Sluggish Start Sets a High Hurdle for 2H '20

NetScout Systems’ (NTCT) fiscal Q1 ’20 results were marred by a revenue shortfall, but tight cost controls enabled the company to post non-GAAP EPS in line with expectations. Delays in securing several service provider deals were the primary culprit for the top line miss, although sales execution challenges also surfaced internationally on the enterprise side. Despite the sluggish start to the year and a tempered outlook for Q2, management reaffirmed its prior top and bottom line guidance for FY ’20. The performance out of the gate and back-end loaded guide feel eerily similar to last year, raising concerns that a cut to guidance may be in the offing. While we share some of the skepticism that 2H ’20 will reflect a markedly improved growth trajectory, we think visibility is better this time around given that NetScout has already secured a large Radio Frequency Propagation Modeling deal early in Q2 that is expected to boost revenue in the back half of the year. Moreover, management also struck a more optimistic tone regarding an uptick in 5G-related activity. Even with a haircut to our expectations for this year and next, shares remain attractively valued, in our opinion, and we continue to be bullish on NetScout’s longer-term prospects. Our price target declines from $33.00 to $32.00, reflecting an unchanged FY ’20 EV/EBITDA multiple of approximately 13x.

Non-GAAP revenue of $186.1 million (-9.7% Y/Y) was below management’s $195.0-$200.0 million guidance, consensus of $196.9 million, and our estimate of $196.7 million. Excluding the impact of the divestiture of the HNT Tools business, which contributed $10.4 million to last year’s results, non-GAAP revenue declined 4.8% Y/Y. Management attributed the revenue shortfall to elongated sales cycles in the service provider vertical and further noted that the company’s efforts to reorganize its sales force also created disruption in enterprise sales abroad. We surmise that the service provider deals that slipped would have enabled NetScout to achieve the low-end of its Q1 revenue guidance with the enterprise sales issues internationally accounting for the rest of the variance versus the midpoint of guidance.

Reflecting lower sales volumes, product gross margin was notably soft at 73.0% on a non-GAAP basis versus 75.0% in the year-ago period and 80.0% in the prior quarter. A lower mix of Arbor revenue arising from the aforementioned international sales disruption also weighed on gross margin. With new security offerings expected to contribute in 2H ’19 and a rebound in enterprise DDoS growth, product gross margin should bounce back in the coming quarters. Turning to operating expenses, cost reduction initiatives undertaken last year and ongoing efforts to restrain spending resulted in lower expenses than anticipated. As such, non-GAAP EPS of $0.07 were consistent with Street expectations and management’s guidance despite the depressed revenue and gross margin performance.

NetScout generated $46.2 million in free cash flow during Q1 and exited the quarter with cash and investments of $443.2 million. Usages of cash in the quarter included the repurchase of $33.2 million worth of common stock and the repayment of $50.0 million of debt, leaving an outstanding balance of $500.0 million. Thus far in Q2, the company has already repurchased another $16.8 million in stock and plans to earmark another $50.0 million for additional repurchases in the near-term. Management also anticipates allocating $50.0 million towards the repayment of debt.

Management’s Q2 guidance calls for revenue of $205.0-$215.0 million and non-GAAP EPS of $0.25-$0.27. The Q2 outlook implies an organic revenue decline in the low to mid-single digit range after excluding $7.6 million in divested HNT Tools revenue from the prior year period. Prior to revisions, we were projecting $218.3 million in revenue and $0.31 in non-GAAP EPS, while consensus was slightly lower at $217.3 million and $0.30. For the full year, management reiterated prior expectations for revenues of $885.0-$915.0 million and non-GAAP EPS of $1.40-$1.45. Considering results to date and management’s Q2 targets, guidance for FY ’20 implies a return to mid-single digit organic growth in the back half of the year.

We reduce our revenue and adjusted EBITDA estimates for this year and next to reflect more conservative expectations for product sales, partially offset by higher service revenue assumptions and lower operating expenses. Our non-GAAP EPS estimate remains unchanged for FY ’19 due in part to a lower tax rate of 23% versus 25% previously. Reflecting the revisions to our estimates, we lower our price target from $33.00 to $32.00, which continues to represent a FY ’20 EV/EBITDA multiple of approximately 13x. Our price target is also supported by our discounted cash flow analysis, which assumes a CAGR of 5% through FY ’24, steady adjusted EBITDA margin expansion into the low-30% range, a terminal growth rate of 2.5% and a WACC of 8.6%. While the specter of a guidance cut precipitated a sell-off in shares following NetScout’s Q1 results, we believe investors with a longer-term perspective should take advantage of the dip. We remain optimistic that the company is poised to benefit from the 5G spending cycle and an expanded suite of security offerings in the coming years, which should in turn drive significant operating leverage and free cash flow generation. Patience and a strong stomach will of course be required, but given a depressed valuation and prevailing negative sentiment, we find the risk/reward potential compelling.

Our Q1 ‘20 variance analysis 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).