Netscout Systems Inc (NTCT) 2009 Q2 法說會逐字稿

Thank you for standing by and welcome to NetScout's second quarter fiscal year 2009 operating results conference call. At this time, all participants are in a listen-only mode. (Operator Instructions). As a reminder, this conference call is being recorded. With us today is NetScout's Chief Financial Officer, Mr. David Sommers, Chief Operating Officer, Mr. Michael Szabados, and Director of Investor Relations, Ms. Cathy Taylor. At this time, I would like to turn the call over to Ms. Taylor to provide the opening remarks.

Thank you and good afternoon, everyone. Welcome to NetScout's second quarter fiscal year 2009 conference call for the period ended September 30. In terms of the format of this call, David will begin with an overview of our financial and operating results and will then discuss our financial results and company performance in detail. At the conclusion, David and Michael will take your questions.

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. Such statements are forward-looking statements made pursuant to the Safe Harbor provisions of Section 21E of the securities exchange act of 1934 and other federal securities laws. These forward-looking statements may involve judgments in that individual judgments may vary. Forward-looking statements include expressed or implied statements regarding future economic and market conditions, our guidance for fiscal year 2009, and our product integration plans. It should be clearly understood that the projections on which we base our guidance and other forward-looking statements 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 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 make today are still valid. For the further discussion of the risks and uncertainties that could cause our actual results to differ, see the specific risks and uncertainties discussed in NetScout's Form 10-K for the year ended March 31, 2008, on file with the Securities and Exchange Commission. I will now turn call over to David Sommers, our Chief Financial Officer.

Good afternoon, everyone. This afternoon, we have a slightly different format because Anil Singhal, our Chief Executive Officer, is ill with the flu. We wish him a speedy recovery. In his place, I will cover our prepared remarks and during the Q&A, both Michael and I will take your questions.

We are pleased to be reporting very strong results in the second quarter. These results are consistent with the preliminary results included with our earlier announcement reaffirming our full-year guidance. The quarter was strong in the face of growing turmoil in the financial markets, which was beginning to cause a slowdown in the global economy. GAAP revenues were $68.9 million, up 14% sequentially, and up 133% year-over-year. Non-GAAP revenues were $73 million, up 12% sequentially, and a year-over-year increase of 147%.

This, of course, is our third full quarter of combined financial results following the merger with Network General. Non-GAAP revenue excludes the effect of purchase accounting adjustments representing the fair value of Network General's deferred revenue. The GAAP profit for the quarter was $4.9 million, or earnings per share per diluted share of $0.12. On a non-GAAP basis, net income was $9.3 million, or $0.23 per diluted share. Non-GAAP net income excludes share-based compensation expenses, amortization of acquired intangible assets, and integration expenses and related income tax adjustments.

Product revenue more than doubled year-over-year, up 13% sequentially on a GAAP basis and up 17% sequentially on a non-GAAP basis. We also saw service revenue up strongly year-over-year, up 174% GAAP and on a non-GAAP basis up 200% year-over-year.

We had a high concentration of business coming from the government, and wireless carrier markets. Despite the broad macroeconomic pressures, business is still strong. We're delighted to be entering our third quarter with solid visibility that gives us great confidence that we will achieve our guidance for the remainder of our fiscal 2009 year.

Notwithstanding this strong quarter, we remain cautious about the economic impact in calendar 2009 on our banking and enterprise customers. And as a result, we are not raising our outlook for the fiscal year and we are reaffirming our previously issued revenue guidance.

Entering the second half of the year, we continue to see good business from the majority of our vertical segments, with particular strength again in government and wireless. As expected, we're seeing some slowing of orders from investment banks within the financial services sector. However, this has been offset with strong orders coming from our high-speed trading and exchange customers. Because of the economic uncertainty, we're in the process of reviewing and resetting our future expense plans to focus incremental investments on direct revenue-producing functions.

Looking beyond the current downturn, we are bullish about our prospects. We believe we have built a strong foundation, underscored by the successful integration -- acquisition integration of Network General that makes us leaders within the network performance and availability market. We're in a strong financial position with continuing strong cash flow and increasing operating margins, which has given us the confidence to raise our long-term operating margin target range, which I will discuss further in a few moments.

Our customers continue to show strong enthusiasm for our products, as evidenced by our continued growth in product revenue. A couple of weeks ago, we hosted our seventh user summit conference in San Diego, and saw a record increase in attendance, up 62% over last year. Customers came from 18 countries around the world, with many former Network General customers meeting our engineering and management teams for the first time. At the summit, we showcased our newly released integrated nGenius Performance Manager and nGenius InfiniStream software, and the InfiniStream continuous capture and deep packet inspection appliances which are key parts of our post-acquisition product integration plan. Customers saw product demonstrations, received training, learned about our partnerships, and collaborated with our engineers and executives. It was a highly energized and successful event for us and our customers.

All of this positive momentum supports the confidence we have in the strength of our market position. Our post-acquisition customer base, new product initiatives, and growing market leadership, combined with our financial strength, positions us better than many other companies in our space to take advantage of the continuing shift toward the highly performance-sensitive modern IP network, and to continue to gain share through any business downturn.

Despite any deterioration in the economy, we will continue to invest in our customer relationships and to broaden our product portfolio with next-evolution products for monitoring applications and services. We are extending our solutions to address other areas of IT management, which include expanded offerings for some of our vertical markets as well as extending our value proposition to other areas of IT operations. And we continue to meet our internal projections. Our confidence in our ability to outperform the market in fiscal 2010 is high.

And now I would like to focus more specifically on our second-quarter results. Our quarterly results are contained in the financial statements which are part of our earnings press release. We are reporting our results on a GAAP basis as well as on a non-GAAP basis. To summarize the difference, we have removed the GAAP purchase accounting effects of the merger with Network General by adding back revenue related to deferred revenue revaluation. And we removed the cost and expense of various acquisition-related items. In addition, we removed the GAAP effects of stock-based compensation, which increased significantly as a result of the acquisition. I will give you the specifics about the difference between our GAAP and non-GAAP earnings as I discuss our results. The adjustments to GAAP revenue cost and expense are disclosed in a reconciliation table in the financial tables attached to the press release. We believe these adjusted financial measures will enhance your overall understanding of our current financial performance and our prospects for the future. We use these adjusted financial measures internally for the purpose of analyzing, managing, and forecasting our business.

Now, our second quarter GAAP revenue was $68.9 million. Non-GAAP revenue was $73 million. Non-GAAP revenue excludes a $4.1 million adjustment, a purchase accounting adjustment, to record at fair value the acquired Network General deferred revenue. Product revenue on a GAAP basis was $39.5 million, up 109% year-over-year and 13% sequentially. Service revenue on a GAAP basis was $29.3 million, up 174% year-over-year, and an increase of 14% sequentially.

Of course, second-quarter results from a year ago do not include contributions from Network General's business and are therefore not fully comparable to the current second quarter.

GAAP net income for the quarter was $4.9 million, yielding earnings per share -- per diluted share of $0.12. GAAP net after-tax margin was 7%. GAAP income from operations was $9.1 million and GAAP operating margin was 13%. Non-GAAP income from operations was $16.2 million, and operating margin non-GAAP was 22%.

The following items, totaling $7.1 million, are adjustments to arrive at non-GAAP operating income. The purchase accounting adjustment to record at fair value the acquired Network General deferred revenue of $4.1 million was added back. Amortization of acquired intangible assets of $1.5 million, which was principally from the Network General acquisition, was removed from GAAP cost and expense. Nonrecurring integration expense of now only $266,000 was removed from GAAP expenses as was share-based compensation expense of $1.2 million.

Non-GAAP net income was $9.3 million, or $0.23 per diluted share. Non-GAAP after-tax margin was 13%. We have used the statutory tax rate of 38% to tax affect the $7.1 million total non-GAAP adjustment amount, removing $2.7 million from non-GAAP tax expense. The non-GAAP adjustments to our GAAP results are summarized in the reconciliation table included with our press release financials.

The provision for income taxes represents an effective tax rate of 35% on a GAAP basis and 37% on a non-GAAP basis. The non-GAAP tax expense rate is calculated by taking the previously calculated GAAP rate of 35% and tax affecting the non-GAAP adjustments, as I said, at 38%, resulting in an overall non-GAAP rate of 37%.

Our GAAP gross profit for the quarter was $51.5 million. GAAP gross margin was 75% in the quarter. On a non-GAAP basis, gross profit was $56.8 million and non-GAAP gross margin was 78%. We made the following adjustments to non-GAAP gross profit. The same $4.1 million was added back to revenue, and we removed $81,000 of share-based comp, expense, $995,000 of amortization of acquired intangible assets, and $39,000 of nonrecurring integration expense.

Non-GAAP operating margin of 22 points was a record high for us in the post dot com bubble era. It is the result of our steady margin expansion over the last six years, which we've achieved through organic and acquired revenue growth, combined with diligent cost and expense management. In the second quarter, that same combination of revenue growth, plus non-revenue related expense containment, drove operating margin up three points to the low end of our revised operating margin target range. That operating margin target range is a non-GAAP measure of the financial performance that we believe we can achieve in the future at the point when our resource growth across the company must begin to grow in parallel with our revenue growth. With our Q2 results, we're approaching that new range.

The new non-GAAP range is a gross margin of 76% to 79%, R&D expense to revenue of 13% to 15%, sales and marketing expense to revenue of 33% to 35%, and G&A expense to revenue of 6% to 8%, yielding an operating margin range of 22% to 25%. So our Q2 non-GAAP result, with an operating margin of 22 points, is at the low end of the range. We expect that the revenue level required to achieve our target operating margin will grow slowly over time when inflation pushes our cost and expense levels higher. However, our Q2 revenue of $73 million is currently the revenue threshold of that operating margin target range.

Because of our historically strengthening operating performance, our balance sheet remains strong. Cash and short-term marketable securities, short- and long-term marketable securities, were $109.4 million compared to $109.8 million in the previous quarter. Our long-term marketable securities include investments at auction rate securities valued currently at $31.5 million. As of September 30, 2008, the value of these securities includes a temporary decline in value of $2.3 million below par, to reflect current liquidity concerns. All of these securities are AA or AAA rated, government-guaranteed, student loan-backed securities, which we believe have no credit issues, only short-term liquidity problems. We've classified these securities as long-term on our balance sheet and recorded the temporary decline in value to other -- accumulated other comprehensive income and loss on the balance sheet.

With our strong cash position and positive cash flow, the illiquidity of these securities poses no liquidity problems for us, and we believe we will achieve liquidity well before the maturity of the underlying bonds and our temporary value adjustment reflects that outlook.

Accounts receivable net of allowances were $26 million, flat with last quarter. Day sales outstanding were 33 days for the quarter, based on a GAAP-on-GAAP revenue. This is down from 39 days in the prior quarter. Using non-GAAP revenue, DSO were at 30 to 31 days. Our DSO of 31 days is the result of strong collections resulting from beneficial shipment and invoicing pattern during the quarter, and seasonally low maintenance renewals. We do not expect that this level of DSO is sustainable. Our expected DSO range is 40 to 50 days.

Inventories were $7.3 million, down from $12.6 million in the prior quarter. The $5.3 million decline is principally the result of recognizing revenue on a large $14 million multi-quarter sale to a wireless carrier customer that had been recorded in deferred revenue, as we've mentioned previously. And with the -- the inventory has been reduced by the product cost that was previously carried in inventory for that deferred revenue.

Turning to other metrics, revenue contribution from direct customers was 52% and reseller revenue was 48% total. The strength of our direct channel business was driven this quarter in large part by the large wireless carrier deal that I just mentioned. Revenue from international sales was 22% of total, down from 24% last quarter. Europe, Middle East, and Africa was 12 points; Asia, at five points of the total. Americas outside the US was five points.

The main drivers of international business outside the US were wireless service provider and financial services.

Summarizing large deals that we booked in the quarter, 140 customers gave us orders over $100,000, up from 116 in the first quarter. Twenty customers were over $500,000 and seven orders over $1 million. Three of the $1 million orders came from financial services companies, including two deals from investment banks and one from a large credit card company. Three came from the government and one $1 million deal came from a large computer manufacturer. In the future, we expect to see some softening of deals coming from investment banks, which we anticipate will be offset, to some degree, from exchange and high-speed trading customers. We expect government and wireless carrier business to remain healthy over the near term.

In our vertical markets this quarter, once again we had strong bookings coming from financial services sector with 28% of dollar order volume. the government sector was up with 23% and telecommunications was 13%. High-tech sector represented 10%, and health and medical followed with 7%.

As of September 30, product backlog orders totaled $23 million. This quarter, we considered this product backlog firm and material to the understanding of our financial results and guidance.

And now for that guidance. We are reaffirming our revenue outlook for 2009 fiscal year, which remains unchanged from last quarter. Our revenue guidance for fiscal 2009 recognizes the challenging economic environment and its potential impact on IT spending. For fiscal 2009, we expect GAAP revenue to be in the range of $250 million to $260 million and non-GAAP revenue to be in the range of $260 million to $270 million.

GAAP net income per diluted share guidance is $0.19 to $0.29. This is an upward adjustment, recognizing the strength of our GAAP EPS results through the first half. Non-GAAP earnings per diluted share guidance is still $0.55 to $0.65. The fiscal year 2009 non-GAAP revenue net income per share estimates exclude purchase accounting adjustments to fair value of approximately $11.3 million of Network General's deferred revenue, amortization of acquired intangibles of approximately $6 million, integration expenses of approximately $1.8 million, and share-based compensation expense of $4.8 million.

That concludes our prepared discussion this afternoon. Thank you for joining us and we look forward to taking your questions. Please go ahead, Brittany.

(Operator Instructions). Aaron [Hoenig].

Great quarter. I know that the new integrated product has only been out for a little while, but how has the reception been and maybe what do you expect in terms of revenue over the next couple quarters from that product?

The product has been out for a couple of months really, the 4.5 release, software release that represents the ability of the combined features there to the combined customer set. And the initial reception was very positive, as demonstrated by the reaction and objective feedback we received from the San Diego user forum, sure. In terms of its impact on our revenues, we factored it into our forecast and we believe that it -- it continues -- a strong product demand, but there is no significantly different prices, item, or any other material difference, other than this has been expected and delivered to the customer base basically as expected on time.

Yes, the delivery was on time and was part of our projections, which we are continuing to meet. So it has met, as Michael said, it's met our expectations in terms of enthusiasm, but don't expect the -- any inflection point in revenue because of it.

Were there any changes in the buying patterns of your customers? I know, I know you talked about investment banks, but were there any other changes in the quarter?

We have seen continued interest, growing interest from telcos. And we've seen actually some increased interest from trading and exchange. Now the interesting thing within the financial services sector, which we have in the past sort of talked about as a unity, is that it is now -- dynamics within that sector are changing dramatically. Investment banks, obviously, are very troubled. And some of our large customers, like Lehman, obviously are disappearing to reemerge, pieces of them, in other places.

But what's gone on with the markets, with extremely high volatility and volume, is that trading is doing very well. So trading and exchange customers in our financial services sector are actually picking up, which is an interesting dynamic in this time. And we have seen -- we had good uptake from government customers at the end of the government fiscal year, and we believe -- at least as far out as we can see -- that that trend -- we expect that trend to continue.

How about cash flow from operations? Did you guys (multiple speakers) provide that?

We will. Give me one second. If you're -- why don't we go onto the next question, then we will dig it out and give it to you.

How about an update on the HP relationship?

Nothing new to report on HP. HP, as they have in past years, participated in our user forum in San Diego, and our customers that are customers of the joint -- of their products and ours were very excited and encouraged about the relationship. But from a NetScout business point of view, there's nothing new to report. Michael, anything you want to add?

It continues steady. There is a recognized strong relationship by our customers between these two companies, and occasionally we engage in joint selling activities with HP, basically at a steady level.

That's all the questions I have. Thanks.

We'll come back on the cash flow from ops as soon as we dig it out.

Eric Martinuzzi, Craig-Hallum Capital Group.

Thank you. You comment in the prepared remarks on resetting future expense plans. I was wondering if you could elaborate on that a little bit. What is it the opportunity -- what is the opportunity that you see and how do you expect to go about getting it?

It's early days. I think the thing that characterizes the market going forward is the unusual degree of variability of possible future outcomes. Uncertainty. In the face of that, although we're confident in the near-term future, the second half of fiscal '09, we are concerned about the longer-term, medium-term future, of what's going to happen -- what's going to happen in fiscal '10. It'll start to happen toward the end of this fiscal year. So we're just prudently reexamining our current investment plans to make sure that we're investing in things that are going to be, in the short term, immediately affect revenue. And those things that may be longer-term investments, we are reconsidering. Nothing more than that.

To me, it doesn't sound like anything more than your normal annual planning process. Is there something --

It is sort of like that except we're starting a little early. And we are going to do it -- watched it more frequently because of the potential volatility of the markets in the future. That's all.

On the balance sheet, cash, $109 million there, and you've got the debt somewhat offsetting that of -- 90-some million. What -- you know you've got options because of the positive net balance there between debt paydown, acquisitions, share repurchases. What's management opinion right now as far as those uses of cash?

We're protecting our options, obviously. That's why we're carrying the debt, for strategic uses. As you know, we've had a buyback in the past. It is currently not active. We have done acquisitions, and having the cash balance gives us the ability to perhaps do something in the future. So those two things are both on the boards as possibilities. Nothing to report, nothing on the acquisition front that's -- otherwise, we would have said so, clearly.

But -- and in the event that neither of those growth-driving, EPS growth-driving investments appear to be the best use of cash, then we will end up paying down the debt. When we took on the debt facility almost a year ago, we had anticipated our ability to pay it down much sooner than the five-year term. And, of course, our performance since then and our cash flow and cash balance growth since then has worn out our ability to do that. So, in the event we can't find something more strategically valuable, we will take it down the debt.

I do now have the cash flow from operations number that Aaron asked about. It's $2 million for the quarter.

Do you have a CapEx for the quarter?

Last quarter, I had that right at my fingertips for you, but it's a little further away at the moment. But I will have it for you in about two minutes.

That covers it for me. Thanks.

Peter Jacobson, Brean Murray, Carret.

Thanks. You mentioned the exchange and the high-speed trading environment being favorably impacted due to market volatility. Can you just explain that a little bit more? How does market volatility translate into NetScout revenue?

It's not quite a direct link, but I wish it were. So -- volatility and the opportunity for momentary profit arbitrage and program trading, algorithmic trading, is really what drives exchange -- much of the exchange and high-speed trading volume. Some of our high-speed trading customers are relatively new companies that have built up high-speed trading operations outside of typical investment banks in order to provide lightning-speed execution. And those people find -- because of their proprietary high-speed platforms, that this kind of environment actually favors them and drives business to them. So as their volume grows and their revenue grows, they look to expand their competitive advantage, extend their competitive advantage by building even faster, higher speed, larger capacity infrastructure. When they do that, then obviously that translates into business for us.

You may have seen (multiple speakers) the CME is one of our customers, we talked about in the past, and you may have seen that when the Fed -- I think it was -- talked about trying to establish a market in the credit default swaps that have been so illiquid and troublesome, they went to, among other players, the CME to say, could you establish a market? That's the kind of thing that is happening in this -- one of the illustrations of things that are happening in this market. Whether the CME gets that business or establishes a market or not isn't the point. The point is that there is a growing trading business that our solutions help support.

Can you say what percentage of financial services that is, roughly?

We don't split it down that way. We don't cut the bologna slices quite that fine. We may start to in the future, because I recognize the validity of the question. We just don't have that at the moment. We'll take it under advisement.

By the way, for Eric, CapEx is $1.9 million for Q2.

David, a follow-up question. Last quarter you did, I believe, 18% non-GAAP operating margin, achieving your -- at the time, target of the high teens. And I believe you said on the last earnings call, don't look for that to happen in the upcoming quarter or so, even though you alluded to revisiting that target -- that high-teens operating margin target. Am I correct that you were not anticipating such a bump up in the subsequent quarter, and if so, what is it that changed?

Good question. When we talked about achieving the high -- when I talked about achieving the high teens, and that that was within our range, and don't expect that to continue sequentially going forward, I was not -- although it sounds like I didn't communicate that clearly -- referring to the second quarter. We knew at the time that the second quarter was likely to be as good or maybe better in terms of operating margin.

However, I think if you look now at our full-year maintenance of full-year guidance, in the face of a very strong, pretty good Q1 and a very strong Q2, you will see that operating margins going forward are in fact not going to remain in the coming sequential quarters as high as 22. It is as simple as, on a non-GAAP basis, adding $65 million and $73 million and getting $138 million, and comparing that to the top end of our non-GAAP guidance of 270, and seeing that second half revenue is going to be lower than the first half at the top end of our guidance. And even lower than that at the low end of our guidance.

So -- and that's, as we've said all along, reflective of our concern about what was going on in financial services and is now spreading to the enterprise, we believe. So it was really with that somewhat longer-term view. Nothing really happened in the second quarter that was a great surprise. The issue with the second quarter revenue was, of course, that large revenue recognition that came in one huge lump, that I mentioned? It's sort of pushed our second quarter revenue up a little higher than the normal secular rate would have otherwise.

My final question is for Michael. Now that Network General is no longer your most common head-to-head competitor, who are the next one or two companies that you're mostly running into competitively? And can you just summarize, just briefly, the product -- how the product roadmap addresses differentiating yourself from competitors?

So the next tier of competitors is basically in the range of 20% of our size. And I would say there are probably three competitors that belong in this tier. [541] is net [queue-wet], another one is Fluke, another one is Network Instruments. And these three companies compete with different strategies, individually. That against all of these companies, our fundamental value -- differential value proposition is an integrated workflow through the problem management process, utilizing a full complement of data derived from packet information, packet flow, a packet flow platform, and this datasets comprises KPIs, which is an abbreviation for key performance indicators. Flow data, which is a traditional flow business from the probe days, and then, the packet data that is residing in the InfiniStream recording storage.

And so, combining these three sets of data into a consistent problem management process, and supporting multiple constituencies in operations, network and application management operations in IT, gives us a much bigger footprint and a much bigger impact on our users' service instruments effectiveness. (multiple speakers) set of features. Larger set of features and more integrated set of features than any of these competitors.

Okay. That's helpful, and maybe we will do some follow-up on that, continue that conversation. Thank you very much.

Alex Kurtz, Merriman Curhan Ford.

Thanks. Good evening, gentlemen. Back to the question about revenue distribution during the fiscal year '09, and how that relates to operating margin and EPS. And just sort of looking at what you guys did in the first half, it looks like you did close to 21% operating margin for the first half. And if I am at the high end of your revenue and EPS range for non-GAAP, I am at an operating margin in the mid-teens. Is there so much fixed costs in your sales infrastructure that you can't dial things down, even though you expect lower revenues in the back half?

Well, so first of all, without endorsing exactly your view of our full year, don't mean to not endorse it either, but without endorsing it --

It's political season, okay.

And I feel strongly about that (multiple speakers) both ways. We do have some ability to scale back, and that's what we have indicated that we're going to be looking at. We're uncertain about the exact direction of the future. We have some strong trends going on in our business that are obviously counter to the weak ones. But we have a history as NetScout of protecting the core asset base, which is mostly our people, as well as our intellectual property, for future growth. And if you look back, I have been here eight years and we have been through a period in which we did that, when it served us very well. It's gotten us to where we are. So we will be judicious about that, looking for the medium- or long-term in the event that we do have to cut back costs and expenses. To make sure that we don't cut off our ability to take advantage of the strength of our position in the market, to drive, to extend our competitive advantage and drive market share gains. So it's a balance. And that's, I think, the way we're going to approach it.

Looking at that one large order that came off of deferred revenues this quarter, why can't something else like that happen in the second half here? You just don't see it happening as far as being able to recognize revenue (multiple speakers)

So it's unusual for us to have deferred product revenue of that size on our balance sheet. Unusual is probably not strong enough. It's unique for us to have that. And I think we've talked in the past about some of the reasons why. What happens when that -- what drives that is when we have a customer who wants the product, but because of specific requirements, and we usually do not engage in these kinds of discussions with customers, but if there are specific requirements, and this happens sometimes in the telco space, as this one was, where the customer says, I really need that but I want your product now. We will ship and invoice the current product and they'll pay us, and then when we deliver the enhanced functionality it' revenue. We do it on rare occasions. It usually -- it almost never -- never before has been of that size. So we expect to have significant telco business, in significant lumps, probably not $14 million lumps, but significant lumps going forward, and you'll see that. But it probably won't come out of deferred revenue, although it might. It might.

Let me run through a couple of quick questions. You're saying that enterprise is starting to weaken. I heard a little bit of that. I never considered that a large portion of your business, straight enterprise.

It isn't, at this point. It used to be, but it isn't a significant portion anymore. You'll notice the -- when we talk about health care, and you could call it perhaps enterprise, and high-tech. But that's it, and they're relatively small portions, and then there's all other, which includes a lot of enterprise. We haven't really seen yet the typical lengthening of approval cycles and more signatures and that sort of thing as a drumbeat coming back from the sales force in the enterprise space. But I think it would be -- we're anticipating that that's likely to happen because of the broader economic impacts which will affect our enterprise customers.

And just getting back to Peter's question about the investment banks as a percent of the total financial. I know you don't have the exact figure, but would you say it's maybe half of that 28%?

I really don't know. As I sit here, it is probably not that big in this quarter, probably not.

Finally, you continue to note strength in wireless and government. Can you give us a sense of the booking strength in the month of October from those guys, and how they can give you the sort of visibility and confidence about maintaining your guidance?

Sure. We have some bookings that were made in October. I can't really tell you about them because we haven't really counted them all up and we're not ready to report them. But what we have seen flowing in from -- in ready to book or already booked since the end of September is part of the visibility that we have going forward, in addition to the backlog that we discussed. So -- and those sectors that I mentioned are among them, right, the three that I mentioned -- high-speed trading and exchange, one, wireless carriers, and government. Those three. So we have seen bookings, order flow from those areas in Q3 already.

Thank you.

Scott Zeller, Needham & Company.

Good afternoon. The backlog number of 23 million, could you tell us roughly how that compares to recent quarters?

Yes. The product backlog number is slightly higher than in recent quarters. You should be aware, though, that product backlog is not the only element of our in-hand product revenue not yet declared. (multiple speakers) We just discussed a large revenue transaction that we recognized in the September quarter that came off the balance sheet, deferred product revenue. Right? So if you include deferred product revenue as well as the product backlog, which we've disclosed, that total is less now than it was in June. And when we've talked in the past about our visibility, we include all of that as well as our pipeline, our view of our pipeline.

And is that 23 million all to be recognized in the December quarter?

When we book -- the short answer is yes, we think so. When we book product orders, it's because they are ready to be shipped and recognized as revenue. And if we don't ship them yet by the end of the quarter, then they are -- put into backlog. So anything that's in backlog should be ready to be recognized as revenue, once shipped and accepted by the customer, if there's acceptance.

Just to go back to your comments about the target operating model, and I know there was a question earlier. I got a little lost, honestly. You made the point of the $73 million revenue run rate, which we are now at. But yet, I wasn't clear on how far away you think you will be running the business in that model. Would be.

That's because I didn't say. It wasn't clear on purpose. Not to obfuscate, but because -- the purpose -- the nature, and as I tried to explain, but obviously not well, the nature of this operating model target is to say that when we reach that level, it's our current judgment that the level -- that level of operating margin, 22 to 25, it's our judgment that we'll have to grow operating expense in parallel then with revenue and gross margin. So that, therefore, there will be no longer any margin expansion unless there is some discontinuity in the business going -- in the future.

So we don't think at 22, we're quite at that level yet because it's the low end of the range, so there is room, therefore, we would say, as we grow revenue, to still do that off of the infrastructure base, human infrastructure base principally, that we have in place. But as we start to hit 25, at whatever revenue level that occurs, 25% operating margin, then we would have to start to step up the growth of operating expenses in order to continue to drive the growth in revenue. So, was that helpful?

Yes. Last question, just to clarify -- I know we have been dealing with the issue of what's happening in deal cycles, but just -- could you clearly state, though, for just for us -- at this point in time now, what the team is currently seeing? Because there's a lot of innuendo about what may come, and what people are fearing. But could you tell us clearly what exactly the state is now with the team in the field, and what they are hearing? And is there a slowdown?

It's uneven. So we have just been -- we're in the process, as we do at the beginning of every quarter, of going through our pipeline scrubbing and our area-by-area sales reviews. And, in general, I think the tone of those is pretty positive. I think the question for us is to what extent do the customers that we're dealing with directly, the customer people we're dealing with directly, really know what's coming?

Fair enough.

So on an operational level, we feel very good, the sales force feels pretty good about that. But we are fearful that the range of our headlights through the sales force doesn't reach the problem yet.

Understood. Thank you.

[Sanjeep Steen].

Could you talk a little bit about what you're seeing in government and telcos or wireless carriers that gives you kind of that near-term confidence over the next few quarters?

I think the basic thing we're seeing is continued activity, including order flow. We had a pretty good government fiscal year-end in terms of order flow. And we have had in Q2 and including -- continuing to the earlier question, point of the earlier question, as so far in Q3, encouraging order flow from telcos. I think if you look at the telco space, in particular, and you look at the growing competition for iPhone business and iPhone competitors, each carrier having its own and starting to start their own app stores to mimic Apple's app store with the iPhone, those things are all very positive. And to the extent that the carriers, wireless carriers, are escalating the competition for application-driving devices, to put into customers' hands, and customers are continuing to buy them despite the coming -- all of the coming economic problems or appearance of coming economic problems, then that's positive for us.

And in the government, despite the election uncertainty and what may happen with a new administration, spending hasn't stopped, or certainly hadn't as through the end of September. It may, if the politicians can figure out how to do that, but I don't think either one of us would make an awful lot of money in the past betting that the government -- government spending would slow down. So that's -- and we're not seeing it yet.

That's helpful. Just a couple of market questions. Are you seeing any effect on the strength -- on the strengthening dollar on results? And maybe, the LIBOR. Is that having any effects on debt payments?

Our foreign currency exposure is pretty minimal. We basically pay -- foreign expenses, employ -- foreign employee expenses in foreign local currency, and therefore, as the dollar improves, that helps us. We do have minimal small amount of non-dollar based balances that we're exposed to as foreign currencies depreciate. But it's not a huge exposure. So we don't -- because we're basically a dollar-based business, we don't have a large foreign currency impact.

And then your question about LIBOR. Yes, our debt facility is LIBOR-based. We have periodic resets. We're at the moment in the middle of a reset, or the second half of a reset period. We have a choice of term. We are now in the second half of a six-month term. And we will reset LIBOR, our debt interest rate again, sometime in December. And we will see what LIBOR is at that point. We are anticipating in our guidance, reaffirmed guidance, that our LIBOR-based interest rate will go up because of the current position of LIBOR. But, of course, LIBOR has been declining more recently, so there may be an opportunity (multiple speakers)

One addition to David's comments is that neither is the demand impacted by the dollar, an increase of the dollar exchange rate. You can talk about the expense for the cost, the impact of that, but the demand is not impacted because we're basically very inelastic in those change ranges. So we're not seeing any impact of -- due to that.

Maybe to that point, could you maybe comment on maybe some of your initiatives going on in Europe right now? I knew Network General was kind of a bigger player there, but could you maybe expand more generally on what the Company plans to do in that theater?

Some of the most important product [issues] have to do with -- and even marketing issues -- have to do with expanding our penetration of the wireless service [polite] industry in the European theaters. And starting in Germany and the UK, to Eastern Europe, as well as southern Europe. That's really the predominant dynamic. And in addition, we have clearly a network channel customer base that we are in the process of upselling with our NetScout product portfolio, but the dominant dynamic is the service polite of business.

Thank you.

Manny Recarey, Kaufman Bros..

Most of my questions have been answered. I just have one. The service revenue was up nicely, sequentially. If you could give a little more color what's driving that, and kind of looking forward. I know you don't necessarily give guidance on that product line basis, but we shouldn't expect to see that same type of sequential increases going forward.

No, that's true. Absolutely true. If you -- one of the things that happens with our business is that we -- unlike what you might expect from the main characteristics of our service revenue, service revenue being driven by basically 12-month maintenance agreements, with our customers, is that when we sign big maintenance agreements, or renewals, there is a lumpy -- there can be a lumpy pattern.

And so, there is a dynamic that happened in the second quarter with that large telco deal where part of that -- the size of that deal was service revenue. And as I mentioned, when we had actually shipped the product sometime ago. And when we shipped the product, the customer signed up for service. And so, because the product was not recognizable as revenue, neither was the service. And so when we recognized the product revenue, we recognized an outsized step-up in service revenue that won't recur. So in fact, as we're talking about -- in the second half, revenue being lower, implicit in our guidance in the first-half revenue, you -- which, I think, you might expect to see that in service as well. Not because anything untoward is happening in the business, because of the lumpiness that I described.

To a follow-up to that, with this large order that you booked, where there any expenses that were associated with that that may not necessarily be -- recur in the December quarter?

There were. There were, yes. Two things. One, when you do a deal that is that big, then it's got probably higher discounts than your average run-of-the-mill million dollar business deal. And this was a legacy Network General deal, which we're very glad for. Pleased to have. And it had a little higher commission expense carry with it. So you'll see in the quarter sequentially our sales and marketing expenses up. And that's one of the drivers of that. And that won't recur.

Jonathan Ruykhaver, ThinkPanmure.

Good evening. I've got a question just related to the packet flow technology that the Sniffer product utilizes. The ability, when I look at it, to classify and prioritize traffic by application protocol seems to be growing in importance in the security market as a way to protection -- further protect against network attacks. And I'm just curious, do you see any use cases of that packet flow technology for identification of, let's say, rogue applications or security in general?

Yes, we definitely see and we see an explicit demand from our customer base for -- applying our data set to those problems that you just mentioned. And that's one of our focus areas going forward, to apply -- within our space, within the network management community, network operations community to expand our footprint in that space, and -- but we're not ready to talk about any product with any other specificity.

But it could be an extension of the current technology, as I see it. I believe back when Sniffer was owned by McAfee, the company had tried to embark on a strategy of anomaly-based detection in the security market. I don't think they quite got there. But you do see that as a potential?

Yes.

David, final question that I have. On that large telecom deal, was it a new or existing customer? What was the application or service that the product is being used to support?

It was a new customer to NetScout. I think they might have been a small existing customer for Network General, but obviously a very large commitment to the product. That is now, of course, carried forward. It was the InfiniStream product that is now the branding, and we're carrying forward as the NetScout recording device product brand. And it is a deployment for their core, very advanced customer network deployments. It's -- a carrier that is currently very active in pushing the most advanced, highest-speed network deployments. It's been in the press.

Is in voice, converged voice, video over a mobile network?

Yes.

That's all I have, thanks.

There are no further questions.

Thank you very much. It's been a very good interactive questioning session, and we appreciate that. We look forward to meeting with you again at the end of our next quarter, and our next earnings conference call. Thank you again and good evening.

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