Netscout Systems Inc (NTCT) 2010 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to NetScout's third quarter of fiscal year 2010 operating results conference call. (Operator Instructions). As a reminder, this conference call is being recorded.

With us today is NetScout's President and CEO, Mr. Anil Singhal. He is accompanied by NetScout's Chief Financial Officer, Mr. 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 will 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 of fiscal year 2010 conference call for the period ended December 31. 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, David or 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 judgment, and individual judgments may vary. Forward-looking statements include expressed or implied statements regarding future economic and market conditions, our guidance for fiscal year 2010 and our new product releases. 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 update that guidance otherwise. 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 Annual Report on Form 10-K for the year ended March 31, 2009, and subsequently 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 reduction to fair value of Network General's deferred revenue, and non-GAAP net income excludes share-based compensation expenses, amortization of acquired intangible assets, costs and expense of various acquisition-related items and related income tax adjustments.

I will now turn the call over to Anil Singhal, our Chief Executive Officer.

Thank you, Cathy. Today we are reporting our third-quarter results of fiscal year 2010. This quarter, our results were sequentially strong and consistent with the full-year guidance that we first issued in April and then revised last October. Our guidance has been based on the belief that bookings and revenue would accelerate significantly in the second half. In Q3, that happened as we expected.

Third-quarter GAAP revenues were $70.7 million and non-GAAP revenues were $70.9 million, both up 18% sequentially. Our results reflect seasonality and end-of-year budget flush, combined with what we believe is the beginning of an improving economic climate. These sectors have affected bookings as expected, except for a slower-than-anticipated improvement in the general enterprise sector of our business.

We are narrowing the range of our full-year revenue guidance today, with only one quarter left, maintaining the lower end of the range. More importantly, our strong booking in the quarter confirm our confidence in our market position and in the long-term growth prospects in all of our vertical markets. We continue to target high-teens percentage annual bookings growth going forward.

Third-quarter bottom-line results were also strong, reflecting our disciplined focus on expense control to maintain our strong margins and cash flow. GAAP net income for the quarter was $8.5 million, up 21% sequentially, with earnings per diluted share of $0.20. Non-GAAP net income was $10.3 million, up 14% sequentially, with earnings per diluted share of $0.25.

GAAP operating margin was 20%, flat sequentially. Non-GAAP operating margin was 24%, down 1 point sequentially. These margins reflect our commitment to invest prudently in growth while continuing to target our long-term non-GAAP operating margin model of 24% to 27%.

This strong financial performance has enabled us to raise once again the low end of our fiscal year 2010 EPS guidance. David will give you those specifics in a few moments.

We saw strong orders coming from our wireless service provider customers, making that vertical our largest bookings contributor for the first time. The telecommunications sector, combined with our high-growth verticals of financial services and government, accounted for 70% of total bookings.

Our investment strategy is focused on expanding our competitive advantage to accelerate growth across all of our verticals, including the enterprise sector. Our goal is to increase market share with innovative technologies and new products and to expand our market reach with a larger salesforce and more proactive channel partners.

We are facing a rapidly expanding opportunity in the wireless service provider space, and we are working on tailoring and enhancing our product with new functionality, focused on carrier-specific needs. Our product solution is ideally suited to the wireless service operator environment.

Major service providers continue their massive transformation from predominantly [subjective] infrastructures to converged high-speed packet-switched infrastructures in order to support the skyrocketing data traffic from smart phones and the multiple services that are rapidly appearing. Network capability is being expanded to support these bandwidth-hungry applications today in the 3G networks.

That expansion will continue in 4G network rollout over the next several years. 4G will expand the use of IP technology from the core of the network out to the edge, expanding our market opportunity substantially.

The result is large-scale, complex service delivery networks requiring solutions like ours that can monitor IP services and provide customer service assurance. Today, [heavy] service offerings and high service quality are the key differentiators for carriers in acquiring and maintaining customers.

NetScout's products are uniquely positioned to solve problems of growing complexity in their networks by monitoring the behavior of the applications, from systemwide performance down to the individual customer's experience.

Last quarter, we launched a new product, nGenius Subscriber Intelligence. Subscriber Intelligence is an [add-on] software module that provides wireless operators a comprehensive session-oriented view of the cell phone subscribers' experience for voice, video and data services.

Continuing our service provider product drive, we plan to release our large, powerful service provider-focused InfiniStream product in the fourth quarter of fiscal 2011. We will continue to enhance our service provider solutions as our customers move towards 4G implementations and launch additional revenue-generating services over the next several years.

There are more growth opportunities for us in cloud computing and virtualization environment. We recently released the nGenius Virtual Agent, a software product that provides high-performance packet flow monitoring deep into the virtualized data center, enabling IT organizations the ability to begin end-to-end visibility of application traffic from within virtual servers.

In addition, we are working on opportunities in the financial services sector, where infrastructures are being upgraded and new data centers are coming online to support high-speed, low-latency [spreading]. We are taking advantage of partnership opportunities and expanding our relationship with Cisco in a number of different areas. We expect to unveil a new product this quarter for Cisco's new Borderless Network initiative they announced earlier in November.

We are currently participating in Cisco's wireless LAN and Unified Communications area with our newly enhanced Sniffer Global product. In addition, two of our products, nGenius Performance Manager and Sniffer Intelligence, have been certified to support Cisco's voice-over-IP installation.

In summary, our partnership efforts, combined with growing success across our vertical market, have strengthened our development pipeline and given us improved visibility into our fiscal 2011 [restructuring effort]. We continue to expect the economy, IT spending and our competitive position to improve throughout fiscal 2011, supporting our drive to high-teens percentage revenue growth. We have the vision, the market-leading products and the talent base to take advantage of the significant opportunities ahead of us. And we are committed to maintaining NetScout's leadership position in the market. We look forward to sharing our accomplishments with you again next quarter.

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

Thank you, Anil. Our quarterly results are in our earnings press release financial statements. We report our results on a GAAP basis, as well as on a non-GAAP basis. Our non-GAAP results eliminate the GAAP purchase accounting effects of the acquisition of Network General by adding back revenue related to deferred revenue valuation and removing the cost and expense of various acquisition-related items. In addition, we remove the GAAP effects of stock-based compensation, which increased significantly as a result of the acquisition.

I will give you the specifics about differences between GAAP and non-GAAP as I discuss our results. These differences 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.

For the third quarter, GAAP revenue was $70.7 million. Non-GAAP revenue was $70.9 million. Non-GAAP revenue excludes $209,000 purchase accounting adjustment to reduce the fair value of the acquired Network General deferred revenue.

Product revenue on a GAAP and non-GAAP basis was $40.8 million, GAAP down 5% year over year and non-GAAP down 6% year over year, with both up 33% sequentially.

Service revenue on a GAAP basis was $29.9 million, up 3% year over year and up 3% sequentially. Non-GAAP service revenue was $30.1 million, down 3% year over year and up 2% sequentially.

GAAP income from operations was $13.8 million. GAAP operating margin was 20%. GAAP net income for the quarter was $8.5 million, yielding an earnings per diluted share of $0.20. GAAP net after-tax margin was 12%.

Non-GAAP income from operations was $16.7 million, and operating margin was 24%. The following items totaling $2.9 million are adjustments to arrive at the non-GAAP operating income. The purchase accounting adjustment to reduce the fair value of the acquired Network General deferred revenue of $209,000 was added back to GAAP revenue. Amortization of acquired intangible assets of $1.5 million, which was principally from the Network General acquisition, was removed from GAAP cost and expense. Share-based compensation expense of $1.2 million was removed from GAAP expenses.

Non-GAAP net income was $10.3 million or $0.25 per diluted share. Non-GAAP net after-tax margin was 15%. We've used the statutory tax rate of 38% to tax-effect the $2.9 million non-GAAP adjustment amount, adding $1.1 million to GAAP tax expense.

The non-GAAP adjustments to our GAAP results are summarized in the reconciliation table included with our press release financial statements. The provision for income taxes is recorded based on a full-year effective tax rate of 34% on a GAAP basis and 35% on a non-GAAP basis.

Our GAAP gross profit for the quarter was $55.3 million. GAAP gross margin was 78% in the quarter. On a non-GAAP basis, gross profit was $56.6 million, and gross margin was 80%. We made the following adjustments to non-GAAP gross profit. $209,000 was added back from revenue. We removed $78,000 of share-based compensation expense and $995,000 of amortization of acquired intangible assets.

GAAP and non-GAAP gross margin were comparable to last quarter. Gross margin remained strong due to continued cost improvement and improving product mix, despite slightly higher discounting from a higher number of very large deals in our Q3 revenue.

We expect non-GAAP gross margin to remain in our long-term target range for the rest of the year. Our current long-term model remains as follows. Non-GAAP gross margin is 78% to 81%. R&D expense to revenue is 13% to 15%. Sales and marketing expense to revenue is 33% to 35% and G&A expense to revenue 6% to 8%, yielding an operating margin range of 24% to 27%.

This quarter, we once again approached that range. In the future, as we invest in driving revenue and return to sustainable expense levels, we expect that higher revenue levels will be required to achieve our target margin range.

Our balance sheet remains strong. Cash and short- and long-term marketable securities were $151.3 million compared to $142.8 million as of the end of the prior quarter, up $8.5 million. Long-term marketable securities include investments in auction rate securities valued at $28.5 million. As of December 31, 2009, the value of these securities includes a temporary decline in value of $3.9 million below par to reflect liquidity concerns.

All of these securities are A-rated or above by Standard & Poor's, with underlying support by the federal government through the Federal Family Education Loan Program. We believe they have no credit issues, only short-term illiquidity.

We have classified these securities as long term on our balance sheet and reported the temporary decline in value to accumulated other comprehensive 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. We believe that we will achieve liquidity of these auction rate securities well below the maturity of the underlying bonds, and our temporary valuation adjustment reflects that outlook.

Because of our strong cash position and cash flow, in the second quarter this year, our Board approved a reinstatement of our previously authorized stock buyback program. This authorization has 3.5 million shares remaining. We did not buy back any shares during the quarter.

Accounts receivable, net of allowances, was $57.7 million, up from $33.2 million last quarter. Days sales outstanding were 74 days for the quarter, based on GAAP and non-GAAP revenue, which is well above our typical DSO range of 40 to 50 days. It's up from 49 days in the prior quarter based on GAAP and 48 days using non-GAAP revenue.

This increase in DSO is due to the high order flow at the end of the quarter, which included unusually high service content. Service renewals are normally for 12-month terms, leading to revenue recognized ratably over that 12-month period. This quarter, we saw a significant number of multiyear maintenance contracts from some of our largest customers, who are reaffirming their confidence in our relationship, which delivers them ongoing new value from our development efforts on their behalf. Multiyear renewals received near the end of the quarter drove DSO up even further.

Inventories were $8.7 million, up from $7.4 million in the prior quarter. Inventory turns were 3.4 times.

Turning to other metrics, revenue contribution from direct customers was 41% and reseller revenue 59%. Revenue from international sales was 30% of total, up from 25% last quarter. Europe delivered 16%, up 3 points. Asia came in at 4%, down 1 point from last quarter. Other international sales were 10%, up 3 points. We expect to continue our international sales expansion, driven by our growing investments in our service provider business outside North America.

Summarizing large deals that we booked in the quarter, there were 133 customers with orders over $100,000, up from 119 in the second quarter. 27 customers gave us orders over $500,000, up from 21 last quarter. Included in those were 13 orders over $1 million, up from six orders in Q2. Five of the million-dollar orders came from telecommunications -- wireless carriers; five from financial services; two from the government; and one from healthcare. As expected, this mix reflects the beginning of the return of our financial services customers to more robust buying patterns.

We saw bookings from the following sectors. Telecommunications sector led the way with slightly over 28%. Financial services was just at 28%. The government was 14%. The healthcare sector was 7%; high-tech followed with 4%.

Our telecommunications bookings included a significant win with a major US wireless carrier that we expect to yield growing future business.

Now, before I get to guidance, let me alert you to a coming change in our revenue accounting policy that will begin to affect our revenue recognition in fiscal 2011. We have concluded, along with many other technology companies, that we will adopt early EITF 0801 and 0903, which were issued last September. We will adopt the new rules effective with the beginning of our upcoming fiscal year.

I'm not going to try to explain the changes that these rules implement here, only their likely impact on NetScout. For most of our product sales, this will result in minimal change to product revenue. Our hardware products, like the InfiniStream, will fall under the new guidelines, but we anticipate that revenue impact will be slight.

For our software and applianced software sales, we anticipate that in the second half of fiscal 2011, we may have to begin ratable revenue recognition over the term of the maintenance period sold with that software. This will result in slower revenue recognition -- slower recognition of software revenue that we would recognize under the current rules -- than we would recognize under the current rules, and therefore lower period revenue, particularly during the initial phase-in period of four or more quarters.

We will report to you revenue and earnings based on both methods of accounting during the phase-in period until ratable revenue recognition is fully established in our results. As a result of this pending change, revenue will become somewhat less meaningful as an indicator of our underlying business performance. Therefore, we will begin this quarter to disclose our quarterly bookings results, as well as backlog, when it is material. We will have a more detailed discussion of EITF 0801 and 0903 expected impact on our fiscal 2011 guidance when we give you that guidance at our next conference call in April.

Bookings in Q3 were $87.2 million, up $14.8 million or 20% year over year. New business bookings were $56.5 million, up $5 million or 10%, while service contract renewal bookings were $30.7 million, up $9.8 million or 47% year over year. Our service renewal total includes $4 million of bookings for service beyond our normal one-year contract period.

Product backlog at the end of Q3 remained immaterial. Driven by the strong service bookings, deferred revenue grew to $85.5 million, up $8.7 million or 11% year over year.

Now, to guidance. We've narrowed the fiscal 2010 revenue guidance range. We now expect GAAP revenue to be in the range of $259 million to $262 million and the non-GAAP revenue range to be $260 million to $263 million. This implies that fourth-quarter GAAP and non-GAAP revenue will be between $70 million and $73 million.

Our continued expense management has allowed us once again to raise the low end of the range for fiscal 2010 net income per diluted share, as we have narrowed the EPS guidance range going into the fourth quarter. GAAP net income per diluted share is now expected to be in the range of $0.69 to $0.73, and non-GAAP net income per diluted share between $0.88 and $0.92.

The implied fourth-quarter range for GAAP net income per diluted share is $0.18 to $0.22. And non-GAAP net income per diluted share is $0.22 to $0.26.

The fiscal year 2010 non-GAAP revenue and net income per share estimates exclude the Network General purchase accounting adjustment of approximately $1.3 million that reduces Network General deferred revenue to fair value, amortization of acquired intangible assets of $5.9 million, share-based compensation expenses of approximately $5.5 million, plus the related impact of these adjustments on the provision of income taxes of $4.8 million.

That concludes our financial discussion this afternoon. Thank you for joining us on the call, and we look forward to taking your questions. Natasha, would you go ahead, please?

(Operator Instructions). Alex Kurtz, Merriman & Co.

So, David, could you just give us a little more color on why these maintenance renewals were assigned so late in the quarter and caused the hockey stick in the DSO?

Well, we often have a closing rush at the end of any quarter. This one was, as the business improved during the quarter, a little stronger. We had one large multiyear maintenance renewal that came in close to the end of the quarter, and that could have come in three weeks earlier and then it would've had less impact, but nothing more dramatic than that.

We often see a hockey stick. The issue with renewals, as you probably appreciate, is with renewals, maintenance renewals, there is almost always never any revenue to offset the receivable. When you have DSO -- so revenue doesn't go up, but the receivable does. DSO -- measuring maintenance renewals is therefore a little bit not the best measure of financials. Our receivables balance is better than ever before. Our aging is extremely strong. There is nothing in the DSO related to collection problems. We don't have any collection problems.

Okay. Well, just to shift real quick and I'll pass it along, the enterprise vertical, if you exclude sort of the core verticals that you report, were up pretty strong quarter over quarter from a bookings perspective. David, what was the vertical that was the weak one that you sort of looked at and said, you know what, that one, we are not seeing as much strength and thus we need to take the top end of our guidance down a bit?

Well, it wasn't that way. The weakest vertical in terms of sequential growth in the quarter was the government vertical, and that's due to seasonality. The issue with the top end of the guidance was that we have not seen in the general enterprise yet the pickup that we had expected we might see. We're starting to see it in carriers, in financials, and we are having strong business in the federal government, just seasonally weak in the December quarter. And it's the general enterprise.

Now, we're seeing spotty pickup in the enterprise, but not across the board yet. And we had in our earlier guidance anticipated that by now we would start to see more of a pickup there. And it's clearly been delayed from what we had expected. So it's really the general enterprise, outside of the three major verticals that we discuss.

Okay. And last question. I think you just mentioned a very large wireless provider that you guys had signed in the quarter. Was that really a new installation for you guys? Had you had a small footprint there? And if you could, maybe talk about who you displaced and why. Thank you.

Well, I think first of all, instead of saying who we displaced, I'd like to just mention that we compete with companies like Tektronix and Agilent and RADCOM in the US, and we replaced -- well, we didn't replace necessarily, but we won against one of these players. And it was an existing account. We had done business with them. But this was for a new project.

So we've had a footprint in that company on the IT side of substance and a small footprint historically on the -- a smaller footprint historically on the customer-facing side. So this is a significant new step for us.

This is an expansion into their wireless network management tools.

Yes.

Yes, correct.

Jonathan Ruykhaver, ThinkEquity.

David, is there any way for you to quantify the actual dollar amount of these -- I will take either your maintenance contracts or in the receivable number for the quarter.

There is about $4 million of additional bookings, deferred revenue, in the quarter and in the DSO that wouldn't be there without the multiyear.

Okay. Good, that's helpful. Also, just looking into the March quarter, should we expect the DSO to trend back into the 40- to 50-day range, or do you expect a continuation of these multiyear renewals to potentially keep that number higher than your target range?

We expect it to trend back. We do expect multiyear renewals to become more of a factor for us in the future, but we don't expect that to drive -- to keep DSO up in the 70-day range. We expect to collect that cash and see a significant increase in our cash as the AR comes down.

Right. Okay, good. The second question, I think, Anil, you commented with comfort around high-teens revenue growth, I think you said in 2011. I just want to get a clarification. Does that assume that the impact to in-period revenue from the adoption of the new accounting standard is incorporated into that statement? I assume it is.

David, you want to -- no, it doesn't include that. It's not because of that, but David, would you like to --

So, no, our high-teens long-term revenue growth target assumes everything is in balance, meaning we've worked through this accounting change, which won't have happened in fiscal '11. We'll just be starting to work through it then. So, no, and it's not -- the high-teens growth isn't until we give guidance in April, is not a fiscal 2010 revenue target either, or bookings target. But to your specific question, no, it does not take into account any short-term transition effect of this new revenue accounting option.

Right, but the more important number when this transition occurs is going to be the bookings growth number, and that, I guess what you are suggesting is you look into 2011, the bookings number on its own should be closer to a high-teens type of growth rate. Is that right?

Well, again, we are not giving guidance for 2011 here today. But our long-term growth target for bookings, yes, is in the high teens. And you're right, bookings will be a better measure going through this accounting transition.

Right. And I'm just curious. Given the comments you made on the enterprise side of the business, what is the Company's view on application performance management and the importance of capabilities around monitoring and analytics on the server and systems side? I think you've alluded to some initiatives at your user conference, the new K2 nGenius service monitor, but how important is that capability to NetScout as you look to broaden your penetration in the enterprise?

I think it's becoming more and more important, and it's both in the enterprise and the service provider sector. And we feel that we have the best application and business intelligence data available through our packet flow technology. But all the value has not necessarily been delivered to all the customers. And K2 allows us to do that. And so we think that's going to have a major impact on our growth and potential and penetration in the accounts.

So is it the need for the specific business-level analytics that a user would value, taking that data and generating it? Is that what's key with K2 and that service monitor platform?

Yes. For example -- I mean, it depends -- we talk about enterprise as a general vertical, but inside the enterprise, there are other verticals which are application focused, for example, Oracle, Microsoft Exchange. And each of these people can benefit from what we are doing, application-centric analytics and monitoring we are doing in the K2 product.

Okay, good. And then just final quick question. The new nGenius Virtual Agent, is that product driving any business yet? Do you see opportunities around that?

I think it gives us more account control. It's not going to have a big dollar impact on the revenue, but it allows us to provide a complete solution and allows us to sell our InfiniStream product once we have that penetration.

Right. And I assume that that is important in terms of your strategy to more broadly penetrate the enterprise in particular?

Yes, that's right.

Mark Kelleher, Brigantine Advisors.

Just wanted to go back to the carrier win. Is there a way you could size that in terms of what the ramp would look like going forward? And was there any incremental revenue from that win in the December quarter?

Well, the ramp is hard to size. Certainly, this carrier is investing heavily in the area in which we are participating. And we expect there to be certainly potential of multiple times what we've done. Obviously, we have to perform and he has to be satisfied with what we do. We think that will happen.

In terms of the quarter, it was a multimillion-dollar booking in the quarter, and about half of that revenue was recognized in the -- half of the booking was recognized as revenue in the quarter.

Okay. And how about Cisco? Can you give us an update on how you perceive that relationship going?

I think we see a more longer-term impact, both on that revenue and account control -- I mean, account control in the short term, and a longer-term impact on the revenue. And we are just at the beginning stages of this. As we talked about, we will be making some announcements this quarter about the first thing which we are doing with them beyond what we already announced with the Sniffer Global product.

So we think, again, this increases our visibility into accounts, gives us account control, provides a broader solution to the customer from a single vendor. But short term, the revenue impact will be minimal.

Eric Martinuzzi, Craig-Hallum.

Congratulations on the solid execution there. That was a significant step up there on the product sales.

The 3G versus 4G, obviously wireless spending up significantly for you guys. Is this all pretty much still 3G, or is there any next-gen spending that's going on, LTE spending that's going on?

Well, next-gen stuff is in the labs. So we are beginning to get some requirements about that. But, yes, most of it is 3G stuff right now.

Okay. The sales and marketing as a percent of revenue, that's definitely higher than I had modeled for. Was there anything in that sales and marketing line this quarter that was an anomaly?

We did have some additional sales incentives in the quarter. As we looked at the beginning of the quarter, we said, we got lots of opportunity; let's make sure it happens. And so we put some additional sales incentives that drove that up.

You shouldn't expect to see that same level of sales incentive going forward as you look at our Q4, end of our fiscal year. We have natural incentives built into our end-of-year sales attainment. So that was something of an anomaly, yes.

Okay. And then just to dive a little bit deeper on the Cisco relationship, I'm wondering how -- I understand the Borderless Networks initiative. I understand the next-generation integrated services router. How does this actually get implemented at a customer? Do they have to roll out new ISRs across their wide-area networks for NetScout to benefit? And then how are you going about training Cisco VARs on this product?

Well, first of all, on the ISRs, they have to have the right hardware in the ISR in order to run our agent. And so many of the ISRs are already capable of that -- I mean, has already been sold with that hardware. So in that case, it will just be a simple software upgrade of our agent and will still be managed through our centralized performance manager. And we are going to have -- I mean, it's too early for that, but we will have some training programs for the VARs and Cisco salespeople for collaboration and other reasons.

But if I'm a Cisco VAR, how do I benefit from this?

Well, I think if you are just a Cisco VAR, they're not going to get paid any commissions on this. But the way they benefit is that there is yet another reason for people to buy that additional hardware, because it's capable of running our technology. So they will get to sell -- I mean, this is assuming that they have not sold before. People have a lot of branches, and not every branch is equipped with their hardware. And it depends on what applications are able to run on that hardware besides how many people are going to buy that hardware blade. So I think in the long run, it will increase the sales of that hardware option on these ISRs, which will benefit the VARs.

Okay. And last question. On the guidance, if I look at the midpoint, it's $71.5 million non-GAAP revenue for Q4. That's -- you just posted a quarter roughly $71 million. The mix there was about a little over $40 million, almost $41 million on the product. Should we expect a similar revenue mix for Q4?

Well, our service revenue changes slowly. So that's a reasonable expectation. Product revenue and service revenue have to be about in the same range.

Scott Zeller, Needham & Co.

Regarding the changes that are coming with revenue recognition, the commentary around how it would impact product hardware revenue versus the software appliance revenue, could you tell us a little bit more about that? Because my impression is that nearly everything you sell, every box has software as a component. So how much of the -- I guess the real question is, how much of the product line is going to be impacted by the change to ratable? Thanks.

Well, Scott, we are still working through the details of this. But as we see it now, having talked with our auditors at some length about this, our hardware products like the InfiniStream products and the probe products and our collector products, although they have software embedded in them, because we don't sell the software separately, it's all an integral part of the product, they will fall under the new rules, which make it easier to recognize revenue upfront, as if this sale were completed. And you don't have to go through all of the VSOE demonstration with those products.

With the software products like K2 and PM that we sell separately from hardware, we can sell it within a hardware appliance, but that's not necessary. Those will still fall under 97-2. And so there will be no change for those. But without, again, going into all the details that we will discuss at more length next time, we believe that because of the change to our hardware products as we do bundled sales, we may well lose -- of renewal, software -- of maintenance renewal, we may well lose VSOE under 97-2 for the software products. And it's in anticipation of that that we would expect that our software products may lose upfront revenue recognition and have to go to ratable.

We should mention that's a small portion of our total.

Yes, between 10% and 15% of our total revenue is software. So we haven't completely sized the impact yet, but we don't expect it to be -- and we will show you both accounting approaches, so you will be able to track as if we hadn't made the change, as well -- and see the effect of the change.

Okay. So it sounds like the bottom line here is that somewhere around 10% to 15% of total product, as a rough estimate, would have some impact.

Yes. And of course, when we change to ratable, the revenue comes back over the period, which is typically a year. So once we've been through four quarters of this, it will be back to about the same levels that we would have expected otherwise. It's just during that four-year -- four-quarter phase-in time that we will see a dip in revenue and associated EPS. But again, we'll report both so you can tell.

Could you offer some color around the pipeline? You know, when we met for analyst day, there was some pretty positive commentary around the wireless pipeline, and we saw some good activity in the quarter. But how would you characterize that now, looking forward today, the pipeline?

We think our wireless pipeline is strengthening and is strong as we see it today. We expect a lot more wireless business around the globe, and we are adding sales resources in new countries, as well as solidifying our position with wireless carriers in the geographies we already have good positions in, principally in North America and Europe.

We are also getting traction with a number of carriers in Asia that -- well, they're not ready to -- we haven't seen the results from yet, but we expect good traction there. So we're getting traction with wireless carriers around the world.

In the enterprise side, there's been some color from you around how that continues to be slower to recover when you look beyond the financials, for instance. How would you characterize the pipeline, though, for the traditional enterprise buyer? Would you say that there is pipeline, but the orders have not yet converted? Are you getting a sense of pent-up demand?

I can't say we see that in the pipeline yet for the enterprise. There is clearly pent-up demand, but it's not manifest yet in our pipeline. Most of our pipeline growth is growing -- is coming from the other verticals, which is why we, as I mentioned earlier, we took down the top end of the guidance for the balance of this year.

Rohit Chopra, Wedbush Securities.

David, can you provide us an update on HP?

We continue to work with them on embedding some of our software technology, just like we are -- similar to what we are doing with Cisco. But there is no new development since the last time we talked about it.

Okay. And then on the wireless side, I wanted to come back to that issue just one more time. Were there any new customers signed, or are these all existing customers or wireless telecom?

Well, the big orders that drove our business, as always happens, are from customers with whom we have a relationship of some sort. The new one that we spoke of was really a big new penetration into the core of their customer-facing network. But the five big deals that we discussed, the four others, were all from existing carriers. So when we -- existing customers. When we talk about the penetration that I spoke of in the market and the pipeline build and getting traction in new areas, the order flow from those new areas is always a slow ramp. But obviously it's important, because it is our future.

Right. And then, were there any in Europe, any of these carriers (multiple speakers) US-based or North American-based?

Yes, we had good order flow from Europe as well. They were not all US.

Okay. And then one last question here. I think at a recent conference, you talked about acquisitions. And you have a lot of new products coming out. I think some have been released and there's a few more on the way. What area is actually missing at NetScout? Maybe Anil can take this question.

Well, I think I would say that most of the areas we are working very hard in, but we must still do some things to accelerate our business. As an example, for the service provider side, we have been focusing more on the data services. But there are opportunities in the voice area. And so we might look into some companies in that area.

Gabe Lowy, Noble Research.

A few questions from me. First, just housekeeping, David, I don't know if you mentioned what cash flow from operations were and if you have the D&A and CapEx along with that?

Yes, cash from operations was $10.1 million, CapEx was $1.5 million, depreciation and amortization $3.3 million in the quarter.

Great. Thanks. Second question, can you talk a little bit about the competitive --

I'm sorry, I'm corrected. I misread the number. $3.7 million D&A, $3.7 million. Sorry.

Okay. Second, if you can talk a little bit about the competitive environment, not only within the three core verticals who you are seeing, if there's any changes in who you are seeing, but also out in the broader enterprise, and if there's been any impact on your take on market shares beyond CA's acquisition of NetQoS?

Yes, there is not a significant change in the competitive landscape. I mentioned already that we compete with two big players, Tektronix in the service provider area and the wireless provider segment, we compete with two big vendors, Tektronix and Agilent, as well as some regional players in Europe and elsewhere, like RADCOM and Nexus. And we feel that we are gaining market share there. We were practically zero a few years ago in that segment, and now we have significant revenue and bookings from that area, which we might share with you at the end of the year. You'll be at able to add up and see how we are gaining market share.

On the enterprise side, there are a lot of small players. And you're right, NetQoS was one of them. And there is a company called Network Instruments. There is a company called OPNET. And so there are several smaller players, and yes, we see some competition. We lose some deals to them. But overall, I think we are doing quite well, not necessarily gaining market share, but not losing either.

Okay. And as you spend particularly behind building out your sales presence in some of the new markets, are we looking at a period of maybe flattening operating margin, I mean, still sort of maybe at the bottom end of the target range, or are you willing to give up a point or two here and there to try and build out that market presence?

Gabe, it's our intent, we've tried to indicate it's our intent to invest now to capture the opportunities we see in front of us that are growing, presenting now and growing. And there will be a window to go capture them, but to maintain our focus on the operating margin range. So you should expect us to be prudent about and resistant to giving up operating margin from where we are.

That doesn't mean to -- I don't mean to imply there that we won't, if we see a significant opportunity, to go do something that we think is worth it, that we won't go do that. But we will come and explain to you what we've done.

Okay. And then lastly, you're still working through the ramifications of the accounting changes that are coming, and you have gone through that well. But a question related to that. Would this be a time to also consider offering the product or a combination of product and service in a Saas-based solution? And do you think there is a market for that?

Yes, I didn't --

SaaS, software as a service.

Well, I think, yes, we have seen that in past. We feel that our product is sophisticated and I think complex enough that we don't see software as a service. Those things work very well with pure software products, like Concorde, where they are taking advantage of the existing instrumentation in the network. That means they will go to servers or routers or switches and collect information from them, and those are easy to put in terms of software as a service.

But since we sell an appliance, which David talked about InfiniStream, it's 90% of our sales. That's very hard to sell as software as a service. And plus there are some technical issues in terms of whether people can deal with that. So we don't expect our solution to be -- you should think of our solution partly as like a Cisco router, and the router has not been, in most cases, has not been sold as a service -- software as a service. And similar to that is a solution set.

(Operator Instructions). Alex Kurtz, Merriman & Co.

Just a quick follow-up. Sorry if you already covered this, David, but could you just talk about the gross margin on the product and services side? And you've seen some variability quarter over quarter through this fiscal year. Can you just give us a sense of where you see that heading on either line?

Well, we expect that the gross margins will stay within our target range. We are about at 80% non-GAAP today. We were about 80% a quarter ago and 81% a quarter before that. But all of those numbers are above where we were last year. So, generally, we believe the trend is of cost improvements is working in our favor. And we expect to be in the 78% to 81% target range going forward.

There hasn't been a great deal of variability. We have seen a slide-down on some -- a modest slide-down this year on some lighter volumes initially, and more recently a little impact of discounting that we mentioned with the very large deals in the December quarter. But we don't expect that to be a major impact going forward.

There are no further questions at this time.

Well, thank you very much for joining us and for a very robust set of questions this time around. We appreciate that. Thanks for your interest. We will plan to see you in 90 or so days at our April earnings call. Have a good evening.

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