Netscout Systems Inc Q3 FY2020 Earnings Call

Ladies and gentlemen, thank you for being here and welcome to NetScout's Third Quarter Fiscal Year 2020 Results Conference Call. All participants are currently in listen-only mode until we reach the question-and-answer segment of the call. Please note that this call is being recorded. Joining us today are Tony Piazza, Vice President of Corporate Finance, along with his colleagues at NetScout. I will now hand the call over to Tony Piazza to start the Company's prepared remarks. Please proceed.

Great, thank you, operator, and good morning everyone. Welcome to NetScout's third quarter fiscal year 2020 conference call for the period ended December 31, 2019. Joining me today are Anil Singhal, NetScout's President and CEO; Michael Szabados, NetScout's Chief Operating Officer; and Jean Bua, NetScout's Executive Vice President and Chief Financial Officer. There is a slide presentation that accompanies our prepared remarks, you can advance the slides in the webcast viewer to follow our commentary, both the slides and the prepared remarks can be accessed in multiple areas within the investor relations section of our website at www.netscout.com including the IR landing page under financial results, the webcast itself and under financial information on the quarterly results page. Moving on to Slide 3, today's conference call will include forward-looking statements. These statements may be prefaced by words such as anticipate, believe, and expect and will cover a range of topics that are not strictly historical facts such as our financial guidance, our market opportunities and market share, key business initiatives and future product plans, along with their potential impact on our financial performance. These forward-looking statements involve risks and uncertainties and actual results could differ materially from the forward-looking statements due to known and unknown risks, uncertainties, assumptions and other factors, which are described on this slide and in today's financial results press release as well as in the Company's Annual Report on Form 10-K for the year ended March 31, 2019 and subsequent Quarterly Reports on Form 10-Q on file with the Securities and Exchange Commission. NetScout assumes no obligation to update any forward-looking information contained in this communication or with respect to the announcements described herein. Let's turn to Slide 4, which involves non-GAAP metrics. While this slide presentation includes both GAAP and Non-GAAP results, unless otherwise stated, financial information discussed on today's conference call will be on a non-GAAP basis only. The rationale for providing non-GAAP measures along with the limitations of relying solely on those measures is detailed on this slide and in today's press release. These measures should not be considered in isolation from or as a substitute for financial information prepared in accordance with GAAP. Additionally, as a result of the sale of the HNT tools business, we will provide certain organic non-GAAP performance trends, which removes HNT tools revenue for comparability purposes. Reconciliations of all non-GAAP metrics with the applicable GAAP measures are provided in the appendix of this slide presentation, in today's earnings press release and they are also on our website. I will now turn the call over to Anil for his prepared remarks. Anil?

Thank you, Tony. Good morning everyone, and thank you for joining us. Let's begin on Slide 6 with a brief recap of our quarterly non-GAAP results. From a financial perspective, we delivered strong third-quarter fiscal year 2020 performance with both revenue and earnings per share exceeding the high end of our expectations for the quarter. Revenue for the quarter increased 6% over the same quarter last year at $260.1 million. The quarter benefited from year-over-year growth in both our service provider and enterprise verticals. We exceeded our expectation on revenue primarily due to the acceleration of a service provider transaction that we originally expected to occur next quarter. Earnings per share was $0.73 which increased more than 60% compared with the same quarter last year. We exceeded our earnings per share expectation due to record software-only revenue that benefited our gross margin as well as corporate tax clarifications and capital structure management initiatives that added incremental benefits in the quarter. From a strategic perspective, we continue to advance our product initiatives at a steady pace and have begun combining elements of our service assurance and security technologies to provide enhanced capabilities to our customers that leverage the strengths of our offerings. We believe this combination provides something unique and valuable in the marketplace. On our go-to-market initiatives, we continue to showcase our products at major industry events and believe that our sales force integration has stabilized, and the teams are beginning to build pipeline and gain good traction. Let's move to Slide 7 for some further perspective as we review business highlights. In our service provider vertical, revenue grew 8% compared with the same quarter last year. In the quarter, we recognized revenue from a tier-1 North American carrier that continues to evolve its nationwide 5G network. This is the second 5G-related order from this carrier this fiscal year. Michael will elaborate further on this transaction in his remarks. During the quarter, we also recognized revenue from a couple of large orders from international carriers that continue to evolve their 4G-LTE networks. These deals were a continuation of our relationships with these carriers that demonstrate the value of our visibility solutions and our incumbency as they evolve their networks. Finally, as I said earlier, the service provider vertical also benefited from the acceleration of revenue associated with a transaction that we originally expected to occur next quarter. We were pleased to recognize the revenue early, but as it is timing related, it does not alter our revenue expectation for this full fiscal year. We see customers advancing their 4G-LTE networks in international geographies, including Latin America, Europe, the Middle East, and parts of Asia. We also continue to work closely with our North American and Asian customers as they advance their 5G initiatives. While we are pleased to see some leading carriers accelerate their 5G initiatives, we believe that 5G is a long-term opportunity and driver of our growth that will benefit our business in numerous ways especially as computing becomes more mainstream. We are looking forward to showcasing our 5G service assurance solutions at the Mobile World Conference in Barcelona, Spain next month. Turning to our Enterprise vertical, revenue grew 3% over the same quarter last year. Overall, in this vertical, our customers continue to advance their digital transformation and security initiatives. Michael will highlight some of these wins during his remarks which demonstrate the value of our visibility solutions at customers' transition to the cloud. We also believe that the past disruption that we experienced from the international side of our sales force reorganization in this vertical is now primarily behind us. In both verticals, our customers are adopting our software-only form factor that and we saw record revenue in this area during the quarter with 42% of service assurance product revenue coming from these software-only products. Finally, we continue to advance our security initiatives and recently announced Arbor Sightline with Sentinel to deliver the next generation of DDoS visibility and protection for service providers and large enterprises. This is an example of how the combination of our service assurance and security technologies can add unique value for our customers. We will showcase this product at the RSA Conference next month in Las Vegas, Nevada. Michael will elaborate further on this during his remarks. Now let's move on to Slide 8 to review our outlook. We remain excited about the opportunities we are seeing and our ability to capitalize on them. With three quarters behind us, the view of our pipeline, and the radio frequency propagation modeling projects that are expected to produce revenue in the fourth quarter, we are narrowing our revenue guidance to a range of $900 million to $910 million which implies a low-single digit organic growth rate over last year and increasing our earnings per share guidance to a range of $1.51 to $1.56. The $0.06 increase primarily reflects benefits associated with tax reform, legislation clarification and capital structure management benefits such as recent share repurchases. As we approach the end of our fiscal year 2020 and start to look to fiscal year 2021, we are excited about the trends we see in front of us such as 5G, digital transformation, security, and business analytics. We believe that these trends should benefit us in the future and that we should transition from dealing with the headwinds that we have experienced over the past few years to seeing growth again in the business. I look forward to sharing our progress with you as we finish this fiscal year and look to the future. I'll now turn the call over to Michael at this point.

Thank you, Anil, and good morning everyone. Slide 10 outlines the areas that I will cover. In the service provider vertical, we continue to gain traction in 5G, evidenced by an additional high 7-figure win for monitoring 5G deployments from the same North American service provider that placed similar orders earlier this fiscal year. Their build-out pace is strong, and the continuation of orders from this provider demonstrates the value of our solutions and our incumbency. In the enterprise vertical, at a large financial institution customer, we won a low-seven-figure service assurance deal due to the customer's digital transformation initiative. We displaced an incumbent competitor at the local and regional head office locations as they standardized on NETSCOUT solutions across the enterprise. The award encompasses deploying our solutions in 13 regional head offices, over 50 remote local offices, within the Data Centers, and into their East and West colocations to support their interconnects to the cloud. Our strong product strategy and close collaboration with both the network and application teams secured this win for us. Our cloud capabilities and alignment with the customer's initiatives for cloud and virtualization positioned NETSCOUT as the superior solution, leading to their decision to standardize on NETSCOUT across the enterprise. In the security space, our Arbor DDoS solutions continue to lead in our large enterprise customer base due to their robust, easy-to-configure protection and network-wide visibility during attacks, unlike as-a-service alternatives. For instance, at another large financial institution, we closed an incremental expansion opportunity in the high six-figure range, showcasing our staying power and critical role in a fast-evolving threat landscape. We also added a low 7-figure deployment to our already large installed base at a major cloud player. Annual revenues from this customer remain strong as they expand their business and continue to be a solid repeat customer for our solutions. Regarding go-to-market activities, we are participating in key industry events, including The Mobile World Congress in Barcelona, where we will highlight our 5G capabilities and share insights and early experiences in the space. We will also participate in RSA in San Francisco, where we will focus on our new DDoS product called Arbor Sightline with Sentinel, announced last week. This product, combining Arbor and NETSCOUT core technologies, will provide ISPs with a deep understanding of the services their customers use and enable them to detect a broader range of application-layer threats, allowing for new visibility and security value-added services. Finally, we will host our annual Engage Technology and User Summit in Hollywood, Florida in April. We are in full recruitment mode and expect to exceed last year's record attendance, excited to showcase our solutions and engage with our customers at this event. That concludes my prepared remarks, and I will now turn the call over to Jean.

Thank you, Michael, and good morning everyone. I will review key metrics for our third quarter and first nine months, or year-to-date fiscal year 2020 performance, along with our guidance for the remainder of the fiscal year. As a reminder, this review focuses on our non-GAAP results unless otherwise stated, and all reconciliations with our GAAP results appear in the presentation appendix. In addition, due to the sale of the HNT tools business in mid-September of 2018, I will highlight certain revenue trends on an organic non-GAAP basis, which removes HNT tools revenue for the applicable period referenced. Regardless, I will note the nature of any such comparisons. Slide 12 details our results for our fiscal third quarter and year-to-date 2020 performance. Focusing on the quarterly performance, revenue grew 5.6% over the same quarter in the prior year to $260.1 million. Product revenue grew 6.9% and service revenue grew 4.1% over the prior year's quarter. Our third quarter fiscal year 2020 gross profit margin was 77.8%, up 2.2 percentage points over the same quarter last year. Contributing to the improved margin was the strong software-only sales at 42% of service assurance revenue as compared to 14% in the third quarter of the prior year. Quarterly operating expenses decreased 1.7% from the prior year, primarily due to continued cost controls and headcount management. We reported an operating profit margin of 27.3% with diluted earnings per share of $0.73. Turning to Slide 13, I'd like to review key revenue trends for the first nine months of the year. For the first nine months of fiscal year 2020, the service provider customer vertical revenue grew approximately 4% while the enterprise vertical declined approximately 3%, after removing the revenue impact of the divested HNT Tools business. Approximately 52% of total revenue was generated from the service provider vertical with the remainder from the enterprise. Turning to Slide 14, which shows our geographic revenue mix, on a GAAP basis. Revenue by geography was relatively consistent with the first three quarters of the prior year. Additionally, there were no customers in the quarter or the first nine months of the year that represented 10% or more of revenue. Slide 15 details our balance sheet highlights and free cash flow. We ended the quarter with cash, cash equivalents, short-term marketable securities and long-term marketable securities of $346.5 million, which is an increase of $38.7 million since the end of the second quarter. Free cash flow generated in the quarter was $63.2 million. During the quarter, we repurchased approximately 1.0 million shares of our common stock at a cost of $25 million or an average price of $24.91 per share. In the first three quarters of this fiscal year, we have returned approximately $125 million to our shareholders. We anticipate continuing to be active in the market, depending on market conditions and subject to daily trading volumes and price considerations. From a debt perspective, as of the end of the third quarter, we have $450 million outstanding on our one-billion-dollar revolving credit facility. To briefly recap other balance sheet highlights, accounts receivable net was $244.9 million, up by $42.6 million since the end of September. DSOs were 77 days versus 88 days at the end of fiscal year 2019 and 91 days at the same time last year. The decrease in the DSO's in the third quarter of this year compared with the third quarter of the prior year is primarily attributable to strong collection activities. Moving to Slide 16 for guidance, I will focus my review on our non-GAAP guidance. As a reminder, we sold the HNT tools business in September 2018 and it contributed $18 million to last year's revenue prior to the completion of the sale. Accordingly, the impact of the divestiture should be taken into consideration when comparing fiscal years 2019 and 2020, especially for the first two quarters of both years. Consistent with Anil's remarks with one quarter to go in the fiscal year, we have narrowed fiscal year 2020 revenue guidance to a range of $900 million to $910 million, which implies low single-digit organic growth. We expect our non-GAAP tax rate to be in the range of 20% to 22% after the issuance of regulations by the U.S. Treasury that clarified the treatment of certain items related to the Tax Cut and Jobs Act that was passed in December of 2017. Assuming approximately 76 million shares outstanding, after updating for our recent share repurchase activities, we are expecting to deliver earnings growth in the high-single to low-teens range with diluted earnings per share between $1.51 and $1.56, compared with our prior year's performance. That concludes my formal review of our financial results and we can now turn the call over to start Q&A.

And we'll take our first question from Matt Hedberg with RBC Capital Markets.

Maybe Anil on the North America service provider, you noted an additional 7-figure win for 5G monitoring; it sounds like this is the second order within this fiscal year for this carrier or this service provider, which is great. I guess I'm wondering based on historic build-out trends, how much more capacity might this service provider have for additional orders such as this, as they continue to build out their 5G network?

Yes for this Matt, I don't think this provider has a lot more capacity next year, but this is being brought to other opportunities in the U.S. So that's a big side because this establishes ourselves and people are even though we don't talk about the names, other vendors know that we won this and run it against the competition. And so this helps us cement other deals next year in fiscal year '21, which are 5G-related with a lot of credibility plus we solidified the solution. So, while I don't see big orders from them in this space next year, I think this is something which is going to really help us in all other places and where 5G is going to be deployed.

That's great. It's really great to hear some of the 5G momentum I know we've talked about this in the last couple of quarters and it really seems like it's starting to come through now. So that's great, and I know you talked about it being a long-term benefit for you guys. And then maybe as a follow-up on the service assurance side, in order to record 42% of revenue from software-only transactions, which is also really good to hear. I know we've been talking about this for the last several years. If you were to look forward in the next couple of years, Anil, what might that mix look like, where can that mix go, I guess is what I'm wondering? And then maybe secondarily, I know we've talked historically about the competitive landscape for software-only transactions. Can you remind us again sort of where you guys sit and what the competitive landscape looks like there, on the sort of service assurance side?

So on the first part, Matt, we have only about one-third of our business or I would say maybe 40% of the business, which is service assurance over service provider is dominated by software solution, that's where we introduced it for us. The Arbor business, we have just started doing that and started offering the pure software model, enterprise was started a little later. So the big reason for the 42% is because of this big order on 5G and higher contribution to service provider. So long-term, I think this trend can span all three areas. And we don't know the timing, but the goal is to get into 60s, 60%, 70% share over the next couple of years. As for the competitive landscape, I mentioned that in the past, I mean we - our challenge has been, as a market leader, to grow the market size, not really competition; most of the direct competition is one-tenth of our size each of them. And there has been price competition in the past, because we needed more higher margin than other competitors who are much smaller; some of them are not even public. And the software model has completely solved that problem. So at the same time, whenever there is a technology term like 5G, there is perceived competition from - we have seen that throughout our life and last 25 years. So I think competition is our number one or number two issue, at the same time, we do need competition to grow the market size.

We'll take our next question from Alex Kurtz. Please go ahead.

Just to follow up on that previous question. Anil, you mentioned the goal of having 60% of your service provider business be software-only in the next couple of years. Did I understand that correctly?

No, 60% of the total business.

Of the total business.

Total business, like I said we may be already there in 60%. I don't know, because the 42% of - if this quarter is big portion is dominated by service provider. What I was saying was one of the reasons we don't have - success in enterprise and Arbor because Arbor business, which is almost 60% of the remaining business, is that we introduced much later like the Arbor business we just introduced six months ago. So long-term we think if this trend continues our goal is 60%, 70% range of the total revenue, not service provider.

And just the unit economics around the software-only deals Anil... Look at this large 5G deal that you just did, I think there's always been a question of like is the gross profit dollars kind of washout between the traditional appliance deal versus the software-only deal; is there any way to kind of guide us through that? Like would you say like it was a net-net push on that front?

I think overall the outcome we want is the gross profits will go up, and they have gone up in the past, but they were masked by what was happening in the downturn on the US service provider on 4G. So, I think overall, I feel that it improves our competitiveness, it increases the deal size. People don't say I want to buy 20 units; they'd say I have this much money to spend. And so when that's the budget, and so if we can have more units, it creates pervasiveness and makes our solution more sticky. So, I think long-term benefit, I mean when we talk about our guidance next year, if we talk about growth, it's going to be in spite of the fact that unit prices are coming down. And so it's a great story that you can drive growth even when the prices are coming down and that has a multiplying effect on EPS growth.

Just to finish then, would you say within you ended up capturing more dollars with the software-only solution than you would have with a traditional appliance?

Yes, as I mentioned earlier, we had announced a $75 million, five-year agreement a few years back. That carrier has utilized half of that amount over the previous five years. Overall, this is a positive outcome, and generally, when companies receive this type of pricing from their current provider compared to the best technology, they tend to eliminate other competitors and consolidate the market. As a vendor and a customer, their overall spending actually decreases, while their net expenditure increases.

And we will take our next question from Eric Martinuzzi with Lake Street. Please go ahead.

Curious about the service revenue line. Historically, if I look back to your normal seasonal patterns, you guys take a breather sequentially between Q3 and Q4, is that seasonal pattern expected to repeat itself in FY 2020?

Hi, Eric. This is Jean. Yes, as you said Q3 is generally a higher service revenue quarter due to it being equated with the calendar year. And so on a revenue basis from Q3 to Q4, there has historically been a slight step down. I think we anticipate that Q4 service revenue will still show growth over Q4 of the prior year.

And then based on that backing into the product side, where it does, we are anticipating growth here, it's nice to see NETSCOUT back in product revenue growth mode. Do you believe this is sustainable, I'm not looking for guidance for 2021, but just from a year-on-year perspective as HNT is product now kind of comfortably back in a growth mode?

Yes, I think that's why you can see the trend line from last year. I mean single-digit growth from minus double-digit in the past. I think you can see the trend. So I think all the investment we have made, even during tough times, we have cemented our leadership, improved the margins. So I think we are expecting this trend to continue next year and we'll wait to share that guidance with you next quarter.

Our next question will come from Chad Bennett with Craig-Hallum. Please go ahead. Chad, your line is open.

Maybe, we can go to the next one then.

And we'll take our next question from Kevin Liu with K. Liu & Company.

First question, just with the completion of this larger RF Propagation Modeling projects. Can you just speak either historically or maybe as you looking at your pipeline and what sort of opportunities as that kind of naturally feed into? And how confident you are in your ability to kind of grow on top of this and as you look forward to the next few quarters?

Are you talking about - did you say RF? It was not very clear. You are talking about calibration. Yeah, I think the calibration order which we got big once if we got last year, I don't think that's going to be up that high order, because that's usually in the early phases of 5G deployment, so that was the case. We expect order on the other front on the core side, not on the radio access side, in a bigger way next year which is actually better from a margin perspective. So we don't expect that kind of calibration-type order this year coming year as we had last year, but there'll be revenue contribution. Some of it in the next year because of the order from last year.

And then you talked about some of the digital transformation opportunities that help grow the enterprise business. As you look into the pipeline going forward what sort of used cases do you see driving enterprise adoption and what are the prospects for continued growth on the enterprise side of the business?

I believe the main point is that as organizations undergo more transformations, they encounter increasing challenges with accountability and identifying the root cause of issues, whether they stem from their actions or those of another provider. Our product plays a crucial role in addressing these problems. Therefore, when companies seek to achieve savings through operational and capital expenditures by transitioning to the cloud and embracing digital transformation, they need assurance that they won't face setbacks related to operational expenses or service reliability. By utilizing our solution, they can reap the benefits of digital transformation without the concerns of potential downsides. Thus, the adoption and acceleration of digital transformation directly contribute to our growth in the enterprise sector.

And we appear to have no further questions at this time. I apologize. We do have a question from James Fish. Please go ahead.

Hey guys, congrats on the quarter and the large win. Jean, one we didn't hear a whole lot on Arbor security revenue, compared to service assurance. Is there still pressure coming in Arbor or how, where the growth rates this quarter?

I think it was slightly down from in general versus the service assurance and we still see some lingering effects of the organization changes, and we see because of those changes winding down this year and the effect of the combined product. We announced the Sentinel product last quarter for this space to pick up next year.

And then maybe Anil on sort of timing of the core deals. How should we think about core service assurance deals, especially related to obviously there is the big spectrum auction in June, power carriers looking to kind of purchase either ahead or after that, that timing?

Yes, I think so they are not necessarily waiting for the auction to complete to do that. They already have plans. I look at 5G as part of the money people want to spend and if they look at all the innovations we have done. How we are helping them in the lab of incumbency. That innovation helped us spend the money. Some of it gets spent on 5G, some gets spent on the 4G expansion because the part of the network for 4G and 5G is common. So we look at it overall, our leadership in 5G and our incumbency in 4G when combined with the price power of software. I'll put that in a unique position, unlike we have before. So I think that's what I see is the reason a lot of people are asking us for PoC and equipment even outside of the U.S. for 5G, and I think that's going to overall help us, our service assurance business and service provider next year.

And we appear to have no further questions at this time, so I'll turn it back to the speakers for any closing remarks.

Great, thank you very much. That concludes our call for today. We appreciate everybody joining and hope everybody has a great day. Thank you.

This does conclude today's program. Thank you for your participation. You may now disconnect.