Netscout Systems Inc (NTCT) 2017 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. And welcome to NetScout's second-quarter 2017 results conference call. (Operator Instructions)

As a reminder, this call is being recorded. Andrew Kramer, Vice President of Investor Relations, and his colleagues at NetScout are on the line with us today. (Operator Instructions). I would now like to turn the call over to Andrew Kramer to begin the Company's prepared remarks.

Thank you, Tony, and good morning everybody. Welcome to NetScout's fiscal year 2017 second-quarter conference call for the period ended September 30, 2016. Joining me on this morning's call are Anil Singhal, NetScout's co-founder, president and CEO. Michael Szabados, NetScout's chief operating officer. And Jean Bua, NetScout's executive vice president and chief financial officer.

We have included a slide presentation that accompanies our prepared remarks. For those dialing into the call this morning who would like to view the slides, you can find it by going to the investor relations section of our netscout.com website and then clicking on today's webcast. You can advance the slides on the webcast viewer to follow our commentary. We will try to remember to call out the slide number we are referencing in our remarks.

Today's agenda will be consistent with prior quarters. Anil Singhal will share his perspective on our second-quarter and first-half results, current market conditions and recent new product highlights, and our outlook for the second half of the year. Our COO, Michael Szabados, will highlight recent key wins and recap notable go-to-market developments. And our CFO, Jean Bua, will then provide greater detail and insight into our financial results and review our fiscal year 2017 guidance.

Moving on to slide number 3, I would like to remind everybody listening that forward-looking statements in this conference call are made pursuant to the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934, as amended, and other federal securities laws. Investors are cautioned that statements in this conference call, which are not strictly historical statements, including but not limited to the statements related to the financial guidance and expectations for NetScout, market conditions and customer demand, and all of the other various product development, sales and marketing, expense management, integration and other initiatives planned for fiscal year 2017 and beyond, constitute forward-looking statements which involve risks and uncertainties. Actual results could differ materially from the forward-looking statements due to known and unknown risk, uncertainties, assumptions and other factors. Such factors are detailed on this slide and I strongly encourage you to review them.

For an even more detailed description of the risk factors associated with the Company, please refer to our Annual Report on Form 10-K for fiscal year ended March 31, 2016 and subsequent Quarterly Reports on Form 10-Q, which are on file with the Securities and Exchange Commission. NetScout assumes no obligation to update any forward-looking information contained in this communication or with respect to the announcements described herein.

Finally, I would like to remind you all that while the slide presentation includes both GAAP and non-GAAP results, unless otherwise stated, financial information discussed on today's conference call will be on a non-GAAP basis only. This slide also provides information about the use of GAAP and non-GAAP measures since non-GAAP measures are not intended to be superior to, or a substitute for, the equivalent GAAP metric. Non-GAAP items are described and reconciled to today's -- or sorry, to GAAP results in today's press release and they are included at the end of the slide presentation made available online on our website.

As a reminder, we completed our acquisition of the Danaher Communications Business on July 14, 2015 and as such, the reported results for the second quarter of fiscal year 2016 do not include the two-week period in which we did not own the business. To provide an apples-to-apples comparison between the second quarters of fiscal year 2016 and 2017, we will provide additional non-GAAP proforma details so that you can better understand the recent performance trends as well as provide further context for our fiscal year 2017 guidance. Nevertheless, when we do note a growth rate, we will strive to clarify the nature of the comparison. Reconciliations between the GAAP and non-GAAP proforma financials are provided in the appendix at the end of the slide presentation.

As we detailed in our press release today, NetScout reported second-quarter results that came in slightly ahead of our plans entering the quarter in terms of both revenue and EPS. We made good progress on our new product cycle that are validated by some exciting customer wins. With that as a high-level background, I will now turn the call over to Anil to provide some further context on our results and plans for the coming quarters. Anil, please go ahead.

Thank you Andy. Good morning everybody, and thank you for joining us today. As Andy mentioned, I will first recap our results for this quarter and the first half of this fiscal year, and then focus the rest of my comments on the second half outlook and long-term prospects.

There are several slides that will accompany my comments, so let's begin on slide number 5. As you know, the second quarter of fiscal year 2017 is the last quarter in which the timing and magnitude of our acquisition of Danaher's Communications Business would have any impact on the comparison of our quarterly results. The table on this slide compares key metrics for the second quarter and the first half of fiscal year 2017 against the prior year periods. Jean will provide a more detailed review of the proforma performance, but I'll share several brief observations on our non-GAAP performance.

I'd like to frame our results to date against the fiscal year 2017 guidance we provided about six months ago at the start of the year. Our original targets were for proforma annual revenue growth of 0% to 4%, operating profit margin growth between 200 and 400 basis points, and significant EPS growth in the range of 10% to 25% using a fixed share count of 94 million shares. This guidance was based on roughly flat top line growth in the first half, with the bulk of potential growth to be delivered in the second half, which has been the traditional pattern for our business in the past.

I am happy to report that we performed well for the first half of fiscal year 2017, both on the revenue and operating margin front. For the first six months, first-half revenue was $561.2 million and our operating profit was $101.1 million. For the second quarter, we generated revenue of $283.3 million, an operating profit of 20.5% and diluted EPS of $0.39, all of which were ahead of plan. We also made substantial progress on our product roadmaps, which we believe will play an important role in helping NetScout reaccelerate its top-line trajectory and drive notable profit margin gains in fiscal year 2018 and beyond.

In terms of our second-quarter results, our revenue performance this quarter was highlighted by another quarter of strong top-line growth at Arbor for its distributed denial of service solutions and solid, low digit -- double-digit revenue growth in the enterprise. Revenue in the service provider segment declined due to the combination of the current sluggish spending environment and the timing of a large order in the year-ago quarter.

Moving onto slide number 6, to help put our prospects for the second half of FY17 and longer term into context, I would like to make some observations about current market conditions and major key technology trends. These views reflect our deep understanding of the service assurance market in which we have been a market leader and technology innovator for multiple decades running, along with my visits over the past three months to key enterprise and service provider customers across each major geographic region and related discussions with our regional sales teams.

First, we believe that we have put any integration concern within our customer base about our strategy and product roadmaps largely behind us, and that our competitive position in the marketplace is excellent. Our incumbency with major mobile operators and MSos worldwide remains very strong and our momentum is starting to build in the enterprise. We secured a number of strategic wins in recent months, and Michael will highlight a few of these in a moment.

In the service provider market, carriers who have made huge investment in recent years to build out their 4G and LTE networks are now striving to monetize this infrastructure and drive ROI. For example, our customers are advancing new projects on the Voice-over-LTE front, and we are well positioned to target these budgets. However, their infrastructure costs are being increasingly taxed by surging traffic from over-the-top content driven by all-you-can-eat data plans and subscriber expectations for high service quality.

As a result, many tier-one service providers are striving to more tightly control CapEx and OpEx, and that is contributing to elongated sales cycles for our products and potentially higher erosion on prior service contracts as they come up for renewal. These carriers move forward intent on leveraging their own cloud and content to deliver a better OTT experience and create new sources of revenue in the process.

Recent M&A like AT&T's just-announced intention to acquire Time-Warner, Verizon's plan to buy Yahoo!, or Comcast's previous purchase of NBC Universal, signal that it may no longer be enough to own the network, they may have to own content too. We believe that these actions will ultimately help spur spending on our products that can provide customers with high-value insight into how subscribers are consuming value-added content and services, via an end-to-end service assurance solution that extends from the last mile Radio Access Network to the core network and across to the content servers.

To help them control infrastructure costs, carriers are very interested in network virtualization and network function, NFV, technologies. NFV represents a major rearchitecting of the networks that will result in a hybrid environment that will link all their physical and virtual networks. While we are well positioned to help these customers with this network evolution, they are still in the very early stage of deployment, and the progress by carriers has been slower than expected by industry experts. At the same time, however, given the market conditions, these activities are contributing to lengthier decision making and inertia when it comes to spending for expansion of their revenue-producing infrastructures.

In the enterprise, we see a number of favorable trends. For example, customers are increasing their investments in cybersecurity. High-volume DDoS attacks are now making headlines, and Arbor Networks is well positioned as the market leader to help customers identify and mitigate these attacks. Enterprises are also rapidly developing new applications due to high-quality development tools, strong middleware components, and commoditized hardware.

However, traditional APM tools are inadequate to convert faster development cycle into successful and faster deployments. This is an opening, is an opportunity for NetScout's patented Adaptive Service Intelligence called ASI technology and our nGeniusONE solution set. Finally, both enterprise and service provider customers are engaged in next-generation, Big Data initiatives, feeding all kinds of data into their own or partner-driven open data lake architectures. We plan to introduce our own set of big data analytics that will enable our service provider and enterprise customers to more effectively leverage actionable intelligence that can be mined from the high-value, high-volume traffic data that we collect.

Last year's strategic acquisition of Danaher's Communications Business, combined with an advanced version of our ASI technology that we now call ASI-Plus, has helped us increase our total addressable market, extend our market leadership, expand the breadth and depth of our solutions, broaden our customer base and solidify our incumbency position in major accounts. We are now advancing a new product cycle and related go-to-market activities that we believe will strengthen our ability to capitalize on these exciting opportunities.

This new product cycle is aimed at enabling our customers to maximize the value they get from NetScout technology to gain the visibility and intelligence necessary to optimize network and application performance, enhance security, increase overall operational efficiency, and help consolidate the disparate tools they use to manage their infrastructure.

We made excellent progress on our product roadmap during this past quarter, and are on schedule to substantially complete this product cycle by the end of our fiscal year. Simultaneously, we are starting to build sales pipelines for these new products, and we are growing increasingly confident about our potential to reaccelerate our revenue growth and drive substantial gains in profitability in fiscal year 2018 and beyond.

Slide number 7 provides a visual backdrop for our product development progress. We are focused on next-generation instrumentation in a variety of form factors with state-of-the-art analytics for service assurance, cybersecurity and business intelligence. By doing this, customers can harness the power of IP intelligence to enhance their service delivery, protect their networks from attack, and deliver a high-quality user experience.

Last month, we delivered the first proof point of our integration effort when we announced that our new real-time information platform, the InfiniStreamNG, is now generally available to both service providers and enterprise customers. The InfiniStreamNG is a true business assurance platform that supports powerful analytics spanning service assurance, cybersecurity and business intelligence. Just as critical, this platform is available in multiple form factors, meaning that it can be sold as a traditional appliance, as software for use with commercial, off-the-shelf hardware that the customer procures, or in virtualized form to monitor virtualized network functions. Within the next several months, we plan to add our big data analytics and cybersecurity support to this platform. Michael will review the traction that this new platform is generating including early adoption by certain legacy customers or TekComms and recent success on the software-only front.

In addition to our ongoing investment in organic R&D during the second quarter, we acquired Avvasi Inc., an award-winning provider of solutions for measuring, improving and monetizing video in service provider networks. The M&A being advanced by service providers is a clear indication that streaming video and video-on-demand is becoming strategically significant to our service provider customers. Avvasi's patented technology and differentiated solution set is used by carriers to monitor the quality of service for streaming video, even when the content is encrypted. This will further bolster our positioning in the emerging OTT space and user plane monitoring. Approximately a dozen engineers and other Avvasi staff joined our organization in conjunction with this transaction.

Let's now turn to slide number 8 for our outlook. Despite an unsettled macroeconomic environment, we expect to generate decent topline growth in enterprise, service assurance, and at Arbor. At the same time, we are seeing continued pressure on our service provider business. To be clear, we are not seeing major projects with service providers being outright canceled, nor do we see competitors making any notable progress. However, it is becoming harder to forecast the timing and magnitude of large orders as customers intensely scrutinize their funding processes for major projects.

Even as we enter a quarter when we generally benefit from yearend budget flush, there is potential that some large orders may be phased into the first quarter of the next calendar year when they get access to new budget dollars. In other cases, projects may receive less funding than what was originally planned. Additionally, there is pressure on our second-half service revenue as we work through a number of maintenance and support contract renewals.

Despite these headwinds, we anticipate sequential revenue growth in the third quarter and a good finish to the fiscal year in the fourth quarter. While we feel it would be premature to update our guidance right now, we currently believe that over-delivering on our revenue goals in fiscal year 2017 appears unlikely. Given current market conditions, achieving the lower end of our revenue targets may be a more realistic outcome. Even without any notable revenue growth, we still would expect to deliver at least 2 percentage points of operating margin expansion.

With our acquisition more than a year behind us, we better appreciate all of the assets that are now part of NetScout, and plan to examine ways that we can align our resources to best support our most attractive growth opportunities and drive operational efficiency. I hope this provides some color into our shorter-term outlook along with our enthusiasm for our long-term prospects. While the near-term environment is presenting some challenging headwinds, we have the products, people and programs that we believe can help us successfully navigate this turbulence.

Finally, I would like to thank the team at NetScout for their focus and hard work over the past quarter along with our shareholders for their ongoing support. That concludes my remarks. I would like to turn the call to Michael at this point for his commentary.

Thank you Anil, and good morning everyone. Slide number 10 provides an overview of the areas I plan to cover. I'll first review some recent customer wins that help illustrate Anil's commentary and then I'll highlight some of our go-to-market activity that is helping to drive greater sales traction and broader market awareness.

In terms of wins and use cases, in the service provider sector we are already generating traction with our InfiniStreamNG platform. We have already received initial InfiniStreamNG orders from two legacy Tektronix Communications customers and evaluations on this platform are underway at many other accounts. Making the InfiniStreamNG available as a software platform is also proving very relevant in today's buying environment.

We are happy to report that we recently closed a multiyear, 8-figure enterprise-wide site license for our InfiniStreamNG software with one of our longstanding Asia-Pacific customers. This was the consummation of a prospective deal that we highlighted for investors at the end of fiscal year 2016. In addition, our software was selected by a leading carrier in Eastern Europe to support their continued rollout of 4G services.

In terms of other next-generation instrumentation developments, we recently announced enhancements to our family of packet flow switches or network packet brokers, and these investments have been critical to gaining greater wallet share with our customers. In particular, we secured a major win in excess of $6 million with a branch of the U.S. military that is deploying our packet flow switches to further standardize on NetScout performance management solutions, and also support planned security applications in the near future. We won this significant deal in competition against another market leading vendor of network visibility fabric technology. We are delivering a very efficient solution to help this customer as they increase the capacity of key network links to 10-gigabit and 40-gigabit speeds, support the monitoring of unified communications services across their enterprise, and feed inline cybersecurity applications.

We are also seeing enterprises lean on NetScout technology to help them effectively leverage applications hosted in both private and public cloud environments. For example, last quarter, a major provider of payment processing services and solutions extended their NetScout footprint to help them successfully migrate to Microsoft's cloud-based Office365 by instrumenting new areas of their on-premise infrastructure on which this service depends. As we move forward, we see attractive opportunities to help our enterprise customers gain greater visibility into the performance of their cloud-based applications. With one of the many acquired capabilities from Fluke Networks, which we are re-launching as nGenius Pulse, we can offer customers additional service-level monitoring capabilities for off premises services using synthetic-agent technology.

As far as our own cybersecurity solutions go, Arbor produced yet another strong quarter of growth for its DDoS solutions as the volume, sophistication and frequency of DDoS attacks are rising at alarming rates. As Anil noted, last week's high-profile DDoS attack that knocked out major streaming sites, e-commerce websites and email for many enterprises should be another major wake up call for the industry and it highlights the need for the type of overall scale and product breadth that Arbor brings to the table. Arbor's incumbency with top network providers, web hosting firms and enterprise software providers is leading to new opportunities as these firms turn to Arbor to help them securely deliver their cloud-based services.

In the second quarter, Arbor expanded upon its incumbency with a major technology firm with an initial, mid-7-figure order to help them protect their newest generation of cloud-based infrastructure services. This customer chose Arbor TMS as they look to build out their public cloud services and include DDoS protection as part of their core service offerings, thereby alleviating one of the major concerns for businesses as they evaluate cloud provider partners.

We have also been making progress with our efforts to drive thought leadership and broader industry awareness for NetScout with industry press and analysts. We participated at VMWorld 2016 in August, which was very productive as it marked one of the first fully integrated industry events where we showcased the new InfiniStreamNG and our business assurance product portfolio.

In addition, Arbor has continued to gain recognition for its technology and market leadership as reflected by some of the logos of recent awards on this slide. As we move forward, we plan to continue to highlight our product development progress as we announce our expanded APM capabilities, new products for virtualization and the cloud, and support for cybersecurity and big data analytics.

In closing, we are very excited about the potential for our service assurance, cybersecurity and new business intelligence offerings that can enable our customers to benefit from true business assurance. I look forward to sharing future success stories regarding the use of our newest innovations on subsequent calls. That wraps up my commentary at this point. I will turn it over to Jean.

Thank you, Michael, and good morning, everyone. This morning, I will review key second-quarter and first-half fiscal year 2017 metrics, and then review our guidance for the remainder of the fiscal year. As we noted earlier, there were a number of acquisition-related items that impacted our GAAP results so our convention will be to refer to our non-GAAP results unless otherwise noted.

Consistent with our comments earlier on the call, our acquisition of Danaher's Communications Business was completed two weeks into the second quarter of fiscal year 2016. This timing slightly impacts comparisons with the second quarter of fiscal year 2017 and any other extrapolations about second-quarter results may not be representative. When possible, we will frame our results against prior periods on a proforma basis. As noted earlier on the call, there is an appendix at the end of the slide presentation that provides a reconciliation of the non-GAAP proforma financials along with other supplemental details.

To begin our financial discussion, we will be starting with slide number 12 of our presentation. I'll review our second-quarter performance with a focus on comparing it against proforma FY'16 results, which assumes our acquisition of Danaher's Communications Business had been completed on April 1, 2015.

For the second quarter of fiscal year 2017, total revenue was $283.3 million, down slightly by 1.8% over the prior year's second quarter proforma revenue. This was modestly ahead of our plan due in part to strength in the federal sector late in the quarter. Product revenue was $174.9 million or 62% of total revenue during the past fiscal quarter. This declined 4.3% from the same quarter one year ago on a proforma basis due to the difficult comparison from the prior year. Service revenue grew 2.6% to $108.4 million, which represented 38% of total revenue.

For the first half of our fiscal year 2017, revenue was $561.2 million representing approximately 1% growth over the prior year's first half. We achieved this revenue performance without the benefit of that very large service provider project that skewed the top-line in the prior year's second quarter.

Our service provider segment for the first half of the fiscal year represented 55% of total revenue with enterprise representing 45%. This is generally consistent with the same period one year ago.

In terms of the geographic mix, which is calculated on a GAAP basis, international revenue was 34% of total revenue, which is generally consistent with our expectations when we completed our acquisition of the Danaher Communications Business. We had one customer that represented greater than 10% of total second-quarter revenue.

In terms of our customer segments, we had 3.1% proforma revenue growth in the enterprise vertical. Through the first six months, we have generated good, low-double digit growth for nGeniusONE in the enterprise with strength across most major verticals including government, financial and healthcare. This growth was offset by a proforma decline of approximately 1% in the service provider segment as we faced a difficult comparison with prior quarter due to the $50 million plus service assurance project that we have previously discussed.

Gross margin was 74.5% this quarter and 73.7% for the first half of the fiscal year. The gross margin is down a half percentage point for the first half of this year primarily due to product mix shifts. In particular, that large $50 million plus deal from the prior year delivered a favorable gross margin. This quarter's official launch of the InfiniStreamNG platform will play an important role in improving gross margin over the longer term.

Our operating margin in the second quarter of fiscal year 2017 was 20.5%, down modestly from 21.3% on a proforma basis at this time last year. For the first half of the year, our operating margin was 18% on a proforma basis compared with 16.8% for the first half of the prior year.

For the second quarter, we reported net income of $36.4 million, or $0.39 per diluted share. The net income margin was 12.9%. The overall impact from our share repurchase activity on earnings per share this quarter was minimal. For the first half of our fiscal year, our net income was $62.8 million, or $0.67 per diluted share.

Slide 13 details our balance sheet highlights and free cash flow. We ended the quarter with cash, cash equivalents, short-term marketable securities and long-term marketable securities of $303.4 million, which declined sequentially by $31.5 million. During the quarter, we used our cash to repurchase our common stock as well as to fund the acquisition of the Avvasi video monitoring technology assets for less than $5 million. We do not expect that Avvasi-related revenue or costs will have a material impact on our results this year.

Our free cash flow for the quarter was $7.4 million. Our free cash flow for the first half of fiscal 2017 was $35.6 million. We expect free cash flow to strengthen in the second half of the fiscal year based on anticipated higher revenue and increased operating profitability. At the end of the quarter, we had $500 million of available credit on our existing facility, which leaves us with total liquidity of just over $800 million. As you can see from this slide, our current financial profile is generally in line with our fiscal year 2017 financial targets.

This quarter, we repurchased approximately 929,000 shares of common stock during the second fiscal quarter at an average price of $28.62 per share, totaling approximately $26.6 million in the aggregate. At present, we have approximately 6.9 million shares remaining on the 20 million shares that the Board authorized for repurchase. While we are not obligated to complete the existing repurchase plan in any specified timeframe, we would ideally like to complete this plan in conjunction with the two-year anniversary of our acquisition in mid-July, 2017. We expect to be active in the market again in our third fiscal quarter.

In terms of a brief recap of our balance sheet highlights, accounts receivable net of allowances was $240.6 million, which was down slightly from the end of our fiscal year but up from the prior quarter primarily as a result of the timing for service renewals. DSOs were 80 days in comparison to 50 days from the second quarter of the prior fiscal year. The DSOs from the prior fiscal year were unusually low due to the timing of the billing and payment of the $50 million plus deal from the prior year's quarter.

Let's move to slide 14 for guidance. The reconciliation of our GAAP guidance to our non-GAAP guidance is in the appendix. As Anil discussed, in the service provider market, carriers are carefully managing their capital and operating expenses as they seek to monetize their infrastructure investments to build out their 4G/LTE footprints. For carriers, this has been translating into greater scrutiny as projects move into the funding process. For us, this translates into reduced visibility regarding timing and magnitude.

Even as we head into the seasonally strongest half of our fiscal year, as Anil detailed, we do not believe the current selling environment lends itself to exceeding our targets. Accordingly, we've left our non-GAAP revenue and non-GAAP EPS targets unchanged. Our revenue guidance ranges between $1.2 billion and $1.25 billion and EPS guidance ranges between $1.87 and $2.12.

For further color into our near-term revenue outlook, our current visibility into various service provider projects is restricted due to fluid end-of-year funding processes. Presently, we see potential for some large orders to be phased into the next calendar year's first quarter, which is our fiscal fourth quarter. Additionally, in this climate we see greater pressure on our maintenance agreements with customers that have very large installed bases. Accordingly, we currently anticipate that fiscal third-quarter revenue will grow sequentially from second-quarter levels on a percentage basis by the mid-single digits up to low-double digits. In other words, third-quarter revenue is currently anticipated to be somewhere between $300 million to $320 million. The range is largely contingent on the strength of the end-of-year budget flush from service providers although we will not have visibility into the magnitude of this event until later in the quarter. Given this view, simple math implies that we are expecting a strong finish to the fiscal year and can see fourth-quarter revenue on par with or ahead of Q3. Based on the projects in our pipeline, we currently believe that the low end of our guidance range is achievable.

From an expense perspective, we expect gross margins to improve over the second quarter due to higher volume and product mix. We anticipate that our third-quarter operating expenses will be relatively flat against second-quarter levels. Consequently, we anticipate our third-quarter operating margin will improve sequentially from the prior-quarter's operating margin and be in the mid to upper 20% range. As Anil also mentioned, after owning the acquired assets for over 12 months, we are examining how to best align our resources with our strongest, most promising opportunities.

In terms of other modeling assumptions for our EPS guidance, the $300 million in draw downs on our credit facility is expected to result in interest and other expense of approximately $2.5 million to $3 million per quarter. We currently anticipate a tax rate in the range of 34.5% to 35%. Based on approximately 92 million shares outstanding for the third quarter, this would translate into a diluted EPS range for the third quarter of $0.50 to $0.60. For the full year, we anticipate 93 million shares outstanding.

That concludes my formal review of our financial results. Before we transition to Q&A, I'd like to outline our calendar for the upcoming various investor conferences that we will attend. We will participate in RBC's Technology, Internet, Media and Telecommunications Conference in New York on November 11th. We are also planning to attend the NASDAQ London Investor Program on November 30th and we will augment these conferences with outreach to our shareholders and prospects, particularly on the West Coast and Mid-Atlantic money centers.

That concludes our prepared remarks this morning. Thank you again for joining us and we are now ready to answer questions.

(Operator Instructions). Alex Kurtz, Pacific Crest Securities.

Hey, guys, can you hear me okay? (Inaudible).

We can't hear you now.

We lost you on that, Alex, can you repeat the question?

Yeah, on the margin expansion comment from Anil about 2 points of margin expansion, is that based off of the 24% that you guys did in fiscal 2016? Am I thinking about that correctly?

It's on a proforma basis, so it would be off of a 21% base for fiscal year 2016.

Okay. And then maybe Anil or Jean, could you talk about sort of the competitive landscape right now and what that's doing to deal flow and visibility with large projects? (Inaudible) some of this softness that you're seeing in current spending? Or is really about the broader trends in the sector, M&A, and some of the comments you talked about, about over the top content?

Yeah, so I think just maybe repeating or expanding on what I said, Alex, earlier, so competitive environment is not changed or actually better for us as people are seeing the power of the combination of TekComm and NetScout on the carrier side. Also, in terms of better conditions, there is some competition from (inaudible) and we think our emerging big data strategy is actually going to convert them to partner. So given those things, our competitive environment is really improving. Yet, we see challenges approach versus last year then moving forward, so in the short term we are doing several things. And some of the visits I had is generating some interest. But the impact of that is not really going to see, it not going to be seen until next year.

And next year, even if the environment is the same, we think our total addressable market will technically improve because of all the product integration which will become aligned before the end of the fiscal year. So that's where we see the market mix.

The M&A we were talking about was that in the enterprise sector, because we are one of the unique companies in service assurance which has decent, big business built on the enterprise sector and on the service provider side. On the enterprise side, the bigger difference has been end to end monitoring. That means we can tell you when there is a problem, is it the network or is it the server? That has not been true on the service provider side because those servers are owned by the content providers. So sometimes there is still finger pointing when you have for example bad quality of service. Is it the network or the server? So we feel that we owning the service provider now getting into the content business, will create yet another differentiator for NetScout because we are the only one who can provide the end to end service assurance. And in the process, customer satisfaction, which in turn will result in more investment in NetScout products.

Chad Bennett, Craig-Hallum.

Good morning. Thanks for taking my questions. To follow up a little bit on the first questions asked, so how much of -- so if you look at your December quarter guide, it's obviously down year over year and this is kind of the first full quarter of apples-to-apples since the Danaher transaction. I guess -- so how much of that would you attribute to service provider weakness versus enterprise? And if we are, I guess the second question would be, how has the service provider pipeline changed from your traditional appliance based solutions as a percentage of the pipeline versus software only probes over the last six months? And has there been a big change there?

Yeah, so maybe let me take the second question first. So pipeline is still building out. As you probably know that, we announced the software based solution only last month. We made the announcement of availability. In fact, probably this month. And so the pipeline I think will gravitate toward the software solution over the next year. But this year we don't see the impact, much impact. Most of the pipeline is still traditional product.

And some of the pipeline which actually will result in product sales next year is actually moving toward the software set. So pipeline is moving towards software, but the revenue is not necessarily going to be significant for the software this year.

And I think to your first question, I think we already mentioned that we saw very good growth on the enterprise sector and on the security part. So if you look at our business as security, enterprise service assurance, and service provider service assurance. So the first two areas, which is Arbor and traditional enterprise where NetScout is doing quite well, we are seeing some growth in that area. But service provider service assurance is biggest portion of the business and we continue to see challenges which offset some of the growth on the other two areas.

And just one follow-up. Are the challenges on the service provider side of the business, are they beyond or across regions? Meaning not only the North American tier ones, but also for international service providers also?

Yes, it's everywhere. But because the number of big providers in US is just a few, and that's a bigger portion of NetScout's business, percentage-wise the impact is more dominant in the US. But yeah, it's across the board and I just gave, we gave two reasons. They appear to have made a big investment in LTE and because of 4G explosion they have not been able to monetize it. And a virtualization initiative has started, some of the decision making, where people say, why should I invest in this right now which is going to change in a year or so? And those two in combination is creating the situation environment of lengthening sales cycles or renewing, negotiating fixed service contracts, or slower spending budgets.

Makes sense. Thank you.

Mark Kelleher, D.A. Davidson.

Great, thanks for taking the question. Just wanted to -- you talked about some weakness in service provider. Is there any differentiation in that weakness between the Tektronix products and the packet switch products, packet switch visibility products of traditional NetScout?

Well I think maybe you are mentioning the Tektronix services solution versus NetScout services solution. Because the packet flow switch solution was identical with both, and that's not necessarily a comparative. Maybe you are mentioning that. So when we look at spending, we are selling, we have a common platform now and on which we put Tektronix software or NetScout software as we go to the customer. So we are able to service the demand of Tek customer or NetScout customer with a common platform. So the spending issues and challenges are independent of whether it's a Tek customer or a NetScout customer.

Yeah, just to step back and just summarize our view on the service provider market, as we've said before, there are general trends, but everything is specific to each particular service provider. As a general trend, the 4G here in the second half, where they are monetizing their networks, trying to get an investment, so we have had wins in VoLTE and we have wins as Anil has mentioned and will continue when it comes to On Demand. We do not see it as a competitive issue whatsoever. In fact, as other geographic areas including India, Asia and EMEA, are rolling out their 4G, they have turned to NetScout. And this is why we have a software only solution. They have bought that to be able to standardize on 4G and build out their areas.

So it is an evolution where there is a fourth half, the second half, I'm sorry, of their 4G and they are scrutinizing their investment. And they're also looking at and designing and contemplating their 5G environment. So we do not see it as a competitive issue. We're in fact very happy after Anil's travels around the globe with all the customers, that we feel secure in our differentiation with our scale, our real-time abilities, and our ability to go from the end of the ramp to their data centers. But we just see it as a general trend as to where they go from implementing their 4G to 5G.

So just to clarify, because it really wasn't a competitive issue I was concerned about, I'm concerned that the Tektronix products aren't growing as fast as the NetScout products. And you're saying that the weakness you're seeing in service providers is even across all products, it isn't specific to certain product lines?

That's right. Obviously, you'll see a bigger difference because Tektronix portion of the revenue was higher than the NetScout portion. So in terms of scale, you'll see that. But the same challenges apply to both, in both areas.

Scott Zeller, Needham & Co.

Hi, good morning. Thank you. I wanted to go back to Jean's guidance around OpEx for the third quarter. Could you tell us -- you mentioned that OpEx will be flat Q to Q. Can you tell us if that's absolute dollars or if that's percentage of revenue?

It should be relatively consistent on an absolute dollar basis from Q2 into Q3.

Okay. And if that's the case, with the commentary around looking at the cost structure of the company now that it's been a year, that would suggest that you're easing into cost management if OpEx is flattish Q to Q. Should we expect that the change to OpEx will accelerate or is it going to be a gradual change?

So what we've done over the last year, the last 12 to 15 months, is we've looked at the businesses, we understand the business models much better. We understand where the market has been moving. And we have been over the past year investing in the areas that are good growth areas as well as strategically looking at the headcount and some resources in some other areas that are not good growers. So just going back to an earlier point, FY15 had proforma operating margins of 18% and then we improved them by 2 percentage points in FY16 to 21%. And then our guidance as you know now, at the low end would imply 23%.

So what we're doing at this juncture, after understanding the market, any shifts in the market from when we bought the Danaher business, communications business, it's just looking at what assets we think make the most sense to continue to invest in. And which other assets we should probably pause and see what makes sense to happen with those.

Okay, and then to follow-up, any color you could give us around the growth rates for the packet flow switch and also for Arbor on a year over year basis.

I think we talked about for Arbor double digit growth. And for packet flow switch, we don't carve it out because we are again, Scott, different than all other packet flow switch vendors because our (inaudible) is the combined probe plus the (inaudible). So that's why we don't carve it out like that. But overall we have been winning competitive deals. We look at PFS as an accessory to our probe business, so that's all bundled into our numbers. And on the enterprise side we are seeing better growth rates because our overall business is growing there. On the service provider, we see lesser growth rate for PFS because it's all a tag along with the probe business.

Eric Martinuzzi, Lake Street Capital Market.

Thanks. I wanted to address the December quarter relative to the December quarter a year ago. In Q3 of 2016 you had revenue of $333 million on a non-GAAP basis, at the midpoint of which you talk about here in December, it would be $310 million. Curious to know, as far as the mix there. Because you said you're entering some I guess maintenance renewals, contract renewals on the services side. What we're talking about on the total non-GAAP revenue is a 7% decline at the midpoint for Q3, and I'm just wondering, does that speak to declines in both product and services? Or is services up versus a year ago and product declines in the 8% to 10% range? Any clarity would be helpful.

Sure, so the first point I would make is that one of our large tier ones has already explained to us their purchasing patterns, their requirements for what they would like from our product and their timing. So that's why we understand that Q3 of last year, they had purchased significantly more in that quarter than they are planning to purchase in Q3. They've actually told us they plan to purchase more in our Q4. So that's the main reason for the shift in the timing of orders from Q3 of last year to Q3 of this year.

This year for service revenue, we might see an overall decline. One, Arbor has been moving some of their traditional product revenue to more of a flex subscription, so that's got a significant impact. And then as we have said, we're in the final stages of closing some large installed base customers' renewals. And in the current environment where operating expenses are very important to them to constrain, we'll have to see how those negotiations go.

Understand. Thank you.

Matt Hedberg, RBC Capital Markets.

Great, thanks for taking my questions, guys. There was a couple of earlier questions on software only solutions and I realize it's still pretty early here, but any sort of anecdotal thoughts on how the pricing is going to line up? In other words, do you think you're able to offset potentially lower software prices with higher volume? Potentially better gross margins? Just any other color on sort of how you are kind of thinking about a more software rich product cycle.

Thanks, Matt. So yeah, when you look over the next 3, 4 years, long term vision, I think the majority of the products will move to the software area. And we already enjoyed prior to the acquisition very high gross margins of 80% plus. And I think this will become even higher. And you're right, the price of the software is going to be about 30% to 50% cheaper per unit, but it will allow us to be deployed in more places where they were going with cheaper solutions or going with other technologies like Netflow and Competent Management. So we believe overall impact, what we are hearing from customers, is people really don't buy our (inaudible). They actually have budgets to buy whatever we have. So we think that budgets for the customers are not going to decrease because they buy cheaper solutions or a cheaper unit. They are going to fill it in more places and that will make us more pervasive. And I think we have seen this trend in the past 10 years in the enterprise and I think we're going to see that again.

That's helpful. Maybe one last quick one on your Arbor products. I know you're still working on getting I think a cleaner sales motion into your installed base to take advantage of cross selling there. Any update on sort of thoughts of selling Arbor and DDoS into the base?

Yeah, so we are looking at that not this year, because we don't want to disrupt the current model. We will look into that, into that area. But the bigger opportunity of cooperation between the NetScout sales team and the Arbor sales team is in the advanced area which is practically zero revenue right now. So Arbor basically had a DDoS product which is bulk of the business, and a product Spectrum which was announced earlier in the year. And that will be consuming ASI technology before the end of the year. And that's going to create great synergies on top of whatever cooperation we can do with the DDoS sales team in the future.

Got it, thanks, guys.

And that's why, just to add on to Anil's question, that's why we're very happy with the Arbor asset. Currently they are the market leader in DDoS and they've been growing very strongly. But what we see is their next evolution and their next growth path is clearly a linkage with NetScout with the differentiation that NetScout's product and Arbor's product technology together can bring to the marketplace.

Alex Kurtz, Pacific Crest Securities.

Hey, Jean, just wanted to follow up on expectations around share count and what the plans are when the program expires. And maybe give us maybe your longer-term view of where you think share count could be fiscal 2018 and beyond. Just maybe high level what you are thinking about as far as buyback and repurchase programs.

Sure. Thank you, Alex. So, as you know, we generate significant free cash flow. And our first priority for deployment is to invest back in the business as we did this quarter with the acquired technology assets from Avvasi. Following that then, our next deployment priority is to patriate excess cash to our shareholders and we've done that in the form of share repurchase. We should be done with our 20 million share authorization in mid-July, and based on our continued anticipated success, we will continue to generate significant share, significant cash flow, to which end we probably will continue with the same deployment priority. So that means we probably will go back to, or continue, I'm sorry, with share repurchase.

NetScout as a standalone basis before the Danaher TekComm communication had about 42 million shares outstanding. And right now we have about 92 million, down from about a little less than 105 million. So clearly there is a sweet spot somewhere between 42 million and 90-ish million that we will probably end up targeting with our next share repurchase program in FY18.

Okay, so fair to say somewhere in the not too distant future we could be looking at a share base of maybe 70 million to 80 million (inaudible). Is that the right way of thinking about number of shares?

I'm sorry, Alex, you broke up. I guess if you wanted to use the past as an example, we bought back 20 million shares over a two-year period, so in FY18, if we did that again, I think I heard you saying that we could be down to close to 70 million shares, which is not unrealistic.

Thank you. At this time, we have no further questions. I'd like to turn the conference back over to management for any closing comments or remarks.

Thank you very much, Operator. And thank you, everybody who joined us for today's call. Appreciate you taking the time to spent with us this morning. We look forward to our next call when we announce our third quarter results. And obviously, if we are on the road, we hope to see you in person. Thank you very much.

Thank you. This does conclude today's conference. You may disconnect at any time and have a great day.