Service Provider Spending Boosts Q3 ’22 Results; Raising Price Target from $37 to $38

NetScout Systems (NTCT) reported Q3 ’22 results well above expectations driven by the earlier than anticipated closure of several large service provider deals and a continued resurgence in the enterprise vertical. Much like last quarter, supply chain constraints impacting other suppliers to its service provider customers prompted additional spending on NetScout’s solutions as the company has remained relatively unaffected by component shortages. Although the upside represents a pull-forward of revenue from Q4, visibility into achieving management’s full year targets is far greater today and should be appreciated by investors. Moreover, with little evidence to suggest that supply chain challenges will abate in the near future, we surmise that the accelerating pace of 5G investments by Tier 1 service providers and NetScout’s ability to meet demand position the company to sustain its recent string of outperformance. In enterprise, NetScout again saw a recovery in spending as projects previously delayed by the pandemic were restarted and its recently launched products gained traction. All told, NetScout generated product growth in excess of 25% Y/Y and saw total revenue growth accelerate to nearly 15% Y/Y. This in turn yielded gross margin well above our assumption and drove both adjusted EBITDA and non-GAAP EPS to levels significantly above our estimates and consensus.

With only one quarter remaining in FY ’22 and considering the strong results to date, management raised the midpoint of its revenue guidance for the year and increased its outlook for non-GAAP EPS. As noted earlier, the upside in Q3 was primarily due to the closure of several large service provider deals originally anticipated in Q4, so the implied guidance for the current quarter was well below Street expectations. More importantly, NetScout enters its fiscal Q4 with $30 million in product backlog and has secured another large calibration project not reflected in that figure. As such, near-term visibility is markedly better than the norm heading into the company’s fiscal year-end, and we see potential for more upside surprises in the coming quarters. Although our Q4 estimates decline to reflect the timing of deals, our FY ’23 projections remain relatively unchanged. We also introduce our FY ’24 estimates, which reflect an acceleration in top line growth and continued margin expansion. Given significantly stronger cash flow generation than we modeled this past quarter and a lower share count, our price target increases from $37.00 to $38.00. We continue to derive our price target based on an unchanged FY ’23 EV/EBITDA multiple of 12x. We also remain constructive on shares as we believe NetScout stands to benefit from both the deployment of 5G networks and broader adoption of its cybersecurity solutions.

Exhibit I: Quarterly Results and Guidance Versus Expectations

Sources: IBES Estimates; K. Liu & Company LLC; NetScout Earnings Release

Q3 revenue of $262.2 million (+14.6% Y/Y) was well above guidance for low single-digit growth, our estimate of $232.8 million and consensus of $233.2 million. Both Product and Service revenue of $144.4 million (+25.6% Y/Y) and $117.8 million (+3.5% Y/Y), respectively, outpaced our estimates of $122.5 million and $110.3 million. Per management, the strength in Product sales arose from the pull-forward of $25-$30 million worth of service provider deals previously expected to close in Q4. With supply chain constraints limiting its customers’ ability to procure products, NetScout benefited from year-end budget flushes and its ability to meet demand. Moreover, the company enters Q4 with approximately $30 million in Product backlog and another $20 million in RF Propagation Modeling projects that will convert to revenue in future periods. Spending among enterprise customers was also strong driven by the restart of projects delayed by the pandemic and early traction for the company’s recently launched Cyber Intelligence and Smart Edge Monitoring solutions. By vertical, service provider comprised 56% of revenue and increased 21% Y/Y, while enterprise comprised the remaining 44% of revenue and increased nearly 8% Y/Y.

Gross margin on a non-GAAP basis was 78.8%, well above our 76.8% assumption due to the upside in Product revenue and associated gross margin of 81.5% versus our 80.0% forecast. Worth noting, software-only sales comprised 34% of service assurance product revenue versus 31% last year. Service gross margin of 75.5% was also ahead of our 73.3% assumption due in part to some catch-up maintenance revenue. Operating expenses were slightly above our expectations, primarily due to higher sales and marketing expenses. Both non-GAAP operating income of $87.2 million (33.2% margin) and adjusted EBITDA of $92.6 million (35.3% margin) exceeded our estimates of $62.3 million and $67.9 million, respectively. Non-GAAP EPS of $0.89 beat our estimate and consensus of $0.62.

In Q3, NetScout generated $90.3 million in free cash flow and repurchased 409,379 shares at a total cost of $11.0 million. Cash and investments at the end of the quarter totaled $553.5 million, while outstanding debt remained unchanged at $350.0 million. Reflecting the strong performance to date, management raised the midpoint of its FY ’22 revenue guidance and increased its non-GAAP EPS guidance. The revised outlook implies Q4 revenue and non-GAAP EPS of $185.6-$190.6 million and $0.19-$0.22, respectively, both of which are well below our prior estimates and consensus due to the aforementioned pull-forward of service provider awards. More importantly, NetScout should have little issue achieving its stated targets for the year and should enter FY ’23 with strong momentum.

Exhibit II: Estimate Revisions

Source: K. Liu & Company LLC

Our estimates remain largely unchanged for this year and next, save for some fine-tuning of our margin and expense assumptions by quarter. We also introduce our FY ’24 projections, which call for revenue of $947.1 million (+6.2% Y/Y), non-GAAP operating income of $224.9 million (23.8% margin) and non-GAAP EPS of $2.21 (+12.2% Y/Y).

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).