10-Q 1 ntgr20180701-10xq.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 July 1, 2018.

¨ 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 31,808,206 as of July 27, 2018.

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
 
July 1,
2018
 
December 31,
2017
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
227,397

 
$
202,870

Short-term investments
128,241

 
126,926

Accounts receivable, net
343,883

 
412,798

Inventories
291,459

 
245,894

Prepaid expenses and other current assets
44,878

 
27,176

Total current assets
1,035,858

 
1,015,664

Property and equipment, net
29,137

 
20,660

Intangibles, net
20,024

 
24,988

Goodwill
85,463

 
85,463

Other non-current assets
86,149

 
61,789

Total assets
$
1,256,631

 
$
1,208,564

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
107,704

 
$
111,915

Accrued employee compensation
38,825

 
27,752

Other accrued liabilities
265,990

 
222,470

Deferred revenue
30,674

 
55,284

Income taxes payable
1,359

 
7,015

Total current liabilities
444,552

 
424,436

Non-current income taxes payable
32,199

 
31,544

Other non-current liabilities
24,144

 
22,099

Total liabilities
500,895

 
478,079

Commitments and contingencies (Note 9)


 


Stockholders’ equity:
 
 
 
Common stock
32

 
31

Additional paid-in capital
625,858

 
603,137

Accumulated other comprehensive loss
(107
)
 
(851
)
Retained earnings
129,953

 
128,168

Total stockholders’ equity
755,736

 
730,485

Total liabilities and stockholders’ equity
$
1,256,631

 
$
1,208,564

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
 
Six Months Ended
 
July 1,
2018
 
July 2,
2017
 
July 1,
2018
 
July 2,
2017
Net revenue
$
366,820

 
$
330,723

 
$
711,793

 
$
654,380

Cost of revenue
257,648

 
238,787

 
498,116

 
465,512

Gross profit
109,172

 
91,936

 
213,677

 
188,868

Operating expenses:
 
 
 
 
 
 
 
Research and development
31,371

 
23,357

 
60,318

 
46,040

Sales and marketing
46,983

 
36,461

 
90,641

 
74,690

General and administrative
20,448

 
12,950

 
37,086

 
26,144

Separation expense
11,984

 

 
18,768

 

Restructuring and other charges
1,376

 
22

 
1,367

 
59

Litigation reserves, net
5

 
53

 
5

 
53

Total operating expenses
112,167

 
72,843

 
208,185

 
146,986

Income (loss) from operations
(2,995
)
 
19,093

 
5,492

 
41,882

Interest income
1,072

 
482

 
1,820

 
887

Other income (expense), net
1,061

 
383

 
(191
)
 
718

Income (loss) before income taxes
(862
)
 
19,958

 
7,121

 
43,487

Provision for income taxes
4,368

 
5,376

 
6,761

 
12,911

Net income (loss)
$
(5,230
)
 
$
14,582

 
$
360

 
$
30,576

Net income (loss) per share:
 
 
 
 
 
 
 
Basic
$
(0.17
)
 
$
0.45

 
$
0.01

 
$
0.94

Diluted
$
(0.17
)
 
$
0.44

 
$
0.01

 
$
0.91

Weighted average shares used to compute net income (loss) per share:
 
 
 
 
 
 
 
Basic
31,674

 
32,352

 
31,550

 
32,650

Diluted
31,674

 
33,116

 
32,722

 
33,656

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

4


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

 
Three Months Ended
 
Six Months Ended
 
July 1,
2018
 
July 2,
2017
 
July 1,
2018
 
July 2,
2017
Net income (loss)
$
(5,230
)
 
$
14,582

 
$
360

 
$
30,576

Other comprehensive income (loss), before tax:
 
 
 
 
 
 
 
Unrealized gains (losses) on derivative instruments
124

 
(6,003
)
 
816

 
(7,700
)
Unrealized gains (losses) on available-for-sale securities
69

 
(27
)
 
31

 
(82
)
Other comprehensive income (loss), before tax
193

 
(6,030
)
 
847

 
(7,782
)
Tax benefit (provision) related to derivative instruments
(15
)
 
809

 
(76
)
 
1,005

Tax benefit (provision) related to available-for-sale securities
(16
)
 
9

 
(27
)
 
29

Other comprehensive income (loss), net of tax
162

 
(5,212
)
 
744

 
(6,748
)
Comprehensive income (loss)
$
(5,068
)
 
$
9,370

 
$
1,104

 
$
23,828

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)
 
 
Six Months Ended
 
July 1,
2018
 
July 2,
2017
Cash flows from operating activities:
 
 
 
Net income
$
360

 
$
30,576

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
11,655

 
14,224

Purchase premium amortization/discount accretion on investments, net
(311
)
 
100

Stock-based compensation
17,120

 
10,829

Impairment charges on investment
1,400

 

Deferred income taxes
1,133

 
1,788

Changes in assets and liabilities:
 
 
 
Accounts receivable
75,028

 
9,252

Inventories
(47,933
)
 
(15,911
)
Prepaid expenses and other assets
(20,860
)
 
5,519

Accounts payable
(4,400
)
 
(39,283
)
Accrued employee compensation
11,074

 
(9,079
)
Other accrued liabilities
(3,224
)
 
(1,870
)
Deferred revenue
4,025

 
1,780

Income taxes payable
(5,000
)
 
(4,544
)
Net cash provided by operating activities
40,067

 
3,381

Cash flows from investing activities:
 
 

Purchases of short-term investments
(70,017
)
 
(56,876
)
Proceeds from maturities of short-term investments
69,412

 
67,648

Purchases of property and equipment
(13,368
)
 
(6,162
)
Purchases of investments

 
(1,400
)
Payments made in connection with business acquisition, net of cash acquired

 
(737
)
Net cash provided by (used in) investing activities
(13,973
)
 
2,473

Cash flows from financing activities:
 
 
 
Repurchases of common stock

 
(56,631
)
Restricted stock unit withholdings
(7,168
)
 
(5,649
)
Proceeds from exercise of stock options
2,869

 
3,972

Proceeds from issuance of common stock under employee stock purchase plan
2,732

 
2,662

Net cash used in financing activities
(1,567
)
 
(55,646
)
Net increase (decrease) in cash and cash equivalents
24,527

 
(49,792
)
Cash and cash equivalents, at beginning of period
202,870

 
240,468

Cash and cash equivalents, at end of period
$
227,397

 
$
190,676

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 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 devices that create and extend wired and wireless networks as well as devices that provide a special function and attach to the network, such as IP security cameras and home automation devices and services. These products are available in multiple configurations to address the changing needs of the customers 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, 2017 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, 2017.
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 six months ended July 1, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018 or any future period.

Planned Separation of Arlo Business

On February 6, 2018, the Company announced that its Board of Directors had unanimously approved the pursuit of a separation of its Arlo business from NETGEAR (the “Separation”), expected to be effected through an initial public offering (“IPO”) of newly issued shares of the common stock of Arlo Technologies, Inc. (“Arlo”), a wholly owned subsidiary of NETGEAR, which will hold the Arlo business. The Company also announced that it expects Matthew McRae, its Senior Vice President of Strategy, to serve as Arlo’s Chief Executive Officer upon the completion of the IPO. On July 6, 2018, a registration statement (as amended, the “IPO Registration Statement”) relating to the IPO of common stock of Arlo was filed with the U.S. Securities and Exchange Commission (the "SEC"). The IPO Registration Statement was declared effective on August 2, 2018. Arlo’s shares began trading on August 3, 2018. At the closing, which is expected to occur on August 7, subject to customary closing conditions, the Company is expected to own approximately 86.0% of the shares of Arlo’s common stock (or approximately 84.2% of the shares of Arlo’s common stock if the underwriters exercise in full their option to purchase additional shares of Arlo’s common stock). The Company currently intends that, following the IPO and no earlier than the expiration or earlier termination of the 145-day lock-up period applicable to NETGEAR, it will complete the Separation by distributing the shares of Arlo common stock then held by NETGEAR to NETGEAR's stockholders in a manner generally intended to qualify as tax-free to our stockholders for U.S. federal income tax purposes (the “Distribution”). Refer to Note 15, Subsequent Event, for details relating to the IPO.

7



The Company incurred Separation expense of $12.0 million and $18.8 million during the three and six months ended July 1, 2018, respectively, and $20.2 million since commencement in December 2017 to date. Separation expense primarily consists of third-party advisory, consulting, legal and professional services, IT costs and employee bonuses directly related to the separation, as well as other items that are incremental and one-time in nature that are related to the separation.

The Separation, including the Distribution, is subject to market, tax and legal considerations, final approval by the Company’s Board of Directors and other customary requirements. However, the Company may abandon or change the structure of the Distribution if it determines, in its sole discretion, that the Distribution is not in the best interest of the Company or its stockholders. This Quarterly Report on Form 10-Q does not constitute an offer to sell or a solicitation of an offer to buy securities, and shall not constitute an offer, solicitation or sale in any jurisdiction in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of that jurisdiction.

 
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 fiscal year ended December 31, 2017. Refer to Note 3. Revenue Recognition, for the updated accounting policy of revenue recognition upon the adoption of ASU 2014-09, "Revenue from Contracts with Customers" (Topic 606) as of January 1, 2018.

Recent accounting pronouncements

Accounting Pronouncements Recently Adopted

ASU 2014-09

In May 2014, the Financial Accounting Standards Board ("FASB") issued ASU 2014-09, "Revenue from Contracts with Customers" (Topic 606). The revenue recognition requirements in Accounting Standards Codification ("ASC") Topic 605, Revenue Recognition ("ASC 605") is superseded by Topic 606 ("ASC 606"). ASC 606 requires the recognition of revenue when promised goods or services are transferred to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. On January 1, 2018, the Company adopted ASC 606 and applied this guidance to the contracts which were not completed at the date of adoption using the modified retrospective method. Refer to Note 3. Revenue Recognition, for further details.

ASU 2016-01

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 requires equity investments to be measured at fair value with changes in fair value recognized in net income. This guidance simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment. 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. The Company adopted the guidance effectively January 1, 2018. The adoption did not have a material impact to the Company. The Company believes the most significant impact will be that the adoption of the new guidance could increase the volatility of its Other income (expense), net, as a result of the re-measurement of its equity investments without readily determinable fair values upon the occurrence of observable price changes and impairments.

ASU 2016-16

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 fiscal quarter of 2018 and early adoption is permitted. The Company adopted the new standard effectively January 1, 2018. Upon adoption, the Company has recorded a deferred tax

8

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

asset of $21.1 million resulting from differences in the tax basis of assets and the consolidated book basis of assets resulting from intra-entity transfers of intangible assets. The recognition of the deferred tax asset results in an increase to retained earnings upon adoption. Further, the Company estimates that adoption of the standard will increase tax expense by an approximate $1.3 million in 2018, but fluctuate over time due to different lives of the intangibles. There is no material impact on the Company's cash flows.

ASU 2017-12

In August 2017, the FASB issued ASU 2017-12, "Derivatives and Hedging: Targeted Improvements to Accounting for Hedging Activities" (Topic 815), which expands and refines hedge accounting for both non-financial and financial risk components and aligns the recognition and presentation of the effects of the hedging instrument and the hedged item in the financial statements. The guidance also makes certain targeted improvements to simplify the application of hedge accounting guidance, ease the administrative burden of hedge documentation requirements and assessing hedge effectiveness and ease the reporting on hedge ineffectiveness. ASU 2017-12 is effective for the Company in the first fiscal quarter of 2019 and early adoption is permitted. Entities should apply the guidance to existing cash flow and net investment hedge relationships using a modified retrospective approach with a cumulative effect adjustment recorded to opening retained earnings on the date of adoption. The guidance also provides transition relief to make it easier for entities to apply certain amendments to existing hedges where the hedge documentation needs to be modified. The Company early adopted the new guidance effectively January 1, 2018. The adoption did not impact opening retained earnings or have a material impact on the Company's consolidated financial statements. Additionally, upon adoption, the Company simplified its hedge accounting application by electing to include time value on currency cash flow hedge relationships prospectively.

ASU 2018-02

In February 2018, the FASB issued ASU 2018-02, "Income Statement—Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income", which permits companies to reclassify tax effects stranded in Accumulated Other Comprehensive Income as a result of tax reform to retained earnings. ASU 2018-02 is effective for the Company in the first fiscal quarter of 2019 and early adoption is permitted. Entities have the option to reclassify these amounts rather than require reclassification and also have the option to apply the guidance retrospectively or at the beginning of the period of adoption. The Company early adopted the new guidance effectively January 1, 2018. Upon adoption, the Company has recognized immaterial adjustments to retained earnings at the beginning of the period of adoption.

Accounting Pronouncements Not Yet Effective

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 fiscal quarter of 2019, with early adoption permitted. The Company does not expect to early adopt the new guidance. The Company has appointed a project team which is in the process of evaluating the impact the new standard will have on its consolidated financial statements. The Company has identified the existing population of leases, including embedded leases, and in the process of reviewing the identified lease contracts. In addition, the Company has selected a lease accounting software to assist with the implementation. The Company expects to complete the impact assessment process by the end of the third fiscal quarter of 2018, and to complete the adoption process, including adding procedures, implementing lease accounting software, and evaluating necessary disclosures, prior to the first fiscal quarter of 2019.

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 fiscal quarter of 2020 and early adoption is permitted. The Company

9

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

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.

With the exception of the new standards discussed above, there have been no other new accounting pronouncements that have significance, or potential significance, to the Company's financial position, results of operations and cash flows.

Note 3.
Revenue Recognition

Adoption of ASC 606

On January 1, 2018, the Company adopted ASC 606 and applied this guidance to those contracts which were not completed at the date of adoption using the modified retrospective method. The Company recognized the cumulative effect of initially applying ASC 606 as an adjustment to the opening balance of retained earnings. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods (ASC 605). The adoption did not have a significant impact to the nature and timing of its revenues, results of operations, cash flows and statement of financial position.
 
The majority of sales revenue continues to be recognized when control of the product transfers to customer upon shipment or delivery. The primary impact of adopting ASC 606 relates to the establishment of liability estimates for channel rebates and discounts upon revenue recognition on the basis of customary business practice. Under ASC 606, the Company is required to estimate for rebates and discounts ahead of commitment date if customary business practice creates an implied expectation that such activities will occur in the future. The Company utilizes channel rebates and discounts to stimulate end user demand. Consequently, this change in guidance results in an adjustment to the statement of financial position to accelerate the recording of a liability for yet to be committed channel marketing rebates and discounts upon adoption. Further, under ASC 606, deferred revenue balances are to be booked at an amount that reflects only the amounts expected to be received for future obligations. As such, an adjustment was made to allocate variable consideration to deferred revenue. Additionally, the balance sheet presentation of certain reserve balances previously shown net within accounts receivable are now presented as refund liabilities within current liabilities and deferrals for undelivered shipments with destination shipping terms are now removed from receivables and deferred revenue.

The following table summarizes the impacts of adopting ASC 606 on the Company’s unaudited condensed consolidated balance sheet for the fiscal year beginning January 1, 2018 as an adjustment to the opening balances:
 
As of
 
Adjustments
 
As of
 
December 31,
2017
 
 
January 1,
2018
 
(In thousands)
Assets:
 
 
 
 
 
Accounts receivable, net
$
412,798

 
$
6,113

 
$
418,911

Inventories
$
245,894

 
$
(2,368
)
 
$
243,526

Other non-current assets
$
61,789

 
$
4,344

 
$
66,133

Liabilities:
 
 
 
 
 
Accounts payable
$
111,915

 
$
(156
)
 
$
111,759

Other accrued liabilities
$
222,470

 
$
45,481

 
$
267,951

Deferred revenue
$
55,284

 
$
(25,181
)
 
$
30,103

Income taxes payable
$
7,015

 
$
724

 
$
7,739

Other non-current liabilities
$
22,099

 
$
(276
)
 
$
21,823

Stockholders’ equity:
 
 
 
 
 
Retained earnings
$
128,168

 
$
(12,503
)
 
$
115,665



10

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

The following table summarizes the impacts of adopting ASC 606 on the Company’s unaudited consolidated balance sheets as of July 1, 2018:
 
As of July 1, 2018
 
As reported
 
Adjustments
 
Balance without adoption of ASC 606
 
(In thousands)
Assets
 
 
 
 
 
Accounts receivable, net
$
343,883

 
$
(14,167
)
 
$
329,716

Inventories
$
291,459

 
$
1,923

 
$
293,382

Other non-current assets
$
86,149

 
$
(4,677
)
 
$
81,472

Liabilities:
 
 
 
 
 
Accounts payable
$
107,704

 
$
136

 
$
107,840

Other accrued liabilities
$
265,990

 
$
(48,237
)
 
$
217,753

Deferred revenue
$
30,674

 
$
15,763

 
$
46,437

Income taxes payable
$
1,359

 
$
(294
)
 
$
1,065

Other non-current liabilities
$
24,144

 
$
721

 
$
24,865

Stockholders’ equity:
 
 
 
 
 
Retained earnings
$
129,953

 
$
14,990

 
$
144,943


The following table summarizes the impacts of adopting ASC 606 on the Company’s unaudited consolidated statement of operations for the three months ended July 1, 2018:
 
Three Months Ended July 1, 2018
 
As reported
 
Adjustments
 
Balance without adoption of ASC 606
 
(In thousands)
Net revenue
$
366,820

 
$
1,423

 
$
368,243

Cost of revenue
$
257,648

 
$
243

 
$
257,891

Gross profit
$
109,172

 
$
1,180

 
$
110,352

Provision for income taxes
$
4,368

 
$
406

 
$
4,774

Net income
$
(5,230
)
 
$
774

 
$
(4,456
)

The following table summarizes the impacts of adopting ASC 606 on the Company’s unaudited consolidated statement of operations for the six months ended July 1, 2018:
 
Six Months Ended July 1, 2018
 
As reported
 
Adjustments
 
Balance without adoption of ASC 606
 
(In thousands)
Net revenue
$
711,793

 
$
3,696

 
$
715,489

Cost of revenue
$
498,116

 
$
446

 
$
498,562

Gross profit
$
213,677

 
$
3,250

 
$
216,927

Provision for income taxes
$
6,761

 
$
763

 
$
7,524

Net income
$
360

 
$
2,487

 
$
2,847


11

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


Revenue Recognition Accounting Policy

Revenue Recognition

Revenue from contracts with customers is recognized when control of the promised goods or services is transferred to the customers, in an amount that reflects the consideration, the Company expects to be entitled to in exchange for those goods or services.

The majority of revenue comes from product sales, consisting of sales of Arlo, Connected Home and Small and Medium Business ("SMB") hardware products to customers (retailers, distributors and service providers). Revenue is recognized at a point in time when control of the good is transferred to the customer, generally occurring upon shipment or delivery dependent upon the terms of the underlying contract. The amount recognized reflects the consideration the Company expects to be entitled to in exchange for the transferred goods.

The Company sells subscription paid services, such as to its Arlo end user customers where it provides customers access to its cloud services. Revenue for subscription sales is generally recognized over time on a ratable basis over the contract term beginning on the date that the service is made available to the customers at the time of registration. The subscription contracts are generally for 30 days or 12 months in length, billed in advance. All such service or support sales are typically recognized using an output measure of progress by looking at the time elapsed as the contracts generally provide the customer equal benefit throughout the contract period. In addition to selling paid subscriptions, the Company also sells services bundled with hardware products and accounts for these sales in line with the multiple performance obligations guidance.

Revenue from all sales types is recognized at transaction price, the amount the Company expects to be entitled to in exchange for transferring goods or providing services. Transaction price is calculated as selling price net of variable consideration which may include estimates for future returns, sales incentives and price protection related to current period product revenue. The Company’s standard obligation to its direct customers generally provides for a full refund in the event that such product is not merchantable or is found to be damaged or defective. In determining estimates for future returns, management analyzes historical data, channel inventory levels, current economic trends and changes in customer demand for the Company's products. Sales incentives and price protection are determined based on a combination of the actual amounts committed and through estimating future expenditure based upon historical customary business practice. Typically variable consideration does not need to be constrained as estimates are based on predictive historical data or future commitments that are planned and controlled by the Company. However, the Company continues to assess variable consideration estimates such that it is probable that a significant reversal of revenue will not occur.

Contracts with Multiple Performance Obligations

Some of the Company's contracts with customers contain multiple promised goods or services. Such contracts include hardware products with bundled services, networking hardware with embedded software, various software subscription services, and support. For these contracts, the Company accounts for the promises separately as individual performance obligations if they are distinct. Performance obligations are determined to be considered distinct if both capable of being distinct and distinct within the context of the contract. In determining whether performance obligations meet the criteria for being distinct, the Company considers a number of factors, such as the degree of interrelation and interdependence between obligations, and whether or not the good or service significantly modifies or transforms another good or service in the contract. The embedded software on most of the hardware products is not considered distinct and therefore the combined hardware and incidental software is treated as one performance obligation and recognized at the point in time when control of product transfers to the customer. Service that is included with certain hardware products, mainly Arlo systems, is considered distinct and therefore the hardware and service are treated as separate performance obligations.

After identifying the separate performance obligations, the transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. Standalone selling prices are generally determined based on the prices charged to customers or using an adjusted market assessment. For Arlo systems, standalone selling price of the hardware is directly observable from add-on camera and base station sales. Standalone selling price of the service is estimated using an adjusted market approach.


12

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

Revenue is then recognized for each distinct performance obligation as control is transferred to the customer. In general, the hardware is recognized at time of shipping or delivery, while services and support are delivered over the stated service or support period or the estimated useful life. For Arlo systems, the hardware is recognized at the time control of the product transfers to the customer and the transaction price allocated to service is recognized over the estimated useful life of the system, beginning when the customer is expected to activate their account. Useful life of the systems is determined by industry norms, frequency of new model releases, and user history.

Warranties

Hardware products regularly include warranties to the end customers that consist of bug fixes, minor updates such that the product continues to function according to published specs in a dynamic environment, and phone support. These standard warranties are assurance type warranties and do not offer any services in addition to the assurance that the product will continue working as specified. Therefore, warranties are not considered separate performance obligations in the arrangement. Instead, the expected cost of warranty is accrued as expense in accordance with authoritative guidance. Extended warranties are sold separately and include additional support services. The transaction price for extended warranties is accounted for as service revenue and recognized over the life of the contract.

Shipping and Handling

Shipping and handling fees billed to customers are included in Net revenue. Shipping and handling costs associated with inbound freight are included in Cost of revenue. In cases where the Company gives a freight allowance to the customer for their own inbound freight costs, such costs are appropriately recorded as a reduction in net revenue. Shipping and handling costs associated with outbound freight are included in Sales and marketing expenses. The Company has elected to account for shipping and handling activities related to contracts with customers as costs to fulfill the promise to transfer the associated products.

Shipping and handling costs associated with outbound freight totaled $2.5 million and $5.2 million for the three and six months ended July 1, 2018, respectively, and $2.2 million and $4.5 million for the three and six months ended July 2, 2017, respectively.

Transaction Price Allocated to the Remaining Performance Obligations

Remaining performance obligations represent the transaction price allocated to performances obligations that are unsatisfied or partially unsatisfied as of the end of the reporting period. Unsatisfied and partially unsatisfied performance obligations consist of contract liabilities, in-transit orders with destination terms, and non-cancellable backlog. Non-cancellable backlog includes goods and services for which customer purchase orders have been accepted that are scheduled or in the process of being scheduled for shipment.

The following table includes estimated revenue expected to be recognized in the future related to performance obligations that are unsatisfied (or partially unsatisfied) as of July 1, 2018:
 
 
1 year
 
2 years
 
Greater than 2 years
 
Total
Performance obligations
 
$
90,374

 
$
10,763

 
$
7,900

 
$
109,037


Contract Costs

Applying the practical expedient, the Company primarily recognizes the incremental costs of obtaining contracts as an expense when incurred if the amortization period of the assets that otherwise would have been recognized is one year or less. These costs are generally included in sales and marketing and general and administrative expenses. If the incremental direct costs of obtaining a contract, which consist of sales commissions, relate to a service recognized over a period longer than one year, costs are deferred and amortized in line with the related services over the period of benefit. Deferred commissions are classified as non-current based on the original amortization period of over one year. As of July 1, 2018 deferred commissions were not significant.



13

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

Contract Balances

The Company records accounts receivable when it has an unconditional right to consideration. Contract liabilities are recorded when cash payments are received or due in advance of performance. Contract liabilities consist of advance payments and deferred revenue, where the Company has unsatisfied performance obligations. Contract liabilities are classified as Deferred revenue on the unaudited condensed consolidated balance sheets.

Payment terms vary by customer. The time between invoicing and when payment is due is not significant. For certain products or services and customer types, payment is required before the products or services are delivered to the customer.

The following table reflects the changes in contract balances for the six months ended July 1, 2018:
 
Balance Sheet Location
July 1, 2018
January 1, 2018 (*)
$ change
% change
 
 
(In thousands)
 
Accounts receivable, net
Accounts receivable, net
$
343,883

$
418,911

$
(75,028
)
(17.9
)%
Contract liabilities - current
Deferred revenue
$
30,674

$
30,103

$
571

1.9
 %
Contract liabilities - non-current
Other non-current liabilities
$
17,293

$
13,839

$
3,454

25.0
 %
_________________________
* Includes the adjustments made to the contracts which were not completed at the date of ASC 606 adoption using the modified retrospective method.

During the six months ended July 1, 2018, contract liabilities increased primarily as a result of increased sales of products containing multiple performance obligations, where cash payments were received or due in advance of satisfying the service related performance obligation.

During the six months ended July 1, 2018, $26.7 million of revenue was deferred due to unsatisfied performance obligations, primarily relating to over time service revenue. During the six months, $22.6 million of revenue was recognized for the satisfaction of performance obligations over time. $17.4 million of this recognized revenue was included in the contract liability balance at the beginning of the period.

There were no significant changes in estimates during the period that would affect the contract balances.


14

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

Disaggregation of Revenue

In the following tables, net revenue is disaggregated by geographic region and sales channel. The Company conducts business across three geographic regions: Americas; Europe, Middle-East and Africa (“EMEA”); and Asia Pacific ("APAC"). The tables also include reconciliations of the disaggregated revenue by reportable segment. The Company operates and reports in three segments: Arlo, Connected Home, and Small and Medium Business ("SMB"). Sales and usage-based taxes are excluded from net revenue.
 
Three Months Ended
 
July 1, 2018
 
July 2, 2017 (*)
 
Arlo
 
Connected Home
 
SMB
 
Total
 
Arlo
 
Connected Home
 
SMB
 
Total
 
(In thousands)
Geographic regions:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Americas
$
80,877

 
$
149,271

 
$
29,678

 
$
259,826

 
$
66,485

 
$
131,674

 
$
28,790

 
$
226,949

EMEA
19,149

 
21,027

 
28,505

 
68,681

 
9,937

 
18,901

 
26,366

 
55,204

APAC
4,787

 
20,866

 
12,660

 
38,313

 
2,310

 
35,330

 
10,930

 
48,570

Total net revenue
$
104,813

 
$
191,164

 
$
70,843

 
$
366,820

 
$
78,732

 
$
185,905

 
$
66,086

 
$
330,723

Sales channels:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Service provider
$
7,591

 
$
46,333

 
$
700

 
$
54,624

 
$
7,972

 
$
48,485

 
$
588

 
$
57,045

Non-service provider
97,222

 
144,831

 
70,143

 
312,196

 
70,760

 
137,420

 
65,498

 
273,678

Total net revenue
$
104,813

 
$
191,164

 
$
70,843

 
$
366,820

 
$
78,732

 
$
185,905

 
$
66,086

 
$
330,723

_________________________
* As noted above, prior period amounts have not been adjusted under the modified retrospective method.

 
Six Months Ended
 
July 1, 2018
 
July 2, 2017 (*)
 
Arlo
 
Connected Home
 
SMB
 
Total
 
Arlo
 
Connected Home
 
SMB
 
Total
 
(In thousands)
Geographic regions:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Americas
$
151,877

 
$
280,875

 
$
60,694

 
$
493,446

 
$
109,157

 
$
267,878

 
$
61,543

 
$
438,578

EMEA
37,890

 
42,454

 
54,966

 
135,310

 
22,407

 
40,903

 
50,339

 
113,649

APAC
11,255

 
45,616

 
26,166

 
83,037

 
7,880

 
71,485

 
22,788

 
102,153

Total net revenue
$
201,022

 
$
368,945

 
$
141,826

 
$
711,793

 
$
139,444

 
$
380,266

 
$
134,670

 
$
654,380

Sales channels:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Service provider
$
15,978

 
$
88,130

 
$
1,763

 
$
105,871

 
$
9,949

 
$
101,678

 
$
1,378

 
$
113,005

Non-service provider
185,044

 
280,815

 
140,063

 
605,922

 
129,495

 
278,588

 
133,292

 
541,375

Total net revenue
$
201,022

 
$
368,945

 
$
141,826

 
$
711,793

 
$
139,444

 
$
380,266

 
$
134,670

 
$
654,380

_________________________
* As noted above, prior period amounts have not been adjusted under the modified retrospective method.



15

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

Note 4.
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 fiscal quarter of 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. Pro forma results of operations for the acquisition are not presented as the financial impact to the Company's consolidated results of operations is not material.
The allocation of the purchase price was as follows (in thousands):
Cash and cash equivalents
$
8

Accounts receivable
11

Prepaid expenses and other current assets
130

Property and equipment
83

Intangibles
6,000

Goodwill
3,742

Accounts payable
(40
)
Other accrued liabilities
(74
)
Deferred tax liabilities
(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 current 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.


16

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

Note 5.
Balance Sheet Components

Available-for-sale short-term investments
 
As of
 
July 1, 2018
 
December 31, 2017
 
Cost
 
Unrealized Gains
 
Unrealized Losses
 
Estimated Fair Value
 
 Cost
 
Unrealized Gains
 
Unrealized Losses
 
Estimated Fair Value
 
(In thousands)
U.S. treasuries
$
125,740

 
$

 
$
(115
)
 
$
125,625

 
$
124,816

 
$

 
$
(146
)
 
$
124,670

Certificates of deposit
154

 

 

 
154

 
162

 

 

 
162

Total
$
125,894

 
$

 
$
(115
)
 
$
125,779

 
$
124,978

 
$

 
$
(146
)
 
$
124,832


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.

Equity investments without readily determinable fair values

As noted above, the Company adopted ASU 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities" on January 1, 2018. The Company's equity investments without determinable fair values was $3.1 million as of July 1, 2018 and $4.5 million as of December 31, 2017, and are included in Other non-current assets in the unaudited condensed consolidated balance sheets. The Company does not have a controlling interest or the ability to exercise significant influence over these investees and these investments do not have readily determinable fair values. Equity investments without readily determinable fair values are accounted for at cost, less impairment and adjusted for subsequent observable price changes obtained from orderly transactions for identical or similar investments issued by the same investee. Such changes in the basis of the equity investment are recognized in Other income (expense), net in the unaudited condensed consolidated statements of operations. $1.4 million of impairment charges were recognized during the six months ended July 1, 2018 and there were no impairments recognized during the six months ended July 2, 2017.

Accounts receivable, net
 
As of
 
July 1,
2018
 
December 31,
2017
 
(In thousands)
Gross accounts receivable
$
345,138

 
$
437,891

Allowance for doubtful accounts
(1,255
)
 
(1,257
)
Allowance for sales returns

*
(20,189
)
Allowance for price protection

*
(3,647
)
Total allowances
(1,255
)
 
(25,093
)
Total accounts receivable, net
$
343,883

 
$
412,798

_________________________
* Upon adoption of ASC 606, allowances for sales returns and price protection were reclassified to current liabilities as these reserve balances are considered refund liabilities. Refer to Note 3. Revenue Recognition, for additional information on the adoption impact.


17

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

Inventories
 
As of
 
July 1,
2018
 
December 31,
2017
 
(In thousands)
Raw materials
$
2,854

 
$
4,465

Finished goods
288,605

 
241,429

Total inventories
$
291,459

 
$
245,894


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
 
July 1,
2018
 
December 31,
2017
 
(In thousands)
Computer equipment
$
12,771

 
$
10,114

Furniture, fixtures and leasehold improvements
21,269

 
21,640

Software
33,051

 
28,997

Machinery and equipment
61,969

 
62,490

Total property and equipment, gross
129,060

 
123,241

Accumulated depreciation and amortization
(99,923
)
 
(102,581
)
Total property and equipment, net
$
29,137

 
$
20,660


Depreciation and amortization expense pertaining to property and equipment was $3.3 million and $6.6 million for the three and six months ended July 1, 2018, respectively, and $3.1 million and $6.5 million for the three and six months ended July 2, 2017, respectively.

Intangibles, net
 
As of July 1, 2018
 
As of December 31, 2017
 
Gross
 
Accumulated Amortization
 
Net
 
Gross
 
Accumulated Amortization
 
Net
 
(In thousands)
Technology
$
66,599

 
$
(63,276
)
 
$
3,323

 
$
66,599

 
$
(62,172
)
 
$
4,427

Customer contracts and relationships
56,500

 
(40,943
)
 
15,557

 
56,500

 
(37,430
)
 
19,070

Other
11,045

 
(9,901
)
 
1,144

 
11,045

 
(9,554
)
 
1,491

Total intangibles, net
$
134,144

 
$
(114,120
)
 
$
20,024

 
$
134,144

 
$
(109,156
)
 
$
24,988


Amortization of intangibles was $2.5 million and $5.0 million for the three and six months ended July 1, 2018, respectively, and $3.2 million and $7.7 million for the three and six months ended July 2, 2017, respectively.


18

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

As of July 1, 2018, estimated amortization expense related to finite-lived intangibles for the remaining years is as follows (in thousands):
2018 (remaining six months)
$
4,432

2019
7,544

2020
6,622

2021
1,413

2022
13

Total estimated amortization expense
$
20,024


Other non-current assets
 
As of
 
July 1,
2018
 
December 31, 2017
 
(In thousands)
Non-current deferred income taxes
$
72,975

 
$
49,468

Other
13,174

 
12,321

Total other non-current assets
$
86,149

 
$
61,789


Other accrued liabilities
 
As of
 
July 1,
2018
 
December 31,
2017
 
(In thousands)
Sales and marketing
$
118,318

 
$
96,153

Warranty obligation
18,759

*
75,824

Sales returns
69,378

*

Freight
7,646

 
10,567

Other
51,889

 
39,926

Total other accrued liabilities
$
265,990

 
$
222,470

_________________________
* Upon adoption of ASC 606 on January 1, 2018, certain warranty reserve balances totaling $57.9 million were reclassified to sales returns as these liabilities are payable to the Company's customers and settled in cash or by credit on account. Under ASC 606, these amounts are to be accounted for as sales with right of return.

Note 6.
Derivative Financial Instruments

The Company’s subsidiaries have had, and will continue to have material future cash flows, including revenue and expenses, which are denominated in currencies other than the Company’s functional currency. The Company and all its subsidiaries designate the U.S. dollar as the functional currency. Changes in exchange rates between the Company’s functional currency and other currencies in which the Company transacts business will cause fluctuations in cash flow expectations and cash flow realized or settled. Accordingly, the Company uses derivatives to mitigate its business exposure to foreign exchange risk. The Company enters into foreign currency forward contracts in Australian dollars, British pounds, Euros, Canadian dollar, 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

19

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

into derivative contracts with high-quality financial institutions and limits the amount of credit exposure to any one counter-party. In addition, the derivative contracts typically mature in less than six months and the Company continuously evaluates the credit standing of its counter-party financial institutions. The counter-parties to these arrangements are large highly rated financial institutions and the Company does not consider non-performance a material risk.

The Company may choose not to hedge certain foreign exchange exposures for a variety of reasons, including, but not limited to, materiality, accounting considerations or the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign exchange rates. The Company’s accounting policies for these instruments are based on whether the instruments are designated as hedge or non-hedge instruments in accordance with the authoritative guidance for derivatives and hedging. The Company records all derivatives on the balance sheets at fair value. Cash flow hedge gains and losses are recorded in other comprehensive income ("OCI") until the hedged item is recognized in earnings. Derivatives that are not designated as hedging instruments are adjusted to fair value through earnings in Other income (expense), net in the unaudited condensed consolidated statements 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 July 1, 2018 and December 31, 2017 are summarized as follows:

Derivative Assets
 
Balance Sheet
Location
 
July 1, 2018
 
December 31, 2017
 
Balance Sheet
Location
 
July 1, 2018
 
December 31, 2017
 
 
 
 
(In thousands)
 
 
 
(In thousands)
Derivative assets not designated as hedging instruments
 
Prepaid expenses and other current assets
 
$
3,824

 
$
1,314

 
Other accrued liabilities
 
$
458

 
$
7,128

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

 
485

 
Other accrued liabilities
 
49

 
1,064

Total
 
 
 
$
3,824

 
$
1,799

 
 
 
$
507

 
$
8,192


Refer to Note 13, Fair Value Measurements, in Notes to Unaudited Condensed Consolidated Financial Statements for detailed disclosures regarding fair value measurements in accordance with the authoritative guidance for fair value measurements and disclosures.

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 July 1, 2018 and December 31, 2017:
As of July 1, 2018
 
 
 
 
 
 
 
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
 
2,181

 

 
2,181

 
(318
)
 

 
1,863

Wells Fargo
 
1,643

 

 
1,643

 
(189
)
 

 
1,454

Total
 
$
3,824

 
$

 
$
3,824

 
$
(507
)
 
$

 
$
3,317



20

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

As of December 31, 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
 
$
1,664

 
$

 
$
1,664

 
$
(1,664
)
 
$

 
$

Wells Fargo
 
135

 

 
135

 
(135
)
 

 

Total
 
$
1,799

 
$

 
$
1,799

 
$
(1,799
)
 
$

 
$


The following tables set forth the offsetting of derivative liabilities as of July 1, 2018 and December 31, 2017:
As of July 1, 2018
 
 
 
 
 
 
 
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
 
$
318

 
$

 
$
318

 
$
(318
)
 
$

 
$

Wells Fargo
 
189

 

 
189

 
(189
)
 

 

Total
 
$
507

 
$

 
$
507

 
$
(507
)
 
$

 
$


As of December 31, 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
 
$
7,815

 
$

 
$
7,815

 
$
(1,664
)
 
$

 
$
6,151

Wells Fargo
 
377

 

 
377

 
(135
)
 

 
242

Total
 
$
8,192

 
$

 
$
8,192

 
$
(1,799
)
 
$

 
$
6,393



21

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

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 less than six months. The Company enters into about ten forward contracts per quarter with an average size of approximately $7.0 million USD equivalent related to its cash flow hedging program.

The effects of the Company's cash flow hedges on the unaudited condensed statements of operations for the three months ended July 1, 2018 are summarized as follows:
 
 
Location and Amount of Gains (Losses) Recognized in Income on Cash Flow Hedges
 
 
Three Months Ended July 1, 2018
 
Net revenue
 
Cost of revenue
 
Research and development
 
Sales and marketing
 
General and administrative
 
 
(In thousands)
Statements of operations
 
$
366,820

 
$
257,648

 
$
31,371

 
$
46,983

 
$
20,448

Gains (losses) on cash flow hedge
 
$
1,783

 
$
(7
)
 
$
(13
)
 
$
(157
)
 
$
(50
)

The effects of the Company's cash flow hedges on the unaudited condensed statements of operations for the six months ended July 1, 2018 are summarized as follows:

 
 
Location and Amount of Gains (Losses) Recognized in Income on Cash Flow Hedges
 
 
Six Months Ended July 1, 2018
 
Net revenue
 
Cost of revenue
 
Research and development
 
Sales and marketing
 
General and administrative
 
 
(In thousands)
Statements of operations
 
$
711,793

 
$
498,116

 
$
60,318

 
$
90,641

 
$
37,086

Gains (losses) on cash flow hedge
 
$
(785
)
 
$
(1
)
 
$
86

 
$
73

 
$
(9
)

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 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 expenses in the same period and in the same statements of operations line item as the related costs of revenue and operating expenses are recognized.

Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur within the designated hedge period or if not recognized within 60 days following the end of the hedge period. Deferred gains and losses in OCI with such derivative instruments are reclassified immediately into earnings through Other income (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 six months ended July 1, 2018 and July 2, 2017.


22

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

The pre-tax effects of the Company’s derivative instruments on OCI and the unaudited condensed consolidated statement of operations for the three and six months ended July 1, 2018 and July 2, 2017 are summarized as follows:
Derivatives Designated as Hedging Instruments
 
Three Months Ended July 1, 2018
 
Gains (Losses)
Recognized in
OCI -
Effective
Portion
 
Location of
Gains (Losses)
Reclassified from OCI
into Income - Effective
Portion
 
Gains (Losses)
Reclassified
from
OCI into
Income -
Effective
Portion (1)
 
 
(In thousands)
Cash flow hedges:
 
 
 
 
 
 
Foreign currency forward contracts
 
$
1,680

 
Net revenue
 
$
1,783

Foreign currency forward contracts
 

 
Cost of revenue
 
(7
)
Foreign currency forward contracts
 

 
Research and development
 
(13
)
Foreign currency forward contracts
 

 
Sales and marketing
 
(157
)
Foreign currency forward contracts
 

 
General and administrative
 
(50
)
Total
 
$
1,680

 
 
 
$
1,556

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

Derivatives Designated as Hedging Instruments
 
Six Months Ended July 1, 2018
 
Gains (Losses)
Recognized in
OCI -
Effective
Portion
 
Location of
Gains (Losses)
Reclassified from OCI
into Income - Effective
Portion
 
Gains (Losses)
Reclassified
from
OCI into
Income -
Effective
Portion (1)
 
 
(In thousands)
Cash flow hedges:
 
 
 
 
 
 
Foreign currency forward contracts
 
$
180

 
Net revenue
 
$
(785
)
Foreign currency forward contracts
 

 
Cost of revenue
 
(1
)
Foreign currency forward contracts
 

 
Research and development
 
86

Foreign currency forward contracts
 

 
Sales and marketing
 
73

Foreign currency forward contracts
 

 
General and administrative
 
(9
)
Total
 
$
180

 
 
 
$
(636
)
_________________________
(1) Refer to Note 10, Stockholders' Equity, which summarizes the accumulated other comprehensive income activity related to derivatives.


23

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

Derivatives Designated as Hedging Instruments
 
Three Months Ended July 2, 2017
 
Gains (Losses)
Recognized in
OCI -
Effective
Portion
 
Location of
Gains (Losses)
Reclassified from OCI
into Income - Effective
Portion
 
Gains (Losses)
Reclassified
from
OCI into
Income -
Effective
Portion (1)
 
 
(In thousands)
Cash flow hedges:
 
 
 
 
 
 
Foreign currency forward contracts
 
$
(6,935
)
 
Net revenue
 
$
(1,008
)
Foreign currency forward contracts
 

 
Cost of revenue
 
(1
)
Foreign currency forward contracts
 

 
Research and development
 
(55
)
Foreign currency forward contracts
 

 
Sales and marketing
 
115

Foreign currency forward contracts
 

 
General and administrative
 
17

Total
 
$
(6,935
)
 
 
 
$
(932
)
_______________________
(1) Refer to Note 10, Stockholders' Equity, which summarizes the accumulated other comprehensive income activity related to derivatives.

Derivatives Designated as Hedging Instruments
 
Six Months Ended July 2, 2017
 
Gains (Losses)
Recognized in
OCI -
Effective
Portion
 
Location of
Gains (Losses)
Reclassified from OCI
into Income - Effective
Portion
 
Gains (Losses)
Reclassified
from
OCI into
Income -
Effective
Portion (1)
 
 
(In thousands)
Cash flow hedges:
 
 
 
 
 
 
Foreign currency forward contracts
 
$
(7,052
)
 
Net revenue
 
$
1,027

Foreign currency forward contracts
 

 
Cost of revenue
 
(14
)
Foreign currency forward contracts
 

 
Research and development
 
(74
)
Foreign currency forward contracts
 

 
Sales and marketing
 
(249
)
Foreign currency forward contracts
 

 
General and administrative
 
(42
)
Total
 
$
(7,052
)
 
 
 
$
648

_______________________
(1) Refer to Note 10, 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 ten non-designated 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.


24

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

The effects of the Company’s non-designated hedge included in Other income (expense), net in the unaudited condensed consolidated statements of operations for the three and six months ended July 1, 2018 and July 2, 2017 are as follows:

Derivatives Not Designated as Hedging Instruments
 
Location of Gains (Losses)
Recognized in Income on Derivative
 
Three Months Ended
 
Six Months Ended
 
July 1, 2018
 
July 2, 2017
 
July 1, 2018
 
July 2, 2017
 
 
 
 
(In thousands)
Foreign currency forward contracts
 
Other income (expense), net
 
$
5,438

 
$
(2,893
)
 
$
3,030

 
$
(4,246
)

Note 7.
Net Income Per Share

Basic net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by dividing the net income (loss) 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 ESPP, which are reflected in diluted net income per share by application of the treasury stock method. Potentially dilutive common shares are excluded from the computation of diluted net income (loss) per share when their effect is anti-dilutive.
Net income (loss) per share for the three and six months ended July 1, 2018 and July 2, 2017 are as follows:
 
Three Months Ended
 
Six Months Ended
 
July 1,
2018
 
July 2,
2017
 
July 1,
2018
 
July 2,
2017
 
(In thousands, except per share data)
Numerator:
 
 
 
 
 
 
 
Net income (loss)
$
(5,230
)
 
$
14,582

 
$
360

 
$
30,576

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Weighted average common shares - basic
31,674

 
32,352

 
31,550

 
32,650

Potentially dilutive common share equivalent

 
764

 
1,172

 
1,006

Weighted average common shares - dilutive
31,674

 
33,116

 
32,722

 
33,656

 
 
 
 
 
 
 
 
Basic net income (loss) per share
$
(0.17
)
 
$
0.45

 
$
0.01

 
$
0.94

Diluted net income (loss) per share
$
(0.17
)
 
$
0.44

 
$
0.01

 
$
0.91

 
 
 
 
 
 
 
 
Anti-dilutive employee stock-based awards, excluded
1,014

 
782

 
892

 
271



Note 8.
Income Taxes

The income tax provision for the three and six months ended July 1, 2018, was $4.4 million, or an effective tax rate of (506.7)%, and $6.8 million, or an effective tax rate of 94.9%, respectively. The income tax provision for the three and six months ended July 2, 2017, $5.4 million, or an effective tax rate of 26.9%, and $12.9 million, or an effective tax rate of 29.7%, respectively. The increase in the effective tax rate and decrease in tax expense for the three and six months ended July 1, 2018, compared to the three and six months ended July 2, 2017, resulted primarily from a decline in pre-tax earnings resulting from an increase in expenses from the separation of the Arlo business coupled with our estimation that a portion of these costs are nondeductible. This was partially offset by a decrease in tax rate from 35% to 21%.

On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Act. The Tax Act reduced the U.S. statutory rate from 35% to 21% effective as of January 1, 2018. In addition, certain new complex

25

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

tax rules related to the taxation of foreign earnings (Global Intangible Low-Taxed Income, Foreign Derived Intangible Income and Base Erosion and Anti-abuse Tax) became effective as of January 1, 2018. Based on information available to date, the Company has evaluated these provisions and estimate that there is no material impact on its income tax provision for the six months ended July 1, 2018.

In the year ended December 31, 2017, the Company recorded the effects of a reduction in tax rates from 35% to 21% on its deferred tax assets and liabilities and to record a one-time transition tax. After the enactment of the Tax Act, the SEC issued Staff Accounting Bulletin No. 118 ("SAB 118") to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Act. The Company has calculated an estimate of the impact of the Tax Act in its tax provision for the period ending December 31, 2017 in accordance with its understanding of the Tax Act and guidance available as of the date of the filing of Form 10-K and as a result recorded $48.3 million as additional income tax expense in the fourth fiscal quarter of 2017, the period in which the legislation was enacted. The provisional amount related to the remeasurement of certain deferred tax assets and liabilities, based on the rates at which they are expected to reverse in the future, was $26.6 million. The provisional amount related to the one-time transition tax on the mandatory deemed repatriation of foreign earnings was $21.7 million. The Company has reviewed these amounts based on additional guidance available and has not changed its estimates.

In accordance with SAB 118, the Company has determined that the $21.7 million of current tax expense recorded in connection with the transition tax on the mandatory deemed repatriation of foreign earnings was a provisional amount and a reasonable estimate at December 31, 2017. The Company has reviewed these amounts based on additional guidance available and has not changed its estimates.
  
The Company is subject to income taxes in the U.S. and numerous foreign jurisdictions. The future foreign tax rate could be affected by changes in the composition in earnings in countries with tax rates differing from the U.S. federal rate. The Company is under examination in various U.S. and foreign jurisdictions.

The Company files income tax returns in the U.S. federal jurisdiction as well as various state, local, and foreign jurisdictions. Due to the uncertain nature of ongoing tax audits, the Company has recorded its liability for uncertain tax positions as part of its long-term liability as payments cannot be anticipated over the next twelve months. The existing tax positions of the Company continue to generate an increase in the liability for uncertain tax positions. The liability for uncertain tax positions may be reduced for liabilities that are settled with taxing authorities or on which the statute of limitations could expire without assessment from tax authorities. The possible reduction in liabilities for uncertain tax positions resulting from the expiration of statutes of limitation in multiple jurisdictions in the next twelve months is approximately $0.9 million, excluding the interest, penalties and the effect of any related deferred tax assets or liabilities.

Note 9.
Commitments and Contingencies

Leases

The Company leases office space, cars and equipment under operating leases, some of which are non-cancelable, with various expiration dates through December 2026. In June 2018, Arlo Technologies Inc., a wholly owned subsidiary of the Company, entered into an office lease agreement expiring December 2028. 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.


26

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

Purchase Obligations

The Company has entered into various inventory-related purchase agreements with suppliers. Generally, under these agreements, 50% of orders are cancelable by giving notice 46 to 60 days prior to the expected shipment date and 25% of orders are cancelable by giving notice 31 to 45 days prior to the expected shipment date. Orders are non-cancelable within 30 days prior to the expected shipment date. As of July 1, 2018, the Company had approximately $164.2 million in non-cancelable purchase commitments with suppliers. The Company establishes a loss liability for all products it does not expect to sell for which it has committed purchases from suppliers. Such losses have not been material to date. 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
 
Six Months Ended
 
July 1,
2018
 
July 2,
2017
 
July 1,
2018
 
July 2,
2017
 
(In thousands)
Balance as of beginning of the period
$
18,978

 
$
56,336

 
$
75,824

 
$
58,520

Reclassified to sales returns upon adoption of ASC 606

 

 
(57,860
)
*

Provision for warranty obligation made during the period
883

 
34,515

 
2,941

 
61,268

Settlements made during the period
(1,102
)
 
(30,400
)
 
(2,146
)
 
(59,337
)
Balance at end of period
$
18,759

 
$
60,451

 
$
18,759

 
$
60,451

________________________
* Upon adoption of ASC 606 on January 1, 2018, certain warranty reserve balances totaling $57.9 million were reclassified to sales returns as these liabilities are payable to the Company's customers and settled in cash or by credit on account. Under ASC 606, these amounts are to be accounted for as sales with right of return.

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 July 1, 2018.

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. The Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of July 1, 2018.


27

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

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 Chief Operations Officer) 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 July 1, 2018.

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 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. On June 22, 2012, Intel filed its Complaint in Intervention, meaning that Intel also became a defendant. During litigation, Ericsson (a) dismissed the '468 Patent with prejudice and gave the Company a covenant not to sue as to products in the marketplace now or in the past, (b) dropped the '516 Patent and (c) dropped the '223 Patent, except for those products that use Intel chips.

A jury trial 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).

The Company and other defendants appealed the jury verdict. On December 4, 2014, the Federal Circuit issued its opinion and order in the appeal. The Federal Circuit vacated the entirety of the $3.6 million jury verdict against the Company and other defendants’ damages awards and also vacated the ongoing 15 cents per unit royalty verdict, finding that the District Court had not properly instructed the jury on royalty rates and Ericsson’s licensing promises.

28

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


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. The case was remanded for further proceedings.

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, ruling these claims were anticipated or obvious in light of prior art. 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. Accordingly, the Company has reversed the accruals related to this case.

Ericsson appealed the PTAB’s Broadcom IPR decision to the Federal Circuit and also requested that the PTAB reconsider its decision. The PTAB denied Ericsson’s request for reconsideration. On appeal to the Federal Circuit, Ericsson argued that the PTAB’s determination that Broadcom had timely filed its IPR petitions was improper, as it was in privity with the defendants, and that the PTAB should not have invalidated the claims of the '625 Patent, the '568 Patent, and '215 Patent. The Federal Circuit upheld the invalidity of the patents’ claims, as previously determined by the PTAB, and ruled that Ericsson could not appeal the timeliness of Broadcom’s IPR petitions. Ericsson petitioned the Federal Circuit for an en banc rehearing of the Federal Circuit's panel decision that Broadcom was timely in bringing its IPRs, and the Federal Circuit agreed to the en banc rehearing. On January 8, 2018, the Federal Circuit sitting en banc ruled that the timeliness of Broadcom’s IPR petitions was an appealable issue. Following this en banc decision finding that PTAB decisions on privity are appealable, on April 20, 2018, the original three judge panel upheld its prior finding of invalidity and found that Broadcom was not in privity with the defendants in the district court case, and had timely filed its IPR petitions. In response, Ericsson filed another motion for an en banc hearing of this decision.

The present status of the case continues to be that the Company does not infringe 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 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 2006 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. A decision favorable to the Company was issued by the Court on July 5, 2017. The

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Italian Tax Authority has appealed the decision to the Supreme Court and the Company has responded with a counter appeal brief on December 3, 2017 and awaits scheduling of the hearing.

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 was held on November 17, 2017 and the Company received a positive decision on December 11, 2017. On June 11, 2018, the Italian government filed its appeal brief with the Supreme Court, and the Company filed its counter brief on July 12, 2018 and awaits scheduling of the hearing.

With respect to 2008 through 2010, the Company filed its appeal briefs with the Provincial Tax Court in October 2015 and the hearing for the validity of the tax assessments was held on April 21, 2016. 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. The hearing was held on May 21, 2018, and the Company received a favorable decision on June 12, 2018.

With respect to 2011 through 2012, the Company has filed its appeal brief on February 26, 2016 with the Provincial Tax Court to contest the relevant tax assessments. The hearing for suspension was held and the Request for Suspension of payment was granted. On October 13, 2016, the Company filed its final 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 before the Regional Tax Court on April 19, 2017. The Company filed its counter brief on June 16, 2017 and awaits the scheduling of the hearing.

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

Via Vadis v. NETGEAR, Inc.

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

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

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

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

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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