Bouncing Along the Bottom

NetScout Systems (NTCT) reported fiscal Q4 ’19 results consistent with its preliminary figures provided last month. Non-GAAP revenue of $235.2 million missed management’s original guidance by approximately $15.0 million, mostly due to delayed revenue recognition on a large international service provider engagement. However, a higher mix of Arbor security and software-only transactions boosted gross margin, which combined with tight cost controls enabled NetScout to deliver profitability consistent with management’s original guidance. Adjusted EBITDA was $76.0 million and non-GAAP EPS of $0.66 actually finished higher than guided due to a lower tax rate.

Digging into the details, reported non-GAAP revenue reflected a decline of 1.4% Y/Y in Q4, but when adjusted for the divestiture of the Handheld Network Test (HNT) tools business in September 2018, revenue increased 3.3% Y/Y. The return to positive organic growth was driven by strong enterprise sales, which rose 8.1% Y/Y on improved traction for Arbor-branded solutions. Service provider revenue was relatively flat Y/Y, a welcome sign given double-digit declines throughout FY ’19 and the aforementioned revenue recognition delay. Per management, a portion of the delayed service provider revenue has since been recognized in Q1. Considering both segments were poised for growth in Q4, we maintain our view that revenue (on a full year basis) has touched bottom and should turn higher from here.

NetScout’s non-GAAP product gross margin of 80% in Q4 reflects the strides the company has made in integrating its acquired assets and provides evidence of traction in both security and software-only deployments, which we believe is critical to achieving management’s long-term operating margin aspirations. Of note, ISNG software revenue increased 40% Y/Y in FY ’19 and accounted for one-third of service provider product sales. Management anticipates sustaining robust growth in ISNG software revenue en route to its goal of generating 70%-80% of service provider revenues from software within the next three years. Of course, this would not only boost margins but also provide for more predictable growth and profitability. Operating expenses were markedly lower on a sequential and Y/Y basis in Q4 as the company’s recent restructuring actions and efforts to rein in spending yielded a non-GAAP operating margin of 29.2%. While we doubt margins stay anywhere near that level in the near-term, the performance lends credibility to management’s long-term target in the low-30% range, especially if revenue growth reaccelerates.

Cash and investments at quarter-end totaled $486.7 million. In Q4, NetScout generated $76.4 million in free cash flow, reduced debt by $50.0 million for an ending balance of $550.0 million, and repurchased 543,251 shares for $14.5 million.

To enhance its product development initiatives and go-to-market effectiveness, NetScout recently realigned leadership roles across it technical, product delivery and sales organizations. Much of the focus is on Arbor, which is receiving more attention and resources given ample opportunity to drive penetration within NetScout’s existing enterprise base. Of note, only 10% of NetScout’s enterprise customers have purchased the company’s security solutions to date. With incentives in the field now better aligned with the cross-selling and up-selling activities management hopes to see and newer solutions such as nGeniusPULSE and Arbor Edge Defense gaining traction, we remain optimistic that the positive enterprise growth realized in recent quarters will be sustained. In service provider, conditions are expected to remain challenging as carriers continue to take a measured approach to 5G network roll-outs. Unlike the past few years, however, spending with the company’s largest Tier-1 North American carriers has stabilized. During the earnings call, management noted that one domestic service provider awarded the company a mid-seven figure deal for the calibration and design of its 5G radio access network (RAN). That customer has also begun to deploy the company’s 5G-compatible RAN monitoring tools, which we believe points to the potential for significant growth as Tier-1 carriers move away from limited market tests to broad-based 5G network deployments in the coming years.

Management’s Q1 and FY ’20 outlook was mixed relative to our estimates and below consensus expectations. Guidance for Q1 includes revenue of $195.0-$200.0 million, which implies nominal organic growth when excluding $10.4 million in HNT tools revenue from the year-ago period, and non-GAAP EPS of $0.06-$0.08. Our prior Q1 estimates of $195.8 million in revenue and $0.07 in non-GAAP EPS were in line with management’s guidance, but consensus was higher at $202.2 million and $0.16. Although obviously still early in the quarter, we see potential upside to management’s Q1 guidance considering the modest growth expectations and the run-rate of expenses exiting Q4. For the full year, management guided to revenues of $885.0-$915.0 million and non-GAAP EPS of $1.40-$1.45. We were projecting $917.4 million in revenue and $1.43 in non-GAAP EPS, while consensus was at $922.1 million and $1.51. As anticipated, management’s FY ‘20 guidance is heavily weighted towards 2H, which is expected to account for 54% of revenue. Also notable, management plans to allocate approximately $100.0 million in cash towards the paydown of debt and share repurchases.

Our Q1 estimates tick up slightly, primarily reflecting a modest uptick in service revenue and gross margin. For FY ’20 and FY ‘21, we reduced our revenue forecast to reflect more moderate growth in product sales, but our non-GAAP EPS estimates remain intact on offsetting reductions in service costs. We note that our adjusted EBITDA estimates decline for this year and next principally due to the correction of a modeling error that inflated the D&A add-back for the full year figures.

With only slight adjustments to our estimates, we maintain our price target of $33.00, which continues to represent a FY ’20 EV/EBITDA multiple of approximately 13x. Our price target is further supported by our discounted cash flow analysis, which assumes a CAGR of 5% through FY ’24, steady margin expansion into the low-30% range, a terminal growth rate of 2.5% and a WACC of 8.9%. We have no qualms with investors building a position here considering our view that Q1 guidance could prove conservative and management’s FY ’20 guidance appears attainable ahead of more meaningful acceleration in fundamentals over the coming years. That said, we prefer to see more upside to our price target before truly pounding the table.

Our Q4 ‘19 variance is available here and our revised model is available here.

Disclosure(s):

The analyst, a member of the analyst’s household, and/or an account in which the analyst exercises discretion hold(s) a long position in the common stock of NetScout Systems (NTCT).