Earnings Call Transcript - NTCT Q2 2023

Operator, Operator

Ladies and gentlemen, thank you for joining us, and welcome to NetScout's financial results conference call for the second quarter of fiscal year 2023. This call is being recorded. Tony Piazza, Senior Vice President of Corporate Finance, along with his colleagues at NetScout, is on the line with us today. I would now like to turn the call over to Tony Piazza to begin the company's prepared remarks.

Tony Piazza, Senior Vice President of Corporate Finance

Thank you, operator, and good morning, everyone. Welcome to NetScout's second quarter fiscal year 2023 conference call for the period ended September 30, 2022. 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's 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. Examples of forward-looking statements include statements regarding our future financial performance or position, results of operations, business strategy, plans and objectives of management for future operations and other statements that are not historical facts. You can identify forward-looking statements by their use of forward-looking words such as anticipate, believe, plan, will, should, expect, or other comparable terms. We caution listeners not to place undue reliance on any forward-looking statements included in this presentation, which speak only as of today's date. 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, including, but not limited to, those described on this slide and in today's financial results press release. For a more detailed description of the risk factors associated with the company, please refer to the company's annual report on Form 10-K for the fiscal year ended March 31, 2022, 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 now 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. 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 on our website. I will now turn the call over to Anil for his prepared remarks. Anil?

Anil Singhal, President and CEO

Thank you, Tony, and good morning, everyone. Welcome, and thank you all for joining us today. Let's now turn to Slide #6 for a brief recap of our non-GAAP financial results for the second quarter and the first half of our fiscal year 2023. In the second quarter, we achieved strong financial results and made significant progress on our strategic growth priorities. Notably, we further expanded our cybersecurity business. Our second quarter revenue was $228.1 million, reflecting nearly 8% growth year-over-year. This revenue growth was driven by a 10% increase in product revenue and more than 5% growth in service revenue, both compared to the previous year. Our cybersecurity and service assurance product lines also saw year-over-year growth in the quarter. With this revenue increase and healthy operating leverage, we recorded earnings of $0.50 per diluted share in the second quarter of fiscal year 2023, which represents approximately 21% growth in diluted earnings per share compared to the previous year. Moving to the first half of fiscal year 2023, overall revenue was $436.9 million, up nearly 9% year-over-year. This growth was fueled by more than 14% increase in product revenue and nearly 4% rise in service revenue. During this period, cybersecurity revenue grew by 14%, while service assurance revenue increased by over 6%. All comparisons are year-over-year. Additionally, we reported $0.81 in diluted earnings per share for the first half of fiscal year 2023, marking approximately 21% year-over-year growth in diluted earnings per share. Now, let's move to Slide #7 for some further market and business insights. On the cybersecurity front, we recently released our DDoS threat intelligence report for the first half of 2022, highlighting current trends and challenges in this critical area. The findings illustrate how sophisticated cybercriminals have become in exploiting new DDoS attack vectors to evade organizational defenses. The report also addresses substantial geopolitical implications tied to today’s DDoS attacks. Many of these malicious actors are actively using online aggression to instigate disruption and geopolitical tensions through prominent DDoS attack campaigns. We believe our advanced platform for visibility and defense plays a crucial role in this ecosystem, and we are confident in our capability to assist customers in navigating these challenges while seizing opportunities in today's digital landscape. In line with these trends, our Omnis suite of cyber intelligence products has continued to gain traction, though it represents a small portion of our overall revenue. For instance, in the second quarter, a large customer integrated Omnis into their existing collaboration with the NetScout platform. We are also innovating in cybersecurity, introducing new solutions like Arbor Insight to tackle the evolving threat landscape. When paired with Arbor Sightline, this solution significantly enhances the company's threat detection capabilities, service delivery, and visibility for network operators. Now, let’s discuss our customer verticals, beginning with our service provider segment. Service provider revenue rose by 11% year-over-year in the first half of fiscal year 2023, primarily due to increased revenue from radio frequency propagation modeling projects involving Tier 1 carriers in North America. We are actively encouraging carriers to invest in 5G deployment for both planning and stand-alone builds, as these carriers also commence commercial traffic deployment. In our enterprise customer segment, revenue increased by about 6% year-over-year in the first half of fiscal year 2023. This growth stemmed from both cybersecurity and service assurance lines as enterprises seek leading cybersecurity solutions and visibility tools to protect their systems and foster digital transformation. Furthermore, we are leveraging our wide-ranging solutions to adopt a platform approach, which is positively resonating with customers. Michael will share more insights about customer accomplishments in our verticals during his comments. Now let’s move to Slide #8 to discuss our outlook. Looking forward, we plan to prudently manage our operations, taking a balanced approach to revenue growth and profitability. While we acknowledge uncertainty in the macroeconomic landscape, we are optimistic about our business prospects and energized by the market opportunities for our NetScout visibility and defensibility platform. In this context, we are reaffirming our fiscal year 2023 outlook, which we shared in early August during our first-quarter earnings call. To recap, this outlook projects revenue in the range of $895 million to $925 million and non-GAAP earnings per share between $1.91 and $2.03 for fiscal year 2023. Jean will provide further details on our outlook in her comments. In summary, we delivered solid results in the second quarter and the first half of fiscal year 2023. We are making significant progress on our strategic priorities, and we remain enthusiastic about our core service assurance and DDoS security solutions as well as our innovative Omnis solution. With our unique platform, extensive industry expertise, and established customer base, we are well-equipped to assist customers with the challenges and opportunities in today's increasingly connected and complex digital world. We look forward to updating everyone on our progress throughout the remainder of our fiscal year. I will now turn the call over to Michael.

Michael Szabados, Chief Operating Officer

Thank you, Anil, and good morning, everyone. Slide 10 outlines the areas that I will be covering today, starting with customer wins. In our service provider customer's vertical, we continue to expand our installed base by leveraging both our incumbency and rich portfolio of offerings to better support providers as they steadily advance their 5G build-outs. As an example, during the quarter, we received a mid-7-figure order from a Tier 1 North American carrier that has consistently increased their 5G-related purchasing from us. This order was a combination of additional radio frequency propagation modeling, service assurance for their radio access network and other 5G-related products in the migration and capacity expansion of their network. Importantly, in addition to leveraging our solutions within their mobile business, this customer is also utilizing our service assurance platform within their corporate IT systems. In our enterprise customer vertical, we received a low 8-figure order from a large North American health insurance organization during the second quarter. Last year, this customer placed a 7-figure order with us for service assurance solutions. And this quarter, they added a full Omnis cybersecurity suite and additional service assurance solution to further utilize our platform's integrated capabilities. With the convenience of our shared visibility platform and the power of our deep packet inspection at scale, we continue to see our comprehensive suite of enterprise solutions receive attention among our customers. Finally, as Anil mentioned in his discussion of our recent Threat Intelligent report, we continue to see an increased awareness around DDoS attacks and capacity expansion stemming from the rapid growth in the application traffic and the increasing geopolitical situation around the world. For example, in the second quarter, we received a mid-7-figure order from a large global financial institution that is based in the U.S. and is also a long-standing customer, to extend the DDoS mitigation capacity and upgrade their key data centers to 100-gigabit capacity. In terms of go-to-market activities, during the quarter, we continue to attend more in-person events. This provided us with additional opportunities to engage with our customers and demonstrate our platform's unique and innovative capabilities. For example, we recently attended the Black Hat Conference, one of the world's leading cybersecurity trade shows, as well as VMware Explore, a conference for digital transformation and cybersecurity. At these high-profile events, we engaged with new prospects and existing customers to demonstrate the power of our platform for integrated visibility and cybersecurity. Looking ahead, we plan to attend the upcoming AWS re:Invent conference in November of this year, where we will showcase NetScout's platform as well as our collaboration with AWS. We have also continued to enhance our customer value proposition by collaborating with other major technology companies and have recently announced several of these initiatives. Through these collaborations, we can help our customers to better address the current threat landscape and navigate the challenges and opportunities of our digital world. An example is a joint strategic initiative with Ericsson and Swisscom, which was officially announced by Ericsson in October. Through this collaboration, we delivered what is believed to be the world's first solution for cloud-based packet data processing. By leveraging the strength of each organization, this solution can deliver meaningful improvements in network service assurance, analytics and cybersecurity. For example, this solution combines Ericsson's and NetScout's technologies to address the challenges of providing end-to-end monitoring and securing 5G networks when in a qualified and encrypted environment. As a result, Swisscom is utilizing the solution in this newly-deployed cloud-native DLS encrypted 5G network as well as for its existing services to ensure the delivery of mission-critical services with 5G. Going forward, we aim to continue leveraging the strength of our platform to help our customers better navigate and capitalize on emerging opportunities in today's increasingly connected world. Thank you, everyone. That concludes my prepared remarks, and I will now turn the call over to Jean.

Jean Bua, Executive Vice President and CFO

Thank you, Michael, and good morning, everyone. I will review key metrics for our second quarter and first half of fiscal year 2023 and provide some additional commentary on our fiscal year 2023 outlook. As a reminder, this review focuses on our non-GAAP results, unless otherwise stated, and all reconciliations within our GAAP results appear in the presentation appendix. Regardless, I will note the nature of such comparisons. Slide #12 details the results for the second quarter and first half of our fiscal year 2023. Focusing on our quarterly performance, total revenue grew 7.6% year-over-year to $228.1 million. Product revenue grew 10% and service revenue grew 5.4%, both on a year-over-year basis. At the end of the quarter, our total backlog was approximately $80 million, consisting of approximately $45 million of fulfillable orders and approximately $35 million of radio frequency propagation modeling projects, with nearly $20 million of the radio frequency propagation modeling amount categorized as deferred revenue from an accounting perspective. As a reminder, while fulfillable orders are those we believe can be readily converted into revenue upon shipment or fulfillment, the radio frequency propagation modeling projects require certain execution steps in conjunction with the carrier's timing before they can convert to revenue. Gross profit margin was 76.8% in the second quarter, down 1.5 percentage points year-over-year. This quarter's gross margin was impacted by approximately $15 million of radio frequency propagation modeling projects, which had an average gross margin of less than 30%. Quarterly operating expenses increased 2.2% year-over-year, mostly due to the return of pre-pandemic activities such as in-person events and travel and partially due to a competitive employment market. We reported an operating profit margin of 23.7% compared with 22.3% in the same quarter last year. Diluted earnings per share was $0.57. Clarifying earlier statements, I'll repeat, the diluted earnings per share was $0.57 compared with $0.47 in the same quarter last year, representing an increase of 21.3% year-over-year. Turning to Slide 13, I'd now like to review key revenue trends by customer verticals and product lines. Please note that all comparisons here are on a year-over-year basis, consistent with our other remarks. For the first 6 months of fiscal year 2023, our service provider customer vertical revenue grew 11%, while our enterprise customer vertical revenue grew 6.4%. During the same period, our enterprise customer vertical accounted for approximately 51% of our total revenue, while provider customer vertical accounted for the remaining 49%. Now turning to our product lines. For the first half of fiscal year 2023, our cybersecurity revenue increased by 14.3% while our service assurance revenue increased by 6.6%. During the same period, our service assurance product line accounted for approximately 73% of our total revenue, while our cybersecurity product line accounted for the remaining 27%. Turning to Slide 14, which shows our geographic revenue mix. In the first half of fiscal year 2023, our revenue was more concentrated than usual in the U.S., primarily due to higher revenue related to radio frequency propagation modeling projects from Tier 1 domestic carriers. Additionally, one customer represented 10% or more of our total revenue in the second quarter and the first half of our fiscal year 2023. Slide 15 details our balance sheet highlights and free cash flow. We ended the second quarter with $367.1 million in cash, cash equivalents and marketable securities, representing a decrease of $7.5 million since the end of the first quarter of fiscal year 2023. Free cash flow for the quarter was $7.1 million. As a reminder with regard to share repurchase program activity, we entered into an accelerated share repurchase agreement in our first quarter of fiscal year 2023 to repurchase $150 million of our common stock. We received approximately 70% of the total shares estimated to be repurchased pursuant to the ASR agreement in our first quarter or approximately 3.3 million shares. We anticipate receiving the remaining approximately 30% of the program shares when the program concludes no later than December 31, 2022. From a debt perspective, we ended the second quarter of fiscal year 2023 with $200 million outstanding on our $800 million revolving credit facility, which expires in July 2026. To briefly recap our other balance sheet highlights, accounts receivable net was $139.1 million, representing a decrease of $9.1 million since March 31, 2022. The DSO metric at the end of the second quarter of fiscal year 2023 was 52 days versus 64 days at the end of the second quarter of the prior year and 64 days at the end of our fiscal year 2022. Let's move to Slide 16 for commentary on our outlook. I will focus my review on our non-GAAP targets for fiscal year 2023. We are reiterating our non-GAAP outlook for fiscal year 2023 that was last presented during our first-quarter fiscal year 2023 earnings call on August 4, 2022. As a reminder, for fiscal year 2023, we anticipate revenue in the range of $895 million to $925 million, which implies a mid- to high single-digit top line growth rate. The effective tax rate is anticipated to be in the range of 20% to 22%, assuming between 73 million and 74 million weighted average diluted shares outstanding, which includes the estimated impact of the $150 million accelerated share repurchase program. With a partial offset for stock compensation dilution, we expect non-GAAP diluted earnings per share to be between $1.97 and $2.03. To reiterate and clarify from previous comments, it's $1.97 and $2.03 for the earnings per share guidance. I'd also like to offer some color on the second half of our fiscal year 2023. Assuming the midpoint of our revenue outlook range, we currently anticipate that our remaining fiscal year 2023 revenue will be nearly evenly split between our third and fourth quarters, with expectations for our third quarter revenue to be 1 to 2 percentage points higher than our fourth quarter revenue in the SKU between third quarter and fourth quarter. With regards to the second half earnings per share, assuming the midpoint of our non-GAAP EPS range, we currently anticipate receiving approximately 60% in the third quarter and approximately 40% in the fourth quarter. As we have discussed previously, our third-quarter gross margin will contain a higher product mix of radio frequency propagation modeling project activities, which has a lower gross margin. 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. Thank you, and I'll now turn the call over to the operator for Q&A.

Operator, Operator

We will take our first question from Matt Hedberg with RBC.

Matt Hedberg, Analyst

Nice consistency in the quarter here. You're reiterating guidance for the year, which is nice to see. Jean, thanks for the added color on expectations for the second half just there. With a lot going on, maybe could you talk to some of your confidence points for the second half?

Jean Bua, Executive Vice President and CFO

Sure. As we previously stated, we've observed strong activity across various trends in which we are involved, particularly in 5G. We've received some 5G projects from Tier 1 clients and are currently working on calibration as part of our backlog. In the enterprise sector, we are witnessing digital transformation, with some customers reassessing previous purchases that may not have performed well in today’s more complex digital landscape. Additionally, in the security sector, we have updated our roadmap and introduced new products, including the initiation of Omnis. Our portfolio of solutions is now well-aligned to address 5G, digital transformation, and cybersecurity threats. I want to highlight that the backlog for shippable items, which could not be shipped by the end of the quarter but has likely been shipped since then and will generate revenue, remains consistent with previous quarters. The only change has been in the execution of calibration. Looking ahead to the end of this year, we are confident in reaffirming our revenue ranges.

Matt Hedberg, Analyst

That's great. And then could you talk to federal business in the quarter with the fiscal year-end? I think you've previously commented to most of those projects being funded. Just anything around federal worth pointing out for us?

Anil Singhal, President and CEO

I believe that while Jean evaluates this, Matt, it was better than last year, but that’s mainly because the previous year wasn’t very strong. There remains uncertainty regarding project budgets and timing, and with the fiscal year just concluded, I think it’s important to note that since this segment is not a significant part of our overall revenue, there are likely other factors that could affect future outcomes beyond the federal business.

Jean Bua, Executive Vice President and CFO

Yes. To provide some numbers, the service revenue from the U.S. federal government, particularly the support aspect, has remained consistent year-over-year, which indicates continued use of our products and a desire for ongoing support. The product revenue was likely slightly flat compared to Q2. Overall, in terms of dollar amounts, it was relatively steady compared to the previous year's Q2. That's the situation regarding the U.S. federal government segment.

Operator, Operator

We will take our next question from James Fish with Piper Sandler.

James Fish, Analyst

I want to follow up on the question before that, before the Fed. With the reiterated guide, I just want to understand the puts and takes you're thinking about here, given the macro environment, especially on the international side where budgets are a little bit tighter, you have elongating sales cycles. Obviously, you got a benefit from the 5G builds. But we did hear from some of your networking peers that have cited weakness here already. Just trying to understand how you guys are thinking about order growth in the back half of the year.

Anil Singhal, President and CEO

So Jim, thanks for the question. So I think there's another dynamic that plays out on our business in addition to the very good backlog we had entering this year. When we look at the networking peers, they are mostly infrastructure companies, and we have a trailing effect on both spending cuts and spending opportunities once the network build-out is done. Then you use tools. So I think if we see some headwinds on the macroeconomic side, we'll probably see that, and we'll update that at the end of the fiscal year. So we feel comfortable the range which we have allows us to manage this and with all the other pipeline and other information and visibility we have. And despite some of the things you are seeing in the international side, we at this point feel comfortable with the guidance.

James Fish, Analyst

That's helpful, Anil. Obviously, still elevated backlog, I'll agree, but how are you guys thinking about that backlog returning to kind of normal as the supply chain does start to open up? Is it by fiscal year-end of '24, earlier or later? And then Jean, it sounds like there was a little bit more professional services mix this quarter in the service revenue. Is that right? Or is it just kind of the natural flow-through of maintenance starting to pick up as products grew last year?

Jean Bua, Executive Vice President and CFO

What is coming through this quarter in service revenue is something that occurs nearly every year. We have maintenance customers who sign contracts after their original due date. Therefore, any service period you’ve provided contributes to revenue at that time. In the third quarter of last year, we had a significant amount of back maintenance. In the second quarter of this year, I would estimate that the change in back maintenance contributed around $5 million.

James Fish, Analyst

Okay. Regarding the backlog timing, historically it was about $25 million to $30 million, and now it's around $80 million. Are you considering it to be a 6-quarter or 8-quarter time frame?

Anil Singhal, President and CEO

Well, I think overall, it will be somewhere in between because of hopefully higher growth because of our cybersecurity initiatives. So some of the new initiatives, even though this year, we feel comfortable with the guidance, a lot of the new things have not significantly contributed to this. And we have a general feeling that cybersecurity is less prone to macroeconomic challenges than service assurance. So the investment we made last year, so our plan is that our backlog will be somewhere between the traditional one, which we had, like you talked about $30 million, $40 million to the elevated one, mainly because of calibration. I mean, calibration business is still possible this year, but nowhere will be at the size of what it was last year. So it's hard to predict what the backlog is going to be like this or lower or higher in the next 18 months. But I think when we talk about the guidance for next year, it will reflect our insights into that.

Operator, Operator

We will take our next question from Kevin Liu with K. Liu & Company.

Kevin Liu, Analyst

Just wanted to clarify some comments around kind of the macroeconomic impacts on your business. Have you guys seen anything to date in terms of delays or project cancellations that are concerning at all? And then I was just wondering, with cybersecurity maybe being a little bit more insulated, whether you're expecting your service provider business to hold up fairly well.

Anil Singhal, President and CEO

Overall, I think we see that so far, we have not noticed any significant delays regarding major deals. We'll have to see how things change over the next few months. We are still experiencing some benefits as we have very few supply chain issues, thanks to being a corporate company and the way we package our software. With the support of our partners, we manage those aspects well. We believe that, even in this environment, we could potentially benefit from some supply chain revenue coming from other vendors in the last quarter. At this moment, we are not seeing any negative impacts. However, we will need to monitor the situation closely, and we'll take it into consideration when providing guidance for the next fiscal year. For now, we are fortunate not to be facing any real issues that we hear about in other earnings calls.

Kevin Liu, Analyst

Understood. That's good to hear. And then just on the expense side of things, you guys talked about things starting to return to kind of pre-pandemic types of spend with in-person activities. Just wondering as we look out to next year and maybe in the future, do you feel like this is kind of a more normalized baseline that should recur from year to year? Or do you think there's even more kind of interest in activities that will continue to pick up and that we should account for?

Jean Bua, Executive Vice President and CFO

I would say that the level of travel is not as high as we initially expected for this fiscal year. Therefore, next year, I anticipate some travel expenses may reappear in the profit and loss statement. Additionally, given the current economic conditions and the fact that many individuals have seen significant salary increases, we will need to assess whether this trend continues into our next fiscal year. Aside from those two points, I don't foresee any other operating expenses emerging. As the company generates additional revenue, we expect to maintain a strong flow-through to our operating margin and earnings per share.

Kevin Liu, Analyst

Great. Congrats on the quarter end.

Operator, Operator

We have no further questions on the line at this time. I will turn the program back over to Tony Piazza for any additional or closing remarks.

Tony Piazza, Senior Vice President of Corporate Finance

Thank you, operator. That concludes our call for today. Thank you for joining us, and have a good day.

Operator, Operator

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