NetScout Systems, Inc.
Q1 2019 Earnings Call Transcript

Published: 26 Jul 2018

[Operator:]

Good day, ladies and gentlemen, thank you for standing by and welcome to NETSCOUT's First Quarter Fiscal Year 2019 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. Andrew Kramer, Vice President of Investor Relations and his colleagues at NETSCOUT are on the line with us today. I would now like to turn the call over to Andrew Kramer to begin the company's prepared remarks. Please go ahead.

[Andrew M. Kramer:]

Thank you, Keith. Good morning, everyone. Welcome to NETSCOUT's first quarter fiscal year 2019 conference call for the period ended June 30th, 2018. Joining me today are Anil Singhal, NETSCOUT's President and CEO; 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. We will call out the slide number we're referencing in our remarks. 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. Our agenda is as follows

[Anil K. Singhal:]

Thank you, Andy. Good morning, everyone and thank you for joining us. Let's begin on slide 6 with a brief recap of our first quarter non-GAAP results. We delivered a relatively solid first quarter earnings performance with diluted EPS of $0.03, primarily due to our ongoing efforts to manage costs. Total first quarter revenue of $2.6 million was at the lower end of our targets, primarily due to order delays within our (00

[Michael Szabados:]

Thank you, Anil, and good morning, everyone. Slide number 10 outlines my plan to highlight some recent wins and recap ENGAGE, our annual technology and user summit. In the service provider market, Anil highlighted the progress we have made in driving adoption of the software-only version of our ISNG platform, which enables carriers and cable operators to cost effectively extend their monitoring coverage. With service provider capital budgets still under pressure, this strategy is helping us stabilize revenue in this important vertical. During the first quarter, a major Tier-1 operator in North America began deploying our ISNG software after deploying our legacy platforms to gain end-to-end visibility. This purchase, which was valued at nearly $10 million, provides them ample and near-term capacity to handle continued traffic and subscriber growth as they focus on upgrading key links (00

[Jean A. Bua:]

Thank you, Michael, and good morning, everyone. This morning, I will review key first quarter fiscal year 2019 metrics. After that, I will briefly recap the guidance for fiscal year 2019. 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. Additionally, in conforming with the new revenue standard ASC 606, our first quarter results reflect the reclassification of certain subscription oriented security offerings as services rather than products. Prior-period revenue and related costs for those offerings have been reclassified to conform to the current period presentation for comparability purposes. That detail is available in the attached financial tables of our press release, in the appendix of our conference call slides, and it can also be downloaded from the Investor Relations website. Slide number 12 shows our results for the first quarter of fiscal year 2019. Total revenue of $206 million declined by 10%, which is at the lower end of our target. The adoption of ASC 606 was not material to first quarter revenue as the headwind associated with adopting ASC 606 was primarily offset by achieving certain milestones related to customer projects that accelerated revenue recognition in the quarter. Our gross profit margin of 74.8% declined by 110 basis points, primarily due to lower sales volume and product mix. Operating expenses declined by 8%, due primarily to lower head count and related personnel costs. We reported an operating profit margin of 3.6%. Diluted earnings per share was $0.03, reflecting the reduced head count and a lower quarterly effective tax rate. Turning to slide 13, I'd like to review key revenue trends. First quarter revenue in our service provider customer segment declined by approximately 13%, primarily due to lower carrier and ISP spending on our DDoS solutions. Consistent with Anil's earlier remarks, revenue for our service assurance products from service providers was essentially flat. Revenue in our enterprise customer segment declined by nearly 7% in the first quarter, due primarily to continued softness in our ancillary product lines. For the first quarter, revenue was evenly split between our service provider customer segment and the enterprise customer segment. In terms of revenue by geography, which is calculated on a GAAP basis, the aforementioned declines contributed to a decrease in revenue in the United States of 8% and a decline of 11% in our international revenue. International customers represented 38% of GAAP revenue versus 39% last year. We did not have a 10% revenue customer in the first quarter. Slide 14 details our balance sheet highlights and free cash flow. During the past three years, we have made considerable progress in our efforts to improve the overall efficiency of our balance sheet and optimize our capital structure. We ended the quarter with cash, cash equivalents, short-term marketable securities and long-term marketable securities of $459.1 million, an increase of $11.3 million from the end of March. Free cash flow for the quarter was $19.1 million, which reflects favorable changes in working capital tied principally to the collection of receivables and lower cash taxes. This was partially offset by higher capital spending, of which approximately $4 million is associated with a facility relocation. Our portion of the facility relocation is anticipated to be approximately $8 million, with the remaining $4 million expected to be recorded in the second quarter. We will receive incentive reimbursements offsetting the relocation costs over a multi-year period through our cash flow from operating activities. To briefly recap other balance sheet highlights, accounts receivable, net, were $165.3 million, down by $48.1 million from the end of March. DSOs were 69 days versus 78 days at the end of fiscal year 2018 and 71 days at the same time last year. I'd like to provide a brief update on our share repurchase activities. We expect to complete our $300 million accelerated share repurchase later this quarter. When the ASR agreement was signed in early February, we received an initial delivery of 7.4 million shares of common stock. Once the repurchase activity is completed, the share count will be further reduced by the number of shares actually repurchased, excluding the number of shares reflected in the initial reduction. Let's move to slide 15 for guidance, which is fundamentally unchanged from the original guidance we issued in May. Although, I typically focus my guidance commentary on our anticipated non-GAAP performance, I would like to point out that our GAAP guidance for fiscal year 2019 was updated to reflect that we recorded a non-cash intangible asset impairment charge of $35.9 million in the first quarter of fiscal year 2019 related to the handheld tools product area as we moved forward with activities related to the divestiture of this asset. Turning to our non-GAAP guidance, on an ASC 606 basis, Anil has already discussed the opportunities and challenges we see in both our enterprise and service provider customer segments. With three quarters still left in the year and consistent with his commentary, we have left our full-year non-GAAP guidance unchanged at this time. Our full-year revenue guidance ranges from a low single-digit decline to low single-digit growth on a percentage change basis over fiscal year 2018. In terms of our diluted earnings per share for the coming year, we expect diluted earnings per share guidance ranging from a 20% decline to low double-digit percentage growth over the last year's diluted EPS of $1.41 per diluted share. Other key assumptions are outlined on this slide. We currently expect that our first half revenue skew will likely be in the low to mid-40% range of the full fiscal year 2019 guidance. As a result, we anticipate second quarter revenue in the range of $215 million to $225 million, which would represent a mid-teens percentage point decline from the prior year. This guidance includes an anticipated revenue reduction of approximately $7 million in deferred revenue that cannot be recognized under ASC 606. We anticipate second quarter operating expenses to be between 7% to 8% lower than the same quarter one year earlier. Diluted earnings per share for the second quarter is expected to range from $0.10 to $0.17. That concludes my formal review of our financial results. Before we transition to Q&A, I will mention that slide 16 details two upcoming investor conferences that we plan to attend. I'll now turn the call over to the operator to start the Q&A.

[Operator:]

We'll take our first question from James Fish with Piper Jaffray. Please go ahead. Your line is open.

[James E. Fish:]

Hey, guys. Thanks for the question. I guess, what gives you the confidence that service provider spending will come back in the second half as this would mark a third year in a row in which company has thought that essentially we would have a good back half?

[Anil K. Singhal:]

Yeah. So a good question. So I think in the past, the anticipation on the second – we anticipated primarily that second half will be better because of increased budgets from top Tier-1 provider. We are not using that as the reason this time to feel good about the second quarter. When I look at our order entry, bookings, performance, which is not easily directly translated (00

[James E. Fish:]

Got it. And then, maybe on the large $10 million deal here in the quarter, was that existing footprint of a NETSCOUT customer that was essentially refreshing? Or is that actually a competitive win? And if so, can you give us some color around that?

[Anil K. Singhal:]

Yeah. So it is – it was a existing customer. I mean, almost all our business will be in existing customer, but trying to completely transform them into our software model has been a challenge, as well as an opportunity. So this is one of the such customers. But it's not a competitive win, but everything is competitive from a budget point of view. But it's not a refresh. It's capacity enhancement. So as the traffic is growing, they'll need more capacity from us. And so, I wouldn't call it a refresh of old technology, it's basically a capacity enhancement.

[James E. Fish:]

Got it. Thanks, guys.

[Anil K. Singhal:]

Okay.

[Operator:]

We'll take our next question from Eric Martinuzzi with Lake Street. Please go ahead. Your line is open.

[Eric Martinuzzi:]

Yeah. On the cost reduction side, which you guys have done a nice job, I think you said down about 8% on the operating expense and expectations for similar, what does that represent? I think you finished out the end of last fiscal year at around 3,000 employees, where were you as of the end of June?

[Jean A. Bua:]

Hi, Eric. This is Jean. At the end of June, we were down at this point about a 100 people. On a year-over-year and quarter-over-quarter basis, we were down about 200 people.

[Eric Martinuzzi:]

Okay. And does that capture the tools business or is that being treated separately?

[Jean A. Bua:]

No, since that divestiture has not yet happened, that does not include any divestiture related to the employees at this point. And the guidance also still includes that the tools business is in there.

[Eric Martinuzzi:]

Okay, all right. And then, and seasonally, this would be the September quarter for you guys, typically, you see a bump-up there from the federal government. First of all, what is on an annual basis your federal government percent of the product sales? And then, what's your expectation trend wise for the September quarter for Fed?

[Anil K. Singhal:]

So, Jean is going to go over the – maybe take about, while she is looking at the percentage. In terms of federal, I mean this has been because of the external budget issue with federal government and timing of the things, it sometimes becomes such a big disappointment, sometime, it's a great opportunity. So we have a big – very big pipeline, we have used average conversion of that in this quarter in our estimates. And so, we're hoping there'll be some upside, but things always are challenging with the federal budget. So Jean, if you want to.

[Jean A. Bua:]

Yeah, hi, Eric. Our government business is about 5% of total revenue and that is predominantly by the Federal Department of Defense.

[Eric Martinuzzi:]

All right. And then, with that, you talked about these enterprise deal push-outs in the June quarter, was that kind of across the board, or can it be – can you point at any particular vertical for the enterprise softness?

[Anil K. Singhal:]

Well, I think we talked about that Arbor business is challenging on both sides of the house, enterprise and service provider, because of the built-in capacity, and we are making some strategy changes, which will take longer to execute. Secondly, on the security side, some of the delays are ongoing, like we talked about transition to cloud, digital transformation and all those, but we are hoping that our traction will start happening in the second quarter for some of the initiatives we had announced at our user conference, some of the Shaper product, some of the security stuff, there were lot of excitement in the meetings, and the customer I visited. But this is just going to take a little longer than we thought. And so, that's why this first half will not benefit from that. And that's also the reason why we are bullish about the second half.

[Jean A. Bua:]

Hi, Eric and this is Jean. Just to add on to the question. As Anil said, Arbor is in a fragmented market, and they have the pure in the enterprise, they have a pure-play DDoS (00

[Anil K. Singhal:]

Yeah, I think one more thing, Eric, and maybe you had asked this question last time also that we talked about why we're feeling good about the next four year plan. And we said our new initiatives have not delivered on revenue, and they'll start doing that this year and even though it's a little slower than I thought, and also our negatives will be start bottoming out and you see that it has already happened on service provider and that's why I think we're going to have a good year. And on the enterprise, to a smaller extent, it's still happening and which is what Jean is talking about the Fluke Networks portion of the business.

[Eric Martinuzzi:]

I'm looking forward to that snapback in the second half.

[Anil K. Singhal:]

Yeah. Thank you.

[Operator:]

We'll take the next question from Chad Bennett with Craig-Hallum. Please go ahead.

[Chad Michael Bennett:]

Great. Thanks for taking my questions.

[Anil K. Singhal:]

Sure.

[Chad Michael Bennett:]

So I guess, I'm trying to understand product revenues for the quarter, I think, were down about 15% year over year off of, I think, what you guys would characterize as a pretty rough June quarter last year, but service provider has stabilized as you indicated and showed in the slide presentation. So should we – I mean, the implication is, enterprise is off materially year over year from a product revenue standpoint, is that a fair characterization?

[Anil K. Singhal:]

I think you will see enterprise pick up in the second quarter to make up for some of the first quarter, and which was we talked about some deals moving in. But yes, the general effect of what we talk about first half versus second half, the reasons is still true. But Q1 versus Q2, there is another effect and I think enterprise will be better in – the service assurance enterprise will be – make up for some of the things, some of the shortfall in Q1.

[Chad Michael Bennett:]

Okay. And then, maybe a couple for Jean. Jean, the gross margins for the quarter, both product and service were below what I was thinking, can you give – and I think you talked about mix and just overall volume being the reasons, I guess, how should we think about product and service gross margins or how do you think about them for the remainder of the year?

[Jean A. Bua:]

I would say that product gross margins when we look out at the forecast, probably somewhere around the midpoint, probably should be relatively flat with gross margins from last year. I think that is, as you said, partially due to some of the higher margin product being in – and anticipated to be left in the revenue mix this year. And some of the products that will drive service provider, like some of our 5G-related initiatives and some of the projects that we've already won so far tend to have a slightly lower margin also, they tend to be a little more labor intensive.

[Chad Michael Bennett:]

And on service?

[Jean A. Bua:]

On service, let me look at that, hold on. Service looks like it's going to be again about, I would say, down maybe a little bit, part of that is because there is less professional services associated with some of the products from legacy tech. So the service revenue itself looks like it's going to be slightly down mostly due to the less product service – sorry, less service related to the products associated with implementation and installation related to some of the legacy tech products.

[Chad Michael Bennett:]

Okay.

[Andrew M. Kramer:]

And just as a reminder, Chad – sorry, just a reminder that the guidance this year does have a fairly notable haircut related to ASC 606, which would drop straight to your gross margin in your operating profit. So, on a comparable year basis, it does become a – it does mask some of the progress that we would expect to see from that transition to higher margin software products.

[Chad Michael Bennett:]

Got it. I appreciate the color, Andy. One last one real quick. What are – have we changed our expectations on where we exit the year from a product revenue standpoint, from a software-only revenue standpoint? Thanks.

[Anil K. Singhal:]

No, I don't think so. (00

[Jean A. Bua:]

Yeah. Software-only as a percentage of total product revenue for this year on the ASC 606 basis was almost 15%. So, I think the software-only is gaining good traction continuously, as we said, around international service providers, somewhat probably a little more in U.S. service providers and then in a few instances, it's starting to gain traction in the enterprise.

[Chad Michael Bennett:]

Thank you.

[Anil K. Singhal:]

Yes.

[Operator:]

We'll take our next question from Matt Hedberg with RBC Capital Markets. Please go ahead.

[Matthew George Hedberg:]

Hey, good morning, guys. Thanks for the questions. In the prepared remarks, Anil, you talked about a seven-figure 5G win in Q1 and you also – you seem bullish on sort of the 5G uptick in the second half of the year. Can you remind us and I know we've asked this in the past, but maybe some refreshed assumptions around the dynamics and spending assumptions around the 5G cycle versus prior cycles?

[Anil K. Singhal:]

So, I think we have basically – if you look at our 4G solution, is a fully developed market and 5G is early market solution, so there we have another solution for calibration and things like that which is the one we are talking about some of the progress we have made in this year. For moving forward, we see our same devices – our 4G devices seeing 5G traffic as the primary way for us to be more sticky in account and drive larger deals. So being an incumbent in LTE and 4G makes us a candidate – automatic candidate for 5G and that's the opportunity of 5G. Now 5G is in two phases. In phase one, there's no big infrastructure upgrade. It's just a capacity increase and there, there'll be incremental opportunity for us for 5G. In the second phase for 5G, my understanding is, there'll be a rebuild out of the network also, something like what has happened on 4G, but not as big and that will create new opportunities. So when I look at early market opportunity, is in the testing, calibration and those areas, some PoCs in the lab, not a huge volume, even though I think the excitement is more about – we are winning those rather than the amount. Then in the mid-term, in the phase one of 5G deployment, which is next year, which will be mostly capacity related increases, and then, after a year-and-a-half or so, when people move to a new infrastructure, then there'll be some major investments. So throughout this process, getting early into the market, which is what we are showing with some of these wins, is going to be a proof point for getting into the phase two and phase three.

[Matthew George Hedberg:]

That's helpful. And then, maybe just, I wanted to follow up on the IBM news. You touched on it briefly in the prepared remarks, but a little bit more color on how that impacts you guys from a revenue perspective, when might we see that flowing into the P&L, any additional detail there will be helpful.

[Anil K. Singhal:]

So, I think there'll be a very small win (00

[Matthew George Hedberg:]

That's great. Thanks a lot, Anil (00

[Anil K. Singhal:]

So just to mention. So I see this not from a revenue point of view, but from other point of view, whether it's marketing, penetration of our technology, endorsement of what we have been saying, I see that as a biggest proof point, at least, in the short term than revenue.

[Matthew George Hedberg:]

That's super helpful. Best of luck.

[Anil K. Singhal:]

Thank you.

[Operator:]

Your next question comes from Kevin Liu with B. Riley FBR. Please go ahead.

[Kevin Liu:]

Hi, good morning. Just in terms of the Tier-1 carrier that you started to move over or at least, see more expansion on the software side with, could you just talk a little bit about whether there is more opportunity over the course of this year to continue to expand that deployment and would you expect other Tier-1s to follow suit in the near-term?

[Anil K. Singhal:]

Well, I think we have – I mean, there are four Tier-1s and we already have big deployments in two Tier-1s and as we talked about, the other two Tier-1s have been bottoming out, but they're also looking at our software solutions, but that's not going to change the numbers. But we work with about 50 other carriers throughout international and you'll hear a lot of endorsement of our software model and what we have done in big data analytic, potential positive feeling about the IBM relationship, because many of these customers have IBM products, and for CM and they'll say, oh, now, we have a plug-and-play. So, I'm very positive about our service provider. I think our business is going to increase this year versus last year, but it's not because of the Tier-1 provider in U.S. I think we are already talking and doing good and other ones have bottomed out and that's the story, so – and some of this progress was there last year also, but it was completely negated by what was happening on (00

[Kevin Liu:]

Understood. And just going back to the enterprise performance in the first quarter, it sounded like a lot of it was just tied to maybe lower expectations in terms of what you could do on the security side there. But just wanted to better understand that dynamic and get a feel for how much of the rebound in the second half would come from, say, new products versus just being able to continue to sell into your base with some of your legacy technologies?

[Anil K. Singhal:]

Yeah. It's new – I mean, it's the new functionality in existing product, not always new products. So, for example, there is some security functionality in existing products then, there are some new security products. So yeah, we're counting on targeting more security budgets, which we thought we'll start seeing that in the first quarter, second quarter also, but maybe that was too ambitious, as the main reason for making up for the first half downward trend from last year. Security being and the enterprise being the key initiative and there are two parts of that. One is advanced threat, other is DDoS. DDoS, we are changing it to – enhancing it to Arbor Edge Defense. So it (00

[Kevin Liu:]

Got it. Thanks for taking the questions.

[Anil K. Singhal:]

Sure.

[Operator:]

We'll go next to Alex Kurtz with KeyBanc. Please go ahead, your line is open.

[Steven Enders:]

Hi thanks for taking my questions, this Steve Enders on for Alex. I know that (00

[Michael Szabados:]

So these products are part of every – almost every sales conversation today. So every time we evaluate and go after a new opportunity, this is part of the portfolio. Often, we end up selling a combination with legacy hardware product, but these two products, vSCOUT and vSTREAM are certainly the scissor on the stake (00

[Anil K. Singhal:]

I think this allows us to give them end-to-end vision, they don't want to use if a application is running in the cloud and/or running on the on-prem and is going to be moved to the cloud or part of it is running in the cloud and part of it is running on the data center. Even if 90% is running in the data center, they would love to have a product which covers both aspects from the same company. And I think – so vSCOUT and vSTREAM currently playing that role. And as over the next 5 years, 6 years, 10 years, as the hybrid environment changes from, let's say, 90% on-prem to 90% cloud, we'll be the best solution for them to allow that migration, in fact, we could accelerate the migration. So, vSCOUT, vSTREAM, as Michael said, is the important component of the portfolio. I think if we didn't have that, it'll affect our non-cloud revenue. That doesn't mean it's driving big deals right now, because it's not because of us, it's our competition, it's because of the time it takes for them to deal with their own initiatives.

[Steven Enders:]

Okay. Thank you. Anything else? (00

[Anil K. Singhal:]

Okay.

[Operator:]

And it appears we have no further questions. I'll return the floor to Andy Kramer for final remarks.

[Andrew M. Kramer:]

Great. Thank you, Keith. Thank you, everybody for joining us here this morning. Look forward to the Q2 results this fall and certainly, if there are any questions, feel free to reach out to investor relations in the interim. Thank you again for your time.

[Operator:]

And this will conclude today's program. Thanks for your participation. You may now disconnect.