Netgear: Strong Enough To Survive This Swing Lower (NASDAQ:NTGR)

It’s never fun to be bullish about a company that ultimately ends up dropping significantly in price. Over the past year or so, markets have been quite volatile. Some companies have performed quite well, but many others have been hit hard. Some, such as NETGEAR, Inc. (NASDAQ:NTGR), have been hit harder than others.

This business, which focuses on providing technologies that center around Internet access, digital security, technical support, as well as physical products like Ethernet switches and enterprise-grade Wi-Fi mesh systems, has seen quite a bit of downside in recent months. This has been driven by a plunge in revenue and a worsening of the company’s bottom line. In fact, the picture is bad enough right now that you can’t even value Netgear with the financial results covering its most recent fiscal year.

However, Netgear’s balance sheet is robust and a return to normal levels of profitability would make the stock incredibly cheap. Add on top of this the fact that the company continues to add paid subscribers during this time, and I believe that it still makes for a solid “buy” candidate at this time.

Processing the pain

In early March of 2022, I wrote my first article detailing the investment worthiness of Netgear. In that article, I acknowledged that the company had struggled to grow its revenue over the prior few years. Even so, profits and cash flows were looking positive. I understood that the company was one that had a decent amount of risk tied to it.

At the same time, I also felt as though Netgear shares were cheap enough to warrant some rather meaningful upside so long as the picture on the bottom line didn’t worsen materially. This ultimately led me to rate the business a “buy” to reflect my view at the time that shares should outperform the broader market moving forward. Since then, things have not gone the way I expected them to. While the S&P 500 (SP500) is down about 9% since the publication of that article, shares of Netgear have seen downside of 31.8%.

Sometimes, significant downside is unwarranted. Other times, it is entirely justified. Some might argue that Netgear fits in the latter category. To see what I mean, we need only look at data covering the entirety of the company’s 2022 fiscal year. During that time, revenue came in at $932.5 million. That’s down 20.2% over the $1.17 billion the company generated in 2021. This plunge in revenue requires a bit more detective work to understand. After all, the company is not a monolith. Instead, Netgear is a slightly more complicated operation that can really be visualized as two separate businesses.

On the one hand, you have the Connected Home segment, while on the other you have the SMB (Small and Medium Business) segment. The first of these, the Connected Home segment, is the far larger of the two. At the same time, it’s also the one experiencing the most pain. For those who need a refresher, this unit is responsible for the production and sale of technologies that help consumers to access the Internet using systems, routers, 4G and 5G products, smart devices, and more. It also provides various services centered around security and privacy, Technical Support, parental control functionality, and more.

During the 2022 fiscal year, sales for the segment came in at $558.8 million. That’s 34.5% lower than the $853.5 million the segment reported only one year earlier, and it’s down 44.5% compared to the $1.01 billion reported for 2020. According to Netgear management, a contraction of the U.S. consumer Wi-Fi market, combined with the impact of retailers reducing their inventory levels, resulted in a meaningful amount of pain for the segment.

From the start of the COVID-19 pandemic through the 2021 fiscal year, consumers were purchasing Wi-Fi networking products at levels that were significantly higher than they would have been without the pandemic. This was driven by work-from-home and school-from-home activities as a result of pandemic-related mandates. Now that the pandemic is essentially over and people are returning back to their previous lifestyles, the company is dealing with levels of activity that are lower than what many might expect. But essentially, the prior two years could be described as times when the firm was front-loading years’ worth of additional revenue.

On the other hand, you have the SMB segment. Through this, the company provides businesses with products like Ethernet switches, enterprise-grade Wi-Fi mesh systems, and Internet security appliances. It also provides a wide variety of services related to those devices. In 2022, this segment accounted for $373.6 million of revenue. That’s 18.8% higher than the $314.6 million reported for 2021 and it’s up 50.9% compared to the $247.7 million reported in 2020. Record demand for the company’s Pro AV product line of managed switches continued to drive sales higher, even though the company was faced with supply chain challenges throughout the year. Although this is the smaller of the two segments, it’s also worth noting that is the only profitable segment if we use data from 2022. Contribution income from it totaled $75.8 million. That’s up from the $42.2 million reported two years earlier. Over the same window of time, the Connected Home segment saw its contribution income fall from $152.5 million to negative $8.5 million.

The drop experienced in 2020 brought with it some pain on the company’s bottom line. The firm went from generating a net profit of $49.4 million in 2021 to generating a net loss of $69 million in 2022. Operating cash flow went from negative $4.6 million to negative $13.7 million. If we adjust for changes in working capital, the picture would have looked even worse, with the metric falling from positive $96 million to negative $15 million. And over that same window of time, EBITDA declined from $106.5 million to negative $10.7 million. As a note, if we don’t add back stock-based compensation to EBITDA, then the metric would have been $88.8 million in 2021.

As you can see in the chart above, results for the company remained weak through the final quarter of the 2022 fiscal year. This is not to say that everything regarding the company is bad. The number of subscribers that are paying for services for the business continue to climb at a nice pace. By the end of the year, the firm boasted around 747,000 paid subscribers. This was up 81,000 compared to just one quarter earlier. Management also said that they are targeting 875 paid subscribers by the end of the 2023 fiscal year. Because management does not break up subscription income from product income, we don’t know the exact impact that this will have on the firm’s top and bottom lines. However, subscription income, by its nature, should add to the stability of the company and reduce year-over-year swings in revenue on the downside.

Because the business generated negative results across the bottom line in 2022, you can’t really value it in the traditional sense. If, instead, we assume that the firm will eventually revert back to the levels of profitability seen in 2020 or 2021, we can see that some significant upside might be on the table for investors. These results can be seen in the chart above. As a note, the chart does include two different calculations for the EV to EBITDA multiple. The one that comes in higher removes stock-based compensation from the firm’s EBITDA since it is, by definition, a real expense.

Investors who are bearish about Netgear may very well make the case that current conditions indicate that the company might take a long time to get back on track from a fundamental perspective. But the great thing about this firm is that it has that time to spare. As of the end of the 2022 fiscal year, the business had no debt. It also had cash and cash equivalents of $227.4 million. Using the cash flow data reported for 2022, it would take the company nearly 17 years to run out of that cash. It’s highly unlikely that current conditions will persist for that long.

Takeaway

I understand why some investors may look at Netgear, Inc. with a jaundiced glance. After all, recent financial performance reported by the company has been far from great. On the other hand, Netgear, Inc. has an amazing balance sheet and a return to normalcy should result in shares trading on the cheap. If the number of paid subscribers for the company was flatlining or declining, I would think that there was something more fundamentally wrong with the firm’s business model.

But the absence of that kind of issue further adds fuel to my argument that Netgear, Inc. has long-term potential. Due to all of these factors, I do remain comfortable with the “buy” rating I assigned the business previously. And in the event that Netgear, Inc. shares get cheaper or we start to see a real turnaround on the bottom line, I could very well upgrade the company further.