Netgear Jumps in Trading Debut

Its IPO is looking hot, but the space keeps getting more competitive.
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Updated from July 30

Just as Wall Street analysts are becoming wary of Wi-Fi, investors are warming up to it.

Netgear

(NTGR) - Get Report

, which makes gear used for wireless fidelity networks (as well as Ethernet networks and broadband), made a strong showing when it started trading Thursday.

The company raised $98 million through an initial public offering of 7 million shares priced at $14 each. The offering was underwritten by Lehman Brothers, Merrill Lynch and UBS Warburg. Tuesday, in light of robust demand, Netgear's offering price was hoisted from the $10 to $12 range to $12 to $14.

At midday, shares of Netgear were gaining $3.30, or 24%, to $17.30.

But just because Netgear qualifies for an IPO (having delayed an earlier attempt to come public in 2001) doesn't mean it's a smart long-term investment. While predicting Netgear's IPO will do well, cautious fund managers and analysts say the company must contend with bruising price pressure and mounting heavyweight competition in the Wi-Fi equipment market.

One fund manager, speaking anonymously, said he plans to buy IPO shares and quickly offload them. He's betting the stock will get a rise from bullish sentiment on Wi-Fi. "It's a theme stock: Wireless LAN, people love it," says the manager. But he's not interested in holding on to shares. "The space is very hot at the moment, but it's drawing a huge amount of competition," he explains.

Wi-Fi Grows Sky-High

Still, Netgear's IPO offers a welcome respite for a growth-starved tech market. Market watchers say the stock should do well in its debut, buoyed by the upbeat buzz around Wi-Fi.

Not surprisingly, Netgear says its wireless networking and broadband products are outgrowing Ethernet, which historically generated most of its revenue.

The broad market for wireless LAN network equipment is showing double-digit growth. Revenue for WLAN gear grew 16% year-over-year in the first quarter of 2003, to $478 million, according to Synergy Research Group.

Synergy expects the market to post compound annual growth of 14% over the next few years, hitting $3 billion by the end of 2006.

On top of that, the resurgence in equity offerings bodes well for Netgear's debut. "In general, the atmosphere for IPOs has been positive of late, and Netgear should be a beneficiary of this environment," says Richard Peterson, an analyst who focuses on corporate finance for Thomson Financial. July alone saw six IPOs -- more than the five deals that came to market in the first and second quarter, respectively.

And shares of another Wi-Fi play, software company

iPass

(IPAS) - Get Report

, shot up more than 33% in its IPO last week. With sales of only $115 million over the past 12 months, iPass already claims a market cap of $1.07 billion.

"So far, of only four tech IPOs this year, each has been markedly higher on the first day of trading. I suspect Netgear will follow suit," says Peterson. "Plus, of the 16 deals priced this year, only one has fallen below its offer price."

"Netgear does fit the criteria of the recent crop of IPOs that are working -- it's a real company; it has real sales, real earnings," says Peter Bard, an analyst at Renaissance Capital, a research firm focusing on new issues. "It's been around for a while."

Hot IPO, Lukewarm Reception

But that doesn't necessarily make Netgear a standout investment, Bard adds. "They're one of the leaders in equipment but not the largest company in the space," he points out.

That distinction is reserved for

Linksys

, which owned nearly 28% of the market in consumer wireless LAN as of the first quarter, according to Synergy. Linksys, which gained even more muscle from its recent acquisition by

Cisco

(CSCO) - Get Report

, claims almost double the share of fourth-ranked Netgear, which has only 15%.

Because of harsh competition from the likes of Linksys,

Microsoft

(MSFT) - Get Report

(a newcomer but formidable rival in Wi-Fi) and

D-Link

, Netgear faces serious pricing pressure in its core markets. And therein lies the biggest worry for investors: Netgear's profits could suffer as the price of networking equipment keeps plunging.

Netgear has posted losses for three of the past four reported years, though more recently it has moved into the black, reporting profits for four quarters running. In 2002, the company slipped to a loss of $9.7 million on sales of $273 million, after shelling out a $17.9 million dividend for preferred stockholders. Without the dividend, it would have seen an $8.1 million profit.

To the company's credit, Netgear has done a smart job of wangling concessions from its suppliers. In other words, its own costs have dropped at about the same pace as the price of the goods it sells. The company has even managed to expand its gross margins over the past few years, from 17.6% in 2000 to 25.4% in 2002.

But there's unanimous agreement that commoditization pressure in WLAN -- the hottest part of Netgear's business -- is a huge challenge for all the players in the business. Indeed, just this month,

investors cheered when chipmaker

Intersil

(ISIL)

announced it was selling off its Wi-Fi business to concentrate on more profitable analog silicon.

Prices in two of Netgear's markets, WLAN access points and network interface cards, are expected to plummet over the next few years. Average selling prices of wireless LAN access points are likely to fall at an annual rate of 8% a year between 2000 and 2008, according to estimates by Allied Business Intelligence Research.

Meanwhile, the cost of NICs (for 802.11b, the most popular current flavor of Wi-Fi) are expected to decline from their current price of just under $50 to less than $35 in another year or two, reckons Aaron Vance of Synergy Research. As recently as a year ago, the cards retailed for around $100.

To be sure, Netgear can boast of solid revenue growth, with sales up 23% between 2001 and 2002. But to translate that into earnings leverage, the company will need to boost sales volume without spending too much on R&D and marketing.

That may be difficult, Bard says: "They're spending a lot on promotions and advertising, basically because the competition's really intense." In 2002, spending on sales and marketing grew by 34%, outpacing the 23% rise in annual sales.

Hands in Pockets

Leery of the fight shaping up in Wi-Fi, fund managers aren't exactly queuing up for Netgear shares -- even though they expect a decent reception to the IPO.

"I think it's going to be a hot deal," says Gil Knight, manager of the

(ARPEX)

ARK Small Cap Equity Institutional fund. "The IPO market's been picking up. Netgear is also growing like topsy." But Knight isn't in any hurry to buy; he says he would want to see how Netgear trades before considering an investment.

Netgear is "not something I'm extremely excited about. It's not something I'd want to hold for the long term," says Vincent Colicchio, manager of the All-American Equity Fund. "But I would get excited for a trade, because there's a lot of

positive sentiment right now for the Web."

He might look to pick up some shares if, for example, one of the bigger Internet names "had a poor earnings number and they all traded down on sentiment. If there was a crack in tech, I may look to pick them up as a short-term trade if I see them becoming cheap."