NTCT-2013.9.30-10Q
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
 
FORM 10-Q
 
 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2013
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                     to                     
Commission file number 0000-26251
 
NETSCOUT SYSTEMS, INC.
(Exact Name of Registrant as Specified in Its Charter)
 
Delaware
 
04-2837575
(State or Other Jurisdiction of
Incorporation or Organization)
 
(IRS Employer
Identification No.)
310 Littleton Road, Westford, MA 01886
(978) 614-4000
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.)    YES  x    NO  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
 
x
Accelerated filer
 
¨
 
 
 
 
 
 
Non-accelerated filer
 
¨  (Do not check if a smaller reporting company)
Smaller reporting company
 
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES  ¨    NO  x
The number of shares outstanding of the registrant’s common stock, par value $0.001 per share, as of October 23, 2013 was 41,530,579.



Table of Contents

NETSCOUT SYSTEMS, INC.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2013
TABLE OF CONTENTS
 
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 6.
 
 
 
 
 
 
 
 



Table of Contents

PART I: FINANCIAL INFORMATION
Item 1. Unaudited Financial Statements
NetScout Systems, Inc.
Consolidated Balance Sheets
(In thousands, except share and per share data)
 
 
September 30,
2013
 
March 31,
2013
Assets
(Unaudited)
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
94,917

 
$
99,930

Marketable securities
42,094

 
37,338

Accounts receivable, net of allowance for doubtful accounts of $147 and $971 at September 30, 2013 and March 31, 2013, respectively
55,672

 
73,900

Inventories
10,728

 
7,563

Prepaid income taxes
1,920

 
0

Deferred income taxes
9,434

 
9,538

Prepaid expenses and other current assets
8,292

 
9,043

Total current assets
223,057

 
237,312

Fixed assets, net
21,797

 
19,678

Goodwill
202,863

 
202,453

Intangible assets, net
60,896

 
63,827

Deferred income taxes
8,065

 
9,211

Long-term marketable securities
22,438

 
16,823

Other assets
2,285

 
2,872

Total assets
$
541,401

 
$
552,176

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
8,719

 
$
10,161

Accrued compensation
23,766

 
31,585

Accrued other
7,292

 
8,256

Income taxes payable
0

 
114

Deferred revenue
88,319

 
95,055

Total current liabilities
128,096

 
145,171

Other long-term liabilities
2,531

 
2,249

Deferred tax liability
979

 
941

Accrued long-term retirement benefits
1,575

 
1,757

Long-term deferred revenue
21,294

 
25,907

Contingent liabilities, net of current portion
4,139

 
4,248

Total liabilities
158,614

 
180,273

Commitments and contingencies (Note 12)

 

Stockholders’ equity:
 
 
 
Preferred stock, $0.001 par value:
 
 
 
5,000,000 shares authorized; no shares issued or outstanding at September 30, 2013 and March 31, 2013
0

 
0

Common stock, $0.001 par value:
 
 
 
150,000,000 shares authorized; 49,706,643 and 49,007,491 shares issued and 41,504,713 and 41,466,921 shares outstanding at September 30, 2013 and March 31, 2013, respectively
50

 
49

Additional paid-in capital
263,887

 
253,202

Accumulated other comprehensive income
2,082

 
671

Treasury stock at cost, 8,201,930 and 7,540,570 shares at September 30, 2013 and March 31, 2013, respectively
(99,829
)
 
(83,480
)
Retained earnings
216,597

 
201,461

Total stockholders’ equity
382,787

 
371,903

Total liabilities and stockholders’ equity
$
541,401

 
$
552,176

The accompanying notes are an integral part of these consolidated financial statements.

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Table of Contents

NetScout Systems, Inc.
Consolidated Statements of Operations
(In thousands, except per share data)
(Unaudited)
 
 
Three Months Ended
 
Six Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
Revenue:
 
 
 
 
 
 
 
Product
$
52,357

 
$
46,162

 
$
95,334

 
$
86,424

Service
39,740

 
38,383

 
78,568

 
74,482

Total revenue
92,097

 
84,545

 
173,902

 
160,906

Cost of revenue:
 
 
 
 
 
 
 
Product
11,810

 
10,330

 
21,583

 
20,400

Service
7,894

 
6,611

 
15,043

 
13,404

Total cost of revenue
19,704

 
16,941

 
36,626

 
33,804

Gross profit
72,393

 
67,604

 
137,276

 
127,102

Operating expenses:
 
 
 
 
 
 
 
Research and development
16,638

 
15,201

 
32,603

 
29,278

Sales and marketing
31,559

 
26,743

 
63,759

 
56,892

General and administrative
7,457

 
6,975

 
14,438

 
13,532

Amortization of acquired intangible assets
857

 
645

 
1,711

 
1,231

Restructuring charges
0

 
1,153

 
0

 
1,066

Total operating expenses
56,511

 
50,717

 
112,511

 
101,999

Income from operations
15,882

 
16,887

 
24,765

 
25,103

Interest and other (expense) income, net:
 
 
 
 
 
 
 
Interest income
57

 
192

 
144

 
308

Interest expense
(187
)
 
(401
)
 
(377
)
 
(792
)
Other income expense, net
71

 
93

 
101

 
12

Total interest and other expense income, net
(59
)
 
(116
)
 
(132
)
 
(472
)
Income before income tax expense
15,823

 
16,771

 
24,633

 
24,631

Income tax expense
5,940

 
6,861

 
9,497

 
9,713

Net income
$
9,883

 
$
9,910

 
$
15,136

 
$
14,918

Basic net income per share
$
0.24

 
$
0.24

 
$
0.37

 
$
0.36

Diluted net income per share
$
0.24

 
$
0.23

 
$
0.36

 
$
0.35

Weighted average common shares outstanding used in computing:
 
 
 
 
 
 
 
Net income per share – basic
41,392

 
41,695

 
41,398

 
41,718

Net income per share – diluted
41,950

 
42,344

 
42,004

 
42,400

The accompanying notes are an integral part of these consolidated financial statements.

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Table of Contents

NetScout Systems, Inc.
Consolidated Statements of Comprehensive Income
(In thousands)
(Unaudited)
 
 
Three Months Ended
 
Six Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
Net income
$
9,883

 
$
9,910

 
$
15,136

 
$
14,918

Other comprehensive income:
 
 
 
 
 
 
 
Cumulative translation adjustments
928

 
1,358

 
1,219

 
284

Changes in market value of investments:
 
 
 
 
 
 
 
Changes in unrealized gains
39

 
37

 
4

 
121

Total net change in market value of investments
39

 
37

 
4

 
121

Changes in market value of derivatives:
 
 
 
 
 
 
 
Changes in market value of derivatives, net of taxes of $76, $178, $1 and $10
124

 
285

 
2

 
13

Reclassification adjustment for net losses included in net income, net of benefits of $71, $30, $103 and $100
113


49


186


163

Total net change in market value of derivatives
237

 
334

 
188

 
176

Other comprehensive income
1,204

 
1,729

 
1,411

 
581

Comprehensive income
$
11,087

 
$
11,639

 
$
16,547

 
$
15,499

The accompanying notes are an integral part of these consolidated financial statements.

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Table of Contents

NetScout Systems, Inc.
Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
 
Six Months Ended
 
September 30,
 
2013
 
2012
Cash flows from operating activities:
 
 
 
Net income
$
15,136

 
$
14,918

Adjustments to reconcile net income to cash provided by operating activities, net of the effects of acquisitions:
 
 
 
Depreciation and amortization
9,512

 
9,069

Loss on disposal of fixed assets
37

 
24

Deal related compensation expense and accretion charges
73

 
140

Share-based compensation expense associated with equity awards
6,742

 
4,790

Net change in fair value of contingent and contractual liabilities
(278
)
 
356

Deferred income taxes
1,823

 
3,910

Other gains
(7
)
 
(21
)
Changes in assets and liabilities
 
 
 
Accounts receivable
18,271

 
40,852

Inventories
(4,946
)
 
(905
)
Prepaid expenses and other assets
(340
)
 
(3,431
)
Accounts payable
(1,511
)
 
1,299

Accrued compensation and other expenses
(5,881
)
 
(224
)
Income taxes payable
(114
)
 
0

Deferred revenue
(11,416
)
 
(14,287
)
Net cash provided by operating activities
27,101

 
56,490

Cash flows from investing activities:
 
 
 
Purchase of marketable securities
(43,750
)
 
(81,055
)
Proceeds from maturity of marketable securities
33,383

 
102,292

Purchase of fixed assets
(6,508
)
 
(4,672
)
Decrease (increase) in deposits
38

 
(347
)
Acquisition of businesses, net of cash acquired
0

 
(15,000
)
Net cash (used in) provided by investing activities
(16,837
)
 
1,218

Cash flows from financing activities:
 
 
 
Issuance of common stock under stock plans
315

 
355

Payment of contingent consideration
(841
)
 
(2,356
)
Treasury stock repurchases
(16,349
)
 
(14,141
)
Excess tax benefit from share-based compensation awards
1,733

 
1,579

Net cash used in financing activities
(15,142
)
 
(14,563
)
Effect of exchange rate changes on cash and cash equivalents
(135
)
 
(14
)
Net (decrease) increase in cash and cash equivalents
(5,013
)
 
43,131

Cash and cash equivalents, beginning of period
99,930

 
117,255

Cash and cash equivalents, end of period
$
94,917

 
$
160,386

Supplemental disclosures:
 
 
 
Cash paid for interest
$
0

 
$
245

Cash paid for income taxes
$
7,922

 
$
8,174

Non-cash transactions:
 
 
 
Transfers of inventory to fixed assets
$
1,781

 
$
583

Additions to property, plant and equipment included in accounts payable
$
(64
)
 
$
490

Gross decrease in contractual liability relating to fair value adjustment
$
(98
)
 
$
(135
)
Gross (decrease) increase in contingent consideration liability relating to fair value adjustment
$
(180
)
 
$
491

Issuance of common stock under employee stock plans
$
2,230

 
$
2,224

The accompanying notes are an integral part of these consolidated financial statements.

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Table of Contents

NetScout Systems, Inc.
Notes to Consolidated Financial Statements
(Unaudited)
NOTE 1 – BASIS OF PRESENTATION
The accompanying unaudited interim consolidated financial statements have been prepared by NetScout Systems, Inc., or NetScout or the Company. Certain information and footnote disclosures normally included in financial statements prepared under generally accepted accounting principles (GAAP) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). In the opinion of management, the unaudited interim consolidated financial statements include all adjustments, consisting of normal recurring adjustments, necessary for a fair statement of the Company’s financial position, results of operations and cash flows. The year-end consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. The results reported in these consolidated financial statements are not necessarily indicative of results that may be expected for the entire year. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements, including the notes thereto, included in the Company’s Annual Report on Form 10-K for the fiscal year ended March 31, 2013.
Recent Accounting Pronouncements

In March 2013, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2013-05 Foreign Currency Matters (Topic 830): Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity (ASU 2013-05).  ASU 2013-05 provides guidance on releasing cumulative translation adjustments when a reporting entity (parent) ceases to have a controlling financial interest in a subsidiary or a business within a foreign entity.   ASU 2013-05 is effective on a prospective basis for fiscal years and interim reporting periods within those years, beginning after December 15, 2013 (the fourth quarter of fiscal year 2014 for the Company). Early adoption is permitted. This standard is not expected to have a material impact on the Company's financial condition, results of operations, or cash flows.
NOTE 2 – CONCENTRATION OF CREDIT RISK AND SIGNIFICANT CUSTOMERS
Financial instruments that potentially subject us to concentration of credit risk consist primarily of investments, trade accounts receivable and accounts payable. Our cash, cash equivalents, and marketable securities are placed with financial institutions with high credit standings.
At September 30, 2013, the Company had one indirect channel partner which accounted for more than 10% of the accounts receivable balance, while no direct customer accounted for more than 10% of the accounts receivable balance. At March 31, 2013, no one direct customer or indirect channel partner accounted for more than 10% of the accounts receivable balance.
During the three months ended September 30, 2013, no direct customer or channel partner accounted for more than 10% of our total revenue, while one direct customer accounted for more than 10% of total revenue during the six months ended September 30, 2013. During the three and six months ended September 30, 2012, one direct customer accounted for more than 10% of total revenue, while no one indirect channel partner accounted for more than 10% of total revenue.
Historically, the Company has not experienced any significant failure of its customers to meet their payment obligations nor does the Company anticipate material non-performance by its customers in the future; accordingly, the Company does not require collateral from its customers. However, if the Company’s assumptions are incorrect, there could be an adverse impact on its allowance for doubtful accounts.


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Table of Contents

NOTE 3 – SHARE-BASED COMPENSATION
The following is a summary of share-based compensation expense including restricted stock units and employee stock purchases made under our employee stock purchase plan (ESPP) based on estimated fair values within the applicable cost and expense lines identified below (in thousands):
 
Three Months Ended
 
Six Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
Cost of product revenue
$
68

 
$
66

 
$
112

 
$
115

Cost of service revenue
226

 
87

 
372

 
153

Research and development
1,263

 
742

 
2,159

 
1,386

Sales and marketing
1,163

 
808

 
2,008

 
1,526

General and administrative
1,210

 
829

 
2,091

 
1,599

 
$
3,930

 
$
2,532

 
$
6,742

 
$
4,779

Employee Stock Purchase Plan – The Company maintains an ESPP for all eligible employees as described in the Company’s Annual Report on Form 10-K for the year ended March 31, 2013. Under the ESPP, shares of the Company’s common stock may be purchased on the last day of each bi-annual offering period at 85% of the fair value on the last day of such offering period. The offering periods run from March 1 through August 31 and from September 1 through February 28 of each year. During the six months ended September 30, 2013, employees purchased 89,765 shares under the ESPP and the value per share was $24.84.
NOTE 4 – CASH, CASH EQUIVALENTS AND MARKETABLE SECURITIES
The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents and those investments with original maturities greater than three months to be marketable securities. Cash and cash equivalents consisted of money market instruments and cash maintained with various financial institutions at September 30, 2013 and March 31, 2013.
Marketable Securities
The following is a summary of marketable securities held by NetScout at September 30, 2013 classified as short-term and long-term (in thousands):
 
Amortized
Cost
 
Unrealized
Gains
 
Fair
Value
Type of security:
 
 
 
 
 
U.S. government and municipal obligations
$
28,172

 
$
3

 
$
28,175

Commercial paper
5,597

 
0

 
5,597

Corporate bonds
5,658

 
5

 
5,663

Certificates of deposit
2,659

 
0

 
2,659

Total short-term marketable securities
42,086

 
8

 
42,094

U.S. government and municipal obligations
10,984

 
8

 
10,992

Corporate bonds
11,438

 
8

 
11,446

Total long-term marketable securities
22,422

 
16

 
22,438

Total marketable securities
$
64,508

 
$
24

 
$
64,532


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Table of Contents

The following is a summary of marketable securities held by NetScout at March 31, 2013, classified as short-term and long-term (in thousands):
 
Amortized
Cost
 
Unrealized
Gains
 
Fair
Value
Type of security:
 
 
 
 
 
U.S. government and municipal obligations
$
17,416

 
$
11

 
$
17,427

Commercial paper
12,390

 
0

 
12,390

Corporate bonds
2,559

 
2

 
2,561

Certificates of deposit
4,960

 
0

 
4,960

Total short-term marketable securities
37,325

 
13

 
37,338

U.S. government and municipal obligations
14,211

 
7

 
14,218

Corporate bonds
2,605

 
0

 
2,605

Total long-term marketable securities
16,816

 
7

 
16,823

Total marketable securities
$
54,141

 
$
20

 
$
54,161

Contractual maturities of the Company’s marketable securities held at September 30, 2013 and March 31, 2013 were as follows (in thousands):

September 30,
2013

March 31,
2013
Available-for-sale securities:



Due in 1 year or less
$
42,094


$
37,338

Due after 1 year through 5 years
22,438


16,823


$
64,532


$
54,161


NOTE 5 – FAIR VALUE MEASUREMENTS
The fair value hierarchy has three levels based on the reliability of the inputs used to determine fair value. Level 1 refers to fair values determined based on quoted prices in active markets for identical assets. Level 2 refers to fair values estimated using significant other observable inputs, and Level 3 includes fair values estimated using significant non-observable inputs. The following tables present the Company’s financial assets and liabilities measured on a recurring basis using the fair value hierarchy as of September 30, 2013 and March 31, 2013 (in thousands).

Fair Value Measurements at
 
September 30, 2013
 
Level 1

Level 2

Level 3

Total
ASSETS:

 

 



Cash and cash equivalents
$
94,917

 
$
0

 
$
0


$
94,917

U.S. government and municipal obligations
39,167

 
0

 
0


39,167

Commercial paper
0

 
5,597

 
0


5,597

Corporate bonds
17,109

 
0

 
0


17,109

Certificate of deposits
0

 
2,659

 
0


2,659

Derivative financial instruments
0

 
341

 
0


341


$
151,193

 
$
8,597

 
$
0


$
159,790

LIABILITIES:

 

 



Contingent purchase consideration
$
0

 
$
0

 
$
(4,139
)

$
(4,139
)
Contingent contractual non-compliance liability
0

 
0

 
(148
)

(148
)
Derivative financial instruments
0

 
(221
)
 
0


(221
)

$
0

 
$
(221
)
 
$
(4,287
)

$
(4,508
)

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Fair Value Measurements at
 
March 31, 2013
 
Level 1

Level 2

Level 3

Total
ASSETS:

 

 



Cash and cash equivalents
$
99,930

 
$
0

 
$
0


$
99,930

U.S. government and municipal obligations
31,645

 
0

 
0


31,645

Commercial paper
0

 
12,390

 
0


12,390

Corporate bonds
5,166

 
0

 
0


5,166

Certificate of deposits
0

 
4,960

 
0


4,960

Derivative financial instruments
0

 
71

 
0


71


$
136,741


$
17,421


$
0


$
154,162

LIABILITIES:

 

 



Contingent purchase consideration
$
0

 
$
0

 
$
(5,087
)

$
(5,087
)
Contingent contractual non-compliance liability
0

 
0

 
(246
)

(246
)
Derivative financial instruments
0

 
(249
)
 
0


(249
)

$
0


$
(249
)

$
(5,333
)

$
(5,582
)
This hierarchy requires the Company to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value. On a recurring basis, the Company measures certain financial assets and liabilities at fair value, including marketable securities and derivative financial instruments.
The Company’s Level 1 investments are classified as such because they are valued using quoted market prices or alternative pricing sources with reasonable levels of price transparency.
The Company’s Level 2 investments are classified as such because fair value is being calculated using data from similar but not identical sources, or a discounted cash flow model using the contractual interest rate as compared to the underlying interest yield curve. The Company's derivative financial instruments consist of forward foreign exchange contracts and are classified as Level 2 because the fair values of these derivatives are determined using models based on market observable inputs, including spot prices for foreign currencies and credit derivatives, as well as an interest rate factor. Commercial paper and certificate of deposits are classified as Level 2 because the Company uses market information from similar but not identical instruments and discounted cash flow models based on interest rate yield curves to determine fair value. For further information on the Company's derivative instruments refer to Note 9.
The Company’s contingent purchase consideration and contingent contractual non-compliance liability at September 30, 2013 and March 31, 2013 were classified as Level 3 in the fair value hierarchy. They are valued by probability weighting expected payment scenarios and then applying a discount based on the present value of the future cash flow streams. The Company has elected to account for the contractual non-compliance liability at fair value. This election has been made as both contingent liabilities are related. The fair value election created parity between the two items during the settlement period. These liabilities are classified as Level 3 because the probability weighting of future payment scenarios is based on assumptions developed by management.
The following table sets forth a reconciliation of changes in the fair value of the Company’s Level 3 financial liabilities for the six months ended September 30, 2013 (in thousands):

Contingent
Purchase
Consideration

Contingent
Contractual
Non-compliance
Liability
Balance at beginning of period
$
(5,087
)

$
(246
)
Change in fair value (included within research and development expense)
107


98

Payments
841


0

Balance at end of period
$
(4,139
)

$
(148
)
The Company has updated the probabilities used in the fair value calculation of the contingent liabilities during the six months ended September 30, 2013 which reduced the liability by $278 thousand and is included as part of earnings for the six

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months ended September 30, 2013. The fair value of the contingent purchase consideration was estimated by applying a probability based model, which utilizes significant inputs that are unobservable in the market. Key assumptions include a 3.3% discount rate and a percent weighted-probability of the settlement of the contingent contractual non-compliance liability. Deal related compensation expense, accretion charges and changes related to settlements of contractual non-compliance liabilities for the six months ended September 30, 2013 were $73 thousand and were included as part of earnings.
During the six months ended September 30, 2013, $841 thousand related to the acquisition of Simena, LLC (Simena) was paid to the former owner.
NOTE 6 – INVENTORIES
Inventories are stated at the lower of actual cost or net realizable value. Cost is determined by using the first in, first out (FIFO) method. Inventories consist of the following (in thousands):

September 30,
2013

March 31,
2013
Raw materials
$
6,665


$
3,986

Work in process
251


272

Finished goods
3,812


3,305


$
10,728


$
7,563

NOTE 7 – ACQUISITIONS
While the Company uses its best estimates and assumptions as part of the purchase price allocation process to value the assets acquired and liabilities assumed on the acquisition date, its estimates and assumptions are subject to refinement. As a result, during the preliminary purchase price allocation period, which may be up to one year from the acquisition date, the Company records adjustments to the assets acquired and liabilities assumed with a corresponding offset to goodwill. The Company records adjustments to the assets acquired and liabilities assumed subsequent to the purchase price allocation period in the Company’s operating results in the period in which the adjustments were determined. The results of operations of the acquired businesses described below have been included in the Company’s consolidated financial statements beginning on their respective acquisition dates unless indicated otherwise below.
ONPATH
On October 31, 2012, the Company acquired ONPATH Technologies, Inc. (ONPATH), an established provider of scalable packet flow switching technology for high-performance networks for the aggregation and distribution of network traffic for data, voice, video testing, monitoring, performance management and cybersecurity deployments. ONPATH’s packet flow switch technology is synergistic with the Company’s network monitoring switch strategy. The acquisition of the packet flow switch technology further strengthens the Company’s Unified Service Delivery Management strategy by enabling scalable access to all relevant network traffic across highly distributed network environments for use by any network monitoring, performance management and security system. ONPATH’s test automation technology is used to monitor networks in test environments which simulate existing and planned network environments. The results of ONPATH’s operations have been included in the consolidated financial statements since October 31, 2012. The total cash transferred and to be transferred of $41.0 million consisted entirely of cash consideration, of which $8.2 million will be paid to employees and directors of ONPATH pursuant to ONPATH’s transaction bonus and retention plan. Approximately $4.0 million of the transaction bonuses are considered compensation and are therefore not included as consideration within the table below.

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The following table summarizes the allocation of the purchase price (in thousands):
Allocation of the purchase consideration:
 
Current assets, including cash and cash equivalents of $527
$
8,356

Fixed assets
784

Identifiable intangible assets
10,970

Goodwill
19,897

Deferred tax asset
7,329

Other assets
1,432

Total assets acquired
48,768

Current liabilities
(6,387
)
Deferred revenue
(921
)
Deferred income tax liabilities
(4,660
)
 
$
36,800

Goodwill was recognized for the excess purchase price over the fair value of the assets acquired. Goodwill of $17.5 million from the ONPATH acquisition was included within the Company’s existing Unified Service Delivery reporting unit and $2.4 million was included within the Test Automation reporting unit. Both reporting units resulting from the acquisition of ONPATH were included in the Company’s annual impairment review on January 31, 2013.
The fair values of intangible assets were based on valuations using an income approach, with estimates and assumptions provided by management of ONPATH and the Company. These assumptions include estimates of future revenues associated with the technology purchased as part of the acquisition and the migration of the current technology to more advanced version of the software. This fair value measurement was based on significant inputs not observable in the market and thus represents Level 3 fair value measurements. The following table reflects the fair value of the acquired identifiable intangible assets and related estimates of useful lives (in thousands, except for years):
 
Fair Value
 
Useful Life
(Years)
Developed technology
$
4,970

 
8
Customer relationships
6,000

 
7
 
$
10,970

 
 
The weighted average useful life of identifiable intangible assets acquired from ONPATH is 7.5 years. Acquired software is amortized using an accelerated amortization method. Customer relationships are amortized on a straight-line basis.
Goodwill and intangible assets recorded as part of the ONPATH acquisition are not deductible for tax purposes.
The Company notes that it acquired net operating losses from ONPATH. ONPATH has represented to the Company that there were no historical changes in control that would limit NetScout’s ability to utilize these net operating losses in its consolidated federal return. During the fourth quarter of the Company's fiscal year ended March 31, 2013, the Company completed a 382 study with its tax advisors and concluded that ONPATH's representations were correct. The Company also notes that ONPATH did not claim research and development credits for historical tax returns. NetScout believes that certain ONPATH activities qualify for a research and development credit, and in the second quarter of fiscal year 2014, performed an analysis on the historical periods to identify and claim credits for historical research and development activities. A net tax credit of $517 thousand has been recorded within the acquisition allocation related to ONPATH's research and development activities.
Accanto
On July 20, 2012, the Company acquired certain assets, technology and employees of Accanto Systems, S.r.l. (Accanto), a supplier of service assurance solutions for telecommunication service providers which enables carriers to monitor and manage the delivery of voice services over converged, next generation telecom architectures. Accanto’s technology is synergistic with the Company’s packet flow strategy and brings voice service monitoring capabilities for legacy environments and for next generation network voice services. The Company maintains a relationship with the selling entity such that the selling entity serves as a distributor for the Company. The results of Accanto’s operations, related to those assets, technology and employees acquired, have been included in the consolidated financial statements since that date. The total purchase price of

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$15.0 million consisted entirely of cash consideration. The goodwill recognized primarily relates to the value in combining Accanto’s product with our customer base.
The following table summarizes the allocation of the purchase price (in thousands):
Allocation of the purchase consideration:
 
Current assets
$
389

Fixed assets
237

Identifiable intangible assets
5,280

Goodwill
11,157

Total assets acquired
17,063

Current liabilities
(839
)
Deferred revenue
(240
)
Deferred income tax liabilities
(984
)
 
$
15,000

Goodwill was recognized for the excess purchase price over the fair value of the assets acquired. Goodwill from the Accanto acquisition is included within the Company’s Unified Service Delivery reporting unit and was included in the Company’s annual impairment review. The acquired software intangible had a tax basis of approximately $2.1 million which carried over as part of the acquisition and will be deductible for tax purposes.  The remaining value of the acquired software intangible asset and the full value of the customer relationship intangible asset and goodwill is not deductible for tax purposes.
The fair values of intangible assets were based on valuations using an income approach, with estimates and assumptions provided by management of Accanto and the Company. These assumptions include estimates of future revenues associated with the technology purchased as part of the acquisition and the migration of the current technology to more advanced versions of the software. This fair value measurement was based on significant inputs not observable in the market and thus represents Level 3 fair value measurements. The following table reflects the fair value of the acquired identifiable intangible assets and related estimates of useful lives (in thousands, except for years):
 
Fair Value
 
Useful Life
(Years)
Developed technology
$
3,500

 
8
Distributor relationships
1,780

 
6
 
$
5,280

 
 
The weighted average useful life of identifiable intangible assets acquired from Accanto is 7.3 years. Acquired software is amortized using an accelerated amortization method. Distributor relationships are amortized on a straight-line basis.
The following table presents unaudited proforma results of the historical Consolidated Statements of Operations of the Company ONPATH and Accanto for the three and six months ended September 30, 2012, giving effect to the mergers as if they occurred on April 1, 2012 (in thousands, except per share data):
 
Three Months Ended
 
Six Months Ended
 
September 30, 2012
 
September 30, 2012
 
(unaudited)
 
(unaudited)
Pro forma revenue
$
87,493

 
$
168,788

Pro forma net income
$
7,516

 
$
8,998

Pro forma income per share:
 
 
 
Basic
$
0.18

 
$
0.22

Diluted
$
0.18

 
$
0.21

Pro forma shares outstanding
 
 
 
Basic
41,695

 
41,718

Diluted
42,344

 
42,400


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The proforma results for the three and six months ended September 30, 2012 primarily include adjustments for amortization of intangibles. This proforma information does not purport to indicate the results that would have actually been obtained had the acquisitions been completed on the assumed date, or which may be realized in the future.
During the six months ended September 30, 2013, the Company has recorded $6.0 million of revenue directly attributable to ONPATH and Accanto within its consolidated financial statements.
NOTE 8 – GOODWILL AND INTANGIBLE ASSETS
Goodwill
The Company has two reporting units: (1) Unified Service Delivery and (2) Test Automation. As of September 30, 2013 and March 31, 2013, goodwill attributable to the Unified Service Delivery reporting unit was $200.5 million and $199.5 million, respectively. Goodwill attributable to the Test Automation reporting unit was $2.4 million and $3.0 million as of September 30, 2013 and March 31, 2013, respectively. Goodwill is tested for impairment at a reporting unit level at least annually, or on an interim basis if an event occurs or circumstances change that would, more likely than not, reduce the fair value of the reporting segment below its carrying value.
The changes in the carrying amount of goodwill for the six months ended September 30, 2013 are due to purchase accounting adjustments and the impact of foreign currency translation adjustments related to asset balances that are recorded in non-U.S. currencies.
The changes in the carrying amount of goodwill for the six months ended September 30, 2013 are as follows (in thousands):

Six months ended
 
September 30, 2013
Balance as of March 31, 2013
$
202,453

Purchase accounting adjustments
(665
)
Foreign currency translation impact
1,075

Balance as of September 30, 2013
$
202,863

Intangible Assets
The net carrying amounts of intangible assets were $60.9 million and $63.8 million as of September 30, 2013 and March 31, 2013, respectively. Intangible assets acquired in a business combination are recorded under the acquisition method of accounting at their estimated fair values at the date of acquisition. The Company amortizes intangible assets over their estimated useful lives, except for the acquired trade name which resulted from the Network General Central Corporation (Network General) acquisition, which has an indefinite life and thus is not amortized. The carrying value of the indefinite lived trade name is evaluated for potential impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired.
Intangible assets include an indefinite lived trade name with a carrying value of $18.6 million and the following amortizable intangible assets as of September 30, 2013 (in thousands):

Cost

Accumulated
Amortization

Net
Developed technology
$
31,041

 
$
(22,416
)

$
8,625

Customer relationships
38,772

 
(12,543
)

26,229

Distributor relationships
1,972

 
(392
)

1,580

Core technology
7,528

 
(2,078
)

5,450

Non-compete agreements
348

 
(232
)

116

Other
637

 
(341
)

296


$
80,298


$
(38,002
)

$
42,296


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Table of Contents

Intangible assets include an indefinite lived trade name with a carrying value of $18.6 million and the following amortizable intangible assets as of March 31, 2013 (in thousands):

Cost

Accumulated
Amortization

Net
Developed technology
$
30,848

 
$
(21,343
)

$
9,505

Customer relationships
38,718

 
(11,038
)

27,680

Distributor relationships
1,895

 
(219
)

1,676

Core technology
7,446

 
(1,455
)

5,991

Non-compete agreements
334

 
(167
)

167

Other
483

 
(275
)

208


$
79,724

 
$
(34,497
)

$
45,227

Amortization of software and core technology included as cost of product revenue was $824 thousand and $1.6 million for the three and six months ended September 30, 2013, respectively. Amortization of other intangible assets included as operating expense was $884 thousand and $1.8 million for the three and six months ended September 30, 2013, respectively.
Amortization of software and core technology included as cost of product revenue was $1.5 million and $2.9 million for the three and six months ended September 30, 2012, respectively. Amortization of other intangible assets included as operating expense was $674 thousand and $1.3 million for the three and six months ended September 30, 2012, respectively.
The following is the expected future amortization expense as of September 30, 2013 for the years ended March 31 (in thousands):
2014 (remaining six months)
$
3,666

2015
6,876

2016
6,358

2017
5,777

2018
4,997

Thereafter
14,622


$
42,296

The weighted average amortization period of developed technology and core technology is 6.7 years. The weighted average amortization period for customer and distributor relationships is 13.3 years. The weighted average amortization period for amortizing all intangibles is 10.1 years.
NOTE 9 – DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
NetScout operates internationally and, in the normal course of business, is exposed to fluctuations in foreign currency exchange rates. The exposures result from costs that are denominated in currencies other than the U.S. dollar, primarily the Euro, British Pound, Canadian Dollar, and Indian Rupee. The Company manages its foreign cash flow risk by hedging forecasted cash flows for operating expenses denominated in foreign currencies for up to twelve months, within specified guidelines through the use of forward contracts. The Company enters into foreign currency exchange contracts to hedge cash flow exposures from costs that are denominated in currencies other than the U.S. Dollar. These hedges are designated as cash flow hedges at inception.
All of the Company’s derivative instruments are utilized for risk management purposes, and the Company does not use derivatives for speculative trading purposes. These contracts will mature over the next twelve months and are expected to impact earnings on or before maturity.

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Table of Contents

The notional amounts and fair values of derivative instruments in the consolidated balance sheets as of September 30, 2013 and March 31, 2013 were as follows (in thousands):
 
Notional Amounts (a)

Other Current Assets

Accrued Other Liabilities
 
September 30,
2013

March 31,
2013
 
September 30,
2013
 
March 31,
2013
 
September 30,
2013
 
March 31,
2013
Derivatives Designated as Hedging Instruments:











Forward contracts
$
15,398

 
$
17,071

 
$
341

 
$
71

 
$
221

 
$
249

 
(a)
Notional amounts represent the gross contract/notional amount of the derivatives outstanding.
The following table provides the effect foreign exchange forward contracts had on other comprehensive income (loss) (OCI) and results of operations for the three months ended September 30, 2013 and 2012 (in thousands):
Derivatives in Cash
Flow Hedging
Relationships
Effective Portion

   Ineffective Portion                    
Gain (Loss) Recognized in
OCI on Derivative
(a)

Gain (Loss) Reclassified from
Accumulated OCI into Income
(b)

Gain (Loss) Recognized in Income (Amount
Excluded from Effectiveness Testing)
(c)
September 30, 2013
 
September 30, 2012

Location

September 30, 2013

September 30, 2012

Location

September 30, 2013
 
September 30, 2012
Forward contracts
$
200

 
$
463


Research and
development

$
(169
)
 
$
(89
)

Research and
development

$
(7
)
 
$
47






Sales and
marketing

(15
)
 
10


Sales and
marketing

28

 
1


$
200


$
463




$
(184
)

$
(79
)



$
21


$
48

(a)
The amount represents the change in fair value of derivative contracts due to changes in spot rates.
(b)
The amount represents reclassification from other comprehensive income to earnings that occurs when the hedged item affects earnings.
(c)
The amount represents the change in fair value of derivative contracts due to changes in the difference between the spot price and forward price that is excluded from the assessment of hedge effectiveness and therefore recognized in earnings. No gains or losses were reclassified as a result of discontinuance of cash flow hedges.
The following table provides the effect foreign exchange forward contracts had on OCI and results of operations for the six months ended September 30, 2013 and 2012 (in thousands):
Derivatives in Cash
Flow Hedging
Relationships
Effective Portion

   Ineffective Portion                    
Gain (Loss) Recognized in
OCI on Derivative
(a)

Gain (Loss) Reclassified from
Accumulated OCI into Income
(b)

Gain (Loss) Recognized in Income (Amount
Excluded from Effectiveness Testing)
(c)
September 30, 2013

September 30, 2012

Location

September 30, 2013

September 30, 2012

Location

September 30, 2013

September 30, 2012
Forward contracts
$
3

 
$
23


Research and
development

$
(184
)
 
$
(237
)

Research and
development

$
97

 
$
(87
)





Sales and
marketing

(105
)
 
(26
)

Sales and
marketing

(6
)
 
(5
)

$
3


$
23




$
(289
)

$
(263
)



$
91


$
(92
)
 
(a)
The amount represents the change in fair value of derivative contracts due to changes in spot rates.
(b)
The amount represents reclassification from other comprehensive income to earnings that occurs when the hedged item affects earnings.
(c)
The amount represents the change in fair value of derivative contracts due to changes in the difference between the spot price and forward price that is excluded from the assessment of hedge effectiveness and therefore recognized in earnings. No gains or losses were reclassified as a result of discontinuance of cash flow hedges.
NOTE 10 – LONG-TERM DEBT
On October 29, 2012, the Company paid down its outstanding balance in the amount of $62.0 million on its credit facility. As of September 30, 2013, there were no amounts outstanding under this credit facility.

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Table of Contents

On November 22, 2011, the Company entered into a credit facility (the Credit Agreement) with a syndicate of lenders led by KeyBank National Association (KeyBank) providing the Company with a $250 million revolving credit facility, which may be increased to $300 million at any time up to 90 days before maturity. The revolving credit facility includes a swing line loan sub-facility of up to $10 million and a letter of credit sub-facility of up to $10 million. The credit facility under the Credit Agreement matures on November 21, 2016.
At the Company’s election, revolving loans under the Credit Agreement bear interest at either (a) a rate per annum equal to the highest of (1) KeyBank’s prime rate, (2) 0.50% in excess of the federal funds effective rate, or (3) one hundred (100.00) basis points in excess of the London Interbank Offered Rate (LIBOR) for one-month interest periods, or the Base Rate; or (b) the one-, two-, three-, or six-month per annum LIBOR, as selected by the Company, multiplied by the statutory reserve adjustment, or collectively, the Eurodollar Rate, in each case plus an applicable margin. Swing line loans will bear interest at the Base Rate plus the applicable Base Rate margin. Beginning with the delivery of the Company’s financial statements for the quarter ended December 31, 2011, the applicable margin began to depend on the Company’s leverage ratio, ranging from 100 basis points for Base Rate loans and 200 basis points for Eurodollar Rate loans if the Company’s consolidated leverage ratio is 2.50 to 1.00 or higher, down to 25 basis points for Base Rate loans and 125 basis points for Eurodollar Rate loans if the Company’s consolidated leverage ratio is 1.00 to 1.00 or less.
The Company may prepay loans under the Credit Agreement at any time, without penalty, subject to certain notice requirements. Debt is recorded at the amount drawn on the revolving credit facility plus interest based on floating rates reflective of changes in the market which approximates fair value.
The loans are guaranteed by each of the Company’s domestic subsidiaries and are collateralized by all of the assets of the Company and its domestic subsidiaries, as well as 65% of the capital stock of the Company’s foreign subsidiaries directly owned by the Company and its domestic subsidiaries. The Credit Agreement generally prohibits any other liens on the assets of the Company and its subsidiaries, subject to certain exceptions as described in the Credit Agreement. The Credit Agreement contains certain covenants applicable to the Company and its subsidiaries, including, without limitation, limitations on additional indebtedness, liens, various fundamental changes (including material mergers and dispositions of assets), dividends and distributions, capital expenditures, investments (including material acquisitions and investments in foreign subsidiaries), transactions with affiliates, sale-leaseback transactions, hedge agreements, payment of junior financing, material changes in business, and other limitations customary in senior secured credit facilities. In addition, the Company is required to maintain certain consolidated leverage and interest coverage ratios as well as a minimum liquidity amount. As of September 30, 2013, the Company was in compliance with all of these covenants.
NOTE 11 – RESTRUCTURING CHARGES
During the fiscal year ended March 31, 2013, the Company restructured part of its international sales organization related to an overlap of personnel acquired as part of the Accanto acquisition. The Company recorded $1.2 million of restructuring charges related to severance costs.
The following table provides a summary of the activity related to these restructuring plans and the related liability included as accrued compensation on the Company's consolidated balance sheet (in thousands):

Three Months Ended

Six Months Ended
Employee Severance:
September 30, 2013

September 30, 2013
Balance at beginning of period
$
785


$
910

Restructuring charges (reversal) to operations



Other adjustments
(49
)

(49
)
Cash payments
(665
)

(790
)
Balance as of September 30, 2013
$
71


$
71

The balance is expected to be paid in full by December 31, 2013.
NOTE 12 – COMMITMENTS AND CONTINGENCIES
Acquisition related The Company recorded two contingent liabilities related to the acquisition of Simena, one relates to future consideration to be paid to the former owner which had an initial fair value of $8.0 million at the time of acquisition and another relates to contractual non-compliance liabilities incurred by Simena with an initial fair value of $1.6 million at the time of acquisition. At September 30, 2013, the present value of the future consideration was $4.1 million and the contractual non-compliance liability was $148 thousand.

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Table of Contents

Legal – From time to time, NetScout is subject to legal proceedings and claims in the ordinary course of business. In the opinion of management, the amount of ultimate expense with respect to any current legal proceedings and claims, if determined adversely, will not have a significant adverse effect on the Company’s financial condition, results of operations or cash flows.
In March 2012, NetScout uncovered and investigated, and in April 2012, disclosed to the U.S. Department of Justice and the California State Attorney General potential violations of federal and California state anti-trust laws. The potential violations involve a former employee and one or more third parties in connection with sales to state governmental agencies during fiscal year 2012. NetScout believes it did not benefit from any of the transactions uncovered and believes that the amounts involved are not material. The California State Attorney General is conducting an investigation into the matter. NetScout is cooperating fully and is providing all requested information. In general, the federal and state agencies have the authority to seek fines and other remedies for anti-trust violations; however, no charges or proceedings have been initiated by any governmental agency against NetScout, and the Company has been informed by the Department of Justice that it does not intend to take any action against NetScout. The Company determined that it is probable that there will be amounts due, those amounts are reasonably estimable and have been accrued as an immaterial liability as of September 30, 2013.
NOTE 13 – TREASURY STOCK
On September 17, 2001, the Company announced an open market stock repurchase program to purchase up to one million shares of outstanding Company common stock, subject to market conditions and other factors. Any purchases under the Company’s stock repurchase program may be made from time to time without prior notice. On July 26, 2006, the Company announced that it had expanded the existing open market stock repurchase program to enable the Company to purchase up to an additional three million shares of the Company’s outstanding common stock, bringing the total number of shares authorized for repurchase to four million shares. Through September 30, 2013, the Company had repurchased a total of 3,231,700 shares of common stock through the open market stock repurchase program. The Company repurchased 475,407 shares for $11.7 million under the program during the six months ended September 30, 2013.
In connection with the vesting and release of the restriction on previously vested shares of restricted stock units, the Company repurchased 185,953 shares for $4.6 million related to minimum statutory tax withholding requirements on these restricted stock units during the six months ended September 30, 2013. These repurchase transactions do not fall under the repurchase program described above, and therefore do not reduce the amount that is available for repurchase under that program.
NOTE 14 – NET INCOME PER SHARE
Calculations of the basic and diluted net income per share and potential common shares are as follows (in thousands, except for per share data):

Three Months Ended

Six Months Ended
 
September 30,

September 30,
 
2013

2012

2013

2012
Numerator:







Net income
$
9,883

 
$
9,910

 
$
15,136

 
$
14,918

Denominator:
 
 
 
 
 
 
 
Denominator for basic net income per share - weighted average shares outstanding
41,392

 
41,695

 
41,398

 
41,718

Dilutive common equivalent shares:
 
 
 
 
 
 
 
      Weighted average stock options
76

 
134

 
81

 
135

      Weighted average restricted stock units
482

 
515

 
525

 
547

Denominator for diluted net income per share - weighted average shares outstanding
41,950

 
42,344

 
42,004

 
42,400

Net income per share:
 
 
 
 
 
 
 
Basic net income per share
$
0.24

 
$
0.24

 
$
0.37

 
$
0.36

Diluted net income per share
$
0.24

 
$
0.23

 
$
0.36

 
$
0.35


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Table of Contents

The following table sets forth restricted stock units excluded from the calculation of diluted net income per share, since their inclusion would be antidilutive (in thousands).

Three Months Ended

Six Months Ended
 
September 30,

September 30,
 
2013

2012

2013

2012
Restricted stock units
123

 
247

 
201

 
187

Basic EPS is calculated by dividing net income by the weighted average number of shares outstanding during the period. Unvested restricted shares, although legally issued and outstanding, are not considered outstanding for purposes of calculating basic earnings per share. Diluted EPS is calculated by dividing net income by the weighted average number of shares outstanding plus the dilutive effect, if any, of outstanding stock options, restricted shares and restricted stock units using the treasury stock method. The calculation of the dilutive effect of outstanding equity awards under the treasury stock method includes consideration of proceeds from the assumed exercise of stock options, unrecognized compensation expense and any tax benefits as additional proceeds.
NOTE 15 – INCOME TAXES
Our effective income tax rates were 38.6% and 36.3% for the six months ended September 30, 2013 and the fiscal year ended March 31, 2013, respectively.  Generally, the effective tax rates differ from statutory rates due to the impact of the domestic production activities deduction, the impact of state taxes, and federal, foreign and state tax credits. The effective tax rate for the six months ended September 30, 2013 is higher than the effective rate for our fiscal year ended March 31, 2013 primarily due to the interim accounting treatment of certain foreign losses for which no benefit can be recognized.

Our effective tax rates were 38.6% and 39.4% for the six months ended September 30, 2013 and 2012, respectively. At this time, the effective tax rate is lower than the comparable year primarily due to the impact of the reinstatement of the research and development credit.
NOTE 16 – SEGMENT AND GEOGRAPHIC INFORMATION
The Company reports revenues and income under one reportable segment. The consolidated financial information is used by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance.
The Company manages its business in the following geographic areas: United States, Europe, Asia and the rest of the world. In accordance with United States export control regulations, the Company does not sell or do business with countries subject to economic sanctions and export controls.
Total revenue by geography is as follows (in thousands):

Three Months Ended

Six Months Ended
 
September 30,

September 30,
 
2013

2012

2013

2012
United States
$
66,853

 
$
66,616

 
$
129,625

 
$
121,711

Europe
12,654

 
8,001

 
21,593

 
18,433

Asia
6,850

 
4,206

 
10,753

 
8,477

Rest of the world
5,740

 
5,722

 
11,931

 
12,285


$
92,097


$
84,545


$
173,902


$
160,906

The United States revenue includes sales to resellers in the United States. These resellers fulfill customer orders and may subsequently ship the Company’s products to international locations. The Company reports these shipments as United States revenue since the Company ships the products to a United States location. A majority of revenue attributable to locations outside of the United States is a result of export sales. Substantially all of the Company’s identifiable assets are located in the United States.

17

Table of Contents

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

In addition to historical information, the following discussion and other parts of this Quarterly Report contain forward-looking statements under Section 21E of the Exchange Act and other federal securities laws. These forward looking statements involve risks and uncertainties. These statements relate to future events or our future financial performance and are identified by terminology such as “may,” “will,” “could,” “should,” “expects,” “plans,” “intends,” “seeks,” “anticipates,” “believes,” “estimates,” “potential” or “continue,” or the negative of such terms or other comparable terminology. These statements are only predictions. You should not place undue reliance on these forward-looking statements. Actual events or results may differ materially due to competitive factors and other factors referred to in Part I, Item 1A. Risk Factors in our Annual Report on Form 10-K for our fiscal year ended March 31, 2013 and elsewhere in this Quarterly Report. These factors may cause our actual results to differ materially from any forward-looking statement.
Overview
NetScout was founded in 1984 and is headquartered in Westford, Massachusetts. We design, develop, manufacture, market, sell and support market leading unified service delivery management, service assurance and application performance management solutions focused on assuring service delivery for the world’s largest, most demanding and complex IP based service delivery environments. We manufacture and market these products in integrated hardware and software solutions that are used by commercial enterprises, large governmental agencies and telecommunication service providers worldwide. We have a single operating segment and substantially all of our identifiable assets are located in the United States.
Our operating results are influenced by a number of factors, including, but not limited to, the mix and quantity of products and services sold, pricing, costs of materials used in our products, growth in employee related costs, including commissions, and the expansion of our operations. Factors that affect our ability to maximize our operating results include, but are not limited to, our ability to introduce and enhance existing products, the marketplace acceptance of those new or enhanced products, continued expansion into international markets, development of strategic partnerships, competition, successful acquisition integration efforts, our ability to achieve significant expense reductions and make structural improvements and current economic conditions.

Our key objectives have been to continue to gain market share in the wireless service provider market and to accelerate our enterprise growth by extending into the application performance management segment. A common component of both initiatives has been the acceptance of our Unified Services Delivery Management Strategy. This strategy has been bolstered by our acquisitions and integration of both voice/video and packet flow or monitoring switch technology.

During the first quarter of our fiscal year 2014, NetScout announced the release of the nGeniusONE Unified Performance Management platform. The nGeniusONE platform converges application and network performance management functionality into a single unified platform that delivers a top-down, serviced-focused perspective of performance characteristics of all infrastructure and application elements associated with service delivery.

During the first quarter of our fiscal year 2014, management performed a review of its summation of revenue by industry. As a result, we changed our method of apportioning revenue to our revenue sectors, and the categorization of certain customers to different sectors. This change in manner of describing fluctuations by sector will not affect our total net revenues, total product and service revenues, or revenue by geography.
Results Overview

We saw continued growth during the quarter ended September 30, 2013, with product revenue growth of 13% and overall revenue growth of 9% compared to the same period in the prior year.

Our business maintained strong gross profit margins. Our gross profit for the quarter ended September 30, 2013 increased by $4.8 million, or 7%, when compared to the quarter ended September 30, 2012. This represents a decrease in our gross profit percentage by one percentage point to 79%, down from 80% in the same period in the prior year.

We continue to maintain strong liquidity. At September 30, 2013, we had cash, cash equivalents and marketable securities of $159.4 million. This represents an increase of $5.4 million from March 31, 2013.



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Use of Non-GAAP Financial Measures

We supplement the generally accepted accounting principles (GAAP) financial measures we report in quarterly earnings announcements, investor presentations and other investor communications by reporting the following non-GAAP measures: non-GAAP revenue, non-GAAP net income and non-GAAP net income per diluted share. Non-GAAP revenue eliminates the GAAP effects of acquisitions by adding back revenue related to deferred revenue revaluation. Non-GAAP net income includes the foregoing adjustment and also removes expenses related to the amortization of acquired intangible assets, share-based compensation, restructuring, certain expenses relating to acquisitions including compensation for post-combination services and business development charges, net of related income tax effects. Non-GAAP diluted net income per share also excludes these expenses as well as the related impact of all these adjustments on the provision for income taxes.

These non-GAAP measures are not in accordance with GAAP, should not be considered an alternative for measures prepared in accordance with GAAP (revenue, net income and diluted net income per share), and may have limitations in that they do not reflect all our results of operations as determined in accordance with GAAP. These non-GAAP measures should only be used to evaluate our results of operations in conjunction with the corresponding GAAP measures. The presentation of non-GAAP information is not meant to be considered superior to, in isolation from or as a substitute for results prepared in accordance with GAAP.

Management believes these non-GAAP financial measures enhance the reader's overall understanding of our current financial performance and its prospects for the future by providing a higher degree of transparency for certain financial measures and providing a level of disclosure that helps investors understand how we plan and measure our business. We believe that providing these non-GAAP measures affords investors a view of our operating results that may be more easily compared to our peer companies and also enables investors to consider our operating results on both a GAAP and non-GAAP basis during and following the integration period of our acquisitions. Presenting the GAAP measures on their own may not be indicative of our core operating results. Furthermore, management believes that the presentation of non-GAAP measures when shown in conjunction with the corresponding GAAP measures provide useful information to management and investors regarding present and future business trends relating to our financial condition and results of operations.

The following table reconciles revenue, net income and net income per share on a GAAP and non-GAAP basis for the three and six months ended September 30, 2013 and 2012 (in thousands, except for per share amounts):
 
Three Months Ended
 
Six Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
GAAP revenue
$
92,097

 
$
84,545

 
$
173,902

 
$
160,906

Deferred revenue fair value adjustment
139

 
133

 
279

 
271

Non-GAAP revenue
$
92,236

 
$
84,678

 
$
174,181

 
$
161,177

GAAP net income
$
9,883

 
$
9,910

 
$
15,136

 
$
14,918

Deferred revenue fair value adjustment
139

 
133

 
279

 
271

Share based compensation expense
3,930

 
2,532

 
6,742

 
4,779

Amortization of acquired intangible assets
1,681

 
2,130

 
3,354

 
4,133

Business development and integration expense
234

 
474

 
404

 
831

Compensation for post combination services
711

 
442

 
1,155

 
814

Restructuring charges

 
1,153

 

 
1,066

Income tax adjustments
(2,308
)
 
(2,330
)
 
(4,093
)
 
(4,242
)
Non-GAAP net income
$
14,270

 
$
14,444

 
$
22,977

 
$
22,570

GAAP diluted net income per share
$
0.24

 
$
0.23

 
$
0.36

 
$
0.35

Per share impact of non-GAAP adjustments identified above
0.10

 
0.11

 
0.19

 
0.18

Non-GAAP diluted net income per share
$
0.34

 
$
0.34

 
$
0.55

 
$
0.53




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Critical Accounting Policies

 Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America consistently applied. The preparation of these consolidated financial statements requires us to make significant estimates and judgments that affect the amounts reported in our consolidated financial statements and the accompanying notes. These items are regularly monitored and analyzed by management for changes in facts and circumstances, and material changes in these estimates could occur in the future. Changes in estimates are recorded in the period in which they become known. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from our estimates.

While all of our accounting policies impact the consolidated financial statements, certain policies are viewed to be critical. Critical accounting policies are those that are both most important to the portrayal of our financial condition and results of operations and that require management's most subjective or complex judgments and estimates. We consider the following accounting policies to be critical in fully understanding and evaluating our financial results:
marketable securities;
revenue recognition;
valuation of goodwill, intangible assets and other acquisition accounting items; and
share-based compensation.
Please refer to the critical accounting policies set forth in our Annual Report on Form 10-K for the fiscal year ended March 31, 2013, filed with the Securities and Exchange Commission (SEC) on May 24, 2013, for a description of all of our critical accounting policies.
Three Months Ended September 30, 2013 and 2012
Revenue
Product revenue consists of sales of our hardware products and licensing of our software products. Service revenue consists of customer support agreements, consulting and training. During the three months ended September 30, 2013, no one customer accounted for more than 10% of total revenue. One customer accounted for more than 10% during the three months ended September 30, 2012.

Three Months Ended

Change
 
September 30,


(Dollars in Thousands)

 
2013

2012

 
 

% of
Revenue

 

% of
Revenue

$

%
Revenue:
 
 
 
 
 
 
 
 
 
 
 
Product
$
52,357

 
57
%
 
$
46,162

 
55
%
 
$
6,195

 
13
%
Service
39,740

 
43

 
38,383

 
45

 
1,357

 
4
%
Total revenue
$
92,097

 
100
%
 
$
84,545

 
100
%
 
$
7,552

 
9
%
Product. The 13%, or $6.2 million, increase in product revenue was due to a $7.4 million increase in revenue from our general enterprise sector and a $3.3 million increase in our government enterprise sector. These increases were partially offset by a $4.5 million decrease in our service provider sector. Our service provider growth in the prior fiscal year was concentrated in the three months ended September 30, 2012.
Compared to the same period in the prior year, we realized a 31% increase in units shipped, partially offset by an 18% decrease in the average selling price per unit of our products. The decrease in average selling price per unit is due to the inclusion in our product solutions of the lower priced packet flow switch components.

We expect continued growth in our fiscal year ended March 31, 2014 and expect our service provider sector to be a significant driver of future growth.

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Service. The 4%, or $1.4 million, increase in service revenue was due to a $913 thousand increase in premium support contracts, and a $668 thousand increase in revenue from maintenance contracts due to increased new maintenance contracts and renewals from a growing support base. These were partially offset by a $283 thousand decrease in training revenue. We expect single digit percentage growth in our service revenues in the foreseeable future. We expect this to be generated by product revenue growth which increases our installed base and therefore our related maintenance contracts.
Total product and service revenue from direct and indirect channels are as follows:
 
Three Months Ended
 
Change
 
September 30,
 
 
(Dollars in Thousands)
 
 
2013
 
2012
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
Indirect
$
48,959

 
53
%
 
$
36,770

 
43
%
 
$
12,189

 
33
 %
Direct
43,138

 
47

 
47,775

 
57

 
(4,637
)
 
(10
)%
Total revenue
$
92,097

 
100
%
 
$
84,545

 
100
%
 
$
7,552

 
9
 %
The 33%, or $12.2 million, increase in indirect channel revenue is the result of the increase in sales to all our international sectors, as well as an increase in sales to our domestic government sector. Sales to customers outside the United States are export sales typically through channel partners, who are generally responsible for distributing our products and providing technical support and service to customers within their territories. Our reported international revenue does not include any revenue from sales to customers outside the United States that are shipped to our United States-based indirect channel partners. These domestic resellers fulfill customer orders based upon joint selling efforts in conjunction with our direct sales force and may subsequently ship our products to international locations; however, we report these shipments as United States revenue since we ship the products to a domestic location. The 10%, or $4.6 million, decrease in direct channel revenue is primarily the result of decreased domestic revenue from our service provider sector.
Total revenue by geography is as follows:
 
Three Months Ended
 
Change
 
September 30,
 
 
(Dollars in Thousands)
 
 
2013
 
2012
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
United States
$
66,853

 
73
%
 
$
66,616

 
79
%
 
$
237

 
%
International:
 
 
 
 
 
 
 
 

 

Europe
12,654

 
14

 
8,001

 
9

 
4,653

 
58
%
Asia
6,850

 
7

 
4,206

 
5

 
2,644

 
63
%
Rest of the world
5,740

 
7

 
5,722

 
7

 
18

 
%
Subtotal international
25,244

 
27

 
17,929

 
21

 
7,315

 
41
%
Total revenue
$
92,097

 
100
%
 
$
84,545

 
100
%
 
$
7,552

 
9
%
United States revenues increased 0%, or $237 thousand, as a result of gains within the government and general enterprise sector, offset by a decrease in our service provider sector. The 41%, or $7.3 million, increase in international revenue is primarily due to an increase in our European government and general enterprise sectors. We expect revenue from sales to customers outside the United States to continue to account for a significant portion of our total revenue in the future. In accordance with United States export control regulations we do not sell to, or do business with, countries subject to economic sanctions and export controls.
Cost of Revenue and Gross Profit
Cost of product revenue consists primarily of material components, manufacturing personnel expenses, manuals, packaging materials, overhead and amortization of capitalized software, acquired software and core technology. Cost of service revenue consists primarily of personnel, material, overhead and support costs.

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Three Months Ended
 
Change
 
September 30,
 
 
(Dollars in Thousands)
 
 
2013
 
2012
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
Cost of revenue
 
 
 
 
 
 
 
 
 
 
 
Product
$
11,810

 
13
%
 
$
10,330

 
12
%
 
$
1,480

 
14
%
Service
7,894

 
8

 
6,611

 
8

 
1,283

 
19
%
Total cost of revenue
$
19,704

 
21
%
 
$
16,941

 
20
%
 
$
2,763

 
16
%
Gross profit:
 
 
 
 
 
 
 
 
 
 
 
Product $
$
40,547

 
44
%
 
$
35,832

 
42
%
 
$
4,715

 
13
%
Product gross profit %
77
%
 
 
 
78
%
 
 
 
 
 
 
Service $
$
31,846

 
35
%
 
$
31,772

 
38
%
 
$
74

 
%
Service gross profit %
80
%
 
 
 
83
%
 
 
 
 
 
 
Total gross profit $
$
72,393

 
 
 
$
67,604

 
 
 
$
4,789

 
7
%
Total gross profit %
79
%
 
 
 
80
%
 
 
 
 
 
 
Product. The 14%, or $1.5 million, increase in cost of product revenue was primarily due to the $6.2 million, or 13%, increase in product revenue during the three months ended September 30, 2013. This was partially offset by a $661 thousand decrease in amortization of software and core technology included as cost of product revenue for the three months ended September 30, 2013. The product gross profit percentage decreased by one percentage point to 77% during the three months ended September 30, 2013 as compared to the three months ended September 30, 2012. Average headcount in manufacturing was 32 and 27 for the three months ended September 30, 2013 and 2012, respectively.
Service. The 19%, or $1.3 million, increase in cost of service revenue was primarily due to a $751 thousand increase in employee related expenses resulting in part from headcount to support our growing installed base, as well as from increased share-based compensation. In addition, there was a $324 thousand increase in cost of materials used to support customers under service contracts and a $113 thousand increase in travel expenses. The service gross profit percentage decreased by three percentage points to 80% for the quarter ended September 30, 2013 as compared to the three months ended September 30, 2012. The 0%, or $74 thousand, increase in service gross profit corresponds with the 4%, or $1.4 million, increase in service revenue, offset by the 19%, or $1.3 million, increase in cost of services. Average service headcount was 144 and 128 for the three months ended September 30, 2013 and 2012, respectively.
Gross profit. Our gross profit increased 7%, or $4.8 million. This increase is attributable to our increase in revenue of 9%, or $7.6 million, partially offset by a 16%, or $2.8 million, increase in cost of revenue. The gross profit percentage decreased by one percentage point to 79% for the three months ended September 30, 2013 as compared to the three months ended September 30, 2012. Overall we expect our gross profit percentage to remain relatively flat in future periods with increased sales volumes offset by corresponding increases in product and service costs.
Operating Expenses
 
Three Months Ended
 
Change
 
September 30,
 
 
(Dollars in Thousands)
 
 
2013
 
2012
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
Research and development
$
16,638

 
18
%
 
$
15,201

 
18
%
 
$
1,437

 
9
 %
Sales and marketing
31,559

 
34

 
26,743

 
32

 
4,816

 
18
 %
General and administrative
7,457

 
8

 
6,975

 
8

 
482

 
7
 %
Amortization of acquired intangible assets
857

 
1

 
645

 
1

 
212

 
33
 %
Restructuring charges

 

 
1,153

 
1

 
(1,153
)
 
(100
)%
Total operating expenses
$
56,511

 
61
%
 
$
50,717

 
60
%
 
$
5,794

 
11
 %

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Research and development. Research and development expenses consist primarily of personnel expenses, fees for outside consultants, overhead and related expenses associated with the development of new products and the enhancement of existing products.
The 9%, or $1.4 mil