Andrew M. Kramer - NetScout Systems, Inc. Anil K. Singhal - NetScout Systems, Inc. Michael Szabados - NetScout Systems, Inc. Jean A. Bua - NetScout Systems, Inc..

Eric Martinuzzi - Lake Street Capital Markets LLC James E. Fish - Piper Jaffray & Co. Alex Kurtz - KeyBanc Capital Markets, Inc. Matthew George Hedberg - RBC Capital Markets LLC Chad Michael Bennett - Craig-Hallum Capital Group LLC.

Ladies and gentlemen, thank you for standing by and welcome to NETSCOUT's Second Quarter Fiscal Year 2019 Results Conference Call. At this time, all participants are in a listen-only mode until the question-and-answer portion of the call. 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. I would now like to turn the call over to Andrew Kramer to begin the company's prepared remarks..

Thank you very much, Erica, and good morning, everybody. Welcome to NETSCOUT'S second quarter fiscal year 2019 conference call for the period ended September 30, 2018.

Joining me today are Anil Singhal, NETSCOUT's President and CEO; 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.

We will call out the slide number we are referring to in our remarks.

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 the Financial Information section on the Quarterly Results page. Our agenda is as follows.

Anil Singhal will briefly review our second quarter financial performance, highlight key trends and recent developments, and discuss our outlook for fiscal year 2019. Michael Szabados will briefly review recent customer wins that help highlight some of our near and longer-term growth drivers, as well as recap go-to-market highlights.

Jean Bua will then review our second quarter results, key first-half performance metrics, and fiscal year 2019 guidance.

Moving on to slide number 3, I'd 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 statements on this conference call, which are not strictly historical statements, including, but not limited to, the statements related to the fiscal year 2019 financial guidance for NETSCOUT; expense management and related cost reduction actions and related benefits; market conditions, technology trends, customers, customer relationships, and customer demand; anticipated revenue from specific customers and specific products; and all of the other various product development, sales and marketing, and other operational initiatives planned for fiscal year 2019, 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, 2018, and subsequent quarterly report on Form 10-Q 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 number 4, which involves non-GAAP metrics.

While the 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.

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 a 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 in the presentation Appendix, which is available on our website.

Additionally, given the sale of the HNT tools business, we may make references to certain pro forma or organic non-GAAP performance trends that exclude revenue or costs associated with the HNT tools business.

As a reminder, we have also provided supplemental data for comparability purposes related to the reclassification of product and service revenue and the applicable costs for prior periods. That information can be found in the press release, in the Appendix of the slide presentation, and on the Investor Relations website.

Overall, we delivered quarterly revenue at the upper end of our plans and our diluted EPS results exceeded our targets for the quarter. We also made important progress to lower costs, while funding key initiatives fundamental to expanding our business.

As we move into the second half of the year, we've also updated our guidance to reflect a number of factors. With that as a backdrop, I'll now turn the call over to Anil for his prepared remarks. Anil..

Thank you, Andy. Good morning, everyone, and thank you for joining us. Let's begin on slide number 6 with a brief recap of our second quarter non-GAAP results. Our second quarter fiscal year 2019 performance was solid. We delivered second quarter diluted EPS of $0.25 on revenue of $224.0 million.

Our top line performance reflected lower revenue across our service assurance and security product lines within the service provider customer segment and relatively flat revenue in our enterprise customer segment.

We also delivered improved gross margins and continued to reduce costs during the second quarter, both of which contributed to the strong diluted EPS performance. Jean will review our second quarter results in more detail in a few moments. During the second quarter, we made important financial, operational, and strategic progress.

We took actions to lower our operating costs by divesting a lower margin, noncore business, restructuring key areas within our organization, and continue to manage expenses. At the same time, we continued to invest in key development projects and go-to-market initiatives that are aligned to our most promising near and long-term growth initiatives.

As we look into the second half of the fiscal year, we are seeing many of the headwinds that have affected our top line in recent quarters dissipate and believe that they will be largely behind us as we exit this year. I would like to briefly expand on this.

In our service provider service assurance product area, we are seeing revenue from our two largest carrier customers stabilize after substantial declines in recent years.

Just as important, we believe our progress to fortify our incumbency at many of the other largest mobile operators and cable customers will contribute to improved top line results in the second half of this year and beyond.

In the enterprise, we took an important step to address revenue declines within the former Fluke enterprise network product lines that we acquired along with other Danaher Communications business assets three years ago. In mid-September, we sold the former Fluke handheld network test, or HNT, tools business.

Although the remaining legacy Fluke system products have been a modest drag on our first-half enterprise revenue, we have integrated many of the highest value capability from those remaining legacy offerings into our broader nGenius enterprise portfolio.

Moving forward, we expect that those initiatives will help fuel growth in our nGenius enterprise offerings and more than offset any ongoing revenue erosion from the remaining legacy Fluke product lines. The final headwind affecting our top line is our security product area, which represented more than 20% of last year's total revenue.

Today, these products largely consist of Distributed Denial of Service, or DDoS, solutions. Our carrier and ISP customer have throttled back their DDoS spending over the past two years, as they absorbed excess capacity following substantial investment arising from high profile DDoS attacks.

DDoS revenue is now trending behind our original plan as service providers continue to spend cautiously on capacity. Nevertheless, we anticipate second-half DDoS revenue from service provider will outpace first-half levels, which would be consistent with historical trends.

As these headwinds dissipate and we strive to resume top line growth, we have also taken actions to lower our operating costs and improve our gross margins, which we believe will help amplify future earnings growth. Let's turn to slide number 7 for some additional color on this.

As I alluded to at the outset of my remarks, we have taken important steps in recent months to reduce our operating costs in ways that do not impede our ability to grow or support customer or run counter to our corporate values and culture.

Earlier this year, we outlined plans to reduce annual run rate operating costs by up to $50 million by adjusting head count-related personnel costs, aggressively managing discretionary spending, and selling certain noncore assets.

We have made excellent progress in each of these areas and now expect to exceed our initial cost reduction target by removing at least $70 million in operating costs. Through the first half of this year, our operating expenses declined by 9% from the same period a year ago.

In particular, personnel costs decreased by over $10 million, largely as a result of lower head count tied to attrition and the management of new hires. As noted earlier, in September, we completed the divestiture of HNT tools business, which removes approximately $30 million of annual operating costs.

And in conjunction with this sale, approximately 120 employees were transitioned from NETSCOUT to the acquirer of the HNT tools business.

During the second quarter, we also initiated a restructuring across various areas of the business to realign our resources in ways that are aimed at prioritizing investment in growth-oriented initiatives and eliminating redundancy arising from the integration of legacy platforms, products and technologies associated with the Danaher Communications acquisition.

In conjunction with these actions, we have combined our previously separate service assurance/security engineering teams, started consolidating certain other facilities, and implemented a voluntary separation, or VSP, program and other related measures.

These programs are expected to result in a net reduction of approximately 145 employees by the end of this fiscal year. We expect that these actions will generate net annual rate savings of $22 million to $24 million, of which $9 million to $10 million will be realized in the second half of this fiscal year.

As we move forward, we believe that we can operate a very scalable infrastructure that would require low incremental increases to our operating costs. In addition to adjusting our operating cost structure, we have also remained focused on improving gross margins.

Over the past three years, we have reshaped and expanded our product portfolio with a focus on delivering higher margin, software-centric solutions that address a broader range of customer use cases. Our progress thus far is most evident in the service provider customer segment with our service assurance solutions.

Only three years ago, carriers deployed our service assurance solution as appliances and majority of this product revenue carried gross margins in the mid-60% range. Through the first half of this year, 16 of our 20 largest service provider already deployed our platform as a software-only solution, which carries gross margins of over 90%.

The software-only ISNG platform represents 30% of service assurance service provider product revenue for the first half of the year, up from 16% one year ago.

As adoption of our software-only platform grows, along with other software-centric solutions for NFV, business intelligence, application performance, and security, we believe that our gross margins have significant upside potential.

Let's turn to slide 8 for some further color on the key drivers for stronger revenue performance not only in the second half of this fiscal year, but over the longer term as well.

In our service provider customer segment, we currently expect second-half revenue for this segment will be relatively flat to slightly higher versus last year, with higher service assurance revenue mostly offset by modestly lower DDoS revenues.

In our service assurance product area, we expect solid growth outside of the U.S., as we benefit from new projects with top mobile operators in Eastern Europe and Asia Pacific to monitor new 4G/LTE networks. Michael will highlight one of those wins shortly.

In addition, as we mentioned on last quarter's call, we also anticipate meaningful contribution from our calibration offering that are helping large Tier 1 operators in North America design their new 5G radio access network infrastructure.

At the same time, however, we believe that the larger Tier 1 service providers will continue to limit near-term spending on their existing 4G networks. Longer term, we are very bullish that 5G represents an important catalyst to drive higher spending.

We believe that this could benefit us as early as next fiscal year, although visibility remains limited.

In addition to expanding their monitoring capacity in their core networks to handle initial 5G traffic volumes, we anticipate that carriers will ultimately evolve their infrastructure over the next few years, with greater emphasis on new edge computing capabilities and NFV technology.

We are well-positioned to help carriers in these areas and expect that 5G field trials for our monitoring solutions will continue to ramp over the coming quarters. In DDoS, we move forward anticipating a more gradual recovery in service provider spending than what we originally expected at the start of the year.

Nevertheless, we remain optimistic about our longer-term growth prospects. As the spending environment continues to improve, we plan to capitalize by further enhancing our market-leading solutions with new automation capabilities, along with more flexible pricing and deployment options.

As we look out into next year, we are focused on delivering new innovations that can help our service provider customers further protect their mobility networks, as well as expand the range of DDoS managed services that can be sold to their enterprise customers.

Within our enterprise customer segment, we have been pleased with the growth of our pipeline in recent quarters and we anticipate modest organic growth during the second half of fiscal year in 2019.

While a majority of our enterprise revenue is still tied to traditional network performance management and related troubleshooting use cases, we have expanded our value proposition to broaden our total addressable market.

For example, our vSCOUT and vSTREAM offering help enterprises extend visibility into application performance across their data center and hybrid cloud infrastructure.

Over the past several months, two of the world's largest public cloud providers, Amazon Web Services and Microsoft Azure, have validated our capabilities by making our application performance management solution available on their respective marketplaces.

In addition, we have worked with Azure on their virtual network TAP initiative, which results in an agentless solution that provides mutual customers with visibility into applications and their dependencies in hybrid environment comprising both on-prem and Azure cloud infrastructure. Michael will provide some further detail on these developments.

Looking ahead, we also believe that enterprise security has the potential to become a major growth engine and we are investing accordingly. Last week, we introduced the Arbor Edge Defense platform, or AED.

This solution not only helps enterprise protect against incoming DDoS attack with proven, market-leading capability, but it also serves as the last line of defense against outbound threats perpetuating malware and other threats.

We see attractive opportunities to cross-sell AED into our service assurance enterprise customer base, and we are pleased with our initial progress on this front. In addition to AED, we introduced new software features within our ISNG, now named Cyber Optimizer.

Enterprises can use this packet-shaping software to cost-effectively collect and filter packet data before forwarding it to other security tools.

We are also advancing plans for a security-specific version of our ISNG platform and new analytics that leverage our strength in packet forensics and an innovative approach to identifying advanced threats through anomalous network behavior. Let's turn to slide number 9 for additional perspective on our outlook and some final thoughts.

We have updated our fiscal year 2019 revenue guidance to primarily reflect the sale of the HNT tools business and more modest second-half recovery in DDoS service provider revenue than we originally expected.

Adjusting our guidance by a total of approximately $47 million to account for those factors, results in a new range for annual revenue between $925 million to $960 million.

Using the comparable accounting standard basis with the prior year and excluding revenue from the HNT tools business, the midpoint of our updated revenue guidance would equate to relatively flat revenue versus pro forma fiscal year 2018.

The skew of revenue between the third and fourth quarter is currently difficult to forecast, primarily as a result of limited visibility into timing of revenue recognition for a small number of moderate-sized service provider service assurance projects.

Accordingly, we currently anticipate third quarter revenue in the range of $230 million to $250 million.

If we are unable to achieve customer acceptance on these projects before the end of the calendar year, we would expect third quarter revenue at the low end of this range and revenue from those projects would likely be recognized in the fourth quarter.

In terms of our earnings performance, we remain on track to achieve our original non-GAAP diluted EPS guidance range and have further refined this target to range from $1.30 to $1.40, largely due to the anticipated cost saving associated with our recent restructuring actions.

Moving forward, we are focused on achieving our second-half goals and demonstrating that we can build the sales momentum necessary to achieve the long-term financial target we outlined this past spring. In closing, we made considerable progress this quarter and implemented significant changes across our global organization.

I would like to thank my fellow guardians at NETSCOUT for the continued support and ongoing focus on moving our business forward. That concludes my commentary and I'll turn the call over to Michael now..

Thank you, Anil, and good morning, everyone. Slide number 11 outlines the areas I plan to cover. As I highlight recent wins, I will also intersperse some comments about related go-to- market activities.

In the service provider market, we are seeing Tier 1 North American carriers aggressively plan for 5G, while top regional carriers in international markets are investing in the build-out of their 4G/LTE networks.

We recently received a substantial seven-figure order for our ISNG software platform as part of a multiyear project with one of the largest carriers in the Asia Pacific region. This relationship has evolved and expanded over the past several years since an initial deployment of legacy hardware probes.

More recently, as part of its plan to increase the speed of deployment and improve its capital efficiency, while keeping pace with robust subscriber growth, the customer began rolling out our ISNG software across its network.

This mobile operator is also using our packet flow switch software capabilities to efficiently feed traffic to our ISNG platform, while also benefiting from our nGenius Business Analytics product to gain greater insight into subscriber experience.

This customer's success in migrating from hardware-based probes to a scalable software solution that unlocks the power of our smart data underscores the reasons why Frost & Sullivan recently recognized NETSCOUT with its Visionary Innovation Leadership Award for the global network data analytics industry.

In the enterprise, we are making steady progress with our initiative to provide customers with consistent visibility into their application workloads across conventional data centers, private clouds, and the public cloud.

Using our smart data solutions, enterprises can deliver consistent and high-quality user experience before, during, and after cloud migration. As Anil noted, we have established relationships to list our application performance management solution on the marketplaces of both Amazon Web Services and Microsoft Azure.

This sends a powerful message to customers and prospects about the operational readiness, scalability, and value of our solutions. Recently, we closed another software deal, around $1 million, with a large U.S. enterprise to support their planned migration to AWS.

To further expand our new sales pipeline for these offerings, we're planning to participate as a Platinum Partner at the AWS re:Invent show toward the end of this month.

In addition, we are working closely with Azure on a virtual network TAP, VTAP, initiative to deliver a comprehensive network and application performance management solution to mutual customers.

By leveraging the native distributed terminal access point, or TAP, functionality developed by Azure and combining it with NETSCOUT technology, customers get an innovative and agentless solution to streamline the acquisition of wire data for effective monitoring and assurance in a hybrid environment.

Last month, at their Ignite user conference we were recognized as the NPM/APM partner in their VTAP program. On the security front, Anil detailed some of the progress we are making on our new product roadmaps, which was highlighted by the recent launch of Arbor Edge Defense, or AED.

We have already closed our first AED sale with a new e-commerce hosting customer in North America. We are accelerating cross-selling activity for this platform and for our other security offerings to drive adoption into our service assurance enterprise customer base.

A great example of our initial success on this front occurred last quarter with Banco Votorantim, one of Brazil's largest banks.

This customer is rolling out nGeniousONE with multiple ISNGs, nGenius packet flow systems, our nGeniusPULSE and other portable platforms, as well as our DDoS solution to ensure that its mission-critical applications and services are always available to both customers and employees.

As we move forward, we are continuing to advance sales campaigns and other go-to- market activities that can leverage a wide array of strategic technology relationships. Our partnership with VMware is a good illustration of this.

As you may recall, last quarter, VMware fully certified the NSX edition of vSCOUT as VMware Ready for Networking and Security. Since then, we have presented regularly at their regional VMUG User Conferences and participated at VMworld in Vegas two months ago.

We've been pleased with the interest that these activities have generated among our mutual customers, and expect similar enthusiasm when we attend at VMworld Europe next week. That 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 second quarter and first-half fiscal year 2019 metrics, along with our updated guidance. As a reminder, this review focuses on our non-GAAP results, unless otherwise stated, and all reconciliations within our GAAP results appear in the presentation Appendix.

In addition, due to the sale of the HNT tools business in mid-September, I will highlight certain revenue trends on a pro forma non-GAAP basis, which excludes the HNT tools revenue. Regardless, I'll be sure to note when the comparisons are pro forma versus reported.

Additionally, as a reminder from last quarter, our second quarter results reflect the reclassification of certain subscription-oriented security offerings as services rather than products. Prior period revenue and related costs for those offerings were reclassified to conform to the current period presentation for comparability purposes.

That detail is available in the attached financial tables of our press release, in the Appendix of our conference call slides, and it can also be downloaded from the Investor Relations website. Slide number 13 details our results for the second quarter and first half of fiscal year 2019.

Total second quarter revenue of $224.0 million, which was at the higher end of our targets, declined 14% due to softness across our service provider customer segment, while our enterprise customer segment posted flat top line results.

Excluding ASC 606 and the timing related to the sale of the HNT tools business, which combined to be a net benefit to revenue of approximately $5 million, revenue would have been at around the midpoint of our targets. Despite the overall decline in revenue, our gross profit margin of 76% increased by 0.5 percentage point.

Operating expenses declined by 11%, due primarily to lower head count and related personnel costs. We reported an operating profit margin of 14.7%, with a diluted EPS of $0.25.

After taking into account the positive $0.08 effect associated with the adoption of ASC 606 on quarterly diluted EPS, our diluted EPS would have been at the high end of the targets that we offered last quarter. I'd like to share a quick update on our head count.

We ended the second quarter with 2,770 employees, which is down 323 people from the same quarter of the prior year. Around one-third of the change is related to transitioning the teams associated with the Fluke HNT tools divestiture in September.

During the quarter, we also began implementing a VSP and other related measures, which we expect to complete by the end of this fiscal year. We anticipate that these actions will result in an additional net reduction of approximately 145 employees and generate $9 million to $10 million in cost savings in the second half of this fiscal year.

For fiscal year 2019, we will incur onetime cash charges associated with these programs totaling approximately $18 million. The full year effect of these actions on fiscal year 2020 operating expenses will be a reduction in the range of $22 million to $24 million. Turning to slide number 14, I'd like to review key revenue trends.

Second quarter revenue in our service provider customer segment declined by approximately 25%, with double-digit percentage decreases in both the service assurance and DDoS product areas. In the enterprise, second quarter revenue was relatively unchanged.

On a pro forma basis, excluding the HNT tools business, our enterprise service assurance revenue grew mid-single digits in the second quarter, while security was flat. In terms of first-half revenue trends, approximately 52% of total revenue was generated from the enterprise customer segment, with the remainder from service provider.

In terms of revenue by geography, which is calculated on a GAAP basis, revenue in the U.S. decreased by 10%, with a 13% decline in international markets. International customers represented 38% of GAAP revenue versus 39% last year. We did not have a 10% revenue customer in either the second quarter or the first half of the year.

Slide 15 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 $452.1 million.

Free cash flow of $1.5 million includes some onetime, nonrecurring items, such as transaction costs associated with the HNT tools divestiture, severance payments associated with the first phase of our head count restructuring programs, and higher capital expenditures to relocate one of our facilities.

We continue to anticipate healthy free cash flow conversion for the full year in excess of 100% of our non-GAAP net income, excluding payments associated with our head count restructuring programs. To briefly recap other balance sheet highlights, accounts receivable, net, were $184.2 million, down by $29.2 million from the end of March.

DSOs were 73 days versus 78 days at the end of fiscal year 2018 and 72 days at the same time last year. The one day increase over the prior year primarily reflects the timing of certain collections associated with international security customers with longer payment terms. I'd like to provide a brief update on our share repurchase activities.

We completed our $300 million Accelerated Share Repurchase, or ASR, during the second quarter. In total, we repurchased 11,067,809 shares of common stock, with an average price of $27.11.

Let's move to slide 16 for guidance, which we've updated to reflect a number of items, including our results to-date, the sale of the HNT tools business, cost-reduction actions, and new assumptions regarding some of the revenue risk we see primarily related to a more gradual recovery in DDoS revenue in the service provider segment.

I will focus my review on our non- GAAP guidance. As Anil detailed earlier, our updated fiscal year 2019 revenue guidance ranges from $925 million to $960 million, which is a reduction of approximately $47 million from our original guidance range.

Of this amount, $26 million is due to selling the HNT tools business in mid-September and removing the revenue that we had otherwise anticipated from those product lines. The remaining $21 million is primarily tied to lower-than- anticipated DDoS revenue in the service provider segment.

We've also updated other key assumptions around our fiscal year 2019 operating model, which are outlined on this slide.

We currently anticipate full year gross margins in the 75% to 76% range, as the benefits of ongoing adoption of our software solutions are likely to be offset by lower sales volume and product mix shift, including the ramping of new 5G calibration design projects that typically begin with lower gross margins and improve significantly over time.

We currently anticipate full year operating costs in the range of $535 million to $555 million.

In the second half of fiscal year 2019, the sale of the HNT tools business will remove $15 million to $16 million of operating expenses, while the restructuring actions detailed earlier are expected to remove costs of approximately $9 million to $10 million.

Our other assumptions regarding tax rate, interest expense, and average weighted shares outstanding, are largely unchanged from last quarter. As a result, we have refined our fiscal year diluted EPS targets within our original guidance range and now expect diluted EPS between $1.30 and $1.40.

In terms of our near-term outlook, Anil already reviewed the dynamics that are creating a range for third quarter revenue between $230 million to $250 million.

We currently anticipate third quarter gross margins to be at least 1 to 1.5 percentage points lower than the second quarter, due primarily to the calibration projects associated with the initial phases of our customers' 5G network roll-outs.

We expect that operating expenses will decline from second quarter fiscal year 2019 levels by $5 million to $8 million, due largely to the previously discussed cost reduction actions. As a result, diluted EPS for the third quarter is expected to range from $0.33 to $0.45. That concludes my formal review of our financial results.

Before we transition to Q&A, I will mention that slide 17 details upcoming investor conferences, which we plan to augment with additional NDRs in key money centers in the U.S. I'll now turn the call over to the operator to start Q&A..

Thank you. We'll take our first question from Chad Bennett with Craig-Hallum. Please go ahead. Chad, your line is open..

Maybe they are on mute..

Well, why don't we go to the next question, operator. We'll get back to Chad..

Certainly. We'll go next to Eric Martinuzzi from Lake Street. Please go ahead..

Hey. Just had a question regarding the growth opportunity. So I'm referring to slide 8 in the presentation here, and to me I think the things get more exciting at NETSCOUT as far as investment opportunity when the service provider business kind of comes back on track.

And the bullets that you highlight under the growth opportunities there, we're talking about talent growth outside the U.S., there's the 5G potential, and then kind of DDoS was a little bit disappointing and we remain optimistic.

But are there any green shoots kind of, so to speak, in that service provider business, where these growth opportunities that you're outlining give us some sense of encouragement? Because really with the bring down on the DDoS for the back half of the year, I'm just looking for some encouragement that that service provider business gets back to growth..

So I think there are a lot of things – I mean, green shoots in terms of potential and excitement about next year, there are few things, additional things. We talked about 5G, depends on how much traction is there in 5G. Also, I think finally virtualization and NFV projects are coming to maturity level in terms of people wanting to spend.

There are other parts outside of U.S., who are investing in 4G. We announced one big opportunity with regard to last quarter. There'll be more things. And then in April, when we have our user conference, we are planning to announce something big in the security space for service provider.

If you look at security opportunity is largely DDoS today and DDoS is partly service provider and partly enterprise. But in the main security advance threat area, we will be talking about things both for the enterprise and service provider segment. We have really not applied security to the mobility part of the network.

We have been basically service assurance. So those are some of the things which we didn't talk about today, because it's too early to announce, but we should be able to share it after the end of this fiscal year..

And just keeping the focus on service provider, you talked about your two large North American Tier 1s being stable.

By stable, does that mean the revenues are flat and are expected to remain flat, or is there – can you give us any visibility on those North American Tier 1s?.

Yeah. We are not counting on – I mean, there could be upside, but yeah, what we meant was, it's not going to deteriorate further this year or next year. And margins will possibly improve because of movement to software models..

Understand. Thanks for taking my questions..

Sure..

Thank you. We'll go next to the line of James Fish from Piper Jaffray. Please go ahead..

Hey, guys. Congrats on the upside this quarter. My first question, competitively, we've been hearing kind of rumblings more from the traditional networking guys adding their software assurance capabilities onto their offerings.

Are you guys seeing more pressure from those guys per se, in takeoffs (00:38:48) compared to kind of the traditional peer group that you guys usually compete against? Thanks..

Yeah. Sorry, go ahead. I didn't want to interrupt.

Is that the – additional thing on the question, or that's it?.

Just that's it..

Okay.

So I think you're referring to the competition from NEMs, and when I look at the history of NETSCOUT since I started 30 years ago, every time there is a technology turn, whether it's going from routing to switching in the mid-1990s, going to – carrier going to IP in mid-2000s, later on with security, and now with virtualization, 5G, there is a feeling that standard solution won't survive.

But customers are looking for – and that gives a impression that people like Huaweis, Ericsson, Ciscos, they're going to provide embedded solution. And every time this theory has been proven wrong, there's always a competition with them, but this somehow escalates at these points.

And people are looking for multi solution, which is independent of multiple vendors. No carrier goes to a single NEMs for they don't want to depend. They, typically, will have a multivendor environment, and we are the only one who can give you a single pane of glass in that multivendor environment without any biases and all those.

So, yes, competition is there. Every time we go to these new things, it creates some disruption. But in the end, it creates more awareness of what we do and usually this doesn't really affect our growth. In fact, it improves our visibility and potential..

Got it. And then maybe just on the Arbor side, the DDoS business, where do you want to secure it from, some of the public CDN guys out there or some of the private guys doing well in the space? Seems actually like a very robust market.

I guess, why is Arbor not more engaged with kind of the broader market and winning more deals? I get that it's more service provider exposed, but I'm just curious as to why that business is actually in more of a decline on easier comps this year..

Yeah, that's a good question. And it's natural to see that because when you look at the market studies, it looks like that market is growing. I think two answers to this is, we are quite big. We are the number one player from a carrier DoS perspective.

And so we were the most affected by – if you remember, two years ago we have like outstanding year, 20% year-over-year growth. That was because (00:41:40) attack and people buying lot of insurance and capacity. So we are somehow paying the price of this as a result of that, plus U.S.

carriers curtailing spending on all fronts, including service assurance, which we discussed earlier. At the same time, we have really not invested in enterprise DDoS opportunities and not taken advantage of some of the NETSCOUT customers who we could cross-sell. So we have invested that.

This year was a transition year and we're going to be announcing our new security strategy, including our DDoS solution at our User Conference in April.

And after that, I think we'll be able to mitigate some of the challenges on the service provider, in the sense that our negatives are bottoming out similar to service assurance, and our new strategy will start taking off. And the new strategy will have a different way of competing with CDN-based solutions, like Akamai.

And so, I guess, that's basically the commentary. Yes, we have been down. There are some good reasons for it, partly because of new investment required on enterprise and reduced spending on service provider, which largely affected NETSCOUT more than other people.

But I think with our new strategy, we are going to leapfrog the competition and start going again next year..

Got it. Thanks, Anil..

Yeah..

Thank you. And we'll go next to the line of Alex Kurtz with KeyBanc Capital..

Good morning, everyone.

Anil, just on the 30% comment you made about software in the service provider segment, is there a way to help investors understand what that number could be in more definitive terms, with specific timelines over the next couple of years? I think it's a very encouraging sign that you're seeing uptick in that adoption, but it's also creating some headwind to revenue that is hard to calculate every quarter.

So two things, are you able to say by, say, fiscal 2021 you think that at least half that business or more could be software? Maybe you have to come back another time.

And then, Jean, is there a way to calculate every quarter what kind of the revenue impact is as some of these service provider customers transition to software versus buying the appliance?.

So let me just mention. So, Alex, good question and I think we talked about it in the past also. So, interestingly, that for large service provider deals, we are not seeing a revenue erosion because of moving to software model.

And so, for example, when we are using the software model for this big deal which we announced recently, and almost a $50 million to $100 million deal we had announced in the past last year, if you remember, Alex, our actual spend on NETSCOUT increased. Because of the software, we came to price points which allowed us to mitigate the price per unit.

So I think overall in terms of percentage of software, yes, in two years getting to 50% in the service provider from current 30% is very possible.

And I think short-term effect of revenue decline because of price per unit go down is actually being made up in many cases, or most cases, by increasing volume and better competitive situation, which is making our technology more pervasive..

Okay. So, I guess, no question for Jean then on that point. Just on your two big domestic operator customers, what would it take to change their momentum with you? It sounds like 5G could be the answer, but it's not clear that's going to happen next year.

So what are the top one or two things that would have to happen to get those two accounts back to, say, maybe 70% of what they used to be?.

So I think, obviously, people like to hear we'll get back to those days. I think our strategy is to not depend on those to do 70%. So we think that that was the problem. We should not have a 20% customer, and at that time we had it. We are moving in direction where we'll have a much broader customer base.

We are still going to be the biggest vendor for these two providers, even at a 5% – so they're like 5% type customer now, and I think it is going to go slightly up and down, but we are not counting on, when we have provided the growth estimates, the plan for next three years, whether it's margin or growth rates, none of them is depending on these two providers doing a much bigger share of the revenue than they do today..

Thank you..

Yeah..

Thank you. We'll go next to Matthew Hedberg with RBC Capital Markets..

Hey, guys. Good morning. Thanks for taking my questions. In your prepared remarks, you talked about vSCOUT and vSTREAM aiding your APM business and, I think, both of them are available now on AWS and Azure.

Can you talk a little bit more on how these products might help the enterprise segment? And maybe just a refresher on what you see as the competitive landscape there..

So when we look at that – see, we are positioning our company as a smart data company, where we say we will provide visibility no matter where you deploy the application. There are players on the cloud side. There are start-ups on the AWS side. And there are players on the data center side like we were.

And there's competition in all three area, but there is no one company which does a great job on providing single pane of glass across all these areas, hybrid cloud environment, public, SDN, SD-WAN, or data center. And that's our differentiator.

And in that vein, we don't look at the revenue for vSCOUT or vSTREAM as particularly important by itself because we look at – we provide the complete picture.

And customers are deploying applications in various places and they have a hybrid environment and they need NETSCOUT solutions rather than bits and pieces, which they'll have to put together from multiple vendors to do that. So our differentiator is vSCOUT/vSTREAM completes the picture.

We don't know when the full transition to cloud is going to happen, but with our software model we have similar margins in all these areas. And I think the margin – the revenue contribution from cloud and vSCOUT and vSTREAM will remain small for short term, but it has enabled the bigger sale, overall sale.

Michael, you had something?.

Yeah, I wanted to add that a number of our customers, we are seeing a trend that IT is becoming a broker of multiple different data center services, whether public cloud, private cloud, or their own on-prem offerings. And in this role, we are finding a new use case.

We are their key tool to be able to migrate how their internal customers pick the right choice or move around these different cloud choices or data center choices. So we are becoming an enabler for this kind of a new IT behavior..

So I think just to summarize what Michael is saying is that, having an end-to-end solution, and it's a big buzzword end-to-end, everyone talks about it, but end-to-end solution with a single architecture where you can compare before and after, pick up the right choices, provide the same visibility, and not just consolidating varying data sources, is our differentiator.

So we compete with cloud-only players by saying we have data center also. We compete with data center people deployment saying we have cloud also. And nobody had the A plus B plus C story like we have..

That's great. That's helpful. And then, Jean, in your prepared remarks you noted the difficultly, I think, to forecast the split of revenue between Q3 and Q4, some timing assumptions there. But I think per your guidance, Q4's expected I think total revenue about 13% of 14% sequential growth into Q4.

That's a little higher than we've seen over the past several years. I guess, my question is, when you think about the second half in general, can you help us on your visibility of just large deals in general on the product side and sort of the comfort level around those.

And then I think federal too, I'm sort of interested in that as sort of an initiative as well..

So our guidance, as Anil said, between Q3 and Q4 is a little uncertain, mostly because we probably have at least three double-digit in the millions deals that we're finishing projects for. They're all service provider that we're finishing some projects on and we just need to get acceptance from the customer.

So whether that happens on December 31, it would be a Q3 revenue; if it happens on January 1, it becomes a Q4 revenue.

And then just traditionally, we have always a Q3 and Q4 heavier skew due to calendar year-end budgets, and then the new budget coming in in January plus just the accelerators that our sales team are in to be able to get to certain incentives that are important to them..

Just to add one thing. So the $20 million gap is not a visibility gap. It's a Q3 versus Q4 visibility, not a second half visibility gap. And if it comes to the high end of the range in Q3, then it won't be 13% to 14% in Q4. It'll be much less..

Okay. So basically you're saying that – more the question is when the deals close between Q3 and Q4, not necessarily if they close in the second half. Sounds like your confidence that these will close in the second half is high..

Yeah. So these deals are mostly deals that have already occurred, meaning the order's already there and we've been doing work on them. And so it's just a matter of – under our control when the projects are completed and implemented, and then under the control of the customer as to for revenue recognition when they agree and give us acceptance.

And like I said, if they did it on January 1, it would be a Q4 event. If they did it on December 31, it would a Q3 event..

Got it. Super helpful. Thanks, guys..

Thank you..

Yeah..

Thank you. And we'll go next to Chad Bennett with Craig-Hallum Capital Group. Please go ahead..

Hey. Good morning. Thanks for taking my questions. And I'm hopping between calls, so hopefully I'm not redundant. So I think in the prepared remarks you talked about 30% of service provider, I believe, product revenue for the first half being software-only.

Do we have a sense of maybe where we – again, if everything goes to plan, where you could end the year as a mix of service provider product revenue from software-only solutions?.

I don't know, Jean – I think this is probably in the same range..

Yeah. I think we would say right now....

Same range..

Yeah, for FY 2019, we're probably – I'm just doing a quick thought for a second – we're probably – given what I had just talked about with the projects completing, 30% is probably a good target for full year of FY 2019..

And so the three double-digit million deals that you just mentioned on the prior question, those are all software-only? Is that safe to say?.

I would say that one ....

Two out of three are....

Yeah, probably two out of three are mostly software..

Okay. Got it. Just on the DDoS expectations for the second half, do you think – I understand kind of the over-buying phenomenon last year and how you're kind of absorbing that this year.

Is there anything else in the overall DDoS market that you believe has changed since last year?.

No, that's it – for us, I think overall market is growing slightly. And we have been more focused on service providers and we have been the biggest player in service provider, and that we are the most impacted. And that combined with the U.S. carriers, so we are – the business is really impacted in Tier 1 U.S. carriers or U.S.

carriers deploying DDoS, which is we sort of were the biggest player in that. And we saw the similar effect two, three years ago in the service assurance area, as we talked about earlier. So I think this is the last year, where even though we'll grow in the second half versus the first half, overall the year will be down.

And from next year we'll start from a lower base and start growing again..

Right. And maybe the last one for me. How much – I guess, as much as you can tell – well, you probably can tell – how much implied 5G spend is in your second half guidance? And I assume you believe that will meaningfully change or improve heading into next fiscal year..

Yeah. No, the next fiscal year is too early to tell, but I'll just make a comment about that in a minute. But there's very little in the second half for 5G, but it's very – if we compare to zero versus last year, then, yeah, it's significant. But the next year, it's all going to depend on 5G rollout – the speed of 5G rollout.

And I mentioned about a single pane of glass comment in response to a previous question. Why customer would prefer our cloud solution versus other people because we cover all sides of the house. We provide – in the hybrid environment we are the best solution.

Similar to our two tier, (00:57:52) we talked about why we are competitive against NEMs is because we provide a true vendor-independent solution. Same story applies to 5G. When you have a call going through 4G, 3G, 5G networks, you need a single pane of glass to look at the quality of the call, troubleshoot, and all those.

So our reestablished incumbency in 4G area because of software and better price point, not just better technology, puts us in front of the line for 5G projects. So it will all depend on how fast 5G rolls out. But if 5G is not rolled out fast enough, then capacity will be built on the 4G side. And either case, we should see some growth because of that..

And just to be clear, Chad, the 5G-related projects is that, part of our thinking for this current fiscal year are tied primarily to calibration services that are used to design those 5G radio access network infrastructures for 5G.

So, it's a different capability than the traditional service assurance network monitoring solution that we – it's been deployed across 3G, 4G, and will eventually be deployed for 5G..

Right. Good color. Thanks for fitting me in..

Sure, Chad..

Thank you. And now I would like to turn it back to Andrew Kramer for closing remarks..

Thanks, Erica. I'd like to thank everybody for tuning in this morning. I know it's a busy day for everybody. Look forward to seeing you out on the road at different investor conferences. If we're in a money center of yours, we'll certainly be looking forward to seeing you there. And otherwise, we'll talk to you in the new calendar year.

Thank you very much..

We'd like to thank everybody for their participation on today's conference call. Please feel free to disconnect your line at any time. And have a great day..