Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)

NetScout Systems (NASDAQ:NTCT)

F3Q09 (Qtr End 12/31/08) Earnings Call

January 22, 2009; 04:30 pm ET

Executive

Anil Singhal - President and Chief Executive Officer

David Sommers - Chief Financial Officer

Michael Szabados - Chief Operating Officer

Cathy Taylor - Director of Investor Relations

Analyst

Mark Kelleher - Canaccord Adams

Eric Martinuzzi - Craig Hallum

Alex Kurtz - Merriman

Jonathan Ruykhaver - ThinkEquity Partners

Scott Zeller - Needham and Company

Manny Recarey - Kaufman Brothers

Rohit Chopra - Wedbush Morgan

Operator

Ladies and gentlemen, thank you for standing by and welcome to NetScout third quarter fiscal year 2009 operating results conference call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Instructions will be given to you at that time. As a reminder this conference call is being recorded.

With us today is NetScout’s president and CEO, Anil Singhal. He is accompanied by NetScout Chief Financial Officer, David Sommers; and NetScout Chief Operating Officer, Mr. Michael Szabados. Also with Mr. Singhal is NetScout’s Director of Investor Relations, Ms. Cathy Taylor.

At this time I will turn the call over to Ms. Taylor to provide the opening remarks. Ms. Taylor, please proceed.

Cathy Taylor

Thank you and good afternoon everyone. Welcome to NetScout’s third quarter fiscal year 2009 conference call for the period ended December 31. In terms of the format of this call, Anil will begin with an overview of our financial and operating results and David will then discuss our financial results and company performance in more detail. At the conclusion, Anil and David will take your questions.

Before we begin, however, let me remind you that during the course of this conference call, we will be providing you with a discussion of the factors we currently anticipate that may influence our results going forward. Such statements are forward-looking statements made pursuant to the Safe Harbor provisions of section 21-E of the Securities and Exchange Act of 1934 and other Federal Securities Laws. These forward-looking statements may involve judgment and that individual judgments may vary.

Forward-looking statements include, express or implied statements regarding future economic and market conditions, our guidance for fiscal year 2009 and our product integration plan. It should be clearly understood that the projections in which we base our guidance and other forward-looking statements and our perception of the factors influencing those projections are highly likely to change overtime. Although those projections and the factors influencing them will likely change, we will not necessarily inform you when they do. Our company policy is to provide guidance only at certain points in the year such as during the quarter earnings call. We do not plan to otherwise update that guidance.

Actual results may differ materially from what we say today and no one should assume later in the quarter that the comments we make today are still valid. For further discussions of the risks and uncertainties that could cause our actual results to differ, see the specific risks and uncertainties discussed in NetScout’s Form 10-K for the year ended March 31, 2008 and subsequent quarterly reported in Form 10-Q on file with the Securities and Exchange Commission.

Also in our discussion non-GAAP revenue excludes the effect of purchase accounting adjustments referring the fair value of Network General’s deferred revenue and non-GAAP net income excludes share-based compensation expenses, amortization of acquired intangible assets and integration expenses and related income tax adjustments.

I’d now like to turn the call over to Anil Singhal, our Chief Executive Officer.

Anil Singhal

Thank you, Cathy. We are very pleased to be reporting another strong quarter. As you’re aware, in early January we see (Inaudible) full fiscal year ‘09 guidance and strong guidance for fiscal Q3. Our third quarter financial results were above the preliminary guidance range on the revenue and EPS front. GAAP revenues were $72 million of 5% sequentially and up 34% year-over-year. Non-GAAP revenue was $74.2 million, up 2% sequentially and a year-over-year increase of 24%.

Our GAAP EPS was $0.02 above the high-end of our preliminary estimate and non-GAAP EPS was $0.01 above the high-end of our expectations. The GAAP profit for the quarter was $7.9 million or earnings per diluted share of $0.20. On a non-GAAP basis, net income was $11.1 million or $0.27 per diluted share.

Despite charitable donations of $100,000 to Habitat for Humanity, the Special Olympics and a local cancer center, lower operating expenses than originally expected rates EPS over our preliminary estimated range. Our high profitability is driven by continued margin improvements with our non-GAAP operating margins hitting a record 25%, driven principally by product cost improvement leading to a non-GAAP gross margin of 80%. GAAP operating margin was 18%, with related gross margin of 78%.

Last quarter, we raised our operating margin model by five points and we have already reached the high end of our new model, so we are executing well and according to plan. We’ll reexamine our long-term operating margin target again in the fourth quarter.

We are generating strong business results at a time when some companies are experiencing the affects from the slowing economy. Our strongest bookings came from the financial services sector with orders led by commercial banking and electronic exchange and high speed trading customers.

Telecommunication was strong with wireless carriers who are pursuing 3G and 4G network expansion, driven by the growing demand for Smartphone and network applications. Our net largest sector was government, healthcare and energy. We believe the long term market drivers of our growth remain intact across our significant vertical market as customers look for a solution like ours to overcome the challenges of managing the Modern IP Network.

That need to monitor and manage the increasing load of mission critical data in addition to voice and video continues to grow and the requirement for network up-time is approaching 100%, particularly for trading and wireless customers. These sectors are driving demand for NetScout products among our increasingly loyal customer base.

This is evidenced by the 90% of our business that comes from existing customers, expanding deployment of our solution. We continue to invest in our technology to support our customers with new functionality, particularly in the areas of high speed electronic trading and wireless mobile voice and applications. With the success of our acquisition and integration of Network General’s, we believe we have become the technology and market share leaders in the high performance and high availability application management market.

While we are cautious about the impact of the current historic global economic downturn on our business next year, we are entering our fourth quarter with solid visibility that gives us confidence in our increased guidance for fiscal 2009. We are carefully developing the outlook for the next fiscal year and we anticipate providing 2010 guidance in our year end earnings call in late April. We remain bullish about our prospects as we believe we have the solid technical, market, and financial position necessary, not only to weather the economic storm, but to gain market share in the coming year.

With that, I would like to turn the call over to David.

David Sommers

Thank you, Anil. Our quarter results are in the financial statements which are part of our earnings press release. We are reporting our results on a GAAP basis as well as the non-GAAP basis.

To summarize the difference we’ve removed the GAAP purchase accounting effects of the merger with Network General by adding back revenue related to deferred revenue revaluation and we have removed the cost and expense of various acquisition related items. In addition we have removed the GAAP effects of stock-based compensation, which increased significantly as a result of the acquisition. I’ll give you the specifics about the difference between our GAAP and non-GAAP earning as I discuss our results.

The adjustments to GAAP, revenue costs and expense are disclosed in the reconciliation table in the financial tables attached to the press release. We believe these adjusted financial measures will enhance the overall understanding of our current financial performance and our prospects for the future. We use these adjusted financial measures internally for the purpose of analyzing, managing and forecasting our business.

Our third quarter GAAP revenue was $72 million; non-GAAP was $72.4 million. Non-GAAP revenue excludes $2.2 million of purchase accounting adjustment to recorded fair value of the acquired Network General deferred revenue. Product revenue on a GAAP basis was $43.9 million, up 19% year-over-year and 9% sequentially. Service revenue on a GAAP basis was $29.1 million, up 65% year-over-year and a decrease of 1% sequentially.

Non-GAAP product revenue was $43.2 million, also up 19% versus last year and 5% versus the second quarter. Non-GAAP service revenue was $31 million, up 31% year-over-year and down 3% sequentially. Third quarter results from a year-ago include two months of contribution from Network General’s business and are therefore not fully comparable to the current third quarter.

GAAP net income for the quarter was $7.9 million, yielding earnings per diluted share of $0.20. Our GAAP net after-tax margin was 11%. GAAP income from operations was $13.3 million and GAAP operating margin was 18%.

Non-GAAP income from operations was $18.4 million and operating margin was 25%. The following items totaling $1.5 million are adjustments to arrive at the non-GAAP operating income. Purchase accounting adjustments recorded fair value and the acquired Network General deferred revenue of $2.2 million was added back to GAAP revenue. Amortization of required intangibles of $1.5 million, which was principally from Network General Acquisition was removed from GAAP cost and expense. Non-recurring integration expense of $280,000 was removed from GAAP expenses as was share based compensation of $1.2 million.

Non-GAAP net income was $11.1 million or $0.27 per diluted share. Non-GAAP net after tax margin was 15%. We've used the statutory tax rate of 38% to tax effect the $1.5 million total non-GAAP adjustment amount, removing $1.9 million from GAAP tax expense. The non-GAAP adjustments to our GAAP results are summarized in the reconciliation table included with our press release and financial statement.

The provision for income taxes reflects an affective tax expense rate of 34% on a GAAP basis and 35% on a non-GAAP basis. The non-GAAP tax expense rate is calculated by taking the previously calculated GAAP rate of 34% and tax affecting the non-GAAP adjustment to statutory 38% rate, resulting in the overall non-GAAP rate of 35%.

Our GAAP gross profit for the quarter was $56 million. GAAP gross margin was 78% from the quarter. On a non-GAAP basis, gross profit was $59.2 million and non-GAAP gross margin was 80%. We made the following adjustments to non-GAAP gross profit; $2.2 million was added back from revenue, we removed $84,000 of share-based comp expense, $995,000 of amortization of required intangible assets and $37,000 of non-recurring integration expenses.

Gross margin improved this quarter because of the realization of cost reductions that we've been making over the last several quarters to legacy Network General Product hardware and by extents into the newly integrated hardware platforms. We anticipate that these and other cost improvements will continue to benefit gross margin going forward.

Non-GAAP operating margin of 25 points was a new record high for us in the post dot com bubble era. It's the result of our steady margin expansion over the last six years, which we've achieved through organic and acquired revenue growth, combined with diligent cost and expense management. In the third quarter that same combination of revenue growth plus non-revenue related expense containment drove operating margin up another three points from last quarter to the high-end of our revised operating margin target range.

As Anil mentioned, we raised our operating margin model last quarter by five points and we’ve already reached the high-end of that new modal range. We’re in the process of reexamining our long-term margin model and we may report new target ranges in the fourth quarter.

Our current model is the following: Non-GAAP gross margin is 76% to 79%; R&D expense to revenue is 13% to 15%; sales and marketing expense is 33% to 35%; and G&A expense is 6% to 8%, yielding an operating margin target range of 22% to 25%.

Our Q3 non-GAAP results, with an operating margin of 25 points is obviously at the high-end of that range and we expect the revenue level required to achieve our operating margins will slowly grow overtime, wherein inflation pushes our cost and expense levels higher. However, the Q3 revenue at $74 million currently marks the high-end of that revenue, thehigh-end of the target range.

Because of our historically strengthening operating performance, our balance sheet remains strong. Cash and short-term and long-term marketable securities were $119.2 million, compared to $109.4 million in the previous quarter, up almost $10 million. Our long-term marketable securities include investments and auction rate securities now valued at $30.7 million.

As of March 31, 2008, the value of these securities includes a temporary decline of $2.4 million below par value to reflect liquidity concerns. All these securities are related A or above, a government guaranteed student loan-backed securities, which we believe we had no credit issues, only short-term liquidity issues. We've classified these securities as long-term on our balance sheet and recorded a temporary decline in value to accumulate it, other comprehensive income and loss on the balance sheet.

With our strong cash position, positive cash flow, the illiquidity of these securities posses no liquidity problems for us and we believe that we will achieve liquidity well before the maturity of the underlying bonds and our temporary valuation adjustment reflects that outline.

Accounts receivable net of allowances was $45.9 million, up from $26 million last quarter. Day sale outstanding was 57 days for the quarter based on GAAP revenue and above our typical DSO range of 40 to 50 days; this is up from 33 days in the prior quarter, although it’s down from 60 days in the year ago quarter. Using non-GAAP revenue, DSO was 56 days. Inventory was $7.9 million, up from $7.3 million in the prior quarter. Turns were 3.8 times.

Turning to other metrics, revenue contribution from direct customers was 36% and reseller revenue 64%. Revenue from international sales was 23% of total revenue, up from 22% last quarter. Europe and Middle East and Africa were 11 points, Asia was 5 points. Americas outside the U.S. was 7 points. The main drivers of international business outside the U.S. were the wireless service provider and financial services sectors.

Summarizing large deals that we booked in the quarter, 134 customers gave us orders over $100,000 and that’s down slightly from 140 in the second quarter. 20 customers gave us orders over $500,000 and nine orders over $1 million. Of the $1 million orders, five came from financial services, two from wireless telecom carries, one from energy and one from healthcare. Of the five financial service customers, three were commercial banks and two were electronic trading.

The third quarter has been our seasonably strongest quarter ever over the last several years and we expect it to remain sort of true this year. We continue to see strong bookings coming from the financial services sector with 30% of order dollar volume, telecommunications sector was very strong with 27%, government was 13%, healthcare was 7% and energy was 6% of orders.

As of December 31, our product backlog and product deferred revenue totaled $20 million, down from $25 million last quarter. Last quarter, when we began to report backlog, we reported a $23 million product backlog. This quarter we’re expanding this measure of future product revenue in hand to include product revenue which is deferred revenue on the balance sheet, because in some quarters, including this one, product deferred revenue can be significant in relation to the product backlog.

We will not break out the two categories because the difference is not meaningful in terms of our future revenue visibility. This quarter we consider the product backlog to be firm in the sum of the product backlog and product deferred revenue to be material to the understanding of our financial results and guidance.

Now for the guidance; we are reaffirming our outlook which we raised a couple of weeks ago on January 6. For the remainder of the fiscal year 2009, ending March 31, we raised GAAP revenue to be in the range of $266 million to $274 million and non-GAAP revenue to be in the range of $278 million to $286 million. This guidance implies that the fourth quarter GAAP revenue will be in the range of $64 million to $72 million and the non-GAAP fourth quarter revenue range of is $66 million to $74 million.

GAAP net income per diluted share for the 2009 fiscal year has been raised to $0.44 to $0.54. Non-GAAP earnings per diluted share have been raised to $0.81 to $0.91. The implicit fourth quarter GAAP EPS range is $0.09 to $0.19 and the non-GAAP range is $0.15 to $0.25.

The fiscal year 2009 non-GAAP revenue and net income per share estimates include a purchase accounting adjustment to fair value of approximately $11.8 million of Network General’s deferred revenue, amortization of acquired intangible assets of approximately $6 million, integration expenses of approximately $1.7 million, share-based compensation expenses of approximately $4.8 million and the related impact of these adjustments on the provision of income taxes of $9.3 million.

That concludes our financial discussion this afternoon, our prepared remarks. Thank you for joining us and we look forward to taking your questions. Kristy would go ahead please.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Mark Kelleher from Canaccord Adams, your line is opened.

Mark Kelleher - Canaccord Adams

Thanks. Congratulations, navigating a difficult environment out there.

David Sommers

Thank you, Mark.

Mark Kelleher - Canaccord Adams

First question, the gross margin seems to be very strong. Can you tell us what your pricing power is out there; tell us about the competitive environment. Who are you winning against and how long do you think that pricing advantage can stay?

David Sommers

Well Mark, we don’t really talk in an open forum about pricing power. We did as you know, I think raise prices in a small amount at the beginning of this fiscal year when we reset our product list, our price list for our products and integrated product lines.

Pricing and discounting in customer situations, particularly with our situation where we have long established relationships with our major customers, is not really so much a competitive issue as it is an issue of delivering price to value for our customers. So we don’t have an awful lot of head-to-head price competition, because that’s not the way many of our deals, most of our deals work.

There are always competitive situations in which that what I said is generally not true in specific circumstances, but I think you can take away from this that we are not seeing pricing pressure, but you should not take away from this that we feel we have substantial pricing power to raise prices for our customers.

Mark Kelleher - Canaccord Adams

Alright and on the balance sheet, can you just talk about why the receivables jumped up a bit?

David Sommers

Yes. There can be two dynamics going on there: one, in the third quarter of every year, it’s of course the December year-end for many customers and that is often the time when many of our customers synchronize their maintenance renewals. So, they make the renewals occur at the beginning of their budget year.

When that happens and we get a renewal in the end of December, we of course bill it and receivables go up, but revenue does not, because the revenue occurs ratably over typically the next year. So, that really skews DSO in every Q3 and as I mentioned a year ago, DSO was 60 days, so it’s comparable to where it is today.

We also had some back end of shipments at the end of the quarter as we were trying to deal with customer needs to get shipments at the end of their budget years. So that phenomenon back ended some of our product shipments as well as in addition to the maintenance renewal issue; it’s really those two things.

In Q2, we had that large revenue recognition that we discussed in October; the large telecom customer who had already accepted and paid for the products and we under the DSA, the software rent rules, we recognized the revenue in September. That was revenue without receivables and so that unusually depressed the Q2 DSO number down to 33 days. So, it was two effects, one on each end that makes the comparison look stark, but it’s really, the Q3 quarter is really pretty normal.

Mark Kelleher - Canaccord Adams

Alright and last question, cash flow from operations?

David Sommers

Cash flow from operations, I had it right here and I left the sheet in my office. So we’re going to have to go get it, because I was prepared for that question, but…

Mark Kelleher - Canaccord Adams

Okay.

David Sommers

I will get it for you and I’ll announce it as soon as we get the data. My apologies for that.

Mark Kelleher - Canaccord Adams

No problem. I’m all set. Thanks.

David Sommers

Okay, thanks.

Operator

Our next question comes from the line of Eric Martinuzzi from Craig Hallum; your line is opened.

Eric Martinuzzi - Craig Hallum

Thanks. Congratulations from me as well on the performance in the December quarter. The verticals you’re seeing, wireless carriers, I guess I shouldn’t call it wireless carriers; it’s Telco as you put it, that at 27% to me was sort of the biggest mover amongst your verticals. I’d like to know your thoughts on where those verticals play out and specifically Telco financial and government? Right now I’ve got financial at 30, Telco at 27 and government at 17. How does that play out? Is there a point where financials actually could become no longer the dominant part of the verticals?

Anil Singhal

Yes, I think it’s possible and that financial may become number two instead of number one, but we think it’s going to be still high for certain applications which David talked about, trading customers and the commercial banks.

So, right now we continue to see interest even though several large customers are having issues and financial is a broad category. I think if you just look at commercial banks and trading customer rather than just the traditional data center deployment in those places, I think we’ll continue to do good, but it’s possible that it becomes number two instead of number one, unless it’s already number two this quarter, financials and sometime a large order can make a big difference and that was the case this time.

Eric Martinuzzi - Craig-Hallum

Okay and then as far as -- I know you’re paying close attention to your customers. I’m interested particularly on the enterprise side. You talked about your top three verticals explaining 74% of the product sales. What about that other 26%? What is the enterprise telling you?

David Sommers

We are seeing slowing down in the enterprise as many other customers, many other vendors are. We expect to see the concentration in the major verticals, including government on the top three continue, because they are the ones whose funding is generally going to be available, even in the down market or to say it in another way, less affected by the economic difficulties. So in the enterprise space, retail manufacturing, distribution, we expect to continue to see weaknesses.

Eric Martinuzzi - Craig-Hallum

Thank you.

David Sommers

You’re welcome. If I can just interrupt I have the answers to Mark’s question. Operating cash flow in Q3 was $11.8 million. Some of you may be interested in CapEx, which was $800,000. Depreciation was $1.9 million; amortization of acquired intangibles and our GAAP results, $1.5 million. I hope that’s what you were looking for. Kristy go ahead, please.

Operator

Alex Kurtz from Merriman, your line is opened.

Alex Kurtz - Merriman

Thanks. Congratulations on the quarter again. Dave, just again a question on the gross margins. Just about sustainability, obviously a big up-tick here this quarter on the product side. Can we expect to see this continue for the next couple of quarters or is there a very specific reason why we wouldn’t expect it to stay at these levels?

David Sommers

There is nothing specific, Alex. We, as we’d remarked the cost reductions, cost improvements that we’ve made to the products over the last couple of quarters are really driving this. You will note probably that our long-term gross margin model tops out at 79% and we hit 80%.

So, we are looking at that in the fourth quarter and as we said, I don’t see anything today that would cause strong gross margins not to be sustainable, but we are looking at it to see whether or not it is inconsistent with our long-term model and our model has to change or not.

Alex Kurtz - Merriman

The next question; in the past you’ve spoken about how NetScout won’t see the slowdown in the economy because you guys have sort of a lagging affect with your projects and your customers. Now, that something you guys have been talking about for almost a year now. Do you feel like that may not be the case as much as you maybe thought it was a year ago or do you still feel like there is a boogie man out there and it just hasn’t caught up with you guys yet, because you’ve talked about that a couple of times in the past.

David Sommers

Yes. Well, of course the lag affect is a lag, right. Eventually it catches you and what we’ve been saying is our projects, because they tend to be strategic to our customers and budget cycle based, tend to continue to stick, although they can be delayed etc, as happens with others.

We see nothing I think in the longer term beyond the obvious and each sector is different. Government is spending more money, but maybe not so much in defense. Wireless volumes continue to be okay, although there may be some doubt growing about that, about the subscriber volumes. High speed trading seems to be continuing strongly. So those things, those underlying trends haven’t changed, but the lag affect of impact to our customers, we will feel eventually and what we said today is we have good visibility in Q4 and we’re still looking at fiscal '10.

Alex Kurtz - Merriman

Okay and then a question to Anil. Riverbed made an announcement on Mazu networks and I want to get your take on that. Obviously, they are company that was focused on similar technologies to you guys and then my final question is China has announced a major investment in their 3G infrastructure; I think over close to $30 billion. Are you guys looking to participate in that? Thank you very much.

Anil Singhal

Yes, so I think just to over the comment about Mazu, if you look at the size of the company versus our revenue, it's what about 1/15 of our size. Clearly, we were not seeing any big competition from them and Riverbed still wants to continue with the partnership, that they have with NetScout. So I don’t see any short-term impact because of this and they talked about the reasons for that position and we also know the reason for continuing with the partnership with NetScout. There has been very little competition from Mazu for NetScout or from Riverbed and I think that will continue.

David Sommers

I had one thing to add to that. I think the Riverbed-Mazu deal is an indication of the growing interest and importance of the instrumented monitoring and measurement that we have been a pioneer in and we think are the leader in. It’s not for win optimization obviously as Riverbed, but for performance and so it's not a surprise to us that others in the industry are starting to concentrate more in this space. It's not the only acquisition that we've seen or the change that we've seen, re-focused that we’ve seen amongst some nearby players and probably won't be the last.

Anil Singhal

And I think the second question was about 3G to 4G transitions and yes, that's one of the areas of investment and WiMax in particular with many of the vendors who have declined that is an interest.

Alex Kurtz - Merriman

Alright. Thank you very much.

Operator

Our next question comes from the line of Jonathan Ruykhaver from ThinkEquity Partners, your line is opened.

Jonathan Ruykhaver - ThinkEquity Partners

Hi. Congratulations on the quarter.

Anil Singhal

Thank you.

Jonathan Ruykhaver - ThinkEquity Partners

Were there any 10% customers in the quarter?

David Sommers

No, there were none.

Jonathan Ruykhaver - ThinkEquity Partners

No. Okay. The activity that you're experiencing in the Telecom vertical, I'm just wondering if we can get a little bit more color on the applications your product is supporting. I assume it's around converged wireless networks, but more color would be helpful, especially I think as it relates to where we are in the spending cycle; how sustainable is that growth that you've experienced recently?

Anil Singhal

First of all, I think we have spoken in the past of what’s happening to the wireless service provider. They are moving from -absolutely call it analog to digital and to IP networks and we have started calling it the modern IP networks. So, they are modernizing the networks. The technology they're using is really similar to what we have been supplying to enterprise.

So because of that, I think there is lot of interest in what we are doing, but not a big investment for us to go into that market. So we think that that will continue for some time at least and while we are a little bit cautious about the financial vertical, I think we see a lot of scope in the service provider and the wireless Telecom carriers.

Jonathan Ruykhaver - ThinkEquity Partners

You mentioned I believe, Dave, two deals over $1 million in that vertical. Were those with new customers? Just trying to get a sense for whether or not there is new activity or if this is follow-on type deployments?

David Sommers

Both of those were with customers that we already had beachheads with, substantial customers, household name customers that we already had beachheads with. What that represents is in one case substantial commitment and expansion of the deployment and in another case, sort of a continuation of the regular pace of deployment, not brand new customers.

Jonathan Ruykhaver - ThinkEquity Partners

Okay. On a different subject, Dave I think you mentioned that the growth in the quarter, the 24% top-line growth included two months contribution from Network General in the prior year period. Did you know what the organic growth was?

David Sommers

No. We haven't actually parched it out and we're not going to, so forgive us for that.

Jonathan Ruykhaver - ThinkEquity Partners

That’s fine. I guess that leads into my next question. If you do look at growth in fiscal ‘09, there’s certainly been an acceleration from historic trends if you look back to 2007 and I’m just trying to think of the growth profile as we look at our models, thinking about fiscal ’10. Should we assume that the strength on the Telco side tapers off and we turn it back to a more historic rate; and you think that that’s going to be somewhat, it sounds like you did think it’s going to be somewhat sustainable, but obviously you to offset it with financial services slowdown.

David Sommers

Well, obviously there is slowdowns in financial services and other enterprise verticals for the short-term, right. We think the trends in wireless; high speed trading and government are working positive and that we have opportunities there as well as in the other verticals when they come back. We think there are great opportunities in healthcare, particularly with some of the government initiatives to support data exchange in healthcare going forward and the potential investment by the government in those initiatives.

So a lot of the verticals that we’re focused on, we think were there because we think that’s where the potential growth in the market is and that includes wireless as Anil just said, significantly. So, we think the wireless business, the rollout of applications and services over 3 and 4G networks is in its very beginning and is nowhere near maturity and the deployments of our products and those of our competitors in the space are not by any means complete and won’t be for years.

So we think there is lots of growth potential, the issue is the short-term, the next several quarters of economic turmoil and how will that work out and that’s everybody’s guess; do you have any ideas?

Jonathan Ruykhaver - ThinkEquity Partners

No, no, but that’s good color, I appreciate that. I guess just one final quick question. There is a small company calls Procera Networks that appears to be delivering on a capability that sounds similar to NetScout in the Telco market; are you familiar with that company? Have you ever seen them in competitive situations?

Anil Singhal

No, we have not seen that. We see Techtronics, which is now part of Danaher, Agilent, Radcom, an Israeli company and we see those companies and a couple of local ones in Europe, but we’ve not heard of the one you’re talking about.

Jonathan Ruykhaver - ThinkEquity Partners

Okay, thanks again. Great quarter.

David Sommers

Thanks John.

Operator

Our next question comes from the line of Scott Zeller with Needham and Company; your line is open.

Scott Zeller - Needham and Company

Thanks. Just to follow up on the previous question about Riverbed and Mazu. At this point is NetScout generating any material revenue from that partnership?

David Sommers

No. Nor had we really anticipated that it would be a material growth market relationship for us. It’s really an accommodation for our joint customers to add value to both solutions. In the case of the NetScout Solution, we now with coordination and cooperation with Riverbed can show our customers the effects of the Riverbed appliances and look into the Riverbed optimized data stream for them that we couldn’t do without that collaboration with Riverbed.

So that will continue we believe, but it was never thought of by us and I think by Riverbed as a significant driver of incremental revenue. Who knows what the future would hold, but that was not the purpose of it.

Scott Zeller - Needham and Company

Okay. Regarding the Telco wireless carrier crowd, we’ve heard previously about targeting tier 1 and tear 2. Could you give us a rough sense of where the revenue is? Like when you look at that verticals contribution as a bucket, of that bucket of revenue, how much of it would you say is currently coming from tier 1’s versus the rest, if you can comment?

Anil Singhal

I think most of it started coming from the tear 1, especially the IT’s obviously and even internationally, China and other places coming from tier 1.

David Sommers

Those tend to be you guys who push the technology envelope the hardest? The guys who roll out the smart phones with a big splash and they’re the tier 1’s and they’re the ones who are willing to spend significant amounts to make sure that the services they roll out on the Smartphones are performed.

Scott Zeller - Needham & Company

Would you characterize the current contribution from tier 1 as early in the cycle?

David Sommers

Yes.

Scott Zeller - Needham & Company

Okay and the last question is, I ask this every quarter, but regarding cross-selling, is there any sort of informal commentary you could offer about cross selling into the historical separate NetGen and NetScout customer bases?

David Sommers

It’s just beginning, right. As we delivered as you know, the integrated product solution, the hardware platform that we are in and the software that runs on it, that integrates the function, that’s really the first time that salesmen and customers could seriously begin to engage and seeing the value of the integrated function starting the cross-selling. So it’s just beginning. All that opportunity is still in front of us.

Scott Zeller - Needham & Company

Are you commenting yet on when that might become material?

David Sommers

Well, we’re anticipating it in FY ’10, alright. When things begin, this is an education process. Our cell is a collaborative cell and so we consult it; when we go in and talk to customers they examine the things we tell them, we show them; they think about it and they give us an order, and maybe two quarters later, three quarters late it becomes a piece of business for us. And so although we’ve been talking to them about it, with these big customers, high speed trading and wireless carriers, they typically want to see it, alright.

Talk is good, but show me and so even though we have trusted relationships, these are big investments and commitments for them and they want to see it and so they’re now just starting to see it, see the beginnings of it, right. This functionality to further integration is going to continue to roll out as we enhance the technology.

So it’s just beginning and you would expect to see impact in fiscal ‘10. That’s one of the things that lifts our outlook for fiscal ‘10, despite the economic issues, the external issues, because we are off the good results we’ve been having, we are just about to see the impact of that cross-selling coming in the maybe not next quarter, but the quarter beyond that and the next beyond that.

So, as we look at it, we listen to the external pundits talking about maybe growing economies again in the second half of calendar 2009. That corresponds to the middle of our fiscal year, so maybe the second half of our fiscal year we’ll start to see some growth and maybe fiscal ‘10 will be not all that much worse than fiscal ‘09 for us in terms of the economic market or maybe it will, that’s the uncertainty. But layered on top of that we have the strength of our underlying verticals, the ones we’ve talked about already, plus the dynamic of this new functionality that we’re just beginning to take advantage of.

So that’s why we said we think we have the opportunity to do better than the market, to gain market share, to gain from this downturn as others are perhaps not so well positioned.

Scott Zeller - Needham & Company

Thank you.

David Sommers

You bet.

Operator

Our next question comes from the line of Manny Recarey from Kaufman Bros; your line is opened.

Manny Recarey – Kaufman Brothers

Thanks, not to beat a dead horse here, but on the wireless side, I mean looking more at near term; I mean it’s fair to assume that they have not come back to you talking about delaying or pushing out any CapEx, because if you look at the CapEx expectations of the service providers in general, it seems like the December quarter was fairly soft and the people were looking and the outlook for the rest of this year is also for a kind of softness. So it’s fair to assume that they have not come back to you with any change?

Anil Singhal

Well I think there is. We are not seeing those pressures, but one thing I wanted to add. While the Telco sector or the wireless sector is looking good for us, as we are increasing our deal sizes there, we’re going to see more competition also. So, we think in that area, maybe that’s going to be a bit bigger affect than the CapEx spending.

David Sommers

So far, our sense from the customers is that they are still building out these infrastructures and competing on new services and application service availability, reliability performance and so far we’ve not gotten the sense that they’re slowing down. There may be other areas of capital spending that aren’t involved in new services, over 3G and 4G networks that they are going to cut back on. But as long as the that appears to be, as long as the Smartphone application traffic networks are the demands are growing and the ranges that we’ve been hearing, 40% a year of growth, that they’re going to spend to try to gain share in the market, each of these major Tier 1 players.

So, we think we are in wireless as well as in financials; we’re narrowly focused on some of the growth verticals, the growth areas of those larger sectors and so when you see or hear that some of the sector maybe flat or maybe down, that doesn’t necessarily apply precisely to the businesses, the narrow business sector that we served served.

Manny Recarey – Kaufman Brothers

Okay, thanks. On the services revenue, its my understanding correct that this March quarter is the last quarter where we’re going to have GAAP and non-GAAP revenue?

David Sommers

Essentially that’s true, yes. By the March quarter, the difference between the two will have narrowed to almost the point of insignificance. We will still have amortization of intangibles and stock-based comp that we will be talking in non-GAAP terms, but the revenue will be pretty much converged.

Manny Recarey – Kaufman Brothers

Okay. So, then thinking about the service revenue, looking at the non-GAAP level -- as we look into fiscal ‘10 from a modeling purpose, we can assume that would be a kind of a base rate to kind of look at.

Anil Singhal

Which would be a base rate?

Manny Recarey – Kaufman Brothers

In looking at the non-GAAP service revenue in the December quarter and then whatever estimate is for the March quarter, kind of carry that?

David Sommers

Yes, I think that’s a reasonable base, yes.

Manny Recarey – Kaufman Brothers

And one last question. I know you’re not giving guidance, but just from a conceptual perspective on kind of your OpEx, as you look into the next fiscal year, I mean there’s no major investment that you have to make where you see any significant ramp up in your OpEx?

David Sommers

No. We don’t anticipate any.

Manny Recarey – Kaufman Brothers

Okay. Alright, thanks.

David Sommers

Thank you.

Operator

Our next question comes from the line of Rohit Chopra from Wedbush Morgan; you're line is open.

Rohit Chopra – Wedbush Morgan

Thank very much; a couple of questions. One, I just want to come back to the operating margin target that you said you’re going to take a look at because you’re already at the high-end of the range and I know you do not want to get into everything here, but where can you squeeze out a little bit more expense, because I know you were embarking on that? I think you mentioned that last quarter. So, I just want to get a sense of where there is still room to push out a little bit.

David Sommers

I think if you look at our operating expense performance, you’ll see that it’s pretty flat. What we’ve really done with operating expenses is contain expenses, manage to low growth or no growth and that’s really our plan going forward. This is not a commentary on our guidance for fiscal ’10, but that’s been our strategy and our plan going forward into Q4 and to achieve operating margin expansion through gross margin expansion, and if you look back at our increased operating margin targets structure that we talked about in October, what we really did there was to raise the gross margin target three points and that flowed through to operating margin.

We didn’t really change the operating margin line item targets at all and so volume and scale allows us to both increase the leverage of operating resources and to increase our leverage over our costs, including our components cost where we can negotiate better arrangements with suppliers with larger volume and that’s really what we’ve been doing for sometime.

So, it’s not coming back to try to squeeze operating expenses; although of course we’re very cautious about growth of those, but we’re not going to -- we shouldn’t look for, think about any large expense cuts from us.

Rohit Chopra – Wedbush Morgan

Okay, thanks and then I had one other question and everyone asks this very often, but HP does have an announcement scheduled at the end of January or early February and they’re going to talk about some of the partners that are involved in this new product announcement and I wanted to know, has there been any positive change with the go-to-market strategy on the HP side?

Anil Singhal

Well they continue to have interest in what we are doing with them and we in every release add support for HP and further integration. So, I don’t know what announcement that you’re talking about, but we have good partnership with HP, but they’re not a general partner or they’re not really selling our product, but there is cooperation in the field.

Rohit Chopra – Wedbush Morgan

Okay. Thanks guys.

David Sommers

Okay. Thank you very much.

Operator

We have no further questions in queue.

Anil Singhal

Alright, well thank you very much. We appreciate your time and interest in NetScout and we hope to talk to you again in 90 days at our next earnings call. Have a good evening.

Operator

This concludes our conference call for today. You may now disconnect your line.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

This Transcript
All Transcripts