NTCT-2014.12.31-10Q
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, 2014
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 22, 2015 was 41,217,480.



Table of Contents

NETSCOUT SYSTEMS, INC.
FORM 10-Q
FOR THE QUARTER ENDED DECEMBER 31, 2014
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,
2014
 
March 31,
2014
Assets
(Unaudited)
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
106,704

 
$
102,076

Marketable securities
87,967

 
75,234

Accounts receivable, net of allowance for doubtful accounts of $177 and $313 at December 31, 2014 and March 31, 2014, respectively
83,415

 
60,518

Inventories
10,274

 
12,580

Prepaid income taxes
2,864

 
1,012

Deferred income taxes
14,174

 
15,846

Prepaid expenses and other current assets
9,846

 
11,496

Total current assets
315,244

 
278,762

Fixed assets, net
23,016

 
23,098

Goodwill
200,271

 
203,446

Intangible assets, net
52,469

 
58,513

Long-term marketable securities
46,055

 
41,484

Other assets
1,873

 
2,460

Total assets
$
638,928

 
$
607,763

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
10,927

 
$
11,541

Accrued compensation
39,369

 
34,901

Accrued other
11,026

 
6,430

Income taxes payable

 
791

Deferred revenue
107,595

 
109,301

Total current liabilities
168,917

 
162,964

Other long-term liabilities
2,147

 
2,370

Deferred tax liability
2,679

 
2,757

Accrued long-term retirement benefits
1,586

 
1,581

Long-term deferred revenue
27,036

 
24,639

Contingent liabilities, net of current portion
4,445

 
4,291

Total liabilities
206,810

 
198,602

Commitments and contingencies (Note 11)

 

Stockholders’ equity:
 
 
 
Preferred stock, $0.001 par value:
 
 
 
5,000,000 shares authorized; no shares issued or outstanding at December 31, 2014 and March 31, 2014

 

Common stock, $0.001 par value:
 
 
 
150,000,000 shares authorized; 50,717,718 and 49,922,959 shares issued and 41,217,480 and 41,165,784 shares outstanding at December 31, 2014 and March 31, 2014, respectively
51

 
50

Additional paid-in capital
292,059

 
273,574

Accumulated other comprehensive income (loss)
(1,552
)
 
2,772

Treasury stock at cost, 9,500,238 and 8,757,175 shares at December 31, 2014 and March 31, 2014, respectively
(149,345
)
 
(117,802
)
Retained earnings
290,905

 
250,567

Total stockholders’ equity
432,118

 
409,161

Total liabilities and stockholders’ equity
$
638,928

 
$
607,763

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,
 
2014
 
2013
 
2014
 
2013
Revenue:
 
 
 
 
 
 
 
Product
$
76,446

 
$
68,561

 
$
198,765

 
$
163,895

Service
46,387

 
41,867

 
135,519

 
120,435

Total revenue
122,833

 
110,428

 
334,284

 
284,330

Cost of revenue:
 
 
 
 
 
 
 
Product
18,310

 
14,534

 
45,015

 
36,117

Service
8,672

 
9,068

 
26,158

 
24,111

Total cost of revenue
26,982

 
23,602

 
71,173

 
60,228

Gross profit
95,851

 
86,826

 
263,111

 
224,102

Operating expenses:
 
 
 
 
 
 
 
Research and development
18,864

 
18,348

 
56,872

 
50,951

Sales and marketing
34,836

 
32,425

 
104,304

 
96,184

General and administrative
13,391

 
7,929

 
33,211

 
22,367

Amortization of acquired intangible assets
821

 
860

 
2,539

 
2,571

Total operating expenses
67,912

 
59,562

 
196,926

 
172,073

Income from operations
27,939

 
27,264

 
66,185

 
52,029

Interest and other income (expense), net:
 
 
 
 
 
 
 
Interest income
95

 
66

 
298

 
210

Interest expense
(191
)
 
(198
)
 
(580
)
 
(575
)
Other (expense) income, net
(416
)
 
176

 
(904
)
 
277

Total interest and other income (expense), net
(512
)
 
44

 
(1,186
)
 
(88
)
Income before income tax expense
27,427

 
27,308

 
64,999

 
51,941

Income tax expense
9,798

 
10,014

 
24,661

 
19,511

Net income
$
17,629

 
$
17,294

 
$
40,338

 
$
32,430

Basic net income per share
$
0.43

 
$
0.42

 
$
0.98

 
$
0.78

Diluted net income per share
$
0.42

 
$
0.41

 
$
0.97

 
$
0.77

Weighted average common shares outstanding used in computing:
 
 
 
 
 
 
 
Net income per share - basic
41,206

 
41,425

 
41,128

 
41,417

Net income per share - diluted
41,536

 
41,884

 
41,679

 
41,969

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,
 
2014
 
2013
 
2014
 
2013
Net income
$
17,629

 
$
17,294

 
$
40,338

 
$
32,430

Other comprehensive income:
 
 
 
 
 
 
 
Cumulative translation adjustments
(1,290
)
 
405

 
(3,397
)
 
1,624

Changes in market value of investments:
 
 
 
 
 
 
 
Changes in unrealized (losses) gains
(75
)
 
3

 
(54
)
 
7

Total net change in market value of investments
(75
)
 
3

 
(54
)
 
7

Changes in market value of derivatives:
 
 
 
 
 
 
 
Changes in market value of derivatives, net of (benefits) taxes of ($327), $31, ($595) and $35
(597
)
 
56

 
(1,068
)
 
55

Reclassification adjustment for net gains (losses) included in net income, net of taxes (benefits) of $133, ($15), $115 and $85
214


(25
)

195


164

Total net change in market value of derivatives
(383
)
 
31

 
(873
)
 
219

Other comprehensive (loss) income
(1,748
)
 
439

 
(4,324
)
 
1,850

Total comprehensive income
$
15,881

 
$
17,733

 
$
36,014

 
$
34,280

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,
 
2014
 
2013
Cash flows from operating activities:
 
 
 
Net income
40,338

 
32,430

Adjustments to reconcile net income to cash provided by operating activities, net of the effects of acquisitions:
 
 
 
Depreciation and amortization
14,449

 
13,774

Loss on disposal of fixed assets
536

 
38

Deal related compensation expense and accretion charges
114

 
114

Share-based compensation expense associated with equity awards
11,947

 
9,959

Net change in fair value of contingent and contractual liabilities
(9
)
 
(289
)
Deferred income taxes
2,151

 
4,259

Other losses (gains)
84

 
(69
)
Changes in assets and liabilities
 
 
 
Accounts receivable
(22,973
)
 
(302
)
Inventories
1,359

 
(5,346
)
Prepaid expenses and other assets
(143
)
 
1,345

Accounts payable
(700
)
 
(1,255
)
Accrued compensation and other expenses
10,132

 
2,259

Income taxes payable
(791
)
 
591

Deferred revenue
828

 
3,259

                Net cash provided by operating activities
57,322

 
60,767

Cash flows from investing activities:
 
 
 
Purchase of marketable securities
(78,547
)
 
(88,802
)
Proceeds from maturity of marketable securities
61,189

 
49,405

Purchase of fixed assets
(8,630
)
 
(8,709
)
Purchase of intangible assets
(131
)
 
(713
)
Decrease in deposits
103

 
37

                Net cash used in investing activities
(26,016
)
 
(48,782
)
Cash flows from financing activities:
 
 
 
Issuance of common stock under stock plans
105

 
755

Payment of contingent consideration

 
(841
)
Treasury stock repurchases
(31,543
)
 
(25,033
)
Excess tax benefit from share-based compensation awards
4,322

 
2,039

                Net cash used in financing activities
(27,116
)
 
(23,080
)
Effect of exchange rate changes on cash and cash equivalents
438

 
(187
)
Net increase (decrease) in cash and cash equivalents
4,628

 
(11,282
)
Cash and cash equivalents, beginning of period
102,076

 
99,930

Cash and cash equivalents, end of period
$
106,704

 
$
88,648

Supplemental disclosures:
 
 
 
Cash paid for income taxes
$
20,830

 
$
12,628

Non-cash transactions:
 
 
 
Transfers of inventory to fixed assets
$
940

 
$
1,781

Additions to property, plant and equipment included in accounts payable
$
380

 
$
233

Gross decrease in contractual liability relating to fair value adjustment
$
(49
)
 
$
(148
)
Gross increase (decrease) in contingent consideration liability relating to fair value adjustment
$
40

 
$
(141
)
Issuance of common stock under employee stock plans
$
2,760

 
$
2,230

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, 2014.
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers: Topic 606 (ASU 2014-09), to supersede nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing U.S. GAAP, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. ASU 2014-09 is effective for the Company in its first quarter of fiscal year 2018 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within ASU 2014-09; or (ii) retrospective with the cumulative effect of initially applying ASU 2014-09 recognized at the date of initial application and providing certain additional disclosures as defined per ASU 2014-09. The Company is currently evaluating the impact of its pending adoption of ASU 2014-09 on its consolidated financial statements.
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, 2014, the Company had no indirect channel partner or direct customer which accounted for more than 10% of the accounts receivable balance. At March 31, 2014, one direct customer accounted for more than 10% of the accounts receivable balance, while no indirect channel partner accounted for more than 10% of the accounts receivable balance.
During the three and nine months ended December 31, 2014, no direct customer or indirect channel partner accounted for more than 10% of our total revenue.
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 our 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,
 
2014
 
2013
 
2014
 
2013
Cost of product revenue
$
85

 
$
62

 
$
238

 
$
174

Cost of service revenue
294

 
194

 
836

 
566

Research and development
1,455

 
1,157

 
3,971

 
3,316

Sales and marketing
1,221

 
944

 
3,419

 
2,952

General and administrative
1,095

 
860

 
3,483

 
2,951

 
$
4,150

 
$
3,217

 
$
11,947

 
$
9,959

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, 2014. 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, 2014, employees purchased 59,897 shares under the ESPP and the value per share was $46.07.
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, 2014 and March 31, 2014.
Marketable Securities
The following is a summary of marketable securities held by NetScout at December 31, 2014 classified as short-term and long-term (in thousands):
 
Amortized
Cost
 
Unrealized
Gains (Losses)
 
Fair
Value
Type of security:
 
 
 
 
 
U.S. government and municipal obligations
$
74,483

 
$
15

 
$
74,498

Commercial paper
7,586

 
4

 
7,590

Corporate bonds
5,882

 
(3
)
 
5,879

Total short-term marketable securities
87,951

 
16

 
87,967

U.S. government and municipal obligations
45,248

 
(45
)
 
45,203

Corporate bonds
852

 
0

 
852

Total long-term marketable securities
46,100

 
(45
)
 
46,055

Total marketable securities
$
134,051

 
$
(29
)
 
$
134,022


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Table of Contents

The following is a summary of marketable securities held by NetScout at March 31, 2014, classified as short-term and long-term (in thousands):
 
Amortized
Cost
 
Unrealized
Gains (Losses)
 
Fair
Value
Type of security:
 
 
 
 
 
U.S. government and municipal obligations
$
53,854

 
$
26

 
$
53,880

Commercial paper
14,581

 

 
14,581

Corporate bonds
6,772

 
1

 
6,773

Total short-term marketable securities
75,207

 
27

 
75,234

U.S. government and municipal obligations
37,875

 
2

 
37,877

Corporate bonds
3,611

 
(4
)
 
3,607

Total long-term marketable securities
41,486

 
(2
)
 
41,484

Total marketable securities
$
116,693

 
$
25

 
$
116,718

Contractual maturities of the Company’s marketable securities held at December 31, 2014 and March 31, 2014 were as follows (in thousands):

December 31,
2014

March 31,
2014
Available-for-sale securities:



Due in 1 year or less
$
87,967


$
75,234

Due after 1 year through 5 years
46,055


41,484


$
134,022


$
116,718

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 at December 31, 2014 and March 31, 2014 (in thousands).

Fair Value Measurements at
 
December 31, 2014
 
Level 1

Level 2

Level 3

Total
ASSETS:

 

 



Cash and cash equivalents
$
106,704

 
$

 
$

 
$
106,704

U.S. government and municipal obligations
39,852

 
79,849

 


119,701

Commercial paper

 
7,590

 


7,590

Corporate bonds
6,731

 

 


6,731

Derivative financial instruments

 
16

 


16


$
153,287

 
$
87,455

 
$


$
240,742

LIABILITIES:

 

 



Contingent purchase consideration
$

 
$

 
$
(4,445
)

$
(4,445
)
Derivative financial instruments

 
(1,223
)
 


(1,223
)

$

 
$
(1,223
)
 
$
(4,445
)

$
(5,668
)

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Fair Value Measurements at
 
March 31, 2014
 
Level 1

Level 2

Level 3

Total
ASSETS:

 

 



Cash and cash equivalents
$
82,079

 
$
19,997

 
$


$
102,076

U.S. government and municipal obligations
21,992

 
69,765

 


91,757

Commercial paper

 
14,581

 


14,581

Corporate bonds
10,380

 

 


10,380

Derivative financial instruments

 
368

 


368


$
114,451


$
104,711


$


$
219,162

LIABILITIES:

 

 



Contingent purchase consideration
$

 
$

 
$
(4,291
)

$
(4,291
)
Contingent contractual non-compliance liability

 

 
(49
)

(49
)
Derivative financial instruments

 
(139
)
 


(139
)

$


$
(139
)

$
(4,340
)

$
(4,479
)
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. The Company classifies municipal obligations as level 2 because the fair values are determined using quoted prices from markets the Company considers to be inactive. Commercial paper is 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 8.
The Company’s contingent purchase consideration at December 31, 2014 and March 31, 2014 was classified as Level 3 in the fair value hierarchy. The contingent contractual non-compliance liability was also classified as Level 3 at March 31, 2014. At December 31, 2014, the contingent contractual obligation has been reduced to zero as NetScout has either settled those liabilities or believes that because of the passage of time that the probability of a future negative settlement is essentially zero. These liabilities are valued by probability weighting expected payment scenarios and then applying a discount based on the present value of the future cash flow streams. They 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, 2014 (in thousands):

Contingent
Purchase
Consideration

Contingent
Contractual
Non-compliance
Liability
Balance at beginning of period
$
(4,291
)

$
(49
)
(Increase) / decrease in fair value and accretion expense (included within research and development expense)
(154
)

49

Balance at end of period
$
(4,445
)

$

The Company has updated the probabilities used in the fair value calculation of the contingent liabilities at December 31, 2014 which reduced the liability by $9 thousand and is included as part of earnings for the nine months ended December 31, 2014. 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

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of contractual non-compliance liabilities for the nine months ended December 31, 2014 was $114 thousand and was included as part of earnings.
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,
2014
 
March 31,
2014
Raw materials
$
3,257

 
$
6,025

Work in process
127

 
161

Finished goods
6,890

 
6,394


$
10,274

 
$
12,580

NOTE 7 – GOODWILL AND INTANGIBLE ASSETS
Goodwill
The Company has two reporting units: (1) Unified Service Delivery and (2) Test Optimization. At December 31, 2014 and March 31, 2014, goodwill attributable to the Unified Service Delivery reporting unit was $197.9 million and $201.0 million, respectively. Goodwill attributable to the Test Optimization reporting unit was $2.4 million at December 31, 2014 and March 31, 2014. 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 change in the carrying amount of goodwill for the nine months ended December 31, 2014 is due to 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, 2014 are as follows (in thousands):
Balance at March 31, 2014
$
203,446

Foreign currency translation impact for the nine months ended December 31, 2014
(3,175
)
Balance at December 31, 2014
$
200,271

Intangible Assets
The net carrying amounts of intangible assets were $52.5 million and $58.5 million at December 31, 2014 and March 31, 2014, 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 fiscal year ended March 31, 2014, the Company acquired certain rights to Accanto Systems, S.r.l. (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 and is being amortized using the economic benefit method and a useful life of 6.3 years.
During the fiscal year ended March 31, 2014, the Company acquired a certain technology license for $300 thousand. This amount is included within developed technology at March 31, 2014 and is being amortized using the economic benefit method and a useful life of 3 years.

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Intangible assets include an indefinite lived trade name with a carrying value of $18.6 million and the following amortizable intangible assets at December 31, 2014 (in thousands):

Cost

Accumulated
Amortization

Net
Developed technology
$
31,374

 
$
(25,201
)

$
6,173

Customer relationships
38,641

 
(16,240
)

22,401

Distributor relationships
1,787

 
(727
)

1,060

Core technology
7,331

 
(3,472
)

3,859

Non-compete agreements
315

 
(315
)


Other
901

 
(525
)

376


$
80,349


$
(46,480
)

$
33,869

Intangible assets include an indefinite lived trade name with a carrying value of $18.6 million and the following amortizable intangible assets at March 31, 2014 (in thousands):

Cost

Accumulated
Amortization

Net
Developed technology
$
31,946

 
$
(23,524
)

$
8,422

Customer relationships
38,801

 
(14,046
)

24,755

Distributor relationships
2,014

 
(568
)

1,446

Core technology
7,572

 
(2,701
)

4,871

Non-compete agreements
355

 
(295
)

60

Other
769

 
(410
)

359


$
81,457

 
$
(41,544
)

$
39,913

Amortization of software and core technology included as cost of product revenue was $905 thousand and $2.8 million for the three and nine months ended December 31, 2014, respectively. Amortization of other intangible assets included as operating expense was $858 thousand and $2.7 million for the three and nine months ended December 31, 2014, respectively.
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.
The following is the expected future amortization expense at December 31, 2014 for the years ending March 31 (in thousands):
2015 (remaining three months)
$
1,759

2016
6,455

2017
5,850

2018
5,004

2019
4,044

Thereafter
10,757


$
33,869

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 intangible assets is 10.1 years.

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NOTE 8 – 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.
The notional amounts and fair values of derivative instruments in the consolidated balance sheets at December 31, 2014 and March 31, 2014 were as follows (in thousands):
 
Notional Amounts (a)

Other Current Assets

Accrued Other Liabilities
 
December 31,
2014

March 31,
2014
 
December 31,
2014
 
March 31,
2014
 
December 31,
2014
 
March 31,
2014
Derivatives Designated as Hedging Instruments:











Forward contracts
$
19,776

 
$
17,483

 
$
16

 
$
368

 
$
1,223

 
$
139

 
(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, 2014 and 2013 (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, 2014
 
December 31, 2013

Location

December 31, 2014

December 31, 2013

Location

December 31, 2014
 
December 31, 2013
Forward contracts
$
(924
)
 
$
87


Research and
development

$
1

 
$
(109
)

Research and
development

$
(46
)
 
$
75






Sales and
marketing

(348
)
 
149


Sales and
marketing

(5
)
 
3


$
(924
)

$
87




$
(347
)

$
40




$
(51
)

$
78

(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.

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The following table provides the effect foreign exchange forward contracts had on OCI and results of operations for the nine months ended December 31, 2014 and 2013 (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, 2014
 
December 31, 2013
 
Location
 
December 31, 2014
 
December 31, 2013
 
Location
 
December 31, 2014
 
December 31, 2013
Forward contracts
$
(1,663
)
 
$
90

 
Research and
development
 
$
23

 
$
(293
)
 
Research and
development
 
$
148

 
$
172

 
 
 
 
 
Sales and
marketing
 
(333
)
 
44

 
Sales and
marketing
 
24

 
(3
)
 
$
(1,663
)
 
$
90

 
 
 
$
(310
)
 
$
(249
)
 
 
 
$
172

 
$
169

(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 9 – LONG-TERM DEBT
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 December 31, 2014, there were no amounts outstanding under this credit facility.
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. The applicable margin depends 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. At December 31, 2014, the Company was in compliance with all of these covenants.

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NOTE 10 – 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 this restructuring plan 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, 2014

December 31, 2014
Balance at beginning of period
$


$
71

Other adjustments



Cash payments


(71
)
Balance at December 31, 2014
$


$

NOTE 11 – COMMITMENTS AND CONTINGENCIES
Acquisition related The Company recorded two contingent liabilities related to the acquisition of Simena, LLC (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, 2014, the present value of the future consideration was $4.4 million and the contractual non-compliance liability was $0. The contingent contractual obligation has been reduced to zero as NetScout has either settled those liabilities or believes that because of the passage of time that the probability of a future negative settlement is essentially zero.
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.
NOTE 12 – 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 June 30, 2014, the Company had repurchased a total of 4,000,000 shares of common stock through the open market stock repurchase program. The Company repurchased 243,300 shares for $9.4 million under this program during the nine months ended December 31, 2014. At June 30, 2014, all authorized shares under this stock repurchase program have been repurchased.
On April 22, 2014, the Company's board of directors approved an additional stock repurchase program. This program authorizes management to make additional repurchases of NetScout outstanding common stock of up to $100 million. The share repurchase authorization does not have an expiration date and the pace and timing of repurchases will depend on factors such as cash generation from operations, cash requirements for acquisitions, economic and market conditions, stock price and legal and regulatory requirements. Through December 31, 2014, the Company has repurchased 256,700 shares totaling $11.5 million in the open market under this stock repurchase plan. At December 31, 2014, $88.5 million of common stock remained available to be purchased under the plan.
In connection with the vesting and release of the restriction on previously vested shares of restricted stock units, the Company repurchased 243,063 shares for $10.6 million related to minimum statutory tax withholding requirements on these restricted stock units during the nine months ended December 31, 2014. 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.

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NOTE 13 – 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,
 
2014

2013

2014

2013
Numerator:







Net income
$
17,629

 
$
17,294

 
$
40,338

 
$
32,430

Denominator:
 
 
 
 
 
 
 
Denominator for basic net income per share - weighted average common shares outstanding
41,206

 
41,425

 
41,128

 
41,417

Dilutive common equivalent shares:
 
 
 
 
 
 
 
      Weighted average stock options
7

 
43

 
11

 
63

      Weighted average restricted stock units
323

 
416

 
540

 
489

Denominator for diluted net income per share - weighted average shares outstanding
41,536

 
41,884

 
41,679

 
41,969

Net income per share:
 
 
 
 
 
 
 
Basic net income per share
$
0.43

 
$
0.42

 
$
0.98

 
$
0.78

Diluted net income per share
$
0.42

 
$
0.41

 
$
0.97

 
$
0.77

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,
 
2014

2013

2014

2013
Restricted stock units
19

 

 
12

 
195

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 14 – INCOME TAXES
Our effective income tax rates were 35.7% and 36.7% for the three months ended December 31, 2014 and 2013, respectively.  Generally, the effective tax rates differ from statutory rates due to the impact of the domestic production activities deduction, research and development credits if enacted, the impact of state taxes, income generated in jurisdictions that have a different tax rate than the U.S. statutory rate, and losses not benefited in certain foreign jurisdictions. The effective tax rate for the three months ended December 31, 2014 is lower than the effective rate for the three months ended December 31, 2013 primarily due to the increase in the domestic production activities deduction as well as the delayed reenactment of the research and development tax credit.

Our effective tax rates were 37.9% and 37.6% for the nine months ended December 31, 2014 and 2013, respectively. At this time, the effective tax rate is higher than the comparable year primarily due to an increase in certain foreign losses for which a benefit cannot be realized.
NOTE 15 – 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 in deciding how to allocate resources and in assessing performance.

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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,
 
2014

2013

2014

2013
United States
$
88,905

 
$
86,747

 
$
254,260

 
$
216,364

Europe
16,981

 
12,313

 
37,032

 
33,906

Asia
8,075

 
4,035

 
19,464

 
14,788

Rest of the world
8,872

 
7,333

 
23,528

 
19,272


$
122,833


$
110,428


$
334,284


$
284,330

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.
NOTE 16 - RELATED PARTY TRANSACTION
A member of the Company’s Board of Directors also serves as a member of the board of directors for EMC, Corp. (EMC) and therefore, the Company considers the sale of equipment to EMC to be a related party transaction.  The Company generated $208 thousand in revenue from EMC during the nine months ended December 31, 2014.
NOTE 17 – PROPOSED ACQUISITION
On October 12, 2014, NetScout Systems, Inc., Danaher Corporation (Danaher), Potomac Holding LLC, a wholly-owned subsidiary of Danaher (Newco), RS Merger Sub I, Inc., a wholly-owned subsidiary of the Company (Merger Sub) and RS Merger Sub II, LLC, a wholly-owned subsidiary of the Company (Merger Sub II and, together with Merger Sub, the Merger Subs), entered into an Agreement and Plan of Merger and Reorganization (Merger Agreement) pursuant to which the Company will acquire the communications group business of Danaher conducted under the brands Tektronix Communications, Fluke Networks and Arbor Networks (Communications Business), but excluding Danaher’s data communications cable installation business and its communication service provider business in a Reverse Morris Trust transaction (the Transaction).
Prior to the Mergers (as defined below) and pursuant to a Separation and Distribution Agreement (Distribution Agreement), dated as of October 12, 2014, among Danaher, Newco and the Company, Danaher will, among other things, transfer the Communications Business to Newco and, thereafter, Danaher will distribute to Danaher stockholders all of the issued and outstanding shares of Newco (the Distribution).
Immediately following the Distribution, the Company, Danaher, Newco and the Merger Subs will effect a two-step merger process whereby (i) Merger Sub I will merge with and into Newco, with Newco continuing as the surviving corporation (the First Merger) and (ii) immediately following the First Merger, Newco will merge with and into Merger Sub II, with Merger Sub II surviving as a wholly-owned subsidiary of the Company (the Second Merger, and together with the First Merger, the Mergers).
Upon consummation of the transactions contemplated by the Merger Agreement and the Distribution Agreement, the common units of Newco then outstanding will be automatically converted into 62.5 million shares of the Company’s common stock (the Company Common Stock) and will represent approximately 59.5% of the Company Common Stock outstanding after giving effect to the stock issuance in the Transaction. The Company’s existing stockholders will continue to hold the remaining approximately 40.5% of the Company Common Stock. The common units of Newco then outstanding could convert into more than 62.5 million shares of the Company’s common stock if the Company issues Company Common Stock in certain acquisitions prior to the First Merger (in which case such additional conversion shares shall be calculated by multiplying 1.46 by the number of shares of Company Common Stock issued in such acquisition).

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Table of Contents

The consummation of the First Merger is subject to various customary closing conditions, including, among other things (i) accuracy of Danaher’s and the Company’ representations and warranties, (ii) compliance by Danaher and the Company with certain covenants in the Merger Agreement, (iii) effectiveness of the registration statements to be filed with the Securities and Exchange Commission to register the Newco common units and the Company Common Stock to be issued to Danaher’s stockholders, (iv) approval of the Company’s stockholders of the issuance of the Company Common Stock in the First Merger, (v) completion of the transactions contemplated by the Distribution Agreement, (vi) no material adverse effect shall have occurred with respect to either the Company or the Communications Business, (vii) expiration or termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvement Act of 1976, as amended, (viii) absence of any law or order from any court or governmental authority restraining, enjoining or prohibiting the Transaction, (ix) receipt of certain rulings from the Internal Revenue Service and (x) receipt of certain tax opinions from tax counsel to Danaher.
The Merger Agreement contains certain termination rights for both the Company and Danaher and further provides that, upon termination of the Merger Agreement under specified circumstances, the Company must pay Danaher a termination fee of $55 million. The circumstances under which the Company must pay Danaher the termination fee include, among other circumstances:
the Merger Agreement is terminated by Danaher following a Company triggering event. A Company triggering event is defined in the Merger Agreement to include, among other things, the failure of the Company’s board of directors to recommend that the Company’s stockholders vote in favor of the issuance of the Company Common Stock in the First Merger, the withdrawal or adverse modification by the Company’s board of directors of such recommendation, or the Company’s material breach of its covenants not to solicit any alternative acquisition proposal.
(1) a competing bona fide acquisition proposal is presented by a third party to the Company or its stockholders, (2) the Merger Agreement is thereafter terminated (A) by either party for failure to close before October 12, 2015, (B) by Danaher as a result of a breach by the Company of its representations or covenants that results in the failure of a closing condition that cannot be cured or (C) by either Danaher or the Company because the Company has failed to obtain stockholder approval, and (3) within 9 months after the termination of the Merger Agreement, the Company enters into an agreement for or consummates an acquisition proposal made by a third party.

The Company has incurred $6.2 million in acquisition related costs during the nine months ended December 31, 2014.
In connection with RBC Capital Markets’ services as NetScout’s financial advisor, NetScout has agreed to pay RBC Capital Markets an aggregate fee of $11 million, a portion of which was payable upon delivery of RBC Capital Markets’ opinion and $9.5 million of which is contingent upon consummation of the Mergers. NetScout also has agreed to reimburse RBC Capital Markets for expenses reasonably incurred in connection with RBC Capital Markets’ services and to indemnify RBC Capital Markets and related persons against certain liabilities, including liabilities under the federal securities laws, arising out of RBC Capital Markets’ engagement.
The transaction is expected to increase NetScout’s scale and broaden its customer base in both the service provider and enterprise markets, while accelerating NetScout’s entry into the Cyber Intelligence market.  The transaction is expected to close in the first half of NetScout’s fiscal year 2016.

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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, 2014 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 are an industry leader for advanced network, application and service assurance solutions, providing high-quality performance analytics and operational intelligence solutions that facilitate the evolution toward new computing paradigms, such as virtualization, mobility and cloud. We design, develop, manufacture, market, license, sell and support these products focused on assuring service delivery quality, performance and availability for some of the world’s largest, most demanding and complex internet protocol (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. The development and mid-2013 launch of our nGeniusONE unified performance management platform, which is powered by our patented, proprietary Adaptive Session Intelligence software, has been a critical component in our ability to make progress toward achieving these objectives. The enhancement and expansion of our nGeniusONE solutions has been bolstered by our acquisitions and integration of both voice/video and packet flow or monitoring switch technology.
On October 12, 2014, NetScout, Danaher Corporation (Danaher), Potomac Holding LLC, a wholly-owned subsidiary of Danaher (Newco), RS Merger Sub I, Inc., a wholly-owned subsidiary of the Company (Merger Sub) and RS Merger Sub II, LLC, a wholly-owned subsidiary of the Company (Merger Sub II and, together with Merger Sub, the Merger Subs), entered into an Agreement and Plan of Merger and Reorganization (Merger Agreement) pursuant to which the Company will acquire the communications group business of Danaher conducted under the brands Tektronix Communications, Fluke Networks and Arbor Networks, but excluding Danaher’s data communications cable installation business and its communication service provider business (Communications Business) in a Reverse Morris Trust transaction (the Transaction). For additional information regarding the proposed acquisition, see Note 17 of our Notes to Consolidated Financial Statements.
Results Overview

We generated continued growth during the quarter ended December 31, 2014, with product revenue growth of 12% and overall revenue growth of 11% compared to the same period in the prior year.

Our business has maintained strong gross profit margins. Our gross profit for the quarter ended December 31, 2014 increased by $9.0 million, or 10%, when compared to the quarter ended December 31, 2013. The gross profit percentage decreased by one point to 78% during the quarter ended December 31, 2014, when compared to the quarter ended December 31, 2013.

The combination of continued revenue growth, strong gross profit margins and a scalable infrastructure supported by prudent investment across key areas of our business, including research and development initiatives, and sales and marketing programs, has enabled us produce strong operating profit margins. Despite higher one-time expenses associated with the aforementioned

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Table of Contents

acquisition of Danaher’s Communications Business, our operating profit margin for the quarter ended December 31, 2014 was 23%, as compared to 25% for the same quarter one year ago.

We continue to maintain strong liquidity. At December 31, 2014, we had cash, cash equivalents and marketable securities of $240.7 million. This represents an increase of $21.9 million from March 31, 2014.
Use of Non-GAAP Financial Measures
We supplement the generally accepted accounting principles (GAAP) financial measures we report in quarterly and annual 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 nine months ended December 31, 2014 and 2013 (in thousands, except for per share amounts):
 
Three Months Ended
 
Nine Months Ended
 
December 31,
 
December 31,
 
2014
 
2013
 
2014
 
2013
GAAP revenue
$
122,833

 
$
110,428

 
$
334,284

 
$
284,330

Deferred revenue fair value adjustment

 
140

 
18

 
419

Non-GAAP revenue
$
122,833

 
$
110,568

 
$
334,302

 
$
284,749

GAAP net income
$
17,629

 
$
17,294

 
$
40,338

 
$
32,430

Deferred revenue fair value adjustment

 
140

 
18

 
419

Share based compensation expense
4,150

 
3,217

 
11,947

 
9,959

Amortization of acquired intangible assets
1,726

 
1,697

 
5,301

 
5,051

Business development and integration expense
4,698

 
78

 
6,175

 
482

Compensation for post combination services
312

 
530

 
1,393

 
1,685

Income tax adjustments
(3,909
)
 
(1,941
)
 
(8,727
)
 
(6,034
)
Non-GAAP net income
$
24,606

 
$
21,015

 
$
56,445

 
$
43,992

GAAP diluted net income per share
$
0.42

 
$
0.41

 
$
0.97

 
$
0.77

Per share impact of non-GAAP adjustments identified above
0.17

 
0.09

 
0.38

 
0.28

Non-GAAP diluted net income per share
$
0.59

 
$
0.50

 
$
1.35

 
$
1.05


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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, 2014, filed with the Securities and Exchange Commission (SEC) on May 20, 2014, for a description of all of our critical accounting policies.
Three Months Ended December 31, 2014 and 2013
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, 2014, no direct customer or indirect channel partner accounted for more than 10% of our total revenue. During the three 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 our total revenue.

Three Months Ended

Change
 
December 31,


(Dollars in Thousands)

 
2014

2013

 
 

% of
Revenue

 

% of
Revenue

$

%
Revenue:
 
 
 
 
 
 
 
 
 
 
 
Product
$
76,446

 
62
%
 
$
68,561

 
62
%
 
$
7,885

 
12
%
Service
46,387

 
38

 
41,867

 
38

 
4,520

 
11
%
Total revenue
$
122,833

 
100
%
 
$
110,428

 
100
%
 
$
12,405

 
11
%
Product. The 12%, or $7.9 million, increase in product revenue was due to a $7.7 million increase in revenue from our general enterprise sector, and a $5.6 million increase in our government enterprise sector. This reflects increased demand primarily from existing customers and, to a lesser extent, success in winning business with new customers. These increases were partially offset by a $5.4 million decrease from our service provider sector which reflects the timing and magnitude of various projects with service providers. Compared to the same period in the prior year, we realized a 9% increase in units shipped, while the average selling price per unit of our products remained flat.

We expect continued growth in all major sectors through the year ended March 31, 2015.
Service. The 11%, or $4.5 million, increase in service revenue was due to a $3.4 million increase in revenue from new maintenance contracts and renewals from a growing support base and a $1.2 million increase in premium support contracts. We

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expect continued service revenue growth 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)
 
 
2014
 
2013
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
Indirect
$
70,380

 
57
%
 
$
53,930

 
49
%
 
$
16,450

 
31
 %
Direct
52,453

 
43

 
56,498

 
51

 
(4,045
)
 
(7
)%
Total revenue
$
122,833

 
100
%
 
$
110,428

 
100
%
 
$
12,405

 
11
 %
The 31%, or $16.5 million, increase in indirect channel revenue is the result of the increase in sales to our government enterprise sector in the United States, as well as in our service provider and general enterprise sector internationally. 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 7%, or $4.0 million, decrease in direct revenue is primarily the result of decreased domestic revenue from our service provider and government sectors, partially offset by increases in our general enterprise sector.
Total revenue by geography is as follows:
 
Three Months Ended
 
Change
 
December 31,
 
 
(Dollars in Thousands)
 
 
2014
 
2013
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
United States
$
88,905

 
72
%
 
$
86,747

 
79
%
 
$
2,158

 
2
%
International:
 
 
 
 
 
 
 
 

 

Europe
16,981

 
14

 
12,313

 
11

 
4,668

 
38
%
Asia
8,075

 
7

 
4,035

 
4

 
4,040

 
100
%
Rest of the world
8,872

 
7

 
7,333

 
6

 
1,539

 
21
%
Subtotal international
33,928

 
28

 
23,681

 
21

 
10,247

 
43
%
Total revenue
$
122,833

 
100
%
 
$
110,428

 
100
%
 
$
12,405

 
11
%
United States revenues increased 2%, or $2.2 million, primarily due to gains within the general enterprise and government sectors, offset by a decrease in the service provider sector. The 43%, or $10.2 million, increase in international revenue is due to increases across the service provider and general enterprise sectors. In Asia, the volume of orders as well as dollar size of the orders increased when compared to the three months ended December 31, 2013. 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.

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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.
 
Three Months Ended
 
Change
 
December 31,
 
 
(Dollars in Thousands)
 
 
2014
 
2013
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
Cost of revenue
 
 
 
 
 
 
 
 
 
 
 
Product
$
18,310

 
15
%
 
$
14,534

 
13
%
 
$
3,776

 
26
 %
Service
8,672

 
7

 
9,068

 
8

 
(396
)
 
(4
)%
Total cost of revenue
$
26,982

 
22
%
 
$
23,602

 
21
%
 
$
3,380

 
14
 %
Gross profit:
 
 
 
 
 
 
 
 
 
 
 
Product $
$
58,136

 
47
%
 
$
54,027

 
49
%
 
$
4,109

 
8
 %
Product gross profit %
76
%
 
 
 
79
%
 
 
 
 
 
 
Service $
$
37,715

 
31
%
 
$
32,799

 
30
%
 
$
4,916

 
15
 %
Service gross profit %
81
%
 
 
 
78
%
 
 
 
 
 
 
Total gross profit $
$
95,851

 
 
 
$
86,826

 
 
 
$
9,025

 
10
 %
Total gross profit %
78
%
 
 
 
79
%
 
 
 
 
 
 
Product. The 26%, or $3.8 million, increase in cost of product revenue was primarily due to the 12%, or $7.9 million, increase in product revenue during the three months ended December 31, 2014. In addition, there was a $1.8 million increase in obsolescence charges for the three months ended December 31, 2014. The product gross profit percentage decreased by three percentage points to 76% during the three months ended December 31, 2014 as compared to the three months ended December 31, 2013. The 8%, or $4.1 million, increase in product gross profit corresponds with the 12%, or $7.9 million, increase in product revenue, offset by the 26%, or $3.8 million, increase in cost of product revenue. Average headcount in manufacturing was 33 and 32 for the three months ended December 31, 2014 and 2013, respectively.
Service. The 4%, or $396 thousand, decrease in cost of service revenue was primarily due to a $732 thousand decrease in the cost of materials used to support customers under service contracts, and a $424 thousand decrease in allocated overhead. These decreases were offset by a $747 thousand increase in employee related expenses resulting in part from headcount to support our growing installed base as well as increased compensation related items. The service gross profit percentage increased by three percentage points to 81% for the three months ended December 31, 2014 as compared to the three months ended December 31, 2013. The 15%, or $4.9 million, increase in service gross profit corresponds with the 11%, or $4.5 million, increase in service revenue, and the 4%, or $396 thousand, decrease in cost of services. Average service headcount was 168 and 145 for the three months ended December 31, 2014 and 2013, respectively.
Gross profit. Our gross profit increased 10%, or $9.0 million. This increase is attributable to our increase in revenue of 11%, or $12.4 million, partially offset by a 14%, or $3.4 million, increase in cost of revenue. The gross profit percentage decreased by one percentage point to 78% for the three months ended December 31, 2014 as compared to the three months ended December 31, 2013. 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)
 
 
2014
 
2013
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
Research and development
$
18,864

 
15
%
 
$
18,348

 
17
%
 
$
516

 
3
 %
Sales and marketing
34,836

 
28

 
32,425

 
29

 
2,411

 
7
 %
General and administrative
13,391

 
11

 
7,929

 
7

 
5,462

 
69
 %
Amortization of acquired intangible assets
821

 
1

 
860

 
1

 
(39
)
 
(5
)%
Total operating expenses
$
67,912

 
55
%
 
$
59,562

 
54
%
 
$
8,350

 
14
 %
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 3%, or $516 thousand, increase in research and development expenses is due to a $584 thousand increase in employee related expenses resulting from increased headcount, a $292 thousand increase in depreciation expense, and a $259 thousand increase in consulting expenses. These increases were partially offset by a $343 thousand decrease in non-recurring engineering expenses, and a $104 thousand decrease in computer supplies expense. Average headcount in research and development was 363 and 347 for the three months ended December 31, 2014 and 2013, respectively.
Sales and marketing. Sales and marketing expenses consist primarily of personnel expenses and commissions, overhead and other expenses associated with selling activities and marketing programs such as trade shows, seminars, advertising, and new product launch activities.
The 7%, or $2.4 million, increase in total sales and marketing expenses was due to a $1.1 million increase in employee related expenses due to increased headcount and other employee related costs. In addition, there was a $465 thousand increase in advertising expenses, a $372 thousand increase in travel expenses, a $278 thousand increase in commissions, and a $224 thousand increase in consulting expenses. Average headcount in sales and marketing was 376 and 361 for the three months ended December 31, 2014 and 2013, respectively.
General and administrative. General and administrative expenses consist primarily of personnel expenses for executive, financial, legal and human resource employees, overhead and other corporate expenditures.
The 69%, or $5.5 million, increase in general and administrative expenses was primarily due to a $4.6 million increase in business development expenses due to the planned acquisition of the Danaher Communications Business as described in Note 17 , a $281 thousand increase in legal expenses, and a $250 thousand increase in employee related expenses due to compensation related items and other employee related costs. Average headcount in general and administrative was 126 and 116 for the three months ended December 31, 2014 and 2013, respectively.
Amortization of acquired intangible assets. Amortization of acquired intangible assets consists primarily of amortization of customer relationships related to the acquisitions of ONPATH Technologies, Inc. (ONPATH), Accanto, Simena, LLC (Simena), Fox Replay BV (Replay), Psytechnics, Ltd (Psytechnics) and Network General.
Interest and Other Income (Expense), Net. Interest and other income (expense), net includes interest earned on our cash, cash equivalents and marketable securities, interest expense and other non-operating gains or losses.
 
Three Months Ended
 
Change
 
December 31,
 
 
(Dollars in Thousands)
 
 
2014
 
2013
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
Interest and other income (expense), net
$
(512
)
 
 %
 
$
44

 
%
 
$
(556
)
 
(1,264
)%

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The $556 thousand increase in interest and other expense was due to a $479 thousand increase in foreign currency exchange expense and a $209 thousand increase in loss on disposal of equipment. This increase to interest and other expense, net was partially offset by a $94 thousand increase in other income and a $29 thousand increase in interest income received on investments.
Income Tax Expense. Our effective income tax rates were 35.7% and 36.7% for the three months ended December 31, 2014 and 2013, respectively.  Generally, the effective tax rates differ from statutory rates due to the impact of the domestic production activities deduction, research and development credits if enacted, the impact of state taxes, income generated in jurisdictions that have a different tax rate than the U.S. statutory rate, and losses not benefited in certain foreign jurisdictions. The effective tax rate for the three months ended December 31, 2014 is lower than the comparable prior year period primarily due to the increase in the domestic production activities deduction as well as the delayed reenactment of the research and development tax credit.
 
Three Months Ended
 
Change
 
December 31,
 
 
(Dollars in Thousands)
 
 
2014
 
2013
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
Income tax expense
$
9,798

 
8
%
 
$
10,014

 
9
%
 
$
(216
)
 
(2
)%
Nine months ended December 31, 2014 and 2013
Revenue
During the nine months ended December 31, 2014, no direct customer or channel partner accounted for more than 10% of our total revenue. During the 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 our total revenue.
 
Nine Months Ended
 
Change
 
December 31,
 
 
(Dollars in Thousands)
 
 
2014
 
2013
 
 
 
 
% of
Revenue
 
 
 
% of
Revenue
 
$
 
%
Revenue:
 
 
 
 
 
 
 
 
 
 
 
Product
$
198,765

 
59
%
 
$
163,895

 
58
%
 
$
34,870

 
21
%
Service
135,519

 
41
%
 
120,435

 
42
%
 
15,084

 
13
%
Total revenue
$
334,284

 
100
%
 
$
284,330

 
100
%
 
$
49,954

 
18
%
Product. The 21%, or $34.9 million, increase in product revenue was due to a $12.8 million increase in revenue from our service provider sector, an $11.2 million increase in revenue from our government enterprise sector, and a $10.9 million increase in revenue from our general enterprise sector. Compared to the same period in the prior year, we realized a 12% increase in units shipped and a 5% increase in the average selling price per unit of our products.
Service. The 13%, or $15.1 million, increase in service revenue was due to an $11.6 million increase in revenue from maintenance contracts due to increased new maintenance contracts and renewals from a growing support base and a $3.7 million increase in premium support contracts. These were partially offset by a $161 thousand decrease in consulting revenue.

23

Table of Contents

Total product and service revenue from direct and indirect channels are as follows:
 
Nine Months Ended
 
Change
 
December 31,
 
 
(Dollars in Thousands)
 
 
2014
 
2013
 
 
 
 
% of
Revenue