Q1 ’21 Results Beat on Robust Enterprise Growth
Considering the challenging backdrop presented by the COVID-19 pandemic, NetScout Systems (NTCT) turned in a strong start to its FY ’21 with results topping Street expectations on both the top and bottom lines. The upside in Q1 was attributable to robust growth in enterprise sales, which increased 21% Y/Y on pandemic-related demand for solutions to support remote work, telemedicine, digital transformation and cybersecurity initiatives and largely offset weakness in the service provider vertical. As for service provider investments in 5G, management expressed excitement over the longer-term opportunity but appeared cautious with respect to any near-term benefits as the ongoing economic uncertainty has created challenges in predicting the timing and funding of projects. Adoption of NetScout’s software-only form factor contributed to a favorable mix shift in service assurance product sales, which combined with another strong quarter of Arbor sales yielded over 400 basis points of product gross margin expansion on a non-GAAP basis. Operating expenses were below our estimates as sales and marketing came in far lower than modeled due to restrictions on travel and reduced spending on marketing events. This in turn resulted in both adjusted EBITDA and non-GAAP EPS significantly exceeding our estimates and consensus.
Looking forward, the ongoing COVID-19 crisis continues to limit visibility, and management again refrained from providing guidance. That said, management remains focused on driving earnings leverage this year and suggested seasonal trends for higher sales in Q2 and Q3 should remain intact, albeit at more muted levels than seen in recent years. Considering these factors, we lower our revenue estimates for Q2 and beyond as we assume a more conservative posture with respect to renewed top line growth. However, declines in our operating expense assumptions more than offset the revenue haircut, resulting in modest increases to our adjusted EBITDA and non-GAAP EPS estimates for this year and next. Reflecting the uptick in our profitability expectations, our price target increases from $30.50 to $31.50, representing an unchanged FY ’21 EV/EBITDA multiple of 12x.
We remain encouraged by NetScout’s traction with enterprise customers, which we believe demonstrates that last year’s salesforce integration efforts are beginning to pay dividends. We also remain optimistic that service provider growth will rebound in the latter half of NetScout’s FY ’21 as 5G investments begin to ramp. With shares trading at approximately 10x and 16x our FY ’21 adjusted EBITDA and non-GAAP EPS estimates, respectively, we believe shares of NetScout are attractively valued and provide for an attractive entry point.
Revenue of $183.8 million (-1.2% Y/Y) was ahead of the Street’s $182.3 million forecast but short of our $185.2 million estimate. Product sales of $71.7 million (-5.3% Y/Y) were slightly above our $70.0 million estimate, while service revenue of $112.1 million (+1.6% Y/Y) was below our estimate of $115.2 million. By segment, sales to enterprise customers increased approximately 21% Y/Y to $104.3 million, while sales to service provider customers declined approximately 20% Y/Y to $79.5 million. Per management, strength in the enterprise segment was driven by ongoing digital transformation and cloud migration efforts as well as a surge in demand for solutions to monitor and secure work-from-home, telemedicine and other pandemic-related initiatives. In the service provider vertical, 5G-related projects paused amid the pandemic although management remains hopeful that momentum will return in the quarters to come.
Reflecting another strong quarter for NetScout’s Arbor security solutions and an uptick in customer adoption of the software-only form factor, which comprised 36% of service assurance product revenue versus 25% last year, non-GAAP product gross margin expanded from 73.0% in the year-ago period to 77.4% in Q1 ‘21. Non-GAAP service gross margin fell from 76.1% last year to 72.8% this year due to higher costs, resulting in non-GAAP gross margin of 74.6% versus 74.9% in the prior year period. Operating expenses were below our projections across the board with sales and marketing materially lower due to the combined impact of travel restrictions arising from the pandemic and reduced spending on marketing events. This in turn resulted in both non-GAAP operating income of $20.6 million (11.2% margin) and adjusted EBITDA of $26.6 million (14.5% margin) exceeding our estimates and consensus. Non-GAAP EPS of $0.17 also topped our $0.08 projection and the Street’s $0.12.
NetScout generated $38.1 million in free cash flow during Q1 and exited the quarter with cash and investments of $426.5 million. Outstanding debt remained unchanged from the prior quarter at $450.0 million. Consistent with management’s previous commentary that capital allocation priorities have shifted to cash preservation amid the ongoing pandemic, the company did not repurchase any shares in Q1 and will not repurchase any shares in Q2. Also reflecting the ongoing uncertainty, guidance for FY ’21 was again withheld pending more clarity on the duration and magnitude of the COVID-19 pandemic.
Our estimate revisions include a reduction in our revenue projections and a corresponding cut to our operating expense assumptions, primarily as it relates to sales and marketing. We expect revenue to remain pressured throughout FY ’21 given the uncertainty wrought by the COVID-19 pandemic but believe management’s scrutiny of the cost structure will enable NetScout to post at least modest growth on the bottom line. As contribution from the service provider segment begins to rebound exiting the year, our model calls for mid-single digit top line growth and more meaningful margin expansion in FY ’22.
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).