[May 25, 2012] NETSCOUT SYSTEMS INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations Tweet (Edgar Glimpses Via Acquire Media NewsEdge) The following information should be read in conjunction with the audited consolidated financial information and the notes thereto included in this Annual Report on Form 10-K. In addition to historical information, the following discussion and other parts of this Annual Report contain forward-looking statements that involve risks and uncertainties. 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 discussed in Item 1A. "Risk Factors" and elsewhere in this Annual Report. These factors may cause our actual results to differ materially from any forward-looking statement. Overview NetScout was founded in 1984 and is headquartered in Westford, Massachusetts. We design, develop, manufacture, market, sell and support market leading unified service delivery management, service assurance and application performance management solutions focused on assuring service delivery for the world's largest, most demanding and complex IP based service delivery environments. We manufacture and market these products in integrated hardware and software solutions that are used by commercial enterprises, large governmental agencies and telecommunication service providers worldwide. We have a single operating segment and substantially all of our identifiable assets are located in the United States. Our operating results are influenced by a number of factors, including, but not limited to, the mix and quantity of products and services sold, pricing, costs of materials used in our products, growth in employee related costs, including commissions, and the expansion of our operations. Factors that affect our ability to maximize our operating results include, but are not limited to, our ability to introduce and enhance existing products, the marketplace acceptance of those new or enhanced products, continued expansion into international markets, development of strategic partnerships, competition, successful acquisition integration efforts, our ability to achieve significant expense reductions and make structural improvements and current economic conditions. On April 1, 2011, we completed the acquisition of Psytechnics, Ltd (Psytechnics), a provider of IP voice, video and telepresence technologies that proactively assures the user experience for unified communications services. Psytechnics' technology strengthens NetScout's unified service delivery management strategy by providing more comprehensive management of the quality of IP voice, video and telepresence service delivery along with all other application and data services. NetScout paid $17.0 million for the acquisition of Psytechnics. On October 3, 2011, we completed the acquisition of Fox Replay BV (Replay), a leading provider of user session reconstruction and replay technology that enables organizations to perform forensic analysis of end-user actions in support of cyberintelligence activities, information assurance, lawful intercept and general security 31 -------------------------------------------------------------------------------- Table of Contents practices. Replay adds critical technology and expertise that we expect will provide an important element of our unified service delivery management product strategy to address growing cybersecurity concerns in our target markets. NetScout paid $20.2 million for the acquisition of Replay. On November 18, 2011, we completed the acquisition of Simena, LLC (Simena), an established provider of high performance, low-latency IP packet flow-based network monitoring switching technology that enables IT organizations and service providers to aggregate, filter and control network traffic for data, voice, and video monitoring and cybersecurity deployments. We expect that Simena's technology will further strengthen NetScout's unified service delivery management strategy by extending visibility capabilities. The technology should enable fine-grained packet-flow control for monitoring environments to better leverage critical network monitoring points. NetScout paid $10.1 million in cash for the acquisition of Simena and an estimated fair value at the time of acquisition for additional contingent consideration of $8.0 million to be paid in the future. At March 31, 2012, the fair value of the contingent consideration was $8.2 million. The three acquisitions described above have brought key new technologies and capabilities to our solution offering that greatly enhance our Unified Service Delivery Management (USDM) strategy, enabling further market differentiation of our solution offerings and will accelerate our customers' time to value. Each of these acquisitions complement our focused packet-flow strategy and will enable us to continue to build a leading solution set that meets customer requirements in streamlining their network monitoring architecture, enhances the usefulness of our solution in cybersecurity implementations and addresses the growing need to support Unified Communications (UC) services along with business data applications. All three of these acquisitions have been completed and are fully integrated into the organization. We made significant enhancements to our service provider solution during our fiscal year ended March 31, 2012 and won new business as a result. Our patent-pending Adaptive Session Intelligence (ASI) technology is giving us an edge over competition providing superior real-time analytics, scalability and price performance. The large service provider carriers and an increasing number of mid-size carriers are directing their capital spending dollars toward our solution because we help them better manage their overall capital spending and deal with the ongoing hyper-growth of data traffic. We expect to continue to gain market share in IP-based service assurance for wireless carriers globally. We also made major enhancements to our USDM platform, prompting our service provider customers to expand their USDM deployments, moving beyond post-event session trace, subscriber-by-subscriber measurements to real-time, tops down user experience by region, mobile device type and service. In addition to wireless carriers, cable companies have become a significant component of our telecommunications sales. As with wireless carriers, our products are now being selected to provide service assurance for cable providers' customer facing networks as they continue to move to IP based service delivery. In enterprise sales worldwide, we saw year-over-year growth which has been supported by our USDM capabilities. This past year we released new functionality for Unified Communications, Application Performance Management and, with the addition of our Packet Flow Switch products, we are enabling our customers to leverage their existing investment in our products into new functional areas. In Unified Communications, we integrated the technology we acquired from Psytechnics with our Infinistream data collectors into a product called nGenius Voice | Video Manager, a performance analysis module for managing the user experience for Unified Communications services, such as telepresence, video, and voice. With the Replay acquisition we have added the nGenius Forensic Intelligence analysis module to our USDM portfolio. This module further strengthens NetScout's USDM strategy by adding cybersecurity network forensic analysis capabilities to the nGenius Service Assurance Solution. 32-------------------------------------------------------------------------------- Table of Contents Results Overview We saw continued growth during the fiscal year ended March 31, 2012, with product revenue growth of 5% and overall revenue growth of 6% compared to the prior fiscal year. Bookings increased by 17% during the fiscal year ended March 31, 2012 when compared to the prior fiscal year. Our total bookings for the service provider sector increased by 31% during the fiscal year ended March 31, 2012 as a result of our investment and expansion in that sector on a global basis, as well as Long-term Evolution (LTE) deployments from the major global carriers. Our total bookings for the financial sector grew 15% when compared to the prior fiscal year despite a weakness in this sector within the European region. We ended fiscal year 2012 with $13.0 million of product backlog, compared to an immaterial amount as of the end of fiscal year 2011. At March 31, 2012, we had cash, cash equivalents and marketable securities of $213.5 million. This represents a decrease of $15.0 million over the previous fiscal year ended March 31, 2011. During the fiscal year ended March 31, 2012, we maintained our liquidity despite acquisitions of product technology as well as cash outflows as a result of our share repurchase program. Use of Non-GAAP Financial Measures From time to time in press releases regarding quarterly earnings, presentations and other communications, we may provide financial information determined by methods other than in accordance with GAAP. Recent non-GAAP financial measures have included non-GAAP revenue, income from operations, net income and net income per diluted share, which were adjusted from amounts determined based on GAAP to exclude the effect of purchase accounting adjustments to acquired deferred revenue resulting from our acquisitions, to eliminate the revenue impact of adopted accounting guidance, to remove: share-based compensation expenses, certain business development and integration expenses, compensation for post combination services resulting from our acquisitions, the amortization of acquired intangible assets, restructuring charges and loss on early extinguishment of debt, net of related income tax effects. Management regularly uses supplemental non-GAAP financial measures internally to understand, manage and evaluate its business and to make operating decisions. These non-GAAP measures are among the primary factors that management uses in planning and forecasting future periods. Management believes these non-GAAP financial measures enhance the reader's overall understanding of NetScout's 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 NetScout plans and measures its 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 against prior periods by enabling investors to consider our operating results on both a GAAP and non-GAAP basis. These non-GAAP measures are not in accordance with GAAP, should not be considered an alternative for measures prepared in accordance with GAAP, 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. 33 -------------------------------------------------------------------------------- Table of Contents The following table reconciles revenue, net income and net income per share on a GAAP and non-GAAP basis for the years ended March 31, 2012, 2011 and 2010 (in thousands): Year Ended March 31, 2012 2011 2010 GAAP revenue $ 308,679 $ 290,540 $ 260,342 Revenue impact of accounting change - (929 ) - Deferred revenue fair value adjustment 312 132 1,317 Non-GAAP revenue $ 308,991 $ 289,743 $ 261,659 GAAP net income $ 32,428 $ 37,265 $ 27,917 Revenue adjustments 312 (797 ) 1,317 Share-based compensation expense 8,702 6,439 5,456 Amortization of acquired intangible assets 6,782 5,887 6,037 Business development and integration expense 4,715 755 - Compensation for post combination services 438 - - Restructuring charges 603 - - Loss on extinguishment of debt 690 - - Income tax adjustments (7,700 ) (4,668 ) (4,868 ) Non-GAAP net income $ 46,970 $ 44,881 $ 35,859 GAAP diluted net income per share $ 0.76 $ 0.87 $ 0.67 Share impact of non-GAAP adjustments identified above 0.34 0.17 0.19 Non-GAAP diluted net income per share $ 1.10 $ 1.04 $ 0.86 Critical Accounting Policies We consider accounting policies related to marketable securities, revenue recognition, valuation of goodwill and acquired intangible assets and share based compensation to be critical in fully understanding and evaluating our financial results. The application of these policies involves significant judgments and estimates by us. Marketable Securities We account for our investments in accordance with authoritative guidance. Under the provisions, we have classified our investments as "available-for-sale" which are carried at fair value based on quoted market prices and associated unrealized gains or losses are recorded as a separate component of stockholders' equity until realized. We consider all highly liquid investments purchased with a maturity of three months or less to be cash equivalents and those with maturities greater than three months are considered to be marketable securities. Cash and cash equivalents typically consist of money market instruments, commercial paper with a maturity of three months or less and cash maintained with various financial institutions. Marketable securities generally consist of U.S. Treasury bills, commercial paper with an original maturity of greater than three months, U.S. government bonds, certificates of deposit, agency bonds, corporate bonds, auction rate securities and municipal bonds. Long-term marketable securities consist of auction rate securities, U.S. Treasury bills, corporate bonds and certificates of deposit. The auction rate securities we hold are all collateralized by student loans with underlying support by the federal government through the Federal Family Education Loan Program (FFELP) and by monoline insurance companies. Auction rate securities typically were stated at par value prior to February 2008 due to liquidity provided through the auction process. While we continue to earn interest on auction rate securities, the failure of these auctions has created illiquidity. As a result, par value no longer approximates the estimated fair value of auction rate securities. A discounted cash flow model was used to determine the estimated fair value of our investments in auction rate securities as of March 31, 2012 and 2011. The assumptions used in preparing the discounted cash flow model include estimates for interest rates, timing and amount of cash flows, a 34 -------------------------------------------------------------------------------- Table of Contents liquidity risk premium and expected holding periods of the investments. Based on this assessment of fair value, as of March 31, 2012 we have recorded a cumulative decline in the fair value of auction rate securities of $190 thousand ($117 thousand net of tax) which was deemed temporary. Assumptions used to value these securities and in determining the temporary nature of this impairment require significant judgment by management. Changes in the assumptions could result in materially different estimates of fair values and the failure of these securities to return to par value or a decision by management to sell these securities at a loss could have a material adverse impact on earnings. Revenue Recognition In October 2009, the FASB amended the accounting standards for revenue recognition to remove tangible products containing software components and non-software components that function together to deliver the product's essential functionality from the scope of industry-specific software revenue recognition guidance. In October 2009, the FASB also amended the accounting standards for multiple deliverable revenue arrangements to: (i) provide updated guidance on how the deliverables in a multiple deliverable arrangement should be separated, and how the consideration should be allocated; (ii) require an entity to allocate arrangement consideration using its best estimate selling price of deliverables if a vendor does not have vendor-specific objective evidence (VSOE) of selling price or third-party evidence (TPE) of selling price; and (iii) eliminate the use of the residual method and require an entity to allocate arrangement consideration using the relative selling price method. We elected to early adopt this accounting guidance at the beginning of our first quarter of fiscal year 2011 on a prospective basis for applicable transactions originating or materially modified after April 1, 2010. The adoption of this guidance did not have a material impact on our financial position or results of operations for the fiscal year ended March 31, 2011. The following reflects our policy for revenue recognition. Product revenue consists of sales of our hardware products (which include required embedded software that works together with the hardware to deliver the hardware's essential functionality), licensing of our software products, and sale of hardware bundled with a software license. Product revenue is recognized upon shipment, provided that evidence of an arrangement exists, title and risk of loss have passed to the customer, fees are fixed or determinable and collection of the related receivable is probable. Because many of our solutions are comprised of both hardware and more than incidental software components, we recognize revenue in accordance with authoritative guidance on both hardware and software revenue recognition. Service revenue consists primarily of fees from customer support agreements, consulting and training. We generally provide software and hardware support as part of product sales. Revenue related to the initial bundled software and hardware support is recognized ratably over the support period. In addition, customers can elect to purchase extended support agreements for periods after the initial software warranty expiration, typically for 12-month periods. Support services generally include rights to unspecified upgrades (when and if available), telephone and internet-based support, updates and bug fixes. Revenue from customer support agreements is recognized ratably over the support period. Reimbursements of out-of-pocket expenditures incurred in connection with providing consulting services are included in services revenue, with the offsetting expense recorded in cost of service revenue. Training services include on-site and classroom training. Training revenues are recognized as the related training services are provided. Generally, our contracts are accounted for individually. However, when contracts are closely interrelated and dependent on each other, it may be necessary to account for two or more contracts as one to reflect the substance of the group of contracts. 35 -------------------------------------------------------------------------------- Table of Contents Multi-element arrangements are concurrent customer purchases of a combination of our product and service offerings that may be delivered at various points in time. For multi-element arrangements comprised only of hardware products and related services, we allocate the total arrangement consideration to the multiple elements based on each element's selling price compared to the total relative selling price of all the elements. Each element's selling price is based on management's best estimate of selling price (BESP) paid by customers based on the element's historical pricing when VSOE or TPE does not exist. We have established BESP for product elements as the average selling price the element was sold for over the past six quarters, whether sold alone or sold as part of a multiple element transaction. Our internal list price for products, reviewed quarterly by senior management, with consideration in regards to changing factors in our technology and in the marketplace, is generated to target the desired gross margin from sales of product after analyzing historical discounting trends. We review sales of the product elements on a quarterly basis and update, when appropriate, BESP for such elements to ensure that it reflects recent pricing experience. We have established VSOE for services related undelivered elements. For multi-element arrangements comprised only of software products and related services, we allocate a portion of the total arrangement consideration to the undelivered elements, primarily support agreements and training, using VSOE of fair value for the undelivered elements. The remaining portion of the total arrangement consideration is allocated to the delivered software, referred to as the residual method. VSOE of fair value of the undelivered elements is based on the price customers pay when the element is sold separately. We review the separate sales of the undelivered elements on a quarterly basis and update, when appropriate, its VSOE of fair value for such elements to ensure that it reflects recent pricing experience. If we cannot objectively determine the VSOE of the fair value of any undelivered software element, we defer revenue until all elements are delivered and services have been performed, or until fair value can objectively be determined for any remaining undelivered elements. For multi-element arrangements comprised of a combination of hardware and software elements, the total arrangement consideration is bifurcated between the hardware and hardware related deliverables and the software and software related deliverables based on the relative selling prices of all deliverables as a group. Then, arrangement consideration for the hardware and hardware-related services is recognized upon delivery or as the related services are provided outlined above and revenue for the software and software-related services is allocated following the residual method and recognized based upon delivery or as the related services are provided. Our product is distributed through our direct sales force and indirect distribution channels through alliances with resellers. Revenue arrangements with resellers are recognized on a sell-in basis; that is, when we deliver the product to the reseller. We record consideration given to a reseller as a reduction of revenue to the extent we have recorded revenue from the reseller. We do not offer contractual rights of return, stock balancing, or price protection to our resellers, and actual product returns from them have been insignificant to date. In addition, we have history of successfully collecting receivables from the resellers. As a result, we do not maintain reserves for reseller product returns. Valuation of Goodwill and Intangible Assets The carrying value of goodwill was $170.4 million and $128.2 million as of March 31, 2012 and 2011, respectively. Goodwill is reviewed for impairment at the enterprise-level at least annually or more frequently when events and circumstances occur indicating that the recorded goodwill may be impaired. During the fiscal year ended March 31, 2012, we adopted authoritative guidance that allows us to utilize a qualitative approach to test goodwill for impairment. This authoritative guidance permits us to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of our reporting units is less than its carrying value. Because NetScout, and its one reporting unit, did not experience any significant adverse changes in its business or reporting structures, we performed the qualitative Step 0 assessment. In performing the qualitative Step 0 assessment, we considered certain events and circumstances specific to the entity as a whole, such as 36 -------------------------------------------------------------------------------- Table of Contents macroeconomic conditions, industry and market considerations, overall financial performance and cost factors when evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. No indicators of impairment were noted as of January 31, 2012. Additionally, the market capitalization of NetScout as a whole significantly exceeded its carrying value. The carrying value of intangible assets was $54.7 million and $47.7 million as of March 31, 2012 and 2011, 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. We amortize intangible assets over their estimated useful lives, except for the acquired tradename which resulted from the Network General acquisition, which has an indefinite life and thus, is not amortized. The carrying value of the indefinite lived tradename is evaluated annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. NetScout completed its annual impairment test of the indefinite lived intangible as of January 31, 2012. As part of the impairment test, the fair value of the asset was compared to its book value, $18.6 million. The indefinite lived intangible asset fair value was estimated using the discounted cash flow method and included assumptions on revenue forecasts earned using the tradename, royalty rate and weighted average cost of capital rate. These estimates were based on historical performance and projections of future revenue and inputs used in current valuations performed for acquisitions made in fiscal year 2012. The resulting fair value of the indefinite lived intangible asset was greater than its carrying value. We have performed a sensitivity analysis and varied each one of the estimated inputs into the impairment test and noted a change in any of the inputs by 20% would not result in the carrying value exceeding the fair value and therefore would not require an impairment charge to be recognized. Share-based Compensation We recognize compensation expense for all share-based payments. Under the fair value recognition provisions, we recognize share-based compensation net of an estimated forfeiture rate and only recognize compensation cost for those shares expected to vest on a straight-line basis over the requisite service period of the award. We are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the share-based compensation expense could be significantly different from what we have recorded in the current period. Based on historical experience, we assumed an annualized forfeiture rate of 0% for awards granted to our directors, and an annualized forfeiture rate of 10% for awards granted to our senior executives and remaining employees. We will record additional expense if the actual forfeitures are lower than estimated and will record a recovery of prior expense if the actual forfeitures are higher than estimated. 37 -------------------------------------------------------------------------------- Table of Contents Results of Operations Comparison of Years Ended March 31, 2012 and 2011 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. No one direct customer or indirect channel partner accounted for more than 10% of our total revenue during fiscal years ended March 31, 2012 and 2011. Fiscal Year Ended March 31, (Dollars in Thousands) 2012 2011 Change % of % of Revenue Revenue $ % Revenue: Product $ 168,141 54 % $ 159,948 55 % $ 8,193 5 % Service 140,538 46 130,592 45 9,946 8 % Total revenue $ 308,679 100 % $ 290,540 100 % $ 18,139 6 % Product. The 5%, or $8.2 million, increase in product revenue was due to a $9.1 million increase in revenue from our service provider sector and a $400 thousand increase in revenue from our enterprise sector. These increases were offset by a $1.3 million decrease in our government sector. Compared to the same period in the prior year, we realized an 11% decrease in units shipped, while the average selling price per unit of our products increased approximately 17%. The increase in average selling price per unit is due to a shift in product mix from our lower priced probes and software to our higher priced Infinistream products. Product revenue related to our acquisitions was $4.1 million during the year ended March 31, 2012. We expect revenue growth to continue to accelerate within the service provider sector as we anticipate further gains due to acceptance of our LTE solution within our large service provider carriers. Service. The 8%, or $9.9 million, increase in service revenue was due to a $10.6 million increase in revenue from maintenance contracts due to increased new maintenance and renewals from a growing support base and an $834 thousand increase in premium support contracts. This was partially offset by a $675 thousand decrease in consulting revenue and a $937 thousand decrease in training revenue mainly due to the one-time recognition of $1.0 million in training revenue during the quarter ended June 30, 2010 from non-refundable expired contracts. Prior to the quarter ended June 30, 2010, we had not been able to demonstrate that we had fulfilled our obligations under these contracts. However, starting with the quarter ended June 30, 2010, we were able to demonstrate that our obligations had been fulfilled. While we will continue to recognize revenue from non-refundable expired contracts, revenue in future quarters from such expired contracts is not expected to be significant. Service revenue related to our acquisitions was $1.4 million during the year ended March 31, 2012. Total product and service revenue from direct and indirect channels are as follows: Fiscal Year Ended March 31, (Dollars in Thousands) 2012 2011 Change % of % of Revenue Revenue $ % Indirect $ 166,483 54 % $ 172,010 59 % $ (5,527 ) (3 %) Direct 142,196 46 118,530 41 23,666 20 % Total revenue $ 308,679 100 % $ 290,540 100 % $ 18,139 6 % 38 -------------------------------------------------------------------------------- Table of Contents The 3%, or $5.5 million, decrease in indirect channel revenue is the result of the decline in sales to government customers, as well as our European service provider and financial customers. Sales to customers outside the United States are export sales 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 20%, or $23.7 million, increase in direct channel revenue is the result of increased domestic revenue from our service provider and financial customers. Total revenue by geography is as follows: Fiscal Year Ended March 31, (Dollars in Thousands) 2012 2011 Change % of % of Revenue Revenue $ % United States $ 230,359 75 % $ 211,711 73 % $ 18,648 9 % International: Europe 32,998 10 37,921 13 (4,923 ) (13 %) Asia 17,637 6 16,260 6 1,377 8 % Rest of the world 27,685 9 24,648 8 3,037 12 % Subtotal international 78,320 25 78,829 27 (509 ) (1 %) Total revenue $ 308,679 100 % $ 290,540 100 % $ 18,139 6 % United States revenues increased 9%, or $18.6 million, as a result of an increase in our service provider and financial sectors. The 1%, or $509 thousand, decrease in international revenue is due to decline in our financial and service provider sectors in Europe. The decline in sales from Europe reflects the impact of economic conditions in the region. 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. 39-------------------------------------------------------------------------------- Table of Contents 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. Fiscal Year Ended March 31, (Dollars in Thousands) 2012 2011 Change % of % of Revenue Revenue $ % Cost of revenue: Product $ 39,271 13 % $ 38,175 13 % $ 1,096 3 % Service 26,401 8 23,186 8 3,215 14 % Total cost of revenue $ 65,672 21 % 61,361 21 % 4,311 7 % Gross profit: Product $ $ 128,870 42 % $ 121,773 42 % 7,097 6 % Product gross profit % 77 % 76 % 1 % Service $ 114,137 37 % 107,406 37 % 6,731 6 % Service gross profit % 81 % 82 % (1 %) Total gross profit $ $ 243,007 $ 229,179 $ 13,828 6 % Total gross profit % 79 % 79 % 0 % Product. The 3%, or $1.1 million, increase in cost of product revenue was primarily due to the 5%, or $8.2 million increase in product revenue for the fiscal year ended March 31, 2012 when compared to the fiscal year ended March 31, 2011. Amortization of software and core technology included as cost of product revenue increased by $671 thousand for the fiscal year ended March 31, 2012. The product gross profit percentage increased by one point to 77% during the fiscal year ended March 31, 2012. This increase was primarily due to lower discounting, offset by the increase in amortization of software and core technology. Average headcount in cost of product revenue was 26 and 29 for the years ended March 31, 2012 and 2011, respectively. Service. The 14%, or $3.2 million, increase in cost of service revenue was primarily due to a $1.9 million increase in employee related expenses resulting from increased headcount to support our growing installed base, a $793 thousand increase in cost of materials used to support customers under service contracts and a $210 thousand increase in allocated overhead costs. The 6%, or $6.7 million, increase in service gross profit corresponds with the 8%, or $9.9 million, increase in service revenue, offset by the 14%, or $3.2 million, increase in cost of services. The service gross profit percentage decreased by one point to 81% for the fiscal year ended March 31, 2012. Average headcount in cost of service revenue was 125 and 115 for the years ended March 31, 2012 and 2011, respectively. Gross profit. Our gross profit increased 6%, or $13.8 million. This increase is attributable to our increase in revenue of 6%, or $18.1 million, offset by a 7%, or $4.3 million, increase in cost of revenue. The gross margin percentage remained flat at 79% during the fiscal year ended March 31, 2012. 40-------------------------------------------------------------------------------- Table of Contents Operating Expenses Fiscal Year Ended March 31, (Dollars in Thousands) 2012 2011 Change % of % of Revenue Revenue $ % Research and development $ 49,478 16 % $ 40,628 14 % $ 8,850 22 % Sales and marketing 109,624 35 105,271 36 4,353 4 % General and administrative 27,488 9 23,308 8 4,180 18 % Amortization of acquired intangible assets 2,131 1 1,907 1 224 12 % Restructuring charges 603 - - - 603 100 % Total operating expenses $ 189,324 61 % $ 171,114 59 % $ 18,210 11 % 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 22%, or $8.9 million, increase in research and development expenses is due to a $4.7 million increase in employee related expenses, due to increased headcount and share-based compensation expenses, a $1.5 million increase in integration costs largely related to the acquisition of Simena, a $987 thousand increase in depreciation, a $438 thousand increase in compensation for post combination services related to the acquisition of Replay, a $404 thousand increase in overhead allocations, a $363 thousand increase in rent and office expense due to the acquisitions of Psytechnics and Replay and a $257 thousand increase in technical supplies. Average headcount in research and development was 291 and 257 for the fiscal years ended March 31, 2012 and 2011, respectively. Sales and marketing. Sales and marketing expenses consist primarily of personnel expenses, including commissions, overhead and other expenses associated with selling activities and marketing programs such as trade shows, seminars, advertising, and new product launch activities. The 4%, or $4.4 million, increase in total sales and marketing expenses was primarily due to a $3.4 million increase in employee related expenses and share-based compensation expenses, an $840 thousand increase in commission expense, an $829 thousand increase in trade show expenses, a $787 thousand increase in travel expenses and a $405 thousand increase in sales meetings. These expenses were partially offset by a $983 thousand decrease in expenses related to the NetScout user conference as this was not held during the year ended March 31, 2012 and a $649 thousand decrease in recruiting costs. Average headcount in sales and marketing was 317 and 312 for the fiscal years ended March 31, 2012 and 2011, 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 18%, or $4.2 million, increase in general and administrative expenses was primarily due to a $2.2 million increase in employee related expenses related to stock-based compensation and incentive compensation, and, a $1.2 million increase in business development costs associated with the acquisitions, a $477 thousand increase in professional services and a $381 thousand increase in consulting fees. Average headcount in general and administrative was 117 and 113 for the fiscal years ended March 31, 2012 and 2011, respectively. Amortization of acquired intangible assets. Amortization of acquired intangible assets consists primarily of amortization of customer relationships related to the acquisitions of Simena, Replay, Psytechnics and Network General. 41-------------------------------------------------------------------------------- Table of Contents Restructuring charges. During the fiscal year ended March 31, 2012, we implemented a plan to restructure parts of our general and administrative organization to centralize operations as well as our international sales organization to better align our resources with forecasted sales opportunities. As a result of the restructuring program, we eliminated 12 positions and recorded $603 thousand of restructuring charges related to severance costs paid to employees. Interest and Other Expense, Net Interest and other expense, net includes interest earned on our cash, cash equivalents, marketable securities and restricted investments, interest expense and other non-operating gains or losses. Fiscal Year Ended March 31, (Dollars in Thousands) 2012 2011 Change % of % of Revenue Revenue $ % Interest and other expense, net $ (2,765 ) (1 %) $ (1,772 ) (1 %) $ (993 ) 56 % The 56%, or $993 thousand, increase in interest and other expense was due to a $690 thousand loss on the extinguishment of debt in connection with the refinancing of our prior credit facility, a $369 thousand increase in a one-time foreign currency transaction expense recorded as a result of the acquisition of Replay, a $256 thousand increase in foreign currency transaction expense and a $253 thousand decrease in interest income due to lower overall market interest rates. These increases to interest and other expense were partially offset by a $686 thousand decrease in interest expense due to a decrease in the interest rate and principal amounts outstanding associated with our debt. During the fiscal years ended March 31, 2012 and 2011, the average interest rates on our term loan were 2.123% and 2.750%, respectively. Income Tax Expense The annual effective tax rate for fiscal year 2012 is 36.3%, compared to an annual effective tax rate of 33.8% for fiscal year 2011. Generally, the annual effective tax rates differ from statutory rates primarily due to the impact of the domestic production activities deduction, differences in tax rates in foreign jurisdictions and federal, foreign and state tax credits. The difference in our effective tax rate compared to the prior year is primarily due to acquisition related items, a lower qualified production activity deduction, tax reserves and differences in tax rates in foreign jurisdictions as compared to the United States. Fiscal Year Ended March 31, (Dollars in Thousands) 2012 2011 Change % of % of Revenue Revenue $ % Income tax expense $ 18,490 6 % $ 19,028 7 % $ (538 ) 3 % Net Income Net income for the fiscal years ended March 31, 2012 and 2011 was as follows: Fiscal Year Ended March 31, (Dollars in Thousands) 2012 2011 Change % of % of Revenue Revenue $ % Net income $ 32,428 11 % $ 37,265 13 % $ (4,837 ) (13 %) The $4.8 million decrease in net income during the fiscal year ended March 31, 2012 was largely attributable to the $18.2 million increase in operating expenses mainly due to increased employee related expenses, incentive compensation and business development costs, a $1.0 million increase in interest and other expenses, net offset by a $13.8 million increase in total gross profit and a $538 thousand decrease in the income tax provision. 42-------------------------------------------------------------------------------- Table of Contents Comparison of Years Ended March 31, 2011 and 2010 Revenue Product revenue consisted of sales of our hardware products and licensing of our software products. Service revenue consisted of customer support agreements, consulting and training. No one direct customer or indirect channel partner accounted for more than 10% of our total revenue during fiscal years ended March 31, 2011 and 2010. Fiscal Year Ended March 31, (Dollars in Thousands) 2011 2010 Change % of % of Revenue Revenue $ % Revenue: Product $ 159,948 55 % $ 142,113 55 % $ 17,835 13 % Service 130,592 45 118,229 45 12,363 10 % Total revenue $ 290,540 100 % $ 260,342 100 % $ 30,198 12 % Product. The 13%, or $17.8 million, increase in product revenue was due to an $11.3 million increase in our enterprise business sector and a $6.5 million increase in our service provider sector. Compared to our previous fiscal year, we realized an increase of approximately 22% in the average selling price per unit of our products offset by a 6% decrease in units shipped. The increase in selling price per unit is due to a shift in product mix towards our higher capacity Infinistream products. The 6% decrease in units shipped was also due to product mix. Service. The 10%, or $12.4 million, increase in service revenue was due in part to a $4.2 million increase in revenue from maintenance contracts due to increased renewals from a growing support base, a $3.9 million increase in revenue from post-contract customer support in connection with product revenue growth, and an $827 thousand increase in other service revenue largely due to on-site revenue. In addition, there was a decline of $1.2 million in purchase accounting adjustments to deferred service revenue associated with our acquisition of Network General. As a result of this acquisition, acquired deferred revenue was reduced to fair value to eliminate selling profit from the contracts that were acquired from Network General. As the fair value adjusted deferred revenue has amortized over time, it comprised a smaller proportion of total maintenance revenue during the fiscal year ended March 31, 2011. Subsequent maintenance renewal contracts are recorded at their full value and thus result in higher recorded revenue. We also recognized $1.7 million in training and consulting revenue during the fiscal year ended March 31, 2011 from non-refundable expired contracts. In prior years, we had not been able to demonstrate that we had fulfilled our obligations. However, starting with the quarter ended June 30, 2010, we were able to demonstrate that our obligations had been fulfilled related to the non-refundable expired contracts. While we will continue to recognize revenue from non-refundable contracts, we do not expect the revenue in future quarters to be significant. Total product and service revenue from direct and indirect channels are as follows: Fiscal Year Ended March 31, (Dollars in Thousands) 2011 2010 Change % of % of Revenue Revenue $ % Indirect $ 172,010 59 % $ 159,379 61 % $ 12,631 8 % Direct 118,530 41 100,963 39 17,567 17 % Total revenue $ 290,540 100 % $ 260,342 100 % $ 30,198 12 % The 8%, or $12.6 million, increase in indirect channel revenue is the result of an increase in international sales. Sales to customers outside the United States are primarily export sales through channel partners, who are generally responsible for distributing our products and providing technical support and service to customers 43 -------------------------------------------------------------------------------- Table of Contents 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 17%, or $17.6 million, increase in direct channel revenue and change in sales mix between direct and indirect is primarily the result of increased domestic revenue from our service provider and enterprise sectors, as well as the $1.2 million reduction in purchase accounting adjustments related to the Network General acquisition which had the effect of increasing revenue. Total revenue by geography is as follows: Fiscal Year Ended March 31, (Dollars in Thousands) 2011 2010 Change % of % of Revenue Revenue $ % United States $ 211,711 73 % $ 189,517 73 % $ 22,194 12 % International: Europe 37,921 13 35,072 14 2,849 8 % Asia 16,260 6 13,694 5 2,566 19 % Rest of the world 24,648 8 22,059 8 2,589 12 % Subtotal international 78,829 27 70,825 27 8,004 11 % Total revenue $ 290,540 100 % $ 260,342 100 % $ 30,198 12 % United States revenues increased 12%, or $22.2 million, as a result of strong growth in our enterprise sector, which includes financial services, and in our service provider sector. The 11%, or $8.0 million, increase in international revenue is also due to growth in both our enterprise and service provider sectors. We expect revenue from sales to customers outside the United States to continue to account for a significant portion of our total revenue in the future. In accordance with United States export control regulations we do not sell or do business with countries subject to economic sanctions and export controls. 44 -------------------------------------------------------------------------------- Table of Contents Cost of Revenue and Gross Profit Cost of product revenue consists primarily of material components, personnel expenses, manuals, packaging materials, overhead and amortization of capitalized software and developed product technology. Cost of service revenue consists primarily of personnel, material, overhead and support costs. Fiscal Year Ended March 31, (Dollars in Thousands) 2011 2010 Change % of % of Revenue Revenue $ % Cost of revenue: Product $ 38,175 13 % $ 35,564 14 % $ 2,611 7 % Service 23,186 8 20,500 8 2,686 13 % Total cost of revenue $ 61,361 21 % 56,064 22 % 5,297 9 % Gross profit: Product $ $ 121,773 42 % $ 106,549 41 % 15,224 14 % Product gross profit % 76 % 75 % 1 % Service $ 107,406 37 % 97,729 38 % 9,677 10 % Service gross profit % 82 % 83 % (1 %) Total gross profit $ $ 229,179 $ 204,278 $ 24,901 12 % Total gross profit % 79 % 78 % 1 % Product. The 7%, or $2.6 million, increase in cost of product revenue was primarily due to the 13%, or $17.8 million increase in product revenue for the fiscal year ended March 31, 2011 when compared to the fiscal year ended March 31, 2010. Our product gross profit percentage increased by one point to 76% during the fiscal year ended March 31, 2011. This increase was primarily due to favorable product mix and improved overhead absorption. Average headcount in cost of product revenue was 29 and 27 for the years ended March 31, 2011 and 2010, respectively. Service. The 13%, or $2.7 million, increase in cost of service revenue was primarily due to a $2.0 million increase in employee related expenses resulting from increased headcount to support our growing installed base as well as increased incentive compensation, a $223 thousand increase in cost of materials used to support customers under service contracts and a $344 thousand increase in travel in our support and consulting groups. The 10%, or $9.7 million, increase in service gross profit corresponds with the 10%, or $12.4 million, increase in service revenue, offset by the 13%, or $2.7 million, increase in cost of services. The service gross profit percentage decreased by one point to 82% for the fiscal year ended March 31, 2011. Average headcount in cost of service revenue was 115 and 105 for the years ended March 31, 2011 and 2010, respectively. Gross profit. Our gross profit increased 12%, or $24.9 million. This increase is attributable to our increase in revenue of 12%, or $30.2 million, offset by a 9%, or $5.3 million, increase in cost of revenue. The net effect of the combined increases in revenue and cost of revenue on gross margin was a one point increase during the fiscal year ended March 31, 2011. 45-------------------------------------------------------------------------------- Table of Contents Operating Expenses Fiscal Year Ended March 31, (Dollars in Thousands) 2011 2010 Change % of % of Revenue Revenue $ % Research and development $ 40,628 14 % $ 36,650 14 % $ 3,978 11 % Sales and marketing 105,271 36 99,059 38 6,212 6 % General and administrative 23,308 8 20,609 8 2,699 13 % Amortization of acquired intangible assets 1,907 1 2,057 1 (150 ) (7 )% Total operating expenses $ 171,114 59 % $ 158,375 61 % $ 12,739 8 % 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 11%, or $4.0 million, increase in research and development expenses is primarily due to increases in incentive compensation and other employee related expenses due to increased headcount associated with continued investment in our service provider and enterprise offerings. In addition, there was a $408 thousand increase due to the capitalization of salaries associated with late stage software development during the fiscal year ended March 31, 2010. Average headcount in research and development was 257 and 238 for the fiscal years ended March 31, 2011 and 2010, respectively. Sales and marketing. Sales and marketing expenses consist primarily of personnel expenses, including commissions, overhead and other expenses associated with selling activities and marketing programs such as trade shows, seminars, advertising, and new product launch activities. The 6%, or $6.2 million, increase in total sales and marketing expenses was primarily due to a $5.0 million increase in employee related expenses resulting from increased headcount tied to new sales territories, a $1.4 million increase in travel expenses tied to increased headcount, marketing events and sales meetings, a $778 thousand increase in recruiting fees, a $750 thousand increase in expenses related to the NetScout user conferences and other sales meetings, a $557 thousand increase in depreciation expense associated with demonstration units and a $195 thousand increase in rent. These were partially offset by a $2.5 million decrease in sales commissions. During the fiscal year ended March 31, 2010, sales commissions were larger due to the impact of unusually high early and multi-year renewal bookings for which expense is recognized when earned. Average headcount in sales and marketing was 312 and 297 for the fiscal years ended March 31, 2011 and 2010, 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 13%, or $2.7 million, increase in general and administrative expenses was primarily due to a $2.0 million increase in incentive compensation and other employee related expenses and a $1.6 million increase in professional services largely due to business development costs. These were partially offset by a $540 thousand decrease in allocated overhead costs due to lower facility costs and depreciation expense, as well as a $341 thousand decrease in consulting costs. Average headcount in general and administrative was 113 and 109 for the fiscal years ended March 31, 2011 and 2010, respectively. Amortization of acquired intangible assets. Amortization of acquired intangible assets consists primarily of amortization of customer relationships related to the acquisition of Network General. 46-------------------------------------------------------------------------------- Table of Contents Interest and Other Expense, Net Interest and other expense, net includes interest earned on our cash, cash equivalents, marketable securities and restricted investments, interest expense and other non-operating gains or losses. Fiscal Year Ended March 31, (Dollars in Thousands) 2011 2010 Change % of % of Revenue Revenue $ % Interest and other expense, net $ (1,772 ) (1 %) $ (2,832 ) (1 %) $ 1,060 37 % The 37%, or $1.1 million, decrease in interest and other expense was primarily due to a $1.0 million decrease in interest expense due to a reduction in the interest rate and principal amounts outstanding associated with our debt. During the fiscal years ended March 31, 2011 and 2010, the average interest rates on our term loan were 2.750% and 3.453%, respectively. Interest income was relatively flat compared to the prior year. Income Tax Expense The annual effective tax rate for fiscal year 2011 is 33.8%, compared to an annual effective tax rate of 35.2% for fiscal year 2010. Generally, the annual effective tax rates differ from statutory rates primarily due to the impact of the domestic production activities deduction, differences in tax rates in foreign jurisdictions and federal and state tax credits. The difference in our effective tax rate compared to the prior year is primarily due to the reinstatement of the federal research and development credit and an increase in our domestic production activities deduction. The federal research and development credit was re-enacted on December 17, 2010 as part of "The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (H.R. 4853)". The impact of this law change was accounted for during the quarter ended December 31, 2010. This act retroactively extends the federal research and development credit to the beginning of calendar year 2010. We have recorded a rate reduction of approximately 1.4% to our annual effective tax rate for fiscal year 2011 attributed to this tax law change. Fiscal Year Ended March 31, (Dollars in Thousands) 2011 2010 Change % of % of Revenue Revenue $ % Income tax expense $ 19,028 7 % $ 15,154 6 % $ 3,874 26 % Net Income Net income for the fiscal years ended March 31, 2011 and 2010 was as follows: Fiscal Year Ended March 31, (Dollars in Thousands) 2011 2010 Change % of % of Revenue Revenue $ % Net income $ 37,265 13 % $ 27,917 11 % $ 9,348 33 % The $9.3 million increase in net income during the fiscal year ended March 31, 2011 was largely attributable to the $24.9 million increase in total gross profit and a $1.0 million decrease in interest expense offset by a $12.7 million increase in operating expenses mainly due to increased employee related expenses and incentive compensation. 47 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations As of March 31, 2012, we had the following contractual obligations: Payment due by period (Dollars in thousands) Less than More than Contractual Obligations Total 1 year 1-3 years 3-5 years 5 years Short and long-term debt obligations(1) $ 66,306 $ 927 $ 1,855 $ 63,524 $ - Unconditional purchase obligations 3,763 3,763 - - - Operating lease obligations(2) 38,893 4,639 7,377 7,520 19,357 Contingent purchase consideration 8,213 2,987 5,226 0 0 Retirement obligations 2,270 510 787 515 458 Total contractual obligations $ 119,445 $ 12,826 $ 15,245 $ 71,559 $ 19,815 As of March 31, 2012, the total amount of net unrecognized tax benefits for uncertain tax positions and the accrual for the related interest was $335 thousand. We are unable to make a reliable estimate when cash settlement, if any, will occur with a tax authority as the timing of examinations and ultimate resolution of those examinations is uncertain. We have also excluded long-term deferred revenue of $18.7 million as such amounts will be recognized as services are provided. (1) Includes estimated future interest at an interest rate of 1.500% for our outstanding term loan at March 31, 2012. (2) We lease facilities and certain equipment under operating lease agreements extending through September 2023 for a total of $38.9 million. Off-Balance Sheet Arrangements We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. Commitment and Contingencies We account for claims and contingencies in accordance with authoritative guidance that requires us to record an estimated loss from a claim or loss contingency when information available prior to issuance of our consolidated financial statements indicates that it is probable that a liability has been incurred at the date of the consolidated financial statements and the amount of the loss can be reasonably estimated. If we determine that it is reasonably possible but not probable that an asset has been impaired or a liability has been incurred or if the amount of a probable loss cannot be reasonably estimated, then in accordance with the authoritative guidance, we disclose the amount or range of estimated loss if the amount or range of estimated loss is material. Accounting for claims and contingencies requires us to use our judgment. We consult with legal counsel on those issues related to litigation and seek input from other experts and advisors with respect to matters in the ordinary course of business. See Note 17 for a discussion of contingencies. We 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 March 31, 2012, the present value of the future consideration was $8.2 million and the contractual non-compliance liability was $700 thousand. 48-------------------------------------------------------------------------------- Table of Contents As disclosed in Item 3, in March 2012, we 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. We believe we did not benefit from any of the transactions uncovered and that the amounts involved are not believed at this time to be material. It is possible that the U.S. Department of Justice and/or the California State Attorney General may conduct an investigation into the matter. We are cooperating fully and intend to provide any requested information if asked. In general, the federal and state agencies have the authority to seek fines and other remedies for anti-trust violations; however, no charges or proceedings have been initiated by any governmental agency against NetScout. We determined that it is probable that there will be amounts due, those amounts are reasonably estimable and have been accrued as an immaterial liability as of March 31, 2012. Backlog Our combined product backlog at March 31, 2012, consisting of unshipped orders and deferred product revenue, was $13.0 million compared to an immaterial amount at March 31, 2011. Due to the fact that most if not all of our customers have the contractual ability to cancel unshipped orders prior to shipment we cannot provide assurance that our product backlog at any point in time will ultimately become revenue. Warranty and Indemnification We warrant that our software and hardware products will substantially conform to the documentation accompanying such products on their original date of shipment. For software, which also includes firmware, the standard warranty commences upon shipment and expires 90 days thereafter. With regard to hardware, the standard warranty commences upon shipment and expires 12 months thereafter. Additionally, this warranty is subject to various exclusions which include, but are not limited to, non-conformance resulting from modifications made to the software or hardware by a party other than NetScout; customers' failure to follow our installation, operation or maintenance instructions; and events outside of our reasonable control. We also warrant that all support services will be performed in a good and workmanlike manner. We believe that our product and support service warranties are consistent with commonly accepted industry standards. No warranty cost information is presented and no warranty costs are accrued since service revenue associated with warranty is deferred at the time of sale and recognized ratably over the warranty period. Contracts that we enter into in the ordinary course of business may contain standard indemnification provisions. Pursuant to these agreements, we may agree to defend third party claims brought against a partner or direct customer claiming infringement of such third party's (i) U.S. patent and/or European Union (EU), or other selected countries' patents, (ii) Berne convention member country copyright, and/or (iii) U.S., EU, and/or other selected countries' trademark or intellectual property rights. Moreover, this indemnity may require us to pay any damages awarded against the partner or direct customer in such type of lawsuit as well as reimburse the partner or direct customer for reasonable attorney's fees incurred by them from the lawsuit. We may also agree from time to time to provide other forms of indemnification to partners or direct customers, such as indemnification that would obligate us to defend and pay any damages awarded to a third party against a partner or direct customer based on a lawsuit alleging that such third party has suffered personal injury or tangible property damage legally determined to have been caused by negligently designed or manufactured products. We have agreed to indemnify our directors and officers and our subsidiaries' directors and officers if they are made a party or are threatened to be made a party to any proceeding (other than an action by or in the right of NetScout) by reason of the fact that the indemnified are an agent of NetScout or by reason of anything done or not done by them in any such capacity. The indemnity is for any and all expenses and liabilities of any type (including but not limited to, judgments, fines and amounts paid in settlement) reasonably incurred by the directors or officers in connection with the investigation, defense, settlement or appeal of such proceeding, provided they acted in good faith. 49-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Substantially all of our cash, cash equivalents and marketable securities are located in the United States. Cash, cash equivalents, and marketable securities consist of the following (in thousands): As of March 31, 2012 2011 2010 Cash and cash equivalents $ 117,255 $ 67,168 $ 63,322 Short-term marketable securities 79,617 133,430 69,875 Long-term marketable securities 16,644 27,880 37,354 Cash, cash equivalents and marketable securities $ 213,516 $ 228,478 $ 170,551 At March 31, 2012, we had a credit facility with a syndicate of lenders led by KeyBank National Association (KeyBank) which provides us 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 matures on November 21, 2016. At March 31, 2012, $62.0 million was outstanding under the credit facility. At our 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 for one-month interest periods, or the Base Rate; or (b) the one-, two-, three-, or six-month per annum London InterBank Offered Rate (LIBOR), as selected by NetScout, 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 our financial statements for the quarter ended December 31, 2011, the applicable margin began to vary depending on our leverage ratio, ranging from 100 basis points for Base Rate loans and 200 basis points for Eurodollar Rate loans if NetScout'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 our consolidated leverage ratio is 1.00 to 1.00 or less. Our consolidated leverage ratio is the ratio of its total funded debt compared to its consolidated adjusted earnings before interest, taxes, depreciation and amortization (EBITDA). Consolidated adjusted EBITDA includes certain adjustments, including, without limitation, adjustments relating to restructuring charges, deferred revenue revaluation, certain non-cash charges not related to such acquisitions, and certain non-cash stock-based expenses, all as set forth in detail in the definition of Consolidated EBITDA in the Credit Agreement. The Credit Agreement provides for payments of interest only during its 5 year term. Interest on Base Rate loans is payable at the end of each calendar quarter. Interest on Eurodollar Rate loans is payable at the end of each interest rate period and at the end of each three-month interval within an interest rate period if the period is longer than three months. We may also prepay loans under the Credit Agreement at any time, without penalty, subject to certain notice requirements. As of March 31, 2012, the interest rate on the term loan was 1.500%, and we expect this to be the rate in effect until April 23, 2012. The loans are guaranteed by each of our domestic subsidiaries and are collateralized by all of our assets and our domestic subsidiaries, as well as 65% of the capital stock of our foreign subsidiaries directly owned by us and our domestic subsidiaries. The Credit Agreement generally prohibits, with certain exceptions, any other liens on the assets of NetScout and our subsidiaries, subject to certain exceptions as described in the Credit Agreement. The Credit Agreement contains certain covenants applicable to us and our subsidiaries, including, without limitation, limitations on additional indebtedness, liens, various fundamental changes (including dispositions of assets and mergers), dividends and distributions, capital expenditures, investments (including acquisitions and investments in foreign subsidiaries), transactions with affiliates, sale-leaseback transactions, hedge agreements, payment of junior financing, changes in business, and other limitations customary in senior secured credit facilities. In addition, we are required to maintain certain consolidated leverage and interest coverage ratios as well as a minimum liquidity amount. As of March 31, 2012, we were in compliance with all covenants. 50 -------------------------------------------------------------------------------- Table of Contents Cash, cash equivalents, and marketable securities decreased by $15.0 million from March 31, 2011 to March 31, 2012. While cash and cash equivalents increased by $50.1 million, short and long-term marketable securities decreased in total by $65.0 million. Our long-term marketable securities include investments in auction rate securities. Beginning in February 2008 and continuing through March 31, 2012, auctions have failed resulting in a lack of short-term liquidity for these securities, which has caused us to classify $1.5 million as long-term on our consolidated balance sheet. The remaining $17.6 million was reported as short-term reflecting redemption notices for certain of our auction rate securities at par value which will occur in June 2012. As of March 31, 2012, our auction rate securities consisted of three positions issued by municipal agencies with a total par value of $19.3 million and a current estimated market value totaling $19.1 million. The auction rate securities held by NetScout at March 31, 2012 have maturity dates ranging from December 2032 through June 2038. As of March 31, 2012, the portion of the securities reported as long-term were all AAA rated. These securities are collateralized by student loans with underlying support by the federal government through the FFELP and by monoline insurance companies. We have the ability and intent to hold these securities until a recovery in the auction process or other liquidity event occurs. The fair value of these securities has been estimated by management based on the assumptions disclosed in the notes to our consolidated financial statements. We will continue to analyze our auction rate securities each reporting period for impairment, and we may be required to record an impairment charge in the consolidated statement of operations if the decline in fair value is determined to be other-than-temporary. The estimated fair value of our auction rate securities could change significantly based on market and economic conditions, including changes in market rates, the estimated timing until a liquidity event, the discount factor associated with illiquidity and the credit ratings of our securities. There is no assurance as to when liquidity will return to this investment class, and therefore, we continue to monitor and evaluate these securities. Based on our expected operating cash flows, and our other sources of cash, we do not expect the lack of liquidity in these investments to affect our ability to execute our current business plan. Cash and cash equivalents were impacted by the following: Year Ending March 31, (Dollars in Thousands) 2012 2011 2010Net cash provided by operating activities $ 68,307 $ 67,189 $ 45,654 Net cash provided by (used in) investing activities $ 9,208 $ (59,964 ) $ (59,505 ) Net cash used in financing activities $ (27,418 ) $ (3,379 ) $ (5,049 ) Net cash provided by operating activities. Net cash provided by operating activities amounted to $68.3 million during the fiscal year ended March 31, 2012. The primary sources of operating cash flow in the fiscal year ended March 31, 2012 included net income of $32.4 million, adjusted to exclude the effects of non-cash items of $31.5 million, including depreciation and amortization, share-based compensation expense, deferred income taxes, loss on extinguishment of debt, loss on disposal of fixed assets, and deal related compensation and accretion charges, a $10.3 million increase in deferred revenue resulting from increased billings and a $1.6 million increase in accrued compensation and other expenses. These increases were offset by a $4.0 million increase in accounts receivable resulting from increased billings. The overall increase in cash provided by operating activities is attributable to net income. Net cash provided by operating activities amounted to $67.2 million during the fiscal year ended March 31, 2011. The primary sources of operating cash flow in the fiscal year ended March 31, 2011 included net income of $37.3 million, adjusted to exclude the effects of non-cash items of $23.9 million, including depreciation and amortization, share-based compensation expense, deferred income taxes and loss on disposal of fixed assets, a $3.4 million increase in accrued compensation resulting from an increase in non-sales incentive compensation and a $2.8 million decrease in accounts receivable resulting from decreased billings. The overall increase in cash provided by operating activities is attributable to net income improvement over the prior year. 51-------------------------------------------------------------------------------- Table of Contents Net cash provided by operating activities amounted to $45.7 million during the fiscal year ended March 31, 2010. The primary sources of operating cash flow in the fiscal year ended March 31, 2010 included net income of $27.9 million, adjusted to exclude the effects of non-cash items of $25.6 million, including depreciation and amortization, share-based compensation expense, deferred income taxes, inventory write-downs and loss on disposal of fixed assets, a $22.3 million increase in deferred revenue resulting from increased billings and a $5.7 million increase in prepaid income taxes, offset by a $25.7 million increase in accounts receivable resulting from increased billings, a $4.0 million decrease in accrued compensation and other expense primarily due to a decrease in non-sales incentive compensation based on Company underperformance in the year ended March 31, 2010. The overall increase in cash provided by operating activities is attributable to net income improvement over the prior year. Net cash provided by (used in) investing activities. For the fiscal years ended March 31, 2012, 2011 and 2010, cash provided by (used in) investing activities reflects the purchase of marketable securities of $117.7 million, $153.9 million and $92.9 million, respectively, offset by the proceeds from maturities and sales of marketable securities due to cash management activities of $184.9 million, $101.1 million and $39.1 million, respectively. The fiscal year ended March 31, 2012 includes the acquisitions of Psytechnics, Replay and Simena for $46.7 million, net of cash acquired in such transactions. The fiscal year ended March 31, 2010 includes $408 thousand in capitalized software development costs. Cash used in investing activities also includes capital expenditures. Capital expenditures for fixed assets of $11.3 million, $7.5 million and $5.2 million for the fiscal years ended March 31, 2012, 2011 and 2010, respectively, represent an investment in our infrastructure as we prepared for future growth. We anticipate that our investment in our infrastructure will grow in future quarters. Net cash used in financing activities. Net cash used in financing activities was $27.4 million during the fiscal year ended March 31, 2012. The primary outflow was due to the repayment of $68.1 million of our long-term debt with KeyBank, $20.6 million for the repurchase of common stock on the open market and an $846 thousand payment related to the Simena contingent consideration. These outflows were offset by net proceeds received from the issuance of long-term debt totaling $60.7 million in connection with the refinancing of the previous credit facility, $965 thousand related to the excess tax benefit from stock options exercised and $473 thousand in proceeds from the issuance of common stock under stock plans. Net cash used in financing activities was $3.4 million during the fiscal year ended March 31, 2011. The primary outflow was due to the repayment of $11.3 million of our long-term debt with KeyBank and $367 thousand for the net issuance of common stock under stock plans, offset by an $8.2 million tax benefit from stock options exercised. Net cash used in financing activities was $5.0 million during the fiscal year ended March 31, 2010. The primary outflow was due to the repayment of $13.1 million of our long-term debt with KeyBank which included a $3.1 million excess cash flow payment, offset by $3.0 million for the net issuance of common stock under stock plans and a tax benefit from stock options exercised of $5.1 million. Liquidity We believe that our cash balances, short-term marketable securities classified as available-for-sale and future cash flows generated by operations will be sufficient to meet our anticipated cash needs for working capital, capital expenditures and scheduled interest payments on our debt for at least the next 12 months. If demand for our product were to decrease substantially, our ability to generate cash flow sufficient for our short-term working capital and expenditure needs could be materially impacted. 52-------------------------------------------------------------------------------- Table of Contents Additionally, a portion of our cash may be used to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies. From time to time, in the ordinary course of business, we evaluate potential acquisitions of such businesses, products or technologies such as our acquisitions of Psytechnics on April 1, 2011, Replay on October 3, 2011 and Simena on November 18, 2011. If our existing sources of liquidity are insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or debt securities. The sale of additional equity or debt securities could result in additional dilution to our stockholders. Recent Accounting Standards In December 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2011-11: Balance Sheet (Topic 210), Disclosures about Offsetting Assets and Liabilities (ASU 2011-11), which requires companies to disclose information about financial instruments that have been offset and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. Companies will be required to provide both net (offset amounts) and gross information in the notes to the financial statements for relevant assets and liabilities that are offset. ASU 2011-11 will be effective for fiscal years, and interim periods within those years, beginning on or after January 1, 2013 (the fourth quarter of fiscal year 2013 for NetScout). The adoption of ASU 2011-11 impacts financial statement presentation only; accordingly, it will have no impact on our financial condition, results of operations, or cash flows. In June 2011, the FASB issued ASU No. 2011-05: Presentation of Comprehensive Income (ASU 2011-05), which requires disclosure of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders' equity. ASU 2011-05 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. In December 2011, the FASB issued ASU 2011-12, Comprehensive Income (Topic 220), that deferred the requirement to separately present within net income reclassification adjustments of items out of accumulated other comprehensive income. NetScout adopted this standard during the first quarter of fiscal year 2013. The adoption of ASU 2011-05 impact financial statement presentation only; accordingly, it will have no impact on our financial condition, results of operations, or cash flows. [ Back To TMCnet.com's Homepage ]