XNAS:NTGR Quarterly Report 10-Q Filing - 4/1/2012

Effective Date 4/1/2012

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
 
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the quarterly period ended April 1, 2012.
¨ 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 or a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large Accelerated filer
 
x
  
Accelerated filer
 
¨
Non-Accelerated filer
 
¨
  
Smaller reporting company
 
¨
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 37,978,883 as of May 4, 2012.



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)
 
 
April 1,
2012
 
December 31,
2011
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
149,258

 
$
208,898

Short-term investments
220,162

 
144,797

Accounts receivable, net
249,208

 
261,307

Inventories
134,314

 
163,724

Deferred income taxes
22,912

 
23,088

Prepaid expenses and other current assets
29,174

 
32,415

Total current assets
805,028

 
834,229

Property and equipment, net
14,716

 
15,884

Intangibles, net
19,977

 
20,956

Goodwill
85,944

 
85,944

Other non-current assets
14,897

 
14,357

Total assets
$
940,562

 
$
971,370

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
79,534

 
$
117,285

Accrued employee compensation
17,775

 
26,896

Other accrued liabilities
115,995

 
120,480

Deferred revenue
25,156

 
40,093

Income taxes payable
5,172

 
4,207

Total current liabilities
243,632

 
308,961

Non-current income taxes payable
19,174

 
18,657

Other non-current liabilities
4,835

 
4,995

Total liabilities
267,641

 
332,613

Commitments and contingencies (Note 9)


 


Stockholders’ equity:
 
 
 
Common stock
38

 
38

Additional paid-in capital
373,934

 
364,243

Cumulative other comprehensive (loss) income
(55
)
 
23

Retained earnings
299,004

 
274,453

Total stockholders’ equity
672,921

 
638,757

Total liabilities and stockholders’ equity
$
940,562

 
$
971,370

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

3


NETGEAR, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
 
 
Three Months Ended
 
April 1,
2012
 
April 3,
2011
Net revenue
$
325,620

 
$
278,823

Cost of revenue
225,771

 
191,037

Gross profit
99,849

 
87,786

Operating expenses:
 
 
 
Research and development
14,121

 
11,014

Sales and marketing
38,970

 
36,648

General and administrative
10,413

 
9,645

Litigation reserves, net
151

 
(53
)
Total operating expenses
63,655

 
57,254

Income from operations
36,194

 
30,532

Interest income
119

 
129

Other income (expense), net
(601
)
 
(330
)
Income before income taxes
35,712

 
30,331

Provision for income taxes
10,565

 
9,142

Net income
$
25,147

 
$
21,189

Net income per share:
 
 
 
Basic
$
0.67

 
$
0.58

Diluted
$
0.65

 
$
0.57

Weighted average shares outstanding used to compute net income per share:
 
 
 
Basic
37,796

 
36,414

Diluted
38,576

 
37,340

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

4



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

 
Three Months Ended
 
 
April 1,
2012

 
April 3,
2011

 
Net income
$
25,147

 
$
21,189

 
Other comprehensive income, net of tax:
 
 
 
 
Unrealized losses on derivative instruments, net of tax of zero
(56
)
 
(341
)
 
Unrealized (losses) gains on available-for-sale securities, net tax (benefit) expense of $(12) and $3, respectively
(22
)
 
7

 
Total other comprehensive income, net of tax
$
(78
)
 
$
(334
)
 
Comprehensive income
$
25,069

 
$
20,855

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


5


NETGEAR, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
 
 
Three Months Ended
 
April 1,
2012
 
April 3,
2011
Cash flows from operating activities:
 
 
 
Net income
$
25,147

 
$
21,189

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
3,609

 
3,707

Purchase premium amortization on investments
718

 
252

Non-cash stock-based compensation
3,392

 
3,372

Income tax benefit associated with stock option exercises
937

 
835

Excess tax benefit from stock-based compensation
(910
)
 
(893
)
Deferred income taxes
(477
)
 
36

Changes in assets and liabilities:
 
 
 
Accounts receivable
12,099

 
29,109

Inventories
29,410

 
(12,719
)
Prepaid expenses and other assets
3,273

 
(3,167
)
Accounts payable
(37,751
)
 
(7,922
)
Accrued employee compensation
(9,121
)
 
(8,773
)
Other accrued liabilities
(4,079
)
 
(8,318
)
Deferred revenue
(14,937
)
 
(9,157
)
Income taxes payable
1,482

 
(2,989
)
Net cash provided by operating activities
12,792

 
4,562

Cash flows from investing activities:
 
 
 
Purchases of short-term investments
(108,517
)
 
(96,904
)
Proceeds from maturities of short-term investments
32,400

 
119,590

Purchase of property and equipment
(1,462
)
 
(1,906
)
Payments made in connection with business acquisitions
(500
)
 
(500
)
Net cash (used in) provided by investing activities
(78,079
)
 
20,280

Cash flows from financing activities:
 
 
 
Purchase and retirement of treasury stock
(596
)
 
(899
)
Proceeds from exercise of stock options
4,378

 
5,818

Proceeds from issuance of common stock under employee stock purchase plan
955

 
709

Excess tax benefit from stock-based compensation
910

 
893

Net cash provided by financing activities
5,647

 
6,521

Net (decrease) increase in cash and cash equivalents
(59,640
)
 
31,363

Cash and cash equivalents, at beginning of period
208,898

 
126,173

Cash and cash equivalents, at end of period
$
149,258

 
$
157,536

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


6


NETGEAR, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1.
The Company and Basis of Presentation
NETGEAR, Inc. (“NETGEAR” or the “Company”) was incorporated in Delaware in January 1996. The Company is a global networking company that delivers innovative products to consumers, businesses and service providers. For consumers, the Company makes high performance, dependable and easy-to-use home networking, storage and digital media products to connect people with the Internet and their content and devices. For businesses, the Company provides networking, storage and security solutions without the cost and complexity of Big IT. The Company also supplies leading service providers with made-to-order and retail proven, whole home networking solutions for sale to their customers. The Company’s products are built on a variety of proven technologies such as wireless, Ethernet and powerline, with a focus on reliability and ease-of-use. The Company sells products primarily through a global sales channel network, which includes traditional retailers, online retailers, wholesale distributors, direct market resellers ("DMRs"), value added resellers ("VARs"), and broadband service providers.
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, 2011, has been derived from audited financial statements at such date. 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 consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011.
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 revenues and expenses during the reported period. Actual results could differ materially from those estimates and operating results for the three months ended April 1, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.

2.
Summary of Significant Accounting Policies
The Company’s significant accounting policies are disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. The Company’s significant accounting policies have not materially changed during the three months ended April 1, 2012.

Recent Accounting Pronouncements

In May 2011, the Financial Accounting Standards Board (“FASB") issued Accounting Standards Update (“ASU") 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”, which amends current fair value measurement and disclosure guidance to converge with International Financial Reporting Standards (“IFRS”) and provides increased transparency around valuation inputs and investment categorization. ASU 2011-04 became effective prospectively for the Company in the first quarter of fiscal 2012. The Company's adoption of ASU 2011-04 did not have an impact on the Company’s consolidated financial position, results of operations or cash flows.

In June 2011, the FASB issued ASU 2011-05, “Presentation of Comprehensive Income.” ASU 2011-05 eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. ASU 2011-05 allows two presentation alternatives: present items of net income and other comprehensive income (1) in one continuous statement, referred to as the statement of comprehensive income or (2) in two separate, but consecutive, statements of net income and other comprehensive income. ASU 2011-05 is effective retrospectively starting in the first quarter of fiscal 2012. In December 2011, the FASB issued ASU 2011-12, which defers the ASU 2011-05 requirement to present components of reclassifications of other comprehensive income on the face of the income statement. The amendments in ASU 2011-12 are effective at the same time as the amendments in Update 2011-05. All other requirements of ASU 2011-05 are not affected by ASU 2011-12. Since the adoption

7


of the authoritative guidance only required additional disclosures, the adoption did not impact the Company’s consolidated financial position, results of operations or cash flows.

3.
Business Acquisitions
Westell Technologies, Inc.
On April 15, 2011, the Company completed the acquisition of certain intellectual property and other assets of the Customer Networking Solutions division of Westell Technologies, Inc. (“Westell”) at a purchase price of $37.0 million in cash. The acquisition included inventories, property and equipment, intangible assets, and liabilities that existed at the closing date, including employee bonuses and product warranties. The acquisition qualifies as a business combination and was accounted for using the acquisition method of accounting. The Company believes the acquisition will bolster its service provider revenue growth and strengthen its market position among U.S. telecommunications operators.
The results of Westell’s operations have been included in the consolidated financial statements since the date of acquisition. The historical results of operations of Westell prior to the acquisition were not material to the Company’s results of operations.
In accordance with the acquisition method of accounting for business combinations, the Company allocated the total purchase price to identifiable intangible assets based on each element’s estimated fair value. Acquisition costs were expensed as incurred, and were immaterial for this transaction. Purchased intangibles will be amortized on a straight-line basis over their respective estimated useful lives. Goodwill was recorded based on the residual purchase price after allocating the purchase price to the fair market value of assets acquired and liabilities assumed. Goodwill arises as a result of, among other factors, future unidentified new products and new technologies as well as the implicit value of future cost savings as a result of the combining of entities. The Company may adjust the preliminary purchase price allocation after obtaining more information regarding, among other things, liabilities assumed, and revisions of preliminary estimates.
The following table summarizes the estimated fair values of the assets and liabilities assumed at the acquisition date (in thousands):
 
Inventories
$
6,290

Property and equipment, net
119

Intangibles, net
19,500

Current liabilities
(646
)
Goodwill
11,746

Total consideration
$
37,009


Of the $11.7 million of goodwill recorded on the acquisition of Westell, approximately $10.6 million and $11.7 million was deductible for U.S. federal and state income tax purposes, respectively.
A total of $15.7 million of the $19.5 million in acquired intangible assets was designated as customer contracts and related relationships. The value was calculated based on the present value of the future estimated cash flows derived from projections of future operations attributable to existing customer contracts and related relationships and discounted at 19.0%. This $15.7 million is being amortized over its estimated useful life of eight years.
A total of $3.7 million of the $19.5 million in acquired intangible assets was designated as core technology. The value was calculated based on the present value of the future estimated cash flows derived from estimated savings attributable to the core technology and discounted at 16.0%. This $3.7 million is being amortized over its estimated useful life of four years.
A total of $0.1 million of the $19.5 million in acquired intangible assets was designated as order backlog. The value was calculated based on an estimate of order backlog using the expected cash flow for the orders and discounted at 3.3%. This $0.1 million was fully amortized in the third quarter of 2011.
Leaf Networks, LLC
On January 15, 2010, the Company completed the acquisition of certain intellectual property and other assets of Leaf Networks, LLC (“Leaf”), a developer of virtual networking software. The acquisition qualified as a business acquisition and was accounted for using the purchase method of accounting. The Company believes the acquisition will accelerate the Company’s continuing networking technology research and development initiatives. The aggregate purchase price was $2.1 million, of which

8


$2.0 million was paid in cash in the first quarter of 2010 and $0.1 million was paid in the first quarter of 2011.
Additionally, the acquisition agreement specified that Leaf shareholders may receive a total additional payout of up to $0.9 million in cash over the three years following the closing of the acquisition if developed products pass certain acceptance criteria. During the first quarter of 2010, the Company initially determined that the present value of the $0.9 million potential additional payout was approximately $0.8 million. For each subsequent reporting period, the Company remeasured fair value of the potential payout and recorded a liability. The Company paid $0.4 million for the first portion of this additional payout in the first quarter of 2011 and the remaining $0.5 million in the first quarter of 2012.
The results of Leaf’s operations have been included in the consolidated financial statements since the date of acquisition. The historical results of operations of Leaf prior to the acquisition were not material to the Company’s results of operations.
In accordance with the acquisition method of accounting for business combinations, the Company allocated the total purchase price to identifiable intangible assets based on each element’s estimated fair value. Acquisition costs were expensed as incurred, and were immaterial for this transaction. Purchased intangibles, representing the existing technology acquired from Leaf, will be amortized on a straight-line basis over their respective estimated useful lives. Goodwill was recorded based on the residual purchase price after allocating the purchase price to the fair market value of intangible assets acquired. Goodwill arose as a result of the $0.8 million present valuation of the $0.9 million potential additional payout, plus $0.1 million in additional payment consideration. The allocation of the purchase price was as follows (in thousands):
 
Intangibles, net
$
2,000

Goodwill
900

Total purchase price allocation
$
2,900


Of the $0.9 million of goodwill recorded on the acquisition of Leaf, approximately $0.5 million and $0.9 million was deductible for federal and state income tax purposes, respectively.
The $2.0 million in acquired intangible assets was designated as existing technology. The value was calculated based on the present value of the future estimated cash flows derived from projections of future revenue attributable to existing technology. This $2.0 million is being amortized over its estimated useful life of seven years.

4.
Balance Sheet Components (in thousands)

Short-Term Investments

 
As of
 
April 1, 2012
 
December 31, 2011
 
Cost
 
Unrealized Gain
 
Unrealized Loss
 
Estimated Fair Value
 
 Cost
 
Unrealized Gain
 
Unrealized Loss
 
Estimated Fair Value
U.S. Treasuries
$
219,983

 
$
10

 
$
(14
)
 
$
219,979

 
$
144,673

 
$
34

 
$
(4
)
 
$
144,703

Certificates of Deposits
183

 

 

 
183

 
94

 

 

 
94

Total
$
220,166

 
$
10

 
$
(14
)
 
$
220,162

 
$
144,767

 
$
34

 
$
(4
)
 
$
144,797


All of the Company’s marketable securities are classified as available-for-sale investments 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 12 months. Accordingly, none of our investments have unrealized losses greater than 12 months. There were no material realized gains or losses from the maturity of available-for-sale securities in three months ended April 1, 2012 and April 3, 2011.


9


Accounts receivable, net
 
 
April 1,
2012
 
December 31,
2011
Gross accounts receivable
$
267,847

 
$
279,932

Less: Allowance for doubtful accounts
(1,298
)
 
(1,335
)
Allowance for sales returns
(13,106
)
 
(13,360
)
Allowance for price protection
(4,235
)
 
(3,930
)
Total allowances
(18,639
)
 
(18,625
)
Total accounts receivable, net
$
249,208

 
$
261,307


Inventories
 
 
April 1,
2012
 
December 31,
2011
Raw materials
$
4,192

 
$
4,676

Finished goods
130,122

 
159,048

Total inventories
$
134,314

 
$
163,724


The Company records provisions for excess and obsolete inventory based on forecasts of future demand. 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
 
 
April 1,
2012
 
December 31,
2011
Computer equipment
$
6,582

 
$
7,109

Furniture, fixtures and leasehold improvements
10,346

 
9,757

Software
20,220

 
19,974

Machinery and equipment
22,756

 
21,797

Construction in progress
208

 
662

 
60,112

 
59,299

Less: accumulated depreciation and amortization
(45,396
)
 
(43,415
)
Total property and equipment, net
$
14,716

 
$
15,884


Depreciation expense for the three months ended April 1, 2012 and April 3, 2011 was $2.6 million and $2.3 million, respectively.


10


Intangibles, net
 
The following table presents changes to the Company’s purchased intangible assets:

 
Gross
 
Accumulated Amortization
 
Net
April 1, 2012
 
 
 
 
 
Customer contracts and relationships
$
15,700

 
$
(1,799
)
 
$
13,901

Existing technology
14,000

 
(12,619
)
 
1,381

Core technology
10,800

 
(7,633
)
 
3,167

Trademarks
2,600

 
(2,130
)
 
470

Patents
1,270

 
(212
)
 
1,058

Non-compete
100

 
(100
)
 

Backlog
100

 
(100
)
 

Total intangibles, net
$
44,570

 
$
(24,593
)
 
$
19,977


 
Gross
 
Accumulated Amortization
 
Net
December 31, 2011
 
 
 
 
 
Customer contracts and relationships
$
15,700

 
$
(1,308
)
 
$
14,392

Existing technology
14,000

 
(12,548
)
 
1,452

Core technology
10,800

 
(7,357
)
 
3,443

Trademarks
2,600

 
(2,021
)
 
579

Patents
1,270

 
(180
)
 
1,090

Non-compete
100

 
(100
)
 

Backlog
100

 
(100
)
 

Total intangibles, net
$
44,570

 
$
(23,614
)
 
$
20,956


Amortization expense related to intangibles in the three months ended April 1, 2012, and April 3, 2011, was approximately $1.0 and $1.4 million, respectively. No impairment charges were recorded in the three months ended April 1, 2012, and April 3, 2011.

Estimated amortization expense related to intangibles for each of the next five years and thereafter is as follows:

Year Ending December 31
Amount
2012 (remaining nine months)
$
2,936

2013
3,626

2014
3,301

2015
2,685

2016
2,377

Thereafter
5,052

Total expected amortization expense
$
19,977



11


Goodwill
 
The following table presents goodwill by segment as of April 1, 2012 and December 31, 2011:

 
April 1,
2012
 
December 31,
2011
Retail
$
33,546

 
$
33,546

Commercial
32,043

 
32,043

Service Provider
$
20,355

 
$
20,355

Total
$
85,944

 
$
85,944


There were no impairments to goodwill during the three months ended April 1, 2012 and April 3, 2011.

Other accrued liabilities
 
 
April 1,
2012
 
December 31,
2011
Sales and marketing programs
$
44,632

 
$
44,394

Warranty obligation
42,029

 
44,846

Freight
7,487

 
7,940

Other
21,847

 
23,300

Total other accrued liabilities
$
115,995

 
$
120,480


5.
Product Warranties
The Company provides for estimated future warranty obligations at the time revenue is recognized. The Company’s standard warranty obligation to its direct customers generally provides for a right of return of any product for a full refund in the event that such product is not merchantable or is found to be damaged or defective. At the time revenue is recognized, an estimate of future warranty returns is recorded to reduce revenue in the amount of the expected credit or refund to be provided to its direct customers. At the time the Company records the reduction to revenue related to warranty returns, the Company includes within cost of revenue a write-down to reduce the carrying value of such products to net realizable value.
The Company’s standard warranty obligation to its end-users provides for replacement of a defective product for one or more years. Factors that affect the warranty obligation include product failure rates, material usage and service delivery costs incurred in correcting product failures. The estimated cost associated with fulfilling the Company’s warranty obligation to end-users is recorded in cost of revenue. Because the Company’s products are manufactured by third party manufacturers, in certain cases the Company has recourse to the third party manufacturer for replacement or credit for the defective products. The Company gives consideration to amounts recoverable from its third party manufacturers in determining its warranty liability.
Changes in the Company’s warranty liability, which is included as a component of “Other accrued liabilities” in the unaudited condensed consolidated balance sheets, are as follows (in thousands):
 
 
Three Months Ended
 
April 1,
2012
 
April 3,
2011
Balance as of beginning of the period
$
44,846

 
$
40,513

Provision for warranty liability made during the period
12,956

 
12,611

Settlements made during the period
(15,773
)
 
(15,072
)
Balance at end of period
$
42,029

 
$
38,052



12


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 euros, British pounds, Australian dollars and Japanese yen to manage the exposures to foreign exchange risk related to expected future cash flows on certain forecasted revenue, costs of revenue, operating expenses and existing assets and liabilities. The Company does not enter into derivatives transactions for trading or speculative purposes.

The Company’s foreign currency forward contracts do not contain any credit-risk-related contingent features. The Company is exposed to credit losses in the event of nonperformance by the counter-parties of its forward contracts. The Company enters into derivative contracts with high-quality financial institutions 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, immateriality, accounting considerations and the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign exchange rates. The Company’s accounting policies for these instruments are based on whether the instruments are designated as hedge or non-hedge instruments in accordance with the authoritative guidance for derivatives and hedging. The Company records all derivatives on the balance sheet at fair value. The effective portions of cash flow hedges are recorded in other comprehensive income until the hedged item is recognized in earnings. Derivatives that are not designated as hedging instruments and the ineffective portions of its designated hedges are adjusted to fair value through earnings in “Other income (expense), net.”

The fair values of the Company’s derivative instruments and the line items on the Unaudited Condensed Consolidated Balance Sheet to which they were recorded as of April 1, 2012, and December 31, 2011, are summarized as follows (in thousands):
 
Derivative Assets
Balance Sheet
Location
 
Fair Value at
April 1, 2012

 
Balance Sheet
Location
 
Fair Value at
December 31,
2011

Derivative assets not designated as hedging instruments
Prepaid expenses and other current assets
 
$
361

 
Prepaid expenses and other current assets
 
$
1,196

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

 
Prepaid expenses and other current assets
 
41

Total
 
 
$
361

 
 
 
$
1,237


 
Derivative Liabilities
Balance Sheet
Location
 
Fair Value at
April 1, 2012

 
Balance Sheet
Location
 
Fair Value at
December 31,
2011

Derivative liabilities not designated as hedging instruments
Other accrued liabilities
 
$
(304
)
 
Other accrued liabilities
 
$
(654
)
Derivative liabilities designated as hedging instruments
Other accrued liabilities
 
(44
)
 
Other accrued liabilities
 
(69
)
Total
 
 
$
(348
)
 
 
 
$
(723
)

For details of the Company’s fair value measurements, see Note 13, Fair Value of Financial Instruments.

13



Cash flow hedges

To help manage the exposure of operating margins to fluctuations in foreign currency exchange rates, the Company hedges a portion of its anticipated foreign currency revenue, costs of revenue and certain operating expenses. These hedges are designated at the inception of the hedge relationship as cash flow hedges under the authoritative guidance for derivatives and hedging. Effectiveness is tested at least quarterly both prospectively and retrospectively using regression analysis to ensure that the hedge relationship has been effective and is likely to remain effective in the future. The Company typically hedges portions of its anticipated foreign currency exposure for three to five months. The Company enters into about five forward contracts per quarter with an average size of about $6 million USD equivalent related to its cash flow hedging program.

The Company expects to reclassify to earnings all of the amounts recorded in other comprehensive income ("OCI") associated with its cash flow hedges over the next 12 months. OCI associated with cash flow hedges of foreign currency revenue is recognized as a component of net revenue in the same period as the related revenue is recognized. OCI associated with cash flow hedges of foreign currency costs of revenue and operating expenses are recognized as a component of cost of revenue and operating expense in the same period as the related costs of revenue and operating expenses are recognized.

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 other comprehensive income associated with such derivative instruments are reclassified immediately into earnings through other income and expense. 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 on discontinued cash flow hedges during the three months ended April 1, 2012 and April 3, 2011, respectively.

The effects of the Company’s derivative instruments on OCI and the unaudited condensed consolidated statement of operations for the three months ended April 1, 2012, and April 3, 2011, are summarized as follows (in thousands):
 
Derivatives Designated as Hedging Instruments
Three Months Ended April 1, 2012
Gain or (Loss)
Recognized in
OCI -
Effective
Portion (a)
 
Location of
Gain or (Loss)
Reclassified from OCI
into Income - Effective
Portion
 
Gain or (Loss)
Reclassified
from
OCI into
Income -
Effective
Portion (a)
 
Location of
Gain or (Loss)
Recognized in
Income and
Excluded from
Effectiveness  Testing
 
Amount of Gain or (Loss) Recognized in
Income and
Excluded from
Effectiveness  Testing
Cash flow hedges:
 
 
 
 
 
 
 
 
 
Foreign currency forward contracts
$
(106
)
 
Net revenue
 
$
2

 
Other income (expense), net
 
$
(45
)
Foreign currency forward contracts

 
Cost of revenue
 
(2
)
 
Other income (expense), net
 

Foreign currency forward contracts

 
Operating expenses
 
(50
)
 
Other income (expense), net
 

Total
$
(106
)
 
 
 
$
(50
)
 
 
 
$
(45
)


14


Derivatives Designated as
Hedging Instruments
Three Months Ended April 3, 2011
Gain or (Loss)
Recognized in
OCI -
Effective
Portion (a)
 
Location of
Gain or (Loss)
Reclassified from OCI
into Income - Effective
Portion
 
Gain or (Loss)
Reclassified
from
OCI into
Income -
Effective
Portion (a)
 
Location of
Gain or (Loss)
Recognized in
Income and
Excluded from
Effectiveness  Testing
 
Amount of Gain  or (Loss)  Recognized in
Income and
Excluded from
Effectiveness  Testing
Cash flow hedges:
 
 
 
 
 
 
 
 
 
Foreign currency forward contracts
$
(218
)
 
Net revenue
 
$
62

 
Other income (expense), net
 
$
(38
)
Foreign currency forward contracts

 
Cost of revenue
 
2

 
Other income (expense), net
 

Foreign currency forward contracts

 
Operating expenses
 
59

 
Other income (expense), net
 

Total
$
(218
)
 
 
 
$
123

 
 
 
$
(38
)

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

The Company did not recognize any net gain or loss related to the ineffective portion of cash flow hedges during the three months ended April 1, 2012, and April 3, 2011.

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 11 non-designated derivatives per quarter. The average size of its non-designated hedges is about $2 million USD equivalent and these hedges range from one to five months in duration.

The effects of the Company’s derivatives not designated as hedging instruments in other income (expense), net on the Statement of Operations for the three months ended April 1, 2012 and April 3, 2011, are as follows (in thousands):
 
Derivatives Not Designated as Hedging Instruments
Location of Gains or (Losses)
Recognized in Income on  Derivative
 
Amount of Gains or (Losses)
Recognized in Income on Derivative
 
Three Months  Ended
April 1, 2012

 
Three Months  Ended
April 3, 2011

Foreign currency forward contracts
Other income (expense), net
 
$
(744
)
 
$
(1,858
)
 
7.
Net Income Per Share
Basic net income per share is computed by dividing the net income for the period by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing the net income for the period by the weighted average number of shares of common stock and potentially dilutive common stock outstanding during the period. Potentially dilutive common shares include outstanding stock options and unvested restricted stock awards, which are reflected in diluted net income per share by application of the treasury stock method. Under the treasury stock method, the amount that the employee must pay for exercising stock options, the amount of stock-based compensation cost for future services that the Company has not yet recognized, and the amount of tax benefit that would be recorded in additional paid-in capital upon exercise are assumed to be used to repurchase shares.

15


Net income per share for the three months ended April 1, 2012, and April 3, 2011, are as follows (in thousands, except per share data):
 
 
Three Months Ended
 
April 1,
2012
 
April 3,
2011
Net income
$
25,147

 
$
21,189

Weighted average shares outstanding:
 
 
 
Basic
37,796

 
36,414

Dilutive potential common shares
780

 
926

Total diluted
38,576

 
37,340

 
 
 
 
Basic net income per share
$
0.67

 
$
0.58

Diluted net income per share
$
0.65

 
$
0.57


Weighted average stock options and unvested restricted stock awards to purchase 1.8 million shares and 1.4 million shares of the Company’s stock for the three months ended April 1, 2012, and April 3, 2011, respectively were excluded from the computation of diluted net income per share because their effect would have been anti-dilutive.

8.
Income Taxes

The income tax provision for the three months ended April 1, 2012 was $10.6 million or an effective tax rate of 29.6% compared to the tax provision for the three months ended April 3, 2011 of $9.1 million or an effective tax rate of 30.1%. The income tax expense increased for the three months ended April 1, 2012 compared to April 3, 2011 was due to higher pre-tax earnings for the three months ended April 1, 2012. The decrease in the effective tax rate for the three month period ended April 1, 2012, compared to the same period in the prior year was primarily caused by higher forecasted pre-tax earnings in foreign jurisdictions with tax rates lower than the U.S. federal rate. This decrease was partially offset by the expiration of the U.S. research tax credit that is no longer available after December 31, 2011. The Company has recorded its liability for uncertain tax positions as part of its long-term liability as payments are not anticipated over the next 12 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 in multiple jurisdictions in the next 12 months is approximately $0.8 million, excluding the interest, penalties and the effect of any related deferred tax assets or liabilities.

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. The terms of some of the Company’s office leases provide for rental payments on a graduated scale. The Company recognizes rent expense on a straight-line basis over the lease period, and has accrued for rent expense incurred but not paid.

Purchase Obligations

The Company has entered into various inventory-related purchase agreements with suppliers. Generally, under these agreements, 50% of orders are cancelable by giving notice 46 to 60 days prior to the expected shipment date and 25% of orders are cancelable by giving notice 31 to 45 days prior to the expected shipment date. Orders are non-cancelable within 30 days prior to the expected shipment date. At April 1, 2012, the Company had $176.3 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.






16


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 these indemnification agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of April 1, 2012.

In its sales agreements, the Company typically agrees to indemnify its direct customers, distributors and resellers for any expenses or liability resulting from claimed infringements by the Company's products of patents, trademarks or copyrights of third parties, subject to customary carve outs. The terms of these indemnification agreements are generally perpetual any time after execution date of the respective agreement. The maximum amount of potential future infringement indemnification is generally unlimited. The Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of April 1, 2012.

Employment Agreements

The Company has signed various employment agreements with key executives pursuant to which, if their employment is terminated without cause, such employees are entitled to receive their base salary (and commission or bonus, as applicable) for 52 weeks (for the Chief Executive Officer), 39 weeks (for the Senior Vice President of Worldwide Operations and Support) and up to 26 weeks (for other key executives). Such employees will also continue to have stock options 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 stock options.

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 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 12 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.

OptimumPath, L.L.C. v. NETGEAR

In January 2008, a lawsuit was filed against the Company by OptimumPath, L.L.C (“OptimumPath”), a patent-holding company existing under the laws of the State of South Carolina, in the U.S. District Court, District of South Carolina. OptimumPath claims that certain of the Company's wireless networking products infringe on OptimumPath's U.S. Patent No. 7,035,281. OptimumPath also sued six other technology companies alleging similar claims of patent infringement. The Company filed its answer to the lawsuit in the second quarter of 2008. Several defendants, including the Company, jointly filed a request for inter partes reexamination of the OptimumPath patent with the United States Patent and Trademark Office (the “USPTO”) on October 13, 2008. On January 12, 2009, a reexamination was ordered with respect to claims 1-3 and 8-10 of the patent, but denied with respect to claims 4-7 and 11-32 of the patent. On February 4, 2009, the defendants jointly filed a petition to challenge the denial of reexamination of claims 4-7 and 11-32. On March 26, 2009, the USPTO confirmed the patentability of claims 1-3 and 8-10 without amendment. Shortly thereafter, in March 2009, the District Court granted defendants' motion to transfer the case to the U.S. District Court, Northern District of California. In July 2009, the defendants' petition to challenge the denial of reexamination of claims 4-7 and 11-32 was denied by the USPTO. Since the petition and prosecution were closed, the USPTO issued a Right of Appeal Notice on July 31, 2009, and the defendants chose to appeal the confirmation of claims 1-3 and 8-10 by filing a notice of appeal on August 31, 2009. The Company and OptimumPath attended a Court-ordered mediation on September 22, 2009 but were unable to make progress towards settlement. The Company and other defendants filed a combined claim construction/summary judgment brief on December 23, 2010. OptimumPath responded on January 20, 2011, and the defendants replied on February 3, 2011. The oral arguments on claim construction and the summary judgment motion were made on February 17, 2011. An oral hearing was held on March 9, 2011 in the USPTO and a decision by the USPTO was issued on March 30, 2011 confirming

17


the patentability of claims 1-3 and 8-10. On April 12, 2011, the District Court granted defendants' motion for summary judgment on OptimumPath's claim for literal infringement and defendants' motion to preclude OptimumPath's infringement claims based on the doctrine of equivalents. The Court also found that the accused devices did not infringe under the doctrine of equivalents. The Court also granted defendants' motion for summary judgment that asserted claims 1, 2, 6, and 9 through 13 of the '281 patent were invalidated by various prior art. The pretrial conference and trial dates were vacated. OptimumPath filed its notice of appeal to the Federal Circuit of the District Court's rulings on May 18, 2011. On May 23, 2011, the District Court entered the defendants' joint request for costs in the amount of $103,000, which have not yet been collected or recognized. On June 29, 2011, the Federal Circuit docketed the appeal. In addition, the defendants appealed the USPTO's ruling confirming the patentability of claims 1-3 and 8-10 to the Federal Circuit by filing a Reexamination Notice of Appeal to the Federal Circuit on October 18, 2011. The parties argued OptimumPath's appeal of the District Court's summary judgment rulings before the Federal Circuit on March 5, 2011. On March 7, 2012, the Federal Circuit affirmed the District Court's summary judgment rulings in favor of the defendants. OptimumPath has not indicated whether or not it will appeal the Federal Circuit's ruling upholding the District Court's summary judgment rulings. On June 5, 2012, the parties are scheduled to argue the defendants' appeal of the USPTO rulings before the Federal Circuit.

Ruckus Wireless v. NETGEAR

In May 2008, a lawsuit was filed against the Company by Ruckus Wireless (“Ruckus”), a developer of Wi-Fi technology, in the U.S. District Court, Northern District of California. Ruckus alleges that the Company infringes U.S. Patent Nos. 7,358,912 ('912 Patent) and 7,193,562 ('562 Patent) in the course of deploying Wi-Fi antenna array technology in its WPN824 RangeMax wireless router. Ruckus also sued Rayspan Corporation alleging similar claims of patent infringement. The Company filed its answer to the lawsuit in the third quarter of 2008. The Company and Rayspan Corporation jointly filed a request for inter partes reexamination of the Ruckus patents with the USPTO on September 4, 2008. The Court issued a stay of the litigation while the reexaminations proceeded in the USPTO. On November 28, 2008, a reexamination was ordered with respect to claims 11-17 of the '562 Patent, but denied with respect to claims 1-10 and 18-36. On December 17, 2008, the defendants jointly filed a petition to challenge the denial of reexamination of claims 1-10 and 18-36 of the '562 Patent. In July 2009, the petition was denied, and the remaining claims 11-17 were confirmed. The Company is appealing the confirmation of claims 11-17. On December 2, 2008, reexamination was granted with regard to the '912 Patent. In early October 2009, the Company received an Action Closing Prosecution in the reexamination of the '912 Patent. All the claims of the '912 Patent, with the exception of the unchallenged claims 7 and 8, were finally rejected by the USPTO. On October 30, 2009, Ruckus submitted an “after-final” amendment in the '912 Patent reexamination proceeding. The Company's comments to Ruckus' “after-final” amendment were submitted on November 30, 2009. On December 1, 2009, the Court found that bifurcating the '562 Patent from the '912 Patent and commencing litigation on the '562 Patent while the USPTO reexamination process and appeals are still pending would be an inefficient use of the Court's resources. Accordingly, the Court ruled that the litigation stay should remain in effect. On September 12, 2010, the Company filed the rebuttal brief in its appeals of the USPTO's rulings during the reexamination of the '562 Patent, and the Company requested an oral hearing with the Board of Appeals at the USPTO to discuss this brief. On September 13, 2010, Ruckus filed a notice of appeal of the '912 Patent to appeal the adverse rulings it received from the USPTO in the reexamination of this patent. The Company filed a respondent's brief in the '912 Patent case on January 24, 2011. An oral hearing in the '562 case was set for February 1, 2011, but the Company decided to cancel it and let the USPTO decide the '562 case based solely on the previously submitted papers. On May 13, 2011, the USPTO indicated that the Company was successful in its appeal of the examiner's previous decision to allow claims 11-17 in the '562 reexamination, and the USPTO Board of Appeals reversed the examiner's decision and declared those claims invalid. On June 13, 2011, Ruckus submitted a request for rehearing by the Board of Appeals of its decision to reject claims 11-17 of the '562 Patent. On September 28, 2011, the Board of Patent Appeals and Interferences denied Ruckus's request for a rehearing in the '562 Patent reexamination case. Ruckus did not timely file a notice of appeal to the Court of Appeals for the Federal Circuit appealing the USPTO's cancellation of claims 11-17 of the '562 patent. Therefore, a reexamination certificate will issue with claims 11-17 cancelled and claims 1-10 and 18-36 confirmed.

On November 4, 2009, Ruckus filed a new complaint in the U.S. District Court, Northern District of California alleging the Company and Rayspan Corporation infringe a patent that is related to the patents previously asserted against the Company and Rayspan Corporation by Ruckus, as discussed above. This newly asserted patent is U.S. Patent No. 7,525,486 entitled “Increased wireless coverage patterns.” As with the previous Ruckus action, the WPN824 RangeMax wireless router is the alleged infringing device. The Company challenged the sufficiency of Ruckus's complaint in this new action and moved to dismiss the complaint. Ruckus opposed this motion. The Court partially agreed with the Company's motion and ordered Ruckus to submit a new complaint, which Ruckus did. The initial case management conference occurred on February 11, 2010. On March 25, 2010, the Court ordered a stay until the completion of the '562 Patent's reexamination proceedings in the first Ruckus lawsuit against the Company and Rayspan. The Court instructed the parties to submit status reports to the Court every six months, apprising the Court of the status of the pending reexamination proceedings in the USPTO. Upon final exhaustion of all pending reexamination proceedings of the '562 Patent, including any appeals, the Court ordered the parties to jointly submit to the Court a letter indicating that all appeals have been exhausted and requesting a further case management conference. The case remains stayed.


18


On November 19, 2010, the Company filed suit against Ruckus in the U.S. District Court, District of Delaware for infringement of four of the Company's patents. The Company alleges that Ruckus's manufacture, use, sale or offers for sale within the United States or importation into the United States of products, including wireless communication products, infringe United States Patent Nos. 5,812,531, 6,621,454, 7,263,143, and 5,507,035, all owned by the Company. The Company granted Ruckus an extension to file its answer to the Company's suit, and on January 11, 2011, Ruckus filed a motion to dismiss the Company's suit based on insufficient pleadings. The Company filed its response to Ruckus's motion on January 31, 2011. In addition, on May 6, 2011, Ruckus filed a motion to transfer venue to the Northern District of California. The Court denied Ruckus' motion to transfer the case to the Northern District of California and granted the Company leave to file an amended complaint rather than address the Ruckus motion to dismiss based on insufficient pleadings. The Company filed the proposed amended complaint. Nevertheless, Ruckus filed a second motion to dismiss based on insufficient pleadings by the Company. The Company has filed its opposition to Ruckus's motion, and the Court has not yet ruled on the motion. On March 28, 2012, the Delaware District Court in a memorandum opinion and order denied Ruckus's second motion to dismiss. A scheduling conference occurred April 18, 2012, but the District Court did not yet set a trial date. The discovery process, however, has commenced for the parties, and the Company's initial disclosures are due on May 15, 2012.
 
Northpeak Wireless, LLC v. NETGEAR

In October 2008, a lawsuit was filed against the Company and 30 other companies by Northpeak Wireless, LLC (“Northpeak”) in the U.S. District Court, Northern District of Alabama. Northpeak alleges that the Company's 802.11b compatible products infringe certain claims of U.S. Patent Nos. 4,977,577 and 5,987,058. The Company filed its answer to the lawsuit in the fourth quarter of 2008. On January 21, 2009, the District Court granted a motion to transfer the case to the U.S. District Court, Northern District of California. In August 2009, the parties stipulated to a litigation stay pending a reexamination request to the USPTO on the asserted patents. The reexaminations of the patents are proceeding. In March 2011, the USPTO confirmed the validity of the asserted claims of the '577 patent over certain prior art references. In April 2011, the USPTO issued a final office action rejecting both asserted claims of the '058 patent as being obvious in light of the prior art. The case remains stayed by stipulation, and no trial date has been set.

Ericsson v. NETGEAR

On September 14, 2010, Ericsson Inc. and Telefonaktiebolaget LM 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; 6,330,435; 6,424,625; 6,519,223; 6,772,215; 5,987,019; 6,466,568; and 5,771,468. Ericsson generally alleges that the Company and the other defendants have infringed and continue to infringe the Ericsson patents through the defendants' IEEE 802.11-compliant products. In addition, Ericsson alleges that the Company has infringed, and continues to infringe, the claimed methods and apparatuses of the '468 Patent through the Company's PCMCIA routers. The Company filed its answer to the Ericsson complaint on December 17, 2010 where it asserted the affirmative defenses of noninfringement and invalidity of the asserted patents. On March 1, 2011, the defendants filed a motion to transfer venue to the District Court for the Northern District of California and their memorandum of law in support thereof. On March 21, 2011, Ericsson filed is opposition to the motion, and on April 1, 2011, defendants filed their reply to Ericsson's opposition to the motion to transfer. On June 8, 2011, Ericsson filed an amended complaint that added Dell, Toshiba and Belkin as defendants. At the status conference held on Jun 9, 2011, the Court set a Markman hearing for June 28, 2012 and trial for June 3, 2013. On June 14, 2011, Ericsson submitted its infringement contentions against the Company. On September 29, 2011, the Court denied the defendants motion to transfer venue to the Northern District of California. The parties are now approaching the Markman hearing. In advance of the Markman hearing, the parties on March 9, 2012 exchanged proposed constructions of claim terms and on April 9, 2012 filed the Joint Claim Construction Statement with the District Court. The remaining deadlines up to and including the Markman hearing are: May 8, 2012 - Ericsson's Markman brief is due; May 16, 2012 - Tutorials are due; June 18, 2012 - Defendants Markman brief is due; June 15 - Ericsson's Reply Markman brief is due; and June 28, 2012 - Markman hearing occurs. Discovery is ongoing.

Fujitsu v. NETGEAR

On September 3, 2010, Fujitsu filed a complaint against the Company, Belkin International, Inc., Belkin, Inc., D−Link Corporation, D−Link Systems, Inc., ZyXEL Communications Corporation, and Zyxel Communications, Inc in the U.S. District Court, Northern District of California alleging that certain of the Company's products infringe upon Fujitsu's U.S. patent Re. 36,769 patent ('769 Patent) through various cards and interface devices within the Company's products. The Company answered the complaint denying the allegations of infringement and claiming that the asserted patent is invalid. In addition, the Company filed a motion to disqualify counsel for Fujitsu. The Company's disqualification motion was argued before the Court on December 16, 2010, and on December 22, 2010, the Court granted the Company's motion and disqualified counsel for Fujitsu. In response,

19


Fujitsu requested a stipulation from all parties to reset the case management conference and scheduled hearing dates for the motions to dismiss. The initial case management conference was held on March 18, 2011. A claim construction hearing was held on October 14, 2011. On February 3, 2012, the Court issued its claim construction order based on the claim construction hearing. On March 3, 2011, the Fujitsu patent emerged from the latest ex-parte reexamination in the USPTO. The USPTO examiner rejected five of the “wired” claims in the patent, but found that the majority of claims of the patent were valid. Expert discovery opens May 4, 2012 with the exchange of initial expert reports. Rebuttal expert reports are due May 25, and expert discovery closes on June 8, 2012. Dispositive motions are due June 28, 2012, and trial is set to commence on November 26, 2012. The parties are continuing to participate in the discovery process.

Chalumeau Power Systems v. NETGEAR.

On June 28, 2011, Chalumeau Power Systems LLC (“Chalumeau”) filed a complaint against several technology companies - including the Company, Cisco Systems Inc., Hewlett-Packard Co., D-Link, and Avaya Inc. - in the U.S. District Court, District of Delaware alleging infringement of a patent for a remote device detection method. The patent number is U.S. Patent No. 5,991,885 ('885 Patent) and is entitled “Method and apparatus for detecting the presence of a remote device and providing power thereto.” Chalumeau claimed that the defendants have all made or sold devices that make use of infringing PoE technology, which allows electrical power and data to pass safely on Ethernet cabling. The Company answered Chalumeau's complaint on September 1, 2011, and asserted various defenses and counterclaims, including those of noninfringement and invalidity of the '885 Patent. In October 2011, a settlement of this lawsuit was reached between Chalumeau and the Company through a third-party intermediary. Without admitting any wrongdoing or violation of law and to avoid the distraction and expense of continued litigation and the uncertainty of a jury verdict on the merits, the Company and Chalumeau signed a binding release agreement in which both parties agreed to mutual general releases from all claims, known or unknown, under the '885 Patent and its foreign counterparts with respect to the manufacture, use, sale, etc. of products by the Company. The Court has since dismissed Chalumeau's claims for relief against the Company and the Company's counterclaims for relief against Chalumeau, with prejudice and with all attorneys' fees, costs and expenses levied against the party incurring the same.

Powerline Innovations, LLC v. NETGEAR

On August 6, 2011 the Company, along with 16 other companies, was sued in the U.S. District Court, Eastern District of Texas, Tyler Division for patent infringement by a non-practicing entity called Powerline Innovations, LLC (“Powerline Innovations”).  This is a single patent case, involving U.S. Patent No. 5,471,190, entitled “Method and Apparatus for Resource Allocation in a Communication Network System.”  On the same day that it filed suit against the Company and 16 other companies, Powerline Innovations sued 14 additional companies in a separate suit in U.S. District Court, Eastern District of Texas for infringement of the same patent.  The complaint against the Company alleges that it infringes  the 5,471,190 patent based on the Company's use of methods for establishing control relationships between plural devices and names the Company's Powerline AV Ethernet Adapter, Model XAV101, as an accused infringing product. The Company answered the plaintiff's complaint on December 12, 2011, and asserted that it has not infringed the patent in suit and that the patent in suit is invalid. In addition, the Company asserted various affirmative defenses. Powerline Innovations has not yet served all the parties. The Court will likely not set an initial status conference before service is completed.

Summit Data Systems LLC v. NETGEAR.

On September 1, 2010, a non-practicing entity, Summit Data Systems LLC (“Summit Data Systems”), sued the Company and seven other companies in the U.S. District Court, District of Delaware alleging infringement of two patents -- U.S. Patent No. 7,392,291 ('291 Patent), entitled Architecture for Providing Block-Level Access over a Computer Network and U.S. Patent No. 7,428,581 ('581 Patent), entitled Architecture for Providing Block-Level Access over a Computer Network. The '581 Patent is a continuation of the '291 Patent. The Company's ReadyNAS and NVX products were listed by the plaintiff in the complaint as accused infringing products. The Company answered the complaint on November 1, 2010, asserting that the patents are not infringed and invalid. Subsequently, the Company participated in discovery, and trial for this matter was scheduled for March 2013. In October 2011, a settlement of this lawsuit was reached between Summit Data Systems and the Company through a third-party intermediary. Without admitting any wrongdoing or violation of law and to avoid the distraction and expense of continued litigation and the uncertainty of a jury verdict on the merits, the Company and Summit Data Systems signed a binding release agreement in which both parties agreed to mutual general releases from all claims, known or unknown, under the '291 Patent and '581 Patents and certain other patents and applications assigned to Summit Data Systems with respect to the manufacture, use, sale, etc. of products by the Company. The Court has since dismissed Summit Data Systems's claims for relief against the Company and the Company's counterclaims for relief against Summit Data Systems, with prejudice and with all attorneys' fees, costs and expenses levied against the party incurring the same.


20


NETGEAR v. Innovatio IP Ventures LLC.

On November 16, 2011, the Company filed a declaratory judgment action in the District of Delaware for non-infringement and invalidity of 17 WiFi-related patents brought in the approximately 15 actions throughout the United States by Innovatio IP Ventures LLC (“Innovatio”) against end user customers of the Company and other companies. Shortly after filing the declaratory judgment action, the Company filed a response supporting Cisco Systems, Inc.'s and Motorola Solutions, Inc.'s Motion to Transfer for Coordinated Pretrial Proceedings Pursuant to 28 U.S.C. § 1407 that was before the United States Judicial Panel on Multidistrict Litigation (“JPML”). The pending motion to transfer would serve to consolidate all of the Innovatio lawsuits - including NETGEAR's pending declaratory judgment action in Delaware-and transfer them to a single court for coordinated pretrial proceedings. On December 28, 2011, the JPML issued an order transferring the Innovatio actions throughout the United States, including the Company's declaratory judgment action, to the United States District Court for the Northern District of Illinois. Thus, the Company's declaratory judgment action and approximately 15 other similar cases will now proceed in the Northern District of Illinois in a consolidated fashion. The status conference originally scheduled for March 27, 2012 was postponed by the District Court until April 10, 2012. At the conference, the District Court discussed two primary issues (1) case phasing (i.e., which subset of defendants should proceed after Markman Hearing through the remaining proceedings) and (2) the defendants' proposal on damages contentions. The District Court stated that it tentatively felt that the case should proceed with one or more WiFi hardware suppliers after the Markman Hearing, but was going to reserve a final ruling on the issue. The District Court withheld ordering damages contentions for the time being. The District Court also ordered that the parties prepare a joint pretrial order reflecting his decisions and the schedule for the case.

Harris Corporation v. NETGEAR.

On November 26, 2011, Harris Corporation (“Harris”) sued the Company in the U.S. District Court, Middle District of Florida alleging that the Company willfully infringes six of Harris's patents -- U.S. Patent Nos. 6,504,515, 7,916,684, 5,787,177, 5,974,149, 6,189,104, and 6,397,336. The Company obtained an extension until February 20, 2012 to answer the complaint and is reviewing the complaint and patents. It appears that Harris is attempting to read four of the patents (the '177, '149, '104, and '336 Patents) on the Company's ProSecure UTM series of products. The other two patents (the '515 and '684 Patents) allegedly read on certain of the Company's access points and wireless routers and gateways with multiple antennas. Harris filed an amended complaint on February 17, 2012 that removed its initial allegations of willful infringement by the Company and also removed the allegations of direct infringement against the Company for U.S. Patent No. 7,916,684, leaving only indirect infringement allegations for the '684 Patent. The Company's answer to the amended complaint was submitted on March 2, 2012. The scheduling order in this case gives the following deadlines: a) Motions to Add Parties or to Amend Pleadings April 30, 2012; b) Disclosure of Expert Reports by the Plaintiff: November 14, 2012; c) Disclosure of Expert Reports by the Defendant: December 14, 2012; d) Discovery Deadline: February 8, 2013; e) Dispositive Motions and Daubert Motions: March 15, 2013 f) Markman Motions: July 2, 2012; g) Meeting In Person to Prepare Joint Final Pretrial Statement: May 8, 2013; h) Joint Final Pretrial Statement: May 20, 2013; i) Trial Term Begins: August 1, 2013. The Court set a length of trial of 5-10 days. The parties are currently participating in discovery.

On April 3, 2012, the Company filed suit against Harris in the District Court of the Northern District of California asserting that Harris infringes four of the Company's patents. In the complaint, the Company alleges that Harris infringes: a) U.S. Patent No. 6,718,030 (“the '030 Patent”), entitled “Virtual Private Network System and Method Using Voice of Internet Protocol” through Harris's VIDA Network and products, the VIDA Telephone Interconnect (VTI), the MASTR III Base Station, and the EDACS MASTR III repeater; b) U.S. Patent No. 7,200,400 (“the '400 Patent”), entitled “Mobile to 802.11 Voice Multi-Network Roaming Utilizing SIP Signaling With SIP Proxy or Redirect Server” through Harris's VIDA Network and products, the Inter-RF Subsystem Interface (ISSI) Gateway, the Interoperability Gateway, and the UNITY XG-100P Portable Radio; c) U.S. Patent No. 7,218,722 (“the '722 Patent”), entitled “System and Method For Proving Call Management Services in a Virtual Private Network Using Voice or Video Over Internet Protocol” through Harris's VIDA Network and products, the VIDA Telephone Interconnect (VTI), the P7200 Portable Radio, the OpenSky Network and Products, the MASTR III Base Station, and EDACS MASTR III repeater; and d) U.S. Patent No. 7,936,714 (“the '714 Patent”), entitled “Spectrum Allocation System and Method For Multi-Band Wireless RF Data Communications” through Harris's UNITY XG-100P Portable Radio. The Company granted Harris's request for an extension until May 25, 2012 to answer the Company's complaint.


21


IP Indemnification Claims

In its sales agreements, the Company typically agrees to indemnify its direct customers, distributors and resellers (the “Indemnified Parties”) for any expenses or liability resulting from claimed infringements by the Company's products of patents, trademarks or copyrights of third parties that are asserted against the Indemnified Parties, subject to customary carve outs. The terms of these indemnification agreements are generally perpetual after execution of the agreement. The maximum amount of potential future indemnification is generally unlimited. From time to time, the Company receives requests for indemnity and may choose to assume the defense of such litigation asserted against the Indemnified Parties.

In June 2006, the Company received a request for indemnification from Charter and Charter Communications Operating, LLC ("Charter") related to a lawsuit filed in the U.S. District Court, Eastern District of Texas, by Rembrandt Technologies, L.P. (“Rembrandt”), a patent-holding company. Rembrandt also filed a similar lawsuit in the same jurisdiction against Comcast Corporation, Comcast Cable Communications, LLC and Comcast of Plano, LP. Rembrandt alleged that products implementing the DOCSIS standard, which are supplied to Charter, Comcast Corporation, Comcast Cable Communications, LLC and Comcast of Plano, LP by, among others, the Company, infringe various patents held by Rembrandt. In June 2007, the Judicial Panel on Multidistrict Litigation ordered these and other similar patent cases brought by Rembrandt consolidated and transferred to the U.S. District Court for the District of Delaware. In November 2007, the Company along with Motorola, Inc., Cisco Systems, Inc., Scientific-Atlanta, Inc., ARRIS Group, Inc., Thomson, Inc. and Ambit Microsystems, Inc. filed a complaint for declaratory judgment in the U.S. District Court for the District of Delaware against Rembrandt, seeking a declaration that eight asserted Rembrandt patents asserted in the transferred cases are either invalid or not infringed. The District Court held a claim construction hearing on August 5, 2008. On November 29, 2008, the District Court issued its claim construction order. After the District Court's order, Rembrandt agreed to drop three patents from the case, leaving five patents at issue. The District Court held a mediation on March 3-4, 2009 but the parties were unable to reach a resolution. On July 21, 2009, Rembrandt delivered to the Company and other parties an executed covenant not to sue on any of the eight patents originally in the suit, contending that the execution of the covenant divests the District Court of jurisdiction or renders moot the remaining claims and counterclaims in the action. On July 31, 2009, Rembrandt filed a motion to dismiss the litigation. While Rembrandt's motion was pending, the defendants filed motions for summary judgment, motions for sanctions, and responses to Rembrandt's motion to dismiss. In early October 2009, the District Court suspended all further dates for the case while it reviewed the pending motions and case status. On October 23, 2009, the Court ordered Rembrandt to supplement the covenant not to sue to include any products or services that comply with DOCSIS 1.0, 1.1, 2.0 or 3 and dismissed Rembrandt's various infringement claims on the eight patents with prejudice. The Court gave Rembrandt five days to withdraw its motion to dismiss the litigation if it found the Court's conditions on dismissal to be unacceptable. Rembrandt did not withdraw its motion to dismiss the litigation, and on October 30, 2009, Rembrandt executed a covenant not to sue on any of the eight patents in the case and any products or services that comply with DOCSIS 1.0, 1.1, 2.0 or 3. The Company and its co-defendants moved for attorneys' fees to be paid by Rembrandt. Rembrandt opposed the motion. On July 8, 2011, the Court denied the defendant's unopposed motion for summary judgment of noninfringement of the one patent remaining in the case, the '627 Patent. This ruling did not affect the Company since that patent was not asserted against the Company, other than postponing the Company's possible recovery of attorneys' fees. On July 13, 2011, the Court dismissed without prejudice the defendants' joint motion for fees because the motion is now not ripe given the Court's denial of the motion for summary judgment of noninfringement of the '627 Patent. The Company is now reviewing its options for recovering attorneys' fees.

Environmental Regulation

The European Union (“EU”) has enacted the Waste Electrical and Electronic Equipment Directive, which makes producers of electrical goods, including home and commercial business networking products, financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. The deadline for the individual member states of the EU to transpose the directive into law in their respective countries was August 13, 2004 (such legislation, together with the directive, the “WEEE Legislation”). Producers participating in the market were financially responsible for implementing these responsibilities under the WEEE Legislation beginning in August 13, 2005. Similar WEEE Legislation has been or may be enacted in other jurisdictions, including in the United States, Canada, Mexico, China, India, Australia and Japan. The Company adopted the authoritative guidance for asset retirement and environmental obligations in the third quarter of fiscal 2005 and has determined that its effect did not have a material impact on the Company's consolidated results of operations and financial position for the three months ended April 1, 2012. The Company continues to monitor WEEE Legislation and similar legislation in other jurisdictions as individual countries issue their implementation guidance. The Company believes it has met the applicable requirements of current WEEE Legislation and similar legislation in other jurisdictions, to the extent implementation requirements have been published.

Additionally, the EU has enacted the Restriction of Hazardous Substances Directive (“RoHS Legislation”), the REACH Directive and the Battery Directive. EU RoHS Legislation, along with similar legislation in China, requires manufacturers to

22


ensure certain substances, including polybrominated biphenyls (“PBD”), polybrominated diphenyl ethers (“PBDE”), mercury, cadmium, hexavalent chromium and lead (except for allowed exempted materials and applications), are below specified maximum concentration values in certain products put on the market after July 1, 2006. The REACH Directive similarly requires manufacturers to ensure the published list of substances of very high concern in certain products are below specified maximum concentration values. The Battery Directive prohibits use of certain types of battery technology in certain products. The Company believes it has met the requirements of the RoHS Legislation, the REACH Directive and the Battery Directive.

Additionally, the EU has enacted the Energy Using Product (“EuP”) Directive, which requires manufacturers of certain products to meet minimum energy efficiency limits. These limits are documented in EuP implementing measures issued for specific types of equipment and document minimum power supply efficiencies and may include required equipment standby modes which also reduce energy consumption. The Company believes it has met the requirements of the applicable EuP implementing measures.

10.
Stockholders' Equity

Common Stock Repurchase Program

On October 21, 2008, the Company’s Board of Directors authorized management to repurchase up to 6,000,000 shares of the Company’s outstanding common stock. Under this authorization, the timing and actual number of shares subject to repurchase are at the discretion of management and are contingent on a number of factors, such as levels of cash generation from operations, cash requirements for acquisitions and the price of the Company’s common stock. The Company did not repurchase any shares under this authorization during the three months ended April 1, 2012, and April 3, 2011.
The Company repurchased approximately 16,000 shares, or $0.6 million of common stock under a repurchase program to help administratively facilitate the withholding and subsequent remittance of personal income and payroll taxes for individuals receiving RSUs during the three months ended April 1, 2012. Similarly, during the three months ended April 3, 2011, the Company repurchased approximately 24,000 shares, or $0.9 million of common stock, respectively, under the same program to help facilitate tax withholding for RSUs.
These shares were retired upon repurchase. The Company’s policy related to repurchases of its common stock is to charge the excess of cost over par value to retained earnings. All repurchases were made in compliance with Rule 10b-18 under the Securities Exchange Act of 1934, as amended.
Cumulative Other Comprehensive Income, Net

The following table sets forth the components of cumulative other comprehensive income, net of related taxes, as of April 1, 2012 and December 31, 2011 (in thousands):
 
 
April 1,
2012
 
December 31,
2011
Net unrealized (losses) gains on derivative instruments
$
(50
)
 
$
6

Net unrealized (losses) gains on available-for-sale securities
(5
)
 
17

Total cumulative other comprehensive income (loss), net of taxes
$
(55
)
 
$
23

 
11.
Employee Benefit Plans
The Company grants options and restricted stock units from the Amended and Restated 2006 Long-Term Incentive Plan, under which awards may be granted to all employees. In addition, the Company’s stock option program includes the 2003 Stock Plan, from which the Company does not currently grant awards, but may choose to do so. Award vesting periods for these plans are generally four years. As of April 1, 2012, a total of 618,643 shares were reserved for future grants under these plans.
Additionally, the Company sponsors an Employee Stock Purchase Plan (the “ESPP”), pursuant to which eligible employees may contribute up to 10% of base compensation, subject to certain income limits, to purchase shares of the Company’s common stock. Employees may purchase stock semi-annually at a price equal to 85% of the fair market value on the purchase date. As of April 1, 2012, a total of 422,460 shares were reserved for future grants under the ESPP.

23


Option Activity
Stock options activity under the stock option plans noted above during the three months ended April 1, 2012, was as follows:
 
 
Options Outstanding
 
Number of shares
 
Weighted Average Exercise Price Per Share
 
(in thousands)
 
(in dollars)
December 31, 2011
3,950

 
$
27.03

Granted
180

 
39.60

Exercised
(203
)
 
21.55

Cancelled
(60
)
 
32.01

April 1, 2012
3,867

 
$
27.82


RSU Activity

RSU activity during the three months ended April 1, 2012, was as follows:

 
RSUs Outstanding
 
Number of shares
 
Weighted Average Exercise Price Per Share
 
(in thousands)
 
(in dollars)
December 31, 2011
177

 
$
27.86

RSUs granted
2

 
40.01

RSUs vested
(43
)
 
19.13

RSUs cancelled

 

April 1, 2012
136

 
$
30.80


Valuation and Expense Information
The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option valuation model and the weighted average assumptions in the following table. The expected term of options granted is derived from historical data on employee exercise and post-vesting employment termination behavior. The risk free interest rate is based on the implied yield currently available on U.S. Treasury securities with an equivalent remaining term. Expected volatility is based on the historical volatility of the Company’s stock for the three months ended April 1, 2012 and April 3, 2011:
 
 
Three Months Ended
 
April 1,
2012
 
April 3,
2011
Expected life (in years)
4.3

 
4.4

Risk-free interest rate
0.58% - 0.91%

 
1.87
%
Expected volatility
52.5
%
 
49.9
%
Dividend yield

 



24


The following table sets forth the total stock-based compensation expense resulting from stock options, restricted stock awards and the ESPP included in the Company’s Unaudited Condensed Consolidated Statements of Operations (in thousands):
 
 
Three Months Ended
 
April 1,
2012
 
April 3,
2011
Cost of revenue
$
270

 
$
235

Research and development
611

 
661

Sales and marketing
1,194

 
1,301

General and administrative
1,317

 
1,175

Total stock-based compensation
$
3,392

 
$
3,372


As of April 1, 2012, $21.9 million of total unrecognized compensation cost related to stock options, adjusted for estimated forfeitures, is expected to be recognized over a weighted-average period of 1.40 years. Additionally, $2.0 million of total unrecognized compensation cost related to non-vested restricted stock awards, adjusted for estimated forfeitures, is expected to be recognized over a weighted-average period of 1.26 years.

12.
Segment Information, Operations by Geographic Area and Significant Customers

Operating segments are components of an enterprise about which separate financial information is available and is regularly evaluated by management, namely the Chief Operating Decision Maker (“CODM”) of an organization, in order to determine operating and resource allocation decisions. By this definition, the Company operated in one segment through the first fiscal quarter of 2011, which comprised the development, marketing and sale of networking products for the commercial business and home markets.

In the second fiscal quarter of 2011, the Company made organizational changes that resulted in changes to the way in which the CODM manages and evaluates the business. The Company’s business is now managed in three specific business units: retail, commercial, and service provider. The retail business unit consists of high performance, dependable and easy-to-use home networking, storage and digital media products to connect people with the Internet and their content and devices. The commercial business unit consists of business networking, storage and security solutions without the cost and complexity of Big IT. The service provider business unit consists of made-to-order and retail proven, whole home networking solutions sold to service providers for sale to their customers. Each business unit is managed by a Senior Vice President/General Manager. There is no change in the CODM before and after the reorganization of the segments.

The Company believes this new structure enables it to better focus its efforts on the Company’s core customer segments and allows it to be more nimble and opportunistic as a company overall. The business units are determined in accordance with how management views and evaluates the Company’s business and based on the criteria as outlined in the authoritative guidance. As a result, beginning in the second fiscal quarter of 2011, the Company changed its segment reporting accordingly, and revised its prior period presentation to conform to the new segments.

The results of the reportable segments are derived directly from the Company’s management reporting system. The results are based on the Company’s method of internal reporting and are not necessarily in conformity with accounting principles generally accepted in the United States. Management measures the performance of each segment based on several metrics, including contribution income. Refer to the reconciliation of segment information to the Company’s consolidated totals below to see the reconciliation of segment data to earnings prepared in conformity with accounting principles generally accepted in the United States.


25


Asset data is not reviewed by the Company’s CODM at the segment level and therefore is not presented. Discrete financial information on individual products and services within the respective segments is not reviewed by the Company’s CODM, and therefore a separate disclosure of similar classes of products and services below the segment level is not presented. Financial information for each reportable segment and a reconciliation of segment contribution income to income before income taxes is as follows (in thousands, except percentage data):

 
Three Months Ended
 
April 1,
2012
 
April 3,
2011
Net revenues:
 
 
 
Retail
$
128,977

 
$
117,125

Commercial
74,632

 
79,622

Service provider
122,011

 
82,076

Total net revenues
325,620

 
278,823

Contribution income:
 
 
 
Retail
$
26,272

 
$
19,878

Retail contribution margin
20.4
%
 
17.0
%
Commercial
12,845

 
17,581

Commercial contribution margin
17.2
%
 
22.1
%
Service Provider
12,930

 
8,381

Service Provider contribution margin
10.6
%
 
10.2
%
Total segment contribution income
52,047

 
45,840

Corporate and unallocated costs
(11,363
)
 
(10,612
)
Amortization of intangible assets (1)
(947
)
 
(1,357
)
Stock-based compensation expense
(3,392
)
 
(3,372
)
Acquisition related compensation

 
(20
)
Litigation reserves, net
(151
)
 
53

Interest income
119

 
129

Other income (expense), net
(601
)
 
(330
)
Income before income taxes
$
35,712

 
$
30,331

________________________________
(1)
Excludes amortization related to patents.

Segment contribution income includes all product line segment revenues less the related cost of sales, research and development and sales and marketing costs. Contribution income is used, in part, to evaluate the performance of, and allocate resources to, each of the segments. Certain operating expenses are not allocated to segments because they are separately managed at the corporate level. These unallocated indirect costs include corporate costs, such as corporate research and development, general and administrative costs, stock-based compensation expenses, amortization of intangibles, acquisition-related integration costs, restructuring costs, litigation reserves and interest and other income (expense), net.

26



The Company conducts business across three geographic regions: Americas, Europe, Middle-East and Africa (“EMEA”) and Asia Pacific ("APAC'). Net revenue by geography comprises gross revenue less such items as end-user customer rebates and other sales incentives deemed to be a reduction of net revenue per the authoritative guidance for revenue recognition, sales returns and price protection. For reporting purposes revenue is attributed to each geographic region based on the location of the customer. The following table shows net revenue by geography for the periods indicated (in thousands):
 
 
Three Months Ended
 
April 1,
2012
 
April 3,
2011
United States
$
164,745

 
$
127,764

Americas (excluding U.S.)
3,610

 
4,183

United Kingdom
49,394

 
46,633

EMEA (excluding U.K.)
75,687

 
75,987

APAC
32,184

 
24,256

Total net revenue
$
325,620

 
$
278,823

Long-lived assets, comprising fixed assets, are reported based on the location of the asset. Long-lived assets by geographic location are as follows (in thousands):

 
April 1,
2012
 
December 31,
2011
United States
$
8,988

 
$
9,901

Americas (excluding U.S.)
41

 
44

EMEA
343

 
331

China
4,729

 
4,909

APAC (excluding China)
615

 
699

 
$
14,716

 
$
15,884

Significant customers as a percentage of net revenues are as follows:
 
 
Three Months Ended
 
 
April 1,
2012
 
April 3,
2011
 
Virgin Media Limited and Affiliates (Service Provider)
11
%
 
10
%
 
Ingram Micro, Inc. and Affiliates (Distributor)
9
%
 
10
%
 
Best Buy Co., Inc. and Affiliates (Retailer)
9
%
 
13
%
 
All others
71
%
 
67
%
 
 
100
%
 
100
%
 


27


13.
Fair Value of Financial Instruments
The Company measures certain financial assets and liabilities at fair value on a recurring basis.
The following tables summarize the valuation of the Company’s financial instruments as of April 1, 2012 (in thousands):
 
 
As of April 1, 2012
 
Total
 
Quoted market
prices in active
markets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Cash equivalents—money-market funds
$
28,738

 
$
28,738

 
$

 
$

Available-for-sale securities—U.S. Treasuries (1)
219,978

 
219,978

 

 

Available-for-sale securities—Certificates of Deposit (1)
183

 
183

 

 

Foreign currency forward contracts (2)
361

 

 
361

 

Total
$
249,260

 
$
248,899

 
$
361

 
$

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

 
As of April 1, 2012
 
Total    
 
Quoted market
prices in active
markets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Foreign currency forward contracts (3)
$
(348
)
 
$

 
$
(348
)
 
$

Total
$
(348
)
 
$

 
$
(348
)
 
$

 
(3)
Included in other accrued liabilities on the Company’s unaudited condensed consolidated balance sheet.
The following tables summarize the valuation of the Company’s financial instruments as of December 31, 2011 (in thousands):
 
 
As of December 31, 2011
 
Total
 
Quoted market
prices in active
markets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Cash equivalents—money-market funds
$
24,844

 
$
24,844

 
$

 
$

Available-for-sale securities—Treasuries (1)
144,703

 
144,703

 

 

Available-for-sale securities-Certificates of Deposit (1)
94

 
94

 

 

Foreign currency forward contracts (2)
1,237

 

 
1,237

 

Total
$
170,878

 
$
169,641

 
$
1,237

 
$

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

 
As of December 31, 2011
 
Total
 
Quoted market
prices in active
markets
(Level 1)
 
Significant
other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Foreign currency forward contracts (3)
$
(723
)
 
$

 
$
(723
)
 
$

Total
$
(723
)
 
$

 
$
(723
)
 
$

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

28


The Company’s investments in cash equivalents and available-for-sale securities are classified within Level 1 of the fair value hierarchy because they are valued based on quoted market prices in active markets. The Company enters into foreign currency forward contracts with only those counterparties that have long-term credit ratings of A+/A2 or higher. The Company’s foreign currency forward contracts are classified within Level 2 of the fair value hierarchy as they are valued using pricing models that take into account the contract terms as well as currency rates and counterparty credit rates. The Company verifies the reasonableness of these pricing models using observable market data for related inputs into such models. Additionally, the Company includes an adjustment for non-performance risk in the recognized measure of fair value of derivative instruments. At April 1, 2012, and December 31, 2011, the adjustment for non-performance risk did not have a material impact on the fair value of the Company’s foreign currency forward contracts. The carrying value of non-financial assets and liabilities measured at fair value in the financial statements on a recurring basis, including accounts receivable and accounts payable, approximate fair value due to their short maturities.

14.
Shipping and Handling Fees and Costs

The Company includes shipping and handling fees billed to customers in net revenue. Shipping and handling costs associated with inbound freight are included in cost of revenue and ending inventory. Shipping and handling costs associated with outbound freight are included in sales and marketing expenses and totaled $3.2 million for the three months ended April 1, 2012, and $3.2 million for the three months ended April 3, 2011.


29


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

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

Business and Executive Overview

We are a global networking company that delivers innovative products to consumers, businesses and service providers. Our products are built on a variety of proven technologies such as wireless, Ethernet and powerline, with a focus on reliability and ease-of-use. Our product line consists of wired and wireless devices that enable networking, broadband access, network connectivity, network storage and security appliances. These products are available in multiple configurations to address the needs of our end-users in each geographic region in which our products are sold.

We operate in three specific business segments: retail, commercial, and service provider. The retail business unit consists of high performance, dependable and easy-to-use home networking, storage and digital media products to connect consumers with the Internet and their content and devices. The commercial business unit consists of business networking, storage and security solutions without the cost and complexity of Big IT. The service provider business unit consists of made-to-order and retail proven, whole home networking solutions sold to service providers for sale to their customers. We conduct business across three geographic regions: Americas, Europe, Middle-East and Africa (“EMEA”) and Asia Pacific (“APAC”).

We sell our networking products through multiple sales channels worldwide, including traditional retailers, online retailers, wholesale distributors, direct market resellers (“DMRs”), value-added resellers (“VARs”), and broadband service providers. Our retail channel includes traditional retail locations domestically and internationally, such as Best Buy, Fry’s Electronics, Radio Shack, Staples, Target, Wal-Mart, Argos (U.K.), Dixons (U.K.), PC World (U.K.), MediaMarkt (Germany, Austria), Dick Smith (Australia), JB HiFi (Australia) and Elkjop (Norway). Online retailers include Amazon.com, Dell, Newegg.com and Buy.com. Our DMRs include CDW Corporation, Insight Corporation and PC Connection in domestic markets and Misco throughout Europe. In addition, we also sell our products through broadband service providers, such as multiple system operators (“MSOs”), DSL, and other broadband technology operators domestically and internationally. Some of these retailers and broadband service providers purchase directly from us, while others are fulfilled through wholesale distributors around the world. A substantial portion of our net revenue to date has been derived from a limited number of wholesale distributors and retailers, including Ingram Micro and Best Buy. We expect that these wholesale distributors and retailers will continue to contribute a significant percentage of our net revenue for the foreseeable future. Our service provider business has grown substantially, with Virgin Media representing 11% of our net revenue for the three months ended April 1, 2012, and it is difficult to ascertain a seasonal pattern given that the business is less predictable than our other core businesses.
Our net revenue increased $46.8 million, or 16.8%, to $325.6 million for the three months ended April 1, 2012, from $278.8 million for the three months ended April 3, 2011. This increase was primarily driven by an increase in Service Provider Business Unit revenue, as a result of increased sales of broadband gateways and home wireless products to our service provider customers. From a geographic perspective, the increase in net revenue was experienced across all three geographic regions, with stronger growth in the Americas and APAC regions, and modest growth in EMEA due to austerity measures in that region.

30



Our gross margin decreased to 30.7% for the three months ended April 1, 2012, from 31.5% for the three months ended April 3, 2011. The decrease in gross margin was primarily attributable to the higher percentage of our total net revenue derived from sales to service providers, which generally carry lower gross margins. Operating expenses for the three months ended April 1, 2012 were $63.7 million, or 19.6% of net revenue, compared to $57.3 million, or 20.5% of net revenue, for the three months ended April 3, 2011. This increase was primarily attributable to increases of $5.0 million in salary and other employee related expenses due to headcount growth, and $1.9 million in outside professional service costs, which included $1.5 million of increased investments in research and development projects and corporate product marketing and $0.4 million of legal services driven by more litigation activities.

Net income increased $3.9 million, or 18.7%, to $25.1 million for the three months ended April 1, 2012, from $21.2 million for the three months ended April 3, 2011. This increase was primarily attributable to an increase in gross profit of $12.1 million. The increase was partially offset by an increase in the provision for income taxes of $1.4 million and an increase in operating expenses of $6.4 million.

The commercial business, consumer, and broadband service provider markets are intensely competitive and subject to rapid technological change. We expect our competition to continue to intensify. We believe that the principal competitive factors in these markets for networking products include product breadth, size and scope of the sales channel, brand name, timeliness of new product introductions, product availability, performance, features, functionality and reliability, ease-of-installation, maintenance and use, and customer service and support. To remain competitive, we believe we must continue to aggressively invest resources in developing new products and enhancing our current products while continuing to expand our channels and maintaining customer satisfaction worldwide.

Results of Operations
The following table sets forth the unaudited condensed consolidated statements of operations and the percentage change for the three months ended April 1, 2012, with the comparable reporting periods in the preceding year.
 
 
Three Months Ended
 
April 1,
2012
 
% Change
 
April 3,
2011
 
(In thousands, except percentage data)
Net revenue
$
325,620

 
16.8
 %
 
$
278,823

Cost of revenue
225,771

 
18.2
 %
 
191,037

Gross profit
99,849

 
13.7
 %
 
87,786

Operating expenses:
 
 
 
 
 
Research and development
14,121

 
28.2
 %
 
11,014

Sales and marketing
38,970

 
6.3
 %
 
36,648

General and administrative
10,413

 
8.0
 %
 
9,645

Litigation reserves, net
151

 
**

 
(53
)
Total operating expenses
63,655

 
11.2
 %
 
57,254

Income from operations
36,194

 
18.5
 %
 
30,532

Interest income
119

 
(7.8
)%
 
129

Other income (expense), net
(601
)
 
82.1
 %
 
(330
)
Income before income taxes
35,712

 
17.7
 %
 
30,331

Provision for income taxes
10,565

 
15.6
 %
 
9,142

Net income
$
25,147

 
18.7
 %
 
$
21,189

 ** Percentage change not meaningful.


31


The following table sets forth the unaudited condensed consolidated statements of operations, expressed as a percentage of net revenue, for the periods indicated:
 
 
Three Months Ended
 
April 1,
2012
 
April 3,
2011
Net revenue
100
 %
 
100
 %
Cost of revenue
69.3
 %
 
68.5
 %
Gross margin
30.7
 %
 
31.5
 %
Operating expenses:
 
 

Research and development
4.3
 %
 
4.0
 %
Sales and marketing
12.1
 %
 
13.1
 %
General and administrative
3.2
 %
 
3.5
 %
Litigation reserves, net
0.0
 %
 
0.0
 %
Total operating expenses
19.6
 %
 
20.5
 %
Income from operations
11.1
 %
 
11.0
 %
Interest income
0.1
 %
 
0.0
 %
Other income (expense), net
(0.2
)%
 
(0.1
)%
Income before income taxes
11.0
 %
 
10.9
 %
Provision for income taxes
3.3
 %
 
3.3
 %
Net income
7.7
 %
 
7.6
 %

Three Months Ended April 1, 2012 Compared to Three Months Ended April 3, 2011

Net Revenue   
 
Three Months Ended
 
April 1,
2012
 
% Change
 
April 3,
2011
 
(In thousands, except percentage data)
Americas
$
168,355

 
27.6
%
 
$
131,947

Percentage of net revenue
51.7
%
 
 
 
47.3
%
EMEA
$
125,081

 
2.0
%
 
$
122,620

Percentage of net revenue
38.4
%
 
 
 
44.0
%
APAC
$
32,184

 
32.7
%
 
$
24,256

Percentage of net revenue
9.9
%
 
 
 
8.7
%
Total net revenue
$
325,620

 
16.8
%
 
$
278,823


Our net revenue consists of gross product shipments, less allowances for estimated returns for stock rotation and warranty, price protection, end-user customer rebates and other sales incentives deemed to be a reduction of net revenue per the authoritative guidance for revenue recognition and net changes in deferred revenue.

Net revenue increased $46.8 million, or 16.8%, to $325.6 million for the three months ended April 1, 2012, from $278.8 million for the three months ended April 3, 2011. The increase in net revenue was primarily due to growth in service provider revenue. For additional information of net revenue by segment see the section entitled “Segment Information.”

The increase in Americas and APAC net revenue was primarily driven by service provider demand for our Docsis 3.0 and DSL gateways. We experienced only a slight increase in EMEA net revenue due to the softening in demand as the region continues to deal with current austerity measures.

32


Cost of Revenue and Gross Margin

 
Three Months Ended
 
April 1,
2012
 
% Change
 
April 3,
2011
 
(In thousands, except percentage data)
Cost of revenue
$
225,771

 
18.2
%
 
$
191,037

Gross margin percentage
30.7
%
 
 
 
31.5
%

Cost of revenue consists primarily of the following: the cost of finished products from our third party contract manufacturers; overhead costs, including purchasing, product planning, inventory control, warehousing and distribution logistics; third-party software licensing fees; inbound freight; warranty costs associated with returned goods; write-downs for excess and obsolete inventory and amortization expense of certain acquired intangibles. We outsource our manufacturing, warehousing and distribution logistics. We believe this outsourcing strategy allows us to better manage our product costs and gross margin. Our gross margin can be affected by a number of factors, including fluctuation in foreign exchange rates, sales returns, changes in average selling prices, end-user customer rebates and other sales incentives, changes in our cost of goods sold due to fluctuations in prices paid for components, net of vendor rebates, warranty and overhead costs, inbound freight, conversion costs and charges for excess or obsolete inventory.

Cost of revenue increased $34.7 million, or 18.2%, to $225.8 million for the three months ended April 1, 2012, from $191.0 million for the three months ended April 3, 2011. Our gross margin decreased to 30.7% for the three months ended April 1, 2012, from 31.5% for the three months ended April 3, 2011. The decrease in gross margin was primarily attributable to relatively faster growth in our revenue from service providers, which generally carries lower gross margins than our other products. The sales from service providers increased as a percentage of net revenue to 37.5% in the three months ended April 1, 2012 compared to 29.4% in the three months ended April 3, 2011. In addition, customer sales incentives that impact gross profit increased as percentage of revenue in the three months ended April 1, 2012 compared to the same period a year ago. However, we utilized less air freight in the three months ended April 1, 2012 as compared to the same period a year ago, which partially offset the decrease in gross margins described above.

Operating Expenses

Research and Development
 
 
Three Months Ended
 
April 1,
2012
 
% Change
 
April 3,
2011
 
(In thousands, except percentage data)
Research and development expense
$
14,121

 
28.2
%
 
$
11,014

Percentage of net revenue
4.3
%
 
 
 
4.0
%

Research and development expenses consist primarily of personnel expenses, payments to suppliers for design services, safety and regulatory testing, product certification expenditures to qualify our products for sale into specific markets, prototypes and other consulting fees. Research and development expenses are recognized as they are incurred. We have invested in building our research and development organization to enhance our ability to introduce innovative and easy-to-use products. In the future, we expect research and development expenses will increase in absolute dollars and as a percentage of revenue as we broaden our core competencies and expand into new software and networking product technologies.

Research and development expenses increased $3.1 million, or 28.2%, to $14.1 million for the three months ended April 1, 2012, from $11.0 million for the three months ended April 3, 2011. The increase was primarily attributable to an increase of $1.5 million in payroll and other employee-related costs driven by additional headcount, and $0.8 million in outside service costs, primarily related to our increased investment in research and development projects. Research and development headcount increased by 50 employees to 232 employees at April 1, 2012 compared to 182 employees at April 3, 2011 to support our research and development efforts.


33


Sales and Marketing
 
 
Three Months Ended
 
April 1,
2012
 
% Change
 
April 3,
2011
 
(In thousands, except percentage data)
Sales and marketing expense
$
38,970

 
6.3
%
 
$
36,648

Percentage of net revenue
12.1
%
 
 
 
13.1
%

Sales and marketing expenses consist primarily of advertising, trade shows, corporate communications and other marketing expenses, product marketing expenses, outbound freight costs, personnel expenses for sales and marketing staff and technical support expenses.

Sales and marketing expenses increased $2.4 million, or 6.3%, to $39.0 million for the three months ended April 1, 2012, from $36.6 million for the three months ended April 3, 2011. The increase was primarily attributable to a $2.8 million increase in payroll and other employee expenses mainly driven by additional headcount. Sales and marketing headcount increased by 46 employees to 364 employees at April 1, 2012 compared to 318 employees at April 3, 2011. Additionally, the increase was attributable to an increase of $0.4 million in outside professional costs primarily driven by corporate product marketing. The increase was partially offset by a decrease in operating expense related marketing campaigns of $1.1 million. The decrease in operating expense related marketing is primarily due to a higher percentage of our revenue coming from sales to service providers, which generally have fewer marketing campaigns.

General and Administrative
 
 
Three Months Ended
 
April 1,
2012
 
% Change
 
April 3,
2011
 
(In thousands, except percentage data)
General and administrative expense
$
10,413

 
8.0
%
 
$
9,645

Percentage of net revenue
3.2
%
 
 
 
3.5
%

General and administrative expenses consist of salaries and related expenses for executives, finance and accounting, human resources, information technology, professional fees, allowance for doubtful accounts and other general corporate expenses.

General and administrative expenses increased $0.8 million, or 8.0%, to $10.4 million for the three months ended April 1, 2012, from $9.6 million for the three months ended April 3, 2011. The increase was primarily attributable to an increase in salary and variable compensation, which was largely driven by headcount growth, and an increase in outside legal service costs due to additional litigation activities. General and administrative headcount increased by 12 employees to 117 employees at April 1, 2012 compared to 106 employees at April 3, 2011.

Litigation Reserve

During the three months ended April 1, 2012 and April 3, 2011, we recorded a litigation reserve expense of $151,000 related to the termination of a disputed vendor contract, and a benefit of $53,000 for the release of estimated costs related to the settlement of various lawsuits filed against us, respectively.

For a detailed discussion of our litigation matters, refer to Note 9, Commitments and Contingencies, in the Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q.
.

34


Interest Income and Other Income (Expense), Net
 
 
Three Months Ended
 
April 1,
2012
 
% Change
 
April 3,
2011
 
(In thousands)
Interest income
$
119

 
(7.8
)%
 
$
129

Other income (expense), net
(601
)
 
82.1
 %
 
(330
)
Total interest income and other income (expense), net
$
(482
)
 
**

 
$
(201
)

Interest income represents amounts earned on our cash, cash equivalents and short-term investments. Other income (expense), net, primarily represents gains and losses on transactions denominated in foreign currencies and other miscellaneous expenses.

Interest income decreased $10,000 to $119,000 for the three months ended April 1, 2012 from $129,000 for the three months ended April 3, 2011. The decrease in interest is primarily attributable to a drop in interest rate for treasuries in the three months ended April 1, 2012, as compared to the three months ended April 3, 2011.

Other income (expense), net, increased $271,000 in expenses, to an expense of $601,000 for the three months ended April 1, 2012, from an expense of $330,000 for the three months ended April 3, 2011. Our foreign currency hedging program reduced volatility associated with hedged currency exchange rate movements during three months ended April 1, 2012. The expense of $601,000 is primarily related to losses and the forward points for hedged currencies. For details of our hedging program and related foreign currency contracts, refer to Note 6, Derivative Financial Instruments, in the Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q.

Provision for Income Taxes

The income tax provision for the three months ended April 1, 2012 was $10.6 million or an effective tax rate of 29.6%, compared to the tax provision for the three months ended April 3, 2011 of $9.1 million or an effective tax rate of 30.1%. The income tax expense increased for the three months ended April 1, 2012 compared to April 3, 2011 due to higher pre-tax earnings. The decrease in the effective tax rate for the three month period ended April 1, 2012 compared to the same period in the prior year was primarily caused by higher forecasted pre-tax earnings in foreign jurisdictions with tax rates lower than the U.S. federal rate. This decrease was partially offset by the expiration of the US research tax credit that is no longer available after December 31, 2011. We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Our 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.

Net Income

Net income increased $3.9 million, or 18.7%, to $25.1 million for the three months ended April 1, 2012, from $21.2 million for the three months ended April 3, 2011. This increase was primarily attributable to an increase in gross profit of $12.1 million. The increase in gross profit was partially offset by an increase in the provision for income taxes of $1.4 million and an increase in operating expenses of $6.4 million.

Segment Information

A description of our products and services, as well as segment financial data, for each segment and a reconciliation of segment contribution income to income before income taxes can be found in Note 12, Segment Information, Operations by Geographic Area and Significant Customers, in the Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q. Future changes to our organizational structure or business may result in changes to the reportable segments disclosed. The discussions below include the results of each of our segments for the three months ended April 1, 2012 with the comparable reporting periods in the preceding year.

Segment contribution income includes all product line segment net revenues less the related cost of sales, research and development, sales and marketing costs. Contribution income is used, in part, to evaluate the performance of, and allocate resources to, each of the segments. Certain operating expenses are not allocated to segments because they are separately managed at the corporate level. These unallocated indirect costs include corporate costs, such as corporate research and development, general and administrative costs, stock-based compensation expenses, amortization of intangibles, acquisition-related compensation, restructuring costs, litigation reserves, and interest and other income (expense), net.


35


Retail
 
 
Three Months Ended
  
April 1,
2012
 
% Change
 
April 3,
2011
 
( in thousands, except percentage data)
Net revenue
$
128,977

 
10.1
%
 
$
117,125

Contribution income
26,272

 
32.2
%
 
19,878

Contribution margin
20.4
%
 
 
 
17.0
%

Net revenue in the retail business unit increased $11.9 million, or 10.1%, to $129.0 million for the three months ended April 1, 2012, from $117.1 million for the three months ended April 3, 2011. The increase is primarily due to strong sales of our home wireless products. Contribution income increased $6.4 million, or 32.2%, to $26.3 million for the three months ended April 1, 2012, from $19.9 million for the three months ended April 3, 2011. The increase is due to strong revenue growth, while cost of sales grew at a slower pace. Specifically costs of sales was impacted by lower excess and obsolete inventory charges and lower air freight costs.
Commercial
 
 
Three Months Ended
  
April 1,
2012
 
% Change
 
April 3,
2011
 
(in thousands, except percentage data)
Net revenue
$
74,632

 
(6.3
)%
 
$
79,622

Contribution income
12,845

 
(26.9
)%
 
17,581

Contribution margin
17.2
%
 
 
 
22.1
%

Net revenue in the commercial business unit decreased $5.0 million, or 6.3%, to $74.6 million for the three months ended April 1, 2012, from $79.6 million for the three months ended April 3, 2011. The decrease is primarily driven by a decrease in sales from our network storage product line, reflective of the continued fallout from the Thailand floods in 2011 and the resulting impact to the storage market. We expect disk supply will continue to improve and pricing will ease over the next three quarters. Contribution income decreased $4.7 million, or 26.9%, to $12.8 million for the three months ended April 1, 2012, from $17.6 million for the three months ended April 3, 2011. The decrease is primarily due to the decrease in revenue, while operating expenses grew at a steady pace. The increase in operating expenses for the commercial business unit was primarily driven by headcount related research and development expenses. Commercial related research and development headcount increased by 20 employees to 114 employees in the three months ended April 1, 2012, from 94 employees in the three months ended April 3, 2011.
Service Provider
 
 
Three Months Ended
  
April 1,
2012
 
% Change
 
April 3,
2011
 
( in thousands, except percentage data)
Net revenue
$
122,011

 
48.7
%
 
$
82,076

Contribution income
12,930

 
54.3
%
 
8,381

Contribution margin
10.6
%
 
 
 
10.2
%

Net revenue in the service provider business unit increased $39.9 million, or 48.7%, to $122.0 million for the three months ended April 1, 2012, from $82.1 million for the three months ended April 3, 2011. The increase is primarily driven by sales growth in Docsis 3.0 products and DSL gateways sold to our service provider customers, partially driven by the acquisition of the Customer Networking Solutions division of Westell Technologies, Inc. Contribution income increased $4.5 million, or 54.3%, to $12.9 million for the three months ended April 1, 2012, from $8.4 million for the three months ended April 3, 2011. The increase is due to revenue growth, while headcount related expenses grew at a steady pace. Due to customer purchase patterns and potential supply constraints the service provider business is less predictable than our other core businesses.

36


Liquidity and Capital Resources
Our cash and cash equivalents balance decreased from $208.9 million as of December 31, 2011 to $149.3 million as of April 1, 2012. Our short-term investments, which represent the investment of funds available for current operations, increased from $144.8 million as of December 31, 2011 to $220.2 million as of April 1, 2012, as we shifted assets from Treasuries to low risk money market funds with higher returns. Operating activities during the three months ended April 1, 2012 provided cash of $12.8 million, compared to $4.6 million provided in the three months ended April 3, 2011. Investing activities during the three months ended April 1, 2012 used cash of $78.1 million, primarily for purchases of short-term investments. During the three months ended April 1, 2012, financing activities provided cash of $5.6 million, resulting primarily from the issuance of common stock related to stock option exercises and our employee stock purchase program.
Our days sales outstanding ("DSO") decreased from 76 days as of December 31, 2011 to 70 days as of April 1, 2012. DSO as of December 31, 2011 was higher due to seasonal payment terms extended to our larger retail customers; as of April 1, 2012 we have returned to a more normal range of DSO.
Our accounts payable decreased from $117.3 million at December 31, 2011 to $79.5 million at April 1, 2012. The decrease was primarily attributable to timing of payments.
Inventory decreased by $29.4 million from $163.7 million at December 31, 2011 to $134.3 million at April 1, 2012. In the three months ended April 1, 2012 we experienced annualized ending inventory turns of approximately 6.7, up from approximately 5.2 in the three months ended December 31, 2011.
We enter into foreign currency forward-exchange contracts, which typically mature in three to five months, to hedge a portion of our exposure to foreign currency fluctuations of foreign currency-denominated revenue, costs of revenue, certain operating expenses, receivables, payables, and cash balances. We record in the consolidated balance sheet at each reporting period the fair value of our forward-exchange contracts and record any fair value adjustments in our Unaudited Condensed Consolidated Statements of Operations and in our Unaudited Condensed Consolidated Balance Sheet. Gains and losses associated with currency rate changes on hedge contracts that are non-designated under the authoritative guidance for derivatives and hedging are recorded within other income (expense), net, offsetting foreign exchange gains and losses on our monetary assets and liabilities. Gains and losses associated with currency rate changes on hedge contracts that are cash flow hedges under the authoritative guidance for derivatives and hedging are recorded within cumulative other comprehensive income until the related revenue, costs of revenue, or expenses are recognized.
In October 2008, the Board of Directors authorized management to repurchase up to 6,000,000 shares of our common stock in the open market. The stock repurchase authorization does not have an expiration date and the pace of repurchase activity is at the discretion of management and contingent on a number of factors, including levels of cash generation from operations, cash requirements for acquisitions and the price of our common stock. We did not repurchase any shares under this authorization during the three months ended April 1, 2012 and April 3, 2011. As of April 1, 2012, we were authorized to repurchase up to 4.8 million shares under the share repurchase plan.

In the three months ended April 1, 2012, we repurchased approximately 16,000 shares, or $0.6 million of our common stock under a repurchase program to help administratively facilitate the withholding and subsequent remittance of personal income and payroll taxes for individuals receiving RSUs. Similarly, during the three months ended April 3, 2011, we repurchased approximately 24,000 shares, or $0.9 million of our common stock, respectively, under the same program to help facilitate tax withholding for RSUs. These shares were retired upon repurchase.

Based on our current plans and market conditions, we believe that our existing cash, cash equivalents and short-term investments will be sufficient to satisfy our anticipated cash requirements for at least the next twelve months. However, we may require or desire additional funds to support our operating expenses and capital requirements or for other purposes, such as acquisitions, and may seek to raise such additional funds through public or private equity financing or from other sources. We cannot assure you that additional financing will be available at all or that, if available, such financing will be obtainable on terms favorable to us and would not be dilutive. Our future liquidity and cash requirements will depend on numerous factors, including the introduction of new products and potential acquisitions of related businesses or technology.

Contractual Obligations
There have been no significant changes during the three months ended April 1, 2012 to the contractual obligations disclosed in Part II, Item 7, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2011.
We lease office space, cars and equipment under non-cancelable operating leases with various expiration dates through December 2026. The terms of certain of our facility leases provide for rental payments on a graduated scale. We recognize rent

37


expense on a straight-line basis over the lease period and have accrued for rent expense incurred but not paid.
We enter into various inventory-related purchase agreements with suppliers. Generally, under these agreements, 50% of the 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. At April 1, 2012, we had approximately $176.3 million in non-cancelable purchase commitments with suppliers. We establish a loss liability for all products we do not expect to sell for which we have committed purchases from suppliers. Such losses have not been material to date.
As of April 1, 2012, we had total gross unrecognized tax benefits and related interest liabilities of $19.2 million. The timing and amount of any payments which could result from these unrecognized tax benefits will depend upon a number of factors including the resolution of ongoing audits. Accordingly, the timing and the amount of payments which may occur within the next 12 months cannot be estimated.

Off-Balance Sheet Arrangements
As of April 1, 2012, we did not have any off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

Critical Accounting Policies and Estimates
Our critical accounting policies are disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011. Our critical accounting policies have not materially changed during the three months ended April 1, 2012.

Item 3.
Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk

We do not use derivative financial instruments in our investment portfolio. We have an investment portfolio of fixed income securities that are classified as “available-for-sale securities.” These securities, like all fixed income instruments, are subject to interest rate risk and will fall in value if market interest rates increase. We attempt to limit this exposure by investing primarily in highly rated short-term securities. Additionally, our investment policy generally limits the amount of credit exposure to any one issuer. Our investment policy requires investments to be rated triple-A with the objective of minimizing the potential risk of principal loss. Due to the short duration and conservative nature of our investment portfolio, a movement of 10% by market interest rates would not have a material impact on our operating results and the total value of the portfolio over the next fiscal year. We monitor our interest rate and credit risks, including our credit exposure to specific rating categories and to individual issuers. There were no impairment charges on our investments during the three months ended April 1, 2012.

Foreign Currency Transaction Risk

We invoice some of our international customers in foreign currencies including, but not limited to, the Australian dollar, British pound, euro, and Japanese yen. As the customers that are currently invoiced in local currency become a larger percentage of our business, or to the extent we begin to bill additional customers in foreign currencies, the impact of fluctuations in foreign exchange rates could have a more significant impact on our results of operations. For those customers in our international markets that we continue to sell to in U.S. dollars, an increase in the value of the U.S. dollar relative to foreign currencies could make our products more expensive and therefore reduce the demand for our products. Such a decline in the demand for our products could reduce sales and negatively impact our operating results. Certain operating expenses of our foreign operations require payment in the local currencies.

We are exposed to risks associated with foreign exchange rate fluctuations due to our international sales and operating activities. These exposures may change over time as business practices evolve and could negatively impact our operating results and financial condition. The objective of these foreign currency forward contracts is to reduce the impact of currency exchange rate movements on our operating results by offsetting gains and losses on the forward contracts with increases or decreases in foreign currency transactions. The contracts are marked-to-market on a monthly basis with gains and losses included in other income (expense), net in the Unaudited Condensed Consolidated Statements of Operations, and in cumulative other comprehensive income on the Balance Sheet. We do not use foreign currency contracts for speculative or trading purposes. Hedging of our balance sheet and anticipated cash flow exposures may not always be effective to protect us against currency exchange rate fluctuations. In addition, we do not fully hedge our balance sheet and anticipated cash flow exposures, leaving us at risk to foreign exchange gains and losses on the un-hedged exposures. If there were an adverse movement in exchange rates, we might suffer significant losses. See Note 6, Derivative Financial Instruments, of the Notes to Unaudited Condensed Consolidated Financial Statements

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for additional disclosure on our foreign currency contracts, which are hereby incorporated by reference into this Part I, Item 3.

We are exposed to credit losses in the event of nonperformance by the counter-parties of our foreign currency forward contracts and non-designated hedges. We enter into foreign currency forward contracts and non-designated hedges with high-quality financial institutions. In addition, the foreign currency forward contracts and non-designated hedges are limited to a time period of less than one year, and we continuously evaluate the credit standing of our counter-party financial institutions. See Note 6, Derivative Financial Instruments, to the Notes to Unaudited Condensed Consolidated Financial Statements.

A hypothetical 10% movement in foreign exchange rates would result in an after-tax positive or negative impact of $344,000 to net income, net of our hedged position, at April 1, 2012. Actual future gains and losses associated with our foreign currency exposures and positions may differ materially from the sensitivity analyses performed as of April 1, 2012 due to the inherent limitations associated with predicting the foreign currency exchange rates, and our actual exposures and positions. For the three months ended April 1, 2012, 7.4% of total net revenue was denominated in a currency other than the U.S. dollar.

Item 4.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Based on an evaluation under the supervision and with the participation of our management (including our Chief Executive Officer and Chief Financial Officer), our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), were effective as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and (ii) accumulated and communicated to management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
Changes in Internal Control over Financial Reporting
There have been no changes in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially effect, our internal control over financial reporting. It should be noted that any system of controls, however well designed and operated, can provide only reasonable assurance, and not absolute assurance, that the objectives of the system are met.  In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events.  Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals in all future circumstances.

PART II: OTHER INFORMATION
Item 1.
Legal Proceedings
The information set forth under Note 9, Commitments and Contingencies, in Item 1 of Part I of this Quarterly Report on Form 10-Q, is incorporated herein by reference. For an additional discussion of certain risks associated with legal proceedings, see the section entitled “Risk Factors” in Part II, Item 1A of this Quarterly Report on Form 10-Q.


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Item 1A.
Risk Factors

Investing in our common stock involves a high degree of risk. The risks described below are not exhaustive of the risks that might affect our business. Other risks, including those we currently deem immaterial, may also impact our business. Any of the following risks could materially adversely affect our business operations, results of operations and financial condition and could result in a significant decline in our stock price. Before deciding to purchase, hold or sell our common stock, you should carefully consider the risks described in this section. This section should be read in conjunction with the unaudited condensed consolidated financial statements and accompanying notes thereto, and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Quarterly Report on Form 10-Q.

We have marked with an asterisk (*) those risks described below that reflect substantive changes from the risks described under Part I, Item 1A "Risk Factors" included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 29, 2012.

We expect our operating results to fluctuate on a quarterly and annual basis, which could cause our stock price to fluctuate or decline.

Our operating results are difficult to predict and may fluctuate substantially from quarter-to-quarter or year-to-year for a variety of reasons, many of which are beyond our control. If our actual results were to fall below our estimates or the expectations of public market analysts or investors, our quarterly and annual results would be negatively impacted and the price of our stock could decline. Other factors that could affect our quarterly and annual operating results include those listed in the risk factors section of this report and others such as:

changes in the pricing policies of or the introduction of new products by us or our competitors;

unanticipated shift or decline in profit by geographical region that would adversely impact our tax rate;

slow or negative growth in the networking product, personal computer, Internet infrastructure, home electronics and related technology markets, as well as decreased demand for Internet access;

operational disruptions, such as transportation delays or failure of our order processing system, particularly if they occur at the end of a fiscal quarter;

geopolitical disruption leading to delay or even stoppage of our operations in manufacturing, transportation, technical support and research and development;

delay or failure of our service provider customers to purchase at the volumes that they forecast;

foreign currency exchange rate fluctuations in the jurisdictions where we transact sales and expenditures in local currency;

changes in or consolidation of our sales channels and wholesale distributor relationships or failure to manage our sales channel inventory and warehousing requirements;

delay or failure to fulfill orders for our products on a timely basis;

allowance for bad debts exposure with our existing customers and new customers, particularly as we expand into new international markets;

disruptions or delays related to our financial and enterprise resource planning systems;

our inability to accurately forecast product demand;

component supply constraints from our vendors;

unfavorable level of inventory and turns;

unanticipated shift in overall product mix from higher to lower margin products that would adversely impact our margins;

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