Oct 24, 2008
Executives
David Sommers - Chief Financial Officer Michael Szabados - Chief Operating Officer Cathy Taylor - Director of Investor Relations
Analysts
Aron Honig - Canaccord Adams Eric Martinuzzi - Craig-Hallum Peter Jacobson - Brean Murray, Carret & Co. Alex Kurtz – Merriman Curhan Ford & Co.
Scott Zeller - Needham & Company Sanjit Singh – Wedbush Morgan Securities Manuel Recarey – Kaufman Brothers LP Jonathan Ruykhaver – ThinkPanmure LLC
Operator
Ladies and gentlemen, thank you for standing by and welcome to NetScout’s second quarter fiscal year 2009 operating results conference call. At this time, all participants are in a listen only mode.
Later, we will conduct a question and answer session. Instructions will be given to you at that time.
As a reminder, this conference call is being recorded. With us today is NetScout’s Chief Financial Officer, Mr.
David Sommers; Chief Operating Officer, Mr. Michael Szabados; and Director of Investor Relations, Ms Cathy Taylor.
At this time, I would like to turn the call over to Ms. Taylor to provide the opening remarks.
Ms. Taylor, please proceed.
Cathy Taylor
Thank you and good afternoon everyone. Welcome to NetScout’s second quarter fiscal year 2009 conference call for the period ended September 30th.
In terms of the format of this call, David will begin with an overview of our financial and operating results, and will then discussed our financial results and Company performance in detail. At the conclusion, David and Michael will take your questions.
Before we begin, however, let me remind you that during the course of this conference call, we will be providing you with a discussion of the factors we currently anticipate that may influence our results going forward. Such statements are forward-looking statements made pursuant to the Safe Harbor Provisions of Section 21-E of the Securities Exchange Act of 1934 and other federal securities laws.
These forward-looking statements may involve judgment and that individual judgments may vary. Forward-looking statements include expressed or implied statements regarding future economic and market conditions, our guidance for fiscal year 2009, and our product integration plans.
It should be clearly understood that the projections on which we base our guidance and other forward-looking statements and perception of the factors influencing those projections are highly likely to change over time. Although those projections and the factors influencing them will likely change, we will not necessarily inform you when they do.
Our Company policy is to provide guidance only at certain points in the year, such as during the quarterly earnings call. We do not plan to otherwise update that guidance.
Actual results may differ materially from what we say today and no one should assume later in the quarter that the comments we make today are still valid. For the further discussion of the risks and uncertainties that could cause our actual results to differ with specific risks and uncertainties discussed in NetScout’s Form 10-K for the year ended March 31, 2008 on file with the Securities and Exchange Commission.
I will now turn the call over to David Sommers, our Chief Financial Officer.
David Sommers
Thanks, Cathy and good afternoon everyone. This afternoon we have a slightly different format because Anil Singhal, our Chief Executive Officer is ill with flu.
We wish him a speedy recovery. In his place, I will cover prepared remarks and during the Q&A both Michael and I will take your questions.
We are pleased to be reporting very strong results in the second quarter. These results are consistent with the preliminary results included with our earlier announcement reaffirming our full year guidance.
The quarter was strong in the face of growing turmoil in the financial markets, which was beginning to cause a slowdown in the global economy. GAAP revenues were $68.9 million, up 14% sequentially, and up 133% year-over-year.
Non-GAAP revenues were $73 million, up 12% sequentially, and the year-over-year increased of 147%. These, of course, is our third full quarter combined financial results following the merger with Network General.
Non-GAAP revenue excludes the effect of purchase accounting adjustments, representing the fair value of Network General’s deferred revenue. The GAAP profit for the quarter was $4.9 million or earnings per diluted share of $0.12.
On a Non-GAAP basis, net income was $99.3 million or $0.23 per diluted share. Non-GAAP net income excludes share based compensation expenses, amortization of acquired intangible assets, and integration expenses and related income tax adjustments.
Product revenue more than doubled year-over-year, up 13% sequentially on a GAAP basis and up 17% sequentially on a non-GAAP basis. We also saw service revenue up strongly year-over-year, upset 174% GAAP and on a non-GAAP basis up 200% year-over-year.
We had a high concentration of business coming from the government and wireless carrier markets. Despite the broad macroeconomic pressures, business is still strong.
We are delighted to be entering our third quarter with solid visibility to gives us great confidence that we will achieve our guidance for the remainder of our fiscal 2009 year. Notwithstanding the strong quarter, we remain cautious about the economic impact in calendar 2009 on our banking and enterprise customers.
And as a result, we are not raising our outlook for the fiscal year and we are reaffirming our previously issued revenue guidance. Entering the second half of the year, we continue to see good business from the majority of our vertical segments with particular strength again in government and wireless.
As expected, we are seeing some slowing of orders from investment banks within the financial services sector. However, this has been offset with strong orders coming from our high speed trading and exchange customers.
The cause of the economic uncertainty, we are in the process of reviewing and resetting our future expense plans to focus incremental investments on direct revenue producing functions. Looking beyond the current downturn, we are bullish about our prospects.
We believe we have built a strong foundation underscored by the successful acquisition integration of Network General that makes us leaders within the network performance and availability market. We are in the strong financial position with continuing strong cash flow and increasing operating margins, which have given us the confidence to raise are long term operating margin target range, which I will discuss further in a few moments.
Our customers continued to show a strong enthusiasm for our products as evidenced by our continued growth in product revenue. A couple of weeks ago we hosted our Seventh User Summit Conference in San Diego and saw our record increased in attendance of 62% over last year.
Customers came from 18 countries around the world with many former Network General Customers meeting our engineering and management teams for the first time. At the Summit, we showcased our newly release integrated n-Genius Performance Manager and n-Genius InfiniStream software and the InfiniStream continuous capture Deep Packet Inspection appliances, which are key parts of our post acquisition product inversion plan.
Customers saw a product demonstrations received training, learned about our partnerships and collaborated with our engineers and executives. It was a highly energized and successful event for us and our customers.
All of this positive momentum supports the confidence we have in the strength of our market position. Our post acquisition customer based, new product initiatives and growing market leadership combined with our financial strength, position us better, than many other companies in our space to take advantage of the continuing shift for the highly performance sensitive modern IT network, and to continue to gain shares through any business downturn.
Despite any deterioration in the economy, we will continue to invest in our customer relationships and to broaden our product portfolio with next evolution products for monitoring applications and services. We are extending our solutions to address other areas of IT management, which include expanded offerings for some of our vertical markets, as well as extending our value proposition to other areas of IT operations, and we continue to meet our internal projections.
Our confidence and our ability to outperform the market in fiscal 2010 are high. And now, I would like to focus more specifically on our second quarter results.
Our quarterly results are contained in the financial statements, which are part of our earnings press release. We are reporting a result on a GAAP basis as well as on a non-GAAP basis.
To summarize the difference, we have removed the GAAP purchase accounting effects of the merger with Network General, by adding back revenue related to deferred revenue revaluation and we have removed the cost and expense of various acquisition-related items. In addition, we have removed the GAAP effects of stock-based compensation, which increased significantly as a result of the acquisition.
I will give you the specifics about the difference between our GAAP and non-GAAP earnings as I discuss our results. The adjustments to GAAP revenue cost and expense are disclosed in the reconciliation table in the financial tables attached in to the press release.
We believe these adjusted financial measures will enhance our overall understanding of our current financial performance and our prospects for the future. We use these adjusted financial measures internally for the purpose of analyzing, managing, and forecasting our business.
Now, our second quarter GAAP revenue was $68.9 million. Our non-GAAP revenue was $73 million.
Non-GAAP revenue excludes of $4.1 million of purchase accounting adjustment to recorded fair value the acquired Network General deferred revenue. Product revenue on a GAAP basis was $39.5 million, up 109% year-over-year and 13% sequentially.
Service revenue on a GAAP basis was $29.3 million, up 174% year-over-year and an increase of 14% sequentially. Of course, second quarter results from a year ago do not include contributions from Network General’s business and are therefore not fully comparable to the current second quarter.
GAAP net income for the quarter was $4.9 million or earnings per diluted share of $0.12. GAAP net after tax margin was 7%.
GAAP income from operations was $9.1 million and GAAP operating margin was 13%. Non-GAAP income operations were $16.2 million and operating margin non-GAAP was 22%.
The following items totaling $7.1 million are adjustments to arrive at non-GAAP operating income. The purchase accounting adjustment to record at fair value the acquired Network General deferred revenue of $4.1 million was added back.
Amortization of acquired intangible assets of $1.5 million, which was principally from the Network General acquisition, was removed from GAAP cost and expense. Non-recurring integration expense of not only $266,000 was removed from GAAP expenses as was share-based compensation expense of $1.2 million.
Non-GAAP net income was $9.3 million or $0.23 per diluted share. Non-GAAP after tax margin was 13%.
We have used the statutory tax rate of 38% to tax effect the $7.1 million total non-GAAP adjustment amount, removing $2.7 million from non-GAAP tax expense. The non-GAAP adjustments to our GAAP results are summarized in the reconciliation table included with our press release financials.
The provision for income taxes represents an effective tax rate of 35% on a GAAP basis and 37% on a non-GAAP basis. The non-GAAP tax expense rate is calculated by taking the previously calculated GAAP rate of 35% and tax effecting the non-GAAP adjustments, as I said at a 38%, resulting in an overall non-GAAP rate of 37%.
Our GAAP gross profit for the quarter was $51.5 million. GAAP gross margin was 75% in the quarter.
On a non-GAAP basis, gross profit was $56.8 million, and non-GAAP gross margin was 78%. We made the following adjustments to non-GAAP gross profit.
The same $4.1 million was added back to revenue and we removed $81,000 of share-based compensation expense and $995,000 of amortization of acquired intangible assets and $39,000 on non-recurring integration expense. Non-GAAP operating margin of 22 points was a record high course in the post.com bubble era.
It is the results of our steady margin expansion over the last six years, which we have achieved through organic and acquired revenue growth combined with diligent cost and expense manager. In the second quarter, that same combination of revenue growth plus non-revenue related expense containment drove operating margin up to three points to the low end of our revised operating margin target range.
That operating margin target range is a non-GAAP measure of the financial performance that we believe we can achieve in the future. At the point, when our resource growth across the Company must begin to grow in parallel with our revenue growth.
With our Q2 results, we are approaching that new range. The new non-GAAP range has a gross margin of 76% to 79%, R&D expense to revenue of 13% to 15%, sales and marketing expense to revenue of 33% to 35%, and G&A expense to revenue with 68%, yielding an operating margin range of 22% to 25%.
So our Q2 non-GAAP results with an operating margin of 22 points, is at the low end of the range. We expect that the revenue level required to achieve our target operating margin would grow slowly over time when inflation pushes our cost and expense levels higher.
However, our Q2 revenue of $73 million is currently the revenue threshold of that operating margin target range. The cost of our historically strength in the operating performance, our balance sheet remains strong.
Cash in short term marketable securities. Short and long term marketable securities were $109.4 million compared to $109.8 million in the previous quarter.
Our long term marketable securities include investments and auction rate securities valued currently at $31.5 million. As of September 30, 2008, the value of these securities includes the temporary decline in value of $2.3 million below par to reflect current liquidity concerns.
All of these securities are double or triple aggregated, government guaranteed, student loan backed securities, which we believe have no credit issues only short term liquidity problems. We classified these securities as long term on our balance sheet and recorded a temporary decline in value to other accumulated, other comprehensive income and loss on the balance sheet.
With our strong cash position and positive cash flow, the illiquidity of these securities causes no liquidity problems for us, and we believe we will achieve liquidity well before the maturity of the underlying bonds and our temporary value adjustment reflects that outlook. Accounts receivable net of allowances were $26 million flat with the last quarter.
Day sales outstanding were 33 days for the quarter based on a GAAP on GAAP revenue. This is down from 39 days on the prior quarter.
Using non-GAAP revenue DSO were 30 to 31 days. Our DSO of 31 days is the result of a strong collections resulting from beneficial shipment and invoicing pattern during the quarter, and seasonally low maintenance renewals.
We do not expect that this level of DSO is sustainable. Our expected DSO range is 40 to 50 days.
Inventories were $7.3 million, down from $12.6 million in the prior quarter. The $5.3 million decline is principally the result of recognizing revenue on a large $14 million multi-quarter sale to a wireless carrier customer that had been recorded in deferred revenue as we have mentioned previously.
And, with the inventory has been reduced by the product cost that was previously carried in inventory for that differed revenue. Turning to other metrics, revenue contribution from direct customers was 52% and reseller revenue was 48% total.
The strength of our direct channel business was driven this quarter in large part by the large wireless carrier deal that I just mentioned. Revenue from international sales was 22% of total down from 24% last quarter.
Europe, Middle East, and Africa were 12 points, Asia at 5 points of the total. America outside the United States was five points.
The main drivers of international business outside the United States were wireless service provider and financial services. Summarizing large deals that we have booked in the quarter, 140 customers gave us orders over $100,000, up from $116,000 in the first quarter.
Twenty customers were over $500,000 and seven orders over a $1 million. Three of the million dollar orders came from financial services companies including two deals from investment banks, and one from a large credit card company.
Three came from the government and $1 million deal came from a large computer manufacturer. In the future we expect to see some softening of deals coming from investment bank which we anticipate will be offset to some degree from exchanged and high speed trading customers.
We expect government and wireless carrier business to remain healthy over the near term. Vertical markets this quarter, once again, we have strong bookings coming financial services sector with 28% of dollar order volume.
The Government sector was up with 23% and telecommunications was 13. High tech sector represented 10% and health and medical follow on with 7.
As of September 30th, product back log orders totaled $23 million. This quarter we consider this product backlog firm and material to the understanding of our financial results and guidance.
And now for that guidance. We are reaffirming our revenue outlook for 2009 fiscal year which remains unchanged from last quarter.
Our revenue guidance for fiscal 2009 recognizes the challenging economic environment and its potential impact on IT spending. For fiscal 2009, we expect GAAP revenue to be in that range of 250 to 260 million dollars and non-GAAP revenue to be in the range of 260 to 270 million.
GAAP net income for diluted share guidance is $0.19 to $0.29; this is an upward adjustment, recognizing the strength of our GAAP EPS results through the first half. Non-GAAP earnings per diluted share guidance are still $0.55 to $0.65.
The fiscal year 2009 non-GAAP revenue net income per share estimate, exclude purchase accounting adjustments to fair value of approximately $11.3 million of network generals differed revenue, Amortization required intangibles of approximately $6 million, Integration expenses are approximately $1.8 million, and share based compensation expense of $4.8 million. That concludes our prepared discussion this afternoon thank you for joining us and we look forward to taking your questions.
Please go ahead Britney.
Operator
(Operator Instruction) Your first question comes from the line of Aron Honig. Your line is open.
Aron Honig - Canaccord Adams
I know that there new integrated product only have been out for a little while. But, how is the reception been and maybe will you expect, in terms of revenue, over the next couple quarters in that product?
Michael Szabados
The product has been out for couple of months through that for the product release, software release. That is the availability of the combined features that to the combined customers set.
And the usual exception was very positive as demonstrated by the reaction and objective feedback we received from the San Diego User Forum Show. In terms of its impact on our revenues, we factored it into our forecast and we believe that it continues to assume product demand, but there is no significant difference that tries to skip item or any other material difference other than this has been expected and deliver to the customer based, basically as expected on time.
David Sommers
Yes, the delivery was on time and was part of our projections which we are continuing to make. So it has met, as Michael said, it has met our expectation in terms of enthusiasm.
But, do not expect to any inflection point and revenue because of it.
Aron Honig - Canaccord Adams
Were there any changes in the buying patterns for your customer, I know you talked about investments banks. Were there any other changes in the quarter?
David Sommers
Well, we have seen a continued interest, growing interest from Telco’s and we have seen actually some increased interest from trading and exchange. Now, the interesting thing within the financial services sector, which we have in the past sort of talked about as a unity, is that it is now dynamics within that sector changing dramatically.
Investment banks obviously are very troubled. And, some of our large customers, like Lehman obviously are disappearing to be reemerged pieces of them in other places.
But, what was going on over the market with extremely high volatility and volume is that trading is doing very well. So, trading and exchange customers in our financial service sector are actually picking up, which is an interesting dynamic in this time.
And we have seen, we have the good uptake from government customers at the end of the government fiscal year and we believe, at least as far as we can see that that we expect that trend to continue.
Aron Honig - Canaccord Adams
How about cash flow from operations, could you guys provide that?.
David Sommers
We will, give me one second. If you want we can go to the next question then we will dig it out, then we will give it to you.
Aron Honig - Canaccord Adams
How about an update on the HP relationship?
David Sommers
Nothing new to report on HP. HP, as they have in past years, participated in our User Forum in San Diego and our customers that our customers of the joint of their products and ours.
We were very exited and encouraged about the relationship, but from a Netscape business point of view. There is nothing new to report.
Michael anything?
Michael Szabados
It continuous study that recognize the strong relationship of buyer customers between these two companies. And occasionally, we engage into excelling activities with HP.
Basically, at a steady level.
David Sommers
Okay, we will comeback on the cash flow from ops as soon as we dig it out.
Operator
Your next question comes from the line of Eric Martinuzzi - Craig-Hallum.
Eric Martinuzzi - Craig-Hallum
You comment in the prepared remarks on resetting future expense plan. I was wondering if you could elaborate on that a little bit.
What is the opportunity that you see, and how do you expect to go about getting it?
David Sommers
Well, it is early days, I think the thing Eric that characterizes the market going forward is the unusual degree of variability of possible future outcomes, uncertainty. In the face of that, although we are confident in the near term future, the second half of fiscal 2009, we are concerned about long term, medium term future.
What is going to happen in fiscal 2010, and start to happen toward the end of this fiscal year? So, we were just prudently reexamining our current investment plans to make sure that we are investing in things that are going to be, in the short term, immediately effect revenue.
And those things that may be longer term investments we are reconsidering, nothing more than that.
Eric Martinuzzi - Craig-Hallum
To me it does not sound like anything more than your normal annual planning process, there is some times –
David Sommers
It is sort of like that, except we were starting a little early. And we were going to do it and watch it more frequently, because of the potential volatility of the marketing markets in the future.
Eric Martinuzzi - Craig-Hallum
And then, on the balance sheet cash on $109 million there and you got the debt somewhat offsetting that of $97 million. What, you get options because of the positive net balance there between debt pay down, acquisition, share repurchases, what is management’s opinion right now as far as its uses of cash?
David Sommers
Well, we were protecting our options obviously, that is why we are carrying the debt four strategic uses. As you know, we have a buy back in the past, it is currently not active.
We have done acquisitions and having the cash balance gives us the ability to, perhaps do something in the future. So, those two things are both on the board responsibilities, nothing to report, nothing on the acquisition front that was otherwise would set so clearly.
And in the event that neither of those growths driving, EPS growth driving investments appear to be the best use of cash, then we will end up paying down the debt. When we took on the debt facility almost a year ago, we have anticipated their ability to pay it down much sooner than the five year term.
And of course, our performance since then in our cash flow and cash balance growth since then has worn out our ability to do that. So, in the event we can not find something more strategically valuable we will take it on the debt.
I do now have the upper cash flow from operations number that Aaron asked about that is $2 million for the quarter.
Eric Martinuzzi - Craig-Hallum
And this is Eric again, do you have a CapEx for the quarter?
David Sommers
Last quarter I have that right at my fingertips for you Eric but it is a little further away at the moment but I will have it for you in about two minutes
Eric Martinuzzi - Craig-Hallum
Okay, that covers it for me, thanks.
Operator
The next question comes from Peter Jacobson - Brean Murray, Carret & Co.
Peter Jacobson - Brean Murray, Carret & Co.
Thanks, you mentioned the exchange and high speed trading environment being favorably impacted due to market volatility. Can you just explain that a little bit more?
How does market volatility translate into NetScout revenue?
David Sommers
Well, it is not quite a direct link but I wish it were. So, volatility and the opportunity for momentary profit arbitrage and program trading, algorithmic trading is really what drive much of exchange in high-speed trading volume.
Some of our high-speed trading customers are relatively new companies that have build up high-speed trading operations outside of this typical investment banks in order to provide lightning speed execution and those people find, because of their proprietary high-speed platforms that this kind of environment actually favors them and drives business to them so as their volume grows and their revenue grows, they look to expand their competitive advantage, extend their competitive advantage by building even faster or higher speed larger capacity infrastructures and when they do that then obviously that translates into business for us. CME is one of our customers we have talked about in the past and you may have seen that when the Fed I think it was talked about trying to establish a market in the credit fall swaps that have been so illiquid and troublesome, they went to, among other players, to CME to say-“could you establish our market?”
Well, that is the kind of thing that is happening in this, one of the element or illustrations of things that are happening in this market whether the CME gets that business or establishes the market or not is not the point. The point is that there is a growing trading business that our solutions help support.
Peter Jacobson - Brean Murray, Carret & Co.
Can you say what percentage or financial services that is roughly?
David Sommers
We do not split it down that way. We do not cut the bologna slices quite that fine.
We might start to in the future because I recognize the validity of the question which just does not have that at the moment. We will take it under advisement.
By the way, for Eric, CapEx is $1.9 million for Q2.
Peter Jacobson - Brean Murray, Carret & Co.
Okay and David, a follow up question, last quarter you did I believe 18% non GAAP operating margin achieving your at the time target of the high teens and I believe that you said on the last earnings call do not look for that to happen in the upcoming quarter or so even though you alluded to revisiting that target, that high teens operating margin target. Am I correct that you were not anticipating such a bump up in the subsequent quarter and if so, what is the change?
David Sommers
Okay, good question. When we talked about achieving, when I talked about achieving the high teens and that was within our range and do not expect that to continue sequentially going forward, it was not although it sounds like I did not communicate that clearly referring it to the second quarter.
We knew at the time that the second quarter was likely to be as good or maybe better in terms of operating margin. However, I think if you look now at our maintenance of full year guidance in the face of a very strong pretty good Q1 and a very strong Q2, you will see that operating margins going forward are in fact not going to remain in the coming sequential quarters as high as 22.
It is as simple as in the non GAAP basis adding $65 million and $73 million and getting a $138 million and comparing that to the top end of the non GAAP guidance of $270 and seeing the second half revenue is going to be lower than the first half at the top end of our guidance and even lower than that at the low end of our guidance. So, and that is as we said along reflective of our concern about what was going on in financial services and it is now spreading to the enterprise, we believe.
So, it was really with that somewhat longer term view, nothing really happened in the second quarter that was one of the great surprise that the issue with the second quarter revenue was of course that large revenue recognition that we came in one with what I mentioned that it sort of pushed our second quarter revenue up a little higher than the normal secular rate we would have otherwise.
Peter Jacobson - Brean Murray, Carret & Co.
Okay, thanks and then my final question is for Michael. Now, that Network General is no longer your most common head-to-head competitor, who are the next one or two companies that you are mostly running into competitively and can you just summarize just briefly how the product roadmap addresses differentiating yourself from competitors?
Michael Szabados
Yes, so the next deal of competitors is basically are in the range of 20% of one size and I would say that probably three competitors that belong in this field likely one is [Net QS] and other one is Fluke and other one is Electric Instruments. These three companies competed with different strategies individually that, I guess, all of these companies are fundamental value but differential value proposition is an integrated workflow through the problem management process utilizing a full complement of data derived from packet information, packet-flow platform and this data set comprises of KPIs which does not have deviation for the key performance indicators through data which is our traditional flow business from the broad base and then the packet data that is designing in InfiniStream recording storage and so on minding this set of data into a consistent problem management process and supporting multiple constituencies in operations as work and application management operations in IP gives us a much bigger footprint and a much bigger impact on our users service insurance effectiveness.
I think that larger set of features and more integrated set of features that any of these competitors.
Peter Jacobson - Brean Murray, Carret & Co.
Okay that is helpful and maybe we will do some follow up on that continue that conversation. Thank you very much.
Operator
Your next question comes from Alex Kurtz – Merriman Curhan Ford & Co.
Alex Kurtz – Merriman Curhan Ford & Co.
David, back to the question about revenue distribution during the fiscal year '09 and how that really is offering margin EPS and just sort of looking at you guys in the first half and just sort of looking at what you guys in the first half, it looks like you did close to 21% operating margin for the first half and if I met the high end of your revenue and EPS range for non GAAP and the operating margin in the mid teens, is there so much fixed cost in your sales infrastructure that you cannot dial things down even though you expect lower revenues in the back half?
David Sommers
So, first of all without endorsing exactly your view of our full year, I t doesn’t mean we are not endorsing it either but without endorsing it…
Alex Kurtz – Merriman Curhan Ford & Co.
It is political season, okay, Dave.
David Sommers
Thank you. I feel strongly about that both ways, yes.
We do have some ability to scale back and that is what we have indicated that we are going to be looking at. We are uncertain about the exact direction of the future.
We have some strong trends going on in our business that are obviously counter to the weak ones but we have a history as NetScout of protecting the core asset base which is mostly our people as well as our intellectual property for future growth and if you look back, I have been here eight years and we have been through a period in which we did that within service very well. It has gotten us to where we are.
So, we will be judicious about that. We are looking for the medium or long term in the event that we do have to cut back costs and expenses to make sure that we do not cutoff our ability to take advantage of the strength of our position in the market, to extend our competitive advantage and drive market share gains.
So, it is a balance and that is I think the way we are going to approach it.
Alex Kurtz – Merriman Curhan Ford & Co.
Okay and looking at that one large order that came off at deferred revenue this quarter why something else like that cannot happen in the second half here? You just do not see it happening as far as being able to recognize revenue from December to March?
David Sommers
Well, so it is unusual for us to have deferred product revenue of that size on our balance sheet, unusual. It is probably not strong enough.
It is unique for us to have that and I think we have talked in the past about some of the reasons why, what happens when that, what drives that is when we have a customer who wants the product but because of specific requirements and we usually do not engage in these kinds of discussions with customers but if there are specific requirement and this happens sometimes in Telco space that this one was where the customer says, "I really need that but I want your product now," we will ship an invoice of the current product and they will pay us and then when we deliver the enhanced functionality, it is revenue. We do it on rare occasions.
It usually, it almost never before has been of that size. So, we expect to have significant Telco business insignificant lumps probably not $14 million lumps but significant lumps going forward and you will see that but it probably will not come out a deferred revenue although it might.
Alex Kurtz – Merriman Curhan Ford & Co.
Okay, so let me just run through a couple of quick questions. You are saying that enterprise is starting to weaken.
I heard a little bit of that. I never consider that a large portion of your business as straight enterprise.
David Sommers
It is not at this point. It used to be but it is not significant portion anymore.
You will notice that when we talk about healthcare, you could call that perhaps enterprise but in high tech but that is in relatively small portions and then there is all other which includes a lot of enterprise. So, we have not really seen yet the typical lengthening of approval cycles and more signatures and that sort of thing as a drumbeat coming back from the sales force in the enterprise space but I think it would be, we are anticipating that that is likely to happen because of the broader economic impacts which will affect our enterprise customers.
Alex Kurtz – Merriman Curhan Ford & Co.
And just coming back to Peter's question about the investment banks as a percentage of totals financial. I know you do not have the exact figure but would you say it is maybe half of that 28%?
David Sommers
I really do not know. As I sit here, it is probably not that big in this quarter, probably not.
Alex Kurtz – Merriman Curhan Ford & Co.
Okay and just finally, you continue to note strength in wireless and government; can you give us a sense of the bookings strength in month of October from those guys and how they can give you the sort of the visibility and confidence about maintaining your guidance here? Thanks.
David Sommers
Sure, well we have some bookings that we made in October. I cannot really tell you about them because we have not really accounted them all up and we are not ready to report them but what we have seen flowing in from ready to book or already booked since the end of September is part of the visibility that we have going forward in addition to the backlog that we discussed.
So, and all the sectors that I mentioned are among them, the three that I mentioned, high-speed trading and exchange is one; wireless carriers and government, those three. So, we have seen bookings, order flow from those areas in Q3 2008.
Operator
Your next question comes from Scott Zeller - Needham & Company.
Scott Zeller - Needham & Company
The backlog number of $23 million, could you tell us roughly how that compares to recent quarters?
David Sommers
Yes, the product backlog number is slightly higher than in recent quarters. You should be aware though that product backlog is not the only element of our in hand product revenue not yet declared.
We just discussed a large revenue transaction that we recognized in the September quarter that came off the balance sheet, deferred product revenue. So, if you include deferred product revenue as well as the product backlog which we have disclosed that total is less now that it was in June and when we talked in the past about our visibility week to all of that as well as our view of our pipeline.
Scott Zeller - Needham & Company
Is that $23 million all to be recognized in the December quarter?
David Sommers
When we booked, the short answer is, yes we think so.
Scott Zeller - Needham & Company
Okay.
David Sommers
When we book product orders it is because they are ready to shipped and recognized as revenue and if we do not ship them yet by the end of the quarter then they are put in the backlog. So, anything that is in backlog should be ready to be recognized as revenue on ship and accepted by the customer there as acceptance.
Scott Zeller - Needham & Company
Okay and then just to go back to your comments, David about the target operating model, I know there is a question earlier, I got a little lost honestly, you made the point of the $73 million revenue run rate which we are now at but yet, I was not clear on how far away you think you will be running the business in that model would be.
David Sommers
Well, that is because I did not say so it was not clear on purpose. Not to obfuscate but because the purpose, the nature as I tried to explain but obviously not well, the nature of this operating model target is to say that when we reach that level, it is our current judgment that that level of operating margin, 22 to 25, it is our judgment that we will have to grow operating expense in parallel than with revenue and gross margin so that therefore there will be no longer any margin expansion unless there is some discontinuity in the business going again in the future.
So, we do not think at 22, we are quite at that level yet because it is the low end of the range and if there is room, therefore we would say as we grow revenue to still do that up at the infrastructure base, human infrastructure base principally that we have in place but as we start to hit 25 at whatever revenue level that occurs, 25% operating margin, then we will have to start to step up the growth of operating expenses in order to continue to drive the growth in revenue. So, was that helpful?
Scott Zeller - Needham & Company
Yes, last question, just to clarify, I know we have dealing with the issue of what is happening in deal cycles but could you clearly state just for us at this point in time now what the team is currently seeing because there is a lot of innuendo about what may come and what people are fearing but could you tell us clearly what exactly the status now with the team in the field and what they are hearing and is there a slowdown?
David Sommers
Well, it is uneven. So, we just did not able to process as we do it at the beginning of every quarter going through our pipeline scrubbing and our area by area sales reviews and in general I think the total of those is pretty positive.
I think the question for us is to what extent do the customers that we are dealing with directly, the customer people were dealing indirectly to really know what is coming.
Scott Zeller - Needham & Company
Fair enough.
David Sommers
So, on an operational level, we feel very good. The sales force feels pretty good about that but we are fearful that the range of our headlights through the sales force does not reach the problem yet.
Scott Zeller - Needham & Company
Understood, okay. Thank you.
Operator
Your next question comes from Sanjit Singh – Wedbush Morgan Securities.
Sanjit Singh – Wedbush Morgan Securities
Could you talk a little bit about what you are seeing in government and Telco or wireless carriers that gives you kind of that near-term confidence over the next few quarters?
David Sommers
Well, Sanjit I think the basic thing we are seeing is the continued activity including order flow. We had a pretty good government fiscal yearend in terms of order flow and we have had in Q2 and including continuing to the earlier question, one of the earlier question so far in Q3 encouraging order flow from Telcos.
I think if you look at the Telco space in particular and you look at the growing competition for iPhone business and the iPhone competitors, each carrier having its own and start their own App stores to mimic Apple App store with the iPhone, those things are all very positive and to the extent that the wireless carriers are escalating the competition for application driving devices to put in the customer's hands and customers are but continuing to buy them despite the coming economic problems or periods of coming economic problems then that is positive for us and in the government, despite the election uncertainty and what may happen with the new administration spending has not stopped or it certainly has not been through the end of September. It may if the politicians can figure out how to do that but I do not think that either one of us would make a lot of money in the past betting that the government spending will slowdown.
So, we are not seeing it yet.
Sanjit Singh – Wedbush Morgan Securities
That is helpful and then just couple of marketing questions, are you seeing any effect on the strengthening dollar on results and maybe on the LIBOR, is that having any effects on debt payments?
David Sommers
Our foreign currency exposure is pretty minimal. We basically pay foreign expenses including foreign employee expenses in foreign and local currency and therefore as the dollar improves that helps us and we do have minimal small amount of non dollar base balances that were exposed to as foreign currencies depreciate but it is not a huge exposure.
Because we are basically a dollar base business, we do not have a large foreign currency impact. Then you question about LIBOR, yes our debt facility is LIBOR base.
We have periodic resets at the moment in the middle of a reset or the second half of the reset period. We have a choice of term we run out in the second half of the six-month term and we will reset LIBOR of our debt interest rate again sometime in December and we will see what LIBOR is at that point.
We are anticipating in our reaffirmed guidance that our LIBOR-base interest rate will go up because of the current position of LIBOR but of course LIBOR is just declining more recently so it may be an opportunity…
Sanjit Singh – Wedbush Morgan Securities
I will just take them to the guidance, okay. Great.
Michael Szabados
Okay, one addition to David's comment is that neither is the demand impacted by the dollar, the increase of the dollar exchange range if you are talking about the expense or the cost, impact of that while the demand is not impacted because we are basically very inelastic and indoors changes so we are not in any impact due to that.
Sanjit Singh – Wedbush Morgan Securities
And maybe to that point, could you maybe comment on maybe some of your initiatives going on in Europe right now? I mean Network General was kind of a bigger player there but could you maybe expand on more generally on what the Company is trying to do in that theater?
Michael Szabados
Well, some of the most important product change has have to do with internet and dealer market initiative has have to do with expanding our penetration of the line of service wide industry in the European theaters and it is starting in Germany and UK to Eastern Europe as well as Southern Europe and that is really the dominant dynamic. In addition, we have clearly the Network General customer-base that we are beginning to process of off selling with them and next cut with product portfolio but the dominant dynamic is the service part of business.
Operator
Your next question comes from Manuel Recarey – Kaufman Brothers LP.
Manuel Recarey – Kaufman Brothers LP
Most of my questions had been answered except one. The service revenue was up nicely sequentially.
Can you give a little bit more color what is driving that and kind of looking forward, I know you do not fairly give guidance on that product line basis but we should not expect to see that same type of sequential increases going forward.
David Sommers
No, that is true, absolutely true. One of the things that happens with our business is that we, unlike what you might expect from the main characteristics of our service revenue, service revenue being driven by basically 12-month maintenance agreements with our customers is that when we sign big maintenance agreements or renewals that can be a lumpy pattern.
So, there is a dynamic that happened in the second quarter with that large Telco deal where part of that, the size of that deal was service revenue. As I mentioned, we had actually shifted the product some time ago and when we shift the product, the customer signed up for service and so because the product was not recognizable as revenue, neither was the service and so when we recognize the product revenue, we recognize an outsized step up in the service revenue that will not recur.
So, in fact as we are talking about in the second half revenue being lower, implicit in our guidance than first half revenue, you might expect to see that in service as well not because anything untoward is happening in the business but because of that lumpiness that has actually right.
Manuel Recarey – Kaufman Brothers LP
Alright. And then follow up to that, with this large order that you booked, was there any expenses that were associated with that that may not necessarily be reoccurring in December quarter?
David Sommers
There were, yes. Two things; one, when you do a deal that is that big then it has got probably a higher discounts than your average run of the mill, million dollar business deal and this was a legacy, Network General deal which were very glad for, pleased to have and it had a little higher commission expense carry with it.
So, you will see in the quarter sequentially our sales and marketing expenses up and that is one of the drivers of that and that will not recur.
Operator
Your next question comes from Jonathan Ruykhaver – ThinkPanmure LLC.
Jonathan Ruykhaver – ThinkPanmure LLC
I have got a question just related to the packet-flow technology Sniffer product utilizes the ability, when I look at it, to classify and prioritize traffic by application and protocol seems to be growing an importance in the security market as a way to further protect against network attacks and I am just curious, do you see any used cases of that packet-flow technology for identification of let us say world application to security in general?
Michael Szabados
Yes, this is Michael Szabados answering the question. Yes, we definitely see an explicit demand from one customer base for applying all data sets to those problems that you just mentioned and that is one of our focus areas going forward to apply regional space, regional network management community, network operations community to expand our footprint in that space but we are not ready to talk about any products with any other specific.
Jonathan Ruykhaver – ThinkPanmure LLC
Okay but it could be an extension of the current technology as I see it and I believe back when Sniffer was owned by [Active Data] Company had to try to embark on a strategy of anomaly based detection and security market and I think they quite got there but do you see that as a potential?
Michael Szabados
Yes.
Jonathan Ruykhaver – ThinkPanmure LLC
Okay and that just, David, final question that I have, on that large telecom deal, was it a new or existing customer? What was the application of service that the product is being used to support?
David Sommers
It was a new customer to NetScout. I think they might have been small existing customer for Network General but obviously a very large commitment to the product that is now, of course, carried forward it was the InfiniStream product that is now branding and were carrying forward as the NetScout recording device product brand and it is a deployment for their core, very advanced customer network deployments.
It is a carrier that is currently very active in pushing the most advanced highest speed network deployments that has been in the press.
Jonathan Ruykhaver – ThinkPanmure LLC
Is it more a converged voice video over a mobile network?
David Sommers
Yes.
Operator
There are no further questions.
David Sommers
Alright, well thank you very much. It has been a very good interactive questioning session and we appreciate that.
We look forward to meeting with you again at the end of our next quarter and our next earning conference call. Thank you again and good evening.
Operator
This concludes today's conference call. You may now disconnect.