Q4 '22 Performance Enhances Visibility into Strong Outlook for FY '23

NetScout Systems (NTCT) reported Q4 ’22 results ahead of our estimates and consensus. Recall that the company benefited from the earlier than anticipated closure of several large service provider deals in Q3, which negatively affected the reported growth rate for Q4. We note, however, that in addition to delivering revenue above expectations for the quarter, NetScout’s product backlog more than doubled from the level exiting Q3 as did its backlog of RF Propagation Modeling projects. In other words, new product bookings were strong in Q4 and visibility into management’s guidance for accelerating revenue growth in the year ahead is better than usual. Additionally, whereas NetScout benefited from supply chain challenges affecting others last quarter, our sense was this quarter’s performance was largely reflective of typical demand. Rounding out the strong finish to FY ’22 was robust free cash flow generation in excess of $155 million. Although far from a normal run rate, NetScout is taking full advantage of its strong cash position and plans to undertake a $150 million accelerated share repurchase and pay down $150 million in debt in Q1.

Looking forward, management guided FY ’23 revenue and non-GAAP EPS above our prior estimates and the Street’s. We note that management’s top line growth expectations for both Q1 and FY ’23 reflect a mid to high single-digit increase, marking an acceleration from the 3% growth seen over the past year. Additionally, growth in product revenues is expected in the mid-single digit to mid-teens range, suggesting further acceleration in the out year should guidance be achieved. Near-term, operating expenses are slated to rise given a return to more normal levels of travel and in-person marketing events and the tight labor market. While this will limit margin expansion in FY ’23, we still anticipate greater operating leverage as revenue growth accelerates into FY ’24.

We raise our revenue estimates for this year and next but our adjusted EBITDA estimates decline slightly due to higher operating expenses. We note that our non-GAAP EPS estimates still move higher due to a marginally lower tax rate assumption and a lower share count from the planned accelerated share repurchase. All told, our price target remains $38.00 based on an unchanged FY ’23 EV/EBITDA multiple of 12x. With another downdraft in the market yesterday, shares of NTCT had a muted response to the positive results and outlook. As such, we continue to believe NetScout is an attractive investment at present. Not only is growth accelerating but visibility into the improvement is greater than we have seen in years. Also worth noting, management plans to provide greater insight into its cybersecurity business as the year progresses, which could prompt more enthusiasm among investors, particularly if NetScout’s new Omnis products see early traction in the market.

Exhibit I: Quarterly Results and Guidance Versus Expectations

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

Q4 revenue of $191.2 million (-10.4% Y/Y) was above guidance for $185.6-$190.6 million, our estimate of $188.1 million and consensus of $188.8 million. Relative to our model, the upside was attributable to higher Product revenue of $82.1 million (-17.1% Y/Y), which was ahead of our $72.5 million estimate. Service revenue of $109.1 million (-4.6% Y/Y) was slightly below our $115.6 million projection. Recall that $25-$30 million in Product sales were pulled from Q4 into Q3, so the Y/Y decline was neither concerning nor surprising. In fact, NetScout exited FY ’22 with approximately $50 million in Product backlog, up from $30 million at the end of Q3. Moreover, the company also received RF Propagation Modeling orders from two domestic Tier-1 carriers and now has a backlog of approximately $60 million in such projects versus $20 million at the end of Q3. In our view, the increase in backlog reflects strong bookings in Q4 and provides greater visibility into management’s outlook for accelerating top line growth in FY ’23. By vertical, service provider comprised 42% of revenue and was down 34% Y/Y due to the aforementioned pull-forward of deals, while enterprise comprised the remaining 58% of revenue and increased 20% Y/Y.

Non-GAAP gross margin of 77.6% was above our 77.2% assumption as Product gross margin of 83.8% comfortably exceeded our 81.5% estimate. This in turn helped to offset lower Services gross margin of 72.9% versus our estimate of 74.5%. Of note, software-only sales comprised 39% of service assurance product revenue versus 33% last year. Operating expenses were marginally above our expectations, primarily due to higher general and administrative expenses. Both non-GAAP operating income of $23.7 million (12.4% margin) and adjusted EBITDA of $29.2 million (15.3% margin) exceeded our estimates of $21.7 million and $27.1 million, respectively. Non-GAAP EPS of $0.29 also beat our estimate of $0.20 and consensus of $0.21. We note that a lower than modeled tax rate contributed $0.06 of the upside relative to our projection.

In Q4, NetScout generated a robust $152.2 million in free cash flow, reflecting benefits from the timing of orders, higher multi-year maintenance renewals and customer prepayments. Cash and investments at the end of the quarter totaled $703.2 million, while outstanding debt remained unchanged at $350.0 million. Although no shares were repurchased in Q4, management plans to repurchase $150 million in stock under an accelerated share repurchase (ASR) agreement in Q1. With the existing share repurchase authorization expected to be largely exhausted following the ASR, the Board of Directors has also authorized a new 25 million share repurchase program. Lastly, NetScout also plans to pay down $150 million in debt on its existing credit facility this quarter.

Turning to the outlook, management’s FY ’23 guidance calls for revenue of $895.0-$925.0 million, which implies growth of +5%-8% Y/Y versus +3% in FY ’22, and non-GAAP EPS of $1.97-$2.03. Prior to revisions, we were projecting FY ’23 revenue and non-GAAP EPS of $891.5 million and $1.97, respectively, while consensus stood at $887.8 million and $1.95. For Q1, management anticipates high single digit growth in both revenue and non-GAAP EPS, implying revenue of $203.6-$207.4 million and non-GAAP EPS of $0.21-$0.22. We were projecting $199.9 million and $0.26, respectively, while consensus called for $194.4 million and $0.25.

Exhibit II: Estimate Revisions

Source: K. Liu & Company LLC

We increase our revenue estimates for this year and next to reflect higher growth in Product sales. For FY ’23, our gross margin assumption declines slightly as we now assume a higher mix of calibration revenues as the company executes against its backlog of RF Propagation Modeling projects. Reflecting higher costs associated with a return to more normalized levels of travel and in-person marketing events, as well as a tight labor market, our operating expense estimates also move higher in both FY ’23 and FY ’24. The net effect is a decline in our FY ’23 adjusted EBITDA estimate from $222.3 million to $212.7 million, and a nominal decrease in our FY ’24 adjusted EBITDA estimate from $247.9 million to $246.7 million. However, our non-GAAP EPS estimates increase by a penny in FY ’23 to $1.98 and by $0.12 in FY ’24 to $2.33 due to the combined benefits of a modestly lower tax rate and NetScout’s accelerated share repurchase plan.

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).