Netscout (NTCT) appears to be a quality business with downside protection afforded by an 11X P/E placed on a growing software company that is actively repurchasing its shares. Near-term (~6-18 months) I think it would take minimal effort for the stock to appreciate to $30+ (FY16 EPS valued at a market multiple or less) and I see a dramatically higher bull case if the business achieves its full potential. At current prices you get a shot at the bull case for free.
Quality business. NTCT provides service assurance and cyber security software to the enterprise and service provider markets. This software is embedded into networks and critical to ensuring they are operating smoothly. For example, a wireless company that prides itself on call quality would use this software to detect and fix disruptions on their network before their customers become aware of them or trouble shoot specific problems after they occur. It’s a sticky business once you are deployed into a network; it tends to stay there until the network is de-commissioned. Prior to their RMT transaction with a subsidiary of DHR, NTCT generated ~80% GPM and a ~30% non-GAAP EBIT margin. Post-integration they are targeting ~80% GPM and ~31% OPM though this business seems capable of 35%+ margins. Free cash flow is substantial and essentially no capital is required to grow.
Quality management. I am not a fan of the hour long monologues that begin each conference call, but I believe that this is an honest and capable management team. The CEO Anil Singhal is the company’s co-founder and very passionate about the business. The company has had very good success integrating past acquisitions, including Network General which was completed during the financial crisis with pre-merger expectations being met.
Cheap valuation. Having been embarrassed by the stock performance over the last year, I believe the current guidance of $1.183-1.233b of revenue and $1.85-2.10 EPS is set up to be conservative. Assuming the high end of EPS implies $197mm net income (94*$2.10). After factoring $10mm of interest and 34.75% tax (34.5-35% guide), EBITA will be about $313mm. Net cash of $39mm should increase by about $175mm of FCF (85-95% FCF conversion in FY16) less my estimate of $250mm in share repurchases (10mm shares @ $25). The 94mm share count should exit the year at 84mm. Putting it together, we have 84mm shares at $23.41 plus $36mm of net debt or an EV of $2,002mm by this time next year. EV/EBITA is 6.4X, which seems absurdly cheap to me. On a P/E basis, the stock is 11X EPS guidance and 10X assuming they complete the share repurchase program. If the stock doesn’t appreciate, this seems like a good LBO candidate in the current interest rate environment.
Why now? The last 12 months have been horrific for the stock, AT&T (a big DHR customer) slowed its spending last year but seems to be stable at worst now, they disappointed with the forward outlook on the Q3 call, they re-set expectations on the Q4 call to beatable numbers, they bought back 10% of the company in the last 9 months and will buyback another 10% over the next 12 or so, they seem to be seriously ratcheting up the investor outreach as evidence by a number of upcoming conference presentations. Q4 results were decent with modest organic revenue growth in a tough macro and deferred revenue increasing 17% sequentially.
Background. NETSCOUT Systems, Inc. (NASDAQ: NTCT) is a market leader in real-time service assurance and cyber security solutions for today’s most demanding service provider, enterprise and government networks. NETSCOUT’s Adaptive Service Intelligence (ASI) technology continuously monitors the service delivery environment to identify performance issues and provides insight into network-based security threats, helping teams to quickly resolve issues that can cause business disruptions or impact user experience. NETSCOUT delivers unmatched service visibility and protects the digital infrastructure that supports our connected world.
The products are probes which sit on top of data networks and gather packet flow data and appliances (off the shelf hardware w/ NTCT software) that collect and analyze the data. They are sold as appliances, but it’s really just off the rack hardware with software on top.
DHR deal: NTCT acquired DHR’s Tektronix business (Tek, Arbor, Fluke) in 2015. The companies had been discussing a deal for many years. My guess is the conversation started with DHR wanting to acquire NTCT and ended with NTCT acquiring Tek. James Lico of DHR subsequently joined NTCT’s board which I view as positive. The deal was controversial because Netscout was growing quickly and Tek was a slow growing legacy business. NTCT saw the deal as a way to acquire an incumbent position / installed base with a number of important telecom companies.
Bull and bear: NTCT’s objective with DHR is to grow revenue 10% and achieve 31% operating margins. If you start with a base of $1.25b in FY17 revenue, assume FY18 remains below trend at +5% and they hit their stride in FY19 and FY20 at +10%/yr then revenue could approach $1.6b with margins north of 31% ($490mm+ EBITA). At 35% this implies >$555mm of EBITA potential. FCF generation should add $700-1000mm of cash to the b/s. 10-12X EBITA + cash on 94mm shares is $60-81 4 years out. I’ve left out stock comp – it’s a good guess that this will be about 3% of sales; you can treat this as an expense or as dilution to the share count. As an expense it is roughly $45mm of the bull case revenue or a $5-6 per share reduction to fair value. This is the bull case.
In a bear-case, if the company only achieves $1.85 EPS in FY17 with no buyback and $215mm of cash at year end, a no-growth 8-10X multiple plus cash gets you to downside of $17-21.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.