Robust Service Provider Spending Fuels Stellar Q3 ’23 Performance
NetScout Systems (NTCT) delivered fiscal Q3 ’23 results well above our estimates and consensus. The outperformance was largely driven by a year-end budget flush in the service provider vertical, enabling NetScout to pull-in deals previously expected to close in Q4. Worth noting, one of the transactions closed was in the mid-eight figure range. The strength in service provider spending naturally produced strong, double-digit growth in sales of service assurance products, which more than offset some softness in demand for cybersecurity solutions. According to management, new cybersecurity offerings launched earlier in the fiscal year have seen slower adoption than anticipated but should exhibit better traction in the coming quarters as NetScout iterates on customer feedback. In any event, the revenue upside and stronger than usual margins on RF Propagation Modeling (RFPM) projects completed in the quarter boosted gross margin ahead of our assumption. As operating expenses were consistent with our expectations, this in turn translated into significant upside in both adjusted EBITDA and non-GAAP EPS.
With several larger deals coming in earlier than anticipated and backlog still at levels above historical norms, management raised its FY ’23 non-GAAP EPS expectations and narrowed its revenue guidance, which remains unchanged at the midpoint. Although this implies Q4 expectations below consensus and our estimates heading into the print, we certainly prefer the lower hurdle to achieve management’s full year outlook. Moreover, we note that similar pull-in dynamics occurred last year, so the implied mid- to high-single digit growth rate for Q4 should be the focal point, in our opinion. Beyond the current quarter, management stated that there are still no indications of a slowdown based on conversations with customers but acknowledged that the macro environment remains uncertain. With this in mind, we lowered our estimates for Q4 and FY ’24, primarily on the assumption that the completion of RFPM projects this year combined with reduced service provider spending will present a headwind to growth in the near-term. That said, we believe the deployment of 5G networks will drive new market opportunities for service providers in areas such as fixed wireless access, private networks and mobile edge compute, creating incremental demand for NetScout’s products over time. As such, our newly introduced FY ’25 projections call for a return to mid-single digit revenue growth along with continued margin expansion. Our price target remains $38.00 based on an unchanged FY ‘24 EV/EBITDA multiple of approximately 12x.
Exhibit I: Quarterly Results and Guidance Versus Expectations
Sources: FactSet Estimates; K. Liu & Company LLC; NetScout Earnings Release
Q3 revenue of $269.5 million (+2.8% Y/Y) was well above our estimate of $238.6 million and consensus of $239.9 million. Product sales of $149.5 million (+3.5% Y/Y) exceeded our $125.0 million estimate and comprised most of the upside on the top line, although Service revenue of $120.1 million (+2.0% Y/Y) also topped our $113.6 million projection. Management attributed the strong sales performance to the pull-forward of $25 million in sales to service providers, which increased 7% Y/Y and accounted for 58% of revenue in the quarter. We note that the company experienced a similar phenomenon in the year-ago period, so the positive top line growth against a difficult comp was a welcome surprise. Revenue from service assurance products comprised nearly 79% of revenue and grew 10% Y/Y, while cybersecurity sales made up the remaining 21% of sales and were down 18% Y/Y. Per management, recently launched products like Omnis Cyber Intelligence have seen some success and were included in the large service provider win secured in Q3, but adoption rates have lagged initial expectations. Regardless, management expects improved traction in Q4 and beyond. Backlog at quarter-end was down from $80 million to $54 million and included $31 million in fulfillable orders and $23 million in RFPM projects. Although backlog continues to normalize, we believe current levels still provide significant visibility into near-term results.
Non-GAAP gross margin of 80.5% was considerably above our 76.8% assumption as Product gross margin of 84.8% far exceeded our 77.5% estimate. The upside reflected both higher sales volumes and above average margins on RFPM revenue recognized in the quarter. Service gross margin of 75.2% was also ahead of our 74.5% estimate. Total operating expenses were in line with our projections. Both non-GAAP operating income of $95.6 million (35.5% margin) and adjusted EBITDA of $100.9 million (37.4% margin) surpassed our estimates of $61.0 million and $66.0 million, respectively. Non-GAAP EPS of $1.00 also beat our $0.64 estimate and the Street’s $0.68.
Cash and investments at quarter-end totaled $416.2 million, while outstanding debt was unchanged at $200.0 million. In Q3, NetScout generated $46.3 million in cash from operations and had $3.1 million in capital expenditures. As for guidance, management narrowed its FY ’23 revenue guidance from $895-$925 million to $905-$915 million and raised its non-GAAP EPS guidance from $1.97-$2.03 to $2.06-$2.10, implying Q4 revenue and non-GAAP EPS guidance of $199-$209 million and $0.25-$0.29, respectively. The implied Q4 outlook was below our prior estimates and consensus due to the aforementioned pull-forward of revenue into Q3. Importantly, guidance for Q4 implies a sequential acceleration in revenue growth.
Exhibit II: Estimate Revisions
We lowered our Q4 estimates to reflect the pull-in of service provider revenues into Q3. We also reduced our FY ’24 expectations slightly given the current macro uncertainty, lower capex spending planned by service providers in the U.S. and headwind posed by the completion of several large RFPM projects in FY ‘23. However, we expect further investments from service providers to support emerging 5G revenue streams exiting the year, and we therefore introduce our FY ’25 estimates calling for revenue of $930.4 million (+4.1% Y/Y) and non-GAAP EPS of $2.17 (+12.3% Y/Y).
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).