Netscout Systems Inc (NTCT) 2009 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to NetScout's third quarter fiscal year 2009 operating results conference call. (Operator Instructions).

With us today is NetScout's president and CEO, Anil Singhal. He is accompanied by NetScout's Chief Financial Officer, David Sommers and NetScout's Chief Operating Officer, Mr. Michael Szabados. Also with Mr. Singhal is NetScout's Director of Investor Relations, Ms. Cathy Taylor. At this time, I'll turn the call over to Ms. Taylor to provide the opening remarks. Ms. Taylor, please proceed.

Thank you, and good afternoon, everyone. Welcome to NetScout's third quarter fiscal year 2009 conference call for the period ended December 31st. In terms of the format of this call, Anil will begin with an overview of our financial and operating results, and David will then discuss our financial results and Company performance in more detail. At the conclusion, Anil and David 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 and Exchange Commission Act of 1934 and other federal securities laws. These forward-looking statements may involve judgment, in that individual judgments may vary.

Forward-looking statements include express or implied statements regarding future economic and market conditions, our guidance for fiscal year 2009, and our product integration plan. It should be clearly understood that the projections in which we base on 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 during 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 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, and subsequent quarterly reports on Form 10-Q on file with the Securities and Exchange Commission. Also in our discussion, non-GAAP revenue excludes the effect of purchase accounting adjustments representing the fair value of Network General's deferred revenue. And non-GAAP net income excludes share based compensation expenses, amortization of acquired and tangible assets, and integration expenses and related income tax adjustments. I'd now like to turn the call over to Anil Singhal, our Chief Executive Officer.

Thank you, Cathy. We are very pleased to be reporting another strong quarter. As you're aware, in early January we announced preliminary results raising full fiscal year '09 guidance and strong guidance for fiscal Q3. Our third quarter fiscal results were above the preliminary guidance range on the revenue and EPS front. GAAP revenues were $72 million up 5% sequentially, and up 34% year-over-year. Non-GAAP revenues were $74.2 million, up 2% sequentially and year-over-year increase of 24%. Our GAAP EPS was $0.02 above the high end of our preliminary estimate, and non-GAAP EPS was $0.01 above the high end of our expectations. The GAAP profit for the quarter was $7.9 million, or earnings per diluted share of $0.20. On a non-GAAP basis, net income was $11.1 million or $0.27 per diluted share.

Despite charitable donations of $100,000 to Habitats for Humanity, the Special Olympics and a local cancer center, lower operating expenses than were originally expected raised EPS over our preliminary estimated range. Our higher profitability is driven by continued margin improvements with our non-GAAP operating margin hitting a record 25%, driven principally by a product cost improvement leading to a non-GAAP gross margin of 80%. GAAP operating margin was 18%, with related gross margin of 78%. Last quarter, we raised our operating margin model by 5 points, and we have already reached the high end of our new model, so we are executing well and according to plan. We'll re-examine our long-term operating margin target again in the fourth quarter. We are generating strong business results at a time, when some companies are experiencing the effects from the slowing economy.

Our strongest bookings came from the financial services sector, with orders led by commercial banking, and electronic exchange and high speed trading customers. Telecommunications was strong with wireless carriers who are pursuing 3G and 4G network expansion, driven by the growing demand for smart phones and network applications. Our next largest sector was government, healthcare and energy. We believe that the long term market drivers of the growth remain intact, across our significant vertical markets, as customers look for a solution like ours, to overcome the challenges of managing the modern IP network. The need to monitor and manage the increasing load of mission critical data, in addition to voice and video continues to grow. And the requirement for network uptime is approaching 100%, particularly for trading and wireless customers. These sectors are driving the demand for NetScout's products among our increasingly loyal customer base.

This is evidenced by the 90% of our business that comes from existing customers, expanding deployment of our solutions. We continue to invest in our technology to support our customers with new functionality, particularly in the areas of high speed electronic trading and wireless mobile voice and applications. With our acquisition and integration of Network General, we believe we have become the technology and market share leader in the high performance, and high availability application management market.

While we are cautious about the impact of the current historical global economic downturn on our business next year, we are entering our fourth quarter, with solid visibility that gives us confidence in our increased guidance for fiscal 2009. We are carefully developing the outlook for the next fiscal year, and we anticipate providing 2010 guidance in our year end earning call in late April. We remain bullish about our prospects, as we believe we have the solid technical, market and financial position necessary, not only to weather the economic storm, but to gain market share in the coming year. With that, I would like to turn the call over to David.

Thank you, Anil. Our quarter results are in the financial statements, which are part of our earnings press release. We are reporting our results on a GAAP basis, as well as a non-GAAP basis. To summarize the difference, we've removed the GAAP purchase accounting effects of the merger with Network General, by adding back revenue related to deferred revenue re-valuation, and we removed the cost and expense of various acquisition related items. And in addition, we removed the GAAP effects of stock-based compensation, which increased significantly as a result of the acquisition. I'll give you the specifics about the difference between the 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 the 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 and managing and forecasting our business. Our third quarter GAAP revenue was $72 million, non-GAAP revenue was $74.2 million. Non-GAAP revenue excludes $2.2 million of purchase accounting adjustment to record fair value the acquired Network General deferred revenue. Product revenue on a GAAP basis was $42.9 million, up 19% year-over-year and 9% sequentially. Service revenue on a GAAP basis was $29.1 million, up 65% year-over-year and a decrease of 1% sequentially.

Non-GAAP product revenue was $43.2 million, also up 19% versus last year, and 5% versus the second quarter. Non-GAAP service revenue was $31 million, up 31% year-over-year and down 3% sequentially. Third quarter results from a year ago include two months of contribution from Network General's business, and are therefore not fully comparable to the full third quarter. GAAP net income for the quarter was $7.9 million, yielding earnings per diluted share of $0.20 . GAAP net after tax margin was 11%. GAAP income from operations was $13.3 million, and GAAP operating margin was 18%. Non-GAAP income from operations was $18.4 million, and operating margin was 25%.

The following items totaling [$5.1 million] (corrected by company after the call) are adjustments to arrive at the non-GAAP operating income. Purchase accounting adjustment to record at fair value the acquired Network General deferred revenue of $2.2 million, was added back to GAAP revenue. Amortization of acquired intangibles of $1.5 million, which was principally from Network General acquisition was removed from GAAP cost and expense. Non-recurring integration expense of $280,000 was removed from GAAP expenses, as was share based compensation of $1.2 million. Non-GAAP net income was $11.1 million, or $0.27 per diluted share. Non-GAAP net after tax margin was 15%. We've used the statutory tax rate of 38%, to tax effect the [$5.1 million] (corrected by company after the call) dollar total non-GAAP adjustment amount, removing $1.9 million from GAAP tax expense.

The non-GAAP adjustments to our GAAP results are summarized in the reconciliation table included with our press release financial statement. The provision for income taxes reflects an effective tax rate expense -- tax expense rate of 34% on a GAAP basis, and 35% on a non-GAAP basis. The non-GAAP tax expense rate is calculated by taking the previous calculated GAAP rate of 34% and tax effecting the non-GAAP adjustment to statutory 38% rate, resulting in the overall non-GAAP rate of 35%.

Our GAAP gross profit for the quarter was $56 million. GAAP gross margin was 78% in the quarter. And on a non-GAAP basis, gross profit was $59.2 million and non-GAAP gross margin was 80%.

We made the following adjustments to non-GAAP gross profit. $2.2 million was added back from revenue. We removed $84,000 of share based comp expense. $995,000 of amortization of acquired intangible assets, and $37,000 of nonrecurring integration expenses. Gross margin improved this quarter because of the realization of cost reductions that we've been making over the last several quarters to legacy Network General product hardware, and by extension to the newly integrated hardware platforms. We anticipate these and other cost improvements will continue to benefit gross margin going forward.

Non-GAAP operating margin of 25 points was a new record high for us in the post dot.com bubble era. It's 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 third quarter, that same combination of revenue growth, plus non-revenue related expense containment, drove operating margin up another 3 points from last quarter, to the high end of our operating margin target range. As Anil mentioned, we raised our operating margin model in last quarter by 5 points, and we already reached the high end of that new model range.

We are in the process of re-examining our long term margin model and we may report new target ranges in the fourth quarter. Our current model is the following: Non-GAAP gross margin is 76% to 79%, R&D expense to revenue is 13% to 15%, sales and marketing expense is 33% to 35% and G&A expense 6% to 8%, yielding operating margin target range of 22 to 25. Our Q3 non-GAAP result with an operating margin of 25 points is obviously at the high end of that range. And we expect the revenue level required to achieve our operating margins will slowly grow over time, when inflation pushes our cost and expense levels higher. However, the Q3 level of $74 million currently marks the high end margin of the revenue, at the high end of the target range.

Because of our historically strengthening operating performance, our balance sheet remains strong. Cash and short and long term marketable securities were $19.2 million, compared to -- sorry -- start again. Cash and short-term and long-term marketable securities were $119.2 million compared to $109.4 million in the previous quarter. Up almost $10 million. Our long-term marketable securities include investments in auction rate securities now valued at $30.7 million. As of March 31, 2008, the value of these securities includes a temporary decline of $2.4 million below par value to reflect liquidity concerns. All of these securities are rated A or above, government guaranteed, student loan backed securities, which we believe have no credit issues, only short-term liquidity issues.

We've classified these securities as long-term on our balance sheet and recorded a temporary decline in value to accumulated other comprehensive income and loss on the balance sheet. With our strong cash position positive cash flow, the illiquidity of these securities poses no liquidity problems for us. And we believe that we will achieve liquidity well before the maturity of the underlying bond, and our temporary valuation adjustment reflects that outlook.

Accounts receivable net of allowances was $45.9 million, up from $26 million last quarter. Days sales outstanding was 57 days for the quarter based on GAAP revenue, and above our typical DSO range of 40 to 50 days. This is up from prior -- from 33 days in the prior quarter, although it's down from 60 days in the year-ago quarter. Using non-GAAP revenue DSO was 56 days. Inventory was $7.9 million, up from $7.3 million in the prior quarter. Turns were 3.8 times.

Turning to other metrics. Revenue contribution from direct customers was 36% and reseller revenue 64%. Revenue from international sales was 23% of total revenue, up from 22% last quarter. Europe and Middle East and Africa were 11 points, Asia was 5 points. Americas outside the US was 7 points. The main drivers of international business outside of the US were the wireless service provider and financial services sectors. Summarizing large deals that we booked in the quarter, 134 customers gave us orders over $100,000 and that's down slightly from 140 in the second quarter. 20 customers gave us orders over $500,000 and nine orders over $1 million. Of the million dollar orders, five came from financial services, two of those from -- two from wireless telecom carriers, one from energy and one from healthcare. Of the five financial services customers, three were commercial banks and two were electronic trading.

The third quarter has been our seasonably strongest quarter ever, over the last several years and we expect it to remain so through this year. We continue to see strong bookings coming from the financial services sector with 30% of order dollar volume, telecommunications sector was very strong with 27%, government was 13%, healthcare was 7% and energy was 6% of orders. As of December 31st, our product backlog and product deferred revenue totaled $20 million, down from $25 million last quarter. Last quarter, when we began to report backlog, we reported a $23 million product backlog. This quarter we're expanding this measure of future product revenue in hand, to include product revenue which is deferred revenue on the balance sheet. Because in some quarters, including this one, product deferred revenue can be significant in relation to the product backlog. We will not break out the two categories because the difference is not meaningful in terms of our future revenue visibility. This quarter we consider product backlog to the -- the product backlog to be firm in the sum of the product backlog and product deferred revenue to be material to the understanding of our financial results and guidance.

And now for the guidance. We are reaffirming our outlook which we raised a couple of weeks ago on January 6th. For the remainder of the fiscal year 2009, ending March 31, we raised GAAP revenue to be in the range of $266 million, to $274 million. And non-GAAP revenue to be in the range of $278 million to $286 million. This guidance implies the fourth quarter GAAP revenue will be in the range of $64 million to $72 million and the non-GAAP quarter revenue range is $66 million to $74 million. GAAP net income per diluted share for the fiscal -- 2009 fiscal year has been raised from $0.44 to $0.54. Non-GAAP earnings per diluted share has been raised to $0.81 to $0.91. The implicit fourth quarter GAAP EPS range is $0.09 to $0.19 and the non-GAAP range is $0.15 to $0.25.

The fiscal year 2009 non-GAAP revenue and net income per share estimates include a purchase accounting to fair value adjustment -- adjustment to fair value of approximately $11.8 million of Network General's deferred revenue, amortization of acquired intangible assets of approximately $6 million, and integration expenses of approximately $1.7 million and share based compensation expenses of approximately $4.8 million, and the related impact of these adjustments on the provision of income taxes of $9.3 million. That concludes our financial discussion this afternoon and our prepared remarks. Thank you for joining us and we look forward to taking your questions. Kristy, would go

(Operator Instructions).

The first question comes from the line of Mark Kelleher from Canaccord Adams. Your line is open.

Thanks. Congratulations navigating a difficult environment out there.

Thank you, Mark.

First question, the gross margin seems to be very strong. Can you tell us what your pricing power is out there, tell us about the competitive environment, who are you winning against, and how long do you think that pricing advantage can stay?

Well, Mark, we do not really talk in an open forum about pricing power. We do -- we did, as you know, I think raised prices in small amounts at the beginning of this fiscal year when we reset our product list, our price list for our products and integrated product lines. Pricing and discounting in customer situations, is particularly with our situation, where we have long established relationships with our major customers, is not really so much a competitive issue as it is the issue of delivering value, price to value for our customers. So we do not have an awful lot of price competition, of head to head price competition because that's not the way our -- many of our deals. Most of our deals work, there are always competitive situations in which what I said is generally not true in specific circumstances. But I think you can take away from this that we're not seeing pricing pressure. But you should not take away from this that we feel we have substantial pricing power to raise prices for our customers.

And on the balance sheet, you can talk about why the receivables jumped up a bit.

Yes. There are two dynamics going on there. One, in the third quarter of every year, it's of course the December year end for many customers, and that's often the time when many customers synchronize their maintenance renewals. So they make the renewals occur at the beginning of their budget year. When that happens, and we get a renewal in the end of December, we of course bill it and receivables go up, but revenue does not because the revenue occurs over typically the next year. So that really skews DSO and every -- in every Q3. And as I mentioned a year ago, the DSO was 60 days so it's comparable to where it is today.

We also had some back end of shipments at the end of the quarter, as we were trying to deal with customer needs to get shipments at the end of their budget years. So that phenomenon back ended some of our product shipments, as well as in addition to the maintenance renewal issue. It's really those two things. In Q2, we had the large revenue recognition that we discussed in October, of a large telecom customer who had already accepted and paid for the products and we - under the software rev rec rules , we recognized the revenue in September. That was revenue without receivables. And so that unusually depressed the Q2 DSO number down to 33 days. So it was two effects, one on each end that makes the comparison look stark, but it's really, the Q3 quarter is really pretty

And last question. Cash flow from operations.

Cash flow from operations? I had it right here but I left the sheet in my office. So we're going to have to go get it because I was prepared for that question.

Okay.

We'll get it for you and I'll announce it as soon as we get the data. My apologies for that.

No problem. I'm all set. Thanks.

Okay. Thanks.

Our next question comes from the line of Eric Martinuzzi from Craig-Hallum, your line is open.

Thanks. Congratulations from me as well on the performance in the December quarter. The verticals, you're seeing wireless carriers -- I guess I shouldn't call it wireless carriers, it's Telco as you put it, that at 27% to me was sort of the biggest mover among your verticals. I would like to know your thoughts on where the verticals play out, specifically telco, financial and government. Right now I got financial at 30, Telco at 27 and government at 17. How does that play out? Is there a point where financials actually could become -- no longer the dominant part of the verticals?

Yes, I think it's possible that financial may become number two instead of number one. But we think it's going to be still high for certain applications, they were talking about certain customers and commercial banks. So right now we continue to see interest even though several large customers are having issues. And financially, the broad category, I think if you look at commercial banks and trading customers, other than the traditional data center deployment, in those places I think we'll continue to do good, but it's possible that it becomes number two instead of number one, unless it's already number two this quarter, financials.

No.

And sometimes one large order can make a big difference and that was the case this time.

Okay. And then as far as -- I know you're paying close attention to your customers. I'm interested particularly on the enterprise side. You talked about your top 3 verticals explaining 74% of the product sales. What about that other 26%? What is enterprise telling you?

We are seeing slowing down in the enterprise as many other customers -- many other vendors are. We expect to see the concentration in the major verticals, including government are the top three, continue, because they're the ones whose funding is generally going to be available, even in a down market. To say it another way, less affected by the economic difficulties. So in the enterprise space, retail manufacturing, distribution, we expect to continue to see weaknesses.

Thank you.

You're welcome. If I can interrupt, I have the answers to Mark's questions. Operating cash flow in Q3 was $11.8 million. Some of you may be interested in CapEx, which was $800,000. Depreciation was $1.9 million, amortization of acquired intangibles and our GAAP results, $1.5 million. I hope that's what you were looking for. Kristy go ahead, please.

Okay. Alex Kurtz from Merriman, your line is open.

Thanks. Congratulations on the quarter again. Dave, just again a question on the gross margin, just about sustainability. Obviously a big uptick here this quarter on the product side. Can we expect to see this continue for the next couple of quarters or is there a very specific reason why we would not expect it to stay at these levels?

There is nothing specific, Alex. We -- as we remarked, the cost reductions, cost improvements that we've made to the products over the last couple of quarters, are really driving this. You will note probably that our long-term gross margin model tops out at 79% and we hit 80%.

Right.

So we are looking at that in the fourth quarter and as we said, I don't see anything today that would cause strong gross margins not to be sustainable, but we are looking at it to see whether or not it is inconsistent with our long-term model and our model has to change or not.

Okay. The next question, in the past you've spoken about how NetScout would not see the slowdown in the economy because you guys have a lagging affect with your projects and customers. Now you've been -- is that something you've have been talking about for almost a year now. Do you feel like that may not be the case as much as you maybe thought it was a year ago, or do you still feel like there is a boogie man out there and it just hasn't caught up with you guys yet? Because you've talked about that a couple of times in the past.

Of course the lag affect is a lag right? Eventually it catches you. And what we've been saying is our projects, because they tend to be strategic to our customers and budget cycle based, tend to continue to stick, although they can be delayed, et cetera as what happens with others. We see nothing, I think, in the longer term beyond the obvious. And each sector is different. Government is spending more money, but maybe not so much in defense. Wireless volumes continue to be okay, although there may be some doubt growing about that, about the subscriber volumes. High speed trading seems to be continuing strongly. So those things -- those underlying trends haven't changed. But the lag affect of impacts to our customers, we will feel eventually. And what we said today is we have good visibility in Q4 and we're still looking at fiscal '10.

Okay. And then a question to Anil. Riverbed made an announcement on a company called Mazu networks and I want to get your take on that. Obviously they are a company that was focused on similar technology to you guys. And my final question is China announced a major investment in their 3 G infrastructure, I think close to $30 billion, are you guys looking to participate in that? Thank you very much.

I think I'll take over the topic about Mazu, if you look at the size of the company versus our revenue, it's about 1/15th our size. So clearly, we were not seeing any competition from them. They still want to continue with the partnership, that they have with NetScout. So I do not see any short-term impact because of this. And they talked about the reasons for that position, and we also know the reason for continuing with the partnership with NetScout. There has been very little competition from Mazu with NetScout or from Riverbed. I think that will continue.

I have one thing to add to that. I think the Riverbed-Mazu deal is an indication of the growing interest and importance of the instrumented monitoring and measurement that we've been a pioneer in and we think we are the leader in. Not for WAN optimization obviously as Riverbed, but for performance. And so it's not a surprise to us that others in the industry are starting to concentrate more in the space. It's not the only acquisition that we've seen or change or focus that we've seen amongst some nearby players and probably won't be the last.

And I think the second question was about 3G to 4G transitions, and yes, that's one of the areas of interest with WiMax in particular with many of the vendors aligning behind that as an interest.

Thank you very much.

Our next question comes from the line of Jonathan Ruykhaver from ThinkEquity Partners.

Hi. Congratulations on the quarter.

Thank you.

Were there any 10% customers in the quarter.

No, there were none.

No. Okay. The activity that you're experiencing in the Telecom vertical, I'm just wondering if we can get more color on the applications your product is supporting. I assume it's around converged wireless networks but more color will be helpful, especially as it relates to where we are in the spending cycle. How sustainable is that growth that you've experienced recently?

First of all -- I think we have spoken in the past as to what is happening to the wireless service providers. They are moving from -- I loosely call it analog to digital, and to IP networks and we've started calling it the modern IP network. So they're modernizing the network and so the technology they're using is really similar to what we have been supplying to enterprise. So because of that, I think there is a lot of interest in what we are doing, but not a big investment for us to go into that market. So we think that that will continue for some time at least, and while we are a little bit cautious about the financial vertical, we see a lot of opportunity in the wireless telecom areas.

You mentioned, I believe, Dave, two deals over a million in that vertical. Were those with new customers?

Hold on one second.

Just trying to get a sense for whether or not there is new activity or if this is follow-on type deployments.

Both of those were with customers that we already had beachheads with. Substantial customers, household name customers that we already had beachheads with. That represents in one case substantial commitment and expansion of the deployment and in another case sort of a continuation of the pace of -- regular pace of deployment.

Okay.

Not brand new customers.

Okay. On a different subject, Dave, I think you mentioned that the growth in the quarter, the 24% top line growth included two month's contribution from Network General in the prior year period. Did you know what the organic growth was?

No. We haven't parsed it out and we're not going to. So forgive us for that.

That's fine. That leads into my next question. If you do look at growth in fiscal '09, there's been an acceleration from historic trends. And I've trying to think of the growth profile, as we look at our models, thinking about fiscal '10. Should we assume that the strength on the telco side tapers off, and we turn back to a more historic rate? Or do you think that it will be somewhat -- it sounds like you think it will be sustainable, but obviously offset with financial services slowdown?

Obviously there is slowdowns in financial services and other enterprise verticals for the short-term. We think the trends in wireless, high speed trading and government are working -- are positive and that we have opportunities there as well as in the other verticals when they come back. We think there is great opportunities in healthcare, particularly with some of the government initiatives to support data exchange in healthcare going forward, and the potential investment by the government in those initiatives. So the verticals that we're focused on are there, because that's where we think the potential growth in the market is. And that includes wireless, as Anil just said, significantly.

We think the wireless business, the rollout of applications and services over 3 and 4 G networks is in the very beginning, and is nowhere near maturity. And the deployments of our products and those of our competitors in the space are not by any means complete and won't be for years. So we think there is lots of growth potential, but the issue is the short term, the next several quarters of economic turmoil and how that will work out and that's everybody's guess. Do you have any ideas?

No. No. But that's good color. A appreciate that. I guess just one final quick question. There's a small company called Procera Networks that appears to be delivering on a capability that sounds similar to NetScout in the telco market. Are you familiar with that company? Have you ever seen them in competitive situations?

No, we have not that. We see Tektronics which is now part of Danaher, Agilent, Radcom and we see those companies and a couple of local ones in Europe, but we've not heard the one you're talking about.

Okay. Thanks again. Great quarter.

Thanks, Jonathan.

Our next question comes from the line of Scott Zeller with Needham & Company. Your line is open.

Thanks. Just to follow up on the previous question about Riverbed and Mazu. At this point is NetScout generating any material revenue from that partnership?

No. Nor had we really anticipated it would be a material go to market relationship for us. It's really an accommodation for our joint customers, to add value to both solutions, in the case of NetScout solution, we now with coordination and cooperation with Riverbed, can show our customers the affects of the Riverbed appliances and look into the Riverbed optimized data stream, for them that we couldn't do without that collaboration of Riverbed. So that will continue, we believe. But it was never thought of by us as -- and I think by Riverbed, as a significant driver of incremental revenue. Who knows what the future would have -- would hold or -- but that was not the purpose of it.

Okay. Regarding the telco wireless carrier crowd, we've heard previously about targeting tier 1 and tier 2. Could you give us a rough sense of where the revenues -- like when you look at that vertical's contribution as a bucket, of that bucket of revenue, how much of it would you say is currently coming from tier 1 versus the rest, if you can comment.

I think most of it started coming from tier 1, especially the large industry and even internationally China and other places coming from tier 1.

Those tend to be the guys who push the technology envelope the hardest. The guys who roll out the smart phones with a big splash and they're the tier 1's and they're the ones who are willing to spend significant amounts to make sure that the services they roll out on the smart phones are up to form.

Would you characterize the current contribution from tier 1 as early in the cycle?

Yes.

Okay. And the last question is regarding -- I ask this every quarter -- but regarding cross selling, is there any sort of informal commentary you can offer about cross selling into historical separate NetScout customer bases.

It's just beginning. As we delivered, as you know, the integrated product solution, the hardware platform that -- and the software that runs on it, that integrates the function, that's really the first time that salesmen and customers could seriously begin to engage in seeing the value of the integrated function starting the cross selling. So it's just beginning. All of that opportunity is still in front of us.

Are you commenting yet on when that might become material?

Well, we're anticipating it in FY '10. When things begin -- this is an education process. Our sell is a collaborative sell and so we consulted -- when we go in and talk to customers they examine, they think, we tell them and we show them, they think about it and they give us an order, and maybe two quarters later, 3 quarters later, it becomes a piece of business for us. So although we've been talking to them about it, with these big customers, high speed trading and wireless carriers, they typically want to see it. Talk is good, but show me. Even though we have trusted relationships, these are big investments and commitments for them and they want to see it. And so they're now just starting to see it, see the beginnings of it, this functionality and further integration is going to continue to roll out as we enhance the technology.

So it's just beginning and you would expect to see impact in fiscal '10. That's one of the things that lifts our outlook for fiscal '10, despite the economic issues, the external issues, because we are, off the good results we are having, we are just about to see the impact of that cross selling coming in the next maybe -- maybe not next quarter, but the quarter beyond that, and the next beyond that. So as we look at, we listen to the external pundits talking about maybe a growing economies again in the second half of calendar 2009, that corresponds to the middle of our fiscal year, so maybe the second half of our fiscal year we'll start to see some growth. And maybe fiscal '10 will be not all that much worse than fiscal '09 for us, in terms of the economic market or maybe it will. It's the uncertainty.

But layered on top of that, we have the strength of our underlying verticals, the ones we talked about already, plus the dynamic of this new functionality that we're just beginning to take advantage of. So we think we have -- that's why we said, we think we have the opportunity to be -- to do better than the market, to gain market share, to gain from this downturn as others are perhaps not so well positioned.

Thank you.

You bet.

Our next question comes from the line of Manny Recarey from Kaufman brothers. Your line is open.

Thanks. Not to beat a dead horse here, but on the wireless side, I mean looking more near term, it's fair to assume they have not come back to you, talking about delaying or pushing out any CapEx. Because if you look at the CapEx expectations of the service providers in general, it seems like the December quarter was fairly -- was soft and if you were looking and the outlook for the rest of this year is -- it also kind of for softness. So it's fair to assume that they have not come back to you with any change?

Well I think there is -- we're not seeing those pressures. But one thing I wanted to add in the telco sector or the wireless sector is looking good for us, as we are increasing our deal sizes there, we're going to see more competition also. So we think in that area, maybe that going to be a bit bigger affect than the CapEx spending.

So far our sense from the customers is that they are still building out these infrastructures, and competing on new services and application service availability, reliability and performance. And so far we've not gotten the sense they're slowing down. There may be other areas of capital spending that are not involved in new services over 3G and 4G networks that they are going cut back on, but as long as the -- as long as it appears, as long as the smart phone application traffic networks are -- the demands are growing and the ranges that we've been hearing, 40% a year of growth, that they're going to try to gain share in the market. So each of the major tier 1 players. So we think we are -- we're in wireless as well as in financials, we're narrowly focused on the growth verticals, the growth areas of those larger sectors. And so when you see or hear that some of the sector may not be maybe flat or maybe down, that doesn't necessarily apply precisely to the businesses that -- the narrow business sector that we serve.

Okay. Thanks.

You bet.

On the services revenue, it's my understanding, correct, that this March quarter being the last quarter where we'll have GAAP and non-GAAP revenue?

Essentially that's true. Yes, the March quarter -- yes, by the March quarter, the difference between the two will have narrowed to almost the point of insignificance. We will still have amortization of intangibles and stock based comp, but we will be talking in non-GAAP terms, but the revenue will be converged.

So thinking at the service revenue, looking at the non-GAAP revenue, as we look at fiscal 10 from a modeling service, we can assume that would be a base rate to kind of look at?

Which would be a base rate?

At looking at the non-GAAP service revenue in the December quarter, and whatever the estimate is for the March quarter, kind of carry that through?

Yes, I think that's a reasonable base, yes.

And then one last question, I know you're not giving guidance but just from a conceptual perspective on your OpEx, as you look into the next fiscal year, there is no major investment that you have to make, where you see any significant ramp up in your OpEx?

No. We do not anticipate any.

Okay. All right. Thanks.

Thank you.

And our next question comes from the line of Rohit Chopra from Wedbush Morgan. You're line is open.

Thanks. A couple of questions. I just want to come back to the operating margin target that you said you're going to take a look at, because you're already at the high end of the range. And I know you do not want to get into everything here, but where can you squeeze out a little bit more expense? Because I know you were embarking on that? I think you mentioned that last quarter and so I just want to get a sense of where there is still room to, push out a little bit.

I think if you look at our operating expense performance, you'll see that its pretty flat. What we've done with operating expenses is contain expense, manage the low growth or no growth and that's really our plan going forward. This is not a commentary on our guidance for fiscal '10. But that's been our strategy and hopefully going forward into Q4. And to achieve operating margin expansion through gross margin expansion, and if you look back at our increased operating margin targets structure that we talked about in October, what we really did there was to raise the gross margin target 3 points. And that flowed through to operating margin.

We didn't really change the operating margin line item targets at all. And so volume and scale allows us to both increase the leverage of operating resources, and to increase our leverage over our costs, including our components cost where we can negotiate better arrangements with suppliers with larger volume. And that's really what we've been doing for some time. So it's not coming back to try to squeeze operating expenses, although of course we're very cautious about growth of those, but we're not going to -- we shouldn't look for, think about any large expense cuts from us.

Okay. Thanks. And then I had one other question. And everyone asks this very often, but HP does have an announcement scheduled at the end of January or early February and they're going to talk about some of the partners that are involved in this new product announcement and I wanted to know, has there been any positive change with the go to market strategy on the HP side?

Well they continue to have interest in what we are doing with them. And we at least have support for HP Openview integrations. So I don't know what announcement that you're talking about. But we have good partnership with HP, but they're not a general partner -- they're not really selling our product. But there is cooperation in the field.

Okay. Thanks, guys.

Thank you very much.

We have no further questions in queue.

All right. Well thank you very much. We appreciate your time and interest in NetScout, and we hope to talk to you again in 90 days at our next earnings call. Have a good evening.

This concludes our conference call for today. You may now disconnect your line.