NetScout Systems, Inc. (NTCT) Q1 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. Thank you for standing by and welcome to NetScout's First Quarter 2017 Results Conference Call. At this time, all parties are in a listen-only mode until the question-and-answer portion of the call. As a reminder, this call is being recorded. Andrew Kramer, Vice President of Investor Relations, and his colleagues at NetScout are on the line with us today. [Operator Instructions] I would like to turn the call over to Andrew Kramer to begin the Company's prepared remarks. Please go ahead sir.

Thank you, Erica, and good morning, everyone. Welcome to NetScout's fiscal year 2017 first quarter conference call for the period ended June 30, 2016. Joining me on this morning's call are Anil Singhal, NetScout's Co-Founder, President and CEO; Michael Szabados, NetScout's Chief Operating Officer; and Jean Bua, NetScout's Executive Vice President and Chief Financial Officer. We've included a slide presentation that accompanies our prepared remarks. For those dialing into the call this morning and would like to view the slides, you can find them by going to our website at www.netscout.com/investors and then clicking on today's webcast. You can advance the slides in the webcast viewer to follow along with our commentary. We'll try to remember to call out the slide number we are referencing in our remarks. In terms of today’s agenda, Anil Singhal will share his perspective on our first quarter results and offer his perspective on some of our promising new product opportunities. Our COO, Michael Szabados, will review our integration progress, highlight some recent wins and recap notable go to market developments. Our CFO Jean Bua, will then provide greater detail and insight into our financial results and our guidance for fiscal year 2017. Moving on to Slide number 3, I would like to remind everybody listening that forward-looking statements in this conference call are made pursuant to the Safe Harbor provisions of the Section 21E of the Securities Exchange Act of 1934 as amended and other federal securities laws. Investors are cautioned that the statements in this conference call, which are not strictly historical statements including without limitation, the statements related to the financial guidance and expectations for NetScout, market conditions and customer demand and all of the various other product development, sales and marketing, expense management, integration and other initiatives planned for fiscal year 2017 and beyond, constitute forward-looking statements which involve risk and uncertainties. Actual results could differ materially from the forward-looking statements due to known and unknown risks, uncertainties, assumptions and other factors. Such factors are detailed on this slide and I strongly encourage you to review them. For an even more detailed description of the risk factors associated with the Company, please refer to the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 2016, which is on file with the Securities and Exchange Commission. NetScout assumes no obligation to update any forward-looking information contained in this communication or with respect to the announcements described herein. Finally, I would like to remind you that while the slide presentation includes both GAAP and non-GAAP results, unless otherwise stated, financial information discussed on today's conference call will be on a non-GAAP basis only. This slide also provides information about the use of GAAP and non-GAAP measures since non-GAAP measures are not intended to be superior to or as a substitute for the equivalent GAAP metrics. Non-GAAP items are described and reconciled to GAAP results in today's press release and they are included at the end of the slide presentation that is made available online on our website. As a reminder, we recently passed the one year anniversary of the completion of our acquisition of Danaher Communications Business. The first quarter of fiscal year 2017 is the last full quarter in which the timing and magnitude of the acquisition skews period-to-period comparisons and potential discussions related to growth rates. To provide an apples-to-apples comparison between the first quarters of fiscal year 2016 and 2017, we will provide additional non-GAAP pro forma details, so that you can better understand recent performance trends, as well as provide further context for our fiscal year 2017 guidance. Nevertheless, when we do note a growth rate, we will strive to clarify the nature of the comparison. Reconciliations between the GAAP and non-GAAP pro forma financial results are provided at the end of the slide presentation. As we detailed in our press release today, NetScout reported its first quarter results that came in ahead of our plans entering the quarter in terms of both revenue and EPS. As we move forward, we are executing well on our product development roadmaps and expect to bring a range of new and enhanced offerings to the marketplace over the coming quarters that integrate the technologies that came to NetScout from our acquisition of Danaher Communications business. With that as a high level background, I will now turn the call over to Anil to provide some further context on our results and plans for the coming quarters. Anil, please go ahead.

Thank you, Andy. Good morning everyone and thank you for joining us today. As Andy mentioned, I will first recap our results this quarter and then focus and then focus my comments on helping you better understand how our product roadmap can help us reinvigorate our top-line performance. There are several slides that will accompany my comments. So let’s begin on Slide number 5. For the first quarter of fiscal year 2017, we generated revenue of $278 million and diluted EPS of $0.28, both of which were slightly ahead of our quarterly plans. This enabled us to generate solid free cash flow, which, in turn, helped support our repurchase of approximately 2.1 million shares of our common stock during the quarter. As you know, the timing and magnitude of our acquisition of Danaher’s Communications business has skewed comparisons with NetScout’s results in the prior fiscal year. The table on this slide provides a pro forma comparison of key metrics for the first quarter for the fiscal years 2016 and 2017 with the first quarter of 2016 being presented as if the acquisition had been completed on April 1, 2015. Jean will provide a more detailed review of the pro forma performance later on the call, but I’ll share several brief observations. In terms of our pro forma, non-GAAP performance, revenue grew 3.6% as we benefited from decent growth with our service provider customers. Within this customer segment we enjoyed robust demand for our distributed denial of service DDoS cyber security solutions along with moderate service assurance growth. This helped offset a modest decline in our enterprise business, primarily arising from transitional challenges related to the acquisition. Our efforts to drive synergies related to the acquisition and control our cost structure enabled us to convert relatively modest revenue growth into a 34% increase in the combined company’s pro forma non-GAAP income from operations. Our operating profit margin improved from 12% to 15.5%. While we have remained disciplined in managing costs, we are continuing to fund innovation in ways that we expect will yield tangible results as we enter a new product cycle. I will cover this in more detail momentarily. We remain in a very strong competitive position in our core markets. Although the service provider capital spending environment was muted during the first half of the calendar year, we did not see any signs of further deterioration during this last quarter, and we continued to win projects with both existing and new customers. In the enterprise, we have made good progress addressing the transitional issues affecting certain acquired product lines, and we are optimistic that our go-to-market plans for the remainder of the year will enhance our position in this area. We also continued to put distance between us and our competition in the DDoS market, and see exciting opportunities in the advanced threat market that we entered in early 2016. I would like to provide greater context for the new product cycle that we entered, so let’s move to Slide number 6. As you may recall, we spent considerable time on last quarter’s call detailing our strategy aimed at maximizing the Danaher Communications assets we acquired. At the foundation of our plans is our patented, proprietary Adaptive Session Intelligence called ASI technology. Only ASI has the requisite scalability, real-time agility and flexibility to serve as the underlying technology for powering a suite of interconnected analytic solutions. We describe this approach internally as ASI plus, with the plus being integration of the technologies we gained from the acquisition, as well as opening up ASI to allow customers to self-configure nGeniusONE, ingesting other data sources, and facilitating easier data export. With these capabilities, we believe customers will gain an even broader, more holistic view into their network and application infrastructure, thereby simplifying the way that our customers manage their technology infrastructure, and helping them consolidate their supplier base. Our product roadmaps are aimed at, extending visibility from core of our customers’ networks to the edge. For service providers, that spans from the radio access network to their mobile core and for physical, virtual and hybrid environments. For enterprises, that spans from their datacenter to their cloud environment, regardless of whether that is a private or public cloud. Just as important, we plan to introduce new products and new capabilities that provide faster, more effective triage of issues impacting both custom and third-party applications, regardless of whether those apps reside in traditional datacenters or in the public cloud. Supporting our customers across both wired and wireless networks, complementing our analysis of packet data with flow data and other machine data and moving us into sizeable growth-oriented adjacencies in cyber security and big data. We believe that we have a tremendous opportunity ahead of us to fortify and expand our customer relationships as we bring new next-generation instrumentation and high-level analytics to the marketplace spanning service assurance, cyber security and big data. By unifying previously separate technologies, we can provide a broader platform that offers a single pane of glass for customers as they strive to enhance service delivery and deliver a high-quality user experience. With that in mind, I would like to focus on two of these initiatives, one for the service provider and one for the enterprise customer. At our recent user forum, we unveiled our new InfiniStream NG platform, which stands for next-generation. For service providers, this new instrumentation platform combines support for the best-in-class monitoring analytics from NetScout with the market-leading subscriber session trace capability from the former TekComms assets. We have designed the InfiniStream NG as a platform-agnostic product, meaning that it can be sold as a traditional appliance; as software that can be added to commercial, off-the-shelf, or COTS, hardware and or the hardware that the customer procures; or to monitor virtualized network function virtualization. We share the view of industry experts who expect that the transition to NFV will proceed gradually over the next five to ten years. As that transition occurs, it will create a hybrid infrastructure where we see opportunity to leverage our position as an incumbent monitoring platform for their physical networks and by expanding the number of instrumentation points that we monitor. We further believe that we are well positioned to win new software-only opportunities with both service provider and enterprise customers, although we expect that spend in this area will remain limited in the near term. Over the longer-term, however, we believe that our software will be increasingly important in enabling customers to deploy our technology more pervasively, while also increasing our flexibility to configure our solutions in ways that can appeal to a broader set of customers with varying technical and budgetary requirements. We have been shipping the InfiniStream NG to our service provider customer with support for the NetScout portion of analytics since the Fall of 2015 and the support for the TekComms analytics covering all of the latest network technologies is now generally available. Just as critical, our NG appliance will leverage NetScout’s technology architecture to deliver a product gross margin profile consistent with pre-acquisition NetScout. Accordingly, while it will take some time to drive adoption of the new platform into the installed base of Tektronix Communications customers, we believe that our success on this front will be instrumental in returning gross margins to their historic levels, while with some benefits anticipated as we exit fiscal year 2017. We also plan to offer software versions of the InfiniStream NG to address our customers’ COTS, virtualization, and private and public cloud environments. In the enterprise, we believe that ASI-plus can help us gain more traction in the application performance management area. Our initial APM success with nGeniusONE involved facilitating faster, more effective service triage for leading third-party applications from Microsoft, Oracle, Citrix and dozens of other vendors. However, IT is increasingly being tasked to rapidly develop custom applications using standard, open source frameworks. While traditional APM tools can do a good job at troubleshooting code-level issues, problems often arise when those apps are launched into production environments where they must seamlessly interact with the broader infrastructure. We believe that NetScout’s capabilities will be value-added and highly complementary with today’s APM tools because our platform excels at quickly identify infrastructure interdependencies that affect an application’s performance in production environment. Later this summer, we plan to make our ASI technology available to DevOps teams so that they can very quickly and easily configure nGeniusONE for their custom applications, which will enable them to put these apps into production with greater confidence. Over the coming months and quarters, we plan to more tightly integrate nGeniusONE with capabilities from the former FlukeNET assets for wireless network analysis and troubleshooting, and we plan to augment our virtualized software solutions with FNET’s tools for monitoring application availability and performance in public cloud environments via an active test sensor. We’ll also bring out new modules for big data that both enterprises and service providers can use to further monetize the rich, timely traffic data we can – we collect on their behalf. We are also excited about accelerating Arbor Networks’ entry into the advanced threat market by complementing Arbor’s timely, robust catalog of advanced threats with NetScout’s insight into anomalistic behavior. We expect that integrated versions of each of these offerings will be re-introduced to customers over the course of fiscal year 2017, and we will provide more insights into these development initiatives on future calls. Turning to Slide number 7, we believe we are off to a good start for fiscal year 2017. Our outlook for fiscal year 2017 is fundamentally unchanged although aspects of our guidance were refined to reflect the quarter’s share repurchase activity and certain assumptions for acquisition-related expenses. Jean will provide some further color on our outlook in a few minutes. Nevertheless, we recognize that there is a lot of work left to do in order to achieve our targets in fiscal year 2017. Although we believe the service provider spending environment is likely to remain fluid in the near-term, we expect that our full-year revenue performance will be weighted toward the second half of the fiscal year, which would be consistent with historical trends. In cyber security, we see good opportunity to build on the momentum we have gained in recent quarters, and we anticipate stronger service assurance demand within both enterprise and service provider customers. Our view is based in large part on orders for certain projects that we have already received, and anticipate orders for projects where we have good visibility. In addition, we are just starting to build sales pipelines for the new products that we plan to bring into the marketplace over the coming months, although we believe it will take at least a couple of quarters for these initiatives to begin making a more substantial impact. At the same time, we anticipate meaningful improvement in our operating margin during the second half of the fiscal year. To achieve this, we intend to continue vigilantly managing our cost structure and advancing acquisition-related synergies even as we fund this new product cycle and support our legacy products and technology platforms. Finally, you may have noted that July 14 marked the one-year anniversary of our acquisition of Danaher’s Communications Business. During this period, we have made good progress with our integration initiative, as well as talent retention, and I would like to thank my colleagues for their tenacity, commitment and hard work. As we look ahead, our team is very excited about the opportunities we see to help customers ensure that their infrastructures are always on for their end-users, enabling them to deliver the high-quality applications and services that underpin our connected world. In fact, we are starting to see a number of similarities between how today’s digital revolution has the potential to act as a catalyst for demand and how key networking innovations helped drive rapid growth for NetScout in the 1990s. That concludes my remarks and I will turn the call over to Michael at this point.

Thank you, Anil and good morning everyone. Slide number 9 provides an overview of the areas I plan to cover. First, I’d like to briefly update you on the integration activity. Next, I will highlight some key customer wins that supports some of Anil’s commentary. I will close by sharing some highlights from our major sales events this past quarter. As Anil noted, last week was the one-year milestone of the consummation of our acquisition of the Communications Business from Danaher. I am pleased that, by end of June, we wound down every significant transition services agreement with Danaher, as we plan to close out the last two smaller ones - TSAs next month. Most notably, we completed the transition of order processing and fulfillment services, and manufacturing operations from the former FNET business, including the portable tools product lines. Critical to this transition, our Connect360 enterprise channel partner program has been up and running for over a quarter in support of the tools business. As a result, we are starting to see major partners for our tool offering move forward with larger orders consistent with traditional restocking activity. As the next step in completing the integration, we have kicked off programs to align and integrate our business processes and IT systems with the legacy Tektronix Communications business, which we expect will extend through fiscal 2017. Just as critical, retention of key talent and senior leaders has remained high. As Anil noted earlier, we have continued to win business with both new and existing customers. In the service provider market, interest in our capabilities remains high although the spending environment has been choppy. Nevertheless, validating our overwhelming technology advantage, we regained traction with a tier-one North American provider over the past quarter who has returned to the combination of TekComms and NetScout solutions after trying, unsuccessfully, to source capability elsewhere. This customer placed a large, eight figure order with us to help them ensure the quality of their VoLTE or Voice Over LTE calls. This carrier has recognized that our ability to help them quickly and efficiently troubleshoot issues is increasingly important especially as overall traffic and the percentage of VoLTE calls on their network continues to grow. We anticipate additional orders from this customer in subsequent quarters this year. In the enterprise, Anil noted our plans to realize product and customer synergies between NetScout and FNET. One prominent opportunity is to more tightly integrate nGeniusONE with the OptiView XG product. OptiView’s portability, ease of use and robust WiFi troubleshooting capabilities already distinguish it in the marketplace. We believe that our enterprise customers are looking forward to this combination so that they can benefit from a consistent and cohesive view across their wired and wireless network infrastructures. This is best exemplified by a notable, six-figure XG order from a large U.S. energy delivery company that has already standardized on nGeniusONE in their datacenters and major campuses. They plan to rollout our XGs for ad hoc troubleshooting, particularly as they use high-speed wireless network in support of a smart metering initiative aimed at making its operations more efficient and to provide consumers with real-time insight that can help better manage their energy consumption. Anil’s remarks also touched on Arbor’s success in extending its leadership in the DDoS market. During this past quarter, Arbor won a highly competitive deal at a North American, Tier-2 service provider who provides video, Internet and phone services to both residential and commercial customers. The customer is deploying Arbor’s service provider - Arbor’s SP solution for comprehensive network visibility and reporting capabilities to help detect and understand availability threats, and improve traffic engineering, peering relationships and service performance. They are relying on one of Arbor’s newest threat management systems, the TMS HD 1000 for up to 160 gigabits per second of surgical mitigation capacity in order to identify and remove DDoS attack traffic from the network without disrupting key network services. In terms of go-to-market developments, we were extremely pleased with the record turnout and positive feedback from our annual user conference, Engage, held in May in Dallas. At this event, we briefed our enterprise and service provider customers on our service assurance and cyber security roadmaps, and their response to these plans was very enthusiastic. In addition, customers have raved about the latest release of nGeniusONE, which we view as another important step towards driving adoption of our solution and addressing new use cases and capturing a larger share of budgets within IT Operations. Also of note, we participated earlier this month at Cisco Live, where we laid out our complete business assurance offering for the enterprise. Unique in the industry, NetScout defines business assurance as the combination of service assurance and cyber security, that both of which are critical in successfully participating in the digital transformation sweeping our industry. It was a very productive show for NetScout and it has been gratifying to see how some of the largest equipment vendors are now adapting and amplifying NetScout’s messages about the value and importance of network traffic intelligence, especially in the context of the software-defined datacenter and software-defined network architectures. This past quarter also saw prominent industry experts affirm NetScout’s position as a market and technology leader. For example, in the packet flow switch area, which is also referred to as network visibility, IHS Infonetics recently ranked NetScout as the number one provider of these solutions to the service provider market. I’ll conclude by echoing Anil’s sentiments about our enthusiasm for our path going forward. I look forward to future calls when we can highlight new wins that validate the investments we are making to drive innovation and help assure the performance and security required to support and accelerate the digital transformation in our industry. That concludes my prepared remarks and I will turn the call over to Jean.

Thank you, Michael, and good morning everyone. This morning, I will plan to review key first quarter fiscal year 2017 metrics, and then I will review our guidance for the upcoming fiscal year. As we noted earlier, there were a number of acquisition-related items that impacted our GAAP results, so our convention will be to refer to our non-GAAP results unless otherwise noted. On a related note, and consistent with our comments earlier on the call, the timing and magnitude of our acquisition of the Communications Business also impacts comparisons with the prior year period and any other extrapolations of our first quarter results may not be representative. When possible, we will frame our results against prior periods on a pro forma basis. As noted earlier on the call, there is an appendix at the end of the slide presentation that provides a reconciliation of the non-GAAP pro forma financials, along with other supplemental data. To begin our financial discussion, we will be starting with Slide number 11 of our presentation. I’ll review our first quarter performance with a focus on comparing it against pro forma FY 2016 results, which assumes our acquisition of Danaher’s Communications Business had been completed on April 1, 2015. Let’s turn to Slide 11 for this review. Please note that a reconciliation of the pro forma results is available in the appendix of these slides, and it is available for downloading on our website. For the first quarter of fiscal year 2017, total revenue was $278 million, up 3.6% over the prior fiscal year’s first quarter pro forma revenue. This was modestly ahead of our plan by more than 1% in part due to the acceleration of a few orders for certain projects that we had originally expected to receive in the second quarter. Our revenue performance reflected low double-digit growth with our service provider customers due to exceptionally strong demand for our DDoS offerings and a mid-single digit increase for our service assurance solutions. This growth was partially offset by a modest mid-single digit decline in the enterprise, primarily resulting from declines in the former Fluke systems and portable tools products. As Anil noted, we believe that the transitional issues affecting these product areas are largely behind us, although we believe it may take a few more quarters for certain product areas to gain momentum. Product revenue was $168.8 million, or 61% of total revenue during the past fiscal quarter. This was up 4.3% percent over the same quarter one year ago on a pro forma basis. Service revenue grew 2.7% to $109.1 million, which represented 39% of total revenue. In terms of other key revenue trends, our service provider segment represented 56% of total revenue with enterprise representing 44%. This is largely consistent with the prior year period. In terms of the geographic mix, which is calculated on a GAAP basis, we generated a higher percentage of international revenue than was the case for the prior year with 36% of total revenue coming from outside of the United States. This reflects the broader and more diverse geographic footprint resulting from the acquisition, as well as the timing and magnitude of various projects for our service provider customer base across the world. This detail can be located in the appendix of the slides that accompany our remarks. We had one customer that represented greater than 10% of total revenue. In terms of profitability, our gross margin of 72.9% this quarter versus 73.4% one year ago on a pro forma basis reflected the overall product mix in the quarter. As Anil outlined, we expect that the launch of our InfiniStream NG platform will play an important role in improving gross margin over the longer term with some marginal benefit anticipated in the latter half of this fiscal year. Our operating margin in the first quarter of fiscal year 2017 was 15.5%, an improvement of 3.5 percentage points from 12% in 2016’s first fiscal quarter on a pro forma basis. In addition to modestly higher revenue, we benefited from ongoing runrate synergies and disciplined cost management. For example, as you know, the majority of our cost base is fixed with headcount being the largest single item. Overall, our headcount as of the quarter end was approximately 3,100 people, which is down about 2% on a year-over-year basis. We’ve taken steps during the past year to realign and focus our sales, marketing, and research and development teams, which have contributed to the headcount change as well as refined our marketing programs and tightened control of other discretionary expenses. For the first quarter, we reported net income of $26.3 million, or 2$0.8 per diluted share. The net income margin was 9.5%. The overall impact from our share repurchase activity on earnings per share this quarter was less than half a penny. Slide 12 details our balance sheet highlights and free cash flow. We ended the quarter with cash, cash equivalents, short-term marketable securities and long-term marketable securities of $334.9 million, which declined sequentially by $17.2 million. During the quarter, we used our cash and free cash flow to fund our share repurchase activity. At the end of the quarter, we had $500 million of available credit on our existing facility, which leaves us with total liquidity of nearly $835 million. As you can see from this slide, our current financial profile is generally in line with our targets. I’d like to quickly review our progress in returning capital to shareholders. NetScout repurchased approximately 2.1 million shares of common stock during the first fiscal quarter at an average price of $23.81 per share, totaling approximately $50 million dollars in the aggregate. At present, we still have approximately 7.8 million shares remaining on the 20 million shares that the Board authorized for repurchase. As a reminder, our capital deployment priorities are to maintain financial capacity to further invest in our product development, either through in-house development or through acquired technologies. We currently seek to distribute excess cash flow to our shareholders through share repurchase and we expect to remain active on the share repurchase front in the second quarter. From a cash flow perspective, we generated free cash flow of $28.2 million. This primarily reflects positive changes in working capital. Given our guidance range, we still believe that fiscal year 2017’s free cash flow should be between 85% to 95% of expected non-GAAP net income. In terms of a brief recap of other balance sheet highlights, accounts receivable net of allowances was $196.2 million, which was down by approximately $51 million from the end of our fiscal year, primarily as a result of the timing for service renewals. This dynamic, in combination with timing of orders and related collections, helped reduce days sales outstanding to 66 days compared with 80 days in the prior quarter. Moving to Slide 13 to review our guidance, which we updated to reflect our recent share repurchase activity and certain changes to acquisition-related costs and expenses. Our non-GAAP revenue outlook is unchanged. We still anticipate revenue between $1.2 billion and $1.250 million. In terms of net income per diluted share, we have updated our guidance to reflect the first quarter’s share repurchase of 2.1 million shares. The EPS guidance range has increased by $0.02 and now ranges from $1.87 to $2.12 per diluted share. The EPS guidance still assumes an operating margin of approximately 23% to approximately 25%. We now assume the average shares outstanding will be approximately 93 million. To be clear, our earnings per share guidance range for fiscal year 2017 does not reflect the potential accretion from any future share repurchase activity. As is our practice, we will update the earnings per share guidance range based on the share repurchase activity. I’d like to provide some further color into our revenue outlook. As a reminder, we are lapping last year’s second quarter that was bolstered by a very large, $50 million plus service provider project. Given the fluidity of the current macroeconomic and geopolitical environments, we are taking a fairly conservative near-term view on second-quarter revenue at this time. As we said on last quarter’s earnings call, we believe that our first-half revenue for fiscal year 2017 will be relatively flat with the prior year’s first-half pro forma revenue. This is expected to result in a revenue skew with about 45% 46% for the first half of the year using the midpoint of fiscal year 2017 guidance. We could see a positive fluctuation from this percentage as we have a strong pipeline in our federal government vertical and in the service provider segment, but some of these potential orders are dependent on funding processes, which have limited visibility right now. From an expense perspective, our second quarter operating costs should see a modest decline from first quarter levels primarily due to the timing of our sales events last quarter and synergies related to the wind down of various transitional support agreements. Consequently, we anticipate our second quarter operating margin to improve sequentially from our first quarter operating margin and it should be in the upper teens. In terms of other modeling assumptions for our earnings per share guidance, based on $300 million in draw downs on our credit facility, we expect interest expense of approximately $2.5 million per quarter and a tax rate in the range of 34.5% to 35%. Based on less than 93 million shares outstanding for the second quarter, this would translate into a diluted earnings per share in the mid $0.30 range for the second quarter of fiscal year 2017. That concludes my formal review of our financial results. Before we transition to Q&A, I’d like to outline our calendar for the upcoming various investor conferences that we will attend. We will participate in a Drexel Hamilton TMT event in New York on September 8. We are also planning to present at Deutsche Bank’s Technology Conference in Las Vegas on September 13 and the Credit Suisse SMID Conference in New York on September 14. Additionally, we’re planning to augment these conferences with outreach to our shareholders and prospects in New York and Boston, among other money centers. That concludes our prepared remarks this morning. Thank you again for joining us and we’re now ready to answer questions.

[Operator Instructions] We will take our first question from Alex Kurtz with Pacific Crest. Please go ahead.

Thanks guys. Can you hear me okay?

Yes.

So, Anil, can you just go back to those transactions that had shifted out of last fiscal year and just give us a quick update on where those said as well as the sort of overall take on service provider spending that you saw exiting the first quarter? And then, Jean, if you can just update us on the timing of the $20 million share repurchase when that ends and sort of when you could sort of start thinking about extending that or sort of adding on to that in future periods?

So, Alex, I’ll just cover the service provider spending environment question and then Jean will talk about those four deals you are talking about from the previous call, as well as cover the other part of the question. So, we don’t see any – as you have noted that in January, we saw some certain changes in spending as the new budget was coming up. And so we have not seen any further deterioration of the spending climate and people are still – have – still looking at – there is some inertia related to virtualization and a few type initiatives. But it’s not related less directly to the spending or anything to do with NetScout. So I think, we are hopeful that things will be same or better as the year progresses.

Related to the four deals, Alex, one of them has closed already, it closed and a portion of it closed in the late part of the fourth quarter with the remainder closing in the beginning of our Q1 quarter and I would say, three of them are still in process. And then, it includes the one that is, like a COTS software only.

Right.

Regarding – I am sorry, what, please?

Just go ahead.

And then regarding the timing of our 20 million shares, so as we said we have 7.8 million shares left. We have until about July 15 of 2017 to use the remaining shares under the R&T rules. That 20 million share repurchase at this time currently does not have a defined timeframe with it and the way we think about share repurchase is it’s a best use at this time for our free cash flow and our cash balances. So the timing of the share repurchase will probably be over the next what we have, four quarters until we enter the R&T limitations. After that, we will think about other ways which could include share repurchase a dividend to continue to return any kind of excess free cash flow capacity to our shareholders.

Okay, thank you.

Thank you.

We’ll go next to the site of Matt Hedberg from RBC Capital Markets.

Hey, thanks for taking my questions guys. In our model, lot of the short-term margin assumptions that we have are more OpEx-driven and on the call, you’d spend a lot of time talking about gross margins and we assume over time they are going to get back to more historic levels. Including the release of your InfiniStream platform, could you outline any possible rank the opportunities for gross margin expansion?

So, let me mention Mark, at a high level and then any specific, maybe Jean can cover it. So, we have – we continue to sell our products in three forms. One is, the NetScout-only, which has the same 80% gross margin type situation as we had before or as tech-only products, which is – has lower margins and then we have the new product which is very similar to the margin levels we had in legacy NetScout. So, we are not pushing people to move in one or the other direction. Greenfield customers, which is a very small portion of our business, I mean, 10% plus is going to be using that NetScout original customer base will be using that, but we are giving the choice right now to the original TekComms customer base which is a big portion of the market share and customer base to decide at their own pace. So as we mentioned on the call that – in my portion of the script that we don’t know what the timing of this will be, because people have different commitments and expectations as far as the deployment. So depending on how fast this transition happens for the customer – from a customer-to-customer, I think margin – there will be margin improvement. So, your comment about the OpEx was right. So I’ll let Jean to cover that part.

Hi, Matt. This is Jean. So just as a recap of the gross margin, the gross margin on a pro forma basis in FY 2015 was about 71.5% and in FY 2016, it improved up to about 73.5%. We would think that gross margin this year could close in again around the mid-75 around 75-ish. And as Anil said, we have good gross margins in a lot of the product lines and as we migrate the tech customer in to the InfiniStream NG which is the platform of very robust platform, it has better product gross margins. We also anticipate that we will be able to simplify the selling processes - selling process and that should also be able to give faster service as well as higher margins to our customers. And then just as aside, the gross margin percentage, as software becomes more and more important in the virtualized world, the gross margin percentage should increase over time also.

Very helpful. And in your prepared remarks, you spent some time talking about the success of your DDoS product. I am curious, could you help us with how successful that product has been selling inside of the traditional NetScout base? I assume, there is certainly a cross-sell opportunity, but I am curious about the adoption inside your traditional base of customers. Thank you.

So, there is a good penetration inside the customer, NetScout customer base, but it’s more accidental right now. It’s not that we have a common sales team working together. We are not leveraging that. We don’t create confusion in the sales force right now. So while lot of the traditional NetScout enterprise customers do use the DDoS product, but they are not because they were original NetScout customers. I think we see that opportunity starting in the next calendar year, which could help us as we make some minor integration changes, that’s when we want to capitalize on that, but at this calendar year, it’s still not taking advantage of the synergies.

Thanks, guys.

We will take our next question from Mike Kelleher from D.A. Davidson. Please go ahead.

Hi guys, it’s Mark. Thanks for taking my question. Yes, I wonder, now you’ve completed a year of the acquisition. I was wondering if you could go kind of review the expectations for the growth rate of your total addressable market? And how you think you can do versus that yourself taking market share perhaps? And then maybe talk about how the expectations for the individual components that you purchased Arbor Tektronix and Fluke have played out versus your expectations? Thanks.

Well, I think so, we have – and we have talked about that, I think expectation on the – if you look at the three big areas, Arbor, FlukeNET and TekComm. In the Arbor area, I think it’s inline with our expectations, but I think we can do more as we provide integrate this solution in the advanced threat product area which was introduced recently and both at the sales level and at the engineering level. On the FlukeNET side, I think there have been some internal challenges because of it was to unwind from the – we didn’t buy the whole FlukeNET or Fluke business. Some – a big portion of that remains with Danaher, so as a result we had to do transition services, we had to look at to the channels, we have to renegotiate the contracts and so there was some disruption because of that. Other than that, I think it’s inline with the – other than that plus some confusion in some duplication of product lines. I think that’s inline with our expectations. On the TekComm side, I won’t talk – think of – we had some lower – I mean, the maybe actually our expectations are higher than where we are right now. But that’s not because the integration is not working or technology is not good or talent is not good, it’s because there is some – there was some change in the spending environment and I think we can overcome that as we come up with the software solution, which will keep the deal sizes bigger, but reduce the cost of instrumentation and they are getting combined functionality which will then take advantage of our incumbency. So all in all, I think it’s a very good situation and lastly, I think 90% to 95% of the talent we have identified at the highest level is still with the company. So I think overall, it’s going very well and we are counting on translating this into revenue growth next year as a result of all the investments we have made.

Hi, Mark. This is Jean. I think I would just add a few comments to Anil’s commentary. The first being that, as we had mentioned on our prepared remarks, we now have the capability to provide operational intelligence and analytics from the edge of our customers’ network whether that’s the cellphone tower or the cloud, right into the datacenter. So one of our thesis for the acquisition was to be a platform to our customers that included economies of scale which will get to a operating margin, but it also means stickier revenue because we will be able to provide one visibility product and solution, so that they can see service assurance from the edge right to their datacenters. As service providers and enterprise have to up 24/7 this consistent approach will enable them to rapidly solve any issues that come up. And as we also talked about in the APM area our nGeniusONE came in with a service triage approach which was how to identify problems quickly. We are now being able to move into the DevOp space, so we will be able to also provide continued visibility in analytics in that area. Finally, the only other point I would make is that, Arbor which is clearly the DDoS leader in service provider right now and it’s moving into enterprise. There it has a good growth in that market also. That market is maturing and the way we view Arbor is that Arbor’s unique capabilities in cyber intelligence along with NetScout forensic ability should be able to be a product differentiation for the customers when it comes to advanced persistent threat. So we really are very happy with the Arbor asset it has grown well. We anticipate as we merge our technologies together that will create opportunities for Arbor to continue their growth rate.

I think just one more thing to add – to I just remember something important which I have been telling customers and to investors in private meetings that, we are a not just a number one player, but the number one player in almost all segments of our space by very, very wide margins. And so, in order to grow, we not only have to maintain our market share, but more importantly, we have to be the leader in increasing the market size and there is addressable market size and there is capitalized market size. And that means, we move other dollars in IT to our kind of solutions and which I call it almost like providing high definition TV at a black and white TV price. And that’s how we increase the market size whether it’s for DDoS, advanced threat, or analytics area which Jean talked about and that’s one of the biggest reasons why we decided to do this combination.

Okay, thanks.

We’ll take our next question from Eric Martinuzzi from Lake Street Capital. Please go ahead.

Yes, just curious to know on the services side, it looks like you had decent – I think it was 3. something percent growth there on the services. As we anniversary these contracts, whether they are Arbor, Fluke or more specifically Tektronix, are you seeing those renewals happening as you would have expected? And is there an end of life program that’s going to help drive transition to next-gen products?

Yes, I think we are very – Eric, so, first of all, our renewal rate continues to be good. There are always timing issues and – but this is from a revenue basis this is recognized over a year, I think, I mean, you don’t see those impacts. But overall, we are very careful with end of life situation because we want to use customers’ timetable to come up with those end of life or end of sales decisions. So a lot of the decisions are – is it going to drive the refresh or additional product or replacement is going to be not end of life type situation, but end of sales situation. So, for example, when we come with InfiniStream NG, which we started selling six or nine months ago, there is no need to continue to sell InfiniStream, because that’s much more cost-effective for customers and it has more functionality for us to go after a biggest market share. So that’s what’s going to happen and that has the best impact of keeping service revenue growing as well as being able to migrate people to new functionality.

Understand. Thank you.

We’ll take our next question from the line of Chad Bennett from Craig-Hallum. Please go ahead.

Chad?

Chad, your line is open. Please check your mute button.

Oh, sorry, I was on mute. Thanks for taking my question and nice job on the quarter.

Yes.

Thank you.

So, you spoke about a large North American tier-1 service provider that, I think, you indicated kind of came back to you and put in an eight-figure order this quarter. I guess, couple questions around that. First, was that traditionally a NetScout customer or Tektronix?

It was – go ahead, Michael.

So it was both. Actually it was both and they came back to both of us. So we essentially continued that.

The reason it’s a combination like Michael said, but it was driven more on the Tech side of the functionality even though they were a bigger customer of Tech than NetScout.

Okay.

Yes, this customer, when we had talked in the past about a tier-1, we have said that, most of them had gone either with a Tech solution approach or with a NetScout, there was always one that when it came to 4G for the most part had tried to couple together, their own analytics using – an outside analytics package and I think we’ve talked about last year they decided that that was not meeting their requirements. So they had purchased the NetScout solution and they have been a customer previously of Tektronix. So this year, they had gone back and purchased more the Tektronix solution also.

Okay, and I assume they are a large customer of Tektronix previously.

Probably, I can say how large they were, but it’s probably been a few years, since they’ve purchased. As I said, they had gone to – I wouldn’t even really call it a competitor, but they had decided to do like an in-house development using a NIM analytics product and that didn’t scale or meet their needs. So they turned to NetScout last year and then this year they turned to some products from Tech.

Got it. Okay. And then, I think, there has been a lot of questions around the gross margin and specifically product gross margin, I guess, what – can you give us an idea of – you talked about seeing the benefits of the new InfiniStream integrated product towards exiting this year, I think is how you described it. Can you kind of quantify how close to historical NetScout product gross margins you can get by the end of this year? Is there any quantification there?

Well, let me just mention high level and then Jean will get to specifics. So everyone understands. So – and these are going to be in very general terms, so you get a relative indication of what the gross margin situation was or is going to be. So NetScout was in the 80% area in terms of gross margins in the past and Tech was more like 70%, Arbor was very close to NetScout as net was somewhere in between. So where we are right now is as Jean mentioned, we could reach the midpoint – mid-70s. So, we basically, which is the average of 70 and 80. As we move towards InfiniStream NG, if everyone moves to InfiniStream NG, we should be in the 80% area back again and then, if people move to software version of InfiniStream NG, then it would go higher than even 80. So how this mix is going to look like is what’s going to moderate where we end up with this, but this year’s estimate is what Jean mentioned. So, Jean anything?

I guess, the only other comment that I would say is that, we’ve always been very bottom-line focused which translates into as our earnings per share for our shareholders. So regardless of how the gross margin rolls out over this year which is in – I said, we would anticipate we would probably be in the mid-70s. We still will focusing on delivering our bottom-line on our earnings per share.

Okay. One last housekeeping for me, Jean. What do you expect depreciation to be this year and CapEx if you have it?

Depreciation this year should be around $30 million to $35 million and CapEx should be about – the capital intensity of the business has not really changed. We have spent in Q1 some money, we had about $9 million of CapEx this quarter and that was mostly I would say, acquisition-related some fitting our facilities as we consolidated certain areas and then some computer-related equipment. So I would say that, CapEx for the year would probably be somewhere around – equates to about the depreciation level, $30 million to $35 million.

Great, thank you.

You are welcome.

I think we have time for a couple more questions.

Okay. We will go next to the line of Scott Zeller with Needham & Company. Please go ahead.

Hi, thank you. Regarding the revenue mix between service provider and enterprise, I think you broken out as 56 service provider, 44 enterprise. Could you tell us though what the growth rates were year-on-year and if it’s a pro forma growth rate, please let us know?

Sure. The service provider growth rate was about 12% and the enterprise growth rate declined about 5%.

And is that pro forma in last fiscal first quarter, so that’s apples-to-apples or is it – how is that calculated?

Yes, it is.

Okay.

It is pro forma of Q1 FY 2016 of enterprise. And then the decline in enterprise, as we have talked about was mainly driven by some of the transitional issues in Fluke and as we’ve said in our prepared remarks, we think those transitional issues have stabilized and will just probably take a few more quarters for the Fluke enterprise system to sum to start growing again.

Thank you.

You are welcome.

And we will take our final question from Kevin Liu from B. Riley & Company. Please go ahead.

Hi, good morning. Just related to kind of enterprise and Fluke, you talked about some major partners starting to re-stock. Can you give us a sense for how many quarters you expect that sort of re-stocking activity to continue?

So, in those comments, that was talking about on the tools-related business that those are tools that we sell mostly to channels and I would say that we would anticipate as we exit FY 2017, we should probably see positive growth albeit in the low single-digits for that piece of the business.

I think you just wanted mention that tools business overall is low to mid single-digit size of the total business. So, it’s not a huge portion of the business.

Understood. Thank you. And then, just lastly, with the new product introduction of NG, I am curious just where you are seeing your customer interest lie in terms of how they wanted to play, are you seeing many of them still want to go the traditional rate of deploying on an appliance basis or is there increasing interest on kind of software only?

Well, I think it’s – I mean, there are – I mean, when you go to software, I think, you have to do a N number of things to make it transmit into people. For example, people, did they still want finished products, so we have to increasingly use the channel and all those. So, there are few things we are working on to really get ready for that model because just getting a one-stop shopping was more convenient for the customer, but lower margin for us and higher price for them and so, everyone is attractive towards that, but I think it’s going to take some time every customer is making a decision on their own timetable and depending on – it also depends on what’s the traffic rates are. If the traffic rates are very high, then going to a software solution is lower price and they will probably want to go on to – will probably want to go to the software model. But when the traffic rates are lower, like tier-2 provider, it’s not big advantageous because there is a minimum threshold of price that you have to cross to take advantage of software. So, all these make a difference, also the software product has basically two versions. One is basically buying software for traditional datacenter and that’s what we are talking about. Moving forward, as we have go to the cloud, the software is the only judge. So, when we say we are releasing multiple versions, there are about 10 to 20 different models, deployment models ranging from software in the cloud to software in the datacenter to buying a full function appliance to buying the tech product the way it was. So, it’s a many choices and we work with them to come out with the right thing for different customers. But it’s not clear right now and at this point, we are not pushing customers one way or other and that’s going to have a impact on the margins, but, we are actually quite conservative when we talk about the gross margins. We are assuming that it is going to take some time to move toward the software model.

Hey, Kevin, this is Jean. Also, just stepping back from a business and market perspective, our technology is such that we can sell in any form factor that the customer wants and as we have talked about in our remarks, we see the move to virtualization. But that will be a process where in the interim there is a hybrid. And so what we are doing right now is we have customers who are potentially interested in buying software only from us as they put it on hardware that they purchase themselves, because we’ve always been hardware-agnostic. Some customers are interested in that idea and some customers are still not interested, because it requires them purchasing and things that are not as easy as just want buying our product. We are in conversations with many of our carriers about potentially will they want to do that, but we sell in any form factor and as the market moves towards virtualization, our technology is there and we are ready to be able to sell it however the customer would prefer.

All right, thank you for taking the questions and congrats on a good quarter.

Thank you, Kevin.

Thank you.

I would like to now turn the call back over to Andrew Kramer for closing remarks.

Great, well I appreciate everybody taking their time this morning to listen to our commentary. If you do have questions, you can certainly give us a call at Investor Relations. You can email us as well. Look forward to seeing folks when we are out at the road, out on the road on various conferences and various money centers. And look forward to connecting with you when we report our Q2 results later this Fall. Thank you very much.

We’d like to thank everybody for their participation on today’s conference call. Please feel free to disconnect your line at any time.