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.