As the internet grows and adds more and more applications, technology companies are rising to meet the challenge of delivering growing amounts of data to individual users. Netgear (NTGR) is one of the leaders in this business as it manufactures all kinds of gateways, routers and access point devices for data traffic. The company prides itself on creativity and typically rolls out 12 new products each quarter according to IBD. Products introduced less than 12 months ago typically make up a quarter of the firms revenue.

The stock got beat up after the last quarters announcement. The company fell short of its own revenue projections and although margins were a bit better than expected, the earnings number came in below consensus. This caused a drop of over 23% the morning after the announcement after a strong run in the stock through the spring. Management attempted to assure investors that their expectations for the second half were strong, but it was little consolation for missing in Q2.

To break out the announcement, there were a few key points to analyze. First, is that the decline was primarily in North America and the Europe, Mid East, and Africa (EMEA), while the Asia Pacific area was strong. Unfortunately Asia Pacific makes up only 11% of sales so that was not enough to offset the other geographies. The second interesting point is that inventories picked up substantially. When asked about this level, management noted that it was to ramp up ahead of the upcoming back to school season. However, the inventory levels were also up compared to last Q2 which should have also accounted for back to school inventories. It is more likely that the company manufactured more products than they were able to sell which could become a problem if technology evolves or prices drop and the company is sitting on stale product.

Good sides to the earnings call included some contracts landed with cable and telephone companies who install internet accessibility in consumer homes. Relationships like these allow the company to reach a greater number of clients without spending as much on direct marketing. These new contracts were in Australia, Japan and Germany and the company hopes these will add significantly to sales in the second half.

The balance sheet is firm with significant cash reserves even after spending $60m to acquire Infrant. This acquisition gives the company access to networked storage devices made by Infrant. These new products should be a good complement to the other network devices offered by NTGR.

My major concern is that the company pushed back growth targets for this year into the second half but management is still optimistic and does not believe the weak sales indicates a long-term problem. Turbulence in the global economic environment will likely weigh down the consumer (not just in N. America, but also in the EMEA regions) which casts a doubt on a rebound in sales. This environment has not been conducive to new small business spending or to consumer spending which could significantly affect the outlook. This is true about many consumer electronic companies but NTGR has already shown weakness even before the true economic weakness began.

I would counsel investors to lighten up on NTGR positions as the outlook remains uncertain. Current investors appear to be taking a “show me” attitude and it will likely take several strong quarters to regain their confidence. In the meantime, any negative surprises could cause swift selling in the stock.

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NTGR Notes

FD: Author has a short position in NTGR