Netscout Systems Inc Q2 FY2021 Earnings Call

Please stand by. Your program is about to begin. Ladies and gentlemen, thank you for standing by and welcome to NETSCOUT's Second Quarter 2021 financial results conference call. At this time all parties are in a listen-only mode until the question and answer portion of the call. As a reminder, this call is being recorded. Tony Peot, our Vice President of Corporate Finance and his colleagues at NETSCOUT are on the line with us today. If you require operator assistance at any time, please press zero. I would now like to turn the call over to Tony Peot to begin the Company's prepared remarks.

Thank you, operator, and good morning everyone. Welcome to NETSCOUT's Second Quarter of Fiscal Year 2021 Conference Call for the period ended September 30, 2020. Joining me today are Anil Singhal, NETSCOUT's President and Chief Executive Officer, 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. 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 we'll cover a range of topics that are not strictly historical facts, such as our outlook, 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, 2020. 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 described on the 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. Reconciliations of all non-GAAP metrics with the applicable GAAP measures are provided in the appendix of the 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.

Thank you, Tony. Good morning everyone and thank you for joining us. Let's begin on Slide 6 with a brief recap of our second quarter non-GAAP results. We delivered solid earnings-per-share growth on lower revenue of $25.3 million compared with the same quarter last year. Earnings per share was $0.38 in the quarter, an increase of more than 35% compared with the same period last year. Both service provider and security revenue grew in the quarter but were more than offset by a decline in spending in the U.S. Federal Government sector which impacted enterprise revenue. The quarter benefited from our focus on cost control as well as by pandemic-related travel restrictions. Let's move to Slide 7 for some further perspective on the business. In the service provider vertical, revenue grew 4% compared with the same quarter last year. We continue to work with our service provider security initiatives with even greater momentum as a result of the pandemic and the new normal of operating with remote resources and interacting with customers in a more virtual fashion as they look to address speed, agility, and cost. On the security front, that landscape continues to rise rapidly and the pandemic has created more opportunities for bad actors to disrupt organizations, given that distributed operations. Last month, we issued our first half 2020 threat intelligence report, which highlighted how cyber criminals are exploiting the pandemic to radically change the methods they are using. The report discussed how cyber criminals launched record-breaking attacks on online platforms and other services during the pandemic, increasingly targeting e-commerce, education platforms, financial services, and healthcare services. These multi-back-to-back attacks were shorter, faster, hard-hitting, and more complex. These new methods put pressure on security teams as they have less time to react to defend their organizational systems, making the job much more difficult and highlighting the need for strong detection and mitigation solutions like ours. This dynamic has certainly played an important part in the strong performance of our security solutions in the quarter and year-to-date. Michael will highlight some additional details related to this during his remarks. Now, let's move to Slide 8 to review our outlook. Our business and operations have proven to be largely resilient as we navigate the global pandemic and macroeconomic uncertainty. This is due to our relevant solutions, tested brand, strong customer relationships, dedicated team, and solid financial profile. That said, we are not immune from the impact of the COVID-19 global pandemic. As we evaluate the outlook for the remainder of the fiscal year, we remain cautious given the uncertainty around the pandemic and the resulting macroeconomic environment. This dynamic has caused elongated purchase cycles, making the timing, magnitude, and funding for these difficult to predict, which we anticipate will negatively impact our traditionally stronger second half of the fiscal year financial results. As a result, we now expect that fiscal year 2021 revenue to decline in the mid to upper single digits on a percentage basis compared with fiscal year 2020. Despite the revenue decline, we are committed to delivering annual non-GAAP earnings per share in line with our fiscal year 2020 non-GAAP earnings per share as we continue to prudently manage our cost structure. In closing, we are pleased with our ability to serve our customers' visibility and security needs while ensuring the safety and productivity of our team as we execute our strategy and deliver stable results in this tough and uncharted COVID-19 environment. We appreciate the continued dedication and support of our employees as we navigate the global pandemic and the long-term market trends in favor of digital transformation, cloud migration, heightened cyber threats, and the emergence of 5G networks. We are well positioned as guardians of the connected world when we emerge from this global crisis. I look forward to sharing our progress with you as the fiscal year continues to unfold. I will now turn the call over to Michael for his remarks.

Thank you, Anil, and good morning everyone. Slide 10 outlines the areas I will cover, first, costs a little bit. Starting with customer events, as Anil mentioned, our service provider vertical has solid growth in the quarter as we continue to see 4G expansions in our international customer base and 5G trials in North America. As we await the 5G investment cycle to kick in, a notable internal 4G win in the quarter was a multi-year, eight-figure software and support deal for a major European carrier, which provided mid-seven figures of revenue in the quarter. The investment enables the carrier to expand their 4G capacity and positions them to transition to 5G solutions in the future. On the 5G front, we will allow a seven-figure user trial with a Tier One North American carrier as they start to explore a stand-alone, so-called 5G network. It is still early days for North American stand-alone 5G visibility projects, but this is a good sign for progress. All these demonstrate the trust in our brand, the strength and value of our solutions, and the importance of our incumbency with our loyal customer base. In the enterprise vertical, service assurance solutions have continued to be highly relevant and are producing important new logos for us in the financial, healthcare, and other sectors. During the quarter, one new global deal we won was with a large domestic medical provider with over 1,000 beds and more than 1.5 million patient visits annually. This was a low to mid-seven-figure deal to implement our visibility platform in a fully virtualized deployment with extensions into the cloud for this provider's patient management system. The scale and completeness of our solution, as well as the expertise of our team, won the deal over multiple competitors with partial solutions. Another new logo and competitive win was our low seven-figure deal with a major stock exchange that needed a faster and more reliable solution to triage real-time application problems. They selected our service assurance solution because of our rich data source and strong analytical capabilities, which solved their challenges as we replaced a major competitor's solution that was falling short of their expectations. In both of these cases, the security of new customers and the result of our reputation as a trusted leader in service excellence allowed us to provide innovative and reliable solutions, and we have also identified opportunities to extend these relationships in these deals as we leverage our cross-selling capabilities through our integrated sales team. On the security front, across the service provider and enterprise verticals, we continue to see strong interest in our DDoS protection, especially as the sophistication and volume of these attacks grow quickly, as we outlined in our first half 2020 threat intelligence report which Anil referenced earlier. During the quarter, we successfully thwarted extortion attacks on large U.S. customers, prompting even more attention in this space. Other solutions that require on-premise deployment, such as our Advanced Threat Detection (ATD) solution, provide both rapid multi-national and sophisticated Layer 7 protection. The demand for our ATD solutions have increased due to large customers redesigning their infrastructure while settling in for remote work for the long haul after the initial rush to shore up their defenses when the pandemic started. This trend is exemplified in a mid-six-figure deal with a large insurance company domestically and a low seven-figure deal with a leading international stock exchange. We are excited about our ability to provide these solutions to our customers through our unified worldwide sales force. In terms of go-to-market activities, we continue to build our vendor partnerships with strategically critical partners, including leading virtualization and cloud providers. In October, we participated in the annual VMworld event as a Technology Alliance Partner; there were more than 150,000 participants that joined this virtual event over a 10-day duration. We showcased our application performance management and troubleshooting capabilities in VMware virtualized on-premise and AWS cloud deployments. Also, recently our AWS Migration ISV partner competency has been approved by AWS, meaning that AWS certifies that NETSCOUT has been validated and verified against high standards, and AWS will promote NETSCOUT through their sponsorship program. On the security front, during the quarter, a global research leader in technology ranked NETSCOUT's Advanced Threat Detection as the top and largest vendor in the DDoS market, highlighting our new security investments in visibility and analytics. Finally, as a leader in our industry, as discussed in September, we published our semiannual threat intelligence report. This report was picked up by approximately 50 publications and translated into five languages, as our threat intelligence report is considered an industry-standard annual report. That concludes my remarks, and I will now turn the call over to Jean.

Thank you, Michael, and good morning everyone. I will briefly review key second quarter and first half of fiscal year 2021 metrics and outlook. 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. Slide 12 details our results for our second quarter and first half of fiscal year 2021, focusing on the quarterly performance. Revenue declined by 5.1% over the same quarter in the prior year to $205.3 million. Product revenue declined 10.5% and service revenue declined 0.3% over the prior year quarter. Our second quarter of fiscal year 2021 gross profit margin was 74.7%, down 1.9 percentage points over the same quarter last year due to product mix, most notably increased radio frequency propagation modeling project revenue, which has much lower gross margins. Our software-only sales were 27% of service assurance product revenue compared with 20% in the second quarter of the prior year. Quarterly operating expenses decreased 15.4% from the prior year, primarily due to continued cost control and pandemic-related travel restrictions. We reported an operating profit margin of 19.4% compared with 14.6% in the same quarter last year. Diluted earnings per share was $0.38 compared with $0.28 in the same quarter last year. Turning to Slide 13, I'd like to review key revenue trends for the first half of the year. For the first six months of fiscal year 2021, the service provider customer vertical revenue declined approximately 8% while the enterprise vertical grew approximately 1%. The service provider and enterprise verticals each contributed approximately 50% to total revenues for the first six months of the fiscal year. Turning to Slide 14, which shows our geographic revenue mix on a GAAP basis, revenue was 58% in the United States and 42% internationally. There were no customers in the quarter of the first half 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 $427.8 million, which is an increase of $1.3 million since the end of the first quarter. Free cash flow generated in the quarter was $8.3 million; we did not repurchase shares of our common stock during this quarter. From a debt perspective, as of the end of the second quarter, we had $450 million outstanding on our $1 billion revolving credit facility. We had approximately 1.5 times cushion against our gross leverage covenant, providing potential borrowing capacity if needed. Our revolving credit facility expires in January 2023, and it has no required principal repayments until maturity. To briefly recap other balance sheet highlights, accounts receivable net was $169.7 million, down by $43.8 million since the end of March. Days Sales Outstanding (DSOs) were 65 days versus 73 days at the end of fiscal year 2020 and 79 days at the same time last year. The improvement in the DSOs in the second quarter of this year compared to the second quarter of the prior year is primarily attributable to the timing of orders within the quarter. Moving to Slide 16 for our outlook from a non-GAAP perspective, as Anil stated in his remarks, for fiscal year 2021, we expect revenue to decline in the mid to upper single digits on a percentage basis compared with fiscal year 2020. Despite lower revenue, we anticipate delivering annual earnings per share in line with our fiscal year 2020 earnings per share number as we continue to prudently manage our cost structure. For the second half of the fiscal year, we anticipate that remaining earnings per share performance should be more equally distributed between our third and fourth fiscal quarters than it was in the prior fiscal year. Given the current pandemic conditions and our cost management focus, we anticipate that our third-quarter operating expenses will be in line with our second-quarter operating expense results. I also want to comment on a few capital structure-related items for fiscal year 2021. We expect the tax rate to be approximately 23%. Additionally, we expect the diluted shares outstanding for the year to be approximately 74 million shares. That concludes my formal review of our financial results. Before we transition to Q&A, I'd like to quickly note that our upcoming IR conference participation is listed on Slide 17. I'll now turn the call over to the operator for Q&A.

[Operator Instructions] We'll take our first question today from Kevin Liu with K. Liu & Company. Your line is open.

Hi, good morning. First question here. You talked about some of the deals elongating. I was wondering if you could elaborate more. So, just in terms of what you're actually seeing in terms of pipeline building, have you still been able to grow that both on the enterprise and service provider side? And then, just from the perspective of deals pushing out, if we can put the government vertical aside, what exactly do you think your customers are waiting for in order to move forward with some of these opportunities?

Thanks for the question, Kevin. So, I think there are two areas: one is certain industries where there is unpredictable timing of whether they will move forward with certain projects in the pipeline, and I would put on the top of that the hospitality industry and the Federal government. A lot of uncertainty around that. So, that is number one. The second one is elongated sales cycles, which can be categorized in two buckets; one is we released some new products, especially in the security space. During the purchase cycle, we have to evaluate these products, and that requires someone to go in and install them—this has been difficult and extends the sales cycle. The second bucket is for new logos. Even though we had some successes, there is a lot of interest in our new software-based offerings, especially in the enterprise, but new logos for first-time buyers also have to go through the cycle of verification and trials, which has slowed down these processes. So, those are the factors that are mostly COVID-related, which we are certainly counting on this year, which has changed.

Got it. And then just quickly, in the past, you've talked about enterprise kind of emerging as an interesting opportunity for 5G. Are you still seeing that trend build-out? Maybe you can talk about in terms of how large of an opportunity you see that over the coming years?

Yes. I see that as a follow-on opportunity. As I mentioned in the last year and partly this year, we see some pre-deployment opportunities like calibration that are smaller in scale, and that’s where we are. The next step will be using our 5G solution for user monitoring, and we are in the early phases of that. Much later, we will participate in private 5G projects because the cloud vendors and the carriers will have to lead those efforts too. So, I see a long-term opportunity in private 5G and the carrier 5G solutions.

Got it. That's helpful. Thank you for taking the question.

Our next question comes from James Fish with Piper Sandler. Your line is open.

Hey, guys. Glad to hear that you're all doing well. On the security side, you said your carrier customers bought additional capacity. And now we're starting to hear from you guys that we're seeing larger and more sophisticated attacks. Are we starting to get to a point where these carrier customers are going to need to add more capacity with our DDoS protection?

I think they will need it, but I don't think they currently have significant shortfalls in their capacity. When we talk about security, there are two product categories we offer: one for the service provider side and another for the enterprise side. We see more opportunity in the enterprise business, especially with our Advanced Threat Detection product, which addresses new attack vectors at the application layer. It's important for us to have our solutions available for both enterprise and carrier customers.

Yes, got it. And then Jean, for you, can you give us some color within DDoS protection across enterprise and carrier like you typically do? Also, billings appeared fairly strong; was there a good amount of product backlog that should give us some confidence here that our trends could be a little bit better than you're expecting, or were you seeing greater attach rates for additional services?

So, for the year-to-date, DDoS generally is doing well; we saw a good second quarter and service provider revenues probably remained flat on a year-over-year basis. In enterprise, they grew about 30%. This growth is mostly in large institutions like financial institutions and government sectors that continue to perform well in security. The integration of our sales force also presents many more opportunities than we have had before. Overall, DDoS has done pretty well for the first half of the year.

And then on the billings being stronger, was it more product backlog than usual, or was it due to a greater attach of additional services this quarter?

It's mostly product; when I review our figures, the product grew very strongly in Q2, and we maintained an okay growth rate for the year-to-date overall.

Again, that is star and one for your questions today. We'll go now to Eric Martinuzzi with Lake Street. Your line is open.

Just a clarification on the full-year revenue guidance. I want to put some numbers around mid to upper single digits. Is this down prior to 8%, down 4.9%? Do you have a preference between those two?

I would say we think mid 4% to 6%. The upper single digits would be 7% to 9%, so my range would be 4% to 9%.

Okay, alright. And then on the Federal side, historically, the September quarter would be a good quarter for NETSCOUT with the federal business. Are we looking at something that's just a vagary of being a sub to the main, where it's just lumpy, or is this potentially killing projects? Is it pending new appropriations? Could you snap back in December? Are we looking at a multi-quarter issue in your view?

I think it could be longer-term. I don't think it's going to snap back in December. In federal government, we have seen projects that sometimes take a while; even without COVID, they sometimes last for two years. I think the budgets are approved, we are the selected partner, but something radically changing in the fiscal year is unlikely.

Okay, alright. And your commentary on the non-GAAP earnings for the business, you guys have always done a good job on cost management. You've done a good job of being able to hit your non-GAAP earnings targets on an annual basis. You did see a decline in Q2 of 15% or 16% in the operating expenses. I would assume part of that is just less travel, less conferences because of COVID. But where are our cost structure points of leverage as you are trying to manage to that non-GAAP EPS target?

The first lever is the continuation of the pandemic condition and the amount of travel that sales will do. In Q3, I don't anticipate them doing incrementally more travel than they did in Q2. Additionally, we have upper-level management decisions regarding the timing of filling any attrition, or if there are certain investment areas in sales that we'll need to manage. Another lever is variable incentive compensation, which depends on revenue performance and meeting earnings per share targets.

And last question for me. It comes down to the services revenue. Historically, we would see an uptick here, but we are not. I guess we are in historic times, we're certainly not in normal times. You had a negative comp in service revenue in Q2. And I would guess based on the product sales in the prior quarters, we're probably looking at negative comps in Q3 and Q4 on the services revenue. Can you give us some insight on Q3 service revenue? Is that up sequentially, or is your expectation that it could in fact be down sequentially?

I would say service revenue is fairly stable; that's why we're generally very accurate on forecasting service revenue. I wouldn't forecast significant changes when I look at our model. I mean, looking at the midpoint, I would say service revenue looks like it's going to be relatively consistent with the service revenue that we achieved in FY 2020. As you pointed out, Q2 of this year compared to last year was essentially flat. Last year, we had about a $2 million catch-up of revenue due to a later signing on a renewal. For the full year, I would estimate that service revenue will be generally flat to last year's level.

That's helpful. Thanks for taking my questions.

Thank you, Eric.

And it does appear that we have no further questions at this time. I would now like to turn the call back to our speakers for any additional remarks.

That concludes our call for today. We appreciate everybody joining us and have a great day.

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