Why Netgear, Inc. Stock Dropped 16.5% in October

By Markets Fool.com

Netgear's high-end Nighthawk routers helped drive growth this quarter. Image source: Netgear, Inc.

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What happened

Shares ofNetgear Inc. (NASDAQ: NTGR) fell 16.5% in the month of October,according to data provided byS&P Global Market Intelligence, after the networking hardware company announced stronger-than-expected third-quarter 2016 results but followed with worrisome guidance.

More specifically, Netgear saw revenue decline 1% year over year, to $338.5 million. Trending toward the bottom line, adjusted operating margin was 11.5%, up from 10.3% in the same year-ago period, while adjusted net income grew 19.4%, to $25.9 million. Adjusted net income per share also increased 13.4%, to $0.76.

So what

Of course, Netgear's top-line decline doesn't look encouraging at first glance. But keep in mind that three months earlier, Netgear told investors to expect lower third-quarter revenue of $315 million to $330 million, and adjusted operating margin of 10.5% to 11.5%.

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According to management, Netgear's outperformance was primarily driven by a strong back-to-school showing from its retail segment -- where sales grew 18.4% year over year, to $194.2 million -- with solid demand for its Nighthawk routers, cable gateways, and Arlo home security cameras. At the same time, its commercial business performed as expected, with revenue climbing 12.6% to $73.4 million. And the recently restructured service provider business saw revenue decline 37.1%, to $70.9 million, which was roughly $5 million above expectations as orders from several customers were unexpectedly pulled forward. Even excluding those orders, though, Netgear's revenue still would have arrived above the high end of its guidance range.

Now what

If you're wondering why Netgear stock fell after its report, look no further than its latest outlook. For the current quarter, Netgear anticipates revenue of $340 million to $355 million, the midpoint of which represents a 3.7% year-over-year decline. And operating margin is expected to be in the range of 10.5% to 11.5%.

To explain the accelerated year-over-year revenue decline in revenue -- and assuming Netgear isn't under-promising with the intention of once again over-delivering -- Netgear management stated the service provider business is now expected to fall to a quarterly revenue run rate of around $55 million, down from the company's previous targets for a quarterly run rate closer to $75 million.

At the same time, the service provider segment also tends to come with lower margins, which is part of the reason Netgear's profitability has improved. Netgear CEO Patrick Lo reiterated this stance, stating during their subsequent conference call, "We continue to effectively manage this business unit, protecting our margin rather than chasing commoditized business at the top line."

In the end, I think that's a wise move by Netgear, and I believe investors should have no problem sacrificing unprofitable revenue as long as the company's burgeoning retail business continues to outperform.

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Steve Symington has no position in any stocks mentioned. The Motley Fool recommends Netgear. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.