Solid Q2 Results Overshadowed by Soft 2H Outlook

NetScout Systems (NTCT) reported Q2 ’21 results ahead of Street expectations as growth in security and service provider revenues more than offset depressed spending in the government vertical. An onslaught of cyberattacks targeting online platforms and other connected services amidst the pandemic has sustained strong demand for NetScout’s DDoS detection and mitigation solutions. Moreover, as organizations reevaluate their infrastructure requirements to support remote work and other digital transformation initiatives over the long haul, the need for new security paradigms is also fueling demand for solutions like Arbor Edge Defense (AED). That said, while AED growth has been robust of late, the on-premises deployment of the appliance has precluded the company from realizing even higher growth given challenges in engaging with new customers and demonstrating AED’s capabilities during the pandemic. Turning to the service provider business, 4G expansions internationally and initial 5G trials in the U.S. drove solid growth on both a sequential and Y/Y basis. Management again expressed optimism that 5G network deployments will serve as a catalyst for growth but noted that until standalone 5G networks are built, a more likely scenario for next year than this, the associated revenue opportunity remains on the come. In the meantime, investments to capitalize on the opportunity and ensure NetScout remains well positioned as the incumbent in major accounts continue to be made. Operating expenses on the whole were well controlled, however, enabling the company to comfortably exceed both the Street’s and our earnings expectations for Q2.

Although no financial outlook was provided earlier in the year due to the onset of the COVID-19 pandemic, management instituted FY ’21 guidance for revenue to decline in the mid- to high-single digit range and for non-GAAP EPS to be consistent with prior year levels in conjunction with the latest earnings release. The outlook suggests the seasonal strength usually realized in the latter half of NetScout’s fiscal year may be more muted this year, which management attributed to elongated sales cycles and ongoing macroeconomic uncertainty tied to the pandemic. Relative to Street expectations, guidance fell short on the top line but was consistent with consensus on the bottom line. We lowered our revenue projections for this year and next to reflect a softer recovery than previously assumed. While a reduction in our operating expense projections mitigated the impact to an extent, our adjusted EBITDA and non-GAAP EPS estimates also declined. Regardless, our thesis has been that NetScout can hold the line from a profitability standpoint ahead of more meaningful growth as service provider spending on 5G begins to ramp. While perhaps delayed by a few more quarters, our view remains intact at this juncture. We therefore maintain our price target of $31.50, which represents an unchanged EV/EBITDA multiple of 12x but now applied to our FY ’22 projection.

Exhibit I: Quarterly Results and Guidance Versus Expectations

Revenue of $205.3 million (-5.1% Y/Y) was above consensus of $203.8 million but shy of our $208.1 million estimate. Product revenue of $92.0 million (-10.5% Y/Y) was short of our $95.0 million estimate, while service revenue of $113.4 million (-0.3% Y/Y) was consistent with our $113.1 million estimate. By vertical, sales were evenly split between enterprise and service provider although revenue from the former declined 14% Y/Y versus a 4% Y/Y increase for the latter. We note that all of the decline in enterprise sales was attributable to the federal government business, which decreased over 60% Y/Y due to a difficult comparison and delays in funding for approved projects. Excluding the government business, enterprise sales increased in the low single-digits driven by continued traction for NetScout’s Arbor products and ongoing demand for service assurance solutions to support digital transformation and cloud migration initiatives.

On a non-GAAP basis, gross margin of 74.7% was relatively flat from the prior quarter but down from 76.6% last year due to mix. Although software-only sales comprised 27% of service assurance product revenue versus 20% in the year-ago period, a higher mix of lower margin revenues associated with a radio frequency propagation modeling project resulted in product gross margin of 76.2% versus 77.8% last year. Service gross margin also declined Y/Y due to higher costs. Operating expenses compared favorably with our estimates, declining both sequentially and Y/Y as expenses were tightly controlled and travel limited amid the pandemic. As a result, both non-GAAP operating income of $39.8 million (19.4% margin) and adjusted EBITDA of $46.8 million (22.8% margin) surpassed our estimates and consensus. Non-GAAP EPS of $0.38 also beat our $0.32 projection and the Street’s $0.29.

NetScout generated $8.3 million in free cash flow during Q2 and exited the quarter with cash and investments of $427.8 million. Outstanding debt remained unchanged from the prior quarter at $450.0 million. Looking forward, management indicated that while the company’s business has proven to be resilient thus far, sales cycles remain elongated due to the COVID-19 pandemic. The stronger seasonality typically seen in NetScout’s 2H is therefore likely to be muted, prompting management to put forth guidance for a mid- to high-single digit decline in revenue for FY ’21. On a more positive note, non-GAAP EPS is expected to be in line with last year’s performance, implying both the prior consensus estimate and our higher forecast remain achievable.

Exhibit II: Estimate Revisions

Reflecting a reduction in our product sales projection, we lowered our FY ’21 revenue and gross margin assumptions. While these declines were largely offset by lower operating expenses, our profitability expectations were also impacted slightly. Turning to the out-year, we continue to expect a return to positive growth as service provider investments in standalone 5G networks begin to ramp and NetScout builds upon its success in cross-selling security solutions into its enterprise base. In light of the ongoing COVID-19 pandemic, however, we have tempered our revenue forecasts. Although our operating expenses estimates also come in slightly, we continue to assume investments in sales and marketing begin to reflect a more normal environment towards year-end, resulting in reductions to our non-GAAP operating margin and EPS estimates.

Our report with model and disclosures 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).