Software-Only Sales Fuel Strong Q2 ’22 Results; Raising Price Target from $33 to $37

NetScout Systems (NTCT) reported strong Q2 ’22 results, exceeding our estimates and consensus top to bottom. We were particularly encouraged to see a second consecutive quarter of double-digit growth in Product sales, which management attributed to the release of pent-up demand in enterprise and a significant increase in the mix of software-only sales. Regarding the latter, supply chain constraints experienced by large service provider customers freed up budget dollars previously slated for the back half of NetScout’s fiscal year, which in turn drove greater demand for software-only deployments. While the pull-forward of some deals contributed to the beat in Q2, we note that NetScout’s product backlog has actually increased by 50% since the start of the year. In other words, we believe the company would have posted strong results even absent the emphasis on software shipments and now has the added benefit of enhanced visibility heading into its seasonally stronger 2H. Of course, the higher mix of software also boosted gross margin well above our assumption and helped to offset higher operating expenses than we modeled. As a result, both adjusted EBITDA and non-GAAP EPS beat our estimates and consensus.

Given the strong performance to date, management reaffirmed its prior guidance for FY ’22. Near-term, management’s expectations for Q3 include a low single digit increase in revenue and a mid-single digit decline in non-GAAP EPS, the latter of which reflects a less favorable mix of product revenue versus last year. We note that the implied revenue guidance compares favorably with our estimate heading into the print and is just a shade lower than consensus despite the pull-forward of a large service provider deal into Q2. Furthermore, the color for Q3 suggests a slight uptick in our non-GAAP EPS estimate is in order, while consensus is likely to remain unchanged. All told, we raised our estimates modestly for this year and next, primarily reflecting an increase in our estimate of service revenue, partially offset by higher operating expenses.

We continue to believe NetScout is poised for accelerating growth once service provider deployments of standalone 5G networks begin to ramp and its expanding portfolio of security solutions gains traction with enterprise customers. Near-term, the build in backlog and potential to benefit from a mix shift towards software leaves us optimistic that the recent string of outperformance can be sustained. Reflecting our greater confidence and the uptick in our estimates, our price target increases from $33.00 to $37.00, representing an unchanged EV/EBITDA multiple of 12x but now rolled forward to our FY ’23 projections.

Exhibit I: Quarterly Results and Guidance Versus Expectations

Q2 revenue of $211.9 million (+3.2% Y/Y) was above our estimate of $205.3 million and consensus of $206.3 million. Both Product sales of $101.6 million (+10.5% Y/Y) and Service revenue of $110.3 million (-2.7% Y/Y) exceeded our estimates of $97.0 million and $108.3 million, respectively. Management attributed the strength in Product sales to the pull-forward of some deals originally expected to close in the latter half of the year. With supply chain constraints restricting its customers’ ability to procure certain products, NetScout benefited from its software-only deployment option, which enabled customers to accelerate the timing of purchases. By vertical, service provider comprised 49% of revenue but declined 8% Y/Y against a difficult comparison. Enterprise comprised the remaining 51% of revenue and increased nearly 18% Y/Y as enterprise and government customers restarted projects previously delayed by the pandemic.

Gross margin on a non-GAAP basis was 78.3%, well above our 75.1% assumption and 74.7% in the year-ago period. The upside was largely attributable to higher Product gross margin of 83.6%, which easily exceeded our 78.0% assumption due to the higher mix of software-only sales. Worth noting, software-only sales comprised 45% of service assurance product revenue versus 27% last year. Service gross margin of 73.4% was ahead of our 72.5% estimate as revenue outpaced our projection. Operating expenses were above our expectations, primarily due to higher sales and marketing expenses and to a lesser extent, higher research and development costs. Both non-GAAP operating income of $47.3 million (22.3% margin) and adjusted EBITDA of $53.0 million (25.0% margin) exceeded our estimates of $37.7 million and $43.6 million, respectively. Non-GAAP EPS of $0.47 beat our $0.37 estimate and the Street’s $0.38.

In Q2, NetScout generated $21.6 million in free cash flow and repurchased 921,299 shares at a total cost of $24.6 million. Cash and investments at the end of the quarter totaled $475.8 million, while outstanding debt remained unchanged at $350.0 million. Looking forward, management expects Q3 revenue growth in the low single digit range and a mid-single digit decline in non-GAAP EPS, implying revenue and non-GAAP EPS of $231.0-$235.6 million and $0.62-$0.64, respectively. The outlook compares favorably with our prior estimates of $231.2 million in revenue and $0.61 in non-GAAP EPS and is generally consistent with Street expectations heading into the print, which included revenue of $236.0 million and non-GAAP EPS of $0.63. For the full year, management reaffirmed its prior guidance for revenue of $835.0-$865.0 million and non-GAAP EPS of $1.71-$1.77.

Exhibit II: Estimate Revisions

Our estimates increase slightly for this year and next, primarily reflecting a higher run rate of Service revenue exiting Q2. The increase in our top line projections was partially offset by modestly higher operating expenses. Still, both our adjusted EBITDA and non-GAAP EPS estimates rise in concert with our higher revenue forecast.

Our report with model and disclosure 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).