10-Q 1 ntgr20180930-10xq.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 September 30, 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 every Interactive Data File required to be submitted 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 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 31,585,939 as of October 26, 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
 
September 30,
2018
 
December 31,
2017
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
393,640

 
$
202,870

Short-term investments
136,173

 
126,926

Accounts receivable, net
358,982

 
412,798

Inventories
330,516

 
245,894

Prepaid expenses and other current assets
39,011

 
27,176

Total current assets
1,258,322

 
1,015,664

Property and equipment, net
56,647

 
20,660

Intangibles, net
22,341

 
24,988

Goodwill
101,965

 
85,463

Other non-current assets
94,047

 
61,789

Total assets
$
1,533,322

 
$
1,208,564

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
168,155

 
$
111,915

Accrued employee compensation
31,168

 
27,752

Other accrued liabilities
282,410

 
222,470

Deferred revenue
35,485

 
55,284

Income taxes payable
6,853

 
7,015

Total current liabilities
524,071

 
424,436

Non-current income taxes payable
21,273

 
31,544

Other non-current liabilities
53,499

 
22,099

Total liabilities
598,843

 
478,079

Commitments and contingencies (Note 10)


 


Stockholders’ equity:
 
 
 
Common stock
32

 
31

Additional paid-in capital
785,694

 
603,137

Accumulated other comprehensive loss
(36
)
 
(851
)
Retained earnings
124,488

 
128,168

Total NETGEAR stockholders’ equity
910,178

 
730,485

Non-controlling interest
24,301

 

Total stockholders’ equity
934,479

 
730,485

Total liabilities and stockholders’ equity
$
1,533,322

 
$
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
 
Nine Months Ended
 
September 30,
2018
 
October 1,
2017
 
September 30,
2018
 
October 1,
2017
Net revenue
$
400,586

 
$
355,483

 
$
1,112,379

 
$
1,009,863

Cost of revenue
276,394

 
252,388

 
774,510

 
717,900

Gross profit
124,192

 
103,095

 
337,869

 
291,963

Operating expenses:
 
 
 
 
 
 
 
Research and development
35,253

 
23,127

 
95,571

 
69,167

Sales and marketing
49,005

 
40,311

 
139,646

 
115,001

General and administrative
23,268

 
14,229

 
60,354

 
40,373

Separation expense
7,054

 

 
25,822

 

Restructuring and other charges
1

 
19

 
1,368

 
78

Litigation reserves, net

 
15

 
5

 
68

Total operating expenses
114,581

 
77,701

 
322,766

 
224,687

Income from operations
9,611

 
25,394

 
15,103

 
67,276

Interest income
1,490

 
501

 
3,310

 
1,388

Other income (expense), net
829

 
666

 
638

 
1,384

Income before income taxes
11,930

 
26,561

 
19,051

 
70,048

Provision for income taxes
2,780

 
5,767

 
9,541

 
18,678

Net income
9,150

 
20,794

 
9,510

 
51,370

Net loss attributable to non-controlling interest
(799
)
 

 
(799
)
 

Net income attributable to NETGEAR, Inc.
$
9,949

 
$
20,794

 
$
10,309

 
51,370

Net income per share attributable to NETGEAR Inc.:
 
 
 
 
 
 
 
Basic
$
0.31

 
$
0.66

 
$
0.33

 
$
1.59

Diluted
$
0.30

 
$
0.64

 
$
0.31

 
$
1.54

Weighted average shares used to compute net income per share attributable to NETGEAR Inc.:
 
 
 
 
 
 
 
Basic
31,802

 
31,704

 
31,634

 
32,335

Diluted
32,974

 
32,393

 
32,826

 
33,269

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

4


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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2018
 
October 1,
2017
 
September 30,
2018
 
October 1,
2017
Net income
$
9,150

 
$
20,794

 
$
9,510

 
$
51,370

Other comprehensive income (loss), before tax:
 
 
 
 
 
 
 
Unrealized gains (losses) on derivative instruments
48

 
22

 
864

 
(7,678
)
Unrealized gains (losses) on available-for-sale securities
41

 
41

 
72

 
(41
)
Other comprehensive income (loss), before tax
89

 
63

 
936

 
(7,719
)
Tax benefit (provision) related to derivative instruments
(8
)
 

 
(84
)
 
1,005

Tax benefit (provision) related to available-for-sale securities
(10
)
 
(15
)
 
(37
)
 
14

Other comprehensive income (loss), net of tax
71

 
48

 
815

 
(6,700
)
Comprehensive income
$
9,221

 
$
20,842

 
$
10,325

 
$
44,670

Comprehensive loss attributable to non-controlling interest
(797
)
 

 
(797
)
 

Comprehensive income attributable to NETGEAR, Inc.
$
10,018

 
$
20,842

 
$
11,122

 
$
44,670

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


5


NETGEAR, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(In thousands)
 
NETGEAR, Inc. Stockholders
 
 
 
 
 
 
 
Common Stock
 
 
 
 
 
 
 
 
 
 
 
 
 
Shares
 
Amount
 
 Additional Paid-In Capital
 
Accumulated Other Comprehensive Income (Loss)
 
Retained Earnings
 
Total NETGEAR Stockholder's Equity
 
Non-controlling Interest
 
Total Stockholder's Equity
Balance as of December 31, 2017
31,320

 
$
31

 
$
603,137

 
$
(851
)
 
$
128,168

 
$
730,485

 
$

 
$
730,485

Adoptions of ASU 2014-09 (ASC 606 Rev Rec), ASU 2016-16, and ASU 2018-02, net of tax

 

 

 

 
8,593

 
8,593

 

 
8,593

Change in unrealized gains and losses on available-for-sale securities, net of tax

 

 

 
(49
)
 

 
(49
)
 

 
(49
)
Change in unrealized gains and losses on derivatives, net of tax

 

 

 
631

 

 
631

 

 
631

Net income

 

 

 

 
5,590

 
5,590

 

 
5,590

Stock-based compensation

 

 
8,150

 

 

 
8,150

 

 
8,150

Restricted stock unit withholdings
(38
)
 

 

 

 
(2,271
)
 
(2,271
)
 

 
(2,271
)
Issuance of common stock under stock-based compensation plans
252

 
1

 
4,589

 

 

 
4,590

 

 
4,590

Balance as of April 1, 2018
31,534

 
$
32

 
$
615,876

 
$
(269
)
 
$
140,080

 
$
755,719

 
$

 
$
755,719

Change in unrealized gains and losses on available-for-sale securities, net of tax

 

 

 
53

 

 
53

 

 
53

Change in unrealized gains and losses on derivatives, net of tax

 

 

 
109

 

 
109

 

 
109

Net loss

 

 

 

 
(5,230
)
 
(5,230
)
 

 
(5,230
)
Stock-based compensation

 

 
8,970

 

 

 
8,970

 

 
8,970

Restricted stock unit withholdings
(85
)
 

 

 

 
(4,897
)
 
(4,897
)
 

 
(4,897
)
Issuance of common stock under stock-based compensation plans
332

 

 
1,012

 

 

 
1,012

 

 
1,012

Balance as of July 1, 2018
31,781

 
$
32

 
$
625,858

 
$
(107
)
 
$
129,953

 
$
755,736

 
$

 
$
755,736

Change in unrealized gains and losses on available-for-sale securities, net of tax

 

 

 
31

 

 
31

 

 
31

Change in unrealized gains and losses on derivatives, net of tax

 

 

 
40

 

 
40

 

 
40

Net income attributable to NETGEAR, Inc.

 

 

 

 
9,949

 
9,949

 

 
9,949

Net loss attributable to non-controlling interest

 

 

 

 

 

 
(799
)
 
(799
)
Stock-based compensation expense

 

 
8,612

 

 

 
8,612

 

 
8,612

Stock-based compensation expense for subsidiary shares

 

 

 

 

 

 
942

 
942

Sale of Arlo's common stock

 

 
146,088

 

 

 
146,088

 
24,158

 
170,246

Repurchases of common stock
(205
)
 

 

 

 
(15,000
)
 
(15,000
)
 

 
(15,000
)
Restricted stock unit withholdings
(6
)
 

 

 

 
(414
)
 
(414
)
 

 
(414
)
Issuance of common stock under stock-based compensation plans
176

 

 
5,136

 

 

 
5,136

 

 
5,136

Balance as of September 30, 2018
31,746

 
$
32

 
$
785,694

 
$
(36
)
 
$
124,488

 
$
910,178

 
$
24,301

 
$
934,479


6


 
NETGEAR Stockholders
 
 
 
Common Stock
 
 
 
 
 
 
 
 
 
Shares
 
Amount
 
 Additional Paid-In Capital
 
Accumulated Other Comprehensive Income (Loss)
 
Retained Earnings
 
Total Stockholder's Equity
Balance as of December 31, 2016
32,958

 
$
33

 
$
566,307

 
$
1,938

 
$
228,541

 
$
796,819

Change in unrealized gains and losses on available-for-sale securities, net of tax

 

 

 
(35
)
 

 
(35
)
Change in unrealized gains and losses on derivatives, net of tax

 

 

 
(1,501
)
 

 
(1,501
)
Net income

 

 

 

 
15,994

 
15,994

Stock-based compensation expense

 

 
5,128

 

 

 
5,128

Repurchases of common stock
(213
)
 

 

 

 
(11,631
)
 
(11,631
)
Restricted stock unit withholdings
(38
)
 

 

 

 
(1,936
)
 
(1,936
)
Issuance of common stock under stock-based compensation plans
246

 

 
5,100

 

 

 
5,100

Cumulative-effect adjustment from adoption of ASU 2016-09

 

 
327

 

 
(235
)
 
92

Balance as of April 2, 2017
32,953

 
$
33

 
$
576,862

 
$
402

 
$
230,733

 
$
808,030

Change in unrealized gains and losses on available-for-sale securities, net of tax

 

 

 
(18
)
 

 
(18
)
Change in unrealized gains and losses on derivatives, net of tax

 

 

 
(5,194
)
 

 
(5,194
)
Net income

 

 

 

 
14,582

 
14,582

Stock-based compensation expense

 

 
5,701

 

 

 
5,701

Repurchases of common stock
(929
)
 
(1
)
 

 

 
(44,999
)
 
(45,000
)
Restricted stock unit withholdings
(81
)
 

 

 

 
(3,713
)
 
(3,713
)
Issuance of common stock under stock-based compensation plans
315

 

 
1,534

 

 

 
1,534

Balance as of July 2, 2017
32,258

 
$
32

 
$
584,097

 
$
(4,810
)
 
$
196,603

 
$
775,922

Change in unrealized gains and losses on available-for-sale securities, net of tax

 

 

 
26

 

 
26

Change in unrealized gains and losses on derivatives, net of tax

 

 

 
22

 

 
22

Net income

 

 

 

 
20,794

 
20,794

Stock-based compensation expense

 

 
5,583

 

 

 
5,583

Repurchases of common stock
(682
)
 

 

 

 
(29,999
)
 
(29,999
)
Restricted stock unit withholdings
(8
)
 

 

 

 
(368
)
 
(368
)
Issuance of common stock under stock-based compensation plans
163

 

 
4,535

 

 

 
4,535

Balance as of October 1, 2017
31,731

 
$
32

 
$
594,215

 
$
(4,762
)
 
$
187,030

 
$
776,515

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



7


NETGEAR, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
 
Nine Months Ended
 
September 30,
2018
 
October 1,
2017
Cash flows from operating activities:
 
 
 
Net income
$
9,510

 
$
51,370

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
17,588

 
20,219

Purchase premium amortization/discount accretion on investments, net
(536
)
 
102

Stock-based compensation
26,674

 
16,412

Impairment charges on investment
1,400

 

Deferred income taxes
(1,574
)
 
(66
)
Changes in assets and liabilities, net of effect of acquisitions:
 
 
 
Accounts receivable
60,148

 
18,248

Inventories
(86,230
)
 
(1,216
)
Prepaid expenses and other assets
(21,389
)
 
5,557

Accounts payable
54,745

 
(20,016
)
Accrued employee compensation
3,417

 
(12,595
)
Other accrued liabilities
8,844

 
11,275

Deferred revenue
11,691

 
11,969

Income taxes payable
(10,432
)
 
173

Net cash provided by operating activities
73,856

 
101,432

Cash flows from investing activities:
 
 

Purchases of short-term investments
(109,931
)
 
(101,951
)
Proceeds from maturities of short-term investments
102,054

 
101,544

Purchases of property and equipment
(19,883
)
 
(9,805
)
Proceeds from sale of investment
624

 

Purchases of investments

 
(2,900
)
Payments made in connection with business acquisition, net of cash acquired
(14,352
)
 
(737
)
Net cash used in investing activities
(41,488
)
 
(13,849
)
Cash flows from financing activities:
 
 
 
Proceeds from Arlo initial public offering, net of offering costs
170,246

 

Repurchases of common stock
(15,000
)
 
(86,630
)
Restricted stock unit withholdings
(7,582
)
 
(6,017
)
Proceeds from exercise of stock options
5,184

 
6,405

Proceeds from issuance of common stock under employee stock purchase plan
5,554

 
4,764

Net cash provided by (used in) financing activities
158,402

 
(81,478
)
Net increase in cash and cash equivalents
190,770

 
6,105

Cash and cash equivalents, at beginning of period
202,870

 
240,468

Cash and cash equivalents, at end of period
$
393,640

 
$
246,573

 
 
 
 
Non-cash investing and financing activities:
 
 
 
Additions to property and equipment included in accounts payable and other accrued liabilities
$
4,472

 
$
797

Estimated fair value of a facility under build-to-suit lease in other accrued liabilities
$
21,858

 
$

Estimated fair value of contingent consideration in connection with business acquisition in other accrued liabilities
$
5,953

 
$

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

8

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 Company operates and reports in three segments: Arlo, Connected Home, and Small and Medium Business ("SMB"). The Arlo segment is included within a majority-owned, publicly traded subsidiary, Arlo Technologies, Inc. (“Arlo”) upon the completion of Arlo’s initial public offering (the "IPO") on August 7, 2018. See Note 4, Planned Separation of Arlo, for details relating to the IPO.

The accompanying unaudited condensed consolidated financial statements include the accounts of NETGEAR, Inc. and its wholly owned subsidiaries, as well as those of its 84.2% interest in Arlo. 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 resulting non-controlling interest’s share in the equity of Arlo is presented as a separate component of stockholders’ equity in the unaudited condensed consolidated balance sheets and unaudited condensed consolidated statements of stockholders’ equity, and the net income (loss) attributable to the non-controlling interest is presented in the unaudited condensed consolidated statements of operations and statements of comprehensive income. 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, stockholder's equity 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 nine months ended September 30, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018 or any future period.
 
 

9

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

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 2016-15

In August 2016, the FASB issued ASU 2016-15, "Classification of Certain Cash Receipts and Cash Payments" (Topic 230), which clarifies the classification of certain cash receipts and cash payments in the statement of cash flows, including settlement of contingent consideration arising from a business combination, insurance settlement proceeds, and distributions from certain equity method investees. The adoption of the guidance is required to be applied retrospectively and is effective for the Company in the first fiscal quarter of 2018. The Company adopted the guidance effectively January 1, 2018 and applied to the business combination transactions occurring on or after the adoption date. The adoption did not have material impacts on its financial position, results of operations or cash flows.

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 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 resulted 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.

10

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


ASU 2017-01

In January 2017, the FASB issued ASU 2017-01, "Business Combinations: Clarifying the Definition of a Business" (Topic 805), which changes the definition of a business to assist entities with evaluating when a set of transferred assets and activities is a business. The guidance requires an entity to evaluate if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets; if so, the set of transferred assets and activities is not a business. The Company adopted the guidance effectively January 1, 2018 and applied prospectively to the transactions occurring on or after the adoption date. The adoption did not have material impacts on its financial position, results of operations or 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

ASU 2016-02

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. The new standard requires a modified retrospective transition through a cumulative-effect adjustment as of the beginning of the earliest period presented in the financial statements, although the FASB recently approved an option for transition relief to not restate or make required disclosures under the new standard in comparative periods in the period of adoption. ASU 2016-02 is effective for the Company in the first fiscal quarter of 2019, with early adoption permitted.


11

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

The Company will adopt the new standard effective January 1, 2019 and will elect to utilize the FASB recently approved option for transition relief and adopt the modified retrospective transition through a cumulative-effect adjustment as of the adoption date. In accordance with the transition relief, the Company will not restate or make required disclosures under the new standard in comparative periods in the period of adoption. While the Company is currently evaluating the impact of the adoption of ASU 2016-02, based on the lease portfolio as of September 30, 2018, the most significant impact will be the recognition of right-of-use ("ROU") assets in the range of $45 million to $55 million, and lease liabilities in the range of $50 million to $60 million on its statement of financial position for operating leases, with limited impact to its results of operations and cash flows. $11 million to $14 million of the expected ROU assets and $12 million to $15 million of the expected lease liabilities are attributable to Arlo based on its lease portfolio as of September 30, 2018, exclusive of the build-to-suite lease arrangement relating to Arlo's San Jose Corporate headquarters. However, the ultimate impact of adopting ASU 2016-02 will depend on the Company’s lease portfolio as of the adoption date. The Company has selected lease software to assist with the adoption and commenced implementation. The Company expects to complete the adoption, including implementing processes and procedures, completing the lease accounting software implementation, and evaluating necessary disclosures prior to the first fiscal quarter of 2019.

ASU 2016-13

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 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.

ASU 2018-15

In August 2018, the FASB issued ASU 2018-15, “Intangibles-Goodwill and Other-Internal-Use Software (Topic 350): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract”, which align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal use software license). ASU 2018-15 is effective for the Company beginning in the first fiscal quarter of 2022, with early adoption permitted. The Company is currently evaluating the impact of the adoption on its consolidated financial statements.


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 or 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 the Company's 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 a 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

12

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

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 sheets 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



13

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 condensed consolidated balance sheets as of September 30, 2018:
 
As of September 30, 2018
 
As reported
 
Adjustments
 
Balance without adoption of ASC 606
 
(In thousands)
Assets
 
 
 
 
 
Accounts receivable, net
$
358,982

 
$
(13,147
)
 
$
345,835

Inventories
$
330,516

 
$
2,491

 
$
333,007

Other non-current assets
$
94,047

 
$
(3,573
)
 
$
90,474

Liabilities:
 
 
 
 
 
Accounts payable
$
168,155

 
$
110

 
$
168,265

Other accrued liabilities
$
282,410

 
$
(53,196
)
 
$
229,214

Deferred revenue
$
35,485

 
$
18,326

 
$
53,811

Income taxes payable
$
6,853

 
$
1,554

 
$
8,407

Other non-current liabilities
$
53,499

 
$
1,884

 
$
55,383

Stockholders’ equity:
 
 
 
 
 
Retained earnings
$
124,488

 
$
16,761

 
$
141,249

Non-controlling interest
$
24,301

 
$
332

 
$
24,633


The following tables summarize the impacts of adopting ASC 606 on the Company’s unaudited condensed consolidated statement of operations for the three and nine months ended September 30, 2018:
 
Three Months Ended September 30, 2018
 
Nine Months Ended September 30, 2018
 
As reported
 
Adjustments
 
Balance without adoption of ASC 606
 
As reported
 
Adjustments
 
Balance without adoption of ASC 606
 
(In thousands)
 
(In thousands)
Net revenue
$
400,586

 
$
2,278

 
$
402,864

 
$
1,112,379

 
$
5,974

 
$
1,118,353

Cost of revenue
$
276,394

 
$
(569
)
 
$
275,825

 
$
774,510

 
$
(123
)
 
$
774,387

Gross profit
$
124,192

 
$
2,847

 
$
127,039

 
$
337,869

 
$
6,097

 
$
343,966

Provision for income taxes
$
2,780

 
$
744

 
$
3,524

 
$
9,541

 
$
1,507

 
$
11,048

Net income
$
9,150

 
$
2,103

 
$
11,253

 
$
9,510

 
$
4,590

 
$
14,100

Net Income (loss) attributable to non-controlling interest
$
(799
)
 
$
332

 
$
(467
)
 
$
(799
)
 
$
332

 
$
(467
)
Net income attributable to NETGEAR, Inc.
$
9,949

 
$
1,771

 
$
11,720

 
$
10,309

 
$
4,258

 
$
14,567



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

14

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

point in time when control of the goods are 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. Additionally, the Company sells technical support services and extended warranty which consist of telephone and internet access to technical support personnel, hardware replacement and updates to software features. 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 because the Company transfers control evenly by providing a stand-ready service. 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, the Company estimates variable consideration at the expected value amounts which is based on management's analysis of 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 they are 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 are 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.

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.


15

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

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 $2.6 million and $7.8 million for the three and nine months ended September 30, 2018, respectively, and $2.4 million and $6.9 million for the three and nine months ended October 1, 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 and 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 September 30, 2018:
 
 
1 year
 
2 years
 
Greater than 2 years
 
Total
 
(In thousands)
Performance obligations
 
$
109,309

 
$
13,334

 
$
8,956

 
$
131,599


Contract Costs

Costs to fulfill a contract are capitalized when they relate directly to an existing contract or specific anticipated contract, generate or enhance resources that will be used to fulfill performance obligations and are recoverable. These costs include direct cost incurred at inception of a contract which enables the fulfillment of the performance obligation and totaled $5.4 million as of September 30, 2018. There was no impairment of capitalized contract costs in the nine months ended September 30, 2018.

Applying the practical expedient, the Company 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 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 September 30, 2018 deferred commissions were not significant.


16

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 nine months ended September 30, 2018:
 
Balance Sheet Location
September 30, 2018
January 1, 2018 (*)
$ change
% change
 
 
(In thousands)
 
Accounts receivable, net
Accounts receivable, net
$
358,982

$
418,911

$
(59,929
)
(14.3
)%
Contract liabilities - current
Deferred revenue
$
35,485

$
30,103

$
5,382

17.9
 %
Contract liabilities - non-current
Other non-current liabilities
$
20,148

$
13,839

$
6,309

45.6
 %
_________________________
* 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 nine months ended September 30, 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 nine months ended September 30, 2018, $46.2 million of revenue was deferred due to unsatisfied performance obligations, primarily relating to over time service revenue. During the nine months, $34.5 million of revenue was recognized for the satisfaction of performance obligations over time. $24.1 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.


17

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
 
September 30, 2018
 
October 1, 2017 (*)
 
Arlo
 
Connected Home
 
SMB
 
Total
 
Arlo
 
Connected Home
 
SMB
 
Total
 
(In thousands)
Geographic regions:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Americas
$
112,851

 
$
141,884

 
$
34,049

 
$
288,784

 
$
88,134

 
$
129,034

 
$
27,220

 
$
244,388

EMEA
11,759

 
27,619

 
25,539

 
64,917

 
17,178

 
22,731

 
22,252

 
62,161

APAC
6,564

 
25,181

 
15,140

 
46,885

 
5,148

 
31,334

 
12,452

 
48,934

Total net revenue
$
131,174

 
$
194,684

 
$
74,728

 
$
400,586

 
$
110,460

 
$
183,099

 
$
61,924

 
$
355,483

Sales channels:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Service provider
$
5,973

 
$
30,769

 
$
1,191

 
$
37,933

 
$
5,794

 
$
44,631

 
$
1,114

 
$
51,539

Non-service provider
125,201

 
163,915

 
73,537

 
362,653

 
104,666

 
138,468

 
60,810

 
303,944

Total net revenue
$
131,174

 
$
194,684

 
$
74,728

 
$
400,586

 
$
110,460

 
$
183,099

 
$
61,924

 
$
355,483

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

 
Nine Months Ended
 
September 30, 2018
 
October 1, 2017 (*)
 
Arlo
 
Connected Home
 
SMB
 
Total
 
Arlo
 
Connected Home
 
SMB
 
Total
 
(In thousands)
Geographic regions:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Americas
$
264,728

 
$
422,759

 
$
94,743

 
$
782,230

 
$
197,291

 
$
396,912

 
$
88,763

 
$
682,966

EMEA
49,649

 
70,073

 
80,505

 
200,227

 
39,585

 
63,634

 
72,591

 
175,810

APAC
17,820

 
70,796

 
41,306

 
129,922

 
13,028

 
102,819

 
35,240

 
151,087

Total net revenue
$
332,197

 
$
563,628

 
$
216,554

 
$
1,112,379

 
$
249,904

 
$
563,365

 
$
196,594

 
$
1,009,863

Sales channels:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Service provider
$
21,951

 
$
118,899

 
$
2,954

 
$
143,804

 
$
15,743

 
$
146,309

 
$
2,492

 
$
164,544

Non-service provider
310,246

 
444,729

 
213,600

 
968,575

 
234,161

 
417,056

 
194,102

 
845,319

Total net revenue
$
332,197

 
$
563,628

 
$
216,554

 
$
1,112,379

 
$
249,904

 
$
563,365

 
$
196,594

 
$
1,009,863

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










18

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

Note 4. Planned Separation of Arlo

On February 6, 2018, the Company announced that its Board of Directors had unanimously approved the pursuit of a separation of the Arlo business from NETGEAR (the “Separation”). On August 2, 2018, Arlo and NETGEAR announced the pricing of Arlo's initial public offering (IPO) at a price to the public of $16.00 per share, subsequently listing on the New York Stock Exchange on August 3, 2018 under the symbol "ARLO". On August 7, Arlo completed the IPO and generated proceeds of approximately $170.2 million, net of offering costs. Upon completion of the IPO, Arlo common stock outstanding amounted to 74,247,000 shares, including the exercise of the underwriters' option of 1,532,250 shares, of which NETGEAR holds 62,500,000 shares of Arlo common stock, representing approximately 84.2% of the outstanding shares of Arlo common stock . The Company presently intends to distribute its holdings of Arlo common stock prior to the end of its first quarter of 2019 to its stockholders in a manner generally intended to qualify as tax-free to its stockholders for U.S. federal income tax purposes (the “Distribution”). 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.

Prior to the completion of the Arlo IPO, NETGEAR entered into agreements with Arlo that govern the separation of Arlo's business from NETGEAR and various interim arrangements. NETGEAR provided for, among other things, the transfer from NETGEAR to Arlo of assets and the assumption by Arlo of liabilities comprising its business through a master separation agreement between NETGEAR and Arlo. In addition, the Company entered into certain other agreements that provide a framework for the relationship between NETGEAR and Arlo after the separation, including a transition services agreement, a tax matters agreement, an employee matters agreement, an intellectual property rights cross-license agreement, and a registration rights agreement.

The Company incurred Separation expense of $7.1 million and $25.8 million during the three and nine months ended September 30, 2018, respectively, and $27.3 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.




19

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

Note 5.
Business Acquisition
Meural Inc.
On August 6, 2018, the Company acquired Meural Inc. ("Meural"), a New York based startup focused on producing and developing hardware and cloud platform capabilities for the digital distribution of curated artwork. Meural aims to provide a premium product to customers and to complement sales of digital canvasses with subscription services by offering customers the ability to subscribe to a large library of curated artworks. The Company believes that the acquisition of Meural will enable the Company to expand its portfolio of hardware and service offerings.
Prior to the business acquisition, the Company had a strategic investment in Meural since 2017. The total purchase consideration was $22.2 million, which consisted of $14.4 million of cash, which was paid in the third quarter of 2018, $1.5 million due to the Company's settlement in its prior equity interest in Meural, and the acquisition date fair value of contingent consideration of $6.3 million.
The merger agreement provides for the payment of contingent consideration to each selling shareholder of Meural based on the achievement of certain technical and service revenue milestones through August 6, 2023, with a maximum payout of $3.5 million on each of two milestones. The valuation of the contingent consideration was derived using estimates of the probability of achievement within specified time periods, in a scenario based model for the technical milestone; and using an option pricing model in a risk neutral framework using a Monte Carlo simulation, based on projections of future service revenues for the service revenue milestone. The fair value of such contingent consideration payable to Meural’s external shareholders is determined to be $5.9 million and is included in Other non-current liabilities on the unaudited condensed consolidated balance sheets. The acquisition qualified as a business combination and was accounted for using the acquisition method of accounting. The results of Meural 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 preliminary purchase price allocation is subject to certain post-closing adjustments and was as follows (in thousands) :
Cash and cash equivalents
20

Accounts receivable
219

Inventories
760

Prepaid expenses and other current assets
500

Property and equipment
16

Intangibles
4,700

Non-current deferred income taxes
815

Goodwill
16,502

Accounts payable
(1,322
)
Other accrued liabilities
(35
)
Total purchase price
22,175

The preliminary $16.5 million of goodwill recorded on the acquisition of Meural is not deductible for U.S. federal or U.S. state income tax purposes. The goodwill was generated as a result of the anticipated synergies, expected to be derived through selling Meural’s products and services through NETGEAR’s established worldwide sales channel and customer base. The goodwill was assigned to the Company's Connected Home segment.
In connection with the acquisition, the Company recorded $0.8 million of preliminary deferred tax assets net of deferred tax liabilities. The deferred tax assets were recorded for the tax benefit of the net operating losses as of the date of the acquisition after consideration of limitations on their use under U.S. Internal Revenue Code section 382. The deferred tax assets were reduced by deferred tax liabilities for the book basis of intangible assets for which the Company has no tax basis.

20

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

The Company preliminarily designated $3.0 million of the acquired intangibles as developed technology. The valuation was derived using an income approach, based on the present value of the estimated future cash flows derived from projections of future operations attributable to the developed technology, discounted at a rate of 16.0% and will be amortized over an estimated useful life of seven years.

The Company preliminarily designated $0.6 million of the acquired intangibles as trade name, $0.6 million of the acquired intangibles as customer relationship and $0.5 million of the acquired intangibles as playlist database. These valuation of these intangibles was derived using variations of the income approach for the trade name and customer relationships, and replacement cost method for the playlist database. The valuations are based on certain key assumptions like the royalty rate, revenue and cash flows derived from projections of future operations and discount rates ranging from 16.0% to 19.0%. The intangibles assets are being amortized over estimated useful lives of three years, two years and seven years for trade name, customer relationships and playlist database, respectively.
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 their 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 derived using the replacement cost method, with consideration 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.

21

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

The Company designated $0.3 million of the acquired intangibles as non-compete agreements. The value was calculated based on the present value of the future estimated cash flows derived from projections of future operations attributable to the non-compete agreements and discounted at 20.0%. The acquired agreements are being amortized over an estimated useful life of three years.

Note 6.
Balance Sheet Components

Available-for-sale short-term investments
 
As of
 
September 30, 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
$
133,239

 
$

 
$
(75
)
 
$
133,164

 
$
124,816

 
$

 
$
(146
)
 
$
124,670

Certificates of deposit
152

 

 

 
152

 
162

 

 

 
162

Total
$
133,391

 
$

 
$
(75
)
 
$
133,316

 
$
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 amounted to $1.6 million as of September 30, 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 nine months ended September 30, 2018 and there were no impairments recognized during the nine months ended October 1, 2017.

Accounts receivable, net
 
As of
 
September 30,
2018
 
December 31,
2017
 
(In thousands)
Gross accounts receivable
$
360,237

 
$
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
$
358,982

 
$
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.


22

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

Inventories
 
As of
 
September 30,
2018
 
December 31,
2017
 
(In thousands)
Raw materials
$
2,072

 
$
4,465

Finished goods
328,444

 
241,429

Total inventories
$
330,516

 
$
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
 
September 30,
2018
 
December 31,
2017
 
(In thousands)
Computer equipment
$
13,127

 
$
10,114

Furniture, fixtures and leasehold improvements
21,811

 
21,640

Software
36,883

 
28,997

Machinery and equipment
66,426

 
62,490

Construction in progress*
21,858

 

Total property and equipment, gross
160,105

 
123,241

Accumulated depreciation and amortization
(103,458
)
 
(102,581
)
Total property and equipment, net
$
56,647

 
$
20,660

* Arlo Technologies, Inc. entered into a build-to-suit lease arrangement in relation to its headquarters in San Jose, California. Refer to Note 10, Commitments and Contingencies, for details of this lease. The construction is expected to be completed in January 2019.

Depreciation and amortization expense pertaining to property and equipment was $3.6 million and $10.2 million for the three and nine months ended September 30, 2018, respectively, and $3.3 million and $9.8 million for the three and nine months ended October 1, 2017, respectively.

Intangibles, net
 
As of September 30, 2018
 
As of December 31, 2017
 
Gross
 
Accumulated Amortization
 
Net
 
Gross
 
Accumulated Amortization
 
Net
 
(In thousands)
Technology
$
69,599

 
$
(63,691
)
 
$
5,908

 
$
66,599

 
$
(62,172
)
 
$
4,427

Customer contracts and relationships
57,100

 
(42,749
)
 
14,351

 
56,500

 
(37,430
)
 
19,070

Other
12,145

 
(10,063
)
 
2,082

 
11,045

 
(9,554
)
 
1,491

Total intangibles, net
$
138,844

 
$
(116,503
)
 
$
22,341

 
$
134,144

 
$
(109,156
)
 
$
24,988


Amortization of intangibles was $2.4 million and $7.3 million for the three and nine months ended September 30, 2018, respectively, and $2.7 million and $10.4 million for the three and nine months ended October 1, 2017, respectively.


23

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

As of September 30, 2018, estimated amortization expense related to finite-lived intangibles for the remaining years was as follows (in thousands):
2018 (remaining three months)
$
2,466

2019
8,544

2020
7,497

2021
2,029

2022
513

Thereafter
1,292

Total estimated amortization expense
$
22,341


Other non-current assets
 
As of
 
September 30,
2018
 
December 31, 2017
 
(In thousands)
Non-current deferred income taxes
$
75,674

 
$
49,468

Other
18,373

 
12,321

Total other non-current assets
$
94,047

 
$
61,789


Other accrued liabilities
 
As of
 
September 30,
2018
 
December 31,
2017
 
(In thousands)
Sales and marketing
$
116,901

 
$
96,153

Warranty obligation
18,526

*
75,824

Sales returns
78,014

*

Freight
8,108

 
10,567

Other
60,861

 
39,926

Total other accrued liabilities
$
282,410

 
$
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 7.
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.


24

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

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

The Company may choose not to hedge certain foreign exchange exposures for a variety of reasons, including, but not limited to, 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 September 30, 2018 and December 31, 2017 are summarized as follows:

Derivative Assets
 
Balance Sheet
Location
 
September 30, 2018
 
December 31, 2017
 
Balance Sheet
Location
 
September 30, 2018
 
December 31, 2017
 
 
 
 
(In thousands)
 
 
 
(In thousands)
Derivative assets not designated as hedging instruments
 
Prepaid expenses and other current assets
 
$
995

 
$
1,314

 
Other accrued liabilities
 
$
189

 
$
7,128

Derivative assets designated as hedging instruments
 
Prepaid expenses and other current assets
 
33

 
485

 
Other accrued liabilities
 
20

 
1,064

Total
 
 
 
$
1,028

 
$
1,799

 
 
 
$
209

 
$
8,192


Refer to Note 14, Fair Value Measurements, 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 consoli