NetScout Systems - Q3 2023

Transcript

Operator (participant)

Ladies and gentlemen, thank you for standing by and welcome to NetScout's third quarter fiscal year 2023 financial results conference call. At this time, all parties are in a listen-only mode until the question-and-answer portion of the call. As a reminder, this call is being recorded. Tony Piazza, Senior Vice President of Corporate Finance, and his colleagues at NetScout are on the line with us today. If you require operator assistance at any time, please press star zero. I would now like to turn the call over to Tony Piazza to begin the company's prepared remarks.

Tony Piazza (SVP of Corporate Finance)

Thank you, operator. Good morning, everyone. Welcome to NetScout's third quarter fiscal year 2023 conference call for the period ended December 31st, 2022. Joining me today are Anil Singhal, NetScout's President and Chief Executive Officer, Michael Szabados, NetScout's Chief Operating Officer, and Jean Bua, NetScout's Executive Vice President and Chief Financial Officer. There is a slide presentation that accompanies our prepared remarks. You can advance the slides in the webcast viewer to follow our commentary. Both the slides and the prepared remarks can be accessed in multiple areas within the investor relations section of our website at www.netscout.com, including the IR landing page under Financial Results, the webcast itself, and under Financial Information on the quarterly results page. Moving on to slide number three. Today's conference call will include forward-looking statements.

Examples of forward-looking statements include statements regarding our future financial performance or position, results of operations, business strategy, plans and objectives of management for future operations, and other statements that are not historical fact. You can identify forward-looking statements by their use of forward-looking words such as "anticipate," "believe," "plan," "will," "should," "expect," or other comparable terms. We caution listeners not to place undue reliance on any forward-looking statements included in this presentation, which speak only as of today's date. These forward-looking statements involve risks and uncertainties, and actual results could differ materially from the forward-looking statements due to known and unknown risks, uncertainties, assumptions, and other factors, including, but not limited to, those described on this slide and in today's financial results press release.

For a more detailed description of the risk factors associated with the company, please refer to the company's annual report on Form 10-K for the fiscal year ended March 31st, 2022, 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. Let's now turn to slide number four, which involves non-GAAP metrics. This 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. The rationale for providing non-GAAP measures, along with the limitations of relying solely on those measures, is detailed on this slide and in today's press release. These measures should not be considered in isolation from or as a substitute for financial information prepared in accordance with GAAP.

Reconciliations of all non-GAAP metrics with the applicable GAAP measures are provided in the appendix of the slide presentation, in today's earnings press release, and on our website. I'll now turn the call over to Anil for his prepared remarks. Anil?

Anil Singhal (President and CEO)

Thank you, Tony. Good morning, everyone. Welcome and thank you all for joining us today. Let's now turn to slide number six for a brief recap of our non-GAAP financial results in the third quarter and first nine months of our fiscal year 2023. In the third quarter, we delivered solid financial results with Q3 revenue of $269.5 million, representing year-over-year growth of approximately 3%. This revenue increase was driven by product revenue growth of 3.5% and service revenue growth of 2%, both on a year-over-year basis. As a result of this top-line growth and our healthy operating leverage, we delivered $1 of diluted earnings per share in the third quarter, representing a growth rate of approximately 12% year-over-year.

Our service assurance performance was strong and was supported by the acceleration of service provider orders previously forecasted to occur in our fourth quarter. We achieved higher quarterly sales, margins, and profitability on a year-over-year basis. Moving to the first nine months of the fiscal year 2023. During the period, revenue was $706.4 million, growing by more than 6% year-over-year. On a year-over-year basis, product revenue grew nearly 10% and service revenue grew approximately 3%, while service assurance revenue grew by more than 8% and cybersecurity revenue grew by more than 1%.

Additionally, we delivered $1.81 of diluted earnings per share in the first nine months of the fiscal year 2023, representing approximately 16% year-over-year growth, more than double that of our revenue growth rate over the same period. Now let's move to slide number seven for some further perspective on market and business insights. In our service provider vertical, revenue grew by more than 9% year-over-year in the first nine months of the fiscal year 2023. This increase was primarily driven by higher revenue related to radio frequency propagation modeling projects from tier one carriers in North America. In addition, as mentioned earlier, we received some service provider customer orders in our third quarter that we had previously forecast to occur in our fourth quarter.

Overall, both domestically and internationally, we continue to see carrier invest in their 5G related network deployments. In our enterprise customer vertical, our revenue grew by approximately 3% year-over-year in the first nine months of fiscal year 2023. This expansion was driven by growth in both our service assurance and cybersecurity business lines during the period. Notably, enterprises continue to require those solutions capable of helping them to better protect their system and accelerate their digital transformation. To better address these market trends, we are focused in leveraging our growing suite of comprehensive offerings to provide customers with an integrated platform for service assurance and cybersecurity solutions. As the market for this solution grows and converges, we are pleased to see that this approach is resonating with our customers. Michael will provide some insight regarding customer wins within our verticals during his remarks.

Now let's move to slide number eight to review our outlook. NetScout continues to play a mission-critical role for organizations around the globe. As guardians of the connected world, we provide our customers with what we believe to be unparalleled visibility into the performance and security of their digital operations. We are a trusted brand with more than three decades of operating experience, and our customers utilize our solutions to navigate and capitalize on the opportunities and challenges of today's digital landscape. Given our solid year-to-date performance, along with the acceleration of service provider orders, we now have increased visibility into our full fiscal year outlook. As such, we are upgrading our fiscal year 2023 outlook, which we most recently shared on our second quarter earnings call.

We are narrowing our target total revenue range to be between $905 million and $915 million from the prior range of $895 million-$925 million, with the midpoint of both ranges remaining the same. We are increasing our non-GAAP diluted earnings per share range to $2.06 and $2.10 from the prior range of $1.97 and $2.03. Jean will provide additional color on our outlook in our remarks. We continue to closely monitor today's macro environment, we recognize that the current landscape remains dynamic. We believe that we are well-positioned for the future and remain focused on achieving our long-term objectives. We plan to continue managing our operations prudently with a balanced approach to revenue growth and profitability.

Before I close my commentary, I wanted to mention for those that may have missed it, that we announced yesterday the addition of Shannon Nash and Marlene Pelage to the NetScout Board of Directors. Shannon and Marlene are two accomplished professionals who will bring additional financial and operational expertise as well as other valuable experience to the board. We are confident that they will play an important role as we advance our business. I personally look forward to working with them both. With that, I'll turn the call over to Michael.

Michael Szabados (COO)

Thank you, Anil, and good morning, everyone. Slide 10 outlines the areas that I will be covering today, starting with customer wins. Customer wins. In our service provider, customer vertical remained focused on supporting providers as they further advance their network build-out. Through this focus, our robust portfolio of offerings and established incumbency, we continued to expand our install base. During the quarter, for example, a long-standing tier one North American carrier customer placed orders with us amounting to close to mid-eight figures. Consistent with Anil's earlier comment, we had expected to receive a portion of these orders in the fourth quarter.

Orders from this customer were for a combination of our service assurance and cybersecurity solutions, which included 5G core and RAN service assurance, additional radio frequency propagation modeling, and our CyberStream and Omnis Cyber Intelligence solutions, with this being the first time this customer purchased certain cybersecurity solutions from us. Importantly, these orders represented full expansion within and outside of our traditional projects, and in certain cases, we replaced competitors' products. Today, this customer is utilizing our solutions with both its mobile business and corporate IT systems, and we remain excited about this collaboration as a model for additional customer engagements going forward. Now, turning to our enterprise customer vertical. We received two notable mid-$7 million orders during the quarter. One was from a financial institution, while the other was from a healthcare organization, both of which are large scale and long-standing customers.

These wins represent an expansion of our service assurance footprint to new mission-critical applications that are directly relevant to these customers' success in their marketplaces. Our ability to win these deals and continue expanding our footprint with our customers is a testament to the strength of our platform offerings, established incumbency, and ability to expand further within our customer base. Now about go-to-market activities. We also remained focused on driving business performance through go-to-market activities. During the quarter, we continued to attend more in-person events and collaborate with our partners. In November, we attended the AWS re:Invent conference, where we showed NetScout's platform as well as our collaboration with AWS. At the event, we announced the successful interoperability between our Omnis Cyber Intelligence and Amazon Web Services' Amazon Security Lake.

By providing comprehensive network visibility, contextual cybersecurity investigation, and smart detection, Omnis Cyber Intelligence can pair with Amazon Security Lake to deliver advanced network detection and response insights, ultimately allowing companies to better manage threats across complex hybrid cloud infrastructures. In line with this progress, we also continued to capture mindshare with industry publications, winning two prestigious awards in recognition of our service assurance and cybersecurity solutions during the quarter. For service assurance, we received Frost & Sullivan's 2022 Global Company of the Year award for our wireless network monitoring and service assurance solutions. Frost & Sullivan presented us with this recognition based on our compelling customer value proposition, customer experience, strong brand equity, and overall solid performance. In addition, we received Security Today's 2022 CyberSecured Award for network security.

This recognition was based on the Arbor Edge Defense solutions' ability to effectively stop both inbound and outbound threats, and in doing so, to serve as both the first and last line of defense for organizations. I'd like to touch on our annual ENGAGE technology and user summit. Usually, this event is held in April, and I provide everyone with an event preview on our third quarterly call, this one. This time, to better align with our customers' planning and budgeting cycles, we plan to hold the ENGAGE 2023 summit in October. I will provide everyone with an update on this event later this year as we move closer to its arrival. Thank you, everyone. That concludes my remarks, and I will now turn the call over to Jean.

Jean Bua (EVP and CFO)

Thank you, Michael. Good morning, everyone. I will review key metrics for our third quarter and first nine months of fiscal year 2023 and provide some additional commentary on our fiscal year 2023 outlook. As a reminder, this review focuses on our non-GAAP results unless otherwise stated, and all reconciliations with our GAAP results appear in the presentation appendix. Regardless, I will note the nature of any such comparisons. Slide number 12 details the results for the third quarter and first nine months of our fiscal year 2023. Focusing first on our quarterly performance, total revenue grew 2.8% year-over-year to $269.5 million. Product revenue grew 3.5%, and service revenue grew 2%, both on a year-over-year basis.

At the end of the third quarter, our backlog was approximately $54 million, consisting of approximately $31 million of fulfillable orders and approximately $23 million of radio frequency propagation modeling projects, with most of the radio frequency propagation modeling amount categorized as deferred revenue from a financial reporting perspective. As a reminder, while fulfillable orders are those we consider ready and available to be converted into revenue upon shipment or fulfillment, the radio frequency propagation modeling projects require certain execution steps in conjunction with the carrier's timing before they can convert to revenue. Gross profit margin was 80.5% in the third quarter, up 1.7 percentage points year-over-year. This quarter's gross margin was impacted by the acceleration of a high-margin radio frequency propagation modeling project that was expected to occur in our fourth quarter.

Quarterly operating expenses increased 1.7% year-over-year, mostly due to the return of pre-pandemic activities, such as travel and events. We reported an operating profit margin of 35.5%, compared with 33.2% in the same quarter last year. Diluted earnings per share was $1, compared with $0.89 in the same quarter last year, representing an increase of 12.4% year-over-year. Turning to slide 13, I'd now like to review key revenue trends by customer verticals and product lines. Please note that all comparisons here are on a year-over-year basis, consistent with other remarks. In the first nine months of fiscal year 2023, our service provider customer vertical grew 9.3%, while our enterprise customer vertical revenue grew 3.2%, both on a year-over-year basis.

During the same period, our service provider customer vertical accounted for approximately 52% of our total revenue, while our enterprise customer vertical accounted for the remaining 48%. Turning to our product lines, for the first nine months of fiscal year 2023, our service assurance revenue increased by 8.1%, while our cybersecurity revenue increased by 1.4%, both on a year-over-year basis. During the same period, our service assurance product line accounted for approximately 75% of our total revenue, while our cybersecurity product line accounted for the remaining 25%. Turning to slide 14, which shows our geographic revenue mix. In the first nine months of fiscal year 2023, our revenue was more concentrated in the U.S. year-over-year, primarily due to the increase in revenue related to radio frequency propagation modeling projects from tier one domestic carriers.

Additionally, one customer represented 10% or more of our total revenue in the third quarter and first nine months of our fiscal year 2023. Slide 15 details our balance sheet highlights and free cash flow. We ended the third quarter with $416.2 million in cash equivalents, and short and long-term marketable securities, representing an increase of $49.1 million since the end of the second quarter of fiscal year 2023. Free cash flow for the quarter was $43.2 million.

During the third quarter of fiscal year 2023, we concluded our accelerated share repurchase transaction, receiving the final 1.3 million shares, which resulted in a total repurchase amount of $150 million or approximately 4.6 million shares at a weighted average price per share of $32.97. From a debt perspective, we ended the third quarter of fiscal year 2023 with $200 million outstanding on our $800 million revolving credit facility, which expires in July 2026. To briefly recap our other balance sheet highlights, accounts receivable net was $215.8 million, representing an increase of $67.6 million since March 31, 2022.

The DSO metric at the end of the third quarter of fiscal year 2023 was 69 days versus 76 days at the end of the third quarter of fiscal year 2022 and 64 days at the end of fiscal year 2022. Let's move to slide 16 for commentary on our outlook. I will focus my review on our non-GAAP targets for the fiscal year 2023. As Anil noted earlier, we are updating our non-GAAP outlook for fiscal year 2023 that was last presented on October 27, 2022 during our second quarter fiscal year 2023 earnings call. We now anticipate revenue in the range of $905 million-$915 million. The midpoint of this range remains the same as that of our prior range and continues to imply a mid-single digit top-line growth rate.

We now anticipate non-GAAP diluted earnings per share to be between $2.06 and $2.10, increasing the midpoint by $0.08 and implying a low double-digit year-over-year growth rate for our bottom line. This forecast utilizes an anticipated effective tax rate in the range of 20%-22%. It also assumes between 73 million and 74 million weighted average diluted shares outstanding, which includes the impact of the $150 million accelerated share repurchase program with a partial offset for stock compensation dilution. The increase in our non-GAAP diluted EPS outlook is primarily attributable to the recent large radio frequency propagation modeling project leveraging library data, which has an above average gross margin when compared with similar projects.

It is also due to the slower return of pre-pandemic travel-related costs than was originally anticipated, as well as continued cost management efforts. That concludes my formal review of our financial results. Thank you, and I'll now turn the call over to the operator for Q&A.

Operator (participant)

At this time, if you'd like to ask a question, please press star one on your telephone keypad. If you wish to remove yourself from the queue, press the pound key. We do ask in the interest of time that you limit yourself to one question and one follow-up. We'll take our first question from Matt Hedberg from RBC Capital.

Matt Hedberg (Managing Director and Software Research Analyst)

Great, guys. Thanks for taking my questions. Anil, strong results in the quarter, particularly service assurance. There's obviously a lot of concern about just general IT spending patterns for calendar 2023. Can you start just by talking about your conversations with customers and executives and how they think about prioritizing new projects this year?

Anil Singhal (President and CEO)

So far, Matt Hedberg, thanks for the question. Right now, we are still gathering data, and we are confident about our guidance for this year. By the time we reach April, where on next conference call, I think we'll have a lot more detail, and that will obviously influence our guidance for next year. Right now, we are not getting any direct indication from the customers about slowdowns and budget controls, but we hear other releases from NEMs and other players which indirectly point to that. Right now we have sort of a wait-and-see attitude. Our customers are still very interested in our solution. Sometime in slower times, there is more tool consolidation. Right now, we are not in the position to really say how that next year is going to work out.

Fortunately, we have three months, to assess that, and then we'll project our guidance accordingly.

Matt Hedberg (Managing Director and Software Research Analyst)

Got it. Thanks. Then maybe on your cyber business, growth is slowing a bit there, which, you know, candidly is consistent with a lot of field work that we've done. Can you talk about, you know, why this might be, and are there any things, you know, on like a new product front in calendar 2023 that might, you know, help that growth profile?

Anil Singhal (President and CEO)

I mean, we introduced a new product about nine months ago, and it has a slow uptake, and there were some learnings from there. Also, you will see that there'll be some pickup when we do year-over-year number. The percentage that will come slightly higher after Q4 in cybersecurity. Really, the new product which we announced has a slower traction, and we got a lot of customer input, and I think it's going to pick up slightly more in Q4. I think next year we should see much better results in cybersecurity.

Matt Hedberg (Managing Director and Software Research Analyst)

Got it. Thanks. Congrats again, especially on the profitability side as well.

Anil Singhal (President and CEO)

Thank you.

Operator (participant)

Our next question comes from James Fish from Piper Sandler.

James Fish (Senior Research Analyst)

Hey, guys. Congrats on the, on the quarter here. Just wanted to touch on that mid eight-figure service provider order a bit. You guys mentioned a little bit of a pull-in from fiscal Q4, and, you know, we're backing in roughly based on your guide for the year, about $90 million of product revenue for fiscal Q4. Is there any way to think about that pull-in and kind of normalizing for that, at this point?

Anil Singhal (President and CEO)

Okay. I think Jean is looking into that, but I don't know whether your question is that. I mean, obviously if that pull forward was not there, then our Q4 would have been bigger than what we are projecting. On a full quarter basis, I think it was just normalized. We got some advance orders in Q3, one big advance order in Q3, which made the Q3 bigger than expected.

James Fish (Senior Research Analyst)

Yeah.

Jean Bua (EVP and CFO)

Hi, Jim.

James Fish (Senior Research Analyst)

Maybe, Anil, while she's kind of looking that up for you know, you mentioned kind of long-term objectives here. Can you just refresh us where we are on kind of those long-term objectives and how you're kind of thinking about those? Additionally, you know, you mentioned on that deal that it's the first time that this customer purchased cybersecurity from NetScout. Do you have any sense to what the white space opportunity is or your current penetration of accounts is with security?

Anil Singhal (President and CEO)

I think basically, I mean, so cybersecurity is a little bit convenient. We have a ongoing business with Arbor, which is roughly 25% of the total business. This other stuff which we talked about today was a new product we announced, Omnis Cyber Intelligence and Omnis CyberStream last year, which was a slow uptake, notwithstanding this big order or a couple of big orders. In terms of number of customers, I mean, less than 5% of our service assurance customer who can use our cybersecurity product has been sold the cybersecurity product. There's a lot of scope, and this is only first nine months, we are counting on much bigger growth from that source.

From the DDoS business, flat to single-digit up. Then additional stuff coming from the Omni cybersecurity. That's what we are saying that while we did get a couple of big orders on this from existing customers, the penetration rate has been slow and we are putting more sales processes and creating a relaunching that product in April, which will have a big, I think impact next year.

Jean Bua (EVP and CFO)

Hi, James Fish. This is Jean. In reference to the question that you were asking about the effect of orders that we received in Q3, I'm sorry, versus Q4, I would say that the pull forward was probably close to $25 million, with a little more than half of that being a radio frequency calibration modeling project that gave us the higher gross margins. In looking at the math that is at the midpoint of our guidance, which is $910 million, the number of, I think you said $92 million in Q4 for product revenue would be accurate. That would represent still a 12% year-over-year growth from Q4 of 2022, and at the midpoint of guidance, we would have about a 6% year-over-year growth from FY 2022.

James Fish (Senior Research Analyst)

Very helpful. Thank you, guys.

Anil Singhal (President and CEO)

Thank you.

Jean Bua (EVP and CFO)

You're welcome.

Anil Singhal (President and CEO)

Yeah.

Operator (participant)

Our last question comes from Kevin Liu from K. Liu & Company.

Kevin Liu (Founder and CEO)

Hey, good morning. Anil, just wanted to get some of your thoughts around kind of a CapEx cycle from the large tier one providers in North America. Could you just comment a bit on if you think NetScout has benefited, you know, disproportionately from kind of the outside spend they had on C-Band spectrum deployment this year? Whether there are any sort of emerging 5G use cases that you think will continue to carry the business forward on the service assurance side?

Anil Singhal (President and CEO)

We are relying a lot, Kevin Liu, on our incumbency with the top-end carriers around the world. There were some challenges two years ago where slow spend on 5G or competition from other sources, and that has all settled down, and we started seeing a lot of business initially in the calibration area. Some of it was in the backlog starting this year, which helped the revenue, and other is just more 5G spend. We think that there is still a lot of spend to be done with the same customers for additional capacity in 5G area. Given some recent announcement of some NEMs, and infrastructure companies are potential slowdown cap expanding. We are just having this wait and see attitude until April.

I think we'll be in a better position when we have, we'll know much more about the budgets. Fortunately, our fiscal year is three months later than some of the other people's fiscal year, our customers. At this point, I think we really, we did benefit from all the investment we made. I mean, almost $100 million was spent on 5G technology over the last three, four years by us. That's beginning to pay off. How that is impacted by the macro environment next year remains to be seen.

Kevin Liu (Founder and CEO)

Understood. Just on cybersecurity, I was hoping you could elaborate on, you know, some of the learnings you've had as you've built out the new solutions. Is it more kind of additional product features that need to be added, integrations? I'm just kind of curious what the customer feedback has been.

Anil Singhal (President and CEO)

I think basically, as happens in the first year of the product, I mean, we gather a lot of information and competitive information, and I think maybe our expectation was too high in the first year. I mean, we're going to do over $10 million-$15 million in the nine months of introduction so far. I think overall, that's the main thing. We are just fine-tuning our strategy, adding some feature sets and some of the comments we got from other customers. The integration with other security tools has actually gone very well, and that was not the reason for it. It just takes time. The sales cycle in a new product takes longer than the other product.

Also sometime, as I mentioned and there'll be some improvement on the percentage growth year-over-year versus the first nine months as the fourth quarter closes.

Kevin Liu (Founder and CEO)

All right. Great. Thanks for taking the questions and congrats on the strong results.

Anil Singhal (President and CEO)

Thank you.

Operator (participant)

We have reached our allotted time for Q&A. I will now turn the call back over to Tony for any additional or closing remarks.

Tony Piazza (SVP of Corporate Finance)

Excellent. Thank you, operator, and thank you all for joining us today. That concludes our call for the third quarter of fiscal year 2023. Enjoy the rest of the day.

Operator (participant)

This does conclude today's program. Thank you for your participation. You may now disconnect.