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NETSCOUT SYSTEMS INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(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 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 solutions are intended to help users in various roles to: quickly analyze data, achieve real-time visibility into and intelligence about their organization's operations, identify service delivery issues early, improve service levels, reduce operational costs, mitigate security risks, and drive better business decisions. Our value proposition to our customers is helping them to achieve their objectives regarding return on investments and risk mitigation as they develop their IT infrastructure to support their business needs. Our proactive intelligence and analytics provides our customer with knowledge regarding potential issues before their users are impacted. Our mission is to enable information technology (IT) and service providers to realize maximum benefit with minimal risk from technology advances, like IP convergence, network function virtualization (NFV), software defined networking (SDN), virtualization, cloud, mobility, bring your own device (BYOD), web, and the evolving Internet by managing the inherent complexity in a cost-effective manner. Our Adaptive Session Intelligence (ASI) technology, which we have developed in support of this mission, has the potential of not only expanding our leadership in the network performance management and application performance management (NPM+APM) space, but can also serve as a gateway for future intelligence solutions including cyber and business intelligence. Many of the largest service providers, cloud based businesses, enterprise and government customers rely on us to assure service delivery and the user experience of their customers. Our customers are in just about every vertical market including financials, health care, utilities, Internet, manufacturing, retail, as well as the service providers. We are a market leader in helping service provider's get a return on their 4G/LTE investment by providing them with the intelligence they need about aspects of service delivery from handset performance to user preferences to network speed. 24 -------------------------------------------------------------------------------- Table of Contents 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. During the first quarter of our fiscal year 2014, NetScout announced the release of the nGeniusONE Unified Performance Management platform. The nGeniusONE platform converges application and network performance management functionality into a single unified platform that delivers a top-down, serviced-focused perspective of performance characteristics of all infrastructure and application elements associated with service delivery. This product is based on our unique ASI technology, which provides real-time performance analytics and operational intelligence. Our key objectives have been to continue to gain market share in the wireless service provider market and to accelerate our enterprise growth by extending into the application performance management segment. A common component of both initiatives has been the acceptance of our unified services delivery management strategy. This strategy has been bolstered by our acquisitions and integration of both voice/video and packet flow or monitoring switch technology. During the first quarter of our fiscal year 2014, management performed a review of its summation of revenue by industry. As a result, we changed our method of apportioning revenue to our revenue sectors, and the categorization of certain customers to different sectors. This change in the manner of describing fluctuations by sector will not affect our total net revenues, total product and service revenues, or revenue by geography. Results Overview We saw continued growth during the fiscal year ended March 31, 2014, with product revenue growth of 18% and overall revenue growth of 13% compared to the prior fiscal year. Our diluted net income per share for the fiscal year ended March 31, 2014 were $1.17 per share, representing a $0.21, or 22%, increase over the same period in the prior year. Our business maintained strong gross profit margins. Our gross margin for the fiscal year ended March 31, 2014 remained flat at 79% compared to the same period in the prior year. Our success during the fiscal year ended March 31, 2014 was the result of a few factors. First, within our traditional enterprise customer base, we have continued to create value with the product launch and successful traction of nGeniusONE. During our fiscal year ended March 31, 2014, our product revenue grew 11% in the enterprise sector. Second, we continue to be successful in the service provider market driven by our success in LTE, and Voice over LTE deployments and capturing new services being deployed over these 4G networks. During the fiscal year ended March 31, 2014 our product revenue growth in the service provider sector was 22%. Additionally, in our packet flow switch product line, which complements our packet flow instrumentation product line, we were successful in executing our strategy and gaining market share. The natural integration of packet flow switch technology with our packet flow instrumentation provided unique opportunities and clear differentiation for our customer base. At March 31, 2014, we had cash, cash equivalents and marketable securities of $218.8 million. This represents an increase of $64.7 million over the previous fiscal year ended March 31, 2013. 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 inventory fair value adjustments, expenses related to the amortization of acquired intangible assets, share-based compensation, restructuring, certain expenses relating to acquisitions including compensation for post-combination services and business development charges, net of related income tax effects. Non-GAAP diluted net income per share also excludes these expenses as well as the related impact of all these adjustments on the provision for income taxes. These non-GAAP measures are not in accordance with GAAP, should not be considered an alternative for measures prepared in accordance with GAAP (revenue, net income and diluted net income per share), and may have limitations in that they do not reflect all our results of operations as determined in accordance with GAAP. These non-GAAP measures should 25 -------------------------------------------------------------------------------- Table of Contents 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 years ended March 31, 2014, 2013 and 2012: Year Ended March 31, (Dollars in Thousands, Except per Share Data) 2014 2013 2012 GAAP revenue $ 396,647 $ 350,550 $ 308,679 Deferred revenue fair value adjustment 558 1,215 312 Non-GAAP revenue $ 397,205 $ 351,765 $ 308,991 GAAP net income $ 49,106 $ 40,609 $ 32,428 Revenue adjustments 558 1,215 312 Inventory fair value amortization - 453 - Share-based compensation expense 12,930 9,580 8,702 Amortization of acquired intangible assets 6,765 7,424 6,782 Business development and integration expense 523 1,618 4,715 Compensation for post combination services 2,215 2,721 438 Restructuring charges - 1,065 603 Loss on extinguishment of debt - - 690 Income tax adjustments (7,879 ) (8,671 ) (7,700 ) Non-GAAP net income $ 64,218 $ 56,014 $ 46,970 GAAP diluted net income per share $ 1.17 $ 0.96 $ 0.76 Share impact of non-GAAP adjustments identified above 0.36 0.36 0.34 Non-GAAP diluted net income per share $ 1.53 $ 1.32 $ 1.10 Critical Accounting Policies We consider accounting policies related to marketable securities, revenue recognition, valuation of goodwill, intangible assets and other acquisition accounting items, 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 measure the fair value of our marketable securities at the end of each reporting period. Fair value is defined as the exchange price that would be received for an asset in the principal or most advantageous market for the asset in an orderly transaction between market participants on the measurement date. Marketable securities are recorded at fair value and have been classified as Level 1 or 2 within the fair value hierarchy. Fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in accessible active markets for identical assets or liabilities. Fair values determined by Level 2 inputs utilize data points that are observable such as quoted prices, interest rates and yield curves. 26 -------------------------------------------------------------------------------- Table of Contents Investments and marketable securities are considered to be impaired when a decline in fair value below cost basis is determined to be other-than-temporary. We periodically evaluate whether a decline in fair value below cost basis is other-than-temporary by considering available evidence regarding these investments including, among other factors, the duration of the period that, and extent to which, the fair value is less than cost basis, the financial health of and business outlook for the issuer, including industry and sector performance and operational and financing cash flow factors, overall market conditions and trends and our intent and ability to retain our investment in the security for a period of time sufficient to allow for an anticipated recovery in market value. Once a decline in fair value is determined to be other-than-temporary, a write-down is recorded and a new cost basis in the security is established. Assessing the above factors involves inherent uncertainty. Write-downs, if recorded, could be materially different from the actual market performance of investments and marketable securities in our portfolio if, among other things, relevant information related to our investments and marketable securities was not publicly available or other factors not considered by us would have been relevant to the determination of impairment. 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. Support services generally include rights to unspecified upgrades (when and if available), telephone and internet-based support, updates and bug fixes. 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. 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 third party evidence (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 based on historical stand-alone sales. 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, our 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. 27 -------------------------------------------------------------------------------- Table of Contents 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 a history of successfully collecting receivables from the resellers. As a result, we do not maintain reserves for reseller product returns. Valuation of Goodwill, Intangible Assets and Other Acquisition Accounting Items The carrying value of goodwill was $203.4 million and $202.5 million as of March 31, 2014 and 2013, respectively. We have two reporting units: (1) Unified Service Delivery and (2) Test Automation. Goodwill is tested for impairment at a reporting unit level at least annually, or on an interim basis if an event occurs or circumstances change that would, more likely than not, reduce the fair value of the reporting segment below its carrying value. Because NetScout, and our two reporting units, did not experience any significant adverse changes in our 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 at the reporting unit level, such as 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, 2014. Additionally, the market capitalization of NetScout as a whole significantly exceeded its carrying value. The carrying value of intangible assets was $58.5 million and $63.8 million as of March 31, 2014 and 2013, respectively. Intangible assets acquired in a business combination are recorded under the acquisition method of accounting at their estimated fair values at the date of acquisition. 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. Indefinite-lived intangible assets are tested for impairment at a reporting unit level at least annually, or on an interim basis if an event occurs or circumstances change that would, more likely than not, reduce the fair value of the reporting segment below its carrying value. To test impairment, we first assess qualitative factors to determine whether the existence of events and circumstances indicate that it is more likely than not that the indefinite-lived intangible asset is impaired. If based on our qualitative assessment we conclude that it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount, quantitative impairment testing is required. However, if we conclude otherwise, quantitative impairment testing is not required. We completed our annual impairment test of the indefinite lived intangible as of January 31, 2014 using the qualitative Step 0 assessment described above, which largely mirrors the Unified Service Delivery analysis, as the tradenames apply to a majority of the products and branding within that reporting unit. No impairment indicators were observed as of January 31, 2014. We have acquired five companies during the three year period ended March 31, 2014. The acquisition method of accounting requires that we estimate the fair value of the assets and liabilities acquired as part of these transactions. In order to estimate the fair value of acquired intangible assets we use a relief from royalty model which requires management to estimate: future revenues expected to be generated by the acquired intangible assets, a royalty rate which a market participant would pay related to the projected revenue stream, a present value factor which approximates a risk adjusted rate of return for a market participant purchasing the assets, and a technology migration curve representing a period of time over which the technology assets or some portion thereof are still being used. We are also required to develop the fair value for customer relationships acquired as part of these transactions which requires that we create estimates for the following items: a projection of future revenues associated with the acquired company's existing customers, a turnover rate for those customers, a margin related to those sales, and a risk adjusted rate of return for a market participant purchasing those relationships. The acquisition of Simena LLC on November 18, 2011 also contained contingent consideration based on the ultimate settlement of assets and liabilities acquired as part of transaction, and the former owners' future period of employment with the Company. Contingent consideration accounting requires the Company to estimate the probability of various settlement 28 -------------------------------------------------------------------------------- Table of Contents scenarios, the former owners' expected period of employment with NetScout, and a risk adjusted interest rate to present value to the payment streams. 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. Results of Operations Comparison of Years Ended March 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 fiscal year ended March 31, 2014, one direct customer accounted for more than 10% of total revenue, while no single indirect channel partner accounted for more than 10% of total revenue. During the fiscal year ended March 31, 2013, no single direct customer or indirect channel partner accounted for more than 10% of total revenue. Fiscal Year Ended March 31, (Dollars in Thousands) 2014 2013 Change % of % of Revenue Revenue $ % Revenue: Product $ 234,268 59 % $ 198,749 57 % $ 35,519 18 % Service 162,379 41 151,801 43 10,578 7 % Total revenue $ 396,647 100 % $ 350,550 100 % $ 46,097 13 % Product. The 18%, or $35.5 million, increase in product revenue was primarily due to a $17.9 million increase in revenue from our service provider sector, an $11.0 million increase in revenue from our general enterprise sector and a $6.7 million increase in revenue from our government enterprise sector. Compared to the same period in the prior year, we realized a 16% increase in units shipped and a 7% increase in the average selling price per unit of our products. We expect continued growth in our service provider sector through the fiscal year ending March 31, 2015. We also expect accelerated growth in our general enterprise market for the fiscal year ending March 31, 2015. Service. The 7%, or $10.6 million, increase in service revenue was primarily due to an $8.0 million increase in revenue from new maintenance contracts and renewals from a growing support base and a $3.3 million increase in premium support contracts. These were partially offset by a $443 thousand decrease in consulting revenue. We expect single digit percentage growth in our service revenues. We expect this to be generated by product revenue growth which increases our installed base and therefore our related maintenance contracts. 29 -------------------------------------------------------------------------------- Table of Contents Total product and service revenue from direct and indirect channels are as follows: Fiscal Year Ended March 31, (Dollars in Thousands) 2014 2013 Change % of % of Revenue Revenue $ % Indirect $ 195,484 49 % $ 172,136 49 % $ 23,348 14 % Direct 201,163 51 178,414 51 22,749 13 % Total revenue $ 396,647 100 % $ 350,550 100 % $ 46,097 13 % The 14%, or $23.3 million, increase in indirect channel revenue is the result of the increases in sales to our general enterprise sectors across all geographies. Sales to customers outside the United States are export sales typically through channel partners, who are generally responsible for distributing our products and providing technical support and service to customers within their territories. Our reported international revenue does not include any revenue from sales to customers outside the United States that are shipped to our United States-based indirect channel partners. These domestic resellers fulfill customer orders based upon joint selling efforts in conjunction with our direct sales force and may subsequently ship our products to international locations; however, we report these shipments as United States revenue since we ship the products to a domestic location. The 13%, or $22.7 million, increase in direct revenue is primarily the result of increased domestic revenue from our service provider customers. Total revenue by geography is as follows: Fiscal Year Ended March 31, (Dollars in Thousands) 2014 2013 Change % of % of Revenue Revenue $ % United States $ 303,364 76 % $ 262,020 75 % $ 41,344 16 % International: Europe 45,837 12 42,884 12 2,953 7 % Asia 20,646 5 18,107 5 2,539 14 % Rest of the world 26,800 7 27,539 8 (739 ) (3 )% Subtotal international 93,283 24 88,530 25 4,753 5 % Total revenue $ 396,647 100 % $ 350,550 100 % $ 46,097 13 % United States revenues increased 16%, or $41.3 million, primarily as a result of an increase in our service provider sector. The 5%, or $4.8 million, increase in international revenue is primarily due to an increase in our general enterprise sector in Asia. 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. 30 -------------------------------------------------------------------------------- Table of Contents Cost of Revenue and Gross Profit Cost of product revenue consists primarily of material components, manufacturing personnel expenses, 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) 2014 2013 Change % of % of Revenue Revenue $ % Cost of revenue: Product $ 51,219 13 % $ 45,752 13 % $ 5,467 12 % Service 33,294 8 28,256 8 5,038 18 % Total cost of revenue $ 84,513 21 % $ 74,008 21 % $ 10,505 14 % Gross profit: Product $ $ 183,049 46 % $ 152,997 44 % $ 30,052 20 % Product gross profit % 78 % 77 % 1 % Service $ 129,085 33 % 123,545 35 % 5,540 4 % Service gross profit % 79 % 81 % (2 )% Total gross profit $ $ 312,134 $ 276,542 $ 35,592 13 % Total gross profit % 79 % 79 % - % Product. The 12%, or $5.5 million, increase in cost of product revenue was primarily due to the 18%, or $35.5 million increase in product revenue for the fiscal year ended March 31, 2014 when compared to the fiscal year ended March 31, 2013. In addition, there was a $641 thousand increase in employee related expenses due to increased headcount as well as increased incentive compensation, a $189 thousand increase in depreciation expense, a $154 thousand increase in allocated overhead, and a $152 thousand increase in testing services due to new product introduction for the fiscal year ended March 31, 2014. These were partially offset by a $1.2 million decrease in amortization of intangible assets, a $453 thousand decrease in inventory fair value adjustment related to inventory recorded from the acquisition of ONPATH, and a $169 thousand decrease in obsolescence charges as we did not discontinue or make plans to discontinue, any product during the fiscal year ended March 31, 2014. The product gross profit percentage increased by one percentage point to 78% during the fiscal year ended March 31, 2014 as compared to the same period in the prior year. Average headcount in cost of product revenue was 32 and 29 for the years ended March 31, 2014 and 2013, respectively. Service. The 18%, or $5.0 million, increase in cost of service revenue was primarily due to a $3.5 million increase in employee related expenses resulting in part from increased headcount to support our growing installed base, as well as from increased share-based compensation and increased incentive compensation. In addition, there was a $889 thousand increase in cost of materials used to support customers under service contracts, a $320 thousand increase in software licenses, a $266 thousand increase in travel expenses, and a $200 thousand increase in allocated overhead. These increases were partially offset by a $348 thousand decrease in consulting expenses. The service gross profit percentage decreased by two percentage points to 79% for the fiscal year ended March 31, 2014 when compared to the fiscal year ended March 31, 2013. The 4%, or $5.5 million, increase in service gross profit corresponds with the 7%, or $10.6 million, increase in service revenue, offset by the 18%, or $5.0 million, increase in cost of services. Average headcount in cost of service revenue was 146 and 132 for the years ended March 31, 2014 and 2013, respectively. Gross profit. Our gross profit increased 13%, or $35.6 million. This increase is attributable to our increase in revenue of 13%, or $46.1 million, partially offset by a $10.5 million, or 14%, increase in cost of revenue. The gross margin percentage remained flat at 79% during the fiscal year ended March 31, 2014 when compared to the same period in the prior year. Overall we expect our gross margin percentage to remain relatively flat in future periods with increased sales volumes offset by corresponding increases in product and service costs. 31 -------------------------------------------------------------------------------- Table of Contents Operating Expenses Fiscal Year Ended March 31, (Dollars in Thousands) 2014 2013 Change % of % of Revenue Revenue $ % Research and development $ 70,454 18 % $ 61,546 18 % $ 8,908 14 % Sales and marketing 129,611 32 116,807 33 12,804 11 % General and administrative 30,623 8 29,718 8 905 3 % Amortization of acquired intangible assets 3,432 1 2,877 1 555 19 % Restructuring charges - - 1,065 - (1,065 ) (100 )% Total operating expenses $ 234,120 59 % $ 212,013 60 % $ 22,107 10 % 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 14%, or $8.9 million, increase in research and development expenses is due to a $6.4 million increase in employee related expenses resulting in part from increased headcount as well as from increased share-based compensation and increased incentive compensation, an $818 thousand increase in non-recurring engineering expenses, an $804 thousand increase in depreciation expense, a $493 thousand increase in temporary hire expenses, a $358 thousand increase in travel expense, a $285 thousand increase in software licenses, a $222 thousand increase in computer supplies and a $183 thousand increase in research and development supplies. These expenses were partially offset by a $728 thousand decrease in deal related compensation related to the acquisition of Simena and a $197 thousand decrease in meeting expenses. Average headcount in research and development was 352 and 338 for the fiscal years ended March 31, 2014 and 2013, 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 11%, or $12.8 million, increase in total sales and marketing expenses was due to $6.0 million increase in employee related expenses resulting in part from increased headcount as well as from increased share-based compensation and increased incentive compensation, a $5.1 million increase in commissions due to an increase in higher quota attainment and special incentive programs related to the nGeniusOne product introduction during the fiscal year ended March 31, 2014 as compared to the fiscal year ended March 31, 2013. In addition, there was a $957 thousand increase in trade show expenses, a $916 thousand increase in travel expenses, a $437 thousand increase in marketing related expenses, a $295 thousand increase allocated overhead, a $292 thousand increase related to the NetScout user conference, and a $180 thousand increase in consulting expenses. These expenses were partially offset by a $524 thousand decrease in recruitment expenses, a $495 thousand decrease in depreciation expense, a $352 thousand decrease in sales meeting expenses, a $326 thousand decrease in temporary help, and a $298 thousand decrease in employee training expenses. Average headcount in sales and marketing was 358 and 340 for the fiscal years ended March 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 3%, or $905 thousand, increase in general and administrative expenses was due to a $1.7 million increase in employee related expenses as a result of increased headcount as well as from increased share-based compensation and increased incentive compensation, a $282 thousand increase in tax and accounting related services, a $169 thousand increase in office expenses, a $153 thousand increase in compensation for post combination services, and a $122 thousand increase in expenses for software licenses. These increases were partially offset by a $1.1 million decrease in business development expenses, and a $294 thousand decrease in bad debt expense. Average headcount in general and administrative was 118 and 115 for the fiscal years ended March 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, Accanto, Simena, Replay, Psytechnics and Network General Central Corporation (Network General). 32 -------------------------------------------------------------------------------- Table of Contents The 19%, or $555 thousand, increase in amortization of acquired intangible assets is due to the increase of expense recorded related to the acquisitions of ONPATH and Accanto. Restructuring charges. During the fiscal year ended March 31, 2013, we restructured part of our international sales organization related to an overlap of personnel acquired as part of the Accanto acquisition. As a result, we recorded $1.2 million of restructuring charges during the fiscal year ended March 31, 2013 related to severance costs. Overall, in future periods we expect our operating margin to remain consistent with historical ranges. Interest and Other Expense, Net Interest and other expense, net includes interest earned on our cash, cash equivalents and marketable securities, interest expense and other non-operating gains or losses. Fiscal Year Ended March 31, (Dollars in Thousands) 2014 2013 Change % of % of Revenue Revenue $ % Interest and other expense, net $ (158 ) - % $ (793 ) - % $ 635 80 % The 80%, or $635 thousand, decrease in interest and other income (expense), net was primarily due to a $523 thousand decrease in interest expense due to the repayment of our outstanding debt during the fiscal year ended March 31, 2013, as well as a $315 thousand decrease in foreign currency exchange expense. These decreases to interest and other expense, net were partially offset by a $199 thousand decrease in interest income received on investments. Income Tax Expense The annual effective tax rate for fiscal year 2014 is 36.9%, compared to an annual effective tax rate of 36.3% for fiscal year 2013. Generally, the annual effective tax rates differ from statutory rates primarily due to the impact of the domestic production activities deduction, the impact of state taxes, and federal, foreign and state tax credits. Our effective tax rate for the fiscal year ended March 31, 2014 is higher than the comparable prior year period primarily due to the exclusion of certain foreign losses for which a benefit cannot be realized, offset by decreases to the state tax rate and income generated in jurisdictions that have a lower tax rate than the statutory U.S. rate. Fiscal Year Ended March 31, (Dollars in Thousands) 2014 2013 Change % of % of Revenue Revenue $ % Income tax expense $ 28,750 7 % $ 23,127 7 % $ 5,623 24 % 33-------------------------------------------------------------------------------- Table of Contents Comparison of Years Ended March 31, 2013 and 2012 Revenue Product revenue consists of sales of our hardware products and licensing of our software products. Service revenue consists of customer support agreements, consulting and training. No single direct customer or indirect channel partner accounted for more than 10% of our total revenue during the fiscal years ended March 31, 2013 and 2012. Fiscal Year Ended March 31, (Dollars in Thousands) 2013 2012 Change % of % of Revenue Revenue $ % Revenue: Product $ 198,749 57 % $ 168,141 54 % $ 30,608 18 % Service 151,801 43 140,538 46 11,263 8 % Total revenue $ 350,550 100 % $ 308,679 100 % $ 41,871 14 % Product. The 18%, or $30.6 million, increase in product revenue was due to a $19.4 million increase in revenue from our general enterprise sector and an $18.8 million increase in our service provider sector. These increases were offset by a $7.6 million decrease in our government enterprise sector. Compared to the same period in the prior year, we realized a 7% increase in units shipped and a 6% increase in the average selling price per unit of our products. The increase in average selling price is due to product mix. Service. The 8%, or $11.3 million, increase in service revenue was due to a $10.8 million increase in revenue from maintenance contracts due to increased new maintenance contracts and renewals from a growing support base and a $1.7 million increase in premium support contracts. These were offset by a $1.3 million decrease in consulting revenue. Total product and service revenue from direct and indirect channels are as follows: Fiscal Year Ended March 31, (Dollars in Thousands) 2013 2012 Change % of % of Revenue Revenue $ % Indirect $ 172,136 49 % $ 166,483 54 % $ 5,653 3 % Direct 178,414 51 % 142,196 46 % 36,218 25 % Total revenue $ 350,550 100 % $ 308,679 100 % $ 41,871 14 % The 3%, or $5.7 million, increase in indirect channel revenue is the result of the increase in sales in Europe to our service provider customers. 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 25%, or $36.2 million, increase in direct revenue is the result of increased domestic revenue from our service provider and domestic general enterprise customers. 34 -------------------------------------------------------------------------------- Table of Contents Total revenue by geography is as follows: Fiscal Year Ended March 31, (Dollars in Thousands) 2013 2012 Change % of % of Revenue Revenue $ % United States $ 262,020 75 % $ 230,359 75 % $ 31,661 14 % International: Europe 42,884 12 32,998 10 9,886 30 % Asia 18,107 5 17,637 6 470 3 % Rest of the world 27,539 8 27,685 9 (146 ) (1 )% Subtotal international 88,530 25 78,320 25 10,210 13 % Total revenue $ 350,550 100 % $ 308,679 100 % $ 41,871 14 % United States revenues increased 14%, or $31.7 million, as a result of an increase in our service provider and general enterprise sectors. The 13%, or $10.2 million, increase in international revenue is primarily due to an increase in our service provider sector in Europe as well as our general enterprise sector throughout the world. We expect revenue from sales to customers outside the United States to continue to account for a significant portion of our total revenue in the future. In accordance with United States export control regulations we do not sell to, or do business with, countries subject to economic sanctions and export controls. Cost of Revenue and Gross Profit Cost of product revenue consists primarily of material components, manufacturing personnel expenses, manuals, packaging materials, overhead and amortization of capitalized software, acquired software and core technology. Cost of service revenue consists primarily of personnel, material, overhead and support costs. Fiscal Year Ended March 31, (Dollars in Thousands) 2013 2012 Change % of % of Revenue Revenue $ % Cost of revenue: Product $ 45,752 13 % $ 39,271 13 % $ 6,481 17 % Service 28,256 8 26,401 8 1,855 7 % Total cost of revenue $ 74,008 21 % 65,672 21 % 8,336 13 % Gross profit: Product $ $ 152,997 44 % $ 128,870 42 % 24,127 19 % Product gross profit % 77 % 77 % - % Service $ 123,545 35 % 114,137 37 % 9,408 8 % Service gross profit % 81 % 81 % - % Total gross profit $ $ 276,542 $ 243,007 $ 33,535 14 % Total gross profit % 79 % 79 % - % Product. The 17%, or $6.5 million, increase in cost of product revenue was primarily due to the 18%, or $30.6 million increase in product revenue for the fiscal year ended March 31, 2013 when compared to the fiscal year ended March 31, 2012. In addition, there was a $453 thousand increase due to the amortization of a fair value adjustment related to inventory recorded from the acquisition of ONPATH. The product gross profit percentage remained flat at 77% during the fiscal year ended March 31, 2013 as compared to the same period in the prior year. Average headcount in cost of product revenue was 29 and 26 for the years ended March 31, 2013 and 2012, respectively. 35-------------------------------------------------------------------------------- Table of Contents Service. The 7%, or $1.9 million, increase in cost of service revenue was primarily due to a $1.7 million increase in employee related expenses resulting from increased headcount to support our growing installed base as well as increased incentive compensation. The 8%, or $9.4 million, increase in service gross profit corresponds with the 8%, or $11.3 million, increase in service revenue, offset by the 7%, or $1.9 million, increase in cost of services. The service gross profit percentage remained flat at 81% for the fiscal year ended March 31, 2013 when compared to the same period in the prior year. Average headcount in cost of service revenue was 132 and 125 for the years ended March 31, 2013 and 2012, respectively. Gross profit. Our gross profit increased 14%, or $33.5 million. This increase is attributable to our increase in revenue of 14%, or $41.9 million, offset by a $8.3 million, or 13%, increase in cost of revenue. The gross margin percentage remained flat at 79% during the fiscal year ended March 31, 2013 when compared to the same period in the prior year. Operating Expenses Fiscal Year Ended March 31, (Dollars in Thousands) 2013 2012 Change % of % of Revenue Revenue $ % Research and development $ 61,546 18 % $ 49,478 16 % $ 12,068 24 % Sales and marketing 116,807 33 109,624 35 7,183 7 % General and administrative 29,718 8 27,488 9 2,230 8 % Amortization of acquired intangible assets 2,877 1 2,131 1 746 35 % Restructuring charges 1,065 - 603 - 462 77 % Total operating expenses $ 212,013 60 % $ 189,324 61 % $ 22,689 12 % 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 24%, or $12.1 million, increase in research and development expenses is due to a $9.0 million increase in employee related expenses due to increased headcount and incentive compensation, a $1.2 million increase in compensation for post combination services related to the acquisitions of Simena, Replay and ONPATH, a $536 thousand increase in consulting costs, a $495 thousand increase in travel expenses, a $443 thousand increase in allocated overhead, a $417 thousand increase in rent expense, a $333 thousand increase in depreciation and a $259 thousand increase in meeting expenses. These were offset by a $1.5 million decrease in business development expenses. Average headcount in research and development was 338 and 291 for the fiscal years ended March 31, 2013 and 2012, 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 7%, or $7.2 million, increase in total sales and marketing expenses was due to a $2.3 million increase in employee related expenses due to increased headcount, a $1.6 million increase in marketing related expenses, a $1.1 million increase in sales meeting costs, a $1.0 million increase in depreciation expense, a $891 thousand increase in expenses related to the NetScout user conference as this was not held during the fiscal year ended March 31, 2012, a $581 thousand increase in recruitment and a $534 thousand increase in employee training. Average headcount in sales and marketing was 340 and 317 for the fiscal years ended March 31, 2013 and 2012, 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 8%, or $2.2 million, increase in general and administrative expenses was due to a $1.4 million increase in employee related expenses related to an increase in incentive compensation, a $973 thousand increase in deal related compensation associated with acquisitions and a $971 thousand increase in software license expenses. These expenses were offset by an $853 thousand decrease in business development costs associated with acquisitions. Average headcount in general and administrative was 115 and 117 for the fiscal years ended March 31, 2013 and 2012, respectively. 36 -------------------------------------------------------------------------------- Table of Contents Amortization of acquired intangible assets. Amortization of acquired intangible assets consists primarily of amortization of customer relationships related to the acquisitions of ONPATH, Accanto, Simena, Replay, Psytechnics and Network General. The 35%, or $746 thousand, increase in amortization of acquired intangible assets is due to the increase of expense recorded related to the acquisitions of ONPATH, Accanto, Simena and Replay. The amortization related to the acquisitions ONPATH and Accanto were not recorded during the prior fiscal year ended March 31, 2012 as the acquisitions have occurred within the past twelve months. In addition, there were increases related to the acquisitions of Simena and Replay during the fiscal year ended March 31, 2013 as compared to the prior fiscal year primarily related to recording an entire year of amortization in the current year. Restructuring charges. During the fiscal year ended March 31, 2013, we restructured part of our international sales organization related to an overlap of personnel acquired as part of the Accanto acquisition. As a result, we recorded $1.2 million of restructuring charges during the fiscal year ended March 31, 2013 related to severance costs. 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) 2013 2012 Change % of % of Revenue Revenue $ % Interest and other expense, net $ (793 ) - % $ (2,765 ) (1 )% $ 1,972 71 % The 71%, or $2.0 million, decrease in interest and other income (expense), net was due to a $690 thousand decrease related to the loss on extinguishment of debt in connection with the refinancing of our previous credit facility during the fiscal year ended March 31, 2012, a $718 thousand decrease in foreign currency transaction expense, a $475 thousand decrease in interest expense due to a decrease in the interest rate as well as the payment of our outstanding debt during the fiscal year ended March 31, 2013. In addition, there was an $89 thousand increase in interest income. Income Tax Expense The annual effective tax rate for fiscal year 2013 is 36.3%, compared to an annual effective tax rate of 36.3% for fiscal year 2012. Generally, the annual effective tax rates differ from statutory rates primarily due to the impact of the domestic production activities deduction, the impact of state taxes, and federal, foreign and state tax credits. Fiscal Year Ended March 31, (Dollars in Thousands) 2013 2012 Change % of % of Revenue Revenue $ % Income tax expense $ 23,127 7 % $ 18,490 6 % $ 4,637 25 % Contractual Obligations As of March 31, 2014, we had the following contractual obligations: Payment due by period (Dollars in thousands) Less than 1 More than Contractual Obligations Total year 1-3 years 3-5 years 5 years Unconditional purchase obligations $ 6,912 $ 6,912 $ - $ - $ - Operating lease obligations (1) 34,166 5,797 10,080 6,961 11,328 Contingent purchase consideration 4,291 - - 4,291 - Retirement obligations 1,604 233 441 456 474 Total contractual obligations $ 46,973 $ 12,942 $ 10,521 $ 11,708 $ 11,802 37-------------------------------------------------------------------------------- Table of Contents As of March 31, 2014, the total amount of net unrecognized tax benefits for uncertain tax positions and the accrual for the related interest was $502 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 $24.6 million as such amounts will be recognized as services are provided. (1) We lease facilities and certain equipment under operating lease agreements extending through September 2023 for a total of $34.2 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, 2014, the present value of the future consideration was $4.3 million and the contractual non-compliance liability was $49 thousand. 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 38 -------------------------------------------------------------------------------- Table of Contents 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. 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: As of March 31, (Dollars in Thousands) 2014 2013 2012 Cash and cash equivalents $ 102,076 $ 99,930 $ 117,255 Short-term marketable securities 75,234 37,338 79,617 Long-term marketable securities 41,484 16,823 16,644 Cash, cash equivalents and marketable securities $ 218,794 $ 154,091 $ 213,516 Cash, cash equivalents and marketable securities At March 31, 2014 cash, cash equivalents and marketable securities totaled $218.8 million, up $64.7 million from $154.1 million at March 31, 2013 due primarily to cash flow from operations of $110.9 million, partially offset by $34.3 million of cash used to repurchase shares of our common stock and $13.1 million of cash used for capital expenditures. Substantially all of our cash, cash equivalents and marketable securities are located in the United States. At March 31, 2014, cash and short-term and long-term investments in the United States was $217.1 million, while cash held offshore was approximately $1.7 million. Cash and cash equivalents were impacted by the following: Year Ending March 31, (Dollars in Thousands) 2014 2013 2012Net cash provided by operating activities $ 110,946 $ 95,412 $ 68,307 Net cash (used in) provided by investing activities $ (76,581 ) $ (21,742 ) $ 9,208 Net cash used in financing activities $ (31,963 ) $ (91,004 ) $ (27,418 ) Net cash provided by operating activities. Fiscal year 2014 compared to fiscal year 2013 Cash provided by operating activities was $110.9 million during the fiscal year ended March 31, 2014, compared to $95.4 million of cash provided by operating activities in the fiscal year ended March 31, 2013. This $15.5 million increase was due in part to accounts receivable, which had a favorable impact in the fiscal year ended March 31, 2014 as compared to the fiscal year ended March 31, 2013. Accounts receivable days sales outstanding was 47 days at March 31, 2014 compared to 68 days at March 31, 2013. In addition, there was an $8.5 million increase in profitability, a $5.3 million favorable impact from deferred revenue due to increased sales of our products, a $3.8 million increase from accounts payable, a $3.3 million increase from share-based compensation, a $1.3 million increase from deferred income taxes and a $563 thousand increase from income taxes payable. These increases were offset by an $8.2 million decrease as a result of an increase in inventory balances to support increases in sales volume, an $8.2 million decrease from prepaid expenses and other assets largely due to a $5.6 million increase from prepaid income taxes and $1.2 million from an increase in prepaid royalties, and a $4.0 million decrease from accrued compensation and other expenses during the fiscal year ended March 31, 2014 when compared to the fiscal year ended March 31, 2013 largely due to the timing of accruals and payments for incentive compensation as a result of an increase in the payout for fiscal year 2013 incentive compensation during the fiscal year ended March 31, 2014 as compared to the payout for the fiscal year 2012 during the fiscal year ended March 31, 2013, as well as severance activities related to restructuring. Fiscal year 2013 compared to fiscal year 2012 Cash provided by operating activities was $95.4 million during the fiscal year ended March 31, 2013, compared to $68.3 million of cash provided by operating activities in the fiscal year ended March 31, 2012. This $27.1 million increase was due to 39 -------------------------------------------------------------------------------- Table of Contents a $9.1 million increase from accrued compensation and other expenses during the fiscal year ended March 31, 2013 when compared to the fiscal year ended March 31, 2012 largely due to the timing of accruals for incentive compensation as a result of achieving performance-based targets during fiscal year 2013 while such targets were not achieved during fiscal year 2012, accruals for the employee stock purchase plan which began in March 2012, as well as accrued commissions. In addition, there was an $8.2 million increase in profitability, a $6.3 million favorable impact from prepaid expenses and other assets largely due $6.0 million favorable impact from a decrease in prepaid income taxes, a $4.1 million favorable impact from accounts receivable in the fiscal year ended March 31, 2013 as compared to the fiscal year ended March 31, 2012 and a $2.3 million increase as a result of a decrease in inventories. These were offset by a $2.7 million unfavorable impact from deferred revenue. Accounts receivable days sales outstanding was 68 days at March 31, 2013 compared to 70 days at March 31, 2012. Net cash (used in) provided by investing activities. Year Ending March 31, (Dollars in Thousands) 2014 2013 2012 Cash (used in) provided by investment activities included the following: Purchase of marketable securities $ (128,122 ) $ (121,133 ) $ (117,682 ) Proceeds from maturity of marketable securities 65,570 163,416 184,899 Purchase of fixed assets (13,066 ) (11,671 ) (11,088 ) Purchase of intangible assets (1,086 ) (277 ) (200 ) Acquisition of businesses, net of cash acquired - (51,273 ) (46,721 ) Increase in deposits 123 (804 ) - $ (76,581 ) $ (21,742 ) $ 9,208 Cash used in investing activities increased by $54.8 million to $76.6 million during the fiscal year ended March 31, 2014, compared to $21.7 million of cash used in investing activities during the fiscal year ended March 31, 2013. Cash used for investing activities was $21.7 million during the fiscal year ended March 31, 2013, compared to $9.2 million of cash provided by investing activities during the fiscal year ended March 31, 2012. During the fiscal years ended March 31, 2013 and 2012, we paid $51.3 million and $46.7 million for acquisitions, respectively. Net cash flow relating to the purchase and sales of marketable securities was down $104.8 million during the fiscal year ended March 31, 2014 when compared to the fiscal year ended March 31, 2013 as we invested our operating cash flow in securities as opposed to funding acquisitions. Net inflow relating to the purchase and sales of marketable securities was down $24.9 million during the fiscal year ended March 31, 2013 when compared to the fiscal year ended March 31, 2012 relating to the amount of investments held at each balance sheet date. In addition, during the fiscal year ended March 31, 2013, redemptions by the issuers for our remaining auction rate securities totaling $19.3 million were settled. As a result of the settlements, we reversed the remaining valuation reserve of $190 thousand. We held no investments in auction rate securities at March 31, 2014 and March 31, 2013. Our investments in property and equipment consist primarily of computer equipment, demonstration units, office equipment and facility improvements. We plan to continue to invest in capital expenditures to support our infrastructure in our fiscal year 2015. Purchases of intangible assets increased by $809 thousand during the fiscal year ended March 31, 2014 compared to the fiscal year ended March 31, 2013. During the fiscal year ended March 31, 2014, we acquired certain rights to Accanto software for $500 thousand not previously purchased as part of the acquisition transaction in fiscal year 2013. In addition, we made an agreement to acquire a technology license for $300 thousand. 40 -------------------------------------------------------------------------------- Table of Contents Net cash used in financing activities. Year Ending March 31, (Dollars in Thousands) 2014 2013 2012 Cash used in financing activities included the following: Issuance of common stock under stock plans $ 812 $ 575 $ 473 Payment of contingent consideration (841 ) (4,038 ) (846 ) Treasury stock repurchases (34,322 ) (27,448 ) (20,595 ) Proceeds from issuance of long-term debt, net of issuance costs - - 60,691 Repayment of long-term debt - (62,000 ) (68,106 ) Excess tax benefit from share-based compensation awards 2,388 1,907 965 $ (31,963 ) $ (91,004 ) $ (27,418 ) Cash used in financing activities was down $59.0 million to $32.0 million during the fiscal year ended March 31, 2014, compared to $91.0 million of cash used in financing activities during the fiscal year ended March 31, 2013. During the fiscal year ended March 31, 2013, we paid down our outstanding credit facility in the amount of $62.0 million. As of March 31, 2014, there were no amounts outstanding under this credit facility. During the fiscal year ended March 31, 2012, we repaid $7.4 million under the terms of our previous credit facility. During the fiscal years ended March 31, 2014, 2013 and 2012, we paid $841 thousand, $4.0 million and $846 thousand, respectively, related to the contingent purchase consideration related to the acquisition of Simena. Our Board of Directors has periodically authorized us to repurchase shares of our common stock. We are currently authorized to repurchase up to four million shares with cash from operations. We repurchased 1,000,407 shares for $28.8 million, 999,499 shares for $23.5 million and 1,270,000 shares for $16.2 million under this program during the fiscal years ended March 31, 2014, 2013 and 2012, respectively. On April 22, 2014, Netscout'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. In addition, in connection with the vesting and release of the restriction on previously vested shares of restricted stock units, the Company repurchased 216,198 shares for $5.5 million, 169,531 for $3.9 million and 216,882 shares for $4.4 million related to minimum statutory tax withholding requirements on these restricted stock units during the fiscal years ended March 31, 2014, 2013 and 2012. Future repurchases of shares will reduce our cash balances. We generated $2.4 million, $1.9 million and $965 thousand during the fiscal years ended March 31, 2014, 2013 and 2012, respectively, of excess tax benefits from share-based compensation awards. Credit Facility On November 22, 2011, we entered into 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, 2014 there were no amounts outstanding under the credit facility. Expectations for Fiscal Year 2015 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 and capital expenditures for at least the next 12 months. In addition, we expect that cash provided by operating activities will continue to increase due to an expected increase in cash collections related to anticipated higher revenues, partially offset by an anticipated increase in operating expenses that require cash outlays such as salaries and commissions. Capital expenditures in our fiscal year 2015 are currently anticipated to be in line with previous years' trend. 41 -------------------------------------------------------------------------------- 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. 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 We have reviewed and considered recent accounting pronouncements through Accounting Standards Update 2014-07 and believe there are none that could potentially have a material impact on our financial condition, results of operations or cash flows. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Credit Risk. Our cash equivalents and marketable securities consist primarily of money market instruments, U.S. Treasury bills, certificates of deposit, commercial paper, corporate bonds and municipal obligations. At March 31, 2014 and periodically throughout the year, we have maintained cash balances in various operating accounts in excess of federally insured limits. We limit the amount of credit exposure with any one financial institution by evaluating the creditworthiness of the financial institutions with which we invest. Foreign Currency Exchange Risk. As a result of our foreign operations, we face exposure to movements in foreign currency exchange rates, primarily the Euro, British Pound, Canadian Dollar and Indian Rupee. The current exposures arise primarily from expenses denominated in foreign currencies. NetScout currently engages in foreign currency hedging activities in order to limit these exposures. We do not use derivative financial instruments for speculative trading purposes. As of March 31, 2014, we had foreign currency forward contracts with notional amounts totaling $17.5 million. The valuation of outstanding foreign currency forward contracts at March 31, 2014 resulted in a liability balance of $139 thousand, reflecting unfavorable contract rates in comparison to current market rates at this date and an asset balance of $368 thousand reflecting favorable rates in comparison to current market rates. As of March 31, 2013, we had foreign currency forward contracts with notional amounts totaling $17.1 million. The valuation of outstanding foreign currency forward contracts at March 31, 2013 resulted in a liability balance of $249 thousand, reflecting unfavorable contract rates in comparison to current market rates at this date and an asset balance of $71 thousand reflecting favorable rates in comparison to current market rates. 42 -------------------------------------------------------------------------------- Table of Contents |