Upside Q3 '20 Results Punctuated by Renewed Growth

NetScout Systems’ (NTCT) Q3 ’20 results comfortably exceeded expectations as a high seven-figure service provider opportunity slated to close in Q4 was secured earlier than anticipated. Importantly, the results also reflected renewed revenue growth driven by increased sales in both the enterprise and service provider verticals. Given two consecutive quarters of upside and a previously awarded calibration deal expected to contribute more materially in Q4, concerns that NetScout could miss management’s FY ’20 guidance should fall by the wayside, in our opinion. Moreover, the return to growth in Q3 coupled with longer term tailwinds from 5G network deployments and digital transformation initiatives bode well for further acceleration in top line growth and more meaningful margin expansion going forward. We raise our estimates slightly for this year and next, and our price target increases from $32.00 to $33.00, representing an unchanged FY ’21 EV/EBITDA multiple of 12x. With the company’s fundamentals improving and shares of NTCT attractively valued at approximately 12x projected free cash flow, we remain buyers of the stock.

Non-GAAP revenue of $260.1 million (+5.6% Y/Y) exceeded management’s $245.0-$255.0 million guidance, consensus of $249.2 million and our estimate of $245.7 million. The outperformance was attributed to the closure of a large 5G monitoring deal with a Tier-1 North American service provider that made a similar purchase earlier in the year. Internationally, investments in existing 4G-LTE networks also contributed to the 8% Y/Y increase in service provider revenues. Enterprise revenues rose a more modest 3% Y/Y, but the increase marked an inflection point given declines earlier in FY ’20. Management cited digital transformation and security initiatives as the primary growth drivers there. Also worth noting, adoption of the software-only form factor was markedly higher across both verticals in the quarter, representing 42% of service assurance product sales.

Between the revenue upside and a favorable mix of software sales, non-GAAP product gross margin rose 280 basis points sequentially to 80.6% and was up from 75.7% in the year-ago period. Overall gross margin was also up nicely on a sequential and Y/Y basis due to mix. Total operating expenses exceeded our estimate as both research and development and general and administrative expenses ran higher than modeled, more than offsetting lower than projected spending on sales and marketing. Regardless, adjusted EBITDA of $77.3 million beat our $67.6 million projection, while non-GAAP EPS of $0.73 topped management’s guidance of $0.57-$0.60, consensus of $0.58 and our estimate of $0.57. We note that a lower than projected tax rate accounted for $0.04 of the upside relative to our estimate.

NetScout generated $63.2 million in free cash flow during Q3 and exited the quarter with cash and investments of $346.5 million. Outstanding debt remained unchanged from the prior quarter at $450.0 million. Usages of cash in Q3 included the repurchase of approximately 1.0 million shares at a total cost of $25.0 million, and management anticipates additional buyback activity in Q4.

With only one quarter remaining, management narrowed its FY ’20 revenue guidance from $885.0-$915.0 million to $900.0-$910.0 million and raised its non-GAAP EPS guidance from $1.45-$1.50 to $1.51-$1.56. The revised guidance ranges imply Q4 revenue and non-GAAP EPS of $237.5-$247.5 million and $0.43-$0.48, respectively, both of which were below our estimates and consensus due to the pull-forward of the aforementioned high seven-figure service provider deal into Q3.

Reflecting the shift in service provider revenues into Q3, we lower our estimates for Q4. That said, our projections for both FY ’20 and FY ’21 tick up slightly on higher assumptions for product growth. We also introduce our FY ’22 estimates, which reflect sustained top line growth in the mid-single digits, another 160 basis points of operating margin expansion and mid-teens growth in non-GAAP EPS. The combination of strong cash flow generation in Q3, an uptick in our estimates and a lower share count yields an increase in our price target from $32.00 to $33.00, representing the same FY ’21 EV/EBITDA multiple of 12x we used previously.

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).