NETSCOUT SYSTEMS INC quarterly report, Q1 FY2017

NetScout Systems, Inc. — Q1 FY2017 Form 10-Q

Reporting period: Three months ended June 30, 2016. Financial statements are unaudited. NetScout provides real-time network performance analytics and cybersecurity products and services. Results include the Communications Business acquired from Danaher in July 2015, so year-over-year comparisons reflect a substantially different business.

Financial results and liquidity

Metric	Q1 FY2017	Q1 FY2016
Revenue	$269.0 million	$100.7 million
Gross profit / margin	$181.9 million / 68%	$79.4 million / 79%
Operating income (loss)	$(10.8) million	$12.4 million
Net income (loss)	$(9.0) million	$7.7 million
Diluted EPS	$(0.10)	$0.19
Operating cash flow	$37.7 million	$9.3 million

Product revenue was $164.6 million, up 207%; service revenue was $104.4 million, up 121%. Management attributed most of the increases to the acquired Communications Business.
GAAP gross margin declined 11 percentage points, with product margin at 64% versus 77% and service margin at 74% versus 81%; management cited product and service mix.
Operating expenses were $192.7 million, including $17.6 million of acquired-intangible amortization and $2.0 million of restructuring charges. Interest and other expense was $2.9 million.
Management’s non-GAAP measures were revenue of $278.0 million, operating income of $43.1 million, net income of $26.3 million and diluted EPS of $0.28. These exclude specified acquisition-related, amortization, share-based compensation, restructuring, and other items; they are not GAAP measures.
Cash, cash equivalents and marketable securities totaled $334.9 million at June 30, down $17.2 million from March 31. Cash and cash equivalents were $210.9 million. Net cash from operations was $37.7 million; investing provided $12.9 million and financing used $50.1 million, primarily for repurchases.
Long-term debt was $300.0 million, drawn under an $800 million senior secured revolving facility due July 2020. The reported interest rate was 1.97%; the company was in compliance with its covenants. Cash and marketable securities exceeded reported debt by approximately $34.9 million.
Total assets were $3.49 billion, including goodwill of $1.71 billion and net intangible assets of $1.02 billion. Deferred revenue and customer deposits totaled approximately $347.0 million, current and long-term combined.

Material changes and notable items

The acquisition contributed $173.8 million of revenue and a $3.7 million net loss in the quarter. Revenue rose 167% year over year, but the acquisition makes the comparison non-comparable without adjustment.
Share repurchases were $50.1 million for approximately 2.10 million shares during the quarter. A further 7.82 million shares remained authorized for repurchase at June 30.
The company recorded $2.0 million of restructuring charges for termination benefits affecting 19 employees; the remaining $1.8 million liability was expected to be paid by September 30, 2016.
Acquisition-related cash retention awards generated $1.7 million of post-combination compensation expense in the quarter. Danaher reimbursement receivable was $8.4 million, net of tax; the related recorded award liability was $9.7 million.
Purchase accounting for the acquisition remained subject to measurement-period refinement, particularly deferred taxes and residual goodwill. No measurement-period adjustments were recorded this quarter.

Outlook, risks and contingencies

No specific revenue or earnings guidance was provided. Management said cash, available debt, marketable securities and expected operating cash flows should meet working-capital and capital-expenditure needs for at least the next 12 months. It expected operating cash flow to increase with collections on anticipated higher revenue, partly offset by higher cash operating expenses.
Management expects continued service revenue growth as product sales expand the installed base and associated maintenance contracts. It cautioned that project timing and magnitude can affect quarterly revenue mix.
Key areas requiring judgment include revenue recognition, goodwill and acquired-intangible valuations, marketable securities and share-based compensation. The filing identifies substantial goodwill and acquired intangibles, with future amortization expected to remain significant.
One direct customer represented more than 10% of quarterly revenue and one direct customer exceeded 10% of accounts receivable. A $38.4 million receivable from Danaher was also disclosed as a credit-risk concentration.
Management said ordinary-course legal matters were not expected to have a significant adverse effect. The filing reported no material changes to the risk factors in the fiscal 2016 Form 10-K. Foreign-currency and interest-rate exposures are hedged or monitored; management assessed hypothetical market changes as not material to historical results.
New accounting standards on share-based compensation, leases and revenue recognition were pending; the company was evaluating their impact. Revenue recognition standard Topic 606 was scheduled to take effect for the company in fiscal 2019.

Important facts for investors to verify

How much of reported growth and future performance reflects acquired operations versus legacy NetScout, and whether acquisition integration produces expected benefits.
Whether gross margins recover from the quarter’s lower product and service margins and how product mix and project timing affect results.
The trajectory of GAAP profitability and cash generation, including the cash impact of compensation, deferred revenue movements and ongoing integration costs.
Debt repayment capacity, interest-rate exposure, covenant headroom and the effect of continued share repurchases on liquidity.
Acquisition purchase-accounting estimates, goodwill and intangible-asset recoverability, and the resolution of the Danaher receivable and cash retention awards.
Customer concentration and the sustainability of revenue from large customers, alongside progress adopting Topic 606 and other new accounting standards.