Q3 '21 Results Beat on Strong Security Tailwinds; Raising Price Target from $31.50 to $33.00
NetScout Systems’ (NTCT) fiscal Q3 ’21 results surpassed Street expectations driven by robust demand for the company’s security products. Per management, customers sought to safeguard their IT infrastructure against an increasing volume of large and sophisticated cyberattacks, leading to another quarter of double-digit growth for NetScout’s Arbor security solutions. Reflecting the favorable mix of higher margin security sales, gross margin expanded markedly on a sequential and Y/Y basis and was well above our assumption. With operating expenses still constrained by pandemic-related restrictions on travel and marketing events, both adjusted EBITDA and non-GAAP EPS also topped our estimates and consensus.
As the Q3 performance was largely consistent with internal expectations, management simply narrowed its FY ’21 revenue guidance and raised its non-GAAP EPS target for the year. Spending by service providers is expected to remain muted in the near-term, and management acknowledged that the enterprise selling environment continues to be challenging due to financial constraints implemented in response to the pandemic. That said, the conclusion of the FCC’s record-breaking auction of C-band spectrum along with 5G trials underway suggest the service provider business may be nearing an inflection point. Even as NetScout awaits the deployment of standalone 5G networks, which we expect to begin in the coming fiscal year, pipeline associated with 4G traffic growth is building and international market conditions are improving. We believe these factors, combined with ongoing traction for NetScout’s security products, will fuel renewed growth in FY ’22 and accelerating growth thereafter.
From a modeling perspective, we lower our Q4 estimates to match the higher level of product sales already secured in Q3. More importantly, our FY ’22 estimates increase slightly on an uptick in our product growth assumptions and a modest reduction in our operating expense estimates. Additionally, we introduce our FY ’23 projections, which call for mid-single digit growth on the top line and mid-teens growth on the bottom line. Based on our revised FY ’22 estimates, our price target rises from $31.50 to $33.00, representing an unchanged EV/EBITDA multiple of 12x. In our opinion, NetScout remains well positioned to benefit from new paradigms for work, the deployment of next generation networks and the proliferation of smart, connected devices. We surmise both our estimates and target multiple may well prove conservative as these opportunities come to fruition and thus see further upside in shares.
Exhibit I: Quarterly Results and Guidance Versus Expectations
Revenue of $228.7 million (-12.0% Y/Y) was slightly ahead the Street’s $224.9 million and above our estimate of $218.8 million. The upside relative to our estimate was attributable to higher than anticipated Product sales, which totaled $115.0 million (-19.8% Y/Y) versus our estimate of $105.0 million. Service revenue of $113.8 million was in line with our forecast. By vertical, service provider comprised 53% of revenue and declined 11% Y/Y as spending remained muted ahead of next generation network deployments. Enterprise sales accounted for the remaining 47% of revenue and declined 13% Y/Y as companies reined in spending in response to the pandemic. Sales of NetScout’s Arbor security products, which represent approximately one-fourth of total revenue, were a bright spot once again, growing in the low double-digit range with contribution from both the enterprise and service provider verticals.
Gross margin on a non-GAAP basis was 78.6%, an increase of nearly 400 basis points sequentially and up from 77.8% last year. Despite software-only sales comprising just 31% of service assurance product revenue versus 42% in the year-ago period, product gross margin rose to 83.3% versus 80.6% in the year-ago period driven by a greater mix of security products. Service gross margin of 73.9% was relatively consistent with both the prior and year-ago quarters, and operating expenses were largely in line with our projection. Reflecting the upside in revenue and gross margin, both non-GAAP operating income of $64.5 million (28.2% margin) and adjusted EBITDA of $70.9 million (31.0% margin) easily exceeded our estimates and consensus. Non-GAAP EPS of $0.66 also beat our $0.51 projection and the Street’s $0.52.
In Q3, NetScout generated $62.0 million in free cash flow and exited the quarter with cash and investments of $490.4 million. Outstanding debt remained unchanged at $450.0 million although management plans to repay $100.0 million in Q4. With only one quarter remaining in the current fiscal year, management narrowed its FY ’21 guidance for a mid- to high-single digit decline in revenue (i.e. $811.7-$856.3 million in revenue) to a range of $825.0-$840.0 million. Additionally, guidance for non-GAAP EPS was raised from approximately $1.57 to $1.60-$1.67. The revised outlook implies Q4 revenue generally consistent with consensus expectations heading into the print and non-GAAP EPS of $0.39-$0.46 versus the Street’s $0.50.
Exhibit II: Estimate Revisions
Given the upside realized in Q3, the bar for achieving management’s full year targets is now lower for Q4 and corresponds to the decline in our estimates for the current quarter. We continue to expect a return to positive growth in FY ’22 driven by strong demand for NetScout’s security solutions and initial service provider deployments of standalone 5G networks. Our estimates move up modestly in this regard, reflecting an uptick in our expectations for product growth, slightly lower operating expense assumptions and a downtick in projected interest expense. We also introduce our FY ’23 revenue and non-GAAP EPS estimates, which sit at $893.7 million and $1.94, respectively, and represent Y/Y growth of 5.1% and 13.0%.
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).