Large Deals Drive Q2 '20 Beat and Improved 2H Visibility

NetScout Systems (NTCT) reported Q2 ’20 results above expectations. The closure of a large deal that slipped from the prior quarter and funding of previously awarded government projects not only boosted the company’s performance in Q2, but also prompted a favorable outlook for Q3 as a portion of the orders are expected to ship this quarter. Together with a large Radio Frequency Propagation Modeling deal already secured and expected to contribute to Q4, visibility into the 2H revenue ramp implied by the company’s FY ’20 guidance appears markedly better. In a similar vein, management sounds increasingly bullish on the potential tailwinds from the upcoming 5G spending cycle and suggested carriers are beginning to accelerate their 5G initiatives. Our estimates tick up slightly for this year and next, and our price target remains $32.00, representing a FY ’21 EV/EBITDA multiple of 12x. Shares of NTCT traded up following the Q2 print, but we were frankly surprised that the bump wasn’t higher given the enhanced visibility and imminent inflection point in growth. We would buy the stock here.

Non-GAAP revenue of $216.5 million (-3.4% Y/Y) exceeded management’s $205.0-$215.0 million guidance, consensus of $207.3 million, and our estimate of $206.4 million. Excluding the impact of the divestiture of the HNT Tools business, which contributed $7.6 million to Q2 ‘19, non-GAAP revenue was flat Y/Y. Strength in the quarter was attributed to an eight-figure deal with a domestic cable company that is expanding into the Mobile Virtual Network Operator (MVNO) space, the funding of several previously awarded government deals, and renewed growth in the service provider vertical. Both product revenue of $102.8 million (-7.2% Y/Y) and service revenue of $113.7 million (+0.4% Y/Y) outpaced our estimates of $95.0 million and $111.4 million, respectively.

Due to stronger sales volumes, product gross margin improved sequentially to 77.8% on a non-GAAP basis and was up from 76.3% in the year-ago period. As for operating expenses, previously enacted restructuring efforts led to reduced costs on a Y/Y basis. However, both research and development and general and administrative expenses were above our projections for the quarter, limiting some of the flow-through from the revenue outperformance to the bottom line. Regardless, non-GAAP EPS of $0.28 beat management’s $0.25-$0.27 guidance as well as our estimate and consensus of $0.25.

NetScout used $6.8 million in free cash flow during Q2 and exited the quarter with cash and investments of $307.8 million. Other usages of cash in the quarter included the repurchase of approximately 2.9 million shares at a total cost of $66.8 million and the repayment of $50.0 million of debt, leaving an outstanding balance of $450.0 million. In aggregate, the company has already repurchased $100.0 million worth of stock this year and repaid as much in debt. With another 10 million shares available for repurchase under the current authorization, management anticipates remaining active in the market.

Management’s Q3 guidance calls for revenue of $245.0-$255.0 million and non-GAAP EPS of $0.57-$0.60. The near-term outlook reflects flat to modest organic revenue growth and implies further acceleration in Q4. Prior to revisions, we were projecting $237.5 million in revenue and $0.45 in non-GAAP EPS, while consensus was higher at $247.4 million and $0.50. As management has historically taken a conservative tact with its quarterly color, the upside view for Q3 is a bullish signal, in our opinion, and also reduces the perceived risk to FY ’20 guidance, which was previously more heavily weighted towards Q4. For the full year, management reiterated prior expectations for revenues of $885.0-$915.0 million and raised its non-GAAP EPS guidance from $1.40-$1.45 to $1.45-$1.50, reflecting the positive benefits from the paydown of debt and share repurchases in 1H ‘20.

Our revenue estimate moves higher in Q3 ’20 and beyond, primarily reflecting a higher run rate of services revenue. While we adjusted our gross margin assumption slightly lower in 2H ’20 to account for the mix of Radio Frequency Propagation Modeling work in Q4, our non-GAAP EPS estimates still rose due to the combination of higher revenues, lower interest expense, and a lower share count. With no substantive changes to our model, we are sticking with our price target of $32.00, which was previously based on a FY ’20 EV/EBITDA multiple of approximately 13x but is now derived on a lower 12x multiple applied to our out-year estimate. Our price target is also supported by our discounted cash flow analysis, which assumes a CAGR of 5% through FY ’24, steady adjusted EBITDA margin expansion into the low-30% range, a terminal growth rate of 2.5% and a WACC of 8.6%. With a potential guidance cut less of a risk than 90 days ago and favorable growth prospects ahead as 5G spending ramps, we continue to like the stock.

Our report with model and disclosures is available here.

Disclosure(s):

The analyst, a member of the analyst’s household, and/or an account in which the analyst exercises discretion hold(s) a long position in the common stock of NetScout Systems (NTCT).