Netscout Systems Inc (NTCT) 2004 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to NetScout's third quarter operating results conference call. [OPERATOR INSTRUCTIONS] With us today is NetScout's President and CEO, Mr. Anil Singhal. He is accompanied by NetScout's CFO, Mr. David Sommers. Also with Mr. Singhal is the NetScout's Director of Investor Relations, Ms. Cathy Taylor. At this time for opening remarks, I would like to turn the call over to Mr. Singhal. Please go ahead.

Thank you and good afternoon, everyone. Welcome to NetScout's third quarter of fiscal year 2004 conference call for the period ended December 31. I'll begin our call today with a brief overview of our financial results achieved this quarter followed by a summary of operating highlights for this quarter. David will then review our financial results for the quarter in greater detail. First, let me turn the call over to Cathy Taylor, Director of Investor Relations, who will read the Safe Harbor statement.

Thank you Anil. During the course of this conference call, we will be providing you with a discussion of the factors we currently anticipate that may influence our results going forward. Before doing so, we would want to emphasize that these forward-looking statements may involve judgment and that individual judgments may vary. Forward-looking statements include expressed or implied statements regarding future economic and market conditions, revenues, profitability, growth, delivery and market acceptance of NetScout's products. It should be clearly understood that the projections on which we base our guidance and our perception of the factors influencing those projections are highly likely to change over time.

Although those projections and the factors influencing them will likely change, we will not necessarily inform you when they do. Our company policy is to provide guidance only at certain points of the year such as during the quarterly earnings call. We do not plan to otherwise update that guidance.

Actual results may differ materially from what we say today and no one should assume later in the quarter that the comments we provide today are still valid. These and other specific factors could change, causing our projections not to be achieved. Specific risks and uncertainties are discussed in NetScout's Form 10-Q for quarter ended September 30th, 2003 on file with the SEC. With that, I will now turn the call back over to Anil Singhal, our CEO.

Thank you, Cathy. We are quite pleased with our overall financial performance this quarter. Our revenues, profitability and cash increased sequentially and we exceeded our previously issued guidance for the quarter. The revenue for this quarter was $18.9 million compared to last quarter's revenue of $17.5 million. The EPS was one cent per share compared to last quarter's break even of zero cents per share.

Our cash flow from operations was positive and cash increased by $1.5 million to a total of $73.7 million. The third quarter ending in December has been traditionally a strong quarter for us due to increased end of calendar year spending. This quarter also benefited somewhat from the improved economic climate. But we are most excited by the fact that our results this quarter were further improved as a result of the market's acceptance of our newly released products based on our patent pending CDM technology.

As you know, last quarter we began shipping nGenious Performance Manager 2.0 and the new 6.0 form upgrade for our nGenious Probe family. Our sales force is enthusiastic about the response to our new products and strategy as the customers recognize the compelling value proposition of our products that provide in simplifying the management of the complex networks.

Orders from both new as well as existing customers were on the rise this quarter and are a testimony that we are achieving these market penetrations.

Our customers also are seeing the value that our solution provides in other important areas of network management. The rich performance analysis and traffic flow data that is gathered and integrated by our CDM technology into a single solution is being used as a unique information source for other vendor applications. Enterprises are using our advanced flow data for a number of applications spanning critical areas of security forensics, virus tracking, billing, modeling assimilation and policy-based orchestration.

Our strategy is to provide our customers with a single performance data source or one box under wire for multiple management application need. This strategy reduces the need for multiple types of data sources tapping into the network for performance management data, thus simplifying the management of complex networks and providing our customers with significant cost savings.

I would like to review two specific examples, which demonstrate the power and usefulness of the strategies. As we mentioned last quarter, network security management is challenged by a plethora of point tools and numerous data sources all gathering similar types of data. To help solve this problem, we have been working with a group of Nextel customers in the development of security management solutions covering multiple aspects of network security including network forensics, intrusion detection, network surveillance and anomalous behavior detection.

Our products have long been used for network forensics and troubleshooting. We recently announced a flow director blade as an option in our nGenious Probes that interfaces with intrusion detection application.

Another large network customer is using the nGenious Probe as a data source for the network surveillance implementation instead of using an outside vendor appliance as a source of data.

In addition, last quarter, we developed application-programming interfaces, which provided direct interface with the nGenious Probe to mine data for anomalous behavior detection in new and emerging application in the security space. In all these cases, the Ingenius Probe can be simultaneously used for performance management offering substantial cost savings and benefits to our customers.

The usefulness of our solution is also being demonstrated in the area of users-based billing and matrix. During the quarter, we secured a very large deal at a financial institution in conjunction with a large system integrator where our solution is supplying data for use in a global users-base billing system to control infrastructure costs. Our high-speed probes are being deployed and business units located twelve countries throughout North America, Europe and Asia.

In summary, our CDM technology provides a single source of integrated data in a simple, yet powerful solution that can be leveraged in a number of applications like those I just mentioned, dramatically reducing the total cost of ownership for our customers.

We are encouraged by the results in Q3 and we continue to see increased sales activity combined with an improvement in our pipeline in the quality as well as quantity of bills. We are pleased that the investments we have made over the past year and half are beginning to show results and we look forward to announcing in upcoming quarters additional products and other initiatives as we continue to execute on our vision. With that I'll turn the call over to David.

Thank you, Anil. I would now like to review our quarterly financial results, those results are contained in the financial statements included with our recent press release. Revenue for the third fiscal quarter of 2004 was $18.9 million, an increase of 8% over last quarter and 4% over the third quarter of fiscal year 2003.

Our product revenue increased 13% over last quarter and increased 5% from a year ago. Service revenue was up 1% over last quarter and up 14% year-over-year. License and royalty revenue was down slightly from last quarter, but down 61% from a year ago, due in large part to lower volume and pricing for Cisco sale of our Inenius real time monitor software.

Revenue from our direct sales force was 54%, flat compared to last quarter, and reseller revenue correspondingly was 46% of total. During this quarter, we added 41 new customers worldwide, representing 15% of total orders compared to 9% in the second quarter. Some of our largest new customers are KBC Banc in Belgium, China net com, Macao Telecom, TelMax of Mexico, the Arizona Supreme Court, and the Los Angeles department of water and power.

We had 273 repeat customers this quarter, representing 85% of order volume. Some of our largest repeat customers include Johnson Controls, Bell Canada, Bank North, The Borders group, Consumers energy, Eastman-Kodak and Cal Pine Corporation. We had 43 deals over $100,000 this quarter, including two customers with deals greater than $1 million.

Competitive wins were up this quarter with orders more than $3.6 million in the third quarter, involving approximately 18 deals against other leading network management vendors.

Turning now to our vertical markets, similar to last quarter we saw continued support from the financial services sector representing 45% of order dollar volume, with orders coming from a mix of investment banks, commercial banks and transaction processors. This was followed by the health sector with 10% of orders, telecom sector with 8%. We had significant orders from government, consumer and manufacturing sectors.

During the quarter, we added a new banking customer, Compass Bank, with 355 banking offices located across six southern states. Compass Bank turned to NetScout to help them troubleshoot problems they were encountering with their network. The bank was receiving complaints about slow response time from its internet banking customers which was impacting their ability to manage their on-line accounts, and slowing the part of mortgages and personal loan business through the bank's website. Our nGenius solution provided troubleshooting capabilities allowing them to rapidly resolve the problem and to provide management with real time and historical reporting capabilities in addition.

One of our large repeat customers this quarter comes from the food and beverage industry. This customer used our nGenius solution to help them quickly identify and eliminate a worm that was spreading through the network. Our nGenius solution enabled them to identify the location of the worm and quarantine the specific areas of infection without having to shut down the entire network. Because the solution played such a critical role, during the security traffic, they purchased additional LAN and WAN probes so they could get greater visibility into other critical links in their network.

We won another new customer in the United Kingdom this quarter. The consulting arms of one of the worlds big four auditing firms.This customer had recently acquired another large consulting firm and was faced with major integration challenges of combining 2 networks into a new single high-speed WAN. Our nGenius solution was selected because of its value in a large-scale network planning and analysis of the network resource consumption by applications running across the new network.

Now, turning back to our financial picture. Our gross profit for the quarter was $14.4 million, up 9% sequentially, and 6% year-over-year. Gross margin was 76% in the quarter up one point both sequentially and year-over-year. In the future, we expect to remain within our gross margin target range of 72 to 75%.

Our revenue from international sales was 18% of revenue, up from 14% last quarter. Operating expenses in total were $14 million, up 6% from last quarter.

The increase was due to two factors. First, higher selling expenses because of higher revenues and second, the completion in the September quarter of software development capitalization for our new products. Expenses were down 3% year-over-year.

Net after tax profit for the quarter was $184,000 versus a break even last quarter and versus a net after-tax loss of $328,000 a year ago.

Turning now to key balance sheet measures, cash and marketable securities are $73.7 million, an increase of $1.5 millionfrom last quarter and up $3.4 million in from the same period in fiscal 2003.

Accounts receivable net of allowances were $9.5 million compared to $10.8 million lastquarter and $10.6 million a year ago. Correspondingly, day sales outstanding were 45 days for the quarter down from 55 days in the prior quarter and within our target range of 45-55 days. Inventories were $3 million, up 33% from last quarter and down 5% year-over-year.

And now for our guidance. We're only issuing guidance for the March quarter today. Our first quarter in March - for first quarter in March, we expect to be revenue to be in the range of $19 to $20 million.

We expect a GAAP loss per share to be in the range of minus one cent to zero, minus one cent to break even, due principally to increases in operating expenses from higher health are costs as we start the new calendar year, and the seasonal effect of payroll taxes.

We expect to be cash neutral in the quarter.

This is the conclusion of our guidance. We plan to make further --provide further guidance at the end of each quarter in our succeeding conference calls. We do not plan to or disclaim any observation to provide updates to this information even though our expectations may change during the quarter. And now, Anil and I will take your questions. Go ahead, please.

[OPERATOR INSTRUCTIONS] Our first question is from the line of Richard Sherman with Janney Montgomery Scott. Please go ahead.

Anil and David good afternoon. Can you hear me?

Yes Richard, we can.

OK, great. Congratulations, outstanding quarter here. I had a couple of questions that maybe you can help me with. The indirect distribution, I guess you've been working with dimension data. Can you give me a comment on how the overseas channels are doing against your expectations?

I think, yes we do work with dimension data. I think our revenue overseas was up into a healthier range at 18%. We would like to see more from the international business. We think there's increasing potential there. We are continuing to invest in Europe and in Asia. We're getting good response, particularly with a list of new customers that we mentioned a lot of them international.

So the channel is working with us. We are not I think where we would ultimately like to be in terms of international penetration yet, although we don't have a specific goal -- percentage goal. But we are pleased with the new customer response we are getting in Europe and in Asia, we are focusing people in China.

In our Asian group we think that the opportunity in China, as many people do, the opportunity in China for products is pretty substantial for going forward, so we are investing there with partners, with channel partners as we develop them. So the channel's working well. We need to do better, and we think we will.

I know that the September quarter was a little bit weaker in Europe. Perhaps even more weaker than seasonably expected, I think was your comment last quarter. How did that rally in the fourth quarter or was it really uptake in the Asian market that helped? And then the other question there, on the revenue side, as opposed to the earnings side, was there any impact of currency?

Almost no impact of currency for us. We are in the position of doing most our business in dollars. So on the revenue side a little -- almost no currency impact. Regarding Europe versus Asia, much of the strength that we saw was in Europe. We are pleased with our performance in Asia, but it is still a seeding business for us in Asia, so much of the strength came from Europe.

OK. I'll just finish it up new one more or two more. You talked about security. Can you identify perhaps what percentage of revenue was related to security or attributable to security demands, and then the express product, maybe talk little about how that did in the quarter.

On the security side, it's still early and we don't report by percentages anyway. But as we talked about three or four initiatives in the security area that most of them are like three to six months old only. But based on that, we have large number of evaluations going on.

We have been able to address certain opportunities, which would have gone to competition. So it's too early to see the revenue impact, even if you were reporting it separately. But we are very excited about the prospect of customers using a single device, single solution for both performance and security, which is unique in the industry.

On the expert side, when we talked about express, it was both initiative -- express was a both a new customer initiative -- and express bundling of the product. The new customer initiative is working very well. As you can see from these number of new customers. And the product's bundling aspect we are reviewing, and that didn't go very well. But overall the express initiative, which was a number one goal of that, has gone very well for us. In terms of both working with the channel and creating awareness among sales force of the importance of new customers to our growth prospects.

Let me add one thing to make clear. We don't have a security -pecific product in the product set per se. Today, our product line is general purpose, right? Single solutions. So, it is unlikely that we will ever be able to say here is the security portion of our revenue stream because customers buy our products and use it for security purposes as well as performance management purposes and we won't be able to allocate between them.

No, I understand that. I was getting at, you're able to at least identify with a couple of customers that there were security requirements that were being met by the products, and I wondered if, even though, you know, your customers are probably using the technology for more than security, I was wondering how many deals, percentage, whatever you can quantify, how much did security play a part in the competitive positioning process?

I think it's a very low number right now, but it's very important deals. And I think a lot of customers are already, they're looking at other vendors for solutions. So they're not necessarily new customers, but I think just the whole bigger presence we can have in the account and go after bigger budgets is our number one target. And so that is working really well, but it's too early to report on the number of deals even. But, I think, we think that this will be -- this will be a very big initiative in terms of what we are doing for growth in the next year based on the six months.

Great, thanks, guys.

Our next question is from the line of Kim Caughey from Parker/Hunter.

Hello, good quarter also. I'm looking at your list of the larger, new customers, and a lot of them seem to have Internet or Telecom exposure. Are they interested in your products because of the higher-speed probes? Or is it just the whole product set?

I think it is generally the whole product set. And both on the WAN and the LAN side. So I don't think it's specific to any specific portion of the product.

Kim, are you talking about the list of new customers?

Yes. China net com, I don't know what they are, but I'm thinking it's some kind of Internet thing.

Actually, I'm not sure what their business is. I'm sorry.

That's OK. Macao Telecom, TeMex of Mexico?

One of the things we're finding in some of the international space, particularly in Asia, is that bandwidth, and bandwidth management, is much more important there to many companies than it is these days in the U.S. And so -- because bandwidth is not yet built out to the same extent there. So many customers like that are using our products essentially to -- because of bandwidth limitations that -- they're not the principal reasons for the purchases elsewhere in the world.

OK. And I think, I misunderstood Anil's answer to the express product that the bundling somehow was not going well, that new customer initiatives were going well?

Yes.

Let me see if I can elaborate or, on that, expand on that a little bit. The express product bundle is a price-reduced bundle of RPM20 software on an appliance and a single probe. Along with some optional service.

Right.

What we're finding is that when the salesman go into new account and say we have this great simple solution bundled for you, the customers say, gee that's great, how come I can only have one probe?

A terrible problem to have.

The salesman of course says well, there's no particular reason you can only have one probe, so I'll sell you more. And then we don't count it as an express bundle. So, it's having success in generating new customer conversations. But we're not selling a lot of the bundled stuff because they want more.

And that's not really a bad problem, is it?

No.

No. And, I guess in Asia, and China specifically, you are going with established resellers over there as opposed to setting up direct sales.

Yes. We're going through resellers in all places. All international places. Our sales force there does, as is our model in the US, does call on end user customers, but in conjunction with an established reseller.

OK. All right. That's all I have right now.

OK. Thank you.

Our next question is from the line of James Capellow with Turn Capital. Please go ahead.

Good afternoon. Could you tell me the sales of the nGenius Performance Manager 2.0, the complete suite? How many of those you sold and how many probes are you selling per deal?

Well, we don't, James, we don't really report that level of detail. The performance manager sales in general, the software, are starting to ramp up because we' are getting through the period when we have provided the upgrade to our existing licensed customers and now they're expanding their use of, by adding additional licenses, or we're selling it to new customers.

So, that is starting to ramp up. And when we sell Performance Manager, we always sell it with probes. I actually don't have a statistic on how many probes go with a typical license of performance manager, but you can think about it in terms of, of an average-sized deal and in the range of 5 to 10 probes.

I think it's good to mention that each PM is, allow you to have license for 50 probes.

5-0?

50, but initial sale is like David said five to ten probes and some people go to 50 or even higher and some people just stay in the 20-25 range over a period of six to 12 months. But I think one of the main reasons, as you can see from the repeat customers is, in the experts or the replacement stuff which David just talked about instead of buying Express which has one probe they buy PM, Performance Manager has two or three probes. But, the ratio is very low. Typically, five or less probes. And so you will see a bigger content but the price is same, except for the PM in both cases.

And third big reason for doing all this stuff on the PM side, on the Performance Manager 2.0, is by seeing new functionality and new ways of using the data from existing probes for the existing customers allows them to justify new probes in places where they didn't have it in the first place. So because of all these reasons it's very hard to quantify the ratio of PM to probes in the new as well as old account.

OK, and regarding, within the financial services vertical, which area within financial services is strongest right now, whether it be investment banking commercial banking, insurance?

The biggest -- the strongest component of that is, for us still is commercial, although we are seeing, as it has been for some time,although, we are seeing renewed activity in investment banking. And we're very hopeful about the prospects that hold out for us because, investment banks have been dormant for us in terms of significant new business for several years. Although they're still using all of our products. Many of them have yet to start to do major new implementations and we think it is going to come at some point as their business continues to do well.

OK, and can you tell me what the large win you had within the financial services vertical, how much revenue you recognized in the quarter and how much revenue you still have yet to recognize?

I'm sorry, the large deal?

Yes, did you have a large financial customer in the quarter?

Yes. Well, we have -- let's see. How can I answer that? We have shipped everything for that large deal that Anil spoke about. All the orders that we have in-house and there may be some more business to come. There often is in significant rollouts and implementations. And so there may be more follow-on business for that. But essentially there is --there is not -- we're not holding orders at the moment that we haven't shipped.

And what are your sales guys coming back to you, reporting? You mentioned with performance manager, there's six things you guys addressed, troubleshooting, (inaudible) prevention, service level, management and capacity planning, network monitoring, and application monitoring. Which of those six are clients really interested in?

Yes. I think all six areas, and although in each customer base, even within commercial banks and financial sector,one thing is more important to a customer than the other - but the reason they go with our solution is they the can use the same probe and the same application for all functions. And which is different they will have to use that with multiple vendors or multiple products from the same vendor.

There is often a hierarchy of requirements. Troubleshooting, problem resolution is often what customers first -- first look for. In a multi element solution like ours. But ultimately, the value of our solution is - as Anil just said - is its breadth and scope and the ability to do so many things, so many different kinds of things efficiently. Both, efficiently in terms of the network and efficiently in terms of cost. So people will typically migrate to the higher-level planning and application performance aspects of our solution as they use it. And find that those are really where the greatest value is. But that's not always where they start.

OK. Finally, can you talk about competition in the quarter?

Well, we continue to see competition from the usual suspects. We continue to have a very high win rate when we go head to head. And so we've discussed I think -- I mentioned 18 deals in which we won. We typically don't release loss statistics but they are losses are low in relation to that number. And that's not new news for us, that pattern continues.

Now, that is not the say -- I mean, obviously our competitors have good revenue streams. So there are many situations in which they -- they're getting revenue from deals that we don't see. And vice versa. Because of our revenue stream, obviously only 3.6 did we identify as competitive wins and we have a lot more revenue than that. So there's a lot of places where they are entrenched or we are entrenched and the deals are not competitive.

What percent of deals are not competitive?

Well, we identified $3.6 million of competitive wins out of our almost $19 million of revenue for the quarter. So there's a measure for you.

Oh, I'm sorry. I misread that.

No I am sorry, probably didn't communicate clearly.

Thank you very much.

You are welcome.

[OPERATOR INSTRUCTIONS]. And our next question is from the line of Maria Lewis with America's Growth Capital. Please go ahead.

Thanks. Good afternoon, everybody.

Good afternoon, Maria.

I was hoping we could talk a little bit more about the business model impact of the CDM traction that you're seeing. It sounds like you're getting pretty good uptake from prospective partners. I think you mentioned a form factor of a blade that someone had developed.

So my question is when you work with a partner in a non NetScout-centric application let's say, who bears the manufacturing cost of the probe? Like is that blade something that you would produce to ship or does the partner license your software and build that form factor in? And what role, if any, does CDM traction play in the margin guidance being down relative to what you saw this quarter?

Let me go about the partner part and then David can go with the guidance part. That blade is basically a hardware card in our own probe, and it's developed by NetScout, manufactured and both the probes as well as the blade are sold by NetScout. Even when we are working with a partner. And partner is just licensed information, to interact with the probe and there is no cost for them obviously there is -- there are some requirements, and so they sell their stuff and support their stuff. We sell our stuff and support it.

So typically a customer will buy our probes, and nGenius performance management application from us. And for any users, whether it's security or billing, which are not directly addressed by performance managers, will be satisfied through that partner. And so there will be a joint sale situation, but in both applications our probe is the main -- the main point from which the flow of data is extracted. Does that make it clear?

Yes. It does. I guess the follow-on question to that was -- would be -- would you anticipate that you would see a different ratio of probes to your software sale in an application that was driven by a partner's requirement than you would if a partner was not involved?

Yeah because partners have their own ratios or licensing methods. Some partners will make it independent of the probe, but make it based onthe number of users, for example, or number of applications, or number of sites. So they have their own margin of probe ratio versus their data application.

But there's another factor involved as well, which is why we of course we have this strategy and sort of the core of the strategy which is, probes deployed solely for performance management created a certain density of instrumentation in the network that makes sense. As you start to add other applications and uses of the data, either through our own PM20 application or through our partner's applications, it increases the requirement, typically, for probe deployment.

So that a customer with probes deployed only for performance management will have a certain density and then as they start to deploy probes for security or for billing that typically causes the number of probes required to go up. And so you would, generally speaking, expect to see a higher density of probes per PM license in an installation where there are multiple -- where our probes are feeding data to multiple partners than when they're not.

And so the connection to the growth margin guidance, if any?

None. I'm sorry. That's really -- you know, the probe -- the mix software -- hardware mix, it does have some influence in our gross margin, but it's not huge. Our software mix for PM license sales is not -- is not the lion's share of our product business. So there isn't a huge mix swing. There isn't a huge mix swing, if that's what you were wondering about.

Our gross margin is at 76% for the quarters were actually higher than our range and we're not anticipating that that will necessarily continue. Although we're certainly pleased with it. It is -- it is principally, we believe, this quarter, an issue of managing discounting a little more tightly than it is anything any other underlying factor.

Right and then one follow-up if I could on the competitive situation. While it may be that your win ratio, you know, didn't change a whole lot and continues to be good, were there competitive dynamics that were consistent across some of the new wins? Can you describe what it was about your solution that led you to be selected over a competitor?

I think that there are maybe two factors that are coming to the fore. One, we are finding that customers as they see our new functionality, including the reporting functionality that's built into -- really enhanced -- built into PM 20, that is driving a significant competitive advantage for us versus many of our traditional competitors. Those who have a model that is something akin to ours, with instrumentation in the network, do not have the reporting functionality that we do.

And those competitors who have software-reporting functionality don't have the data capability, the deep bridge data that we do. So we have been on this path to expand our functionality to compete better at both -- in sort of both spaces of the -- or segments of the network management market, and it seems to be succeeding with customers in competitive win situations.

I think the other, sort of related I guess, but maybe second aspect of that, is that as customers look at our functionality, and look at the possibility of having multiple network management vendors and their solutions employed and they look at the breadth of our functionality, they're increasingly saying that they can reduce, they can simplify their lives by reducing the number of vendors and number of systems that they use by focusing on ours.

And that has been our hope and remains our hope that that message that we have the broadest, best overall solution in that you need simplicity in your network implementations, your network management implementations, so you should converge your network management use around our solution and then of course we'll provide the data to other kinds of analytical applications that we have described, that that message is starting to resonate. And we think we're starting to see signs of that.

Right. Well, thank you very much.

You're welcome.

We have no further questions at this time. So Mr. Sommers, I will turn it back to you.

OK. Thank you very much for joining us on this call. We look forward to executing another, a good quarter in March and to seeing you all on the call, which will be our fiscal '04 year-end conference call. Therefore in April slightly later in the month than this one was. Thank you for coming and we'll see you then.