NetScout Systems, Inc. (NTCT) Q2 2018 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to NETSCOUT's Second Quarter Fiscal Year 2018 Results Conference Call. [Operator Instructions]. 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 now like to turn the call over to Andrew Kramer to begin the company's prepared remarks.

Thank you, Keith, and good morning, everyone. Welcome to NETSCOUT's second quarter fiscal year 2018 conference call for the period ended September 30, 2017. Joining me today 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. There's a slide presentation that accompanies our remarks. And that can be accessed on the Investor Relations section of our website at www.netscout.com. The slides can be advanced in the webcast viewer to follow our commentary. We will call out the slide numbers we are referencing in our remarks. Today's agenda will be consistent with prior calls. Anil Singhal, our President and CEO, will review our performance and major highlights. Our COO, Michael Szabados, will briefly discuss key wins and go-to-market developments. Our CFO, Jean Bua, will then review second quarter results and our fiscal year 2018 guidance. Moving on to Slide #3. I would like to remind everybody listening that forward-looking statements as part of this communication are made pursuant to the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934, as amended, and other federal securities laws. Investors are cautioned that the statements in this call, which are not strictly historical statements, including, but not limited to, the statements related to the financial guidance and expectations for NETSCOUT, share repurchase activity, market conditions and customer demands, anticipated revenue from specific customers and specific products, along with all of the other various product development, sales and marketing and expense management and other initiatives planned for fiscal year 2018 and beyond, constitute forward-looking statements, which involve risks and uncertainties. Actual results could differ materially from the forward-looking statements due to known and unknown risks, uncertainties, assumptions and other factors. This slide details these factors. And I strongly encourage you to review each of them. For a more detailed description of the company's risk factors, please refer to the company's annual report on Form 10-K for the fiscal year ended March 31, 2017, and the subsequent quarterly report on Form 10-Q, which are 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. Let's turn to Slide #4, which involves non-GAAP metrics. While this slide presentation includes both GAAP and non-GAAP results, unless otherwise stated, financial information discussed on today's call will be on a non-GAAP basis only. This slide, which we also encourage you to read, provides information about the use of GAAP and non-GAAP measures because non-GAAP measures are not intended to be superior to or substitute for the equivalent GAAP metric. Non-GAAP items are described and reconciled to GAAP results in today's press release. And those and other reconciliations and supplemental details are included at the end of this slide presentation, which is available on the website. As we detailed in our press release today, our second quarter results came in ahead of our expectations entering the quarter. We continue to innovate and make further progress on our product road maps. We move into the second half of the year focused on addressing the challenges that lie ahead and capitalizing on the opportunities we see. With that as the high-level background, I'll now turn the call over to Anil. Anil?

Thank you, Andy. Good morning, everyone, and thank you for joining us. Let's begin on Slide 6 with a recap of our non-GAAP results. NETSCOUT's second quarter performance exceeded our plans entering the quarter with revenue coming in at $259.9 million, a gross margin of 75.5%, an operating margin of 16.3% and diluted EPS of $0.29 per share. Jean will review our performance in more detail, but I'll share a few observations. Our quarterly revenue exceeded our plans for the quarter due largely to certain service provider orders that were previously expected for the third quarter and accelerated into the second quarter. While revenue was higher than the anticipated, it declined by 8% from the same quarter in the prior year in part due to the ongoing moderation in spending by one of our large Tier 1 customers. Our gross margin improved by a full percentage point, primarily as a result of favorable shifts in product mix as we continue to make progress with our software-driven product strategy. In terms of our profitability, we have continued to prudently manage our cost even while funding a range of development activities that we believe will play a critical role in our long-term growth and success. On the new product front, we continue to make important progress with our efforts to innovate and expand our product portfolio and capabilities. Let's move to Slide #7 to cover that in more detail. As we've discussed, our approach to collecting and analyzing network traffic or wire data is differentiated by our patented Adaptive Service Intelligence or ASI technology, which instantly converts high-volume network traffic at the collection point into highly structured, multidimensional metadata or what we call smart data. We are using this smart data to power an expanding range of analytics that address a growing number of use cases. At the foundation of our smart data strategy is our real-time information platform, the ISNG, which offers deployment options that range from traditional appliance to software-only. We introduced this platform last fall, and we are making excellent progress in driving adoption of this platform in the software form factor with our service provider customers. Later on in the call, Michael will highlight how one of our cable MSO customers is deploying our ISNG software to monitor their expansive WiFi infrastructure. While the majority of the ISNG deals we are striking are for onetime, perpetual software licenses, a number of international carriers of varying sizes are now advancing discussions for multiyear enterprise license agreements. The software-only version of our ISNG was approximately 10% of our second quarter product revenue, up from the low single digits in the first quarter. This progress reinforces our confidence that this platform will represent 8% to 10% of the total product revenue in fiscal year 2018 and help drive notable improvement in our gross margins this year. We have executed well on our product road maps to augment our new ISNG platform. Last quarter, we unveiled new complementary instrumentation options and new analytics that extend visibility and enabling deeper, more flexible and comprehensive analysis of both wires and nonwire data to support our customers' network performance, application performance, infrastructure performance, cybersecurity and Big Data requirements. These new offerings are intended to expand our total addressable market and elevate our value proposition as we help our customers monitor virtualized network functions, ensure application performance across both conventional IT data centers and private and public cloud environments, identify the root cause of infrastructure issues that impact the end-user experience and detect advanced security threats. We have been pleased with the growing interest in these offerings from both existing customers and prospects. During the past quarter, we continued to innovate. In July, we announced the integration between our ISNG and the Arbor Spectrum analytics for network threat analysis, which enables network and security operations team to each benefit from access to network traffic as its data source. Earlier this summer, as part of our plan to further differentiate the Arbor Spectrum, we acquired Efflux Systems, which brings us a small but extremely talented engineering team with deep security and machine learning expertise. Over the coming quarters, we plan to integrate their technology and capabilities into our advanced threat offerings in ways that can support faster, more accurate and insightful detection of threat actor behavior. In September, we formally introduced our nGenius Business Analytics, which makes wired data consumable for Big Data applications in a scalable, cost-effective manner. The product is already being used by more than a dozen service providers to help them automate operations, enhance customer care and deliver personalized services. Similar to how we've decoupled our ISNG software from the appliance itself, we are doing the same for our network packet broker product line. Earlier this month, we announced the availability of the nGenius Packet Flow eXtender or PFX software for service assurance and cybersecurity monitoring. This disaggregation of software-driven packet broker functionality from the underlying hardware is unique in the industry and disrupts how traditional packet broker using proprietary hardware have been priced and licensed. We believe that this will enhance our ability to compete in an increasingly price-sensitive market, particularly for small- and mid-sized enterprise accounts. As a result of our progress in bringing our newest offerings and capabilities to the marketplace, we are nearing the end of our latest product cycle. We move into the second half of the year having made good progress across multiple fronts during the first 6 months of fiscal year 2018. This brings us to our outlook, which is covered on Slide #8. Entering into fiscal year 2018, we set our top line target at around $1.2 billion, recognizing that keeping revenue relatively unchanged against the prior year would be an ambitious goal since our largest Tier 1 service provider customer was continuing to significantly moderate their 4G-related spending. We continue to expect that this customer's year-end -- year-over-year decline in spending with us could be up to $100 million. Our plan at the beginning of this year was to offset this decline through a combination of growth in other Tier 1 service provider accounts and by expanding our enterprise business. While our results to date are slightly ahead of our original expectations, we do see some challenges ahead in the second half. In particular, the service provider spending environment remains under pressure. And this is likely to continue influencing the timing and magnitude of larger service assurance and security purchases at many of our largest service provider customers. We are also concerned that carrier spending activity in North America could be further compromised by potential M&A activity. In the enterprise customer segment, second quarter orders from the government vertical were not as strong as we originally anticipated. And it's unclear which projects, if any, that went unfunded last quarter will move forward during the second half of this fiscal year. For these reasons, we are taking a more conservative view into the third quarter. Although these dynamics make it more challenging to fill the revenue gap created by the anticipated decline in spending at our largest Tier 1 customer, we have left our non-GAAP revenue and EPS guidance for the year unchanged. We continue to focus on mitigating the potential risks that we see through a variety of sales programs that are aimed at realizing potential upside opportunities from across our customer base over the next 5 months. As we have demonstrated consistently over the years, delivering on our EPS targets continues to be our top priority. And if necessary, we are prepared to take certain actions to adjust our cost structure and preserve our EPS performance to the greatest extent possible. In closing, we remain confident about our strategic direction and our ability to deliver tangible value to all of our customers, employees and shareholders over the long term. We are seeing a steady adoption of our new real-time information platform across our expansive service provider customer base. Our newest enterprise products are amplifying our value proposition to make us even more strategic, valuable and trusted partner to our customers. Our DDoS solutions remain best-in-class. And we expanded our security offerings to help customer address advanced security threats. Consistent with this perspective, the board authorized a new 25 million share repurchase program that provides us with the scope to further optimize our capital structure as we move forward. We'll give due consideration to the timing, magnitude and approach to our buyback activity, particularly as we achieve greater visibility on the issues that could impact our near-term results. That concludes my prepared remarks. And I'll now turn the call over to Michael at this point.

Thank you, Anil. And good morning, everyone. Slide #10 outlines the areas that I will cover. As we've discussed on our prior calls, a top priority in fiscal year 2018 is to fortify our incumbency with service providers by driving adoption of our software-only platform. We are continuing to make good progress on this front. This morning, I'd like to cover a new ISNG software win at a major North American cable MSO. Over the years, this customer has used our traditional solutions to monitor voice applications, programming guide activity across set-top boxes and mobile apps and WiFi connectivity. WiFi is a strategic area for this customer, particularly as it seeks to continue promoting this offering to its expansive subscriber base as well as market new, high-quality mobile calling services for which it can cost-effectively offload mobile traffic to the existing WiFi infrastructure. However, tight budgets had limited the customer's WiFi monitoring to only its largest markets. Given these dynamics, our ISNG software played perfectly into the customer's plans. And it has freed up well over $5 million to fund the rollout of our software across the remaining markets over the next couple of quarters. In addition, this customer is also one of the dozen-plus accounts that has started to deploy our nGenius Business Analytics product. This cable provider plans to use the capabilities -- these capabilities in conjunction with our ISNG to enhance visibility into its network infrastructure, thereby further enriching the key datasets that should ultimately helps it make better business decisions and improve the customer experience. In the enterprise, we are starting to generate additional traction with our new vSCOUT and vSTREAM offerings that we introduced last quarter. These offerings provide enterprises with deeper application visibility, regardless of whether those apps run in a traditional data center or in the various forms of the cloud. We believe that these new products will ultimately bring us into new areas of IT organization and enable us to tap into new budgets that were previously quite difficult for us to access. During the second quarter, a large civil service agency selected and began deploying vSCOUT in conjunction with NETSCOUT's traditional solutions to ensure that key applications operate with peak performance for both internal users and public customers. More specifically, vSCOUT will provide visibility into its critical applications running in virtual environments on Linux and Windows servers, where the agency was previously blind to issues. This deal, which was valued in the high 6 figures, further illustrates the flexibility of our technology to help our customers enhance their ability to deliver high-quality applications and quickly identify and triage issues that arise. In security, Arbor enjoyed another strong quarter of enterprise growth. This quarter, Arbor secured a $4 million DDoS order from a blue-chip U.S. financial services company to refresh and expand its existing deployment of Arbor TMS, our inline DDoS attack mitigation solution. Arbor TMS is the most broadly deployed mitigation solution in the market due to its strength in filtering traffic in real time, thereby allowing business services to remain available even while a DDoS attack is being mitigated. Over the past year, Arbor has made significant investments in the TMS platform, increasing its mitigation capacity from 40 gigabits per second to 100 gigabits per second while at the same time significantly improving the overall total cost of ownership. The new Arbor TMS solution has allowed this customer to substantially extend its deployment to cover more data centers around the globe. To further strengthen its reach with smaller- and medium-sized enterprises, Arbor recently announced a suite of new, affordable, flexible advanced DDoS protection options for unified protection across hybrid cloud environments. Now a few words about go-to-market. As we move forward, we are very excited about the potential for our newest products as they move through the initial stages of their respective sales cycles. In addition to vSCOUT and vSTREAM, we are also very pleased to see growing interest in our new nGeniusPULSE offering as a highly complementary active testing and infrastructure performance monitoring capability to diagnose infrastructure performance issues impacting servers, routers, load balancers and other infrastructure equipment. We are investing in lead generation activities that will enable us to drive demand and raise greater awareness for these new offerings with both existing customers and prospects. For example, as the hybrid cloud continues to gain momentum across our customer base, we believe that our participation in events, like last quarter's VMworld and the upcoming AWS re:Invent conference, will yield good results. At the same time, the market continues to recognize our products as best-in-class. For example, during the past 4 weeks alone, our Arbor Cloud service received 3 significant awards for excellence in DDoS protection. I hope to share news of similar accolades for our newest products on future calls. This concludes my prepared remarks. And at this point, I will turn the call over to Jean.

Thank you, Michael, and good morning, everyone. This morning, I will review key metrics for the second quarter and key revenue trends through the first 6 months of fiscal year 2018. After that, I will review our fiscal year 2018 guidance. As a reminder, this review will focus on our non-GAAP results and all reconciliations of with our GAAP results are in the appendix of the slide presentation. Slide #12 shows our results for the second quarter and the first 6 months of fiscal year 2018. Focusing on our second quarter results, total revenue decreased by $23.3 million or 8% to $259.9 million. Our overall gross margin of 75.5% increased by approximately 100 basis points this quarter. This reflected good progress in improving product gross margins, especially in light of a $25 million decline in product revenue. This improvement primarily reflects favorable shifts in product mix due to ongoing progress with our product strategy that is aimed at replacing legacy hardware-dependent offerings with our ASI software technology. Our operating expenses were essentially flat and our operating profit margin was 16.3%. This translated into diluted earnings per share of $0.29. Turning to Slide 13. I'd like to review key revenue trends. As we've discussed on prior calls, we are managing through a significant moderation in purchasing by one of our large Tier 1 service provider customers following several years of elevated purchasing. We continue to expect fiscal year 2018 spending from this customer will decline by up to approximately $100 million from the prior year. In the second quarter, this customer's spending declined by approximately $25 million. Within our service provider segment, overall revenue declined by 10%. The decline from that large Tier 1 customer was compounded by a mid-teens decrease in Arbor's service provider business as it lapped a tough comparable that was boosted by a product transition for one of its offerings this time last year. These declines were partially offset by 25% growth in all other service assurance service provider accounts. Our enterprise vertical declined by roughly 6% in the second quarter. We saw strong revenue growth with Arbor's enterprise DDoS offerings. Revenue from the core NETSCOUT enterprise offerings declined modestly due to the government vertical not being as robust as we had expected. Additionally, we continue to see revenue declines in certain other ancillary product lines. The composition of the first half's revenue reflected the decline in our service provider vertical. And the mix was 52% of total revenue coming from service provider and 48% from enterprise. In terms of revenue by geography, which is calculated on a GAAP basis, our first half revenue in the United States declined due to the decrease in revenue from that large Tier 1 carrier while international revenue was relatively flat. International represented 39% of total first half revenue versus 35% in last year's comparable period. We did not have a 10% revenue customer for either the second quarter or the first 6 months of the fiscal year. Slide 14 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 $313.4 million. During the second quarter, we used $100 million to repurchase our stock. At the end of the second quarter, our revolver had $500 million of available credit under the existing facility, which left us with total liquidity of nearly $815 million. Our free cash flow for the second quarter of fiscal year 2018 was $13.9 million and it was $63.2 million for the first half of the year. We anticipate that our free cash flow for fiscal year 2018 will equate to approximately 100% of our non-GAAP net income. In terms of our share repurchase activity, we repurchased 3,022,355 shares of common stock at an average price of $33.09 per share, totaling approximately $100 million in the aggregate. While this represented a negligible effect on the second quarter's earnings per share, our buyback activity for the first 6 months represents an incremental $0.07 increase to our earnings per share outlook for the year. We ended the quarter with approximately 971,000 shares remaining under our existing 20 million share repurchase authorization. As detailed in today's press release, the board has authorized a new 25 million share repurchase program that will go into effect once we complete the existing program. We expect to be active in the market during this quarter. To briefly recap other balance sheet highlights, accounts receivable net were $215.2 million, down from the end of last fiscal year. DSOs were 72 days, an improvement from 80 days at the end of the fiscal year 2017 and 80 days at the same time last year. Moving to Slide 15 for guidance. I will focus on the non-GAAP guidance and remind you that the reconciliation of our GAAP guidance to our non-GAAP guidance is in the appendix. This slide details our revenue and earnings per share targets for the year. Earlier on the call, Anil detailed certain risks that we see in the second half of our fiscal year that may limit our ability to absorb the anticipated full year decline in spending by one of our largest Tier 1 service provider customers and meet our annual revenue target. However, we are focused on advancing plans and tactics that will help mitigate those risks by accelerating and maximizing a range of opportunities across our customer base over the next 5 months. Accordingly, we have left our fiscal year 2018 guidance unchanged at this time. As Anil noted, we are taking a cautious view into the third quarter and anticipate revenue in the range of $300 million to $320 million. Other full year modeling assumptions based on our outlook are outlined on this slide. Based on the quarterly impact of these assumptions, most notably relatively flat operating costs and roughly 88.5 million diluted shares outstanding for the next 2 quarters, this would translate into third quarter diluted earnings per share in the range of $0.60 to $0.66. That concludes my formal review of our financial results. Before we transition to Q&A, I will note that Slide #16 highlights the various investor conferences we plan to participate in over the next couple of months. That concludes our prepared remarks this morning. Thank you again for joining us. And we're now ready to answer questions. Keith, you may now begin the Q&A session.

[Operator Instructions]. We'll take our first question from Eric Martinuzzi with Lake Street Capital.

I had a question. You talked a little bit about the carrier weakness continuing here. So this is just kind of a continuation of a theme. But you did feel it back and talked a little bit about both on the assurance and on the security side. I was wondering, are those both under pressure in equal amounts? Or is security more of a surprise for you?

I think security is more of a surprise. Not a surprise, but I mean, as a lot of customers are also finding out that -- slowly discovering that Arbor is really a part of NETSCOUT, so there is some deal consolidation, discount pressures, removal pressures. So that's somewhat different than what we thought earlier. But most of the pressure is on the service assurance side.

I think -- just to answer that, Eric, I think the other thing that Arbor would tell you is it's also an absorption of a lot of the equipment of the DDoS protection that the service providers had bought in the last part of our fiscal year after there was that large attack. And so they probably see it as a little bit of a digestion pause.

Appreciate it. Now you also talked about potential impact of carrier consolidation. This isn't the first time that NETSCOUT has been impacted by the potential for a carrier consolidation. Are you seeing a pattern repeat here? I'm specifically thinking back to the AT&T play for T-Mobile as far as how it's impacting pipelines.

Yes, I think there is some uncertainty. I think that was -- this may be a bigger impact because that was -- I think that there was a big difference between the sizes of the 2 companies. And right now, what's going on, it's isolated to 1 or 2 cases. So I think it's slightly more complex than the AT&T, T-Mobile situation previously.

Yes. And just to further add on to that, both of those customers that are being -- both of those carriers that are being contemplated in the news today are both customers of NETSCOUT. And on the positive side, their business strategy is to try to gain subscribers in a fight with subscriber population with the other large Tier 1s. And in that effort, as you know, they're cutting prices on their programs, but they're expanding their network and they are focusing on the quality of their network. So both of those customers are NETSCOUT customers. And we've seen good growth with them over the last couple of years as they continue to invest. The one thing that we would have to watch is as a combination, would that distract people from focusing on the network? And would the inventory that both of these customers have cause any kind of pause in spending? So there's upside and downside to that combination.

We'll take our next question from Matt Hedberg with RBC Capital Markets.

Anil or maybe Jean, I guess for both of you guys, you mentioned on the prepared remarks that there are some challenges you're seeing. I think, Anil, you said you're taking a little bit more conservative view to Q3. I'm curious, to offset that, you're talking about some increased sales initiatives to help, I assume, harvest additional revenue from your base. Can you talk about what some of those sales initiatives are of those sales programs?

So I think one of the things -- one of the traditional one is discounts. I think giving them a bigger solution, some assurance on that solution is going to be again spend and across the virtual and the physical infrastructure with traditional sales programs plus there are some incentives from the sales team in the second half, over and beyond for meeting the quota. So those are -- I mean, nothing special, fairly traditional and -- but somewhat more aggressive than what we had at the beginning of the year.

Yes. And the only thing I would add to that, Matt, is, as you know, we have an excellent DDoS product in Arbor. And they have good traction in the enterprise. And then as you also are familiar with, we have an excellent customer base in the NETSCOUT core enterprise sales force, who are also focusing efforts on the cross-selling and the combination of those 2 strengths to try to accelerate any kind of DDoS or enterprise selling.

Got it. That's helpful. And then maybe another one for Anil. Again, kind of referencing your prepared remarks, you talked about the software-only version of ISNG. I think what you said was 10% of product revenue. That's great to hear. Can you talk about the ACV, the annual contract value of a software-only deal for ISNG versus maybe what a hardware/software deal several years ago might look like for a similar type commitment?

I think what we are seeing is -- so the biggest trend going on in the service provider side is one of the most important places to monitor for quality and business analytics is the link where there's a lot of OTT traffic. And those traffic where it's because of all-you-can-you-eat plan and other things is doubling every year. So there's no way they could have monitored that with an effective cost and everything at the price levels before. So overall, I would say the size of the deals is roughly the same, but they are buying a lot more for that. So normally, you would have expected growth that the traffic has doubled and our revenue for that deal would be doubled or at least 1.5. But because of the budget pressure and other things, it's not linear to the traffic growth. And so whether we do it with hardware or software combination or a software combination -- software-only right now, a deal size right now will be the same. With this tested budget, you do it however you want to do it. The advantage of the software model for us is that we are able to manage this without impacting the margin, in fact, improving the margin. So that's what is the dynamic playing in. It's not really software/hardware combinations customers are demanding. They are demanding a lower price. And for a company of our size, the only way we can mitigate that is through a better margin model, which is software versus small competitors who can just throw a discount that [indiscernible].

We'll take the next question from Zach Cummins with B. Riley & Co.

So starting off, you talked a little bit about your release of nGenius Business Analytics, which is already in use with about a dozen-plus of your service provider customers. Can you talk about the potential impact this new solution can have on deal sizes down the road?

So I think -- so in terms of -- for the next, I would say, several quarters that the biggest impact is it makes us more sticky in account. It doesn't necessarily increase the deal size, but it makes us sticky in account and it makes us much more competitive. In the past, they will buy a separate InfiniStream-like product from a different vendor for business analytics and they'll buy one from us for service assurance. Now that functionality being in the same solution set makes it possible to do the big deals and multiyear agreements we have been doing across the world, especially outside of the U.S. And so that's what the big role of business analytics. Second part of that is a lot of people -- customers have big data lakes. And so they want our rich dataset feed into their data lakes. So one of the roles of the business analytic is to make, convert some of those people into our partners. And we might be announcing one of those partnerships over the next 3 to 6 months.

All right, great. That was helpful. And then on the buyback, you've bought back $1 million in stock over the first 2 quarters. And then the board recently approved a new 25 million share program. So should we assume this $100 million pace continues going forward? Or what are some of the factors that could change the pace of the buyback?

So we have bought, for the first half of the year, roughly $200 million, $100 million per quarter of our outstanding stock. And I think, as we've talked about in the past, what we generally look at is the actual market itself and what we think of the effects on our share price and whether as an investment in that share price at that time, if we think it's a good return for our dollar. So we continue to do that going forward. We have substantial liquidity. So we do have the availability to do something that would be more of a magnitude if we so chose. But this quarter, we expect that we will continue with our share repurchase program and we'll be active in the market.

And we'll go next to Chad Bennett with Craig-Hallum.

So I guess just a question on the guide and maintaining the guide. Considering, Anil, your commentary and kind of the caution that you've talked about before and then the Q3 color that you gave on the call, the fact that Arbor is a little bit weaker, enterprise was on a pretty good trend of growth year-over-year, it looks like that reversed. I guess, maybe it's a simple question. Why stick with the revenue guide considering how back-end loaded it now is and the risks that you guys talked about in the call?

So I'll mention maybe a couple of factors. Just to mention at the beginning of the year, despite ups and downs, a tough service provider market, Arbor, I think except for this one Tier 1 making up for the shortfall in the Tier 1 providers, things are going quite well. But they're not going well enough to make up for that big number. And that probably has changed as time is passing by. But the second half, even though it's much more polarized on a bigger portion versus the past, there is -- these are our best quarters because, especially in service providers, because there is a budget flush in Q3, and then there is a new budget in Q4. How much of that helps us close this gap is not clear to us. So we have traditionally updated guidance in January because we have a better view and better visibility into -- if you want to change guidance, then we want to also have to change it into something. So right now, it's not very clear how -- we see a lot of upside. We see a lot of challenges. And we need to see how this Q3 phases out and how the forecast and funnel looks for Q4 before making the decision.

Got it. And then second question for me, the Tier 1 customer that you highlight that you believe will be down, I think, $100 million this year, have they adopted your software-only service assurance solution yet?

Not yet. But basically, one of the things they were waiting for is they want -- they love the functionality, which were delivered. This was one of the -- one of the reason it was the biggest customer was they were a customer of both Tektronix and NETSCOUT. And so they want -- and both the solutions in the past were hardware/software combinations. After the acquisition, they're expecting to, before they deploy our software-only solution, to not only have both the features available in software because they like it, but in a single product. And that just happened 6 months ago. So that's why we think the future sales to even this customer will be in the software form. But that has not happened yet.

We'll take the next question from Alex Kurtz with KeyBanc Capital Markets.

I just had some modeling questions here, then a bigger question for Anil. So Jean, just running through the Q3 numbers, what you've outlined here and looking into the implied Q4 guide, it's just -- and then your high single-digit number for -- or high single digit to low double digit for EPS growth, I mean, what has to happen in OpEx and margins to get to you to that outcome when you look from Q3 to Q4?

What has to happen in the operating expenses to get to...

Yes, did you expect a big decline in OpEx to get there? And what do you think about product and services margins? Because services margin looked like it dipped this quarter. So how do you see margins ramping? And how do you see OpEx ramping from Q3 to Q4?

So I guess I would say at this point, based on where we come in at the implied fourth quarter guide, we are remaining with our $1.2-ish billion revenue guidance, that the margins are basically improving. Because you have higher volume, the operating cost will stay relatively flat. So we still anticipate that -- and as Anil has said earlier, it's 5 months, 6 months that we have left in this quarter and this year to achieve our goals. So we anticipate that the margins will improve through gross margins and that the operating cost would stay relatively flat. Given if there is some kind of a change in the revenue, there is about -- if you want to use operating cost as a proxy, there's probably about 5% of cost that we could easily identify to moderate any kind of a change in revenue.

Okay. Well, we can get into a little bit more offline. And just back to your previous question about why not derisk the March quarter a bit relative to your guide, I mean, Anil, I know you've outlined some challenges with Arbor, which is kind of a new item in my view and obviously some challenges with domestic carriers. So why kind of put yourself in a corner here with the big sequential growth into the March quarter?

Well, like I said, I think we do the best job of managing the risk versus expectations as we go. And we still have 0.5 year to go and a lot of good things happen. And if you remember, last year also, there was a similar question around this time about -- concerned about the second half and we managed to pull it up. And right now, I think the gap is bigger. And so we just feel that we want to not just change something, we need to give the reasons and change it to some X to Y. And we are not in a position to have the level of visibility to do that and don't want to make a second change again. And so all these are leading up to saying, "Let's do our analysis." We already gave you guidance for Q3 based on this caution. Yes, that puts pressure on Q4, but I think -- we'll -- we don't feel that this is the right time to make the change.

Do you feel like there's enough service provider backlog our pipeline that's pretty well along the process that kind of gives you that confidence to sort of stick with the number for the second half? Or is there enough activity in the pipeline to get there? Or at least it sounds like it's progressed enough that you feel that you can have some confidence in hitting the back half numbers there?

Well, I think confidence may be a strong word. At the same time, not having visibility is another type of strong word. I think basically if the probability was 0, we would be making the change right now. And I think that, that probability is higher than that. It's lower than when we started with the year. But it's still good, good enough to not make the change right now.

Okay. And just last question, your product growth most likely will be down year-over-year in fiscal '18. Do you think products can grow next year, Anil?

Yes, I think we have mentioned that there are a lot of -- I think this is a tough transition year for us and tough service provider environment changed, a lot of pressure on Tier 1 in the U.S., Tier 1 providers in the U.S. We had integration challenges. We had some issues with this. I think all the side effects or negative effects of that Danaher acquisition are starting -- reaching their tail end. And so I think -- and all the positives of the integrated product road map, all the investments we have made, whether in security or service assurance or service provider, has just beginning to start. So I think I'm feeling, despite what happened this year, regardless of that, it will be a good next year because we think that we are on to something, a good growth starting next year.

[Operator Instructions]. We'll go next to Mark Kelleher with D.A. Davidson.

Just want to go back to that Tier 1 issue, you talked about the decline there. Is there any risk that, that situation develops at another one of your Tier 1 carriers? And do you sense any competitive dynamic change at the Tier 1 carriers?

Yes, so good questions. So first thing is that there is no other customer anywhere close to that size. And that's number one. Second is there was another customer like that. And they tapered up last year and is actually on the rise. And it's possible that once we hit the bottom here, it might go on the rise, one of the big reasons being integrated solution and their software product. Our competitive environment is actually getting better for us, partly because only reason competitions would win against us was price. And software model has given us a leg up on that front also. I mean, everyone -- anytime anyone was winning, it will only be -- most of the time the big factor was the price. We have the reach. We are worldwide. We have the combination of Tektronix and NETSCOUT. We have the best technology. We're in business for 25 years versus many people for 5, 10 years. So price was the big reason. And our ability to discount our solutions was compromised by margin and other issues, which was not a problem with smaller private companies. And going to a software model has increased our ability for both driving bigger deals in terms of stickiness and otherwise plus we're very competitive. So I think our competitive situation is constantly improving.

And it appears we have no further questions at this time. I'll turn the floor to management for any closing remarks.

Thank you very much, Keith. I'd like to thank everybody for listening in this morning. If you do have any follow-up questions, certainly feel free to reach out to Investor Relations. Look forward to seeing those of you out at various conferences and look forward to our next communication with you.

And this will conclude today's program. Thanks for your participation. You may now disconnect. Have a great day.