NetScout Systems: When a Stock Slips on Reduced Outlook

| About: NetScout Systems, (NTCT)

While the entire country was getting settled into lawn chairs to watch Fourth of July fireworks displays, NetScout Systems, Inc. (NASDAQ:NTCT), a provider of information technology solutions for government and enterprise, issued a press release lowering guidance for the June 2011 quarter. Talk about a dud! The first day back from the three-day holiday, the stock gapped down 19.1%.

Although the new, lower company guidance still suggests there is a net profit in NetScout’s June quarter, revenue is down on weak government budgets for IT. Furthermore, NetScout’s sweet spot in the financial services industry has gone a bit sour as its customers fight to maintain profitability. Can the company withstand a protracted period of weak demand?

In the fiscal year ending March 2011, NetScout operations generated an impressive $68.4 million in cash, representing a conversion of 23.6% of sales to cash. Over half of the cash generated came from net income. Depreciation and favorable changes in working capital accounts accounted for most of the balance. Thus NetScout’s cash flow measure is higher quality than many companies, suggesting it is a strong operation that does not rely on a lot corporate shell games to boost results.

The purists might exclude stock-based compensation and deferred income taxes from NetScout’s operating cash flow measure. These adjustments leave cash flow from operations in fiscal year 2011 at $58.6 million, still a comforting figure for shareholders left holding the bag after the stock rout.

If we make similar adjustments to cash flow from operations in the four previous fiscal years, we reach an annual average cash conversion rate of 15.5% over the last five years. This period begins with the very difficult years between 2007-09 when many of NetScout’s customers were in survival mode and making few IT investments. The company managed to grow revenue each year except in fiscal year 2010, when sales were down $6 million compared to the previous year and operating cash flows followed.

Consistent cash generation is one of the reasons NetScout has over $200 million in cash and marketable securities on its balance sheet. Perhaps the more important question for shareholders than financial strength is whether NetScout management has done enough to invest its cash resources for growth. NetScout touts its solutions for several industries besides financial services and government, including healthcare, education, manufacturing, utilities and energy companies. Despite the appearance of diversification that the list suggests, NetScout is still dependent upon the financial services sector and government.

Granted, NetScout management has not been sitting on its hands all the time. In April 2011, the company acquired Psytechnics, a provider of IP voice, video and telepresence technologies. Although the deal does not take the company into new markets, Psytechnics’ technology could enhance the marketability of NetScout's overall product and service portfolio. Shareholders’ first view on Pystechnics contribution to the company is to be the June 2011 quarter, which we now know is less than management had targeted.

Ample cash resources and a history of growth through difficult times should give shareholders reason to hold rather than fold. However, diversification of target markets or the addition of that “must have” product to the portfolio should be on investors list of questions for NetScout Systems when final June 2011 quarter results are announced.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.