NetScout Systems, Inc. (NTCT) Q3 2013 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and welcome to the NetScout third quarter of fiscal year 2013 operating results conference call. [Operator Instructions] As a reminder, this conference call is being recorded. With us today is NetScout’s President and CEO, Mr. Anil Singhal. He is accompanied by NetScout’s Chief Operating Officer, Mr. Michael Szabados; and NetScout’s Chief Financial Officer, Ms. Jean Bua. At this time, I will turn the call over to Ms. Cathy Taylor, NetScout’s Director of Investor Relations to provide the opening remarks. Ms. Taylor, please proceed.

Thank you and good morning, everyone. Welcome to NetScout’s Fiscal 2013 Third Quarter Conference Call for the period ended December 31. Before we begin, let me remind you that during the course of this conference call, we will be providing you with a discussion of the factors that we currently anticipate may influence our results going forward. These statements include forward-looking statements made pursuant to the Safe Harbor provisions of Section 21E of the Securities Exchange Act of 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, guidance for fiscal year 2013, acquisition integration success and 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 over time. 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 risks and uncertainties discussed in NetScout’s annual report on Form 10-K for the year ended March 31, 2012 on file with the Securities and Exchange Commission. Our quarterly financial results are included with our earnings press release. We report our results on a GAAP basis as well as on a non-GAAP basis. Our non-GAAP results eliminate the GAAP effects of our acquisitions by adding back revenue related to deferred revenue revaluation and removing expenses related to the amortization of acquired intangible assets, the GAAP effects of stock-based compensation and restructuring charges. Our non-GAAP results also exclude certain expenses relating to our acquisitions, including compensation for post-combination services and business development charges. We exclude the related impact of all these adjustments on the provision for income taxes. The differences between GAAP and non-GAAP are disclosed in reconciliation tables in 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. We have included on today’s webcast a slide presentation that provides a summary of key financial data that accompanies the financial section of today’s discussion. For those listeners who have dialed into the call this morning and would like to view this presentation, you can find it by going to our website at www.netscout.com/investors and then clicking on today’s webcast. I would now like to turn the call over to Mr. Anil Singhal, our Chief Executive Officer.

Thank you, Cathy. We are very pleased to report another strong quarter in fiscal year '13. Q3 non-GAAP revenue grew 10% to $92 million while our non-GAAP earnings per share grew 3% to $0.36 this quarter compared to the same period of the last fiscal year. Jean will discuss our third quarter comparison in more detail later in the call. Looking at the results of the first 3 quarters of our fiscal year, we have made good progress against the goals we set at the beginning of fiscal year 2013. On a year-to-date basis, we achieved 15% revenue growth over last year while our product revenue grew by 22%. Another successful benchmark is that we ended the third quarter with a product backlog of over $70 million. This was the sixth consecutive quarter that ended with a material backlog. Based on our solid 9 months results and in anticipation of continuing to execute in our fourth quarter, we are in a very good position to deliver within the full year guidance we provided at the beginning of the fiscal year. We are therefore reaffirming and in fact tightening the revenue and EPS guidance we provided 9 months ago. During the quarter, we saw growth in total bookings coming in at 20% over the same quarter last year. Total bookings include new business and renewal bookings. Our service provider business remains strong with year-to-date new business bookings up 51% over last year. Despite the challenging economic environment, we saw growth in new business bookings of 9% in both financial services and general enterprise. The government sector is still facing uncertain funding. Even though we are involved in long-term strategic projects, the timing of funding is not clear and our visibility continues to be poor. This is reflected in our year-to-date government verticals new business bookings decline of 30%. Notwithstanding the current weakness in government, particularly the federal portion, we more than made up for it in the service provider sector of our business. We achieved these good results against a backdrop of economic uncertainty, so we are pleased that our regional strategy continued to strengthen our market leadership. Our research and development teams remain focused on providing our customers in both the enterprise and the service provider segments with a steady stream of new product capabilities and enhancement, many of which we'll be announcing at our next user forum in early April. With a steady stream of small and focused acquisitions in the last 18 months, we have not only enhanced our technology and product portfolio but we have also increased our R&D resources and skill set, positioning us for continued strong output and accelerating time to market with industry-leading new products in the next fiscal year. At the beginning of November, we acquired privately held ONPATH Technologies based in New Jersey. ONPATH is a provider of high performance packet flow switching technology that adds to the intelligent switch product that we acquired from Simena a year ago. ONPATH brings us a newly developed state-of-the-art switch that is based upon a scalable modular chassis-based design and targeted towards high density networks with ultra-low latency requirement. Their technology is used in high performance networks for the aggregation and distribution of network traffic for data, voice, video testing, monitoring, performance management and cyber security deployment. These switches support more than 500 ports of 10 Gigabit Ethernet per chassis, along with market-leading densities for 40 Gigabit Ethernet and future support for 100 Gig interfaces. We can now deliver a comprehensive ultra-low latency switch portfolio with industry-leading performance in poor densities that will be easier for customers to integrate and manage. This will give enterprise and service provider organizations the ability to address a diverse range of deployment requirements to improve their efficiency, control and distribution of valuable network traffic flows. The overall success we are seeing in the market scene stems from our strategy of unified service delivery management which is aimed at consolidating service assurance and performance management capabilities for multiple IT operations team on a common packet flow platform. Our strategy of one box on the wire combined with continuous enhancement of our software solution is gaining traction across our dual markets. Our focus on pro-consolidation, a single data source supporting both network and application performance management, as well as both data, voice service assurance makes NetScout easier to do business with and is aligned with our customers’ go-green initiatives. In summary, looking ahead into the fourth quarter we anticipate maintaining a steady growth trend. Based on our 9 months results, we are reaffirming but tightening our full year guidance range from -- with GAAP revenue to be in the range of $346 million to $350 million, and non-GAAP revenue to be between $347 million and $352 million. On the bottom line, we have narrowed GAAP net income per diluted share to be in the range of $0.92 to $0.96, and we have raised our non-GAAP net income per share to be between $1.28 and $1.32. We look forward to sharing our full year accomplishments and results with you next quarter. Michael will now discuss some additional highlights of our performance.

Thank you, Anil. In my comments, I will focus on our execution and operational performance this past quarter. As Anil mentioned, the acquisitions made last year are delivering results. In addition, we are extending our leadership in the IT assurance segment in the wireless service provider market, particularly from our investment in capabilities for the cable providers and increased focus on the wireless service provider customers in the EMEA, or Europe, Middle East and Africa market. In the enterprise, we have continued our engineering development to expand the engineers' platform to address the needs of application performance management based on our unique ESI technology and to deliver an extended packet flow switch portfolio to capture additional growth from the fast-growing monitoring switch market. Looking at our bookings performance, I’d like to highlight our continued strong execution in the service provider sector. As noted, our expansion continues into the cable MSO segment where we are providing solutions that allow these providers to manage user experience in the areas of Wi-Fi hotspots and TV Everywhere in particular, allowing the sector to better compete with wireless service providers and minimize customer churn. This quarter, we won 2 large deals over $1 million with leading U.S. cable providers and also see growing opportunity in Europe for our solutions. We also saw increased demand in LTE deployments globally, particularly in Tier 2 operators in Asia-Pac and EMEA. In EMEA, we saw a good uptick in business from established Tier 1 customers resulting from our sales organization realignment. In addition, we have been focusing on increasing post-sale services to drive faster time to value and customer satisfaction for our service provider customers. We are on track with the integration of voice service assurance product that we acquired from Accanto Systems, and the first release based on a common [indiscernible] platform is slated for launch in the first half of this calendar year. In addition to early VoLTE initiatives, the demand for solutions combining 2.5 and 3G voice and 4G LTE data continues strong in the wireless service provider segment, and NetScout is well positioned to meet this demand with the expanded nGenius service provider portfolio. Based on this new capability and our continued investment in IP assurance, we expect that the service provider part of our business will continue sustain significant growth. On the enterprise side, we have many exciting initiatives on the way. We continue our focus on expanding in international markets and are happy to acquire a new customer within Latin America. During this quarter, we saw business in a Latin America with a large – with a deal larger than $1 million from a financial institution in Brazil. NetScout gives this customer real-time services ability and enables proactive service delivery management across its globally distributed cloud network and data center infrastructure. Another area of expansion within our enterprise business is expansion in the packet flow switch market. The packet flow switch product line is highly synergistic with our nGenius monitoring solutions, allowing our existing customers to extend the value of their investment in NetScout. The expanded product line also gives us the capability to participate in large-scale data center products ranging from enterprise to service provider to cloud applications, providing us with the opportunity to expand our customer base. Finally and of most interest for our enterprise business, we are continuing the ongoing development of functionality for employment of our nGenius USDM within [indiscernible] service delivery management solutions to address application performance management. Our expanding focus on APM is leveraging our market-leading packet flow platform to provide unique value to the entire IT operations team, including the applications support team and the unified communications team. We are in close dialogue with our leading NetScout user forum members and incorporating their input into our development process. General availability is slated for early in the next fiscal year and we will begin the sales effort during the first quarter. Our solutions will bring unique real-time information to the application support teams about the application services actually delivered to the end users, complementing their current tool sets. Earlier this week, we announced that NetScout joined the Open Networking Foundation to help address the expected opportunities and challenges of managing the delivery of services from SDN, or software-defined networking architecture. The Open Networking Foundation is a non-profit organization recognized throughout the networking industry for its dedication to improving SDN standards and solutions worldwide. As a member of the Foundation, we will collaborate on approaches to address the new performance management challenges associated with implementing and running SDN-based service delivery environments for both enterprise and service provider customers. NetScout believes SDN will help drive the transformation of modern enterprise service provider and cloud operator data center and service delivery networks and will bring substantial infrastructure efficiencies, as well as enable new services. However, the resulting virtualized network will create an even greater level of interdependency between network traffic, control traffic, applications and enabling technology. Consequently, assuring service levels and providing a superior user experience require complete visibility and understanding of multiple dynamically changing traffic flows. Finally, during the quarter we were ranked 402nd on Deloitte’s Technology Fast 500, a ranking of 500 fastest growing technology, media, telecommunications, life sciences and clean technology companies in North America. According to Deloitte, NetScout grew 184% from 2007 to 2011, which were the subject years, and we were ranked 44th in the communications networking category. This was our third consecutive year on the Deloitte list. I would now like to turn the call over to Jean for the financial discussion.

Thank you, Michael, and good morning everyone. We will be starting with the third slide of our presentation, which is accompanying our call and is posted on our website. As Anil outlined, our business continued to perform against our goals for the third quarter of fiscal year 2013. Our third quarter non-GAAP product revenue grew 15% and our total revenue grew 10%. Our non-GAAP earnings per share increased by 3% over our third quarter FY '12 earnings per share as this quarter absorbed the operating expenses associated with our recent acquisitions that are in the product development stages. Our third quarter non-GAAP total revenue was $92 million, which is an increase of 10% from the same quarter in fiscal year '12. Within non-GAAP total revenue, non-GAAP product revenue was $52.7 million, which is an increase of 15% over the same quarter in fiscal year '12. Service revenue was $39.3 million on a non-GAAP basis, which is a 5% increase from the same quarter in the prior year. The GAAP total revenue for the same period was $91.6 million, which is an increase of 10% from the same quarter in fiscal year '12. Within GAAP total revenue, GAAP product revenue was $52.7 million, which is an increase of 15% over the same quarter prior year. Service revenue was $38.9 million on a GAAP basis, which is a 4% increase from the same quarter in the prior year. On a non-GAAP basis, our earnings per share for the second quarter were $0.36. This is $0.01 higher than the third quarter of fiscal year '12 and represents a 3% increase. On a GAAP basis, our earnings per share were $0.26. This is $0.02 higher than the third quarter of fiscal year '12 and represents an 8% increase. Our third quarter operating margin, net income margin and earnings per share, both on a GAAP and non-GAAP basis, were impacted by this quarter’s acquisition of ONPATH Technologies and the second quarter’s acquisition of Accanto. Our engineering teams are in the development stages of incorporating and integrating the technologies that we have acquired from these 2 acquisitions into our existing product suites. As we have previously discussed, the product development for these technologies is being engineered over the second, third and fourth quarters of this fiscal year with the product offerings anticipated being available beginning in the fourth quarter of this fiscal year and the beginning of our next fiscal year. Turning to Slide 4, the business maintained strong gross profit margins. On a non-GAAP basis, our gross profit was $74.2 million, representing an 80.7% margin. Our GAAP gross profit for the quarter was $72.4 million and GAAP gross margin was 79.1%. Non-GAAP income from operations was $24 million. Our non-GAAP operating margin for the quarter was 26.1%, which is a 2.5 percentage point decrease from the same quarter of prior year. This decrease is attributable to the integration of our recently acquired technologies, as I discussed earlier. GAAP income from operations was $17.6 million. GAAP operating margin was 19.2%, which is a 1.7% decline over the same quarter in the previous year. Non-GAAP net income was $15.3 million or $0.36 per diluted share. The non-GAAP net income margin was 16.7%, which is down 1.1 percentage points from a year ago. GAAP net income for the quarter was $11.1 million, yielding earnings per diluted share of $0.26. GAAP net income margin was 12.2% which is an increase of 0.2 percentage points from a year ago. The major differences between our non-GAAP and GAAP income from operations for the quarter is the exclusion of stock-based compensation for $2.5 million and about $3.6 million of costs associated with our acquisition, which includes amortization of intangibles for $1.8 million, business development expenses totaling $500,000, $1 million for deal-related compensation and $250,000 for inventory fair value adjustment. These are detailed in our reconciliation of our non-GAAP to GAAP results presented in our press release. The quarter’s provision for income taxes is recorded based upon a full year tax rate of 36.8% on a GAAP basis, and this does not include any impact of the recently signed fiscal cliff legislation. Our GAAP tax rate for the quarter is 36.2%. Consistent with past practice, we have used the statutory tax rate of 38% to tax effect the non-GAAP adjustments. The adjustments reconciling our non-GAAP results to our GAAP results are summarized in the reconciliation table included with our press release. Turning to Slide 5, which shows our total bookings and new business bookings composition, total bookings in Q3 were $99.7 million, an increase of $16.9 million or 20% year-over-year. Within total bookings, our new business bookings were $66.3 million, an increase of $8.9 million or 16% over the prior year third quarter. Service contract renewals in the quarter were $33.4 million, an increase of $8 million or 31% year-over-year. Product backlog at the end of the quarter was $17.3 million. The components of our new business bookings for the third quarter of fiscal year '13 were as follows: service provider 36%, financial enterprise 25%, government enterprise 7%, general enterprise 32%. This compares with the prior year’s quarter’s new business booking components as follows: service provider 33%, financial 24%, government 11%, general enterprise 32%. Slide 6 is a summary of our deals for this quarter. For large deals within the quarter, 197 customers gave us orders of over $100,000 in comparison to 166 customers from last year. We received 17 orders over $1 million, of which 9 came from service providers, 3 from financial services, 5 from general enterprise. This compares to 10 orders over $1 million that we received last year in the third quarter. Last year’s orders that were greater than $1 million included 5 from service provider, one from financial services, 2 from government and 2 from general enterprise. For year-to-date fiscal 2013, Slide 7 shows our results. For the first 3 quarters of fiscal year '13, non-GAAP revenue was $253.1 million, which is an increase of 15% from fiscal year '12. GAAP revenue for the 3 quarters of fiscal year '13 was $252.5 million, which is also an increase of 15% from fiscal year '12. Non-GAAP and GAAP product revenue was $139.1 million for the first 3 quarters of fiscal year '13, an increase of 22% over prior year non-GAAP and GAAP product revenue. Non-GAAP service revenue was $114 million and GAAP service revenue was $113.4 million for the first 3 quarters of fiscal year '13. This is an increase of 8% over prior year for non-GAAP and 7% for GAAP service revenue. On a non-GAAP basis, our year-to-date gross profit was $204.7 million, representing an 80.9% margin. This margin was 50 basis points higher than the prior year. Our GAAP year-to-date gross profit was $199.5 million and GAAP gross margin was 79%, which is 30 basis points higher than the prior year. Non-GAAP year-to-date income from operations was $61 million. Our year-to-date non-GAAP operating margin was 24.1%, which is 1.8 percentage points higher than prior year. GAAP year-to-date income from operations was $42.7 million. GAAP operating margin was 16.9% or 1.7 percentage points higher than the previous year. On a non-GAAP basis, our year-to-date earnings per share for fiscal year '13 are $0.90. This is $0.19 higher than year-to-date for fiscal year '12 and represents a 27% increase. On a GAAP basis, our year-to-date earnings per share were $0.62. Turning to Slide 8, which shows our total bookings and new business bookings growth for the first 3 quarters of fiscal year 2013, total bookings year-to-date for fiscal year '13 was $253.7 million, up $29.8 million or 13% year-over-year. Within total bookings, new business bookings were $187.8 million, up $24.8 million or 15% over the prior year. Renewal bookings were $65.9 million, which is an increase of $5 million or 8%. In spite of the economic challenges facing our customers across the globe, in the first 3 quarters of fiscal year '13 all of our business verticals experienced growth in new business bookings over the prior year, except for government. We believe the decline in government new business bookings is due to the budget uncertainty around long-term government projects, as Anil discussed earlier. Our new business bookings for service provider sector grew 51% on a year-over-year basis as we continued to win new customers and LTE deployments across the globe. Our new business bookings for the financial enterprise sector have grown 9% on a year-over-year basis. We have experienced a third quarter of domestic financial services institutions purchasing for their service offering enhancements as well as data center changes. Our general enterprise sector grew 9% on a year-over-year basis. The growth in this vertical has come from diversified sectors including utilities, manufacturing and communications industries. The new business bookings for government verticals decreased 30% over year, largely due to the federal government deferring spending on long-term strategic initiatives. Our federal government new business bookings decreased 32% while the rest of the government business, which includes foreign governmental agencies and state governmental agencies, decreased 26%. Slide 9 shows our new business bookings composition by vertical. The components of our new business bookings for fiscal year '13 were as follows: service provider 39%, financial enterprise 26%, government enterprise 10%, general enterprise 25%. This compares with the prior year new business bookings components as follows: service provider 30%, financial enterprise 28%, government enterprise 16%, general enterprise 26%. Turning to Slide 10, this is a depiction of our year-to-date revenue by geography. For the first 3 quarters of the fiscal year, revenue from international sales was 25% of total revenue as compared with 26% of total revenue for fiscal year '12. Within our international sales, Europe delivered 12%, which is 1 percentage point higher than last year; our Asia sales were 5% for the first 3 quarters as compared to 6% last year and the remaining international business was 8% compared to 9% last year. Our European revenue of $31.4 million has grown 30% over the FY '12 year-to-date period. Our Asian markets have declined by about $700,000 over the prior year results. While we continue to see a difficult climate for our European and Asian financial services institutions, we have been able to expand our footprint in our European service provider market. Slide 11 includes highlights from our balance sheet. We continue to maintain strong liquidity. At the end of the quarter, we have invested cash, short-term marketable securities and long-term marketable securities of $136.7 million. This represents a decrease of $76.8 million from the prior year’s ending balance for cash and short- and long-term marketable securities of $213.5 million. Our year-to-date free cash flow generation of $58.8 million was $22.8 million higher compared to the first 3 quarters of fiscal year 2012. In the quarter, we repurchased 250,000 shares for $6.1 million. On a year-to-date basis, we have repurchased 750,000 shares for $17 million. Accounts receivable net of allowances was $61.9 million, down from $69.8 million at the end of fiscal year 2012. Days sales outstanding were 61 days for the quarter. This is up from 54 days for the third quarter of last year. Inventories were $7.4 million. This is a $600,000 decrease from the fourth quarter of fiscal 2012. Inventory turns have increased to 4.3 times in the quarter from 3.0 times for Q3 fiscal '12. During this quarter, we paid the outstanding balance of $62 million on our revolving debt facility. Since this is a revolver, the $250 million facility is available to us should we need it over the remaining 4-year term of the agreement. Our liquidity at the end of the third quarter was approximately $387 million. Additionally, our total deferred revenue was $113 million, which is an increase of $1 million from fiscal '12 year-end. Turning to our guidance for fiscal year '13, Slide 12 illustrates our growth for revenue and earnings per share. For fiscal year 2013, we are narrowing the non-GAAP revenue guidance to $347 million to $352 million, yielding a revenue growth rate of 12% to 14%. We are raising guidance for our non-GAAP net income per share to be in the range of $1.28 to $1.32, yielding EPS growth of 16% to 20%. For fiscal year 2013, we are narrowing our GAAP revenue guidance to $346 million to $351 million and adjusting our GAAP net income per diluted share to be in the range of $0.92 to $0.96. The EPS guidance reflects tax legislation which reinstates the research and development tax credit on a federal basis. This reinstatement is retroactive for the calendar year of 2012 and effective for the calendar year of 2013. Accordingly, we will experience an R&D tax credit in our fiscal year '13 results for 5 quarters and will experience in fiscal year '14 results an R&D tax credit for 3 quarters. This skewing of the quarters correlates the calendar years of 2012 and 2013 with our fiscal years. For fiscal year 2013, the non-GAAP net income per diluted share expectation excludes the purchase accounting adjustment to fair value of approximately $1.2 million for deferred revenue, forecasted share-based compensation expenses of approximately $9.7 million, estimated amortization of acquired intangible assets of approximately $7.5 million, inventory fair value adjustment of approximately $500,000, compensation for post-combination services of approximately $2.5 million, restructuring charges of approximately $1.1 million, business development charges of approximately $1.4 million, and the related impact of these adjustments on the provision for income taxes of $8.6 million. That concludes our financial discussion this morning. Thank you for joining us and we look forward to taking your questions. Denise, we will now take questions from the attendees.

[Operator instructions] Your first question comes from Mark Kelleher with Dougherty & Company.

I was just wondering, the 4G LTE rollout, I know we talk about this each quarter, but could you give us an update on where the sector is and where the CapEx spending is in the cycle? Is that something that’s surging now and going to peter off? How do you see your revenue into that sector playing out over the next couple years?

Well, first of all, the sector includes -- the way we report it includes a lot more than 4G and LTE because there is still -- as you know, we bought this company Accanto and we have not been playing the voice space until now seriously, so we expect some revenue coming from there. So we think the sector growth will be -- may not be [indiscernible] as big as this quarter, but it’s going to be very decent and above our enterprise growth next year. In terms of LTE, I think we are sort of in the middle of the wave and so I think we expect this trend to continue for a while, and maybe trend downwards later in next year.

It’s shifting from North America to the international markets. That’s the general trend.

And also we have been most -- a lot of our LTE deals have been coming from Tier 1 providers, but Tier 2 is also an opportunity moving forward. So overall, that trend will be in the -- we will see good growth like this year in the overall sector. Maybe the LTE component will be slightly lower than this year.

Okay. And a quick balance sheet question. The receivables seemed to jump up a little bit from September to December. Was there some linearity or some effect of acquisitions driving that?

There would be minimal effect of acquisitions. The vast majority of it is the linearity and the skewing of when the orders come in, especially when we had large renewal bookings this quarter, as you noticed. When they come in in the last few days, the receivable isn’t collected at that point.

Your next question comes from the line of Eric Martinuzzi from Lake Street Capital.

First a comment, I think there’s a disagreement between your Slide 9 script and the PDF out there, a reversal between the fiscal years on the slide, so you’d want to correct that as quickly as possible, I think.

Okay, thank you, Eric.

Yes. And then you talked about the acquisitions and how quickly they contribute. I realize it’s early days in Q4, but between Accanto and ONPATH, which do you see between those 2 as contributing and are you seeing any evidence in your pipeline?

Well, we are seeing some evidence in the pipeline for ONPATH, but that impact this year is virtually 0 from both of them. It’s not a big impact we are going to see. ONPATH is still -- we’re just about to announce formally the product, and the pipeline is growing. On the Accanto side, we'll be finishing the full integration of the product in the next quarter time frame. So yes, pipeline, it’s affecting -- as you know, the pipeline was packet flow switch was already building with the previous acquisition to ONPATH, and so we don’t separate the pipeline for packet flow switch between the first acquisition and second. But overall, there is lot of interest and there are a lot of evaluations going on in terms of customers trying to proof of concepts.

Okay. And then on the federal side, obviously times are tough there. Just curious if there’s any relief in sight, again looking into the pipeline; and if not, are there moves that need to be made on the cost structure side?

Well, I think we see that -- we don’t see any need to make any changes right now in the cost structure side. The pipeline has not changed. Pipeline has really not changed because our sales team still thinks that all those deals will come through, and so what we have to watch out is let’s see what happens over the next 3, 4 months. Certainly we are not planning to make any changes this fiscal year.

Your next question comes from the line of Alex Kurtz with Sterne Agee.

Jean, if we could just go back to the DSO question from earlier. Again, it looked like it's doubled sequentially here, and if I look back at last year, DSOs were down from September to December. So can you just give us a little bit more color about why this wasn’t abnormal?

Sure. Well, when you compare it to last quarter, if you recollect, we had some large deals from a service provider that came in earlier in the quarter, so we would have had the opportunity to collect those receivables during the same quarter. And I think as I mentioned last quarter, that was a major impact as to why the DSOs were so low, and they were probably lower than the trend. In this quarter, we really don’t have any collection issues or any issues like that. It just happens when you have larger orders come in toward the end of the quarter, you don’t have the same time period, the time to collect them, and this is especially true in any kind of a quarter where you get large renewal deals. And this quarter, as you saw, our renewals were the $31 million, and last quarter they were about $16.5 million. So we don’t see an abnormal -- we don’t see any trends in there that we’re worried about with DSO. It’s just more a function of the timing of the orders coming in for the quarter and then when we have the ability to actually collect the cash in the next quarter.

Okay, that makes sense. And my last question here is if I look at your guidance, it implies product growth sort of single-digit for the March quarter. I know you’re up against a tough comp from last year -- I think you grew like 21% last year in March. So is that just an element of conservatism? Is it really just because you’re up against a tough comp, or you think there’s potential to do more than that?

I think, Alex, as we spoke at IR meeting in November, I think with the lumpiness of the deals and the way of business growth, I think we should not be looking at our comps, our numbers on a quarterly basis. We have programs in place, for example, which allowed us to pull in some business from Q4 into Q3, and probably did it earlier in the first quarter also. That’s why we give yearly guidance, so I think the yearly guidance still shows strong growth and we feel very good that we're maintaining the guidance after one full year and will probably be delivering toward the high end of the guidance. So I’m not looking at the Q4 number growth just by itself. I think we have different ways in different years to meeting the yearly guidance, and individual quarters will be up and down. We do have to do these earning calls every quarter, but really we are looking at on a yearly basis what we are going to do.

Your next question comes from the line of Aaron Schwartz with Jefferies.

In addition to the commentary on the service provider vertical, it looks like fin services for the quarter here had sort of a rebound quarter. Was that maybe a little bit of a function of some Q4, some December quarter budget flush, or do you have any sort of better visibility into trends in fin services right now?

I think it’s 2 things. One, as we’ve been discussing over the last few quarters, the domestic financial service institutions have been buying at a good clip, so we had, as we’ve talked before, one of our customers, a large financial institution who was enhancing their service offering, was doing a website rollout and bought then. We’ve also, through our new product enhancement, the NVVM and certain things, have gotten some financial institutions in the last few quarters that have been making low single-digit million dollar deals to kind of a new customer entrée. And then we’ve had a customer who is a large financial institution who had not been buying for the last few fiscal years, who has started to come back and work on their data centers, whether they're expanding them or whether they're upgrading them, and they’ve been purchasing also. And then as Michael had mentioned to you, we were very happy this quarter that in Latin America, some of our international efforts were fruitful where we did get a new customer of a financial institution in Brazil. So at this point, it’s 3 quarters of domestic-based spending that is, for the most part, that is causing the 9% increase in financial services.

Okay. And then the commentary on some of the new products there, I mean does that give you any sort of different view into the pipeline into that vertical going forward, or is it still just somewhat of a lumpy outlook into fin services?

Probably in dealing with me, you know I tend to be more conservative. That's why this is the first time that we’ve mentioned it’s the third quarter of domestic growth. I think we would say we see the domestic market purchasing. It could be a degree of budget flush, but we continue to leverage our relationships and we have long-term excellent relationships there. In the international markets, we have seen a little bit of business but not a lot. I wouldn’t call it any kind of a trend that’s starting over there.

Okay. Just had a question on the OpEx side -- actually, sort of 2 questions. One, the sales expenses jumped up a little bit here. You’d expect that, given the bookings growth. But the bookings growth has also seen, or based on very strong renewals. I guess is the increase in comp here tied to the renewals as well, or is that variable comp tied more to just the product side of the new bookings?

When you look at our first 3 quarters of FY '13, it was like $25.5 million for sales in Q1, and then this quarter is around the same, it’s about $1 million. It does reflect higher incentive compensation. It really was that, as we discussed last quarter, there was some significant purchases and the incentive compensation structure around those purchases in service provider were such that they hadn’t attained their quota yet, and they had lower sales incentive compensation. So it was more that Q2 was an abnormality than any kind of change in Q1 over Q3. And we do have incrementally a few – some more sales people from the ONPATH Technologies, but it doesn’t move the needle that dramatically.

Okay. And last question from me, if I could. I hate to keep hitting on the receivables here, but it also looks like the deferred has seen just very modest shift more to the long-term side. Are you seeing more multi-year renewals here, and do you collect the cash up front on the multi-year deal side as well? And then do you have any update on the collections since the quarter has closed?

Sure. One, you’re definitely correct -- we have extreme customer loyalty, and our renewal bookings continue to show that. And the fact that many of our long-term large customers continue to renew on multi-years, which shows the significance and the importance of how we are to their infrastructure. When we collect those, they are collected up front for the most part, so they will pay upfront and then we just do the deferred revenue, the revenue recognition over the rest of the period. And honestly, I’m not worried about anything in the receivables. There is nothing of interest in there. We have -- most of the Fortune 500 is what is in our receivables, so we really don’t have many credit risk or credit worthiness issues.

Your next question comes from the line of Matt Robison with Wunderlich Securities.

What should we expect your tax rate to be on this catch-up for the R&D credits this quarter?

So for the next quarter -- so for the annual rate, we’re looking at basically the same rate year-over-year. So last year, we would probably say it’s going to be in the 35.75% to 36%. So in the Q4, the tax rate will probably dip down to about 32.5% as we take the 5 quarters of the R&D credit.

Okay. What was the operating cash flow and CapEx and depreciation in the fourth quarter -- I mean, the third quarter?

So CapEx was $8 million for the year. It would have been about $3 million for the quarter, and let me get the depreciation for you. Depreciation for the quarter was $2.8 million; amortization was $1.8 million.

That was for the quarter?

That was for the quarter.

Okay, I can back into the operating cash flow, I guess, since you gave free cash flow.

Yes, free cash flow was -- we had said in the script it was about $66.8 million from cash from operations less the $8 million. And you want free cash flow for the quarter, you mean?

Well, I can get there, so that’s okay. How much did you spend on the ONPATH acquisition?

We usually don’t disclose that amount. It will be in the Q, as we’ve discussed before, and it would have been a significant reduction of cash this quarter.

Yes, help us work with that, since you’re putting it in the Q anyway.

So for ONPATH, we paid around -- in cash, about $35 million to $40 million, and then we did a – debt repay down of $62 million.

Yes, okay. On the voice over LTE, are we seeing any meaningful orientation towards HD voice, or do you see it more as this general IP convergence as far as what’s getting the carriers going? And if you’re seeing HD voice, what does that mean for you in terms of things you can bring to the customer from a value proposition?

Yes, we don’t really see HD voice yet. I think it’s more just the IP convergence is at play.

Your next question comes from the line of Chad Bennett with Craig-Hallum Capital.

Probably a couple for Jean. Jean, can you give me the service provider geographic breakdown from a bookings standpoint?

Sure. For the full year, we had -- you want the composition?

Yes, yes, so how much was U.S. versus however many segments you do for international. And for the quarter too, if you have it.

If you’re talking about before, predominantly it is U.S.-based. The split is still about the same -- it’s 75% for the first 3 quarters of fiscal year. Still 75% or so U.S.-based with the rest coming from EMEA and APAC.

Would that be kind of comparable for the December quarter also as far as you can tell?

It probably would be shifting slightly more towards international, only as we’ve talked about we’re getting expansion and traction there. I doubt it would -- at this point, I doubt it would significantly move any of the dials.

Okay, okay. And then going back to a prior question on kind of how you’re feeling about the financial vertical and consistent traction there or an uptick in spending, I guess a question on that is in the financial vertical, is the growth you experienced this quarter and for the last few quarters, quite frankly, is it mainly existing customers kind of catching up on spending or kind of refreshing data centers and infrastructure, or is it -- are you seeing new customer additions in that vertical?

I think we -- maybe Jean has something, but we certainly talked about a big deal international which was a new customer. But U.S. financials are mostly existing customers. It’s not a mass refresh of the data centers, but we are really getting most of the business from existing customers financial.

There is also good, increasing opportunity in Asia and China. We see some promise there.

Yes. So the financial institutions, to go back to your question, we actually see all 3 of those. So we do see one long-term customer who has been doing some data center refreshes in the last 2 quarters. We have seen some financial institutions that may have been long-term customers but that had been dormant that are interested in some of our new technologies. We also have the domestic financial institutions that have been long-term customers that continue to enhance their service offering, and then as we’ve talked about, we saw a new deal in Latin America. But again, the European and the Asia-Pac banks have yet to come back. That would probably be the way we’d summarize the financial sector at this point.

Okay. The ONPATH and Simena products, packet switch products, can you talk about at least kind of directionally what we should expect from a margin, gross margin profile on those products relative to the corporate average for product gross margin?

I think it’s going to be slightly lower. It’s has more hardware component, so it'll be slightly lower than the current margins, but we don’t see any big change in our overall gross margin model for next year despite that mix, because still the non-CFS, non-Simena and ONPATH will still be a fairly small portion of the total revenue.

Your next question comes from the line of Scott Zeller with Needham & Company.

Wanted to ask about the prepared remarks and your comments on the cable MSO group. I don’t recall that being a significant contributor in the past. Can you tell us when you think about telco and service provider versus MSO, how do you look at the balances of contribution right now, and how’s it trending?

Well, cable is still a small percentage of the overall service provider revenue picture. Wireless service providers and Tier 1s in particular are driving that still, but there is a very nice trend of growth in the cable MSO segment as we are able to apply our solutions developed for the wireless service providers to this segment as well, essentially very similar fashions solving similar problems. And we see this opportunity as continuing to grow but remaining a small portion for the foreseeable future.

Okay. And I may have missed it earlier, but I’m curious about any changes in the field now that OPNET has had its change. Can you talk about maybe the intensity of competition in the field and how that’s changed?

Yes, surprisingly we are not seeing any change right now. Maybe they are still trying to get reorganized and closing the acquisition and all those, so we have not seen any change in the market. Absolutely [indiscernible] surprisingly. We expected more, but overall we see the Riverbed and OPNET acquisition is more positive for us, both in terms of creating awareness but I think we might be in a much better position to win.

Yes. And I believe, Jean, earlier you'd mentioned the year-to-date contribution from international, but could you tell us what the quarter itself looked like for international versus domestic?

Sure. That’s for revenue. Probably not -- I don’t think I have that at my fingertips. I can give you a call back and we can talk about it.

Well, in that case, maybe you could just say if the split has been consistent over the past few quarters.

When you do it, the split is consistent year-over-year-over-year. What we did see this quarter, which slightly moved the European mix higher, was that the reorganization that we did in the summer and the focus that we have on service provider in that market added -- expanded our footprint so that the European portion went up about 30% year-over-year. But consistently, it’s ranged from 24%, 26% as a portion of our revenue.

Your next question comes from the line of Sanjit Singh with Wedbush.

I wanted to see if we could get an update on your moves into the APM market, what new products we could see along those lines. And then digging into the general enterprise market, I think we understand what’s going on in federal, but what are you seeing in terms of sales cycles, how cautious is the spending environment, particularly in the general enterprise?

I think general enterprise is cautious but is, I think, still reasonable; and as our number shows, we expect that environment to not change that much. I think in terms of our market opportunity, we were getting -- even though we played all the time in both APM and NPM market, most of the revenue and relationship was attached to the NPM market, and APM market is significantly bigger. So we have been working on some modifications to our ASA technology to create an enhanced product in the next quarter for the APM market, and I think that will increase our access to more budget in existing accounts because of the focus on APM. So we expect that to be a big contributor in terms of maintaining or exceeding the percentage of growth in enterprise segment next year.

Great. And on R&D, I was a little bit surprised to see it generally flat quarter-over-quarter, given the 2 acquisitions, Accanto and ONPATH. Does that imply that you guys took more sales and marketing heads versus development heads? Why was R&D flat quarter-over-quarter, given the acquisition?

We do take mostly R&D headcount when we do these acquisitions, especially for Accanto and ONPATH. R&D is flat over the quarter probably because we’ve had some significant meetings and such that occurred in Q2 that we didn’t experience in Q3.

Your next question comes from the line of Kevin Liu with B. Riley.

Regarding the SDN opportunity, I know it’s kind of early days there, but just wanted to know if you could talk a little bit about what sort of enhancements, if any, were kind of required of the platform in order to pursue that market.

Well, there are 2 things we have to do. One is -- and they all fall actually in new opportunity. One of the things which we cannot do in a probe-type solution where we are snipping the wire and doing various things, is to what’s happening to the configuration of devices because those are done with some proprietary method. What SDN does is brings that configuration management to the mainstream, so now the open floor SDN is itself an APM-like application and we can -- people will need more management and ways to manage the configuration across the infrastructure, so that is an opportunity for us with SDN when time comes. The second thing is for the PFS market, we will need to have our own device managed through SDN and open flow, so that will require some extra work. It’s not going to drive the business, but it’s going to require extra work. So in general then, supporting other people’s configuration through monitoring architecture of APM and maintaining our -- being able to manage our own devices, just like a Cisco router would be managed by SDN products, are the 2 things we'll need to do next year.

Got it. And just one last, on the packet flow switches, I know you’ve talked about near term maybe it’s not a big revenue contributor, but certainly with the Simena progress you guys have shown as well as the recent acquisition and the amount you paid for that, I would assume your thoughts are that that turns into a fairly sizeable market opportunity for you. Any sense for how many points of growth that could add over time on the product side, and is that contemplated within your prior outlook?

Yes, when we give the guidance for next year, you will see that number embedded in there. We don’t separate it out, are not planning to separate it out, so your guidance, when we give, I think will be a reflection of that. And also I want to correct that we are not saying that PFS business will be small. We are saying it’s not going to be big enough to make a big change in our gross margin model. So we think that number will be significantly bigger than this year.

[Operator Instructions] Your next question comes from Gary Spivak with ABR Investments.

I want to dig into the backlog a little bit. I know it’s not something you guide for, but do you have a target, is there a level where backlog is just too much, or is that a case where more -- the bigger, the better? And then also, if you could discuss the split in the backlog between service provider and enterprise?

The backlog, as we’ve talked about in the past, is pretty varied. It’s not really consolidated in any industry or anything like that, and it’s more a function of as we get towards the end of the quarter when customers place orders, how much can we actually physically get out the door. So to that end, we -- the backlog definitely adds a level of comfort. Anything above $10 million is what we would be reporting as material. We don’t really target what we want to keep in backlog, and it does get too -- if backlog does get too large, as you talked about, it does become operationally sometimes difficult to start shipping things out in the beginning and still attaining -- still getting all of your other customers orders. So there’s not really a strategy, per se, around backlog other than it’s a very nice amount to have on our financials.

Right. I’m sure it is. And I guess the other question, Jean, is again if we look at the receivables again, let me ask the question a little bit differently. Given the profile of the renewals in the December quarter, can we expect the phenomenon not to be quite as strong in March, which could potentially result in better linearity in the March quarter?

Well, Q3, as it’s the calendar year close of many of our customers, the renewals, because it’s of a contract nature, tends to be heavier. It tends to be heavier towards Q3. With that said, I probably would see maybe the same levels to slightly lower in Q4, and it could affect the DSOs so that they’re comparable to what they were last year. But we’re not -- I just want to stress, we don’t have an issue with our receivables, we’re not doing anything with collections. Our cash flow, as you can see, and our free cash generation is very good this year, so we’re comfortable with the receivables.

Right. I guess my question is just about anticipated linearity versus the -- a little bit more back-end loaded this quarter because of the renewals.

The DSO, yes. It was probably a little more back-end loaded because of the renewals at the end of the year, at the end of the calendar year; and again, that Q2 was artificially low due to the fact that we got some very large orders early in the quarter last quarter and we were able to collect them by the end of the quarter.

Your last question comes from the line of Mark Jordan with Noble Financial.

Would like to talk about the compensation after the post-combination services. Should that decline precipitously in the fourth quarter, or how is that going to go moving forward?

That probably will be about the same amount in the fourth quarter, flat. That represents earn-outs and other things on some past acquisitions, so we would just see until that burns off or earns comparable periods over the next few quarters.

Okay. Secondly, relative to the higher R&D relative to the integration of some of the acquired products into your product line, as those new products become integrated and become generally available, should you see efficiencies generated in the R&D expense as you move into the new year?

So what we will see is leverage because the amount of cost that you see embedded in the R&D structure right now is in development of products that haven’t shipped yet, so the leverage on that line should improve. For efficiencies, generally we have multiple centers of excellence that are worldwide that allow excellent product development and coordination. So at this point, at least through FY '14, we’re not really looking for any kind of efficiencies from our R&D cost expenses.

There are no further questions queued up at this time. I turn the call back over to the presenters.

Okay, thank you, everyone. We’ll see you again at the end of our fiscal year in 3 months.

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