Netscout Systems Inc (NTCT) 2007 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the NetScout second quarter fiscal year 2007 operating results conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session. Instructions will be given to you at that time. As a reminder, this conference call is being recorded.

With us today is NetScout's President and Chief Executive Officer, Mr. Anil Singhal. He is accompanied by NetScout's Chief Financial Officer, Mr. David Sommers. Also with Mr. Singhal is NetScout's Director of Investor Relations, Ms. Cathy Taylor. At this time, I will turn the call over to Ms. Taylor to supervise the opening remarks. Ms. Taylor, please proceed.

Thank you and good afternoon everyone. Welcome to NetScout's second-quarter fiscal year 2007 conference call for the period ended September 30. In terms of the format of this call, Anil will begin with a brief overview of our second quarter financial results, followed by a summary of our operating highlights. David will follow with a review of our financial results and company performance in greater detail. At the conclusion, there will be opportunity for questions and answers.

Before we begin, however, let me remind you that 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 want to emphasize that these forward-looking statements may involve judgments and that individual judgments may vary. Forward-looking statements include expressed our implied statements regarding future economic and market conditions, the Company's revenues, profitability and growth and delivery and market acceptance of NetScout product. 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 in the year, such as during the quarterly earnings calls. 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 make today are still valid. The risks and uncertainties that could cause our projections not to be achieved include the specific risks and uncertainties that are discussed in NetScout's Form 10-K for the year ended March 31, 2006, on file with the Securities and Exchange Commission. I will now turn the call back over to Anil Singhal, our Chief Executive Officer.

Thank you, Cathy. Our financial results for the second quarter were at or above our previously issued expectations and we are pleased with the Company's performance and I believe (indiscernible) bounce back following a slower-than-expected start in the first quarter of the fiscal year.

Revenue was within our previously issued guidance at $35.1 million, while an operating margin of 10% helped to drive earnings per share of $0.07 per share (indiscernible) the high end of our previously issued guidance. Our improved profitability is a result of our continued focus to drive operating leverage and our year-to-year EPS growth of 40% for the quarter was in line with our goals for the full fiscal year.

In addition, I'm pleased to report other quality financial metrics that highlighted the strength of our financial performance during the quarter. We saw strong revenue coming from international sales, representing 33% of revenue. In particular, the contribution from Europe was up this quarter to 15% compared to 10% last quarter in spite of the fact that September quarter tends to be a seasonably weaker quarter in Europe. This is a big improvement over last quarter and we are pleased that the sales restructuring we initiated last year is beginning to produce a positive impact.

In addition, we saw strength coming from our government sector as well as the high-technology sector with a seven-figure deal coming from a very large personal computer manufacturer. This was also a large competitive win for NetScout. During the quarter, we saw significant revenue traction with our new nGenius application fabric monitor, which is based upon our next-generation application fabric performance management architecture. The nGenius application fabric monitor is a new product we released in Q1 that combines the capabilities of our nGenius probe and nGenius Flow Recorder product in a single high-capacity, high-performance platform. This product puts us in a superior [cost] (indiscernible) capability position versus our key competitors and we are pleased with customer interest to date.

The increasing interest of our new products was further validated by record attendance at the recent user forum held during the fourth week of October in Las Vegas. The theme of the conference -- Conquering the Chaos -- Real Performance in a Virtualized World -- was focused on the new challenges that our customers are facing with complex operations introduced by virtualization and convergence in today's application and network infrastructures. We had more than 40 educational sessions headed by NetScout employees and key customers that covered many topics, including the challenges of application monitoring within complex [LDF] and service-oriented architectures, managing the performance of MPLS in converted networks, troubleshooting voiceover IP deployment, and how our products can be used to instrumental in shortening mean time to repairs.

We showcased the newly patented automated problem detection capabilities of our new nGenius analytic products and the combination of flow and packet recording for the application (indiscernible) monitor that is being well accepted by the market. Our customers are already excited about these new products that will help them automate the process of detecting and diagnosing application and network performance problems before they impact critical business services.

I would like to end my discussion with some comments on the short-term and long-term growth initiatives we have set for the Company and we entered the second half of our fiscal year. Our confidence in our growth prospects and our ability to execute remains strong. At the beginning of this fiscal year, we set EPS growth targets of at least 40% for each of fiscal year '07 and fiscal year '08. These targets were set in anticipation of continued operating margin leverage in the short term and success with our new top line growth initiatives in the long term. We have made good progress in improving profitability and we believe our strategic growth initiatives have produced a good foundation for future top line growth. These initiatives include an expanded sales team and territory coverage, competitive market share gains based on our new application flow monitoring and analytic products and deeper penetration into the [wireless of this] provider customer segment. During our recent user forum, we received a lot of interest and enthusiasm from our key users in support of these initiatives. I'm happy to report that we have been making steady progress in each of these areas, which gives us confidence that top-line growth will further (indiscernible) during the next 12 months.

With that, I would like to turn the call over to David.

Thank you very much, Anil. Our quarterly financial results, which you can find in the financial statements, are included with our press release.

Our second quarter revenue of $25.1 million was up 6% year-over-year and over the previous quarter. Net income for the quarter on a GAAP basis was $22.3 million, or $0.07 per diluted share, compared to a net income of $1.4 million, or $0.04 per diluted share for the previous quarter and compared to net income of $1.5 million, or $0.05 per diluted share in the second quarter of fiscal 2006. Revenue contribution from direct customers was 37% compared to 40% last quarter. Reseller revenue made up the balance.

During this quarter, we added 33 new customers worldwide, delivering 14% of total orders. The rest of our order volume came from 247 repeat customers. 57 customers gave us orders over $100,000 this quarter, including seven customers with orders over $500,000. Revenue from international sales was 23% of total revenue, up from 16% last quarter with Asia share representing 8 points and Europe 15 points of the total. As Anil mentioned, this is a big improvement over last quarter.

Our vertical markets this quarter -- in our vertical markets, the financial services sector represents 35% of order dollar volume, followed by government at 14% and high tech at 13%. Manufacturing, telecom and consumer sectors followed each representing 7% to 9% of the quarter volume. During the quarter, we saw significant strength and competitive wind involving 37 deals totaling approximately $6.9 million against Network General and a number of other competitors.

Turning back to our financial picture, our gross profit for the order was $19.4 million, up 7% year-over-year and 5% sequentially. Gross margin was 77% in the quarter, flat year-over-year and down 1 point sequentially. Operating expenses in total were $16.8 million, up 2% year-over-year and down 3% from last quarter as we continued our expense focus.

Income from operations was $2.6 million, which included $330,000 of stock-based compensation expense and $143,000 of amortization of intangible assets from the acquisition of Quantiva. Operating margin was 10% for the second quarter, up 3 points from last year and 6 points from last quarter. Our long-term operating margin model goal is 15% to 20%.

Turning now to key balance sheet measures, cash and marketable securities are $90.7 million, flat sequentially and a year-over-year increase of $13.2 million. Cash was flat due to cash outflows for annual incentive compensation payments and our share repurchase program. Last quarter, we announced a 3 million share increase to the repurchase program to provide shareholder value and support the growth of EPS and return on equity. During the quarter, we repurchased 152,000 shares. We expect to continue the execution of the buyback program going forward.

Accounts receivable, net of allowances, was $17.9 million compared to $15 million last quarter and $12.2 million a year ago. Days sales outstanding were 65 days for the quarter, up from 25 days in the prior quarter and above our target range of 45 to 55 days. Inventories were $4.3 million, down from $4.4 million in the prior quarter.

And now for our guidance. We are issuing detailed guidance only for the December quarter today. We expect third quarter revenue to be in the range of $25.5 million to $26.5 million. We expect net income per diluted share on a GAAP basis to be the range of $0.05 to $0.06. In addition, we expect annual net income per diluted share to grow by at least 40% annually in fiscal years 2007 and 2008.

This is the conclusion of our guidance. We plan to provide further guidance at the end of each quarter in our succeeding conference call. We do not plan to and disclaim any obligation to provide updates to this information, even though our expectations may change during the quarter.

And now, Anil and I will take your questions. Meredith, would you go ahead please?

(Operator Instructions). Peter Jacobson, Kaufman Brothers.

With respect to the guidance, given anticipated -- I guess the midpoint would represent a sequential improvement in revenue in the upcoming quarter. Why would EPS be lower?

Good question, Peter. We anticipate continued growth in investment in our development and sales organizations, and so we expect that there will be that dampening effect in Q4. However, I should point out that our guidance -- operating margin target guidance still stands going forward. So that's a short-term impact only.

Okay, and that operating margin goal of 15% to 20% is at what revenue level?

Well, we haven't really disclosed that. I think a lot of moving parts to go into determine that, but I think you can sort of project forward from our long-term historical performance of revenue growth and operating margin growth over the last several years and come to the conclusion that it's not too far in the future, but not this fiscal year, clearly.

Okay. And how far along are you with respect to the sales hiring as of the end of the quarter, and how much left to go in the fiscal year?

We're pretty much done with our sales hiring. We, this year, as we said we would, front-end loaded the hiring so that we could get the folks on board and get them starting to come up the learning and productivity curve, and so we're pretty much -- we're at the target that we set.

Okay. And I believe your product as a percentage of total revenue went up sequentially in the September quarter to 63% versus 16% in the June quarter, and yet the gross margin declined sequentially. Can you explain what's happening there?

Sure. When we have an effect, it often occurs when inventory grows, which it did in the first quarter. When inventory grows, it's often, as it was in the first quarter because we are building finished goods inventory to be -- obviously in the first quarter, we did not achieve our revenue target. So when we don't achieve our revenue target and we can see that coming, we built inventory to be sure we are ready to fulfill any orders that may come in toward the end of the quarter. And when that happens and we build finished goods inventory, the dynamic of our cost accounting calls for us to take some of our fixed manufacturing costs and allocate them to that inventory. So instead of going to expense in the quarter in which we spend the money and pay the people -- principally, the people -- that spending goes into -- onto the balance sheet as inventory. Then in the quarter in which inventory doesn't change much as it didn't between Q1 and Q2, those costs basically stay in inventory, but all of the current expense, that fixed labor expense, goes back into the cost of product. So that's what happened. It's really not an artifact of the Q2 gross margin, it's really a dynamic that happened in Q1. So the issue is -- Q1 was high. Q2 was more like our -- is obviously closer to our target gross margin of 73% to 76%.

Okay, that's all I have. Thank you.

Eric Martinuzzi, Craig Hallum.

Good afternoon. The guidance implies a relatively slow growing at the midpoint -- I think I meant 4% -- total revenue year-on-year for the coming quarter. And then I have 6% for the current quarter and then we had a decline of 5% the prior quarter. The good old days, we saw solid double-digit growth for many quarters in a row. Now your script talks about acceleration during the coming 12 months, but your script, your prepared remarks, have said that for some time. What is the catalyst that gets that revenue line moving again? I'm very impressed with the operating margins, but it's just -- I'm concerned about the single-digit revenue growth.

Let me make a couple of comments, Eric, and then David can add to it. I think I mentioned at the end of my portion that some of the initiative we have started, which is along the lines of new product; some of it we introduced last quarter, and it's just slower time to gain traction. The number of people we've hired, even though we hired (indiscernible), it's just taking longer than we thought it might in terms of having additional impact on the top line. And also, as we talked about on the partnership initiative, some of the things happening in the industry -- consolidation and all those -- have slowed down some of the partnership -- it's a positive impact from partnership and those initiatives. So, because of that, I think the growth is slower than we expect, and at the same time, we made sure that we can fulfill our commitment for 40% EPS growth this year. But, obviously, in the next year, it will rely on top-line growth.

Okay, well, just let me shift to the EPS growth, and the guidance implies basically flat there if we look at -- you guys posted $0.06 in December '05, and I think we're at $0.06 at the high end for December '06. And I know your guidance is for a full year, as opposed to quarter-by-quarter, but is there a reason -- you know, we had terrific year-on-year EPS growth in Q1 and Q2 that Q3 -- is this just conservatism on your part, or is it a seasonality, a spike in Q4 that we should look for?

Well, with the revenue growth that we anticipate, as Anil explained, we think we are, as I mentioned, continuing to invest in those revenue growth-driving initiatives longer-term, and that's really what's dampening down the December quarter earnings by a small amount. You're right, it is about level with the year-ago quarter, and you're also right that we are focused on -- increasingly on annual performance, rather than quarterly performance. And so as not to overlay constrain expense as we still try to manage for operating leverage, but overly constraining -- we don't want to overlay constrain expense to cut off the investment in future growth. So that's really the only thing that's going on here. Our full-year guidance of 40% EPS growth, obviously, we have reiterated, as you alluded to.

One last question on the operating expenses. If you're investing in the sales and marketing, I was surprised to see that down sequentially by about $800,000. Is there a onetime issue that would help clear that up?

Good observation. There are a couple of things that happened, and again, this isn't so much a current quarter issue as a prior quarter issue. In the prior quarter, we have all of our sales meetings and celebrations for prior-year performance, and that involves a lot of travel and meeting expense. And at the same time, we were of course in the first quarter bulking up the sales force, and that added not just -- and obviously, they added people who are still there, or still here -- but it also added a significant amount of recruiting and other costs. And then, there is another factor that starts to kick in this time of year, not just in sales, but because of our successful close to the prior fiscal year in March, which is included in the current tax year, personal tax year, we start to see highly compensated people coming off of payroll tax. And for -- and it's because the sales force had a relatively strong finish in FY '06, we're starting -- we started to see those effects in the September quarter in sales. So those are the three major factors why --. One of them, the last one, is a Q2 effect. The other two are really Q1 effects. But that's why the difference between Q1 and Q2 is so pronounced.

Okay, then a normalized sales and marketing line is more like $10 million than it is like 10.8 million -- is that fair?

Yes, I would say so, or 10 -- or someplace in the middle of those numbers, yes.

Thank you.

Jeff Meyers, Intrepid Capital.

Thanks guys. So how much of revenue this quarter was from the AF Mon products?

Jeff, we don't break it out, and it will be too early to see that, but it was significant. But in terms of the percentage growth, but it was not still significant compared to other products. But as it was for second quarter, that avenue in the early first and second quarter, it was much better traction than some of the previous products.

Gotcha. How much of the revenue this quarter was from wireless carriers?

Jeff, I think that was about --.

7% to 9%.

Yes, it was in 7% to 9% range -- I think it was about in the middle of that range.

And how does that compare to previous quarters?

Well, this was a lower quarter for that. Our carrier business is pretty lumpy. More than the enterprise business, the carrier business tends to come in big chunks because they buy -- that's the way they buy. And we didn't have -- we just didn't have a number of big chunks this quarter. That's just the sort of luck of the way things fell. It's not an indication that the business is weaker. We don't think it's any weaker; in fact, we think it's better going forward.

Alright. Maybe talk a little bit about -- the sort of WAN optimization market has been extremely robust recently, and just wondering if you're seeing any spillover of that into your markets, or if you're seeing any sort of takeaway from your markets for some of those players?

I think in some sense, we're not necessarily increasing our RAM business. In fact, when the WAN is optimized, in some places, people may not use our products. So it could have a negative impact. But, it's having a positive impact in terms of troubleshooting aspects. So, typically, even if they're doing WAN optimization or they're deploying WAN optimization gear on the WAN side, they'll need some troubleshooting edge on the LAN side for the same traffic. And that's one of the reasons AF Mon, there's a lot of interest in the application fabric monitor product, which is basically -- can help you troubleshoot the problem before and after. So it's not necessarily improving our RAM business, but it does improve our overall business.

Gotcha. Last question is, I guess receivables were up and your DSOs were kind of to a level they were I guess the third quarter last year. Is there any dynamic behind that or --?

It is higher than we target, and higher than we want. We had a significant customer order that was still on the books at the end of the quarter that -- it was just slightly longer terms than some orders; that's all. And we expect that to come back down into the range shortly.

Okay, thanks.

[Sam Saunders], [F.I.T.].

Congratulations on the nice profitable quarter. I was hoping you could speak qualitatively about your pipeline and compare it to maybe the same time last year. Is there any difference in the dispersion among the verticals of opportunities that you're seeing or in the different product offerings?

Well, Sam, we don't -- we do talk in general terms about the pipeline, and I can tell you that the pipeline is stronger now than it was a year ago and is supportive of the kinds of revenue growth directions that Anil talked about earlier. We don't really break it down into verticals the way you have asked -- or products, the way you've asked, partly because the pipeline is uncertain, and therefore, the statistics aren't really too robust; that is, they're not too stable. But we continue to see interest in growth in service provider. We are seeing -- and the ongoing interest in financial services that has been our core for a long time, but that is broadening now, not just in the telecommunications service provider area, but we think there's going to be growing strength or continuing strength in our government business, which was good in Q2 but not -- it didn't indicate a sort of end of government fiscal year finish in part because a lot of the things that we've been working on are not apparently tied to fiscal year money. They are programmatic -- that's program money that's continuing. So we expect to see continued strength in the government business as we move into the December quarter and beyond.

Beyond that, it's some of the usual suspects -- health care, increasingly some retail customers, and as long as the oil price doesn't go down too much, the energy business.

I think one thing to add, that is the introduction of new products, and our product being is even more competitive with some of our nearest competitors. We will -- the closure rate will be much higher on the pipeline. So overall, the effective pipeline will look bigger because of that also. So one of the advantages of this new AF Mon product analytics is that we expect our closure rates will be higher moving forward, or the sales cycle will be shorter.

Great, that's really helpful. And if I could just follow up, sorry I'm new to the company, but I'm not sure whether the seven deals that you had that were over $500,000, whether that was a lot or a little for the Company, but I did notice that last quarter you had some $1 million deals. Were those deals lower than you expected? Is there an opportunity for those customers to come back in the future?

Well, there's a couple of facets to your question. First of all, we don't always announce the over-$1 million deals. We have pretty steadily announced the $100,000 and larger deals, and sometimes the $500,000 deals. Our experience this quarter was not all that different, slightly more robust, but not all that different than recent quarters in the number of large deals, and then it was a year ago. We don't target that specifically. Obviously, we try to, for productivity reasons, grow the size of the deals and we have been over the last few years pretty successful in doing that.

Now to the last part of your question about customers coming back, yes, and our business is one of longtime customer relationships. So the 33 new customers that we earned in this quarter, typically new customer business is in the range of $100,000 or less. And then over time, they will come back for larger orders. Most of the large orders that we talk about here -- not the over $100,000, but the larger ones -- are almost always repeat business. So customers will establish a small footprint and then come back with a significant expansion of that footprint or the deployment of our product in their networks. And our customer relationships are long-lived, so we will do ongoing business, not just maintenance business, but new product business for multiple reasons, including new products that we introduce, but also additional deployments of existing products throughout the networks over multiple years. And so our longest customer relationships are now more than a decade old, and those customers are still active, buying more products.

Great, thank you. And then last question, if you could just -- I don't know if you disclose this on a quarterly basis, but could you tell us how many sales folks you added and what the quota-carrying sales reps are?

Sure. We had talked about that. We are 57 quota-carrying -- direct quota-carrying sales reps this quarter. That is up two from where we ended last quarter, the June quarter. And as I answered in an earlier question, that is about our goal, so we are done. Obviously, we may do some replacement hiring if there's any attrition, which hasn't been very high, so -- but we're not going to grow the overall number for this year because we're at our target. You asked about quota? Did you have a follow-on piece of that?

Sure. Did you accrue for quotas this quarter?

Yes. We always accrue for quotas that are for compensation, sales compensation that is tied to the revenue that we book. We pay commissions on a slightly different basis than we approve and expense it in the financial statements, but we always do that.

Great, thank you.

Ted Levy, Excel Securities.

Yes, good afternoon, gentlemen, and congratulations on an excellent quarter in terms of sequential and year-to-year growth. Quite pleasing. And I just have several questions here. I was wondering, with the $91 million, or $90 million approximate in cash between current and long-term assets, and I have several questions; I have a follow-up. Are there any acquisitions out there that might enhance or fill out your product line, enhance your distribution with all that cash that you're sitting with? And a previous mention was made of WAN optimizations versus troubleshooting. Is that an area that you could fill out a little bit in the WAN optimization and so forth to balance off your troubleshooting? But that was my first question -- whether using some of that cash [where in acquisition] is something in the back of your mind, if there is anything that makes sense out there?

First of all, that is always in the back of our mind, and we have done two things since we went public a few years ago; five, six years ago. But, we wanted to do things which are complementary to what the expertise company has and complementary to that existing product line. And WAN optimization doesn't fit that category, because our product is, regardless of whose WAN optimization we use, regardless of whose network product you use or infrastructure you use, our product can be used to give you the before and after effect, whether the investment was worth it. So, by putting WAN optimization in (indiscernible) not only we we'll have to compete with these lot of established players, but people will be questioning that independent view. So we keep looking for things (indiscernible) we talk about every month somewhat (indiscernible) [other] opportunities. And there is something which is -- fits the model we have, and then we'll be looking at that. Until that time, we have talked about buybacks as one use of some of the cash.

Understand. And I appreciate you filling me in on that. The next question -- with 31 million shares outstanding, I know that you have initiated an increase in your buyback from I think it was 800,000 and added 3 million shares. I note that you bought 158,000 shares back in the quarter, which is during the last several months or something like that. Your stock trades about 70,000 shares a day I think or something. It seems like that's a mere pittance. Maybe that's just because you just started or maybe there's some restrictions and so forth. But do you really mean, when you say that you authorized a buyback, is this -- sometimes, you send a signal which is not really -- whereas you're -- you may not mean it to the fullest extent. I mean, 158,000 share buyback, that would take a mighty long time to buy back 3.8 million shares, I'm just curious. And also, with 31 million shares outstanding, does it really make that much sense? It seems like you're heading towards like some sort of in the direction that one would go for an LBO in a sense, because you own quite a few shares.

And lastly, wouldn't it make more sense to pay a dividend out? And I know that you and some of your key people own 10 million shares basically. Distributing some sort of cash dividend, whether it's a special or something like that, you get some favorable tax treatment of that. Those are some of the issues that are running through my mind. But I love your company, you have leading-edge technology, and I think you're doing a great job in staying on top of that. But, these are just a couple of things that pass through my mind, being a relatively long-term investor. Thank you.

Certainly. Let me try to tackle some of those questions, Ted. First of all, to make sure we were clear, it was 152,000 shares that we acquired in the September quarter, and there were startup issues. We announced the program and had to get it in gear. Our blackout, trading blackout -- the Company follows its own trading blackout, and so our number of trading days open during the quarter is relatively restricted. And so when the trading window closed, we stopped buying.

We intend to, as we announced, and we by implication tried to reiterate that we're going to be active in executing the buyback. As with any program like this, there are constraints around the buying activity, which we don't disclose. But we intend to be active. It is, we think, the best way to deliver value back to the shareholders. We think it's better than a dividend. Obviously, you pointed out that there are insiders who have significant holdings, and the purpose of this use of cash is not obviously to deliver it to the insiders, but to deliver it to all current and prospective investors, and the Board has deliberated on the issues of best use of cash and concluded that this is the one that we should pursue at the moment.

In terms of LBO and other kinds of possible directions, we don't comment on anything of that sort. So, I'm not sure if I missed any of the aspects of your question, but if I did, please bring them up again.

I'm just sort of doing a positive venting of what's flowing through my mind. I have been in this business for 40 years and done research on everything. But as I sit here, I actually bought about 150,000 shares during the last quarter, so -- for my clients, which isn't that much. So I'm just sitting here and just musing on it and sending a little bit of a message and so forth. But I realize it's a thin stock and so forth, and I had no restrictions at all. In fact, it created a buying opportunity I guess when you blacked out. And the only thing, I'm just punctuating again, a cash dividend can be helpful. I don't know what you would pay in a special dividend, like (indiscernible) a Microsoft or something, or -- but institutional investors sometimes, maybe they're not any more, maybe they're (indiscernible). But anyway, congratulations on a great quarter. I've been following the new product rollout. It is excellent and that's all I can say and we'll sit back until the next quarter.

Thank you.

At this time, there are no further questions. Gentlemen, are there any closing remarks?

Yes. Thank you all very much, thank you for a robust set of questions. We appreciate your interest and attendance, and we will hope to see you in 90 days at our next earnings conference call. Thank you very much.

This concludes today's conference call. You may now disconnect.