Reports Q2 ’23 Results Ahead of Expectations on Strong Cybersecurity Growth

NetScout Systems (NTCT) reported fiscal Q2 ’23 results above our estimates and consensus. The strong performance reflected accelerating growth in cybersecurity sales to enterprise customers along with a slight increase in service assurance sales. Backlog was down slightly from the prior quarter but remains well above historical norms as NetScout again exited the quarter with high levels of fulfillable orders, which convert to revenue in fairly short order, and RF Propagation Modeling projects that will be completed over time. Gross margin was above our assumption due to a greater mix of higher margin cybersecurity sales, while operating expenses were in line with our projection. Both adjusted EBITDA and non-GAAP EPS beat our estimates.

Despite reports of increasing economic uncertainty of late, management has yet to see any signs of a slowdown. As such, guidance for FY ’23 was reaffirmed. For the remainder of the year, management’s implicit guidance for 2H assumes revenue will be modestly higher in Q3 than in Q4, while non-GAAP EPS skews more heavily towards the former. We made only minor tweaks to our revenue forecasts for the rest of FY ’23, while increasing our operating expense estimates exiting the year. All told, our estimates for FY ’23 move up nominally on the strength in Q2.

Although NetScout has been largely insulated from any broader macro weakness thus far, we are proactively reducing our estimates for next year to reflect more conservative growth assumptions. We note that our prior projections called for accelerating topline growth driven by a double-digit increase in Product revenue. While we believe this scenario may still be achievable given the company’s increasing traction in cybersecurity and sustained service provider spending on 5G network deployments, we believe it is more prudent to moderate our expectations at this juncture. As such, we now project both revenue and non-GAAP EPS growth in the low single-digit range.

With NetScout continuing to execute well amid an increasingly challenging macro backdrop, we think shares of NTCT should still be held. Our price target remains $38.00, representing an unchanged EV/EBITDA multiple of approximately 12x but now rolled forward to our FY ’24 projections. In our view, NetScout remains a compelling play on the rollout of 5G network services given its ability to address both service assurance and security threats at scale.

Exhibit I: Quarterly Results and Guidance Versus Expectations

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

Q2 revenue totaled $228.1 million (+7.6% Y/Y), exceeding our estimate of $222.3 million and consensus of $223.0 million. Both Product sales of $111.8 million (+10.0% Y/Y) and Service revenue of $116.3 million (+5.4% Y/Y) were ahead of our estimates of $110.0 million and $112.4 million, respectively. The growth in Product sales reflected strong demand for NetScout’s cybersecurity solutions, which comprised 27% of total revenue in the quarter and grew 23% Y/Y. Revenue from service assurance products comprised the remaining 73% of revenue and grew 3% Y/Y. Per management, Service revenue benefited from approximately $5 million in back maintenance. Backlog at quarter-end was down slightly from $85 million to $80 million and included $45 million in fulfillable orders and $35 million in RF Propagation Modeling projects. We note that the backlog of higher margin fulfillable orders actually increased by $5 million sequentially, while the backlog of RF Propagation Modeling projects was down $10 million from Q2 as NetScout recognized $15 million in associated revenue during the quarter and secured some new awards. As we have previously noted, NetScout’s backlog remains above historical levels and provides enhanced visibility into management’s guidance.

Non-GAAP gross margin of 76.8% was above our 75.7% assumption. Product gross margin of 79.2% was well above our 77.5% estimate due to the strong growth in higher margin cybersecurity solutions, while Service gross margin of 74.5% was slightly ahead of our 74.0% estimate. Total operating expenses were largely consistent with our expectations as higher general and administrative expenses were offset by lower sales and marketing expenses. Both non-GAAP operating income of $54.0 million (23.7% margin) and adjusted EBITDA of $59.1 million (25.9% margin) exceeded our estimates of $46.6 million and $51.9 million, respectively. Non-GAAP EPS of $0.57 also beat our estimate and consensus of $0.49.

Cash and investments at quarter-end totaled $367.1 million, while outstanding debt was unchanged at $200.0 million. In Q3, NetScout generated $10.1 million in cash from operations and had $3.0 million in capital expenditures.

Turning to guidance, management reaffirmed its prior outlook for FY ‘23. Based on the midpoint of management’s guidance, revenue in Q3 is expected to be 1%-2% higher than in Q4, while non-GAAP EPS in the latter half of the year is expected to be split 60/40 between Q3/Q4. This implies Q3 revenue and non-GAAP EPS in the neighborhood of $238 million and $0.71, respectively, which was mixed versus our estimates of $242.2 million and $0.65 and consensus of $244.4 million and $0.70.

Exhibit II: Estimate Revisions

Source: K. Liu & Company LLC

We raised our estimates nominally for FY ’23, primarily reflecting the upside in Q2. For FY ’24, we reduced our estimates to reflect more conservative growth assumptions. Although there is nothing at present within NetScout’s own business to suggest a slowdown is around the corner, we believe it is more prudent at this stage to factor in a more challenging economic environment and the corresponding impact on Product sales.

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).