-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, NucCyHUKS5eE7KzQ92OAZyprX0ZkePcmSSpZIPVjY5pDeJEXoaqLNV80Zlq3BtR2 RoXFykwLfhIb7BlPSipDrA== 0000912057-00-006620.txt : 20000215 0000912057-00-006620.hdr.sgml : 20000215 ACCESSION NUMBER: 0000912057-00-006620 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19991231 FILED AS OF DATE: 20000214 FILER: COMPANY DATA: COMPANY CONFORMED NAME: NETSCOUT SYSTEMS INC CENTRAL INDEX KEY: 0001078075 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-COMPUTER INTEGRATED SYSTEMS DESIGN [7373] IRS NUMBER: 042837575 STATE OF INCORPORATION: DE FISCAL YEAR END: 0331 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-26251 FILM NUMBER: 542117 BUSINESS ADDRESS: STREET 1: 4 TECHNOLOGY PARK DR CITY: WESTFORD STATE: MA ZIP: 01886 BUSINESS PHONE: 9786144000 MAIL ADDRESS: STREET 1: 4 TECHNOLOGY PARK DRIVE CITY: WESTFORD STATE: MA ZIP: 01886 10-Q 1 FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [ X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended December 31, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to -------------- -------------- Commission file number 0000-26251 NETSCOUT SYSTEMS, INC. (Exact name of registrant as specified in its charter) Delaware 04-2837575 --------------------- ---------------------- (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 4 Technology Park Drive, Westford, MA 01886 ----------------------------------------------------------- (Address of principal executive offices) (Zip Code) (978) 614-4000 ----------------------------------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X ] NO [ ] The number of shares outstanding of the registrant's common stock, as of February 1, 2000 was 26,105,766. FORM 10-Q FOR THE QUARTER ENDED DECEMBER 31, 1999 TABLE OF CONTENTS
Item Number Page PART I: FINANCIAL INFORMATION Item 1. Financial Statements 3 a.) Consolidated Balance Sheet: As of December 31, 1999 (unaudited) and March 31, 1999 (unaudited) b.) Consolidated Statement of Income: For the three and nine months ended December 31, 1999 (unaudited) and December 31, 1998 (unaudited) c.) Consolidated Statement of Cash Flows: For the nine months ended December 31, 1999 (unaudited) and December 31, 1998 (unaudited) d.) Notes to the Consolidated Financial Statements Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 8 Item 3. Quantitative and Qualitative Disclosures About Market Risk 18 PART II: OTHER INFORMATION Item 1. Legal Proceedings 18 Item 2. Changes in Securities and Use of Proceeds 18 Item 6. Exhibits and Reports on Form 8-K 19 SIGNATURES 20 EXHIBIT INDEX 21
2 PART I: FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS NETSCOUT SYSTEMS, INC. CONSOLIDATED BALANCE SHEET (IN THOUSANDS) (UNAUDITED)
DECEMBER 31, MARCH 31, 1999 1999 ---- ---- ASSETS Current assets: Cash and cash equivalents $ 51,277 $ 25,477 Short-term investments 12,747 - Accounts receivable, net of allowance for doubtful accounts and returns of $1,025 and $1,036 at December 31, 1999 and March 31, 1999, respectively 8,600 6,550 Inventories 4,452 3,165 Refundable income taxes 304 217 Deferred income taxes 1,196 1,196 Prepaids and other current assets 3,330 821 ---------- ---------- Total current assets 81,906 37,426 Fixed assets, net 5,327 4,227 Notes receivable - stockholders - 2,000 Deferred income taxes 321 321 ---------- ---------- Total assets $ 87,554 $ 43,974 ========== ========== LIABILITIES, REDEEMABLE CONVERTIBLE COMMON STOCK AND STOCKHOLDERS' EQUITY (DEFICIT) Current liabilities: Accounts payable $ 2,802 $ 3,945 Accrued compensation 3,761 3,539 Accrued other 2,468 1,165 Customer deposits 34 34 Deferred revenue 6,332 4,254 ---------- ---------- Total current liabilities 15,397 12,937 Commitments and contingencies Redeemable convertible common stock: Class B redeemable convertible common stock, $0.001 par value; no shares authorized, issued or outstanding at December 31, 1999; 6,977,254 shares authorized, issued and outstanding at March 31, 1999 - 44,161 ---------- ---------- Stockholder's equity (deficit): Preferred stock: Preferred stock (undesignated), $0.001 par value, 5,000,000 shares authorized, no shares issued or outstanding at December 31, 1999; no shares authorized, issued or outstanding at March 31, 1999 - - Series A convertible preferred stock, $0.001 par value; no shares authorized, issued or outstanding at December 31, 1999; 631,579 shares authorized and issued, 315,790 shares outstanding at March 31, 1999 - 5,964 Common stock, $0.001 par value: Voting, 150,000,000 shares authorized, 29,852,305 shares issued, 25,875,051 shares outstanding at December 31, 1999; 121,798,382 shares authorized, 16,000,000 shares issued, 11,250,502 shares outstanding at March 31, 1999 30 16 Non-voting, no shares authorized, issued or outstanding at December 31, 1999; 21,224,364 shares authorized, 4,035,858 shares issued, 3,071,258 shares outstanding at March 31, 1999 - 4 Additional paid-in capital 63,252 2,143 Deferred compensation (973) (1,312) Treasury stock (25,306) (44,394) Retained earnings 35,154 24,455 ---------- ---------- Total stockholder's equity (deficit) 72,157 (13,124) ---------- ---------- Total liabilities, redeemable convertible common stock and stockholders'equity (deficit) $ 87,554 $ 43,974 ========== =========
The accompanying notes are an integral part of these consolidated financial statements. 3 NETSCOUT SYSTEMS, INC. CONSOLIDATED STATEMENT OF INCOME (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, 1999 1998 1999 1998 ---- ---- ---- ---- Revenue: Product $14,584 $13,327 $40,939 $36,737 Service 3,348 2,172 8,912 6,329 License and royalty 4,910 1,972 12,366 5,814 ------- ------- ------- ------- Total revenue 22,842 17,471 62,217 48,880 ------- ------- ------- ------- Cost of revenue: Product 5,389 4,927 15,290 13,614 Service 422 222 1,242 838 ------- ------- ------- ------- Total cost of revenue 5,811 5,149 16,532 14,452 ------- ------- ------- ------- Gross margin 17,031 12,322 45,685 34,428 ------- ------- ------- ------- Operating expenses: Research and development 2,322 1,803 7,022 5,295 Sales and marketing 7,370 5,191 20,121 14,726 General and administrative 1,334 1,030 3,421 3,058 ------- ------- ------- ------- Total operating expenses 11,026 8,024 30,564 23,079 ------- ------- ------- ------- Income from operations 6,005 4,298 15,121 11,349 Interest income, net 833 224 1,609 667 ------- ------- ------- ------- Income before provision for income taxes 6,838 4,522 16,730 12,016 Provision for income taxes 2,467 1,629 6,031 4,327 ------- ------- ------- ------- Net income $4,371 $2,893 $10,699 $7,689 ======= ======= ======= ======= Basic net income per share $ 0.17 $ 0.15 $ 0.53 $ 0.39 Diluted net income per share $ 0.16 $ 0.12 $ 0.40 $ 0.32 Shares used in computing: Basic net income per share 25,796 19,668 20,249 19,568 Diluted net income per share 28,154 23,980 26,562 23,792 Pro forma basic net income per share $ 0.17 $ 0.13 $ 0.44 $ 0.35 Pro forma diluted net income per share $ 0.16 $ 0.12 $ 0.40 $ 0.32 Shares used in computing: Pro forma basic net income per share 25,796 22,194 24,235 22,095 Pro forma diluted net income per share 28,154 23,980 26,562 23,792
The accompanying notes are an integral part of these consolidated financial statements. 4 NETSCOUT SYSTEMS, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
NINE MONTHS ENDED DECEMBER 31, 1999 1998 ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 10,699 $7,689 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,006 1,454 Loss on disposal of fixed assets 49 50 Compensation expense associated with equity awards 339 194 Deferred income taxes - (108) Changes in assets and liabilities: Accounts receivable (2,050) (2,823) Inventories (1,287) 422 Refundable income taxes (87) 708 Prepaids and other current assets (2,509) 18 Accounts payable (1,143) (316) Accrued expenses 1,525 856 Income taxes payable - 306 Customer deposits - (117) Deferred revenue 2,078 428 ----- --- Net cash provided by operating activities 9,620 8,761 ----- ----- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of marketable securities (14,747) - Proceeds from maturity of marketable securities 2,000 8,834 Proceeds from notes receivable 2,000 - Purchase of fixed assets (3,155) (1,955) ------- ------- Net cash provided (used) by investing activities (13,902) 6,879 -------- ----- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock 30,082 43 ------ -- Net increase in cash and cash equivalents 25,800 15,683 Cash and cash equivalents, beginning of year 25,477 6,341 ------ ----- Cash and cash equivalents, end of period $ 51,277 $ 22,024 ========= ========= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid for interest $ 5 $ 2 Cash paid for income taxes $ 6,131 $ 3,421
The accompanying notes are an integral part of these consolidated financial statements. 5 NETSCOUT SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying consolidated financial statements as of December 31, 1999 and for the three and nine months ended December 31, 1999 and 1998 are unaudited. In the opinion of NetScout's management, the December 31, 1999 and 1998 unaudited interim consolidated financial statements include all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the financial position and results of operations for that period. The results of operations for the nine month period ended December 31, 1999 are not necessarily indicative of the results of operations for the year ended March 31, 2000. The balance sheet at March 31, 1999 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in NetScout's Registration Statement on Form S-1, as amended (No. 333-76843), as filed with the Securities and Exchange Commission. 2. CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS NetScout considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents and those with maturities greater than three months are considered to be investments. Cash equivalents and investments are stated at amortized cost plus accrued interest, which approximates fair value. Cash equivalents and investments consist primarily of money market instruments and U.S. Treasury bills. NetScout accounts for its investments in accordance with Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Under the provision of SFAS No. 115, NetScout has classified its investments as "available-for-sale" and any associated unrealized gains or losses, if material, are recorded as a separate component of stockholders' equity until realized. At December 31, 1999 and March 31, 1999, any unrealized gains or losses were immaterial. 3. INVENTORIES Inventories consist of the following:
December 31, March 31, 1999 1999 ---- ---- Raw materials $3,718 $2,620 Work-in-process 263 348 Finished goods 471 197 -------- -------- $4,452 $3,165 ====== ======
4. STOCKHOLDERS' EQUITY In August 1999, NetScout completed an initial public offering of 3,000,000 shares of its common stock for net proceeds of $29.6 million after underwriter commissions and offering expenses. As a result, all issued and outstanding shares and shares held in treasury of Series A Preferred Stock, Class B Convertible Common Stock and Non-Voting Common Stock were automatically converted into 2,526,316, 6,977,254 and 4,062,321 shares, respectively, of voting common stock. 6 5. NET INCOME PER SHARE Basic net income per share is computed by dividing income available to common stockholders by the weighted average number of shares of common stock outstanding during the period, excluding shares of common stock subject to repurchase. Diluted net income per share is computed by dividing income available to common stockholders by the sum of the weighted average number of shares of common stock outstanding during the period and the weighted average number of potential shares of common stock from the assumed exercise of stock options and shares of common stock subject to repurchase using the "treasury stock" method and the assumed conversion of Series A Preferred Stock and the Class B Convertible Common Stock. 6. PRO FORMA NET INCOME PER SHARE Pro forma basic and diluted net income per share are computed assuming the conversion of all shares of Series A Preferred Stock, Class B Convertible Common Stock and Non-Voting Common Stock into Voting Common Stock, as if the shares had been converted immediately upon their issuance. 7. GEOGRAPHIC INFORMATION Revenue was distributed geographically as follows:
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, 1999 1998 1999 1998 ---- ---- ---- ---- North America.......... $20,881 $15,557 $54,198 $43,260 Other international...... 1,961 1,914 8,019 5,620 ------- ------- ------- ------- $22,842 $17,471 $62,217 $48,880 ======= ======= ======= =======
Substantially all of NetScout's identifiable assets are located in the United States. 8. CONTINGENCIES In August 1998, a former employee made claims against NetScout and an employee stockholder and alleged unspecified damages. The former employee filed a related claim with the Massachusetts Commission Against Discrimination (the "MCAD") and the Equal Employment Opportunity Commission (the "EEOC") in December 1998. In July 1999, the former employee requested that the claim be withdrawn from the MCAD and the EEOC so that the claim may be filed in state and/or federal court. In accordance with this request, the MCAD closed this matter on July 14, 1999 and the EEOC closed this matter on August 12, 1999. On or about November 5, 1999, the former employee filed an action in the Superior Court Department of the Trial Court, Middlesex County. On December 30, 1999, NetScout filed a Notice of Removal to the United States District Court for the District of Massachusetts, thereby removing the action to that Court. Based on the information available to date, NetScout believes that the claim is without merit and intends to vigorously defend this claim. NetScout has recorded an accrual to address this matter, however, since this matter is at a preliminary stage, NetScout is unable to predict the outcome or amount of related expense, or loss, if any. In addition to the matter noted above, from time to time NetScout is subject to legal proceedings and claims in the ordinary course of business. In the opinion of management, the amount of ultimate expense with respect to any other current legal proceedings and claims will not have a material adverse effect on NetScout's financial position or results of operations. 7 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following information should be read in conjunction with the consolidated historical financial information and the notes thereto included in Item 1 of this Quarterly Report on Form 10-Q and Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Registration Statement on Form S-1 as filed with the Securities and Exchange Commission, as amended (No. 333-76843). In addition to the other information in this report, the following Management Discussion and Analysis should be considered carefully in evaluating the Company and our business. This Form 10-Q contains forward-looking statements. These statements relate to future events or our future financial performance and are identified by terminology such as "may", "will", "could", "should", "expects," "plans," "intends," "seeks," "anticipates," "believes," "estimates," "potential," or "continue" or the negative of such terms or other comparable terminology. These statements are only predictions. You should not place undue reliance on these forward-looking statements. Actual events or results may differ materially. In evaluating these statements, you should specifically consider various important factors, including the risks outlined under "Certain Factors Which May Affect Future Results" in this section of this report and our other filings with the Securities and Exchange Commission. These factors may cause our actual results to differ materially from any forward-looking statement. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We are under no duty to update any of the forward-looking statements after the date of this Form 10-Q to conform such statements to actual results. OVERVIEW NetScout designs, develops, manufactures, markets and supports a family of products that enable businesses and network service providers to manage the performance of their computer networks and software applications. Our products include data collection devices, consisting of probes and software agents, which collect, aggregate and perform detailed analysis of computer network and application data, and analytical and presentation software, which provides current network and application performance information in an easy-to-use, graphical format. We were incorporated in 1984 and primarily provided consulting services until 1992 when we began to develop and market our first computer network performance management products. Our operations have been financed principally through cash provided by operations and we have been profitable for each of the last six years. 8 RESULTS OF OPERATIONS The following table sets forth for the periods indicated the percentage of total revenue of certain line items included in our Statement of Income: NETSCOUT SYSTEMS, INC. STATEMENT OF INCOME PERCENTAGES
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, 1999 1998 1999 1998 ---- ---- ---- ---- Revenue: Product 63.8% 76.3% 65.8% 75.2% Service 14.7% 12.4% 14.3% 12.9% License and royalty 21.5% 11.3% 19.9% 11.9% ----- ----- ----- ----- Total revenue 100.0% 100.0% 100.0% 100.0% ------ ------ ------ ------ Cost of revenue: Product 23.6% 28.2% 24.6% 27.9% Service 1.8% 1.3% 2.0% 1.7% ---- ---- ---- ---- Total cost of revenue 25.4% 29.5% 26.6% 29.6% ----- ----- ----- ----- Gross margin 74.6% 70.5% 73.4% 70.4% ----- ----- ----- ----- Operating expenses: Research and development 10.2% 10.3% 11.3% 10.8% Sales and marketing 32.3% 29.7% 32.3% 30.1% General and administrative 5.8% 5.9% 5.5% 6.3% ---- ---- ---- ---- Total operating expenses 48.3% 45.9% 49.1% 47.2% ----- ----- ----- ----- Income from operations 26.3% 24.6% 24.3% 23.2% Interest income, net 3.6% 1.3% 2.6% 1.4% ---- ---- ---- ---- Income before provision for income taxes 29.9% 25.9% 26.9% 24.6% Provision for income taxes 10.8% 9.3% 9.7% 8.9% ----- ---- ---- ---- Net income 19.1% 16.6% 17.2% 15.7% ===== ===== ===== =====
THREE MONTHS ENDED DECEMBER 31, 1999 AND 1998 REVENUE Total revenue increased 31% from $17.5 million for the three months ended December 31, 1998 to $22.8 million for the three months ended December 31 1999. PRODUCT. Product revenue increased 9% from $13.3 million for the three months ended December 31, 1998 to $14.6 million for the three months ended December 31, 1999. This increase was primarily due to a 38% increase in average selling price attributable to larger volumes of higher speed and multi-port probes. SERVICE. Service revenue increased 54% from $2.2 million for the three months ended December 31, 1998 to $3.3 million for the three months ended December 31, 1999. This increase was primarily due to an increase in support agreements attributable to new product sales and an increase in the sale of support agreements to new and existing customers attributable to increased sales and marketing efforts. 9 LICENSE AND ROYALTY. License and royalty revenue increased 149% from $2.0 million for the three months ended December 31, 1998 to $4.9 million for the three months ended December 31, 1999. The December 31, 1999 license and royalty revenue includes $818,000 in royalties for the period ended September 30, 1999 that one of our partners did not report until the period ended December 31, 1999. Beyond this, the additional increase in license and royalty revenue was primarily due to a proportionate growth in unit sales of our software and embedded software products by Cisco. We anticipate that license and royalty revenue will decrease in absolute dollars, and as a percentage of total revenue. COST OF REVENUE AND GROSS MARGIN PRODUCT. Cost of product revenue consists primarily of components, personnel costs, media duplication, manuals, packaging materials, licensed technology fees and overhead. Cost of product revenue increased 9% from $4.9 million for the three months ended December 31, 1998 to $5.4 million for the three months ended December 31, 1999. This increase was primarily due to a 35% increase in the average cost per unit. Product gross margins were 63% for the three months ended December 31, 1998 and 1999. SERVICE. Cost of service revenue consists primarily of personnel costs. Cost of service revenue increased 90% from $222,000 for the three months ended December 31, 1998 to $422,000 for the three months ended December 31, 1999. This increase was primarily due to a 116% increase in personnel costs. Service gross margins decreased from 90% for the three months ended December 31, 1998 to 87% for the three months ended December 31, 1999. Gross margin increased 38% from $12.3 million for the three months ended December 31, 1998 to $17.0 million for the three months ended December 31, 1999. This increase was primarily due to an increase in license and royalty revenue as a percentage of total revenue. OPERATING EXPENSES RESEARCH AND DEVELOPMENT. Research and development expenses consist primarily of personnel costs, fees for outside consultants and related costs associated with the development of new products and the enhancement of existing products. Research and development expenses increased 29% from $1.8 million for the three months ended December 31, 1998 to $2.3 million for the three months ended December 31, 1999. This increase was primarily due to a 33% increase in personnel costs and a 31% increase in consulting expenses. We anticipate that research and development expenses will increase in absolute dollars and as a percentage of total revenues as staffing reaches planned levels. SALES AND MARKETING. Sales and marketing expenses consist primarily of personnel costs and costs associated with marketing programs such as trade shows, seminars, advertising and new product launch activities. Sales and marketing expenses increased 42% from $5.2 million for the three months ended December 31, 1998 to $7.4 million for the three months ended December 31, 1999. This increase was primarily due to a 36% increase in sales and marketing personnel costs. We anticipate that sales and marketing expenses will increase in absolute dollars as we expand our sales force and marketing programs to support international expansion, increased sales efforts to major accounts, brand awareness and product launches. GENERAL AND ADMINISTRATIVE. General and administrative expenses consist primarily of personnel costs for executive, financial, information services and human resource employees. General and administrative expenses increased 30% from $1.0 million for the three months ended December 31, 1998 to $1.3 million for the three months ended December 31, 1999. This increase was primarily due to a 12% increase in personnel costs. We expect that our general and administrative expenses will increase in absolute dollars as we continue to expand our staff to support expanded operations and facilities and incur expenses relating to our responsibilities as a public company. INTEREST INCOME, NET. Interest income, net of interest expense, increased 272% from $224,000 for the three months ended December 31, 1998 to $833,000 for the three months ended December 31, 1999. This increase was primarily due to an increase in our cash balances related to the proceeds from our initial public offering. 10 PROVISION FOR INCOME TAXES. The provision for income taxes increased from $1.6 million for the three months ended December 31, 1998 to $2.5 million for the three months ended December 31, 1999, primarily due to higher pre-tax income. Our effective tax rate remained constant at 36% for the three months ended December 31, 1998 and 1999. NINE MONTHS ENDED DECEMBER 31, 1999 AND 1998 REVENUE Total revenue increased 27% from $48.9 million for the nine months ended December 31, 1998 to $62.2 million for the nine months ended December 31, 1999. PRODUCT. Product revenue increased 11% from $36.7 million for the nine months ended December 31, 1998 to $40.9 million for the nine months ended December 31, 1999. This increase was primarily due to a 30% increase in average selling price attributable to larger volumes of higher speed and multi-port probes. SERVICE. Service revenue increased 41% from $6.3 million for the nine months ended December 31, 1998 to $8.9 million for the nine months ended December 31, 1999. This increase was primarily due to an increase in support agreements attributable to new product sales and an increase in the sale of support agreements to new and existing customers attributable to increased sales and marketing efforts. LICENSE AND ROYALTY. License and royalty revenue increased 113% from $5.8 million for the nine months ended December 31, 1998 to $12.4 million for the nine months ended December 31, 1999. This increase was primarily due to a proportionate growth in unit sales of our software and embedded software products by Cisco. COST OF REVENUE AND GROSS MARGIN PRODUCT. Cost of product revenue increased 12% from $13.6 million for the nine months ended December 31, 1998 to $15.3 million for the nine months ended December 31, 1999. This increase was primarily due to a 27% increase in the average cost per unit. Product gross margins were 63% for the nine months ended December 31, 1998 and 1999. SERVICE. Cost of service revenue increased 48% from $838,000 for the nine months ended December 31, 1998 to $1.2 million for the nine months ended December 31, 1999. This increase was primarily due to a 46% increase in personnel costs. Service gross margins decreased slightly from 87% for the nine months ended December 31, 1998 to 86% for the nine months ended December 31, 1999. Gross margin increased 33% from $34.4 million for the nine months ended December 31, 1998 to $45.7 million for the nine months ended December 31, 1999. This increase was primarily due to an increase in license and royalty revenue as a percentage of total revenue. OPERATING EXPENSES RESEARCH AND DEVELOPMENT. Research and development expenses increased 33% from $5.3 million for the nine months ended December 31, 1998 to $7.0 million for the nine months ended December 31, 1999. This increase was primarily due to a 35% increase in personnel costs and to a lesser degree a 30% increase in consulting expenses. SALES AND MARKETING. Sales and marketing expenses increased 37% from $14.7 million for the nine months ended December 31, 1998 to $20.1 million for the nine months ended December 31, 1999. This increase was primarily due to a 29% increase in sales and marketing personnel costs. GENERAL AND ADMINISTRATIVE. General and administrative expenses increased 12% from $3.1 million for the nine months ended December 31, 1998 to $3.4 million for the nine months ended December 31, 1999. This increase was primarily due to a 25% increase in personnel costs. 11 INTEREST INCOME, NET. Interest income, net of interest expense, increased 141% from $667,000 for the nine months ended December 31, 1998 to $1.6 million for the nine months ended December 31, 1999. This increase was primarily due to an increase in our cash balances related to the proceeds from our initial public offering. PROVISION FOR INCOME TAXES. The provision for income taxes increased from $4.3 million for the nine months ended December 31, 1998 to $6.0 million for the nine months ended December 31, 1999, primarily due to higher pre-tax income. Our effective tax rate remained constant at 36% for the nine months ended December 31, 1998 and 1999. LIQUIDITY AND CAPITAL RESOURCES As of December 31, 1999, we had $51.3 million in cash and cash equivalents and $12.7 million in short-term investments. Prior to our initial public offering, we financed our operations through cash provided by operating activities. On August 17, 1999, we completed our initial public offering of 3,000,000 shares of common stock at a price of $11.00 per share. We received net proceeds of approximately $29.6 million after underwriter commissions and offering expenses. We have a line of credit with a bank, which allows us to borrow up to $5.0 million for working capital purposes and to obtain letters of credit. The line of credit expires in March 2000. Amounts available under the line of credit are a function of eligible accounts receivable and bear interest at the bank's prime rate. At December 31, 1999, we had letters of credit outstanding under the line aggregating $561,000. The bank line of credit is secured by our inventory and accounts receivable. Cash, cash equivalents and short-term investments were $64.0 million at December 31, 1999. Cash provided by operating activities was $9.6 million and $8.8 million for the nine months ended December 31, 1999 and 1998, respectively. Cash provided by operating activities was primarily derived from net income and to a lesser degree, increases in depreciation and amortization, accrued expenses and deferred revenue in each period. This was partially offset by increases in accounts receivable for the nine months ended December 31, 1999 and 1998, respectively, and increases in prepaids and other current assets for the nine months ended December 31, 1999. These changes were due to the growth of our business. Cash used by investing activities was $13.9 million for the nine months ended December 31, 1999, which reflects the purchase of short-term investments and, to a lesser degree, fixed assets. Cash provided by investing activities was $6.9 million for the nine months ended December 31, 1998, which was primarily due to the maturity of short-term investments, partially offset by the purchase of fixed assets. Cash provided by financing activities was $30.1 million for the nine months ended December 31, 1999 which is due to the initial public offering proceeds. We believe that our current cash balances and the cash flows generated by operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for the next 12 months. Thereafter, if cash generated from operations is insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or convertible debt securities. The sale of additional equity or debt securities could result in additional dilution to our stockholders. 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. We have no current plans, agreements or commitments, and are not currently engaged in any negotiations with respect to any such transaction. YEAR 2000 READINESS DISCLOSURE Many computers and software products accept only two digit entries in date fields which could cause problems distinguishing dates after December 31, 1999. The use of computers and software products that are not year 2000 compliant could result in system failures or miscalculations causing business disruptions, including the inability to process transactions, send invoices or perform other business activities. As a result, many computers and software products may need to be upgraded or replaced in order to meet year 2000 requirements. 12 We believe that we have three general areas of potential exposure with respect to the year 2000 problem: - - our own products; - - our internal information systems and equipment-related systems; and - - the effects of third party compliance efforts. We have completed our review of our products to determine whether they are year 2000 compliant. As of February 14, 2000 customers have not reported to us any year 2000 related problems or disruptions with any of our products. In addition, we are not aware of any year 2000 related problems with any of our equipment, facilities, or material suppliers. Based on our review, we believe that our products are year 2000 compliant. However, there can be no assurance that our products will not interact with non-year 2000 compliant products, which could cause our products to malfunction. This malfunction could expose us to claims from our customers or third parties or result in a reduction in market acceptance of our products and services and increased service costs to us. With respect to our internal information systems, we believe our current financial and accounting systems are year 2000 compliant. We anticipate that our financial and accounting systems will be upgraded in the first calendar quarter of 2000 and that such systems will also be year 2000 compliant. All other internal systems used in our daily operations, including our computers, software packages, telephones, security systems and shipping systems, have either been determined to be compliant, have been certified compliant by the commercial provider or have been tested and upgraded. We believe that our review of our internal information systems and equipment-related systems is complete. To date, costs of making our internal information systems and equipment-related systems year 2000 compliant have not been material and we do not expect any future costs to be material. The third aspect of our year 2000 analysis involves evaluating the year 2000 efforts of third parties, including suppliers and indirect channel partners. We have evaluated many of these third parties and believe that they are year 2000 compliant. Failure of our suppliers' systems, however, to operate properly could require us to incur significant expenses to remedy problems or replace suppliers. Failure of our indirect channel partners' systems to operate properly, however, could reduce our revenue from our indirect channel partners. Problems with our suppliers or indirect channel partners could have a material adverse effect on our business, operating results and financial condition. To date, we have not incurred significant costs in connection with identifying and evaluating year 2000 issues or complying with year 2000 requirements. We have not experienced any significant year 2000 problems and have not deferred the release of any of our products or any IT projects as a result of year 2000 complications. However, we have not used any independent verification or validation processes to support our assertions regarding year 2000 risks and cost estimates. While we do not expect to incur significant costs in the foreseeable future, the identification and evaluation process is ongoing and year 2000 complications are not fully known, therefore, there can be no assurance that year 2000 errors or defects will not be discovered in our products or internal software systems. If such errors or defects are discovered, there can be no assurance that the costs of making such systems year 2000 compliant will not have a material adverse effect on our business, operating results and financial condition. Some of our products are sold to original equipment manufacturers who incorporate them into their own product offerings. We do not know whether original equipment manufacturer products incorporating our products are year 2000 compliant. If such original equipment manufacturer products are not year 2000 compliant, their customers could cancel or delay orders which, in time, would affect the orders that we receive from our original equipment manufacturer partners. Therefore, the failure of our original equipment manufacturer partners to be year 2000 compliant could have a material adverse effect on our business, results of operation and financial condition. Under the reasonably likely worst case scenario, our products could interact with non-year 2000 compliant products, which could cause our products to malfunction; our indirect channel partners, our customers or we may not be able to process orders; or our suppliers may not be able to supply us with critical components needed to make our products. 13 CERTAIN FACTORS WHICH MAY AFFECT FUTURE RESULTS We do not provide financial performance forecasts. Our operating results and financial condition have varied in the past and may in the future vary significantly depending on a number of factors. Except for the historical information in this report, the matters contained in this report include forward-looking statements that involve risks and uncertainties. The following factors, among others, could cause actual results to differ materially from those contained in forward-looking statements made in this report. Such factors, among others, may have a material adverse effect upon our business, results of operations and financial condition. A REDUCTION IN ORDERS FROM CISCO SYSTEMS, INC. WOULD MATERIALLY ADVERSELY AFFECT OUR BUSINESS. Our operating results and financial condition for a particular fiscal period would be materially adversely affected if there is a substantial reduction in orders from Cisco Systems, Inc. or if we are unable to complete one or more Cisco orders planned for that period. We derive a significant portion of our revenue from Cisco, which distributes some of our products under its private label and incorporates some of our software in its products. Cisco accounted for 50% of our total revenue for the nine months ended December 31, 1999 and 49% of our total revenue for the nine months ended December 31, 1998. Our future performance is significantly dependent upon Cisco's continued promotion of our products. Cisco has no obligation to purchase any products from us. Further, we do not control Cisco's distribution of our products, whether incorporated into Cisco's products or sold under private label. Finally, Cisco may decide to internally develop products that compete with our solution or partner with our competitors or bundle or sell competitors' solutions, possibly at lower prices. If our relationship with Cisco were terminated or adversely affected for any reason, our business, operating results and financial condition would be materially adversely affected. OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE. Our quarterly revenue and operating results are difficult to predict and may fluctuate significantly from quarter to quarter. Most of our expenses, such as employee compensation and rent, are relatively fixed in the short term. Moreover, our expense levels are based, in part, on our expectations regarding future revenue levels. As a result, if revenue for a particular quarter is below our expectations, we may not be able to reduce operating expenses proportionately for that quarter, and therefore this revenue shortfall would have a disproportionately negative effect on our operating results for that quarter. Our quarterly revenue may fluctuate as a result of a variety of factors, many of which are outside our control, including the following: - the market for network and application performance management solutions is in an early stage of development and therefore demand for our solutions may be uneven; - the timing and receipt of orders from customers, particularly Cisco, especially in light of our lengthy sales cycle; - the timing and market acceptance of new products or product enhancements by us or our competitors; - distribution channels through which our products are sold could change; - the timing of hiring sales personnel and the speed at which such personnel become productive; - we may not be able to anticipate or adapt effectively to developing markets and rapidly changing technologies; and - our prices or the prices of our competitors' products may change. We operate with minimal backlog because our products typically are shipped shortly after orders are received. Therefore, product revenue in any quarter is substantially dependent on orders booked and shipped in that quarter and revenue for any future quarter is not predictable to any degree of certainty. Therefore, any significant deferral of orders for our products would cause a shortfall in revenue for that quarter. OUR RELIANCE ON SOLE SOURCE SUPPLIERS COULD ADVERSELY AFFECT OUR BUSINESS. Many components that are necessary for the assembly of our probes are obtained from separate sole source suppliers or a limited group of suppliers. These components include some of our network interface cards, which are produced for us solely by SDL Communications, Inc. Our reliance on sole or limited suppliers involves several risks, including a potential inability to obtain an adequate supply 14 of required components and reduced control over pricing, quality and timely delivery of components. We do not generally maintain long-term agreements with any of our suppliers or large volumes of inventory. Our inability to obtain adequate deliveries or the occurrence of any other circumstance that would require us to seek alternative sources of these components would affect our ability to ship our products on a timely basis. This could damage relationships with current and prospective customers, cause shortfalls in expected revenue and materially adversely affect our business, operating results and financial condition. OUR CONTINUED GROWTH DEPENDS ON OUR ABILITY TO EXPAND OUR SALES FORCE. We must increase the size of our sales force in order to increase our direct sales and support our indirect sales channels. Because our products are very technical, sales people require a long period of time to become productive, typically three to six months. This lag in productivity, as well as the challenge of attracting qualified candidates, may make it difficult to meet our sales force growth targets. Further, we may not generate sufficient sales to offset the increased expense resulting from growing our sales force. If we are unable to successfully expand our sales capability, our business, operating results and financial condition could be materially adversely affected. OUR SUCCESS DEPENDS ON OUR ABILITY TO EXPAND AND MANAGE INDIRECT DISTRIBUTION CHANNELS. To increase our sales, we must further expand and manage our indirect distribution channels, including original equipment manufacturers, distributors, resellers, systems integrators and service providers. Sales to our indirect distribution channels accounted for 78% and 82% of our total revenue for the nine months ended December 30, 1999 and 1998, respectively. Sales to Cisco accounted for 50% and 49% of our total revenue for the nine months ended December 31, 1999 and 1998. Our indirect channel partners have no obligation to purchase any products from us. In addition, they could internally develop products which compete with our solutions or partner with our competitors or bundle or resell competitors' solutions, possibly at lower prices. Our inability to expand and manage our relationships with our partners, the inability or unwillingness of our partners to effectively market and sell our products or the loss of existing partnerships could have a material adverse effect on our business, operating results and financial condition. IF WE FAIL TO INTRODUCE NEW PRODUCTS AND ENHANCE OUR EXISTING PRODUCTS TO KEEP UP WITH RAPID TECHNOLOGICAL CHANGE, DEMAND FOR OUR PRODUCTS MAY DECLINE. The market for network and application performance management solutions is relatively new and is characterized by rapid changes in technology, evolving industry standards, changes in customer requirements and frequent product introductions and enhancements. Our success is dependent upon our ability to meet our customers' needs, which are driven by changes in computer networking technologies and the emergence of new industry standards. In addition, new technologies may shorten the life cycle for our products or could render our existing or planned products obsolete. If we are unable to develop and introduce new network and application performance management products or enhancements to existing products in a timely and successful manner, it would have a material adverse effect on our business, operating results and financial condition. WE FACE SIGNIFICANT COMPETITION FROM OTHER TECHNOLOGY COMPANIES. The market for network and application performance management solutions is intensely competitive. We believe customers make network management system purchasing decisions based primarily upon product performance, functionality and price; name and reputation of vendor; distribution strength; and alliances with industry partners. We compete with probe vendors, such as Hewlett-Packard Company, providers of network performance management solutions, such as Concord Communications, Inc. and Micromuse, Inc., and providers of portable network traffic analyzers, such as Network Associates, Inc. In addition, leading network equipment providers could offer their own or competitors' solutions in the future. Many of our current and potential competitors have longer operating histories, greater name recognition and substantially greater financial, management, marketing, service, support, technical, distribution and other resources than we do. Therefore, they may be able to respond more quickly than we can to new or changing opportunities, technologies, standards or customer requirements. As a result of these and other factors, we may not be able to compete effectively with current or future competitors, which would have a material adverse effect on our business, operating results and financial condition. 15 THE SUCCESS OF OUR BUSINESS DEPENDS ON THE CONTINUED GROWTH IN THE MARKET FOR AND THE COMMERCIAL ACCEPTANCE OF NETWORK AND APPLICATION PERFORMANCE MANAGEMENT SOLUTIONS. We derive all of our revenue from the sale of products and services that are designed to allow our customers to manage the performance of computer networks and software applications. The market for network and application performance management solutions is in an early stage of development. Therefore, we cannot accurately assess the size of the market and may be unable to predict the appropriate features and prices for products to address the market, the optimal distribution strategy and the competitive environment that will develop. In order for us to be successful, our potential customers must recognize the value of more sophisticated network and application performance management solutions, decide to invest in the management of their networks and the performance of software applications and, in particular, adopt our management solutions. Any failure of this market to continue to develop would materially adversely affect our business, operating results and financial condition. Businesses may choose to outsource the management of their networks and applications to service providers. Our business may depend on our ability to develop relationships with these service providers and successfully market our products to them. FAILURE TO PROPERLY MANAGE GROWTH COULD ADVERSELY AFFECT OUR BUSINESS. We have been experiencing a period of rapid growth over the past several years. We plan to continue to expand our business by hiring additional personnel. The growth in size and complexity of our business and our customer base has been and will continue to be a significant challenge to our management and operations. To manage further growth effectively we must enhance our financial and accounting systems and controls, integrate new personnel and manage expanded operations. We anticipate that our financial and accounting systems will be upgraded in the first calendar quarter in 2000. If we are unable to successfully integrate these systems and controls and to effectively manage our growth, our costs, the quality of our products, the effectiveness of our sales organization, and our ability to retain key personnel, our business, operating results and financial condition could be materially adversely affected. LOSS OF KEY PERSONNEL COULD ADVERSELY AFFECT OUR BUSINESS. Our future success depends to a significant degree on the skills, experience and efforts of Anil Singhal, our Chairman of the Board, Chief Executive Officer and co-founder and Narendra Popat, our President, Chief Operating Officer and co-founder. We also depend on the ability of our other executive officers and senior managers to work effectively as a team. The loss of one or more of our key personnel could have a material adverse effect on our business, operating results and financial condition. WE MUST HIRE AND RETAIN SKILLED PERSONNEL IN A TIGHT LABOR MARKET. Qualified personnel are in great demand throughout the computer software, hardware and networking industries. The demand for qualified personnel is particularly acute in the New England area due to the large number of software and high technology companies and the low unemployment in the region. Our success depends in large part upon our ability to attract, train, motivate and retain highly-skilled employees, particularly sales and marketing personnel, software engineers, and technical support personnel. We have had difficulty hiring and retaining these highly skilled employees in the past. If we are unable to attract and retain the highly skilled technical personnel that are integral to our sales, marketing, product development and customer support teams, the rate at which we can generate sales and develop new products or product enhancements may be limited. This inability could have a material adverse effect on our business, operating results and financial condition. OUR SUCCESS DEPENDS ON OUR ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS. Our business is heavily dependent on our intellectual property. We rely upon a combination of copyright, trademark and trade secret laws and non-disclosure and other contractual arrangements to protect our proprietary rights. The reverse engineering, unauthorized copying or other misappropriation of our intellectual property could enable third parties to benefit from our technology without compensating us. Legal proceedings to enforce our intellectual property rights could be burdensome and expensive and could involve a high degree of uncertainty. In addition, legal proceedings may divert management's attention from growing our business. There can be no assurance that the steps we have taken to protect our intellectual property rights will be adequate to deter misappropriation of proprietary information, or that we will be able to detect unauthorized use by third parties and take appropriate steps to enforce our intellectual property rights. Further, we also license software from third parties for use as part of our products, and if any of these licenses were to terminate, we may experience delays in product shipment until we develop or license alternative software. 16 OTHERS MAY CLAIM THAT WE INFRINGE ON THEIR INTELLECTUAL PROPERTY RIGHTS. We may be subject to claims by others that our products infringe on their intellectual property rights. These claims, whether or not valid, could require us to spend significant sums in litigation, pay damages, delay product shipments, reengineer our products or acquire licenses to such third-party intellectual property. We may not be able to secure any required licenses on commercially reasonable terms or secure them at all. We expect that these claims will become more frequent as more companies enter the market for network and application performance management solutions. Any of these claims or resulting events could have a material adverse effect on our business, operating results and financial condition. IF OUR PRODUCTS CONTAIN ERRORS, THEY MAY BE COSTLY TO CORRECT, REVENUE MAY BE DELAYED, WE COULD GET SUED AND OUR REPUTATION COULD BE HARMED. Despite testing by us and our customers, errors may be found in our products after commencement of commercial shipments. If errors are discovered, we may not be able to successfully correct them in a timely manner or at all. In addition, we may need to make significant expenditures of capital resources in order to eliminate errors and failures. Errors and failures in our products could result in loss of or delay in market acceptance of our products and could damage our reputation. If one or more of our products fails, a customer may assert warranty and other claims for substantial damages against us. The occurrence or discovery of these types of errors or failures could have a material adverse effect on our business, operating results and financial condition. OUR SUCCESS DEPENDS ON OUR ABILITY TO EXPAND AND MANAGE OUR INTERNATIONAL OPERATIONS. Sales outside North America accounted for 13% and 11% of our total revenue for the nine months ended December 31, 1999 and 1998, respectively. We currently expect international revenue to continue to account for a significant percentage of total revenue in the future. We believe that we must continue to expand our international sales activities in order to be successful. Our international sales growth will be limited if we are unable to expand international indirect distribution channels, hire additional sales personnel, adapt products for local markets, or manage geographically dispersed operations. The major countries outside of North America in which we do, or intend to do, business are the United Kingdom, Germany and Japan. Our international operations, including our operations in the United Kingdom, Germany and Japan, are generally subject to a number of risks, including failure of local laws to provide the same degree of protection against infringement of our intellectual property, protectionist laws and business practices that favor local competitors, dependence on local indirect channel partners, multiple conflicting and changing governmental laws and regulations, longer sales cycles, greater difficulty in collecting accounts receivable, foreign currency exchange rate fluctuations and political and economic instability. OUR BUSINESS MAY BE AFFECTED BY UNEXPECTED YEAR 2000 PROBLEMS. Many existing computer systems and software products do not properly recognize dates after December 31, 1999. This year 2000 problem could result in miscalculations, data corruption, system failures or disruptions of operations. Our products, our internal systems, our customers' systems, our distributors' systems and our suppliers' systems may experience year 2000 problems, any of which could have a material adverse effect on our business, operating results and financial condition. Under the reasonably, likely worst case scenario our products could interact with non-year 2000 compliant products, which could cause our products to malfunction, our indirect channel partners, our customer or we may not be able to process orders, or our suppliers may not be able to supply us with critical components needed to make our products. Year 2000 errors or defects in our products could give rise to warranty and other claims by our customers. In addition, there can be no assurance that year 2000 errors or defects will not be discovered in our internal software systems and, if errors or defects are present, there can be no assurance that the costs of making such systems year 2000 compliant will not be material. If we are unable to make our products and internal systems year 2000 compliant in a timely manner, our business, operating results and financial condition could be materially adversely affected. Changing purchasing patterns of customers impacted by year 2000 issues may result in reduced purchases of our solutions. Any year 2000 errors or defects in our distributors' systems or the products of our original equipment manufacturer partners could cause a reduction in their orders to us. Finally, year 2000 errors or defects in the internal systems of our suppliers, including our sole and limited source suppliers, could require us to incur significant unanticipated expense to remedy any problems or replace affected vendors and could cause cancellations or delays in product shipments. 17 THE PRICE OF OUR COMMON STOCK MAY DECREASE DUE TO MARKET VOLATILITY. The stock market in general has recently experienced extreme price and volume fluctuations. In addition, the market prices of securities of technology companies have been extremely volatile and have experienced fluctuations that often have been unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations could adversely affect the market price of our common stock. Recently, when the market price of a stock has been volatile, holders of that stock have occasionally instituted securities class action litigation against the company that issued the stock. If any of our stockholders brought such a lawsuit against us, even if the lawsuit is without merit, we could incur substantial costs defending the lawsuit. The lawsuit could also divert the time and attention of our management. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We consider all highly-liquid investments purchased with a maturity of three months or less to be cash equivalents and those with maturities greater than three months are considered to be investments. Cash equivalents and investments are stated at amortized cost plus accrued interest, which approximates fair value. Cash equivalents and investments consist primarily of money market instruments and U.S. Treasury bills. We currently do not hedge interest rate exposure, but do not believe that an increase in interest rates would have a material effect on the value of our investments. On January 1, 1999, eleven of the existing members of the European Union joined the European Monetary Union. Ultimately there will be a single currency within certain countries of the European Union, known as the Euro, and one organization, the European Central Bank, responsible for setting European monetary policy. We have reviewed the impact the Euro will have on our business and whether this will give rise to a need for significant changes in our commercial operations or treasury management functions. Because our transactions are denominated in U.S. dollars, we do not believe that the Euro conversion will have any material effect on our business, financial condition or results of operations. PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. In August 1998, a former employee made claims against NetScout and an employee stockholder and alleged unspecified damages. The former employee filed a related claim with the Massachusetts Commission Against Discrimination (the "MCAD") and the Equal Employment Opportunity Commission (the "EEOC") in December 1998. In July 1999, the former employee requested that the claim be withdrawn from the MCAD and the EEOC so that the claim may be filed in state and/or federal court. In accordance with this request, the MCAD closed this matter on July 14, 1999 and the EEOC closed this matter on August 12, 1999. On or about November 5, 1999, the former employee filed an action in the Superior Court Department of the Trial Court, Middlesex County. On December 30, 1999, NetScout filed a Notice of Removal to the United States District Court for the District of Massachusetts, thereby removing the action to that Court. Based on the information available to date, NetScout believes that the claim is without merit and intends to vigorously defend this claim. NetScout has recorded an accrual to address this matter, however, since this matter is at a preliminary stage, NetScout is unable to predict the outcome or amount of related expense, or loss, if any. In addition to the matter noted above, from time to time NetScout is subject to legal proceedings and claims in the ordinary course of business. In the opinion of management, the amount of ultimate expense with respect to any other current legal proceedings and claims will not have a material adverse effect on NetScout's financial position or results of operations. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS. On August 17, 1999, we completed our initial public offering of 3 million shares of common stock at a price of $11.00 per share. The principal underwriters for the transaction were Deutsche Banc Alex. Brown, Bear, Stearns & Co. Inc. and Dain Rauscher Wessels, a division of Dain Rauscher Incorporated. The registration statement relating to this offering was declared effective by the Securities and Exchange Commission (SEC File Number 333-76843) on August 11, 1999. The aggregate offering price of the initial public offering of our 18 securities to the public was $33.0 million. We received proceeds of $30.7 million after deducting $2.3 million in underwriting discounts and commissions. We also incurred $1.1 million in other offering expenses. The net proceeds we received after deducting underwriting discounts and commissions and other offering expenses was approximately $29.6 million. Upon the exercise of the over allotment option by the underwriters, certain selling security holders sold 450,000 shares of common stock for net proceeds of approximately $4.6 million after deducting underwriting discounts and commissions. To date, we have not utilized any of the net proceeds from our initial public offering. We have invested all such net proceeds primarily in US Treasury obligations and other interest bearing investment grade securities. From September 1, 1999 to December 31, 1999, NetScout issued 181,335 shares of Common Stock for an aggregate purchase price of $276,495 pursuant to the exercise of stock options. No underwriters were involved in the sale of such securities. These sales were made in reliance upon an exemption from the registration provisions of the Securities Act set forth in Rule 701 under the Securities Act. These securities are deemed restricted securities for purposes of the Securities Act. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits The following exhibits are filed or incorporated by reference as part of this Report. 10.1* Amendment No. 5 effective as of December 26, 1999 to Private Label Agreement and Project Development and License Agreement between Cisco Systems, Inc. and NetScout Systems, Inc. 11.1 Statement re Computation of Per Share Earnings 27.1 Financial Data Schedule (b) Reports on Form 8-K None * Confidential treatment requested pursuant to Rule 24b-2 of the Securities Exchange Act of 1934 19 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. NetScout Systems, Inc. /S/ ANIL SINGHAL ----------------------------------- Date: February 14, 2000 Name: Anil Singhal Title: Chairman of the Board, Chief Executive Officer and Treasurer NetScout Systems, Inc. /S/ LISA FIORENTINO ----------------------------------- Date: February 14, 2000 Name: Lisa Fiorentino Title: Vice President, Finance and Chief Accounting Officer 20 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION 10.1* Amendment No. 5 effective as of December 26, 1999 to Private Label Agreement and Project Development and License Agreement between Cisco Systems, Inc. and NetScout Systems, Inc. 11.1 Statement re Computation of Per Share Earnings 27.1 Financial Data Schedule
* Confidential treatment requested pursuant to Rule 24b-2 of the Securities Exchange Act of 1934 21 EX-10.1 2 EX 10-1 AMENDMENT NO. 5 TO PRIVATE LABEL AGREEMENT AND PROJECT DEVELOPMENT AND LICENSE AGREEMENT BETWEEN CISCO SYSTEMS, INC. AND NETSCOUT SYSTEMS, INC. This Amendment No. 5 ("Amendment #5"), having an Effective Date of Dec 26, 1999, is made by and between Cisco Systems, Inc., a California corporation having its principal place of business at 170 West Tasman Drive, San Jose, CA 95134-1706, U.S.A. ("Cisco"), and NetScout Systems, Inc., (Formerly known as Frontier Software Development, Inc.) a Delaware corporation having its principal place of business at 4 Technology Park Drive, Westford, Massachusetts 01886 ("NetScout"). WHEREAS, Cisco and NetScout entered into the Project Development and License Agreement on July 13, 1994 ("Software Agreement"), a Private Label Agreement on October 17, 1995 ("Hardware Agreement") and four amendments dated January 4, 1995 ("Amendment #1"), May 15, 1996 ("Amendment #2"), October 29, 1996 ("Amendment #3"), and Feb 23, 1998 ("Amendment #4"), collectively the "Agreement"; and WHEREAS, Cisco and NetScout desire to change and add certain terms to the Agreement as specified below. NOW THEREFORE, in consideration of the covenants and conditions contained herein, the parties agree as follows: 1.0 DEFINITIONS. All defined terms shall have the meaning as defined in the Agreement except that terms defined herein shall have the meaning as defined in this Amendment #5. "Applications" shall mean, collectively, all NetScout RMON and other management and monitoring application programs shipped to Cisco as Products (see Section 1 of Amendment #2) under the Agreement, including but not limited to, TrafficDirector and TrafficScout. SwitchProbes, RMON Agents, and Embedded Agents are not considered Applications. "CWSI-LAN Bundle" shall mean a Cisco LAN management product that includes one or more Cisco LAN management applications, and specifically includes the NetScout TrafficScout Application or the Cisco version of NetScout's NetScout Manager Plus Application known as TrafficDirector as a bundled component. In the event that the parties choose to include additional NetScout Applications within the CWSI-LAN Bundle, the parties shall negotiate in good faith to establish royalty payments and other terms and conditions relating to the inclusion of these additional Applications to this bundle. "Effective Date" as used herein shall mean the Effective Date of this Amendment #5. "First Customer Shipment (FCS)" shall mean first shipment for revenue of a new release of a product by Cisco per Cisco's then existing new product release process. Cisco Systems Confidential Information Page 1 [*] INDICATES MATERIAL THAT HAS BEEN OMITTED AND FOR WHICH CONFIDENTIAL TREATMENT HAS BEEN REQUESTED. ALL SUCH OMITTED MATERIAL HAS BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION PURSUANT TO RULE 24b-2 PROMULGATED UNDER THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. "Strategic Feature Set" shall mean one or more product features, as agreed to by the parties, for which Cisco shall pay an incremental royalty for Products that incorporate such feature set. "WAN Bundle" shall mean a Cisco WAN (Wide Area Networking) management product that includes one or more Cisco WAN management applications, and specifically includes the NetScout TrafficScout Application or the Cisco version of NetScout's NetScout Manager Plus Application known as TrafficDirector as a bundled component. In the event that the parties choose to include additional NetScout Applications within the WAN Bundle, the parties shall negotiate in good faith to establish the royalty payments and other terms and conditions relating to the inclusion of these additional Applications to this bundle. 2.0 TERM EXTENSION. The term of the Agreement is hereby extended to October 31, 2002. Thereafter, this Agreement shall be automatically renewed for additional successive one (1) year periods, unless written notice of non-renewal is received by the other party no later than ninety (90) days prior to the expiration of the then current term 3.0 ROYALTIES. (a) CWSI-LAN Bundle Royalties. Notwithstanding anything to the contrary in the Agreement, the royalty for each unit of the CWSI-LAN Bundle shipped for revenue by Cisco, but excluding units shipped pursuant to Cisco's customer support contract obligations for CWSI-LAN products (which are covered under the maintenance fees in Section 4.0 below and except as provided in subsection (b) below), shall be as follows: (i) Beginning on the Effective Date, the base royalty for the CWSI-LAN Bundle shall be [*] per unit. (ii) Thereafter the base royalty shall be reduced [*] per unit for units shipped after the start of the seventh (7th) complete Cisco fiscal month after the Effective Date and shall be reduced an additional [*] per unit for units shipped at each successive six (6) month interval thereafter, provided however that the minimum base royalty (exclusive of incremental royalties for Strategic Features) shall be [*] per unit. (iii) The royalty shall be increased above the then current base royalty by [*] per unit for each Strategic Feature Set incorporated within the for CWSI-LAN Bundle. (b) CWSI-LAN Bundle Upgrades. Cisco shall pay a one-time upgrade fee of [*] per unit to upgrade a customer who had previously licensed a Cisco product containing TrafficDirector to the CWSI-LAN Bundle containing TrafficScout. (c) WAN Bundle Royalties. Notwithstanding anything to the contrary in the Agreement, the royalty for each unit of the WAN Bundle shipped for revenue by Cisco, but excluding units shipped pursuant to Cisco's support contract obligations (which are covered under the maintenance fees in Section 4.0 below), shall be as follows: (i) Beginning at FCS for the first commercial release of the WAN Bundle accepted by Cisco the base royalty shall be [*] per unit. Cisco Systems Confidential Information Page 2 [*] INDICATES MATERIAL THAT HAS BEEN OMITTED AND FOR WHICH CONFIDENTIAL TREATMENT HAS BEEN REQUESTED. ALL SUCH OMITTED MATERIAL HAS BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION PURSUANT TO RULE 24b-2 PROMULGATED UNDER THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. (ii) Beginning at the start of the thirteenth (13th) complete Cisco fiscal month after FCS the base royalty shall be [*] per unit. (iii) Beginning at the start of the nineteenth (19th) complete Cisco fiscal month after FCS the base royalty shall be [*] and shall continue at this level. (iv) The royalty shall be increased above the then current base royalty by [*] per unit for each Strategic Feature Set incorporated within the for WAN Bundle. (d) WAN Bundle Upgrades. Cisco shall have no obligation to pay an upgrade fee or any other royalty, for units of WAN Bundle shipped by Cisco pursuant to its obligations under support contracts, to upgrade customers who had previously purchased the WAN Bundle including TrafficDirector to a WAN Bundle which includes TrafficScout. (e) Other Application Royalties. Notwithstanding anything to the contrary in the Agreement, except as provided for the CWSI-LAN Bundle and WAN Bundle herein, and excluding units shipped pursuant to Cisco's support contract obligations, Cisco shall pay a royalty of [*] of the then existing NetScout [*] for its comparable product for each unit of an Application shipped for revenue by Cisco. 4.0 MAINTENANCE FEES. Beginning on the Effective Date, Cisco shall pay NetScout a consolidated maintenance fee of [*] per Cisco fiscal quarter for all maintenance activity relating to all Applications hereunder. (First quarter shall be paid on a pro rata basis.) Such maintenance fee shall be paid within 45 days after the completion of each Cisco fiscal quarter. At the beginning of the fifth complete Cisco fiscal quarter after the Effective Date, the maintenance fee shall be increased to [*]. Thereafter, at yearly intervals, the parties shall review the maintenance activity to determine the appropriate maintenance fee for the next four Cisco fiscal quarters. In the event the parties cannot agree upon a new maintenance fee, the maintenance fee shall increase by [*] at each annual anniversary of the first increase. Notwithstanding anything to the contrary in the Agreement, except for the upgrade payments pursuant to Section 3 (b) herein, after the Effective Date, Cisco shall not be obligated to pay per-unit maintenance fees or royalties for units of Applications shipped as updates or upgrades pursuant to Cisco's product support obligations (including but not limited to, SAS Software Application Support, SASU, Software Application Support with Upgrades, SMARTnet). It is the intent of the parties that the maintenance fees per this Section 4 shall constitute the sole and total maintenance fees payable by Cisco to NetScout for Applications. 5.0 YEAR 2000. (a) Year 2000 Warranty. NetScout hereby represents and warrants to Cisco that the occurrence in or use by the Product of dates before, on or after January 1, 2000 ("Millennial Dates") will not adversely affect its performance with respect to date-dependent data, computations, output, or other functions (including, without limitation, calculating, comparing and sequencing) and that the Product will create, store, process and output information related to or including Millennial Dates without error or omissions and at no additional cost to Cisco. The Product includes calendar year 2000 date conversion and compatibility capabilities, including, but not limited to, date data century recognition, same century and multiple century formula and date value calculations, and user interface date data values that reflect the century, and that the Product will (i) manage and manipulate data involving dates, including single century and multiple century dates (including proper handling of leap year), and will not cause an abnormal abend or abort or result in the generation of incorrect values or invalid output involving such dates; and (ii) Cisco Systems Confidential Information Page 3 [*] INDICATES MATERIAL THAT HAS BEEN OMITTED AND FOR WHICH CONFIDENTIAL TREATMENT HAS BEEN REQUESTED. ALL SUCH OMITTED MATERIAL HAS BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION PURSUANT TO RULE 24b-2 PROMULGATED UNDER THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. include the indication of the correct century in all date-related user interface functionalities; (iii) include the indication of the correct century in all date-related system-to-system or application-to-application data interface functionalities; and (iv) respond to two-digit year-date input in a way that resolves the ambiguity as to century in a disclosed, defined, and predetermined manner. (b) Compliance with Year 2000 Specification. The parties agree that for a Product to comply with the warranty in Section 5(a) above, the Product must pass all relevant tests conducted by Cisco per Cisco's then existing Year 2000 Specification which Cisco applies for all of its products. 6.0 CHANGES AND CANCELLATIONS. Section 4.5 of the Hardware Agreement shall be deleted and replaced in its entirety with the following: "4.5 Cancellations and Reschedules Prior to the delivery of any item, Cisco may notify NetScout in writing of its intent to cancel the order for the Products. Written notice may be provided via e-mail. Such emails must be sent to Robert Massad at the email address of massadb@netscout.com, Tracy Steele at the email address of steelet@netscout.com and Tom Hill at the email address of thill@netscout.com. It is solely up to NetScout to notify Cisco of any changes to this list of people to be notified in the case of a cancellation notification. Cisco shall have the right to cancel orders or portions of orders per the terms herein, and subject to the cancellation charges per the "NetScout/Cisco - Maximum Cancellation Charges" table below, provided the aggregate Cisco purchase price of units cancelled is limited to [*] per calendar quarter. Additional cancellations, which exceed the [*], will be reviewed and agreed upon by Cisco and NetScout on a case by case basis. NetScout may not unreasonably withhold acceptance of the cancellation request. In the event that Cisco requests additional cancellations, NetScout shall not add value to nor ship any Product subject to the cancellation request. Cisco and NetScout shall have the right to request a mutually agreed upon third party auditor to settle any cancellation disputes. In the event that Cisco cancels additional quantity of Product, Cisco shall be liable for time, materials, reasonable markups on components or WIP that is not sellable, by NetScout, within 120 days of cancellation. As a part of this overall settlement, but not in addition to it, Cisco shall prepay the charges outlined in "NetScout/Cisco - Maximum Cancellation Charges" table. In the event that Cisco chooses to cancel additional quantities of Product, Cisco shall be liable for time, materials, reasonable markups on any components or WIP that is not sellable, by NetScout, within 120 days of cancellation or for the cancellation charges outlined in the "NetScout/Cisco Maximum Cancellation Charges" table below, whichever is greater. NetScout and Cisco will work together to use commercially reasonable efforts to mitigate the cancellation costs. A claim by NetScout for cancellation charges shall be limited to the reasonable markups previously referred to and the actual, documented costs incurred by NetScout related to the canceled portion of the purchase order, including, only to the extent that any components, materials and other inventory cannot be used in any of NetScout's non-Cisco products, as follows: (i) NetScout's cost of component inventory for the terminated portion of the purchase order(s), (ii) NetScout's cost of work in process materials including manufacturing operations completed at the time of cancellation for the canceled portion of Cisco's purchase order, and (iii) reasonable cancellation charges incurred by NetScout from component suppliers for the canceled portion of Cisco's purchase order. Cisco and NetScout shall have the right to request a mutually agreed upon third party auditor to settle any component cost issues. Cisco Systems Confidential Information Page 4 [*] INDICATES MATERIAL THAT HAS BEEN OMITTED AND FOR WHICH CONFIDENTIAL TREATMENT HAS BEEN REQUESTED. ALL SUCH OMITTED MATERIAL HAS BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION PURSUANT TO RULE 24b-2 PROMULGATED UNDER THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. NETSCOUT/CISCO - MAXIMUM CANCELLATION CHARGES Notice prior to Scheduled Delivery Date* Cancellation Charge Greater than 15 days [*] 11 to 15 days [*] 6 to 10 days [*] 3 to 5 days [*]
*Due date at Cisco's dock Cisco may reschedule the delivery of all or any portion of Products ordered under a purchase order or modify the delivery locations provided that NetScout has received written notice at least [*] working days prior to the due date at Cisco's dock. Cisco may reschedule the delivery of Product up to 120 days from the original delivery date without incurring cancellation charges. NetScout may charge Cisco an inventory-carrying cost for Product rescheduled thirty (30) calendar days or more past the original purchase order date. Carrying cost shall not exceed [*] of Cisco purchase price of the Product for each full thirty (30) day period past the original purchase order [delivery] date." 7.0 ON-TIME PERFORMANCE. NetScout's on-time performance shall be measured as [*] early, [*] days late. Cisco has the right to cancel any late product providing that the order was placed within the normal lead time parameters ** and expedited service is not requested** . All other terms and conditions of the Agreement remain in full force and effect except as modified herein by Amendment #5. IN WITNESS WHEREOF, the parties have caused this Amendment to be executed by their duly authorized representatives effective as of the last date given below. CISCO SYSTEMS, INC. NETSCOUT SYSTEMS, INC. /s/ Jeff Krause /s/ Anil K. Singhal - -------------------------------- -------------------------------- Signature Signature Jeff Krause Anil K. Singhal - -------------------------------- -------------------------------- Name Name VP & GM, EMBU Chairman & CEO - -------------------------------- -------------------------------- Title Title Cisco Systems Confidential Information Page 5 [*] INDICATES MATERIAL THAT HAS BEEN OMITTED AND FOR WHICH CONFIDENTIAL TREATMENT HAS BEEN REQUESTED. ALL SUCH OMITTED MATERIAL HAS BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION PURSUANT TO RULE 24b-2 PROMULGATED UNDER THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. EX-11.1 3 EXHIBIT 11.1 EXHIBIT 11.1 NETSCOUT SYSTEMS, INC. STATEMENT RE COMPUTATION OF PER SHARE EARNINGS (UNAUDITED) Below is a summary of the shares used in computing basic and diluted net income per share for the periods indicated.
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, 1999 1998 1999 1998 ---- ---- ---- ---- Weighted average number of shares outstanding ............................... 25,796,397 19,668,172 20,249,284 19,568,493 Shares attributable to Class B Convertible Common Stock .............................. -- -- 3,374,454 -- Shares attributable to Series A Preferred Stock ..................................... -- 2,526,316 610,910 2,526,316 Shares attributable to unvested Non-Voting Common Stock .............................. -- 126,250 -- 155,075 Stock options ............................. 2,357,949 1,659,726 2,327,330 1,542,181 ---------- ---------- ---------- ---------- Shares used in computing diluted net income per share ................................. 28,154,346 23,980,464 26,561,978 23,792,065 ========== ========== ========== ==========
Below is a summary of the shares used in computing pro forma basic and diluted net income per share for the periods indicated.
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, 1999 1998 1999 1998 ---- ---- ---- ---- Weighted average number of shares outstanding ................................ 25,796,397 19,668,172 20,249,284 19,568,493 Shares attributable to Class B Convertible Common Stock ............................... -- -- 3,374,454 -- Shares attributable to Series A Preferred Stock ...................................... -- 2,526,316 610,910 2,526,316 ---------- ---------- ---------- ---------- Shares used in computing pro forma basic net income per share ........................... 25,796,397 22,194,488 24,234,648 22,094,809 Shares attributable to unvested Non-Voting Common Stock ............................... -- 126,250 -- 155,075 Stock options .............................. 2,357,949 1,659,726 2,327,330 1,542,181 ---------- ---------- ---------- ---------- Shares used in computing pro forma diluted net income per share ....................... 28,154,346 23,980,464 26,561,978 23,792,065 ========== ========== ========== ==========
For both diluted net income per share and pro forma diluted net income per share, stock options to purchase 57,652 for the three months ended December 31, 1998 (unaudited) and 20,072 and 94,429 shares of Non-Voting Common Stock for the nine months ended December 31, 1999 and 1998 (unaudited), respectively, were outstanding at period end but were not included in the computation of diluted or pro forma diluted net income per share because the exercise prices of the options were greater than the average fair value of the common stock for the respective period. EX-27.1 4 EXHIBIT 27.1
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM CONSOLIDATED BALANCE SHEET AND CONSOLIDATED STATEMENT OF INCOME. 1,000 12-MOS 3-MOS 3-MOS 9-MOS 9-MOS MAR-31-1999 MAR-31-2000 MAR-31-1999 MAR-31-2000 MAR-31-1999 APR-01-1998 OCT-01-1999 OCT-01-1998 APR-01-1999 APR-01-19 98 MAR-31-1999 DEC-31-1999 DEC-31-1998 DEC-31-1999 DEC-31-1998 25,477 51,277 0 0 0 0 12,747 0 0 0 7,586 9,625 0 0 0 1,036 1,025 0 0 0 3,165 4,452 0 0 0 37,426 81,906 0 0 0 8,505 11,462 0 0 0 4,278 6,135 0 0 0 43,974 87,554 0 0 0 12,937 15,397 0 0 0 0 0 0 0 0 0 0 0 0 0 5,964 0 0 0 0 44,181 30 0 0 0 (43,563) 36,973 0 0 0 43,974 87,554 0 0 0 0 14,584 13,327 40,939 36,7 37 0 22,842 17,471 62,217 48,880 0 5,389 4,927 15,290 13,6 14 0 5,811 5,149 16,532 14,452 0 11,026 8,024 30,564 23,0 79 0 0 0 0 0 0 0 0 0 0 0 6,005 4,298 15,121 11,349 0 2,467 1,629 6,031 4,3 27 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 4,371 2,893 10,699 7,689 0 0.17 0.15 0.53 0. 39 0 0.16 0.12 0.40 0.32
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