
April 3,
2016
Net revenue
$
323,657

 
$
310,256

Cost of revenue
226,725

 
209,691

Gross profit
96,932

 
100,565

Operating expenses:
 
 
 
Research and development
22,683

 
22,137

Sales and marketing
38,229

 
37,277

General and administrative
13,194

 
12,849

Restructuring and other charges
37

 
2,678

Litigation reserves, net

 
10

Total operating expenses
74,143

 
74,951

Income from operations
22,789

 
25,614

Interest income
405

 
234

Other income (expense), net
335

 
(366
)
Income before income taxes
23,529

 
25,482

Provision for income taxes
7,535

 
8,893

Net income
$
15,994

 
$
16,589

Net income per share:
 
 
 
Basic
$
0.49

 
$
0.51

Diluted
$
0.47

 
$
0.50

Weighted average shares used to compute net income per share:
 
 
 
Basic
32,944

 
32,519

Diluted
34,136

 
33,269

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
 
April 2,
2017
 
April 3,
2016
Net income
$
15,994

 
$
16,589

Other comprehensive loss, before tax:
 
 
 
Unrealized losses on derivative instruments
(1,697
)
 
(547
)
Unrealized gains (losses) on available-for-sale securities
(55
)
 
101

Other comprehensive loss, before tax
(1,752
)
 
(446
)
Tax benefit related to derivative instruments
196

 

Tax benefit (provision) related to available-for-sale securities
20

 
(38
)
Other comprehensive loss, net of tax
(1,536
)
 
(484
)
Comprehensive income
$
14,458

 
$
16,105

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


5


NETGEAR, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
 
 
Three Months Ended
 
April 2,
2017
 
April 3,
2016
Cash flows from operating activities:
 
 
 
Net income
$
15,994

 
$
16,589

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
7,866

 
8,508

Purchase premium amortization/discount accretion on investments, net
64

 
20

Non-cash stock-based compensation
5,128

 
4,411

Income tax impact associated with stock option exercises

 
(24
)
Deferred income taxes
468

 
489

Changes in assets and liabilities:
 
 
 
Accounts receivable
48,585

 
72,221

Inventories
(19,964
)
 
(2,189
)
Prepaid expenses and other assets
3,508

 
3,784

Accounts payable
(22,106
)
 
(16,101
)
Accrued employee compensation
(12,582
)
 
(6,297
)
Other accrued liabilities
(20,230
)
 
(18,591
)
Deferred revenue
(2,794
)
 
(2,726
)
Income taxes payable
5,324

 
1,930

Net cash provided by operating activities
9,261

 
62,024

Cash flows from investing activities:
 
 
 
Purchases of short-term investments
(33,917
)
 
(30,148
)
Proceeds from maturities of short-term investments
33,894

 
20,143

Purchase of property and equipment
(3,434
)
 
(2,056
)
Cost method investment
(1,400
)
 

Payments made in connection with business acquisition, net of cash acquired
(737
)
 

Net cash used in investing activities
(5,594
)
 
(12,061
)
Cash flows from financing activities:
 
 
 
Repurchases of common stock
(11,631
)
 
(10,006
)
Restricted stock unit withholdings
(1,936
)
 
(350
)
Proceeds from exercise of stock options
2,438

 
3,661

Proceeds from issuance of common stock under employee stock purchase plan
2,662

 
1,645

Net cash used in financing activities
(8,467
)
 
(5,050
)
Net increase (decrease) in cash and cash equivalents
(4,800
)
 
44,913

Cash and cash equivalents, at beginning of period
240,468

 
181,945

Cash and cash equivalents, at end of period
$
235,668

 
$
226,858

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 networking and Internet connected products to consumers and growing businesses. 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, 2016 has been derived from audited financial statements at such date. Accordingly, these unaudited 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 audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016.
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 months ended April 2, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017 or any future period.

Reclassification

In the first quarter of fiscal 2017, the Company reorganized its operating segment structure resulting in a change to its reportable segments. This change primarily impacted Goodwill in Note 4, Balance Sheet Components and Note 11, Segment Information. The prior-year segment financial information has been reclassified to conform to the current-year presentation. None of the changes impact previously reported consolidated net revenue, income from operations, net income per share, total assets, or stockholders’ equity. Refer to Note 11, Segment Information, for a further discussion of the segment reorganization. Additionally, upon adoption of ASU 2016-09, the Company elected to apply the presentation requirements for cash flows related to excess tax benefits retrospectively to all periods presented. Refer to recently adopted accounting pronouncement under Note 2, Summary of Significant Accounting Policies, for a further discussion of the impact from the adoption of ASU 2016-09.

 
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, 2016. The Company’s significant accounting policies have not materially changed during the three months ended April 2, 2017.


7

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

Recent accounting pronouncements

Accounting Pronouncement Recently Adopted

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. The new guidance requires excess tax benefits and tax deficiencies to be recorded in the income statement when stock awards vest or are settled. In addition, cash flows related to excess tax benefits will no longer be separately classified as an inflow from financing activities with a corresponding outflow from operating activities but will be classified along with other income tax cash flows as an operating activity. The standard also allows the entity to repurchase more of an employee’s vesting shares for tax withholding purposes without triggering liability accounting, clarifies that all cash payments made to tax authorities on an employee’s behalf for withheld shares should be presented as a financing activity on the cash flows statement, and provides an accounting policy election to account for forfeitures as they occur. The new guidance became effective for the Company in the first quarter of fiscal 2017.

Upon adoption on January 1, 2017, the Company prospectively recorded all excess tax benefits and tax deficiencies arising from stock awards vesting or settlement as income tax expense or benefit rather than in equity. For the three months ended April 2, 2017, the impact of the adoption was the recognition of $0.8 million excess tax benefits as a component of the provision for income taxes. The Company elected to account for forfeitures as they occur, rather than estimating expected forfeitures, which resulted in net cumulative-effect adjustment of $0.2 million decrease to retained earnings as of January 1, 2017. The Company elected to apply the presentation requirements for cash flows related to excess tax benefits retrospectively to all periods presented, which resulted in an increase to both net cash provided by operations and net cash used in financing of $0.2 million for the three months ended April 3, 2016 on the consolidated statement of cash flows. The presentation requirement for cash flows related to employee taxes paid for withheld shares had no impact to any of the periods presented on the consolidated statements of cash flows since the Company has historically been presented such cash flows as a financing activity.

Accounting Pronouncements Not Yet Effective

In May 2014, the Financial Accounting Standards Board ("FASB") issued ASU 2014-09, "Revenue from Contracts with Customers" (Topic 606), which was further updated in March, April, May and December 2016. 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 retrospectively to each prior reporting period presented (full retrospective method) or retrospectively with the cumulative effect of initially applying this update recognized at the date of initial application (modified retrospective method). 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 of fiscal 2018 and early adoption is permitted. The Company currently anticipates adopting the new standard effective January 1, 2018. The Company continues to evaluate the impact of the new standard on its financial position, results of operations and cash flows and related disclosures. Although the Company is still in the process of evaluating its contracts, at this stage of the process, it does not believe the adoption of ASU 2014-09 will have a significant impact on the amount or timing of its revenues. The accounting for consideration payable to a customer under ASU 2014-09 differs from the superseded guidance, which consequently may require the Company to estimate for future consideration payable to a customer ahead of commitment date. The impact of this guidance change is still being evaluated but may result, upon adoption, of an adjustment to the financial position to bring forward the recognition of yet to be committed liabilities at the adoption date. The Company expects to complete the assessment process, including selecting a transition method for adoption, by the end of the third quarter of fiscal 2017, and to complete the implementation process, including adding procedures and evaluating necessary disclosures, prior to the first quarter of fiscal 2018.

In January 2016, the FASB issued ASU 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities" (Subtopic 825-10), which addresses certain aspects of recognition, measurement, presentation and disclosure of financial instruments. This guidance also clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. ASU 2016-01 is effective for the Company in the first quarter of fiscal 2018 and early adoption is permitted. The Company is currently evaluating the impact the update will have on its financial position, results of operations and cash flows and related disclosures.


8

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

In February 2016, FASB issued ASU 2016-02, "Leases" (Topic 842), which requires lessees to recognize on the balance sheets 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. The liability will be equal to the present value of lease payments while the right-of-use asset will be based on the liability, subject to adjustment, such as for initial direct costs. In addition, ASU 2016-02 expands the disclosure requirements for lessees. Upon adoption, the Company will be required to record a lease asset and lease liability related to its operating leases. ASU 2016-02 will be applied using a modified retrospective transition method and is effective for the Company in the first quarter fiscal 2019, with early adoption permitted. The Company does not plan to early adopt the guidance and is currently evaluating the impact the update will have on its financial position, results of operations and cash flows and related disclosures.

In June 2016, the FASB issued ASU 2016-13, "Measurement of Credit Losses on Financial Instruments" (Topic 326), which replaces the incurred-loss impairment methodology and requires immediate recognition of estimated credit losses expected to occur for most financial assets, including trade receivables. Credit losses on available-for-sale debt securities with unrealized losses will be recognized as allowances for credit losses limited to the amount by which fair value is below amortized cost. ASU 2016-13 is effective for the Company beginning in the first quarter of 2020 and early adoption is permitted. The Company continues to assess the potential impact of the new guidance, but does not expect it to have material impacts on its financial position, results of operations or cash flows.

In October 2016, the FASB issued ASU 2016-16, "Income Taxes: Intra-Entity Transfers of Assets Other Than Inventory" (Topic 740), which requires the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. This removes the exception to postpone recognition until the asset has been sold to an outside party. ASU 2016-16 is effective for the Company in the first quarter of fiscal 2018 and early adoption is permitted. The Company is currently evaluating what impact, if any, the adoption of this guidance will have on its financial position, results of operations and cash flows.

In January 2017, the FASB issued ASU 2017-01, "Business Combinations: Clarifying the Definition of a Business" (Topic 805), which changes the definition of a business to assist entities with evaluating when a set of transferred assets and activities is a business. The guidance requires an entity to evaluate if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets; if so, the set of transferred assets and activities is not a business. ASU 2017-01 is effective for the Company in the first quarter of fiscal 2018 and early adoption is permitted. The guidance should be applied prospectively to any transactions occurring on or after the adoption date. The Company does not expect it to have material impacts on its financial position, results of operations or cash flows.

In January 2017, the FASB issued ASU 2017-04, "Intangibles-Goodwill and Other: Simplifying the Test for Goodwill Impairment" (Topic 350), which simplifies the subsequent measurement of goodwill by removing Step 2 of goodwill impairment test that requires the determination of the fair value of individual assets and liabilities of a reporting unit. The new guidance requires goodwill impairment to be measured as the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. ASU 2017-04 will be applied prospectively and is effective for the Company in the first quarter of fiscal 2020, with early adoption permitted. The Company does not expect it to have material impacts on its financial position, results of operations or cash flows.

Note 3.
Business Acquisition
Placemeter, Inc.
On November 30, 2016, the Company acquired Placemeter, Inc. ("Placemeter"), an industry leader in computer vision analytics, for total purchase consideration of $9.6 million. The Company believes that Placemeter’s engineering talent will add value to NETGEAR’s Arlo smart security team, and that their proprietary computer vision algorithms will help to build video analytics solutions for the Arlo platform.
The Company paid $8.8 million of the aggregate purchase price in the fourth quarter of 2016 and paid the remaining $0.8 million in the first quarter of fiscal 2017. The acquisition qualified as a business combination and was accounted for using the acquisition method of accounting. The results of Placemeter have been included in the unaudited condensed consolidated financial statements since the date of acquisition. Proforma results of operations for the acquisition are not presented as the financial impact to the Company's consolidated results of operations is not material.

9

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

The allocation of the purchase price was as follows (in thousands):
Cash and cash equivalents
$
8

Accounts receivable, net
11

Prepaid expenses and other current assets
130

Property and equipment, net
83

Intangibles, net
6,000

Goodwill
3,742

Accounts payable
(40
)
Other accrued liabilities
(74
)
Deferred tax liabilities, net
(308
)
Total purchase price
$
9,552

The $3.7 million of goodwill recorded on the acquisition of Placemeter is not deductible for U.S. federal or U.S. state income tax purposes. The goodwill recognized, which was assigned to the Company's former retail segment upon acquisition and was allocated to the Arlo segment under its new reporting structure, is primarily attributable to expected synergies resulting from the acquisition.
In connection with the acquisition, the Company recorded $0.3 million of deferred tax liabilities net of deferred tax assets. The deferred tax liabilities were recorded for the book basis of intangible assets for which the Company has no tax basis. The deferred tax liabilities are reduced by the tax benefit of the net operating losses as of the date of the acquisition after consideration of limitations on the use under U.S. Internal Revenue Code section 382.
The Company designated $5.5 million of the acquired intangibles as software technology and a further $0.2 million of the acquired intangibles as database. The valuations were arrived at using the replacement cost method, with consideration having been given to the estimated time, investment and resources required to recreate the acquired intangibles. A discount rate of 15.0% was used in the valuation of each intangible. The acquired intangibles are being amortized over an estimated useful life of four years.
The Company designated $0.3 million of the acquired intangibles as non-compete agreements. The value was calculated based on the present value of the future estimated cash flows derived from projections of future operations attributable to the non-compete agreements and discounted at 20.0%. The acquired agreements are being amortized over an estimated useful life of three years.

Note 4.
Balance Sheet Components

Available-for-sale short-term investments
 
As of
 
April 2, 2017
 
December 31, 2016
 
Cost
 
Unrealized Gain
 
Unrealized Loss
 
Estimated Fair Value
 
 Cost
 
Unrealized Gain
 
Unrealized Loss
 
Estimated Fair Value
 
(In thousands)
U.S. treasuries
$
123,818

 
$

 
$
(86
)
 
$
123,732

 
$
123,869

 
$
9

 
$
(40
)
 
$
123,838

Certificates of deposit
158

 

 

 
158

 
148

 

 

 
148

Total
$
123,976

 
$

 
$
(86
)
 
$
123,890

 
$
124,017

 
$
9

 
$
(40
)
 
$
123,986


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 twelve months. Accordingly, none of the available-for-sale securities have unrealized losses greater than twelve months.


10

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

Accounts receivable, net
 
As of
 
April 2,
2017
 
December 31,
2016
 
(In thousands)
Gross accounts receivable
$
281,512

 
$
333,080

Allowance for doubtful accounts
(1,255
)
 
(1,255
)
Allowance for sales returns
(12,267
)
 
(13,506
)
Allowance for price protection
(2,736
)
 
(4,480
)
Total allowances
(16,258
)
 
(19,241
)
Total accounts receivable, net
$
265,254

 
$
313,839


Inventories
 
As of
 
April 2,
2017
 
December 31,
2016
 
(In thousands)
Raw materials
$
4,026

 
$
4,596

Work in process
4



Finished goods
263,796

 
243,266

Total inventories
$
267,826

 
$
247,862


The Company records provisions for excess and obsolete inventory based on assumptions about future demand and market conditions. 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.

Property and equipment, net  
 
As of
 
April 2,
2017
 
December 31,
2016
 
(In thousands)
Computer equipment
$
10,237

 
$
10,557

Furniture, fixtures and leasehold improvements
21,007

 
20,827

Software
28,698

 
28,663

Machinery and equipment
65,747

 
63,446

Total property and equipment, gross
125,689

 
123,493

Accumulated depreciation and amortization
(106,341
)
 
(104,020
)
Total property and equipment, net
$
19,348

 
$
19,473


Depreciation and amortization expense pertaining to property and equipment was $3.4 million for the three months ended April 2, 2017 and $3.9 million for the three months ended April 3, 2016.


11

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

Intangibles, net
 
As of April 2, 2017
 
Gross
 
Accumulated Amortization
 
Net
 
(In thousands)
Technology
$
66,599

 
$
(59,769
)
 
$
6,830

Customer contracts and relationships
56,500

 
(32,147
)
 
24,353

Other
11,045

 
(8,790
)
 
2,255

Total intangibles, net
$
134,144

 
$
(100,706
)
 
$
33,438


 
As of December 31, 2016
 
Gross
 
Accumulated Amortization
 
Net
 
(In thousands)
Technology
$
66,599

 
$
(57,381
)
 
$
9,218

Customer contracts and relationships
56,500

 
(30,375
)
 
26,125

Other
11,045

 
(8,489
)
 
2,556

Total intangibles, net
$
134,144

 
$
(96,245
)
 
$
37,899


Amortization of intangibles was $4.5 million for the three months ended April 2, 2017 and $4.2 million for the three months ended April 3, 2016.

Estimated amortization expense related to intangibles for each of the next five years and thereafter is as follows:
 
As of April 2, 2017
 
(In thousands)
2017 (remaining nine months)
$
8,450

2018
9,396

2019
7,544

2020
6,622

2021
1,413

Thereafter
13

Total estimated amortization expense
$
33,438


Goodwill

As discussed in Note 11, Segment Information, during the first quarter fiscal 2017, the Company's Chief Operating Decision Maker requested changes in the information that he regularly reviews for purposes of allocating resources and assessing performance. With these changes, the Company revised its reportable segments. Beginning fiscal 2017, the Company operates and reports in three new segments: Arlo, Connected Home, and Small and Medium Business ("SMB") segments. Goodwill was reallocated to the new reportable segments using a relative fair value approach. As a result, the Company completed assessments of any potential goodwill impairment for all reportable segments immediately prior to and after the reallocation and determined that no impairment existed.


12

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

The carrying amount of goodwill under the new segments during the three months ended April 2, 2017 are as follows:
 
 
Arlo
 
Connected Home
 
SMB
 
Total
 
 
(In thousands)
Goodwill as of January 1, 2017
 
$
21,149

 
$
28,035

 
$
36,279

 
$
85,463

Goodwill as of April 2, 2017
 
$
21,149

 
$
28,035

 
$
36,279

 
$
85,463


Other non-current assets
 
As of
 
April 2,
2017
 
December 31, 2016
 
(In thousands)
Non-current deferred income taxes
$
70,484

 
$
70,859

Other
9,136

 
7,977

Total other non-current assets
$
79,620

 
$
78,836


Other accrued liabilities
 
As of
 
April 2,
2017
 
December 31,
2016
 
(In thousands)
Sales and marketing
$
60,572

 
$
74,330

Warranty obligation
56,336

 
58,520

Freight
5,008

 
8,980

Other
27,366

 
28,844

Total other accrued liabilities
$
149,282

 
$
170,674

 
Note 5.
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 less than 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

13

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

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.

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 April 2, 2017 and December 31, 2016 are summarized as follows:
Derivative Assets
 
Balance Sheet
Location
 
Fair Value at
April 2, 2017
 
Balance Sheet
Location
 
Fair Value at
December 31, 2016
 
 
 
 
(In thousands)
 
 
 
(In thousands)
Derivative assets not designated as hedging instruments
 
Prepaid expenses and other current assets
 
$
1,746

 
Prepaid expenses and other current assets
 
$
5,873

Derivative assets designated as hedging instruments
 
Prepaid expenses and other current assets
 
1,136

 
Prepaid expenses and other current assets
 
2,890

Total
 
 
 
$
2,882

 
 
 
$
8,763


Derivative Liabilities
 
Balance Sheet
Location
 
Fair Value at
April 2, 2017
 
Balance Sheet
Location
 
Fair Value at
December 31, 2016
 
 
 
 
(In thousands)
 
 
 
(In thousands)
Derivative liabilities not designated as hedging instruments
 
Other accrued liabilities
 
$
603

 
Other accrued liabilities
 
$
1,002

Derivative liabilities designated as hedging instruments
 
Other accrued liabilities
 
455

 
Other accrued liabilities
 
703

Total
 
 
 
$
1,058

 
 
 
$
1,705


For details of the Company’s fair value measurements, see Note 12, 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 April 2, 2017 and December 31, 2016:
As of April 2, 2017
 
 
 
 
 
 
 
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
 
 
(In thousands)
Bank of America
 
$
537

 
$

 
$
537

 
$
(79
)
 
$

 
$
458

J.P. Morgan Chase
 
1,036

 

 
1,036

 
(236
)
 

 
800

Wells Fargo
 
1,309

 

 
1,309

 
(743
)
 

 
566

Total
 
$
2,882

 
$

 
$
2,882

 
$
(1,058
)
 
$

 
$
1,824



14

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

As of December 31, 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
 
 
(In thousands)
J.P. Morgan Chase
 
$
1,492

 
$

 
$
1,492

 
$
(442
)
 
$

 
$
1,050

Wells Fargo
 
7,271

 

 
7,271

 
(1,263
)
 

 
6,008

Total
 
$
8,763

 
$

 
$
8,763

 
$
(1,705
)
 
$

 
$
7,058


The following tables set forth the offsetting of derivative liabilities as of April 2, 2017 and December 31, 2016:
As of April 2, 2017
 
 
 
 
 
 
 
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

 
(In thousands)
Bank of America
 
$
79

 
$

 
$
79

 
$
(79
)
 
$

 
$

JP Morgan Chase
 
236

 

 
236

 
(236
)
 

 

Wells Fargo
 
743

 

 
743

 
(743
)
 

 

Total
 
$
1,058

 
$

 
$
1,058

 
$
(1,058
)
 
$

 
$


As of December 31, 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
 
 
(In thousands)
J.P. Morgan Chase
 
$
442

 
$

 
$
442

 
$
(442
)
 
$

 
$

Wells Fargo
 
1,263

 

 
1,263

 
(1,263
)
 

 

Total
 
$
1,705

 
$

 
$
1,705

 
$
(1,705
)
 
$

 
$


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 five to nine 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.


15

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

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 (expense), net. 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 months ended April 2, 2017 and April 3, 2016.

The pre-tax effects of the Company’s derivative instruments on OCI and the unaudited condensed consolidated statement of operations for the three months ended April 2, 2017 and April 3, 2016 are summarized as follows:
Derivatives Designated as Hedging Instruments
 
Three Months Ended April 2, 2017
 
Gains (Losses)
Recognized in
OCI -
Effective
Portion
 
Location of
Gain (Loss)
Reclassified from OCI
into Income - Effective
Portion
 
Gains (Losses)
Reclassified
from
OCI into
Income -
Effective
Portion (1)
 
Location of
Gains (Losses)
Recognized in
Income and
Excluded from
Effectiveness Testing
 
Amount of Gains (Losses) Recognized in
Income and
Excluded from
Effectiveness Testing
 
 
(In thousands)
Cash flow hedges:
 
 
 
 
 
 
 
 
 
 
Foreign currency forward contracts
 
$
(117
)
 
Net revenue
 
$
2,035

 
Other income (expense), net
 
$
287

Foreign currency forward contracts
 

 
Cost of revenue
 
(13
)
 
Other income (expense), net
 

Foreign currency forward contracts
 

 
Operating expenses
 
(442
)
 
Other income (expense), net
 

Total
 
$
(117
)
 
 
 
$
1,580

 
 
 
$
287

_________________________
(1) Refer to Note 9, Stockholders' Equity, which summarizes the accumulated other comprehensive income activity related to derivatives.
Derivatives Designated as Hedging Instruments
 
Three Months Ended April 3, 2016
 
Gains (Losses)
Recognized in
OCI -
Effective
Portion
 
Location of
Gain (Loss)
Reclassified from OCI
into Income - Effective
Portion
 
Gains (Losses)
Reclassified
from
OCI into
Income -
Effective
Portion (1)
 
Location of
Gains (Losses)
Recognized in
Income and
Excluded from
Effectiveness Testing
 
Amount of Gains (Losses) Recognized in
Income and
Excluded from
Effectiveness Testing
 
 
(In thousands)
Cash flow hedges:
 
 
 
 
 
 
 
 
 
 
Foreign currency forward contracts
 
$
(787
)
 
Net revenue
 
$
(312
)
 
Other income (expense), net
 
$
35

Foreign currency forward contracts
 

 
Cost of revenue
 
2

 
Other income (expense), net
 

Foreign currency forward contracts
 

 
Operating expenses
 
70

 
Other income (expense), net
 

Total
 
$
(787
)
 
 
 
$
(240
)
 
 
 
$
35

_________________________
(1) Refer to Note 9, 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 four non-designated

16

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

derivatives per quarter. The average size of its non-designated hedges is approximately $2.0 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 months ended April 2, 2017 and April 3, 2016 are as follows:
Derivatives Not Designated as Hedging Instruments
 
Location of Gains (Losses)
Recognized in Income on Derivative
 
Three Months Ended
 
April 2, 2017
 
April 3, 2016
 
 
 
 
(In thousands)
Foreign currency forward contracts
 
Other income (expense), net
 
$
(1,353
)
 
$
(1,944
)

Note 6.
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 common shares issuable upon exercise of stock options, vesting of restricted stock awards, and issuances of shares under the Employee Stock Purchase Plan (the "ESPP"), which are reflected in diluted net income per share by application of the treasury stock method.
Net income per share for the three months ended April 2, 2017 and April 3, 2016 are as follows:
 
Three Months Ended
 
April 2,
2017
 
April 3,
2016
 
(In thousands, except per share data)
Numerator:
 
 
 
Net income
$
15,994

 
$
16,589

 
 
 
 
Denominator:
 
 
 
Weighted average common shares - basic
32,944

 
32,519

Potentially dilutive common share equivalent
1,192

 
750

Weighted average common shares - dilutive
$
34,136

 
$
33,269

 
 
 
 
Basic net income per share
$
0.49

 
$
0.51

Diluted net income per share
$
0.47

 
$
0.50

 
 
 
 
Anti-dilutive employee stock-based awards, excluded
70

 
486


Note 7.
Income Taxes

The income tax provision for the three months ended April 2, 2017 and April 3, 2016, was $7.5 million, or an effective tax rate of 32.0%, and $8.9 million, or an effective tax rate of 34.9%, respectively. The effective tax rate for the three months ended April 2, 2017, compared to the three months ended April 3, 2016, decreased mainly due to differences in the accounting treatment of excess tax benefits related to stock awards. The Company adopted ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting" on January 1, 2017, which requires excess tax benefits or deficiencies to be reflected in the unaudited condensed consolidated statements of income as a component of the provision for income taxes whereas they previously were recorded in equity. Total excess tax benefits recognized in the three months ended April 2, 2017 was $0.8 million. 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.


17

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

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 $1.0 million, excluding the interest, penalties and the effect of any related deferred tax assets or liabilities.


Note 8.
Commitments and Contingencies

Leases

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

Purchase Obligations

The Company has entered into various inventory-related purchase agreements with suppliers. Generally, under these agreements, 50% of orders are cancelable by giving notice 46 to 60 days prior to the expected shipment date and 25% of orders are cancelable by giving notice 31 to 45 days prior to the expected shipment date. Orders are non-cancelable within 30 days prior to the expected shipment date. As of April 2, 2017, the Company had approximately $181.7 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:
 
Three Months Ended
 
April 2,
2017
 
April 3,
2016
 
(In thousands)
Balance as of beginning of the period
$
58,520

 
$
56,706

Provision for warranty obligation made during the period
26,753

 
16,216

Settlements made during the period
(28,937
)
 
(23,014
)
Balance at end of period
$
56,336

 
$
49,908


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 April 2, 2017.


18

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

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 April 2, 2017.

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 April 2, 2017.

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 non-infringement 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.


19

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

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 cents 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.

On 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 cents 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 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 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 Federal Circuit's appeal decision, and the Federal Circuit agreed to the en banc rehearing. 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 encompassed 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

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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 filed a counter appeal on July 23, 2016 and is awaiting scheduling of the hearing.

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 and the hearing was held on March 22, 2017. The Company is awaiting a decision.

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 filed its appeal to the Regional Tax Court and the Company has submitted its counter brief. The hearing has not yet been scheduled.

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 filed its appeal to the Regional Tax Court. The Company filed its counter brief on February 5, 2017.

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 and a decision favorable to the Company was issued by the Court. The Inland Revenue Agency appealed the decision on April 24, 2017.

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

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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. In early March of 2017, The Patent Trial and Appeal Board (PTAB) issued various decisions regarding Amazon’s and Blizzard’s IPRs of the patents in suit. One of the IPRs of the '125 patent resulted in a finding by the PTAB that Amazon and Blizzard had had failed to show invalidity. The second IPR on the '125 patent, however, resulted in cancelation of all claims asserted in Via Vadis’s suit against the Company. Reissue '521 did not have any claims found invalid by the PTAB, and some dependent claims of the '680 patent survived the IPRs, and some claims of the '680 patent were canceled. The Northern District of California case against the Company remains stayed.

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.

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. Juniper’s four IPR petitions were instituted by the PTAB in January 2017, and the Company subsequently moved to join the IPR petitions as an “understudy” to Juniper, only assuming a more active role in the petitions in the event Juniper settles with CMS. For all four patents in suit against the Company, the PTAB ordered that (a) the Petitioners’ (the Company, Ruckus, and Brocade) Motion for Joinder to the Juniper IPRs is granted; (b) the Petitioners IPRs are instituted on the same grounds as in the Juniper ‘IPRs and Petitioners are joined with the Juniper IPRs; and (c) all further filings by Petitioners in the joined proceedings will be in the Juniper IPRs. The Company is now proceeding on the Juniper IPR schedule. The Northern District of California CMS cases remain stayed in their entirety by the Court.

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

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.

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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; 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.

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.

The Company stipulated 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 in the ITC case. As per the ITC schedule, the parties exchanged direct exhibits and witness statements on February 20, 2017; rebuttal exhibits and witness statements on March 3, 2017; pre-trial briefs on March 9, 2017; and Motions in limine on March 13, 2017. The 5-day evidentiary hearing before the ITC Administrative Law Judge (“ALJ”) commenced on March 27, 2017 and ended on March 31, 2017. The ITC rules provide for possible closing arguments before the ALJ after post-hearing briefing, which were submitted on April 19, 2017. Reply post-trial briefs were submitted on May 1, 2017. The ALJ’s Initial Determination is due June 26, 2017, and the target date for the Commission to issue a final determination is October 24, 2017. After that, there is the 60-day Presidential review period during which importation of any Company products found to infringe the Tessera patents can still occur subject to payment of a Bond set by the ITC.

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

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.


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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 submitted its answer to the e.Digital complaint in early November 2016, denying the infringement allegations and asserting several defenses.

In February of 2017, the Court consolidated some, but not all, of the e.Digital cases for purposes of claim construction. In particular, the Court ordered that the iSmart case, for which claim construction is already fully briefed, move forward as scheduled, while the later Company, Netatmo, and Utility Associates cases be informally consolidated for claim construction purposes. As such, claim construction briefing is set to begin in August 2017, and a claim construction hearing is set for October 2017. The Court has not yet set a trial date. The Company served invalidity contentions on March 6, 2017. Discovery is ongoing.

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

Rothschild Patent Imaging v. NETGEAR, Inc.

On December 9, 2016, a non-practicing entity named Rothschild Patent Imaging ("RPI") filed a patent infringement lawsuit against the Company in the U.S. District Court, Eastern District of Texas. RPI asserts infringement of U.S. Patent Nos. 8,204,437, 8,437,797, and 8,594,722, each entitled “Wireless Image Distribution System and Method.”

In its complaint, RPI alleges that its patents cover the wireless transmission of images from a mobile capturing device (e.g., security camera) to a user mobile device (e.g., smart phone) based on some pairing criterion between the capturing device and the user mobile device (e.g., proximate location, use of same user account). RPI specifically identifies the Company’s “Arlo Q and Arlo Q Plus cameras” of infringing claim 1 of the ’437 Patent, claim 6 of the ’797 Patent, and claims 1 and 5 of the ’722 Patent.

The answer was originally due on January 12, 2017, but the Company received an extension until February 13, 2017 to answer the complaint, and on that date the Company answered the complaint by denying the infringement allegations, asserting various affirmative defenses, and bringing declaratory judgment counterclaims of non-infringement and invalidity of the patents in suit. On March 7, 2017, RPI answered the Company’s counterclaims. Subsequently, on March 20, 2017, RPI agreed to dismiss the suit with prejudice with no payment by the Company.

This litigation matter did not have a material financial impact on the Company.

Script Security Solutions v. NETGEAR, Inc.

On December 12, 2016, Script Security Solutions L.L.C. (“Script”) sued the Company in U.S. District Court, Eastern District of Texas for alleged patent infringement of U.S. Patent Nos. 6,542,078 and 6,828,909. Script is a non-practicing entity and has filed over twenty other lawsuits alleging infringement of the same patents. A first wave of cases was filed in March 2015 against 11 defendants. All but one of those cases has settled or been terminated. A second wave of cases was filed in June 2015 against six defendants. Only two of those cases remain active. The third and most recent wave of cases was filed on December 12, 2016, against the Company and six other defendants.

The asserted patents are related. The ‘909 patent is a continuation-in-part of the ’078 patent. The asserted patents are titled “Portable Motion Detector and Alarm System and Method” and allegedly claim priority to May 30, 1996. The asserted patents generally are directed to a portable security alarm system that detects movement of objects relative to a variety of predetermined positions.

The complaint is directed to the Company’s Arlo Home Security Systems and VueZone wireless home video system and alleges that the Company directly infringes at least claim 1 of the ’078 patent and claim 1 of the ’909 patent.

The answer was originally due on January 12, 2017, but the Company received an extension until February 21, 2017 to answer the complaint.  On that date, the Company answered the complaint by submitting a motion to dismiss the complaint because of Script’s failure to properly and sufficiently state a claim for relief. On March 3, 2017, Script filed its consolidated

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response to the various Defendants’ (including the Company’s) Motions to Dismiss for Failure to State a Claim. The Company’s reply brief was submitted on March 10, 2017. The Company also recently received Script’s infringement contentions.

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

Realtime Data v. NETGEAR, Inc.

On February 27, 2017, the Company was sued in the Eastern District of Texas by Realtime Data LLC (“Realtime”), which claims to do business as “Ixo.” The complaint includes four (4) asserted patents:

    US 9,054,728, Data compression systems and methods;
    US 7,415,530, System and methods for accelerated data storage and retrieval;
    US 9,116,908, System and methods for accelerated data storage and retrieval; and
    US 8,717,204, Methods for encoding and decoding data

The accused products specifically include the Company’s “ReadyDATA RD5200, RDD516, ReadyRECOVER” products. Generally, the complaint alleges that the asserted patents are directed to various compression / decompression algorithms and systems and is directed at the Company’s ReadyDATA, ReadyNAS, and ReadyRECOVER products.
 
Realtime has filed several patent suits over the last few years and the asserted patents have gone through various rounds of litigation and IPRs. In this particular tranche of Realtime lawsuits, Realtime also sued Array Networks, Barracuda Networks, Carbonite, Circadence, Comm Vault, Exinda and Snacor.

The Company has received an extension until May 8, 2017 to answer the complaint. It is too early to reasonably estimate any financial impact to the Company resulting from this litigation matter.

Hybrid Audio v. NETGEAR, Inc.

On March 8, 2017, Hybrid Audio, LLC (“Hybrid Audio”) filed a patent infringement suit against the Company in the District of Massachusetts. Hybrid Audio alleges that the Company infringes United States Patent No. RE40,281 (the ’281 Patent), titled “Signal Processing Utilizing a Tree-Structured Array,” via the sale of EVA2000, EVA9100, and EVA9150 digital media players and other Company products because of their capability of playing MP3 encoded content.
 
The ’281 Patent was originally filed on February 25, 1997, and it issued as U.S. Patent No. 6,252,909 on June 26, 2001. A reissue application was filed on November 23, 2004, which issued on April 29, 2008. The ’281 Patent claims priority to September 21, 1992 via a chain of divisional and continuation-in-part applications. It includes 121 claims, which can be grouped into four categories: Claims directed towards (1) a communication system, (2) a signal processing method or system, (3) an information storage medium, and (4) a method of regenerating or reconstructing a signal. In short, the ’281 Patent covers a method of compressing and decompressing signal information using a tree-structured array of sub-band filter banks.

The ’281 Patent expired on September 21, 2012, and thus, the statute of limitations period for damages calculations is limited to March 8, 2011 to September 21, 2012.

The Company has not yet answered the complaint, and after requesting an extension to answer, the Company’s answer is now due on May 22, 2017. It is too early to reasonably estimate any financial impact to the Company resulting from this litigation matter.

Magnacross v. NETGEAR, Inc.

On April 12, 2017, Magnacross LLC (“Magnacross”) sued the Company in U.S. District Court, Eastern District of Texas for alleged patent infringement of exemplary claim 12 of US Patent 6,917,304, and appears to contend that compliance with 802.11 standards necessarily results in infringement, specifically mentioning 802.11b/g and 802.11n-compliant radios in the Company’s products. Magnacross sued five other companies on April 12, 2017, seven others in December 2016, and 17 others in May 2016 on the same patent. The complaint identifies the AC1750, AC1450, AC1200, and AC750 WiFi routers as exemplary accused products and also references the Company’s Arlo cameras.

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The Company has not yet answered the complaint. It is too early to reasonably estimate any financial impact to the Company resulting from this litigation matter.

Williams v. NETGEAR, Inc.

On April 14, 2017, Plaintiff Stewart Williams filed a putative class action against the Company in the United States District Court for the Northern District of California. Plaintiff is represented by Schubert Jonckheer & Kolbe LLP.
 
Plaintiff Stewart Williams alleges violations of California and Nevada state consumer protection laws based on NETGEAR’s sale and marketing of its CM700 cable modem (the “Modem”). Specifically, Plaintiff alleges that the Modem contains a defect that causes severe network latency, impairing network connectivity and preventing consumers from utilizing the maximum advertised network bandwidth. According to Plaintiff, NETGEAR had exclusive knowledge of this alleged defect and actively concealed the defect from consumers with false marketing and labeling.
 
Based on these allegations, Plaintiff seeks to bring his lawsuit as a class action representing a nationwide class of consumers. Plaintiff states causes of action under California’s (1) Song-Beverly Consumer Warranty Act; (2) Consumer Legal Remedies Act, (3) False Advertising Law, and (4) Unfair Competition Law. In addition, Plaintiff seeks to represent a subclass of Nevada consumers and brings a claim under Nevada’s Deceptive Trade Practices Act.
 
The Company has not yet answered the complaint. It is too early to reasonably estimate any financial impact to the Company resulting from this litigation matter.

Vivato v. NETGEAR, Inc.

On April 19, 2017, the Company was sued by XR Communications (d/b/a) Vivato (“Vivato”) in the United States District Court, Central District of California.

Based on its complaint, Vivato purports to be a research and development and product company in the Wi-Fi area, but it appears that Vivato is not currently a manufacturer of commercial products. The three (3) patents that Vivato asserts against the Company are U.S. Patent Nos. 7,062,296, 7,729,728, and 6,611,231. The ’296 and ’728 patents are entitled “Forced Beam Switching in Wireless Communication Systems Having Smart Antennas.” The ’231 patent is entitled “Wireless Packet Switched Communication Systems and Networks Using Adaptively Steered Antenna Arrays.” Vivato also has recently asserted the same patents in the Central District of California against D-Link, Ruckus, and Aruba, among others.

According to the complaint, the accused products include WiFi access points and routers supporting MU-MIMO, including without limitation access points and routers utilizing the IEEE 802.11ac-2013 standard. The accused technology is standards-based, and more specifically, based on the transmit beamforming technology in the 802.11ac Wi-Fi standard.

The Company has not yet answered the complaint. 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

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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 9.
Stockholders' Equity

Stock Repurchases

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 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. As of April 2, 2017, 1.1 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, as reported based on trade date, 0.2 million shares of common stock at a cost of $11.6 million during the three months ended April 2, 2017. The Company repurchased, reported based on trade date, 0.3 million shares of common stock at a cost of $10.0 million under the repurchase authorization during the three months ended April 3, 2016. On April 25, 2017, the Company's Board of Directors authorized the repurchase of up to 3.0 million shares of the Company’s outstanding common stock which, at the time of authorization, were incremental to the remaining shares under the Company's previous share repurchase program.

The Company repurchased, as reported based on trade date, approximately 38,000 shares of common stock at a cost of $1.9 million to help administratively facilitate the withholding and subsequent remittance of personal income and payroll taxes for individuals receiving RSUs during the three months ended April 2, 2017. Similarly, during the three months ended April 3, 2016, the Company repurchased, as reported based on trade date, approximately 9,000 shares of common stock at a cost of $0.4 million 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.



27

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

Accumulated Other Comprehensive Income

The following table sets forth the changes in accumulated other comprehensive income ("AOCI") by component, for the three months ended April 2, 2017 and April 3, 2016:
 
Unrealized gains (losses) on available-for-sale securities
 
Unrealized gains (losses) on derivatives
 
Estimated tax benefit (provision)
 
Total
 
(In thousands)
Balance as of December 31, 2016
$
(31
)
 
$
2,230

 
$
(261
)
 
$
1,938

Other comprehensive loss before reclassifications
(55
)
 
(117
)
 
(337
)
 
(509
)
Less: Amount reclassified from accumulated other comprehensive income

 
1,580

 
(553
)
 
1,027

Net current period other comprehensive income (loss)
(55
)
 
(1,697
)
 
216

 
(1,536
)
Balance as of April 2, 2017
$
(86
)
 
$
533

 
$
(45
)
 
$
402

 
Unrealized gains (losses) on available-for-sale securities
 
Unrealized gains (losses) on derivatives
 
Estimated tax benefit (provision)
 
Total
 
(In thousands)
Balance as of December 31, 2015
$
(64
)
 
$
43

 
$
24

 
$
3

Other comprehensive income (loss) before reclassifications
101

 
(787
)
 
(38
)
 
(724
)
Less: Amount reclassified from accumulated other comprehensive income

 
(240
)
 

 
(240
)
Net current period other comprehensive income (loss)
101

 
(547
)
 
(38
)
 
(484
)
Balance as of April 3, 2016
$
37

 
$
(504
)
 
$
(14
)
 
$
(481
)

28

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


The following tables provide details about significant amounts reclassified out of each component of AOCI for the three months ended April 2, 2017 and April 3, 2016:
Details about Accumulated Other Comprehensive Income Components
 
Three Months Ended April 2, 2017
 
Amount Reclassified from AOCI
 
Affected Line Item in the Statements of Operations
 
 
(In thousands)
Gains (losses) on cash flow hedge:
 
 
 
 
Foreign currency forward contracts
 
$
2,035

 
Net revenue
Foreign currency forward contracts
 
$
(13
)
 
Cost of revenue
Foreign currency forward contracts
 
(442
)
 
Operating expenses
 
 
$
1,580

 
Total before tax
 
 
(553
)
 
Tax impact
 
 
$
1,027

 
Total, net of tax

Details about Accumulated Other Comprehensive Income Components
 
Three Months Ended April 3, 2016
 
Amount Reclassified from AOCI
 
Affected Line Item in the Statements of Operations
 
 
(In thousands)
Gains (losses) on cash flow hedge:
 
 
 
 
Foreign currency forward contracts
 
$
(312
)
 
Net revenue
Foreign currency forward contracts
 
2

 
Cost of revenue
Foreign currency forward contracts
 
70

 
Operating expenses
 
 
(240
)
 
Total before tax
 
 

 
Tax impact
 
 
$
(240
)
 
Total, net of tax

Note 10.
Employee Benefit Plans

The Company grants options and RSUs under the 2016 Incentive Plan (the "2016 Plan"), under which awards may be granted to all employees. Award vesting periods for this plan are generally four years. As of April 2, 2017, approximately 3.0 million shares were reserved for future grants under the 2016 Plan.

Additionally, the Company sponsors 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. 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. As of April 2, 2017, approximately 0.9 million shares were available for issuance under the ESPP.


29

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

Option Activity

Stock option activity during the three months ended April 2, 2017 was as follows:
 
Number of shares
 
Weighted Average Exercise Price Per Share
 
(In thousands)
 
(In dollars)
Outstanding at December 31, 2016
1,884

 
$
31.14

Granted

 

Exercised
(83
)
 
29.35

Cancelled

 

Expired

 

Outstanding at April 2, 2017
1,801

 
$
31.23


RSU Activity

RSU activity during the three months ended April 2, 2017 was as follows:
 
Number of shares
 
Weighted Average Grant Date Fair Value Per Share
 
(In thousands)
 
(In dollars)
Outstanding at December 31, 2016
996

 
$
36.22

Granted
59

 
57.00

Vested
(106
)
 
37.64

Cancelled
(14
)
 
44.34

Outstanding at April 2, 2017
935

 
$
37.25


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. Upon the adoption of ASU 2016-09, the Company elected to account for forfeitures as they occur, rather than estimating expected forfeitures. Refer to recently adopted accounting pronouncement under Note 2, Summary of Significant Accounting Policies, for a further discussion of the impact from the adoption of ASU 2016-09.



30

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 and purchase rights granted under the ESPP during the three months ended April 2, 2017 and April 3, 2016.
 
Three Months Ended
 
Stock Options
 
ESPP
 
April 2,
2017
 
April 3,
2016
 
April 2,
2017
 
April 3,
2016
Expected life (in years)
N/A
 
4.4
 
0.5
 
0.5
Risk-free interest rate
N/A
 
1.28%
 
0.66%
 
0.42%
Expected volatility
N/A
 
35.4%
 
27.6%
 
44.7%
Dividend yield
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:
 
Three Months Ended
 
April 2,
2017
 
April 3,
2016
 
(In thousands)
Cost of revenue
$
436

 
$
439

Research and development
1,319

 
866

Sales and marketing
1,247

 
1,197

General and administrative
2,126

 
1,909

Total stock-based compensation
$
5,128

 
$
4,411


As of April 2, 2017, $5.8 million of unrecognized compensation cost related to stock options, adjusted for estimated forfeitures, is expected to be recognized over a weighted-average period of 2.3 years. $25.9 million of unrecognized compensation cost related to unvested RSUs is expected to be recognized over a weighted-average period of 2.1 years.

Note 11.
Segment Information

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.

In the first quarter of fiscal 2017, the Company's CODM requested changes to the information that he regularly reviews for purposes of allocating resources and assessing performance. The Company reorganized its operating segment structure, resulting in a change to its reportable segments. The former Service Provider segment was integrated into the new segments, with the new segments organized by product groups. Beginning fiscal 2017, the Company operates and reports in three new segments: Arlo, Connected Home, and Small and Medium Business ("SMB") segments:

Arlo: Focused on intelligent internet-connected products for consumers and business that provide security and safety;

Connected Home: Focused on consumers and consists of high-performance, dependable and easy-to-use LTE and WiFi internet networking solutions; and

SMB: Focused on small and medium-sized businesses and consists of business networking, storage and security solutions that bring enterprise-class functionality down to small and medium-sized businesses at an affordable price.

The Company believes that this new structure reflects its current operational and financial management, and provides the best structure for the Company to focus on growth opportunities while maintaining financial discipline. Each segment contains leadership focused on the product development efforts, both from a product marketing and engineering standpoint, to service the unique needs of their customers.


31

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

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 revenue, research and development and sales and marketing expenses. Contribution income is used, in part, to evaluate the performance of, and allocate resources to, each of the segments. The CODM does not evaluate operating segments using discrete asset information. Certain operating expenses are not allocated to segments because they are separately managed at the corporate level. These unallocated indirect costs include corporate expenses, such as corporate research and development, corporate marketing expense and general and administrative expense, amortization of intangibles, stock-based compensation expense, restructuring and other charges, litigation reserves, net, interest income and other income (expense), net.

Financial information for each reportable segment and a reconciliation of segment contribution income to income before income taxes is as follows:
 
Three Months Ended
 
April 2, 2017
 
April 3, 2016*
 
(In thousands, except percentage data)
Net revenue:
 
 
 
Arlo
$
60,712

 
$
24,265

Connected Home
194,361

 
216,110

SMB
68,584

 
69,881

Total net revenue
$
323,657

 
$
310,256

Contribution income:
 
 
 
Arlo
$
321

 
$
(3,830
)
Arlo contribution margin
0.5
%
 
(15.8
)%
Connected Home
$
31,712

 
$
42,029

Connected Home contribution margin
16.3
%
 
19.4
 %
SMB
$
18,504

 
$
15,395

SMB contribution margin
27.0
%
 
22.0
 %
 
 
 
 
Total segment contribution income
$
50,537

 
$
53,594

Corporate and unallocated costs
(18,201
)
 
(16,716
)
Amortization of intangibles (1)
(4,382
)
 
(4,165
)
Stock-based compensation expense
(5,128
)
 
(4,411
)
Restructuring and other charges
(37
)
 
(2,678
)
Litigation reserves, net

 
(10
)
Interest income
405

 
234

Other income (expense), net
335

 
(366
)
Income before income taxes
$
23,529

 
$
25,482

_________________________
(1) 
Amount excludes amortization expense related to patents within purchased intangibles in cost of revenue.
* Prior year financial information for each reportable segment has been recast to conform to the current reportable segment structure effective on January 1, 2017.


32

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

The following table shows net revenue from service provider customers within each of the reportable segments for the periods indicated:
 
Three Months Ended
 
April 2, 2017
 
April 3, 2016
 
(In thousands)
Arlo
$
1,977

 
$
5,981

Connected Home
53,193

 
76,852

SMB
790

 
1,448

Total service provider net revenue
$
55,960

 
$
84,281


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:
 
 
Three Months Ended
 
April 2,
2017
 
April 3,
2016
 
(In thousands)
United States (U.S.)
$
206,125

 
$
189,366

Americas (excluding U.S.)
5,504

 
4,484

EMEA
58,445

 
64,505

Australia
33,481

 
31,134

APAC (excluding Australia)
20,102

 
20,767

Total net revenue
$
323,657

 
$
310,256


Long-lived assets include purchased intangibles, goodwill and property and equipment. The Company's property and equipment are located in the following geographic locations:
 
As of
 
April 2,
2017
 
December 31,
2016
 
(In thousands)
United States
$
8,950

 
$
9,542

Canada
2,440

 
2,745

EMEA
192

 
210

China
6,199

 
5,219

APAC (excluding China)
1,567

 
1,757

Total property and equipment, net
$
19,348

 
$
19,473



33

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

Note 12.
Fair Value Measurements
The following tables summarize assets and liabilities measured at fair value on a recurring basis as of April 2, 2017:
 
As of April 2, 2017
 
Total
 
Quoted market
prices in active
markets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
 
(In thousands)
Assets:
 
 
 
 
 
 
 
Cash equivalents: money-market funds
$
12,971

 
$
12,971

 
$

 
$

Available-for-sale securities: U.S. treasuries (1)
123,732

 
123,732

 

 

Available-for-sale securities: certificates of deposit (1)
158

 
158

 

 

Trading securities: mutual funds (1)
1,677

 
1,677

 

 

Foreign currency forward contracts (2)
2,882

 

 
2,882

 

Total assets measured at fair value
$
141,420

 
$
138,538

 
$
2,882

 
$

________________________
(1) 
Included in short-term investments on the Company’s unaudited condensed consolidated balance sheets.
(2) 
Included in prepaid expenses and other current assets on the Company’s unaudited condensed consolidated balance sheets.
 
As of April 2, 2017
 
Total
 
Quoted market
prices in active
markets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
 
(In thousands)
Liabilities:
 
 
 
 
 
 
 
Foreign currency forward contracts (3)
$
1,058

 
$

 
$
1,058

 
$

Total liabilities measured at fair value
$
1,058

 
$

 
$
1,058

 
$

_________________________
(3) 
Included in other accrued liabilities on the Company’s unaudited condensed consolidated balance sheets.
The following tables summarize assets and liabilities measured at fair value on a recurring basis as of December 31, 2016:
 
As of December 31, 2016
 
Total
 
Quoted market
prices in active
markets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
 
(In thousands)
Assets:
 
 
 
 
 
 
 
Cash equivalents: money-market funds
$
17,027

 
$
17,027

 
$

 
$

Available-for-sale securities: U.S. treasuries (1)
123,838

 
123,838

 

 

Available-for-sale securities: certificates of deposit (1)
148

 
148

 

 

Trading securities: mutual funds (1)
1,528

 
1,528

 

 

Foreign currency forward contracts (2)
8,763

 

 
8,763

 

Total assets measured at fair value
$
151,304

 
$
142,541

 
$
8,763

 
$

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


34

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

 
As of December 31, 2016
 
Total
 
Quoted market
prices in active
markets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
 
(In thousands)
Liabilities:
 
 
 
 
 
 
 
Foreign currency forward contracts (3)
$
1,705

 
$

 
$
1,705

 
$

Total liabilities measured at fair value
$
1,705

 
$

 
$
1,705

 
$

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

The Company’s investments in cash equivalents and available-for-sale securities are classified within Level 1 of the fair value hierarchy because they are valued based on quoted market prices in active markets. The Company enters into foreign currency forward contracts with only those counterparties that have long-term credit ratings of A-/A3 or higher. The Company’s foreign currency forward contracts are classified within Level 2 of the fair value hierarchy as they are valued using pricing models that take into account the contract terms as well as currency rates and counterparty credit rates. The Company verifies the reasonableness of these pricing models using observable market data for related inputs into such models. Additionally, the Company includes an adjustment for non-performance risk in the recognized measure of fair value of derivative instruments. As of April 2, 2017 and December 31, 2016, the adjustment for non-performance risk did not have a material impact on the fair value of the Company’s foreign currency forward contracts. The carrying value of non-financial assets and liabilities measured at fair value in the financial statements on a recurring basis, including accounts receivable and accounts payable, approximate fair value due to their short maturities.


Note 13.
Shipping and Handling Fees and Costs

The Company includes shipping and handling fees billed to customers in net revenue. Shipping and handling costs associated with inbound freight are included in cost of revenue and ending inventory. Shipping and handling costs associated with outbound freight are included in sales and marketing expenses and totaled $2.3 million and $2.1 million for the three months ended April 2, 2017 and April 3, 2016, respectively.


Note 14.
Restructuring and Other Charges

The Company accounts for its restructuring plans under the authoritative guidance for exit or disposal activities. The Company presents expenses related to restructuring and other charges as a separate line item in the unaudited condensed consolidated statements of operations. Accrued restructuring and other charges are classified within other accrued liabilities in the unaudited condensed consolidated balance sheets.

No significant restructuring and other charges were recognized during the three months ended April 2, 2017. Restructuring and other charges recognized in the three months ended April 3, 2016 was primarily related to severance, other one-time termination benefits and other associated costs attributable to the restructuring actions announced in January 2016. Amounts attributable to lease contract termination charges will be paid over the remaining lease term until January 2022.


35

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

The following table provides a summary of the activity related to accrued restructuring and other charges for the three months ended April 2, 2017:
 
Accrued Restructuring and Other Charges at December 31, 2016
 
Additions
 
Cash Payments
 
Adjustments
 
Accrued Restructuring and Other Charges at April 2, 2017
 
(In thousands)
Restructuring
 
 
 
 
 
 
 
 
 
Employee termination charges
$
6

 
$

 
$

 
$

 
$
6

Lease contract termination and other charges
1,402

 
37

 
(100
)
 

 
1,339

Total Restructuring and other charges
$
1,408

 
$
37

 
$
(100
)
 
$

 
$
1,345



36


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

Forward-looking Statements

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, Section 21E of the Securities Exchange Act of 1934, as amended and the Private Securities Litigation Reform Act of 1995. Such statements are based upon current expectations that involve risks and uncertainties. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. For example, the words “believes,” “anticipates,” “plans,” “expects,” “intends,” “could,” “may,” “will,” and similar expressions are intended to identify forward-looking statements. Our actual results and the timing of certain events may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a discrepancy include, but are not limited to, those discussed in “Part II—Item 1A—Risk Factors” and “Liquidity and Capital Resources” below. All forward-looking statements in this document are based on information available to us as of the date hereof and we assume no obligation to update any such forward-looking statements. The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and the accompanying notes contained in this quarterly report. Unless expressly stated or the context otherwise requires, the terms “we,” “our,” “us” and “NETGEAR” refer to NETGEAR, Inc. and our subsidiaries.

Business and Executive Overview

We are a global networking company that delivers innovative networking and Internet connected products to consumers and growing businesses. Our 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. Our product line consists of wired and wireless devices that enable networking, broadband access and network connectivity. These products are available in multiple configurations to address the needs of our end-users in each geographic region in which our products are sold.

In the first quarter of fiscal 2017, our CODM requested changes to the information that he regularly reviews for purposes of allocating resources and assessing performance. We reorganized the operating segment structure, resulting in a change to our reportable segments. The former Service Provider segment was integrated into the new segments, with the new segments organized by product groups. Beginning fiscal 2017, we operate and report in three new segments: Arlo, Connected Home, and Small and Medium Business ("SMB") segments. For additional information on the changes in the reportable segments, refer to Note 11, Segment Information, in the Notes to Unaudited Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q.

We believe that this new structure reflects our current operational and financial management, and provides the best structure for us to focus on growth opportunities while maintaining financial discipline. Each segment contains leadership focused on the product development efforts, both from a product marketing and engineering standpoint, to service the unique needs of their customers. The Arlo segment is focused on intelligent internet-connected products for consumers and business that provide security and safety. The Connected Home segment is focused on consumers and consists of high-performance, dependable and easy-to-use LTE and WiFi internet networking solutions. The SMB segment is focused on small and medium-sized businesses and consists of business networking, storage and security solutions that bring enterprise-class functionality down to small and medium-sized businesses at an affordable price. We conduct business across three geographic regions: Americas; Europe, Middle-East and Africa (“EMEA”) and Asia Pacific (“APAC”).

The markets in which all of our segments operate in are intensely competitive and subject to rapid technological change. We believe that the principal competitive factors in the consumer and small and medium-sized businesses markets for networking products include product breadth, size and scope of the sales channel, brand name, timeliness of new product introductions, product availability, performance, features, functionality and reliability, ease-of-installation, maintenance and use, security, and customer service and support. To remain competitive, we believe we must continue to aggressively invest resources in developing new products and enhancing our current products while continuing to expand our channels and maintaining customer satisfaction worldwide. Among these investments is an enhanced focus on cybersecurity relating to our products and systems, as the threat of cyber-attacks and exploitation of potential security vulnerabilities in our industry is on the rise and is increasingly a significant consumer concern.

We sell our networking products through multiple sales channels worldwide, including traditional retailers, online retailers, wholesale distributors, direct market resellers (“DMRs”), value-added resellers (“VARs”), and broadband service providers. Our retail channel includes traditional retail locations domestically and internationally, such as Best Buy, Costco, Fry’s

37


Electronics, Staples, Target, Wal-Mart, Argos (U.K.), PC World (U.K.), MediaMarkt (Europe), Darty (France), JB HiFi (Australia), Elkjop (Norway) and Sunning and Guomei (China). Online retailers include Amazon.com worldwide, Newegg.com (US), JD.com and Alibaba (China), as well as NBB.com (Germany) and Coolblue.com (Netherlands). Our DMRs include CDW Corporation, Insight Corporation and PC Connection in domestic markets and Misco throughout Europe. In addition, we also sell our products through broadband service providers, such as multiple system operators (“MSOs”), xDSL, and other broadband technology operators domestically and internationally. Some of these retailers and broadband service providers purchase directly from us, while others are fulfilled through wholesale distributors around the world. A substantial portion of our net revenue to date has been derived from a limited number of wholesale distributors and retailers. We expect that these wholesale distributors and retailers will continue to contribute a significant percentage of our net revenue for the foreseeable future.

During the three months ended April 2, 2017, we experienced a 4.3% increase in net revenue compared to the first quarter of 2016. The increase was primarily attributable to the performance of our Arlo segment which we saw net revenue increase 150.2% over the prior year. The increase was partially offset by declines in both the Connected Home and SMB segments which fell 10.1% and 1.9%, respectively. The increase in Arlo segment net revenue was driven by our Arlo smart camera product line which continues to generate strong end user demand within a fast growing market. The decrease in Connected Home segment net revenue was primarily related to lower gross shipments to service provider customers of broadband gateways and home wireless products, partially offset by higher shipments of mobile products. The fall in gross shipments to service provider customers was offset by increased gross shipments to non-service provider customers of home wireless products, led by our Orbi WiFi system. SMB segment net revenue decreased year over year due primarily to lower gross shipments of network storage and SMB wireless products, offset in part by increased gross shipments of switch products. On a geographic basis, net revenue increased in the Americas and, to a lesser extent, in APAC, while EMEA declined. The increase in the Americas was primarily driven by higher gross shipments of our home security cameras and mobile products, offset by declines in gross shipments of our broadband gateways and home wireless products mainly attributable to our service provider customers. The increase in APAC was attributable to increased gross shipments of mobile, and home security camera products, offset by declines in gross shipments of broadband gateways and home wireless products. The fall in EMEA net revenue was as a result of lower gross shipments of broadband gateways, home wireless and mobile products, partially offset by increased gross shipments of home security camera products.

Looking forward, we expect strong growth in our Arlo segment driven by increasing demand for our Arlo smart camera products as well as through new product category introductions. We expect growth in our Connected Home segment mainly driven by increasing demand for our broadband gateways and home WiFi systems and we expect to enhance our product portfolio to further service these markets. In addition, we expect a shift in consumer preference away from single point WiFi routers to whole Home WiFi Systems which may require increased marketing and promotional expenditure to achieve similar levels of market share. We also expect growth in our SMB segment driven by sales of our 10Gig, PoE, and web-managed switches and rackmount storage products. We expect net revenue from service provider customers to be approximately $55 million per quarter for the remainder of 2017.



38


Results of Operations
The following table sets forth the unaudited condensed consolidated statements of operations for the three months ended April 2, 2017, with the comparable reporting period in the preceding year.
 
 
Three Months Ended
 
April 2,
2017
 
April 3,
2016
 
(In thousands, except percentage data)
Net revenue
$
323,657

 
100.0
%
 
$
310,256

 
100.0
 %
Cost of revenue
226,725

 
70.1
%
 
209,691

 
67.6
 %
Gross profit
96,932

 
29.9
%
 
100,565

 
32.4
 %
Operating expenses:
 
 
 
 
 
 
 
Research and development
22,683

 
7.0
%
 
22,137

 
7.1
 %