Kevin Liu - K. Liu & Company James Fish - Piper Sandler Eric Martinuzzi - Lake Street

Please stand by your program is about to begin. Ladies and gentlemen, thank you for standing by and welcome to NETSCOUT's Second Quarter 2021 financial 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. Tony Peot, our Vice President of Corporate Finance and his colleagues at NETSCOUT are on the line with us today. If you require operator assistance at any time, please press zero. I would now like to turn the call over to Tony Peot to begin the Company's prepared remarks.

Thank you, operator and good morning everyone. Welcome to NETSCOUT's Second Quarter of Fiscal Year 2021 Conference Call for the period ended September 30, 2020. Joining me today are Anil Singhal NETSCOUT's President and Chief Executive Officer, Michael Szabados, NETSCOUT's Chief Operating Officer and Jean Bua NETSCOUT's Executive Vice President and Chief Financial Officer. There is a slide presentation that accompanies our prepared remarks, you can advance the slides in the webcast viewer to follow our commentary. Both the slides and the prepared remarks can be accessed in multiple areas within the Investor Relations section of our website at www.NetScout.com including the IR landing page under financial results. The webcast itself and under financial information on the quarterly results. Moving on to Slide 3. Today's conference call will include forward-looking statements. These statements may be preface by words such as anticipate, believe and expect and we'll cover a range of topics that are not strictly historical facts, such as our outlook, our market opportunities and market share, key business initiatives and future product plans along with their potential impact on our financial performance. These forward-looking statements involve risks and uncertainties and actual results could differ materially from the forward-looking statements due to known and unknown risks, uncertainties, assumptions and other factors, which are described on this slide and in today's financial results press release as well as in the company's Annual Report on Form 10-K for the year ended March 31, 2020. 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 involve non-GAAP metrics. While this 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. The rationale for providing non-GAAP measures, along with the limitations of relying solely on those measures is described on the slide and in today's press release. These measures should not be considered in isolation from or as a substitute for financial information prepared in accordance with GAAP. Reconciliations of all non-GAAP metrics with the applicable GAAP measures are provided in the appendix of the slide presentation in today's earnings press release and they are also on our website. I will now turn the call over to Anil for his prepared remarks. Anil?

Thank you, Tony. Good morning everyone and thank you for joining us. Let's begin on Slide 6 with a brief recap of our second quarter non-GAAP results. We delivered solid earnings-per-share growth on lower revenue of $25.3 million compared with the same quarter last year. Earnings per share was $0.38 in the quarter, an increase of more than 35% compared with the same period last year. Both service provider and security revenue grew in the quarter but were more than offset by a decline in spending in the U.S. Federal Government sector which impacted enterprise revenue. The quarter benefited from our focus on cost control as well as by pandemic related travel restriction. Let's move to Slide 7 for some further perspective on the business. In the service provider vertical revenue grew 4% compared with the same quarter last year. We continue to work with our service provider security initiated in the year with even greater as a result of the pandemic and the new normal of operating with remote resources and interacting with the customers in a more virtual fashion as they look to address speed agility and cost. On the security front that landscape continues to rise rapidly and the pandemic has created more opportunities for bad this to disrupt organization given that distributed operations. Last month we issued our first half 2020 third intelligence report which highlighted how cyber criminals are exploiting the pandemic to a radical change in deed of method they are using. The report discuss how cyber criminals launch record breaking tags on online platforms and other services during the pandemic and increasingly going to connect network these attacks targeted e-commerce, education platform, financials services and healthcare services. There multi back to back attacks were shorter, faster hard hitting and more complex. These new…

Thank you, Anil. And good morning everyone. Slide 10 outlines the areas I will cover, first, it cost a little bit. Starting with customer events as Anil mentioned our service provider vertical has solid growth in the quarter as we continue to see 4G expansions in our international customer base and 5G trials in North America. As we await the 5G investment cycle to kick-in a notable internal 4G win in the quarter was a multi-year eight figure software and support deal forward a major European carrier, a long-standing oil cost that provided mid seven figures of revenue in the quarter. The investment enables the carrier to expand their 4G capacity and positions then to transition to 5G solutions in the future. On the 5G front we will allow to make seven figure a user trial with a Tier one North American carrier as they start to explore a stand-alone, so-called 5G network. It is still early days for North American stand-alone 5G visibility project but this is a good sign for progress all these demonstrate the trust in our brand, the strength and value of our solutions and the importance of our incumbency with our loyal customer base. In the enterprise vertical service Assurant Solutions has continued to be highly relevant and are producing important new logos for us in the financial healthcare and other sectors. During the quarter one new global and deal we won, was it a large domestic medical provider with over 1,000 beds and more than 1.5 million patient visits annually. This was a low to mid seven figure deal to implement our visibility platform in a fully virtualized deployment with extensions into the cloud for this provider patient management system, the scale and completeness of our solution as well as the expertise of our…

Thank you Michael and good morning everyone. I really feel key second quarter and first half of fiscal year 2021 metrics and outlook. As a reminder, this review focuses on our non-GAAP results unless otherwise stated and all reconciliations with our GAAP results appear in the presentation appendix. Slide number 12 details our results for our second quarter and first half of fiscal year 2021 focusing on the quarterly performance. Revenue declined by 5.1% over the same quarter in the prior year to $205.3 million product revenue declined 10.5% and service revenue declined 0.3% over the prior year quarter. Our second quarter of fiscal year 2021 gross profit margin was 74.7%, down 1.9% points over the same quarter last year due to product mix, most notably increased radio frequency propagation modeling project revenue much lower gross margins, our software-only sales were 27% of service assurance product revenue compared with 20% in the second quarter of the prior year. Quarterly operating expenses decreased 15.4% for the prior year, primarily due to continued cost control and pandemic related travel restriction. We reported an operating profit margin of 19.4% compared with 14.6% in the same quarter last year. Diluted earnings per share was $0.38 compared with $0.28 in the same quarter last year. Turning to Slide 13, I'd like to review key revenue trends for the first half of the year. For the first six months of fiscal year 2021, the service provider customer vertical revenue declined approximately 8% while the enterprise vertical grew approximately 1%. The service provider and enterprise verticals each contributed approximately 50% to total revenues for the first six months of the fiscal year. Turning to Slide 14, which shows our geographic revenue mix on GAAP basis, revenue budget. The gain was 58% in the United States and 42%…

[Operator Instructions] We'll take our first question today from Kevin Liu with K. Liu & Company. Your line is open.

Hi, good morning. First question here. You talked about some of the deals elongating. I was wondering if you could elaborate more. So, just in terms of what you're actually seeing in terms of pipeline building, have you still been able to grow that both on the enterprise and service provider side? And then, just from the perspective of deals pushing out, if we kind of put the government vertical aside, what exactly do you think your customers are waiting for in order to move forward with some of these opportunities?

Thanks for the question, Kevin. So, I think there are two areas, one is certain industries where there is unpredictable timing of whether there was go with certain projects in the pipeline and I would put on the top of that is hospitality industry and the Federal government. A lot of uncertainty around that. So, that is buyback the number one. The second one is elongated sales cycle and those are in two buckets, one is we released some new products, especially in the security space. And normally during the purchase cycle, we have to evaluate them and that requires somebody to go in and install that and that has been difficult and that extend the sales cycle. And second thing is people who are new logos. Even though we had some successes, there are a lot of interest in our new software-based offerings, especially in the enterprise. But new logos for the first time buyers also has to go through the cycle of verification and trials and that has slowed down. So, those are the factors which are mostly are COVID-related and which we certainly counting on this year, which has changed.

Got it. And then just quickly in the past, you've talked about enterprise kind of emerging as an interesting opportunity for 5G. Are you still seeing that trend build-out? Maybe you can talk about in terms of how large of an opportunity you see that over the coming years?

Yes. I see that as a follow on opportunities. So, if you had been talked about. I think in the last year and partly this year for some revenue, we see some pre-deployment opportunities like calibration which are small and but that's where we are. Then, next step will be caveat using our 5G solution for user monitoring. And we are in the early phases of that. And much later than that will be carry participating in private 5G because the cloud vendors and the carriers will have to leave those efforts also. So, I see that as a more private 5G and more of a longer-term opportunity. And then the carrier 5G.

Got it. That's helpful, thank you for taking the question.

Sure.

Our next question comes from James Fish with Piper Sandler. Your line is open.

Hey, guys. Glad to hear that you're all doing well. On the security side, you said your carrier customers bought additional capacity. And now we're starting to hear from you guys that we're seeing larger and more attacks. Are we starting to get to a point where these carrier customers are going to need to add more capacity with harbor?

I think they have I mean, they will need, but I don't I think they have quite I mean, good capacity. I think when we talk about security, there are two products which we have: one is for the service provider side and other is for the enterprise side. We see the next part being much bigger enterprise business versus harbor. We have seen a lot of opportunity in that area with the product called AED and which basically looks at application layer type, which is a new set of attack vectors. It's the on-prime device or in the entry to the cloud and then it gets into trouble it fix signals to harbor cloud. So, that's a big area of growth we are counting on and we have released couple of solutions. And it started the go-to-market initiative, which has been sort of slowed down because our people are not being able to do speedy trials. So, while there will be, we see some steady-state business on the carrier side and the growth area for securities is DDoS for the enterprise with application-layer attack forecast Layer seven attack and a new product we have announced at our user conference called Genius Cyber Investigator. So, those are the things we see more opportunity through those products in the enterprise sector. And then sometime next year, similar functionality will be needed for mobility provider, both for 4G and 5G. And those are the things -- so those are somewhat different than the past harbor revenue growth area more capacity in the carriage.

Yes, got it. And then Jean, for you. Can you give us some color between within harbor across enterprise and carrier like you typically do and also billings appeared fairly strong? Was there a good amount of product backlog that should give us some confidence here that our trends are or it could be a little bit better than you're expecting or were you just seeing greater attach of additional services?

So, all of our I guess we -- If we can talk about the year-to-date harbor generally and service provider a good Second quarter and probably is flat on a year-over-year basis. An enterprise for the year to date, they grew very strongly. They grew about a 30% increase. And that's mostly in the areas where they again play too very large institutions like financial institutions for the government. They continue to do well in harbor given the details of the security in nature. They are also doing much better because of the integration of the sales force that has many more opportunities now with the service assurance in any of the issues that they had more than a year ago with understanding their territories are behind them. So, harbor has done pretty well for the first half of this year.

And then on the billings being stronger. I mean is it more product backlog than normal or was it greater cash of additional services this quarter?

Let me just check. One second. It's mostly -- I would say it's mostly product when I look at it. The product grew very strongly in Q2 and is okay growth rate for the year-to-date on them.

Got it, thank you.

You are welcome.

Again, that is star and one for your questions today. We'll go now to Eric Martinuzzi with Lake Street. Your line is open.

Just a clarification on the full-year revenue guide. I want to make to try and put some numbers around the mid to upper single digits. Is this down prior to 8%, down 4.9%. Do you have a preference between those two?

I guess I would say we think mid 4% to 6%. And then the upper single digits is 7% to 9%. So, my range would be 4% to 9%.

Okay, alright. And then on the Fed, historically, the September quarter would be a good quarter for NETSCOUT with the federal business. Are we looking at something that's just a vagary of being a sub to the main, where it's just lumpy, or is this potentially kill projects? Is it pending new appropriations? Could you snap back in December? Are we looking at a multi-quarter issue in your view?

I think it could be a longer-term, I don't think it's going to snap back in December. And in federal government, we have seen projects, even without COVID in the past, they never die, they just, sometimes, last for two years. So, I think that the budgets are approved. We are the selected partner but something radically changing in the fiscal year, I think, is unlikely.

Okay, alright. And your commentary on the non-GAAP earnings for the business, you guys have always done a good job on the cost management. You've done a good job of being able to hit your non-GAAP earnings targets on an annual basis. You did see a decline in Q2 of I think it was 15% or 16% in the operating expense. I got to believe part of that is just less TV, less conferences because of COVID. But we're -- what are our cost structure points of leverage as you are trying to manage to that non-GAAP EPS target?

So, for the first one would obviously be the condition of the pandemic and the amount of travel that the sales once will do. In Q3, I don't view them doing incrementally more travel than they did in Q2. The upper levels that we have for the rest of the year, generally, our headcount, the backfilling of any attrition, or if there are certain investment areas that we'd like to make in sales, whether we continue with that investment or delay that investment. And they are one of the other larger levers goes down to basically variable incentive compensation, which is in the form in the sales force obviously of commissions, which is a function of revenue or the rest of the employee population, the incentive compensation that comes with the achievement of earnings per share, targets on an annual basis, and the resources available to achieve those earnings per share.

And last question for me. It comes down to the services revenue. Historically, we would see an uptick here, but this is -- we're not. I guess we are in historic times, we're certainly not in normal times. You had a negative comp in the services revenue in Q2. And I would guess based on the product sales in the prior quarters, we're probably looking at negative comps in Q3 and Q4 on the services revenue. Can you give us some insight on Q3 services revenue? Is that up sequentially or is your expectation that it could in fact be down sequentially?

I would say service revenue is fairly based in which is why we're generally very accurate on that forecasting service revenue. I wouldn't say when I look at our model, I mean, just one thing for. I'm looking at the midpoint. I would say service revenue looks like it's going to be relatively consistent with the service revenue that we achieved in FY 2020. As you point out, Q2 of this year compared to last year was actually pretty flat. Last year, you had about a $2 million catch-up of revenue due to a later signing on a renewal. But for the full year, I would look at estimates that service revenue will be generally flat to last year's level.

That's helpful. Thanks for taking my questions.

Thanks, Eric.

And it does appear that we have no further questions at this time. I would now like to turn the call back to our speakers for any additional remarks.

That concludes our call for today. We appreciate everybody joining us and have a great day.

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