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NetScout Systems Inc. (NASDAQ:NTCT)

Q3 2010 Earnings Call

January 21, 2010 04:30 p.m. ET

Executives

Cathy Taylor - Investor Relations

Anil Singhal - President and CEO

David Sommers - CFO

Analysts

Alex Kurtz - Merriman & Co

Jonathan Ruykhaver - ThinkEquity

Mark Kelleher - Brigantine Advisors

Eric Martinuzzi - Craig-Hallum

Scott Zeller - Needham & Co

Rohit Chopra - Wedbush Securities

Gabe Lowy - Noble Research

Alex Kurtz - Merriman & Company

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to NetScout third quarter of fiscal year 2010 operating results conference call. (Operator Instructions).

With us today is NetScout’s President and CEO, Mr. Anil Singhal. He is accompanied by NetScout’s Chief Financial Officer, Mr. David Sommers; and NetScout’s 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 2010 conference call for the period ended December 31st. 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, David or Michael 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 the 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 21E of the Securities and Exchange Act, 1934 and other Federal Securities Laws.

These forward-looking statements may involve judgment and individual judgments may vary. Forward-looking statements include expressed or implied statements regarding future economic and market conditions. Our guidance for fiscal year 2010 and our new product releases. It should be clearly understood that the projections on 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 quarterly earnings call. We do not plan to update that guidance otherwise. 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 the further discussion of the risks and uncertainties that could cause our actual results to differ, see the specific risk and uncertainties discussed in NetScout’s annual report on Form 10-K for the year ended March 31 2009 and subsequent quarterly reports on Form 10-Q on file with the Securities & Exchange Commission. Also in our discussion non-GAAP revenue excludes the effect of purchase accounting adjustments representing the reduction to fair value of Network General’s deferred revenue and non-GAAP net income excludes share-based compensation expenses, amortization of acquired and tangible assets, costs and expense of various acquisition related items and related income tax adjustments.

I will now turn the call over to Anil Singhal, our Chief Executive Officer.

Anil Singhal

Thank you, Cathy. Today we are reporting our third quarter results of fiscal year 2010. This quarter, our results were sequentially strong and consistent with the full year guidance that we first issued in April and then revised last October. Our guidance has been based on the belief that bookings and revenue would accelerate significantly in the second half.

In Q3, that happened as we expected. Third quarter GAAP revenues were $70.7 million and non-GAAP revenue were $70.9 million, both up 18% sequentially. Our results reflect seasonality and end of the year budget, plus combined with that we believe is the beginning of an improving economic climate. These factors have affected bookings as expected, except for a slower than anticipated improvement in the general enterprise sector of our business.

We are narrowing the range of our full-year revenue guidance today with only one quarter left maintaining the lower end of the range. More importantly our strong booking in the quarter confirm our confidence in our market position and in the long-term growth prospect in all of our vertical markets. We continue to target high teens percentage annual bookings growth going forward.

Third quarter bottom-line results were also strong reflecting a discipline focus on expense control to maintain our strong margins and cash flow. GAAP net income for the quarter was $8.5 million, up 21% sequentially with earnings per diluted shares of $0.20.

Non-GAAP net income was $10.3 million, up 14% sequentially with earnings per diluted share of $0.25. GAAP operating margin was 20% flat sequentially, non-GAAP operating margin was 24% down one point sequentially. These margins reflect our commitment to invest prudently in growth while continuing to target our long-term non-GAAP operating margin model of 24% to 27%. This strong financial performance has enabled us to raise once again the low end of our fiscal year 2010 EPS guidance. David will give you those specifics in a few moment.

We saw strong orders coming from our wireless service provider customers making that vertical our largest bookings contributed for the first time. The telecommunication sector combined with our high growth verticals of financial services and government accounted for 70% of total bookings. Our investment strategy focused on expanding our competitive advantage to accelerate growth across all our verticals including the enterprise sector.

Our goal is to increase market share with innovative technologies and new products and to expand our market reach with a larger sales force and most of active channel partner. We are facing a rapidly expanding opportunity in the wireless service provider phase and we are working on tailoring and enhancing our product with new functionality focused on carrier specific needs.

Our product solution is ideally suited to the wireless service operator environment. Major service provider continue their massive transformations from predominately [circuit-based] infrastructure to converged higher speed packet switch infrastructure in order to support the skyrocketing data traffic from smart phones and the multiple services that are rapidly appealing. Network capability is being expanded to support the bandwidth hungry applications today in the 3G network.

That expansion will continue in 4G network roll out over the next several years. 4G will expand the use of IP technology form the core of the network out to the EDGE expanding our market opportunity substantially. The result is large scale complex service delivery network requiring solutions like ours that can monitor IP services and provide customer service assurance. Today rich servicing offering and high service quality are the key differentiators for carriers in acquiring and maintaining customer.

NetScout's products are uniquely positioned to solve problem of growing complexity in their network by monitoring the behavior of the application from additional byte performance down to the individual customers experience.

Last quarter we launched a new product nGenius(NYSE:R) Subscriber Intelligence. Subscriber Intelligence is an [add on] software module that provides wireless operator a comprehensive fashion oriented view of the cell phone subscribers experience for voice, video and data services.

Continuing our service root provide the product live, we plan to release our large powerful service provider focus inclusive product in the fourth quarter of fiscal 2011. We will continue to enhance our service provider solutions as our customers move towards 4G implementation and launch additional revenue generating services over the next several years. There are more growth opportunities for us in cloud computing and virtualization environment. We recently released the nGenius Virtual Agent, a software product that provide a high performance packet flow monitoring deep into the virtualized data center enabling IT organizations the ability to regain end-to-end visibility of application traffic from within virtual server.

In addition, we're working on opportunities in the financial services sector where infrastructures are being upgraded and new data centers are coming online to support high-speed low latency [trading]. We are taking advantage of partnership of opportunities and expanding our relationship with Cisco in a number of different areas. We expect to unveil a new product this quarter, but Cisco has new borderless network initiative, they announced earlier in November. We are currently participating in Cisco in wireless LAN and unified communications area with our newly enhanced Sniffer Global products. In addition, to of our products nGenius Performance Manager and Sniffer Intelligence have been certified to support Cisco's Voice-over-IP installation.

In summary our partnership efforts combined with growing success of crossover vertical markets have strengthened our 12-month pipeline and have given us improved visibility into our fiscal 2011 that starts in April. We continue to expect the economy IT spending a competitive position to improve throughout fiscal 2011 supporting our drive to high teens, high teens percentage revenue growth. We have a vision, the market leading products and the talent base to take advantage of the significant opportunities ahead of us. And we are committed to maintaining NetScout leadership position in the market. We look forward to sharing our accomplishment with you again next quarter.

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

David Sommers

Thank you Anil. Our quarterly results are in our earnings press release financial statements. We report our results on a GAAP basis as well as on a non-GAAP basis. Our non-GAAP results eliminate the GAAP purchase accounting effects of the acquisition of Network General, by [adding] back revenue related to deferred revenue evaluation and removing the cost and expense of various acquisition related items.

In addition, we removed the GAAP effects of stock-based compensation which increased significantly as a result of the acquisition. I will give you the specifics about the differences between GAAP and non-GAAP as I discuss our results. These differences are disclosed in a reconciliation table and the financial tables attached to the press release. We believe these adjusted financial measures will enhance your 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. For the third quarter, GAAP revenue was $70.7 million and non-GAAP revenue was $70.9 million. Non-GAAP revenue excludes $209,000 purchase accounting adjustment to reduce the fair value of the acquired Network General deferred revenue. Product revenue on a GAAP and non-GAAP basis was $40.8 million, GAAP down 5% year-over-year and non-GAAP down 6% year-over-year with both up 33% sequentially.

Service revenue on a GAAP basis was $29.9 million, up 3% year-over-year and up3% sequentially. Non-GAAP service revenue was $30.1 million, down 3% year-over-year and up 2% sequentially. GAAP income from operations was $13.8 million. GAAP operating margin was 20%. GAAP net income for the quarter was $8.5 million yielding an earnings per diluted share of $0.20. GAAP net-after-tax margin was 12%. Non-GAAP income from operations was $16.7 million and operating margin was 24%.

The following items totaling $2.9 million are adjustments to arrive at the non-GAAP operating income. The purchase accounting adjustment to reduce the fair value of the acquired Network General deferred revenue of $209,000 was added back to get revenue. Amortization of acquired intangible assets of $1.5 million which was principally from the Network General acquisition was removed from GAAP cost and expense. Share-based compensation expense of $1.2 million was removed from GAAP expenses.

Non-GAAP net income was $10.3 million or $0.25 per diluted share. Non-GAAP net-after-tax margin was 15%. We have used the statutory tax rate of 38% to tax affect the $2.9 million non-GAAP adjustment amount, adding $1.1 million to GAAP tax expense. The non-GAAP adjustments to our GAAP results are summarized in the reconciliation table included with our press release financial statements.

The provision for income taxes is recorded based on the full year effective tax rate of 34% on a GAAP basis and 35% on a non-GAAP basis. Our GAAP gross profit for the quarter was $55.3 million. GAAP gross margin was 78% in the quarter. On a non-GAAP basis, gross profit was $56.6 million and gross margin was 80%. We made the following adjustments to non-GAAP gross profit. $209,000 was added back from revenue. We remove $78,000 of share-based compensation expense and $995,000 of amortization of acquired intangible assets. GAAP and non-GAAP gross margin were comparable to last quarter. Gross margin remained strong due to continued cost improvement and improving product mix, despite slightly higher discounting from a higher number of very large deals in our Q3 revenue. We expect non-GAAP gross margin to remain in our long-term target range for the rest of the year.

Our current long-term model remains as follows, non-GAAP gross margin is 78% to 81%. R&D expense to revenue is 13% to 15%. Sales and marketing expense to revenue is 33% to 35% and G&A expense to revenue 6% to 8% yielding an operating margin of 24% to 27%.

This quarter we once again approached that range. In the future as we invest in driving revenue and return to sustainable expense levels, we expect that higher revenue levels will be required to achieve our target margin range. Our balance sheet remained strong. Cash in short-term and long-term marketable securities were $151.3 million compared to $142.8 million as of the end of the prior quarter, up $8.5 million. Long-term marketable securities include investments and auction rate securities valued at $28.5 million. As of December 31 2009, the value of these securities includes a temporary decline in value of $3.9 million below par to reflect liquidity concerns.

All of these securities are A rated or above by Standard & Poor’s with underlying support by the federal government through the Federal Family Education Loan program. We believe they have no credit issues, only short-term illiquidity. We have classified these securities as long term on our balance sheet and recorded the temporary decline in value to accumulated other comprehensive loss on the balance sheet.

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

Because of our strong cash position and cash flow in the second quarter this year, our Board approved a reinstatement of our previously authorized stock buyback program. This authorization has 3.5 million shares remaining. We did not buyback any shares during the quarter. Accounts receivable net of allowances was $57.7 million up from $33.2 million last quarter. Day sales outstanding were 74 days for the quarter based on GAAP and non-GAAP revenue which is well above our typical DSO range of 40 to 50 days.

It's up from 49 days in the prior quarter based on GAAP and 48 days using non-GAAP revenue. This increase in DSO is due to a high order flow at the end of the quarter which includes unusually high service content. Service renewals are normally per 12 month firms leading to revenue recognized ratably over that 12-month period.

This quarter, we saw significant number of multi-year maintenance contracts from some of our largest customers who are reaffirming our confidence in our relationship which delivers them on-going new value from our development efforts on their behalf. Multi-year renewals received near the end of the quarter grow DSO up even further. Inventories were $8.7 million up from $7.4 million in the prior quarter. Inventory terms were 3.4 times. Turning to other metrics, revenue contribution from direct customers was 41% and reseller revenue 59%. Revenue from international sales was 30% of total, up from 25% last quarter. Europe delivered 16% up three points. Asia came in at four down one point from last quarter.

Other international sales were 10%, up three points. We expect to continue our international sales expansion driven by our growing investments in our service provider business outside North America. Summarizing large deals that we booked in the quarter, there were 133 customers with orders over a $100,000 up from a 119 in the second quarter. 27 customers gave us orders over $500,000 up from 21 last quarter. Included in those were 13 orders over $1 million up from six orders in Q2.

Five of the $1 million orders came from telecommunications, wireless carriers, five from financial services, two from the government and one from healthcare. As expected this mix reflects the beginning of the return of our financial services customers to more robust buying patterns. We saw bookings from the following sectors. Telecommunications sector led the way with slightly over 28%, financial services was just at 28%, the government was 14%, the healthcare sector was 7%, high tech followed with 4%. Our telecommunications bookings included a significant win with a major U.S wireless carrier that we expect to yield growing future business.

Now before I get to guidance let me alert you to a coming change in our revenue accounting policy that will begin to effect our revenue recognition in fiscal 2011. We have concluded along with many other technology companies that we will adopt early EITF 08-01 and 09-03 which were issued last September. We will adopt the new rules effective with the beginning of our upcoming fiscal year. I'm not going to try to explain the changes that these rules implement here, only their likely impact on NetScout.

For most of our product sales this will result in minimal change to product revenue. Our hardware products like the InfiniStream will fall under the new guidelines but we anticipate that revenue impact will be slight. For our software and appliance software sales, we anticipate that in the second half of fiscal 2011 we may have to begin ratable revenue recognition over the term of the maintenance period sold with that software. This will result in slower revenue recognition, slower recognition of software revenue that we would recognize under the current rules, then we would recognize under the current rules and therefore lower period revenue particularly during the initial phase in the period of four more quarters.

We will report to you revenue and earnings based on both methods of accounting during the phase in period until ratable revenue recognition is fully established in our results. As a result of this pending change revenue will become somewhat less meaningful as an indicator over our underlying business performance, therefore we will begin this quarter to disclose our quarterly bookings results as well as backlog when it is material. We will have a more detailed discussion of EITF 08-01 and 09-03 expected impact on our fiscal 2011 guidance when we give you that guidance at our next conference call in April.

Bookings in Q3 were $87.2 million up $14.8 million or 20% year-over-year. New business bookings were $56.5 million up $5 million or 10% while service contract renewal bookings were $30.7 million up $9.8 million or 47% year-over-year. Our service renewal total includes $4 million of bookings for service beyond our normal one-year contract period. Product backlog at the end of Q3 remained immaterial. Driven by the strong service bookings, differed revenue grew to $85.5 million up $8.7 million or 11% year-over-year.

Now the guidance, we have narrowed the fiscal 2010 revenue guidance range. We now expect GAAP revenue to be in the range of $259 million to $262 million and the non-GAAP revenue range to be $260 million to $263 million. This implies that fourth quarter GAAP and non-GAAP revenue will be between $70 million and $73 million. Our continued expense management has allowed us once again to raise the low end of the range for fiscal 2010 net income per diluted share as we have narrowed the EPS guidance range going into the fourth quarter.

GAAP net income per diluted share is now expected to be in the range of $0.69 to $0.73 and non-GAAP net income per diluted share between $0.88 and $0.92. The implied fourth quarter range for GAAP net income per diluted share is $0.18 to $0.22 and non-GAAP net income per diluted share is $0.22 to $0.26. The fiscal year 2010 non-GAAP revenue and net income per share estimates exclude the Network General purchase accounting adjustment of approximately $1.3 million that reduces Network General deferred revenue to fair value.

Amortization of acquired intangible assets of $5.9 million share-based compensation expenses of approximately $5.5 million plus the related impact of these adjustments on the provision of income taxes of $4.8 million.

That concludes our financial discussion this afternoon. Thank you for joining us on the call and we look forward to taking your questions. Natasha, would you go ahead please?

Question-and-Answer Session

Operator

(Operator instruction). Your first question comes from the line of Alex Kurtz , Merriman & Co. Your line is open.

Alex Kurtz - Merriman & Co

David, can you just give us a little more color on why these maintenance renewals were signed so late in the quarter and caused the hockey stick in the DSO?

David Sommers

Well, we often have a closing rush at the end of any quarter. This one was as the business improved during the quarter, a little stronger we had one large multi-year maintenance renewal that came in close to the end of the quarter and that could have come in three weeks earlier and then it would have less impact, but nothing more dramatic than that, we often see a hockey stick. The issue with renewals as you probably appreciate is with renewals there are maintenance renewals, there is almost always never any revenue to offset the receivable. When you have DSO, so revenue doesn’t go up, but the receivable does. DSO measuring maintenance renewals is therefore, a little bit not the best measure of financials.

Our receivables balance is better than ever before. Our ageing is extremely strong. There is nothing in the DSO related to collection problems. We don't have any collection problems.

Alex Kurtz - Merriman & Co

Okay. I’ll just shift real quick and I'll pass it along. The enterprise vertical if you exclude sort of the core verticals that you report were up pretty strong quarter-over-quarter from a bookings perspective, David, what was the vertical that was the weak one that you sort of looked at and said you know what that one we're not seeing as much strength and thus we need to take our top end of our guidance down a bit.

David Sommers

Well, it wasn’t that way. The weakest vertical in terms of sequential growth in the quarter was the government vertical and that's due to seasonality. The issue with the top-end of the guidance was that we've not seen in the general enterprise yet, the pickup that we had expected we might see. We are starting to see it in carriers and financials, and we're having strong business in the federal government, just seasonally weak in the December quarter.

It's the general enterprise, now we're seeing spotty pickup in the enterprise, but not across the board yet and we had in our earlier guidance anticipated that by now we would start to see more of a pickup there, and it's clearly been delayed from what we had expected. So that, it's really the general enterprise outside of the three major verticals that we discussed.

Alex Kurtz - Merriman & Co

Okay and last question. I think you just mentioned a very large wireless provider that you guys had signed in the quarter. Was that really a new installation for you guys? Had you had a small footprint there and if you could maybe talk about who you displaced and why?

Anil Singhal

Well I think first of all, instead of saying who we displaced, I’d like to just mention that we compete with companies like Tektronix, Agilent and Radcom in the US and we didn’t replace (inaudible) necessarily, but we won against one of these players and it was a distinct account. We had done business with them, but this was for a new project.

David Sommers

So we've had a footprint in that company on the IT side of [substance] and a smaller equipment historically on the customer facing side. So this is a significant new step for us.

Alex Kurtz - Merriman & Co

This is an expansion into their wireless network management tools?

David Sommers

Yes, yes correct.

Operator

Your next question comes from the line of Jonathan Ruykhaver from ThinkEquity. Your line is open.

Jonathan Ruykhaver - ThinkEquity

Hey, David, is there anyway for you to quantify the actual dollar amount of these multi-year maintenance contracts that are in the receivable number for the quarter?

David Sommers

There is about $4 million of additional bookings, deferred revenue in the quarter and in the DSO that wouldn’t be there without the multi-year.

Jonathan Ruykhaver - ThinkEquity

Just looking into the March quarters, should we expect the DSO to turn back into the 40 to 50 day range or you expect the continuation of these multi-year renewals to potentially keep that number higher than your target range?

David Sommers

We expect it to trend back I mean we do expect multi-year renewals to become more of a factor for us in the future but we don’t expect that to drive to keep DSO up in the 70 day range. We expect to collect that cash and see a significant increase in our cash as the AR comes down.

Jonathan Ruykhaver - ThinkEquity

Second question I think Anil you commented with a comfort around high teens revenue growth I think you said in 2011 I just want to get a clarification does that assume that the impact to impaired revenue from the adoption of the new accounting standard is incorporated into that statement I assume it is.

Anil Singhal

David you want to go? No it doesn’t include that it's not because of that but David will add something.

David Sommers

So no on our high teens long-term revenue growth target assumes everything’s in balance meaning we have worked through this accounting change which will happen in fiscal '11 will just be starting to work through with them. So no, and its not the high teens growth isn’t until we give guidance in April is not a fiscal 2010 revenue target either or bookings target. So but to your specific question no it does not take into account any short-term transition effect of this new revenue accounting adoption.

Jonathan Ruykhaver - ThinkEquity

But the more important number when this transition occurs is going to be the bookings growth number and I guess what you are suggesting is that you look into 2011 the bookings number on its own should be closer to high teens type of growth rate is that right?

Anil Singhal

No again we are not giving guidance for 2011 here today but our long-term growth target for bookings is in the high teens. And bookings will be a better measure going through this accounting transition.

Jonathan Ruykhaver - ThinkEquity

I am just curious given the comment you made on the enterprise side of the business. What is the company’s view on application performance management and the importance of capabilities around monitoring in analytics on the server and system side? I think you have alluded to some initiatives at you user conference that the new K2 nGenius service monitor. But how important is that capability to NetScout is looking to broaden your penetration at the enterprise?

Anil Singhal

I think its becoming more and more important both in the enterprise and the service provider sector and we feel that we have the best application and business intelligence data available through our packet flow technology but all the value had not necessarily been delivered to all the customers and K2 allows us to do that and we think that’s going to have a major impact on our growth and potential and penetration in the account.

Jonathan Ruykhaver - ThinkEquity

Or is it the need for the specific business level analytics that a user would value taken data and generated as that with K2 and that service monitor platform?

Anil Singhal

Yes for example I mean it depends and we talk about enterprise as a general vertical but inside the enterprise there are other verticals which are application focus for example Oracle, Microsoft Exchange and each of these people can benefit from what we are doing application centric analytics and monitoring we are doing in the K2 product.

Jonathan Ruykhaver - ThinkEquity

Okay good and then just final quick question the new nGenius Virtual Agent is that product driving any business yet you see opportunities around them?

Anil Singhal

I think if we give those more account control it’s not going to have a big dollar impact on the revenue but it allows us to provide a complete solution and allow us to sell our InfiniStream product once we have that penetration.

Jonathan Ruykhaver - ThinkEquity

Right, and I assume that is important in terms of your strategy to more broadly penetrate the enterprise in particular?

Anil Singhal

Yeah. That's right.

Operator

Your next question comes from the line of Mark Kelleher from Brigantine Advisors. Your line is open.

Mark Kelleher - Brigantine Advisors

Just want to go back to the carrier win, is there a way you could size out in terms of what the ramp would look like going forward and was there any incremental revenue from that win in the December quarter?

David Sommers

Well, the ramp is hard to size. Certainly this carrier is investing heavily in the area in which we're participating and we expect there to be those certainly potential of multiple times what we've done where obviously we have to perform and you have to be satisfied with what we do. We think that will happen. And in terms of the quarter, it was a multi-million dollar booking in the quarter and about half of that revenue was recognized in the (inaudible); half of the booking was recognized as revenue in the quarter.

Mark Kelleher - Brigantine Advisors

Okay. And how about Cisco, can you give us an update on how you perceive that relationship going?

Anil Singhal

I think we see a more longer term impact both on the revenue and account control in the short-term and longer term impact on the revenue, and we are just at the beginning stages of this, as we talked about we'll be making some announcements this quarter about the first thing which we are doing with them beyond what we have already announced with the Sniffer Global products. So we think again this increases our visibility into account, gives us account control, provides a broader solution to the customer from a single vendor, but short-term, the revenue impact will be minimal.

Operator

Your next question comes from the line of Eric Martinuzzi from Craig-Hallum. Your line is open.

Eric Martinuzzi - Craig-Hallum

Thanks and congratulations on the solid execution. That was a significant step up there on the product sales. The 3G versus 4G, obviously wireless spending up significantly for you guys. What, is this all pretty much still 3G or is there any next-gen spending that's going on, LTE spending going on?

Anil Singhal

The next-gen stuff is in the lab. So we are beginning to get some requirements about that but yes, most of it is 3G stuff right now.

Eric Martinuzzi - Craig-Hallum

Okay. The sales and marketing as a percent of revenue, that’s definitely higher than I had modeled for. Was there anything in the sales and marketing line this quarter that was an anomaly?

Anil Singhal

We did have some additional sales incentives in the quarter. As we looked at the beginning of the quarter, we say we got lots of opportunity, let’s make sure it happens and so we put some additional sales incentives that grow that up. You shouldn’t expect to see that same level of sales incentive going forward as you look in our, at our Q4, end of our fiscal year. We have natural incentives built into our end-of-year sales attainment. So that was something of an anomaly, yes.

Eric Martinuzzi - Craig-Hallum

Then just to dive a little bit deeper on the Cisco relationship, I'm wondering, I understand the borderless networks initiative. I understand the next generation integrated services router. How does this actually get implemented as a customer. Do they have to rollout new ISRs across their wide area networks for NetScout to benefit and then how are you going about training Cisco VARs on this product?

Anil Singhal

Well first of all on the ISRs, they have to have the right hardware in the ISR in order to run our agent and so many of the ISRs are already capable of that, it has already been sold with that hardware. So, in that case it will just be a simple software upgrade, upper agent and which will be managed through our centralized performance manager and we are going to have and it’s too early for that, but we will have some training programs for the VARs and Cisco sales people for collaboration and other reasons.

Eric Martinuzzi - Craig-Hallum

But if I’m a Cisco VAR, how do I benefit from this?

Anil Singhal

Well, I think if you are just at Cisco VAR, they are not going to get paid any commissions on this, but the way they have benefited that there is yet another reason for people to buy that additional hardware because it’s capable of running our technology. So, they will get to sell -- this is assuming that they have not sold before -- people have lot of branches and not every branch is equipped with that hardware and it depends on what application are able to run on that hardware besides how many people are going to buy that hardware [blade]. So, I think in the long run it will increase the sales of that hardware option on these ISRs which will benefit the VARs.

Eric Martinuzzi - Craig-Hallum

Okay. And last question on the guidance. If I look at the midpoint at $71.5 million non-GAAP revenue for Q4, that’s you just posted a quarter roughly $71 million, the mix there was about a little over $40 million, almost $41 million on the product. Should we expect a similar revenue mix for Q4?

David Sommers

Well our service revenue changes slowly, so that’s a reasonable expectation, product revenue had some and service revenue had to be about in the same range.

Operator

Your next question comes from the line of Scott Zeller from Needham & Co. Your line is open

Scott Zeller - Needham & Co

Regarding the changes that are coming with revenue recognition, the commentary around how it would impact product hardware revenue versus the software appliance revenue, could you tell us a little bit more about that because my impression is that nearly everything you sell, every box has software as a component, so how much of the I guess the real question is how much of the product line is going to be impacted by the change throughout it?

David Sommers

Scott, we are still working through the details of this, but as we see it now, talk with our auditors at some length about this, our hardware products likely InfiniStream products and the Probe products and our collective products, although they have software embedded in them because we don’t sell the software separately it’s all an integral part of the product, they will fall under the new rules which make it easier to recognize revenue as upfront as if the sale were completed. You don’t have to go through all of the DSO demonstration with those products. With the software products like the K2 and PM that we sell separately from hardware. We can sell it within the hardware appliance, but that’s not necessary, those will still fall under 97-2. And so there will be no change for those, but without again going into all the details that we'll discuss it more length next time.

We believe that because of the changed for our hardware products, as we do bundled sales, we may well lose of maintenance renewal. We may well lose VSOE under 97-2 for the software products. And it's an anticipation of that we would expect that our software products may lose upfront revenue recognition and have to go to ratable.

Anil Singhal

But that we should mention that's a small portion of our total.

David Sommers

Yeah. Between 10% and 15% of our total revenue is software. So, we haven’t completely sized the impact yet, but we don't expect it to be and we will show you both accounting approaches, so you will be able to track as if we hadn’t made the change as well and see the effect of the change.

Scott Zeller - Needham & Co

Okay, so it sounds like the bottom-line here is that somewhere around 10% to 15% of total products, has a rough estimate would have some impact.

David Sommers

Yes. And of course, when we change the ratable, the revenue comes back over the period, which is typically a year, so once we been through fourth quarters of that, we'll be back to about the same levels that we would expect it otherwise.

Scott Zeller - Needham & Co

Yeah.

David Sommers

It's just during that four year phase, four quarter phase in time that will see a dip in revenue and the associated EPS, but again we will report both, so you can help.

Scott Zeller - Needham & Co

Could you offer some color around the pipeline when we meet for Analyst Day that was pretty positive commentary around the wireless pipeline, and we felt some good activity in the quarter, but how would you characterize that now. I'm looking forward to that, the pipeline.

David Sommers

We think our wireless pipeline is strengthening and is strong as we see it today. We expect a lot more of wireless business around the globe and we're adding sales resources in new countries as well as solidifying our position with wireless carriers in the geographies we already have good positions in principally in North America and Europe. We're also getting traction with a number of carriers in Asia that will, they're not ready to, we haven’t seen results from yet but we expect good traction there. So we're getting traction with wireless carriers around the world.

Scott Zeller - Needham & Co

And the enterprise side, there has been some color from you around how that continues to be slower to recover when you look beyond financials for instance. How would you characterize the pipeline though for the traditional enterprise buyer? Would you say that there is pipeline but the orders have not yet converted? Are you getting a sense of pent up demand?

David Sommers

I can't say we see that in the pipeline yet, for the enterprise. There is clearly pent up demand but it's not manifest yet in our pipeline. Most of our pipeline growth is coming from the other verticals which is why as I mentioned earlier we took down the top end of the guidance for the balance of this year.

Scott Zeller - Needham & Co

Okay. Thank you.

Operator

Your next question comes from the line of Rohit Chopra from Wedbush Securities. Your line is open.

Rohit Chopra - Wedbush Securities

David can you provide us an update on HP?

Anil Singhal

I think there is, we continue to work with them on embedding some of our software technology and just like we are similar to what we are doing with Cisco but there is no new development since the last time we talked about it.

Rohit Chopra - Wedbush Securities

And then on the wireless side I wanted to come back to that issue just one more time. Were there any new customer signed or are these all existing customers' wireless telecoms?

David Sommers

Well the big orders that drove our business as always happens are from customers with whom we have a relationship of some sort. The new one that we spoke of was really a big new penetration into the core of their customer facing network but the five big deals that we discussed before others were all from existing customers. So when we talk about the penetration that I spoke of in the market and the pipeline build and getting traction in new areas. The order flow from those new areas is always a slow ramp but obviously it's important because it is our future.

Rohit Chopra - Wedbush Securities

And then were there any in Europe and of these carriers?

Anil Singhal

Yes U.S. or North American.

David Sommers

Yes we had good order flow from Europe as well they were not all U.S.

Rohit Chopra - Wedbush Securities

Okay and then one last question here I think at a recent conference you talked about acquisitions and you have a lot of new products coming out. I think some have been released and there is a few more on the way. What area is actually missing at NetScout? May be Anil can take this question.

Anil Singhal

I think that I would say that I mean most of the areas we are working very hard, but we might still do some things to accelerate our business, as an example for the service provider side we have been focusing more on the data services, but there are opportunities in the voice area and so we might look into some companies in that area.

Operator

And your next question comes from line of Gabe Lowy from Noble Research. Your line is open.

Gabe Lowy - Noble Research

A few questions from me, first just house keeping. David, I don’t know if you mentioned what cash flow from operations were and if you have the D&A and CapEx along with that?

David Sommers

Yes, cash from operations was $10.1 million. CapEx was 1.5, depreciation and amortization 3.7.

Gabe Lowy - Noble Research

Second if you can talk a little about the competitive environment, not only within the three core verticals who you are seeing, if there is any changes in who you are seeing, but also out in the broader enterprise and if there’s been any impact on your take on market shares beyond CA’s acquisition of NetQoS?

Anil Singhal

Yes, there is no significant change in the competitive landscape. I mentioned already that we compete with two big players Tektronix and in the service provider area and the wireless service provider segment we compete with the two big vendors Tektronix and Agilent and as well as some regional players in Europe like Radcom and Nexus and we feel that we're gaining market share there. We lived practically zero a few years ago in that segment, and now we have a significant revenue and bookings from that area, which we might share with you at the end of the calendar year, you will be able to add up and see how we're gaining market share.

On the enterprise side, there are a lot of small players and you are right, NetQoS was one of them, and there is a company called Network Instrument, there is company called [Offnet] and so there are several smaller players and yes, we see some competition. We lose some deals to them, but overall I think we're doing quite well, not necessarily gaining market share, but not losing either.

Gabe Lowy - Noble Research

As you spend particularly behind building out your sales presence in some of the new markets, are we looking at a period of maybe flattening operating margin, I mean still sort of maybe at the bottom end of the target range or are you willing to give up a point or two here and there to try and build out that market presence.

David Sommers

Gabe, it's our intent, we’ve tried to indicate, it's our intent to invest now to capture the opportunities we see in front of those that are growing, presenting now and growing and there will be a window to go capture them, but to maintain our focus on the operating margin range, so you should expect us to be prudent about and resistant to giving up operating margin from where we are.

I don't mean to imply there that we won't if we see a significant opportunity to go do something that we think is worth it, that we won't go, do that, but we will come and explain to you what we've done.

Gabe Lowy - Noble Research

Okay, and then lastly you're still working through the ramifications of the accounting changes that are coming and you can't see that well but a question related to that. Would this be a time to also consider offering the product or a combination of product and service in a fast based solution and do you think there is a market for that?

David Sommers

Software to service.

Anil Singhal

Well I think yes. We have seen back in the past, we feel that our product is sophisticated and I think complex enough that we don’t see software as a service. I mean, those things work very well with pure software products like conquered. They are taking advantage of the existing instrumentation in the network. That means they'll go to the servers or routers or switches and collect information from them and those are easy to put in terms of software as a service but since we sell a appliance that David talked about InfiniStream is 90% of our sales. That’s very hard to sell a software as a service and plus there are some technical issues in terms of whether people can deal with that. So we don’t expect our solution to be, you should think of our solution partly as like a CISCO router and the router has not been, in most cases not been sold as a service, software as a service and similar to that is a solution for that.

Gabe Lowy - Noble Research

Okay, thanks, that’s it for me.

David Sommers

Thank you Gabe.

Operator

(Operator Instructions) The next question comes from the line of Alex Kurtz from Merriman & Company. Your line is open.

Alex Kurtz - Merriman & Company

Hey guys, just a quick follow-up on sorry if you already covered this David but could you just talk about the gross margin on the product and service side and you have seen some variability quarter-to-quarter all through this fiscal year. Can you just give us a sense of where you see that heading on either line?

David Sommers

We expect that the gross margins will stay within our target range, we are about at 80% non-GAAP today, we were about 80% a quarter ago and 81% a quarter before that and all of those numbers are above where we were last year. So generally we believe the trend is cost improvements is working in our favor. And we expect to be in the 78% to 81% target range going forward. It hasn’t been a great deal of variability, we have seen the modest slide down this year on some lighter volumes initially and more recently a little impact of discounting that we mentioned with very large deals in the December quarter. But we don’t expect that to be a major impact going forward.

Alex Kurtz - Merriman & Company

Okay, thank you.

David Sommers

You bet.

Operator

There are no further questions at this time.

David Sommers

Well, thank you very much for joining us and for a very robust set of questions this time around. We appreciate that, thanks for your interest, we will plan to see you in 90 or so days at our April earnings call. Have a good evening.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: NetScout Systems Inc. Q3 2010 Earnings Call Transcript
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