NTCT-2013.12.31-10Q
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 December 31, 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 January 24, 2014 was 41,329,074.



Table of Contents

NETSCOUT SYSTEMS, INC.
FORM 10-Q
FOR THE QUARTER ENDED DECEMBER 31, 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)
 
 
December 31,
2013
 
March 31,
2013
Assets
(Unaudited)
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
88,648

 
$
99,930

Marketable securities
56,343

 
37,338

Accounts receivable, net of allowance for doubtful accounts of $147 and $971 at December 31, 2013 and March 31, 2013, respectively
74,263

 
73,900

Inventories
11,128

 
7,563

Deferred income taxes
9,419

 
9,538

Prepaid expenses and other current assets
8,800

 
9,043

Total current assets
248,601

 
237,312

Fixed assets, net
21,350

 
19,678

Goodwill
203,201

 
202,453

Intangible assets, net
59,827

 
63,827

Deferred income taxes
5,629

 
9,211

Long-term marketable securities
37,222

 
16,823

Other assets
2,047

 
2,872

Total assets
$
577,877

 
$
552,176

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
8,679

 
$
10,161

Accrued compensation
32,327

 
31,585

Accrued other
7,070

 
8,256

Income taxes payable
705

 
114

Deferred revenue
102,010

 
95,055

Total current liabilities
150,791

 
145,171

Other long-term liabilities
2,415

 
2,249

Deferred tax liability
991

 
941

Accrued long-term retirement benefits
1,578

 
1,757

Long-term deferred revenue
22,285

 
25,907

Contingent liabilities, net of current portion
4,219

 
4,248

Total liabilities
182,279

 
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 December 31, 2013 and March 31, 2013
0

 
0

Common stock, $0.001 par value:
 
 
 
150,000,000 shares authorized; 49,826,807 and 49,007,491 shares issued and 41,326,074 and 41,466,921 shares outstanding at December 31, 2013 and March 31, 2013, respectively
50

 
49

Additional paid-in capital
267,649

 
253,202

Accumulated other comprehensive income
2,521

 
671

Treasury stock at cost, 8,500,733 and 7,540,570 shares at December 31, 2013 and March 31, 2013, respectively
(108,513
)
 
(83,480
)
Retained earnings
233,891

 
201,461

Total stockholders’ equity
395,598

 
371,903

Total liabilities and stockholders’ equity
$
577,877

 
$
552,176

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

1

Table of Contents

NetScout Systems, Inc.
Consolidated Statements of Operations
(In thousands, except per share data)
(Unaudited)
 
 
Three Months Ended
 
Nine Months Ended
 
December 31,
 
December 31,
 
2013
 
2012
 
2013
 
2012
Revenue:
 
 
 
 
 
 
 
Product
$
68,561

 
$
52,676

 
$
163,895

 
$
139,100

Service
41,867

 
38,891

 
120,435

 
113,373

Total revenue
110,428

 
91,567

 
284,330

 
252,473

Cost of revenue:
 
 
 
 
 
 
 
Product
14,534

 
12,182

 
36,117

 
32,582

Service
9,068

 
6,982

 
24,111

 
20,386

Total cost of revenue
23,602

 
19,164

 
60,228

 
52,968

Gross profit
86,826

 
72,403

 
224,102

 
199,505

Operating expenses:
 
 
 
 
 
 
 
Research and development
18,348

 
15,352

 
50,951

 
44,630

Sales and marketing
32,425

 
30,105

 
96,184

 
86,997

General and administrative
7,929

 
8,539

 
22,367

 
22,071

Amortization of acquired intangible assets
860

 
846

 
2,571

 
2,077

Restructuring charges
0

 
(1
)
 
0

 
1,065

Total operating expenses
59,562

 
54,841

 
172,073

 
156,840

Income from operations
27,264

 
17,562

 
52,029

 
42,665

Interest and other income (expense), net:
 
 
 
 
 
 
 
Interest income
66

 
115

 
210

 
423

Interest expense
(198
)
 
(293
)
 
(575
)
 
(1,085
)
Other income, net
176

 
74

 
277

 
86

Total interest and other income (expense), net
44

 
(104
)
 
(88
)
 
(576
)
Income before income tax expense
27,308

 
17,458

 
51,941

 
42,089

Income tax expense
10,014

 
6,320

 
19,511

 
16,033

Net income
$
17,294

 
$
11,138

 
$
32,430

 
$
26,056

Basic net income per share
$
0.42

 
$
0.27

 
$
0.78

 
$
0.62

Diluted net income per share
$
0.41

 
$
0.26

 
$
0.77

 
$
0.62

Weighted average common shares outstanding used in computing:
 
 
 
 
 
 
 
Net income per share - basic
41,425

 
41,709

 
41,417

 
41,715

Net income per share - diluted
41,884

 
42,298

 
41,969

 
42,364

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
 
Nine Months Ended
 
December 31,
 
December 31,
 
2013
 
2012
 
2013
 
2012
Net income
$
17,294

 
$
11,138

 
$
32,430

 
$
26,056

Other comprehensive income:
 
 
 
 
 
 
 
Cumulative translation adjustments
405

 
719

 
1,624

 
1,003

Changes in market value of investments:
 
 
 
 
 
 
 
Changes in unrealized gains (losses)
3

 
(24
)
 
7

 
97

Total net change in market value of investments
3

 
(24
)
 
7

 
97

Changes in market value of derivatives:
 
 
 
 
 
 
 
Changes in market value of derivatives, net of taxes (benefit) of $31, ($17), $35 and ($6)
56

 
(29
)
 
55

 
(16
)
Reclassification adjustment for net (losses) gains included in net income, net of (benefits) taxes of ($15), ($6), $85 and $94
(25
)

(9
)

164


154

Total net change in market value of derivatives
31

 
(38
)
 
219

 
138

Other comprehensive income
439

 
657

 
1,850

 
1,238

Comprehensive income
$
17,733

 
$
11,795

 
$
34,280

 
$
27,294

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)
 
Nine Months Ended
 
December 31,
 
2013
 
2012
Cash flows from operating activities:
 
 
 
Net income
32,430

 
26,056

Adjustments to reconcile net income to cash provided by operating activities, net of the effects of acquisitions:
 
 
 
Depreciation and amortization
13,774

 
13,826

Loss on disposal of fixed assets
38

 
71

Deal related compensation expense and accretion charges
114

 
205

Share-based compensation expense associated with equity awards
9,959

 
7,254

Net change in fair value of contingent and contractual liabilities
(289
)
 
400

Deferred income taxes
4,259

 
6,237

Other gains
(69
)
 
(16
)
Changes in assets and liabilities
 
 
 
Accounts receivable
(302
)
 
12,130

Inventories
(5,346
)
 
1,568

Prepaid expenses and other assets
1,345

 
(4,358
)
Accounts payable
(1,255
)
 
(3,137
)
Accrued compensation and other expenses
2,259

 
6,400

Contingent liabilities
0

 
449

Income taxes payable
591

 
0

Deferred revenue
3,259

 
(107
)
                Net cash provided by operating activities
60,767

 
66,978

Cash flows from investing activities:
 
 
 
Purchase of marketable securities
(88,802
)
 
(102,478
)
Proceeds from maturity of marketable securities
49,405

 
153,046

Purchase of fixed assets
(8,709
)
 
(8,115
)
Purchase of intangible assets
(713
)
 
(197
)
Decrease (increase) in deposits
37

 
(804
)
Acquisition of businesses, net of cash acquired
0

 
(51,273
)
                Net cash used in investing activities
(48,782
)
 
(9,821
)
Cash flows from financing activities:
 
 
 
Issuance of common stock under stock plans
755

 
516

Payment of contingent consideration
(841
)
 
(3,197
)
Treasury stock repurchases
(25,033
)
 
(20,727
)
Repayment of long-term debt
0

 
(62,000
)
Excess tax benefit from share-based compensation awards
2,039

 
1,934

                Net cash used in financing activities
(23,080
)
 
(83,474
)
Effect of exchange rate changes on cash and cash equivalents
(187
)
 
(102
)
Net decrease in cash and cash equivalents
(11,282
)
 
(26,419
)
Cash and cash equivalents, beginning of period
99,930

 
117,255

Cash and cash equivalents, end of period
$
88,648

 
$
90,836

Supplemental disclosures:
 
 
 
Cash paid for interest
$
0

 
$
325

Cash paid for income taxes
$
12,628

 
$
12,460

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

 
$
583

Additions to property, plant and equipment included in accounts payable
$
233

 
$
370

Gross decrease in contractual liability relating to fair value adjustment
$
(148
)
 
$
(135
)
Gross (decrease) increase in contingent consideration liability relating to fair value adjustment
$
(141
)
 
$
535

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 December 31, 2013, the Company had no single indirect channel partner which accounted for more than 10% of the accounts receivable balance, while two direct customers accounted for more than 10% of the accounts receivable balance. At March 31, 2013, no single direct customer or indirect channel partner accounted for more than 10% of the accounts receivable balance.
During the three and nine months ended December 31, 2013, one direct customer accounted for more than 10% of our total revenue, while no indirect channel partner accounted for more than 10% of total revenue during the three and nine months ended December 31, 2013. During the three and nine months ended December 31, 2012, no one direct customer or 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.


5

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
 
Nine Months Ended
 
December 31,
 
December 31,
 
2013
 
2012
 
2013
 
2012
Cost of product revenue
$
62

 
$
61

 
$
174

 
$
176

Cost of service revenue
194

 
96

 
566

 
249

Research and development
1,157

 
778

 
3,316

 
2,164

Sales and marketing
944

 
775

 
2,952

 
2,301

General and administrative
860

 
754

 
2,951

 
2,353

 
$
3,217

 
$
2,464

 
$
9,959

 
$
7,243

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 nine months ended December 31, 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 December 31, 2013 and March 31, 2013.
Marketable Securities
The following is a summary of marketable securities held by NetScout at December 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
$
39,433

 
$
5

 
$
39,438

Commercial paper
7,093

 
0

 
7,093

Corporate bonds
7,749

 
4

 
7,753

Certificates of deposit
2,059

 
0

 
2,059

Total short-term marketable securities
56,334

 
9

 
56,343

U.S. government and municipal obligations
35,147

 
18

 
35,165

Corporate bonds
2,057

 
0

 
2,057

Total long-term marketable securities
37,204

 
18

 
37,222

Total marketable securities
$
93,538

 
$
27

 
$
93,565


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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 December 31, 2013 and March 31, 2013 were as follows (in thousands):

December 31,
2013

March 31,
2013
Available-for-sale securities:



Due in 1 year or less
$
56,343


$
37,338

Due after 1 year through 5 years
37,222


16,823


$
93,565


$
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 December 31, 2013 and March 31, 2013 (in thousands).

Fair Value Measurements at
 
December 31, 2013
 
Level 1

Level 2

Level 3

Total
ASSETS:

 

 



Cash and cash equivalents
$
88,648

 
$
0

 
$
0


$
88,648

U.S. government and municipal obligations
74,603

 
0

 
0


74,603

Commercial paper
0

 
7,093

 
0


7,093

Corporate bonds
9,810

 
0

 
0


9,810

Certificate of deposits
0

 
2,059

 
0


2,059

Derivative financial instruments
0

 
367

 
0


367


$
173,061

 
$
9,519

 
$
0


$
182,580

LIABILITIES:

 

 



Contingent purchase consideration
$
0

 
$
0

 
$
(4,219
)

$
(4,219
)
Contingent contractual non-compliance liability
0

 
0

 
(98
)

(98
)
Derivative financial instruments
0

 
(138
)
 
0


(138
)

$
0

 
$
(138
)
 
$
(4,317
)

$
(4,455
)

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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 December 31, 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 nine months ended December 31, 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)
27


148

Payments
841


0

Balance at end of period
$
(4,219
)

$
(98
)
The Company has updated the probabilities used in the fair value calculation of the contingent liabilities during the nine months ended December 31, 2013 which reduced the liability by $289 thousand and is included as part of earnings for the nine

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months ended December 31, 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 nine months ended December 31, 2013 were $114 thousand and were included as part of earnings.
During the nine months ended December 31, 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):

December 31,
2013
 
March 31,
2013
Raw materials
$
6,959

 
$
3,986

Work in process
246

 
272

Finished goods
3,923

 
3,305


$
11,128

 
$
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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Table of Contents

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 nine months ended December 31, 2012, giving effect to the mergers as if they occurred on April 1, 2012 (in thousands, except per share data):
 
Three Months Ended
 
Nine Months Ended
 
December 31, 2012
 
December 31, 2012
 
(unaudited)
 
(unaudited)
Pro forma revenue
$
94,221

 
$
263,009

Pro forma net income
$
11,038

 
$
20,036

Pro forma income per share:
 
 
 
Basic
$
0.26

 
$
0.48

Diluted
$
0.26

 
$
0.47

Pro forma shares outstanding
 
 
 
Basic
41,709

 
41,715

Diluted
42,298

 
42,364


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The proforma results for the three and nine months ended December 31, 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 nine months ended December 31, 2013, the Company has recorded $9.0 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 December 31, 2013 and March 31, 2013, goodwill attributable to the Unified Service Delivery reporting unit was $200.8 million and $199.5 million, respectively. Goodwill attributable to the Test Automation reporting unit was $2.4 million and $3.0 million as of December 31, 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 unit below its carrying value.
The changes in the carrying amount of goodwill for the nine months ended December 31, 2013 are due to purchase accounting adjustments and the impact of foreign currency translation adjustments related to asset balances that are recorded in currencies other than the U.S. dollar.
The changes in the carrying amount of goodwill for the nine months ended December 31, 2013 are as follows (in thousands):

Nine Months Ended
 
December 31, 2013
Balance as of March 31, 2013
$
202,453

Purchase accounting adjustments
(665
)
Foreign currency translation impact
1,413

Balance as of December 31, 2013
$
203,201

Intangible Assets
The net carrying amounts of intangible assets were $59.8 million and $63.8 million as of December 31, 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.
During the three months ended December 31, 2013, the Company acquired certain rights to Accanto software not previously purchased as part of the acquisition transaction in fiscal year 2013 for $500 thousand.  This amount is included within developed technology as of December 31, 2013 and will be amortized using the economic benefit period over 6.3 years.
Intangible assets include an indefinite lived trade name with a carrying value of $18.6 million and the following amortizable intangible assets as of December 31, 2013 (in thousands):

Cost

Accumulated
Amortization

Net
Developed technology
$
31,603

 
$
(22,964
)

$
8,639

Customer relationships
38,789

 
(13,294
)

25,495

Distributor relationships
1,996

 
(480
)

1,516

Core technology
7,553

 
(2,389
)

5,164

Non-compete agreements
352

 
(264
)

88

Other
696

 
(371
)

325


$
80,989


$
(39,762
)

$
41,227


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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 $837 thousand and $2.5 million for the three and nine months ended December 31, 2013, respectively. Amortization of other intangible assets included as operating expense was $891 thousand and $2.7 million for the three and nine months ended December 31, 2013, respectively.
Amortization of software and core technology included as cost of product revenue was $1.0 million and $3.9 million for the three and nine months ended December 31, 2012, respectively. Amortization of other intangible assets included as operating expense was $906 thousand and $2.2 million for the three and nine months ended December 31, 2012, respectively.
The following is the expected future amortization expense as of December 31, 2013 for the years ended March 31 (in thousands):
2014 (remaining three months)
$
2,052

2015
6,984

2016
6,439

2017
5,858

2018
5,078

Thereafter
14,816


$
41,227

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 December 31, 2013 and March 31, 2013 were as follows (in thousands):
 
Notional Amounts (a)

Other Current Assets

Accrued Other Liabilities
 
December 31,
2013

March 31,
2013
 
December 31,
2013
 
March 31,
2013
 
December 31,
2013
 
March 31,
2013
Derivatives Designated as Hedging Instruments:











Forward contracts
$
15,675

 
$
17,071

 
$
367

 
$
71

 
$
138

 
$
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 December 31, 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)
December 31, 2013
 
December 31, 2012

Location

December 31, 2013

December 31, 2012

Location

December 31, 2013
 
December 31, 2012
Forward contracts
$
87

 
$
(46
)

Research and
development

$
(109
)
 
$
(52
)

Research and
development

$
75

 
$
51






Sales and
marketing

149

 
67


Sales and
marketing

3

 
(9
)

$
87


$
(46
)



$
40


$
15




$
78


$
42

(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 other comprehensive income (loss) (OCI) and results of operations for the nine months ended December 31, 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)
December 31, 2013

December 31, 2012

Location

December 31, 2013

December 31, 2012

Location

December 31, 2013

December 31, 2012
Forward contracts
$
90

 
$
(22
)

Research and
development

$
(293
)
 
$
(289
)

Research and
development

$
172

 
$
137






Sales and
marketing

44

 
41


Sales and
marketing

(3
)
 
(4
)

$
90


$
(22
)



$
(249
)

$
(248
)



$
169


$
133

 
(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 December 31, 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 December 31, 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

Nine Months Ended
Employee Severance:
December 31, 2013

December 31, 2013
Balance at beginning of period
$
71


$
910

Other adjustments


(49
)
Cash payments


(790
)
Balance as of December 31, 2013
$
71


$
71

The balance is expected to be paid in full by December 31, 2014.
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 December 31, 2013, the present value of the future consideration was $4.2 million and the contractual non-compliance liability was $98 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.

As disclosed in Part II, Item 1, 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.   The California State Attorney General is conducting an investigation into the matter.  NetScout has been informed by the Department of Justice that it does not intend to take any action against NetScout.  NetScout believes we did not benefit from any of the transactions uncovered and believes that the amounts involved are not material.  

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 December 31, 2013, the Company had repurchased a total of 3,506,700 shares of common stock through the open market stock repurchase program. The Company repurchased 750,407 shares for $19.7 million under the program during the nine months ended December 31, 2013.
In connection with the vesting and release of the restriction on previously vested shares of restricted stock units, the Company repurchased 209,756 shares for $5.3 million related to minimum statutory tax withholding requirements on these restricted stock units during the nine months ended December 31, 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

Nine Months Ended
 
December 31,

December 31,
 
2013

2012

2013

2012
Numerator:







Net income
$
17,294

 
$
11,138

 
$
32,430

 
$
26,056

Denominator:
 
 
 
 
 
 
 
Denominator for basic net income per share - weighted average shares outstanding
41,425

 
41,709

 
41,417

 
41,715

Dilutive common equivalent shares:
 
 
 
 
 
 
 
      Weighted average stock options
43

 
111

 
63

 
127

      Weighted average restricted stock units
416

 
478

 
489

 
522

Denominator for diluted net income per share - weighted average shares outstanding
41,884

 
42,298

 
41,969

 
42,364

Net income per share:
 
 
 
 
 
 
 
Basic net income per share
$
0.42

 
$
0.27

 
$
0.78

 
$
0.62

Diluted net income per share
$
0.41

 
$
0.26

 
$
0.77

 
$
0.62


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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

Nine Months Ended
 
December 31,

December 31,
 
2013

2012

2013

2012
Restricted stock units

 
43

 
195

 
283

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 37.6% and 36.3% for the nine months ended December 31, 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 nine months ended December 31, 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 37.6% and 38.1% for the nine months ended December 31, 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

Nine Months Ended
 
December 31,

December 31,
 
2013

2012

2013

2012
United States
$
86,747

 
$
66,990

 
$
216,364

 
$
188,701

Europe
12,313

 
12,940

 
33,906

 
31,373

Asia
4,035

 
4,201

 
14,788

 
12,678

Rest of the world
7,333

 
7,436

 
19,272

 
19,721


$
110,428


$
91,567


$
284,330


$
252,473

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 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 the 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 December 31, 2013, with product revenue growth of 30% and overall revenue growth of 21% compared to the same period in the prior year.

Our business maintained strong gross profit margins. Our gross profit for the quarter ended December 31, 2013 increased by $14.4 million, or 20%, when compared to the quarter ended December 31, 2012. The gross profit percentage remained flat at 79% during the quarters ended December 31, 2013 and 2012.

We continue to maintain strong liquidity. At December 31, 2013, we had cash, cash equivalents and marketable securities of $182.2 million. This represents an increase of $28.1 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 inventory fair value adjustments, 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 nine months ended December 31, 2013 and 2012 (in thousands, except for per share amounts):
 
Three Months Ended
 
Nine Months Ended
 
December 31,
 
December 31,
 
2013
 
2012
 
2013
 
2012
GAAP revenue
$
110,428

 
$
91,567

 
$
284,330

 
$
252,473

Deferred revenue fair value adjustment
140

 
400

 
419

 
671

Non-GAAP revenue
$
110,568

 
$
91,967

 
$
284,749

 
$
253,144

GAAP net income
$
17,294

 
$
11,138

 
$
32,430

 
$
26,056

Deferred revenue fair value adjustment
140

 
400

 
419

 
671

Inventory fair value adjustment

 
249

 

 
249

Share based compensation expense
3,217

 
2,464

 
9,959

 
7,243

Amortization of acquired intangible assets
1,697

 
1,805

 
5,051

 
5,938

Business development and integration expense
78

 
543

 
482

 
1,374

Compensation for post combination services
530

 
1,005

 
1,685

 
1,819

Restructuring charges

 
(1
)
 

 
1,065

Income tax adjustments
(1,941
)
 
(2,257
)
 
(6,034
)
 
(6,498
)
Non-GAAP net income
$
21,015

 
$
15,346

 
$
43,992

 
$
37,917

GAAP diluted net income per share
$
0.41

 
$
0.26

 
$
0.77

 
$
0.62

Per share impact of non-GAAP adjustments identified above
0.09

 
0.10

 
0.28

 
0.28

Non-GAAP diluted net income per share
$
0.50

 
$
0.36

 
$
1.05

 
$
0.90



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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 December 31, 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 December 31, 2013, one customer accounted for more than 10% of total revenue. During the three months ended December 31, 2012, there were no customers that accounted for more than 10% of total revenue.

Three Months Ended

Change
 
December 31,


(Dollars in Thousands)

 
2013

2012

 
 

% of
Revenue

 

% of
Revenue

$

%
Revenue:
 
 
 
 
 
 
 
 
 
 
 
Product
$
68,561

 
62
%
 
$
52,676

 
58
%
 
$
15,885

 
30
%
Service
41,867

 
38

 
38,891

 
42

 
2,976

 
8
%
Total revenue
$
110,428

 
100
%
 
$
91,567

 
100
%
 
$
18,861

 
21
%
Product. The 30%, or $15.9 million, increase in product revenue was due to a $12.3 million increase in revenue from our service provider sector, a $2.2 million increase in our general enterprise sector and a $1.4 million increase in our government enterprise sector.
Compared to the same period in the prior year, we realized a 30% increase in units shipped, as well as a 15% increase in the average selling price per unit of our products.

We expect continued growth in our service provider sector through the year ended March 31, 2014.
Service. The 8%, or $3.0 million, increase in service revenue was due to a $2.4 million increase in revenue from new maintenance contracts and renewals from a growing support base and a $685 thousand increase in premium support contracts.

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These were partially offset by a $96 thousand decrease in consulting revenue and an $88 thousand decrease in training revenue. We expect single digit percentage growth in our service revenues. 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
 
December 31,
 
 
(Dollars in Thousands)
 
 
2013
 
2012
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
Indirect
$
53,930

 
49
%
 
$
47,907

 
52
%
 
$
6,023

 
13
%
Direct
56,498

 
51

 
43,660

 
48

 
12,838

 
29
%
Total revenue
$
110,428

 
100
%
 
$
91,567

 
100
%
 
$
18,861

 
21
%
The 13%, or $6.0 million, increase in indirect channel revenue is the result of the increase in sales to our general enterprise sectors across all geographies. 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 29%, or $12.8 million, increase in direct revenue is primarily the result of increased domestic revenue from our service provider sector.
Total revenue by geography is as follows:
 
Three Months Ended
 
Change
 
December 31,
 
 
(Dollars in Thousands)
 
 
2013
 
2012
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
United States
$
86,747

 
79
%
 
$
66,990

 
73
%
 
$
19,757

 
29
 %
International:
 
 
 
 
 
 
 
 

 

Europe
12,313

 
11

 
12,940

 
14

 
(627
)
 
(5
)%
Asia
4,035

 
4

 
4,201

 
5

 
(166
)
 
(4
)%
Rest of the world
7,333

 
6

 
7,436

 
8

 
(103
)
 
(1
)%
Subtotal international
23,681

 
21

 
24,577

 
27

 
(896
)
 
(4
)%
Total revenue
$
110,428

 
100
%
 
$
91,567

 
100
%
 
$
18,861

 
21
 %
United States revenues increased 29%, or $19.8 million, as a result of gains within the service provider and general enterprise sectors. The 4%, or $896 thousand, decrease in international revenue is primarily due to a decrease in our international service provider sector. 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
 
December 31,
 
 
(Dollars in Thousands)
 
 
2013
 
2012
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
Cost of revenue
 
 
 
 
 
 
 
 
 
 
 
Product
$
14,534

 
13
%
 
$
12,182

 
13
%
 
$
2,352

 
19
%
Service
9,068

 
8

 
6,982

 
8

 
2,086

 
30
%
Total cost of revenue
$
23,602

 
21
%
 
$
19,164

 
21
%
 
$
4,438

 
23
%
Gross profit:
 
 
 
 
 
 
 
 
 
 
 
Product $
$
54,027

 
49
%
 
$
40,494

 
44
%
 
$
13,533

 
33
%
Product gross profit %
79
%
 
 
 
77
%
 
 
 
 
 
 
Service $
$
32,799

 
30
%
 
$
31,909

 
35
%
 
$
890

 
3
%
Service gross profit %
78
%
 
 
 
82
%
 
 
 
 
 
 
Total gross profit $
$
86,826

 
 
 
$
72,403

 
 
 
$
14,423

 
20
%
Total gross profit %
79
%
 
 
 
79
%
 
 
 
 
 
 
Product. The 19%, or $2.4 million, increase in cost of product revenue was primarily due to the $15.9 million, or 30%, increase in product revenue during the three months ended December 31, 2013. This was partially offset by a $249 thousand decrease in amortization of inventory fair value adjustment resulting from a fair value adjustment to acquired inventory in the ONPATH acquisition and a $122 thousand decrease in amortization of software and core technology included as cost of product revenue during such period. The product gross profit percentage increased by two percentage points to 79% during the three months ended December 31, 2013 as compared to the three months ended December 31, 2012. The 33%, or $13.5 million, increase in product gross profit corresponds with the 30%, or $15.9 million, increase in product revenue, offset by the 19%, or $2.4 million, increase in cost of product revenue. Average headcount in manufacturing was 32 and 30 for the three months ended December 31, 2013 and 2012, respectively.
Service. The 30%, or $2.1 million, increase in cost of service revenue was primarily due to a $1.1 million increase in employee related expenses resulting in part from headcount to support our growing installed base. In addition, there was an $847 thousand increase in cost of materials used to support customers under service contracts. The service gross profit percentage decreased by four percentage points to 78% for the three months ended December 31, 2013 as compared to the three months ended December 31, 2012, primarily related to the increases in cost mentioned above. The 3%, or $890 thousand, increase in service gross profit corresponds with the 8%, or $3.0 million, increase in service revenue, offset by the 30%, or $2.1 million, increase in cost of services. Average service headcount was 145 and 135 for the three months ended December 31, 2013 and 2012, respectively.
Gross profit. Our gross profit increased 20%, or $14.4 million. This increase is attributable to our increase in revenue of 21%, or $18.9 million, partially offset by a 23%, or $4.4 million, increase in cost of revenue. The gross profit percentage remained flat at 79% for the three months ended December 31, 2013 as compared to the three months ended December 31, 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.

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Operating Expenses
 
Three Months Ended
 
Change
 
December 31,
 
 
(Dollars in Thousands)
 
 
2013
 
2012
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
Research and development
$
18,348

 
17
%
 
$
15,352

 
17
 %
 
$
2,996

 
20
 %
Sales and marketing
32,425

 
29

 
30,105

 
33

 
2,320

 
8
 %
General and administrative
7,929

 
7

 
8,539

 
9

 
(610
)
 
(7
)%
Amortization of acquired intangible assets
860

 
1

 
846

 
1

 
14

 
2
 %
Restructuring charges

 

 
(1
)
 
0

 
1

 
(100
)%
Total operating expenses
$
59,562

 
54
%
 
$