10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 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 September 30, 2004

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 incorporation or organization)	(IRS Employer Identification No.)

310 Littleton Road, Westford, MA 01886

(978) 614-4000

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  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    YES  ¨    NO  x

The number of shares outstanding of the registrant’s common stock, par value $0.001 per share, as of November 3, 2004 was 30,631,123.

NETSCOUT SYSTEMS, INC.

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2004

TABLE OF CONTENTS

PART I: FINANCIAL INFORMATION
Item 1. Financial Statements	3
a.) Condensed Consolidated Balance Sheets:
As of September 30, 2004 and March 31, 2004	3
b.) Condensed Consolidated Statements of Operations:
For the three and six months ended September 30, 2004 and September 30, 2003	4
c.) Condensed Consolidated Statements of Cash Flows:
For the six months ended September 30, 2004 and September 30, 2003	5
d.) Notes to Condensed Consolidated Financial Statements	6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3. Quantitative and Qualitative Disclosures About Market Risk	35
Item 4. Controls and Procedures	36
PART II: OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	37
Item 4. Submission of Matters to a Vote of Security Holders	37
Item 6. Exhibits and Reports on Form 8-K	38
SIGNATURES	39
EXHIBIT INDEX	40

2

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

NetScout Systems, Inc.

Condensed Consolidated Balance Sheets

(In thousands, except share and per share data)

(Unaudited)

	September 30, 2004			March 31, 2004
Assets
Current assets:
Cash and cash equivalents	$	37,870		$	19,011
Marketable securities		34,416			50,432
Accounts receivable, net of allowance for doubtful accounts of $35 and $40 at September 30, 2004 and March 31, 2004, respectively		9,653			10,851
Inventories		2,949			3,366
Refundable income taxes		1,411			2,102
Deferred income taxes		1,750			1,667
Prepaids and other current assets		2,706			2,175
Total current assets		90,755			89,604
Fixed assets, net		5,810			5,415
Goodwill, net		28,839			28,839
Capitalized software development costs, net		552			884
Deferred income taxes		8,645			8,378
Long-term marketable securities		5,962			6,016
Other assets		39			45
Total assets	$	140,602		$	139,181
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	1,863		$	1,984
Accrued compensation		4,995			4,481
Accrued other		2,480			2,140
Income taxes payable		-			490
Deferred revenue		14,832			15,968
Total current liabilities		24,170			25,063
Deferred revenue		1,258			1,006
Total liabilities		25,428			26,069
Commitments and contingencies (Note7)
Stockholders’ equity:
Preferred stock, $0.001 par value: 5,000,000 shares authorized; no shares issued or outstanding at September 30, 2004 and March 31, 2004		-			-
Common stock, $0.001 par value: 150,000,000 shares authorized; 34,747,450 and 34,584,577 shares issued and 30,544,227 and 30,381,354 shares outstanding at September 30, 2004 and March 31, 2004, respectively		35			34
Additional paid-in capital		111,474			110,683
Accumulated other comprehensive (loss) income		(77	)		7
Treasury stock at cost, 4,203,223 shares at September 30, 2004 and March 31, 2004		(26,490	)		(26,490	)
Retained earnings		30,232			28,878
Total stockholders’ equity		115,174			113,112
Total liabilities and stockholders’ equity	$	140,602		$	139,181

The accompanying notes are an integral part of these condensed consolidated financial statements.

3

NetScout Systems, Inc.

Condensed Consolidated Statements of Operations

(In thousands, except per share data)

(Unaudited)

	Three Months Ended September 30,						Six Months Ended September 30,
	2004			2003			2004		2003
Revenue:
Product	$	12,224		$	9,878		$	23,784	$	18,506
Service		7,826			7,192			15,931		13,749
License and royalty		439			445			871		863
Total revenue		20,489			17,515			40,586		33,118
Cost of revenue:
Product		3,901			3,358			7,554		6,139
Service		1,077			1,022			2,142		2,066
Total cost of revenue		4,978			4,380			9,696		8,205
Gross profit		15,511			13,135			30,890		24,913
Operating expenses:
Research and development		4,058			3,670			8,377		6,679
Sales and marketing		8,802			8,038			17,585		15,982
General and administrative		1,806			1,550			3,760		3,199
Amortization of other intangible assets		-			-			-		272
Total operating expenses		14,666			13,258			29,722		26,132
Income (loss) from operations		845			(123	)		1,168		(1,219	)
Interest income and other expenses, net		119			160			298		357
Income (loss) before income tax expense (benefit)		964			37			1,466		(862	)
Income tax expense (benefit)		(93	)		37			112		(310	)
Net income (loss)	$	1,057		$	-		$	1,354	$	(552	)
Basic net income (loss) per share	$	0.03		$	-		$	0.04	$	(0.02	)
Diluted net income (loss) per share	$	0.03		$	-		$	0.04	$	(0.02	)
Shares used in computing:
Basic net income (loss) per share		30,533			30,058			30,491		30,046
Diluted net income (loss) per share		31,288			30,585			31,517		30,046

The accompanying notes are an integral part of these condensed consolidated financial statements.

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NetScout Systems, Inc.

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

	Six Months Ended September 30,
	2004			2003
Cash flows from operating activities:
Net income (loss)	$	1,354		$	(552	)
Adjustments to reconcile net income (loss) to cash provided by operating activities:
Depreciation		1,207			1,515
Amortization of other intangible assets		-			272
Amortization of capitalized software		332			110
Loss on disposal of fixed assets		62			35
Compensation expense associated with equity awards		-			83
Deferred income taxes		(327	)		(156	)
Changes in assets and liabilities:
Accounts receivable, net		1,198			1,148
Inventories		417			751
Refundable income taxes		691			(341	)
Prepaids and other current assets		(541	)		1,024
Other assets		6			-
Accounts payable		(121	)		989
Accrued compensation and other expenses		854			106
Income taxes payable		(490	)		-
Deferred revenue		(884	)		(1,982	)
Net cash provided by operating activities		3,758			3,002
Cash flows from investing activities:
Purchase of marketable securities		(31,857	)		(60,384	)
Proceeds from maturity of marketable securities		47,854			46,324
Purchase of fixed assets		(1,664	)		(885	)
Capitalized software development costs		-			(1,325	)
Net cash provided by (used in) investing activities		14,333			(16,270	)
Cash flows from financing activities:
Proceeds from issuance of common stock		768			292
Repurchase of common stock as treasury stock		-			(124	)
Net cash provided by financing activities		768			168
Net increase (decrease) in cash and cash equivalents		18,859			(13,100	)
Cash and cash equivalents, beginning of year		19,011			43,823
Cash and cash equivalents, end of period	$	37,870		$	30,723
Supplemental disclosure of cash flow information:
Cash paid for interest	$	122		$	8
Cash paid for income taxes	$	251		$	202
Non-cash financing activities:
Tax benefits of disqualifying dispositions of incentive stock options	$	24		$	24

The accompanying notes are an integral part of these condensed consolidated financial statements.

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NetScout Systems, Inc.

Notes to Condensed Consolidated Financial Statements

(In thousands, except share and per share data)

(Unaudited)

1.    Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements as of September 30, 2004 and for the three and six months ended September 30, 2004 and 2003, respectively, have been prepared by NetScout Systems, Inc. (“NetScout”) in accordance with generally accepted accounting principles for interim financial reports and the instructions for Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared under generally accepted accounting principles have been condensed or omitted pursuant to such regulations. In the opinion of NetScout’s management, the unaudited interim condensed consolidated financial statements include all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of NetScout’s financial position, results of operations and cash flows. The results of operations for the three and six months ended September 30, 2004 are not necessarily indicative of the results of operations for the year ending March 31, 2005. The balance sheet at March 31, 2004 has been derived from the audited consolidated 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 Annual Report on Form 10-K for the fiscal year ended March 31, 2004, as filed with the Securities and Exchange Commission on June 14, 2004.

2.    Stock-Based Compensation

NetScout accounts for stock-based awards to employees using the intrinsic value method as prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. NetScout has adopted the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure, an Amendment to FAS No. 123.” All stock-based awards to non-employees are accounted for using the fair value method in accordance with SFAS No. 123 and Emerging Issues Task Force (“EITF”) Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

Had compensation cost for NetScout’s option plans been determined based on the fair value at the grant dates, as prescribed in SFAS No. 148, NetScout’s net income (loss) and basic and diluted net income (loss) per share on a pro forma basis would have been as follows:

	Three Months Ended September 30,						Six Months Ended September 30,
	2004			2003			2004			2003
Net income (loss) as reported	$	1,057		$	-		$	1,354		$	(552	)
Add: stock-based compensation under APB No. 25		-			36			-			83
Deduct: stock-based employee compensation expense determined under fair value-based methods for all awards, net of tax		(1,277	)		(2,303	)		(2,792	)		(4,576	)
Pro forma net income (loss)	$	(220	)	$	(2,267	)	$	(1,438	)	$	(5,045	)
Basic net income (loss) per share:
As reported	$	0.03		$	-		$	0.04		$	(0.02	)
Pro forma	$	(0.01	)	$	(0.08	)	$	(0.05	)	$	(0.17	)
Diluted net income (loss) per share:
As reported	$	0.03		$	-		$	0.04		$	(0.02	)
Pro forma	$	(0.01	)	$	(0.07	)	$	(0.05	)	$	(0.17	)

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NetScout Systems, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(In thousands, except share and per share data)

(Unaudited)

2.    Stock-Based Compensation (Continued)

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions:

	Three Months Ended September 30,						Six Months Ended September 30,
Option Plans	2004			2003			2004			2003
Expected option term		4 years			4 years			4 years			4 years
Weighted average risk-free interest rate		3.6	%		2.8	%		3.6	%		2.6	%
Expected volatility		100	%		100	%		100	%		100	%
Dividend yield		-			-			-			-
Weighted average fair value	$	4.04		$	0.82		$	4.55		$	0.87

	Three Months Ended September 30,		Six Months Ended September 30,
Stock Purchase Plan	2004	2003	2004			2003
Expected option term	-	-		0.5 years			0.5 years
Weighted average risk-free interest rate	-	-		1.2	%		1.0	%
Expected volatility	-	-		100	%		100	%
Dividend yield	-	-		-			-
Weighted average fair value	-	-	$	2.28		$	1.15

3.    Cash, Cash Equivalents and Marketable Securities

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 marketable securities. Cash equivalents and short-term marketable securities are stated at cost plus accrued interest, which approximates fair value. Long-term marketable securities are stated at fair value based on quoted market prices. Cash equivalents and marketable securities consist primarily of money market instruments and U.S. Treasury bills.

Marketable Securities

Marketable securities held by NetScout at September 30, 2004, with maturity dates of October 2004 through March 2006, are as follows:

	Amortized Costs		Unrealized Losses			Fair Value
U.S. government and municipal obligations	$	16,497	$	(73	)	$	16,424
Commercial paper		24,909		-			24,909
Less restricted investment		965		(10	)		955
Available-for-sale marketable securities	$	40,441	$	(63	)	$	40,378
Short-term marketable securities						$	34,416
Long-term marketable securities						$	5,962

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NetScout Systems, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(In thousands, except share and per share data)

(Unaudited)

3.    Cash, Cash Equivalents and Marketable Securities (Continued)

Marketable securities held by NetScout at March 31, 2004, with maturity dates of April 2004 through March 2006, are as follows:

	Amortized Costs		Unrealized Gains/ (Losses)			Fair Value
U.S. government and municipal obligations	$	16,219	$	7		$	16,226
Commercial paper		40,906		-			40,906
Less restricted investment		688		(4	)		684
Available-for-sale marketable securities	$	56,437	$	11		$	56,448
Short-term marketable securities						$	50,432
Long-term marketable securities						$	6,016

Restricted Investment

NetScout has a restricted investment account related to a deferred compensation plan of $955, which is currently included in prepaids and other current assets. At September 30, 2004 and March 31, 2004, there were unrealized losses of $14 and $4, respectively, recorded as other comprehensive loss.

4.    Income Taxes

The effective income tax rates for the three months and six months ended September 30, 2004 were (9.6%) and 7.7%, respectively, compared with 99.2% and 36.0% for the three and six months ended September 30, 2003. The change in the effective income tax rates is primarily due to the favorable resolution of a federal income tax audit for the fiscal years ended March 31, 2000, 2001, 2002 and 2003 during the three months ended September 30, 2004. As a result of favorably completing this income tax audit, NetScout reduced previously accrued income taxes and recorded a $490 income tax benefit during the quarter ended September 30, 2004.

5.    Inventories

Inventories consist of the following:

	September 30, 2004		March 31, 2004
Raw materials	$	1,998	$	2,545
Work in process		62		70
Finished goods		889		751
	$	2,949	$	3,366

6.    Capitalized Software Development Costs

Costs incurred in the research and development of NetScout’s products are expensed as incurred, except for certain software development costs. Costs associated with the development of computer software are expensed prior to establishment of technological feasibility (as defined by SFAS No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed”) and capitalized thereafter until the related

8

NetScout Systems, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(In thousands, except share and per share data)

(Unaudited)

6.    Capitalized Software Development Costs (Continued)

software products are available for first customer shipment. During the six month period ended September 30, 2003, NetScout capitalized $1.3 million of software development costs. Beginning in August 2003 NetScout commenced amortization of capitalized software development costs on a straight-line basis over a two-year period. Amortization of capitalized software development costs were $332 and $110 for the six months ending September 30, 2004 and 2003, respectively.

Capitalized software development costs are periodically assessed for recoverability in the event of changes to the anticipated future revenue for the software products or changes in product technologies. Unamortized capitalized software development costs that are determined to be in excess of the net realizable value of the software products would be expensed in the period in which such a determination is made. NetScout believes that there is no additional adjustment to the carrying amount required at this time.

7.    Commitments and Contingencies

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 current legal proceedings and claims will not have a significant adverse effect on NetScout’s financial position or results of operations.

Guarantor’s Agreements

NetScout warrants that its software and hardware products will substantially conform to the documentation accompanying such products on their original date of shipment. For software, which also includes software embedded in our probes, the standard warranty commences upon shipment and expires ninety (90) days thereafter. With regard to hardware, the standard warranty commences upon shipment and expires twelve (12) months thereafter. Additionally, this warranty is subject to various exclusions which include but are not limited to non-conformance resulting from modifications made to the software or hardware by a party other than NetScout or damage to hardware caused by a power surge or a force majeure event. We also warrant that all of our support services shall be performed in a good and workmanlike manner. We believe our product and support services warranties are consistent with commonly accepted industry standards. No warranty cost information is presented since service revenue associated with warranty is deferred at the time of a sale and recognized over the warranty period, therefore, no warranty costs are accrued.

Contracts that we enter into in the ordinary course of business may contain standard indemnification provisions. Pursuant to these agreements, we may agree to defend any third party claims brought against a partner or direct customer claiming infringement of such third party’s (i) U.S. patent, (ii) Berne convention member country copyright, and/or (iii) U.S., EU and/or OHIM trademark or intellectual property rights. Moreover, this indemnity may require NetScout to pay any damages awarded against the partner or direct customer in such type of lawsuit as well as reimburse the partner or direct customer for any reasonable attorney’s fees incurred by them from the lawsuit.

On very limited occasions, we may agree to provide other forms of indemnification to partners or direct customers, such as indemnification that would obligate us to defend and pay any damages awarded to a third party against a partner or direct customer based on a lawsuit alleging that such third party has suffered personal injury and/or tangible property damage legally caused by negligently designed or manufactured products.

9

NetScout Systems, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(In thousands, except share and per share data)

(Unaudited)

7.    Commitments and Contingencies (Continued)

The term associated with these indemnification agreements is generally perpetual. The maximum potential amount of future payments that we could be required to pay arising from indemnification agreements may be limited to a certain monetary value. However, the monetary exposure associated with the majority of these indemnification agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. Historically, the Company has incurred no costs to defend lawsuits or settle claims relating to such indemnity agreements and the Company accordingly believes the estimated fair value of these agreements is immaterial. If we were to have to defend a lawsuit and settle claims, they could potentially have a material impact on our financial results.

8.    Treasury Stock

On September 17, 2001, NetScout announced an open market stock repurchase program to purchase up to one million shares of outstanding NetScout common stock, subject to market conditions and other factors. Any purchases under NetScout’s stock repurchase program may be made from time to time without prior notice. During the six months ended September 30, 2004 and 2003, NetScout repurchased 0 and 34,000 shares of common stock, respectively. As of September 30, 2004, NetScout has repurchased 158,000 shares of common stock under this program.

9.    Computation of Net Income (Loss) Per Share

Below is a summary of the shares used in computing basic and diluted net income (loss) per share:

	Three Months Ended September 30,		Six Months Ended September 30,
	2004	2003	2004	2003
Weighted average shares used in calculating basic net income (loss) per share	30,532,876	30,058,403	30,490,893	30,046,085
Stock options	755,382	526,862	1,026,146	-
Shares used in computing diluted net income (loss) per share	31,288,258	30,585,265	31,517,039	30,046,085

The following table sets forth common stock excluded from the calculation of diluted net loss per share, since the inclusion would be antidilutive:

	Three Months Ended September 30,		Six Months Ended September 30,
	2004	2003	2004	2003
Stock options	1,570,757	1,499,365	1,457,529	4,394,415

10.    Other Comprehensive Income (Loss)

Other comprehensive income (loss) consists of unrealized gains and losses on marketable securities, restricted investment, and foreign currency translation adjustments. Other comprehensive income (loss) for the three and six months ended September 30, 2004 and 2003 is as follows:

	Three Months Ended September 30,					Six Months Ended September 30,
	2004		2003			2004			2003
Net income (loss)	$	1,057	$	—		$	1,354		$	(552	)
Unrealized gains (loss) on marketable securities and restricted investment, net of $0 tax		46		(18	)		(84	)		(14	)
Other comprehensive income (loss)	$	1,103	$	(18	)	$	1,270		$	(566	)

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NetScout Systems, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(In thousands, except share and per share data)

(Unaudited)

11.    Geographic Information

Revenue was distributed geographically as follows:

	Three Months Ended September 30,				Six Months Ended September 30,
	2004		2003		2004		2003
North America	$	16,730	$	14,994	$	33,999	$	27,170
Europe – Middle East – Africa		2,328		2,032		4,044		4,141
Asia-Pacific		1,431		489		2,543		1,807
		$20,489	$	17,515	$	40,586	$	33,118

The North America revenue includes sales to North American resellers. These North American resellers may sell NetScout products to international locations. NetScout reports these shipments as North America revenue since NetScout ships the products to a North American location. Revenue attributable to locations outside of North America is a result of export sales. Substantially all of NetScout’s identifiable assets are located in the United States.

12.    Recently Issued Accounting Pronouncements

In March 2004, the EITF reached a consensus on EITF No. 03-01, “The Meaning of Other-Than Temporary Impairment and its Application to Certain Investments.” EITF No. 03-01 addresses disclosures about unrealized losses on available-for-sale debt and equity securities and the evaluation of other-than temporary impairment related to securities accounted for under FASB Statements No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The provisions of EITF No. 03-01 are effective for other-than temporary impairment evaluations and disclosures in fiscal periods beginning after June 15, 2004. The adoption of EITF No. 03-01 had no impact on NetScout’s financial position or operating results.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following information should be read in conjunction with the unaudited condensed consolidated financial information and the notes thereto included in this Quarterly Report on Form 10-Q.

In addition to the other information in this report, the following Management’s Discussion and Analysis should be considered carefully in evaluating NetScout and our business. This Quarterly Report on 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 Impact 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.

Overview

NetScout Systems, Inc. designs, develops, manufactures, markets, sells and supports a family of integrated products that enable performance and optimization of complex, high-speed networks, including the ability to efficiently deliver critical business applications and content to end-users. We manufacture and market these products in an integrated hardware and software solution that has been used by enterprises, large governmental agencies and service providers worldwide. We manage our business as a single operating segment and substantially all of our identifiable assets are located in the United States.

NetScout was incorporated in 1984 as a consulting services company. In 1992, we began to develop, manufacture and market our first infrastructure performance management products. Our operations have been financed principally through cash provided by operations.

Our operating results are influenced by a number of factors, including the mix of products, services and license and royalties sold, pricing, costs of materials used in our products and the expansion of our operations during the fiscal year. Factors that affect our ability to maximize our operating results include: our ability to introduce and enhance existing products, the marketplace acceptance of those new or enhanced products, continued expansion into international markets and current economic conditions.

For the three months ended September 30, 2004, our total revenue increased $3.0 million to $20.5 million compared to the $17.5 million of total revenue for the three months ended September 30, 2003. In addition, our cost of revenue increased by $598,000 to $5.0 million for the three months ended September 30, 2004 compared to $4.4 million in the three months ended September 30, 2003. Gross profit at $15.5 million, or 75.7% of revenue, in the three months ended September 30, 2004 increased from $13.1 million, or 75.0% of revenue, in the three months ended September 30, 2003. Our gross profit is primarily impacted by the mix and volume of product, service, license and royalty revenue and by the proportion of sales though direct versus indirect distribution channels. We realize significantly higher gross profits on license and royalty revenue relative to product and service revenue and higher gross profits on service revenue relative to product revenue. We typically realize higher gross profits on direct sales relative to sales through indirect distribution channels.

For the three months ended September 30, 2004, our total operating expenses were at $14.7 million, which include research and development, sales and marketing, and general and administrative expenses, as well as amortization of other intangible assets, increasing by $1.4 million compared to the $13.3 million of total operating expenses in the three months ended September 30, 2003. Primary contributors to this increase in overall expenses were a $237,000 increase in personnel costs due to increased headcount, $168,000 in engineering consulting costs due to hardware product development, a $759,000 increase in commissions which

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was mainly due to increased revenue attainment and higher attainment of incentive programs, as well as the capitalization of software development costs of $258,000 for the three months ended September 30, 2003, which did not occur for the three months ended September 30, 2004.

Net income for the three months ended September 30, 2004 at $1.1 million increased by $1.1 million compared to a net income of $0 for the three months ended September 30, 2003. This increase is primarily due to the increase in gross profit of $2.4 million, partially offset by the increase in operating expenses of $1.4 million, and a decrease in tax expense of $490,000 due to the favorable resolution of a federal income tax audit in the three months ended September 30, 2004, offset by income tax expense of $360,000 associated with a projected increase in pre-tax income for the three months ended September 30, 2004.

For the six months ended September 30, 2004, our total revenue increased $7.5 million to $40.6 million compared to the $33.1 million of total revenue for the six months ended September 30, 2003. In addition, our cost of revenue increased by $1.5 million to $9.7 million for the six months ended September 30, 2004 compared to $8.2 million in the six months ended September 30, 2003. Gross profit at $30.9 million, or 76.1% of revenue, in the six months ended September 30, 2004 increased from $24.9 million, or 75.2% of revenue, in the six months ended September 30, 2003.

For the six months ended September 30, 2004, our total operating expenses were at $29.7 million, which include research and development, sales and marketing, and general and administrative expenses, as well as amortization of other intangible assets, increasing by $3.6 million compared to the $26.1 million of total operating expenses in the six months ended September 30, 2003. Primary contributors to this increase in overall expenses were a $693,000 increase in personnel costs due to increased headcount, $257,000 in engineering consulting costs due to hardware product development, a $1.2 million increase in commissions which was mainly due to increased revenue attainment and higher attainment of incentive programs, as well as the capitalization of software development costs of $1.3 million for the six months ended September 30, 2003, which did not occur for the six months ended September 30, 2004.

Net income for the six months ended September 30, 2004 at $1.4 million increased by $1.9 million compared to a net loss of $552,000 for the six months ended September 30, 2003. This increase is primarily due to the increase in gross profit of $6.0 million, partially offset by the increase in operating expenses of $3.6 million, and a decrease in tax benefit of $912,000 due to income tax expense associated with a projected increase in pre-tax income, offset by the favorable resolution of a federal income tax audit in the six months ended September 30, 2004 of $490,000.

Critical Accounting Policies

NetScout considers accounting policies related to revenue recognition, accounts receivable and allowance for doubtful accounts, valuation of inventories, valuation of goodwill, capitalization of software development costs, and accounting for income taxes to be critical in fully understanding and evaluating our financial results.

Revenue Recognition

Product revenue consists of sales of our hardware products and licensing of our software products. Product revenue is recognized upon shipment, provided that evidence of an arrangement exists, title and risk of loss have passed to the customer, fees are fixed or determinable and collection of the related receivable is probable.

Service revenue consists primarily of fees from customer support agreements, consulting and training. NetScout generally provides three months of software support and 12 months of hardware support as part of product sales. Revenue from software support is deferred and recognized ratably over the three-month support period. Revenue from hardware support is deferred and recognized ratably over the 12-month support period. In addition, customers can elect to purchase extended support agreements, typically for 12-month periods. Revenue from these agreements is deferred and recognized ratably over the support period. Revenue from consulting and training is recognized as the work is performed.

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License and royalty revenue consists primarily of royalties under license agreements by original equipment manufacturers who incorporate components of our data collection technology into their own products or who reproduce and sell our software products. License revenue is recognized when delivery of the original equipment manufacturer’s product has occurred and when we become contractually entitled to receive license fees, provided that such fees are fixed or determinable and collection is probable. Royalty revenue is recognized based upon reported product shipments by the license holder.

Multi-element arrangements are customer purchases of a combination of NetScout product and service offerings which may be delivered at various points in time. For multi-element arrangements, each item of the purchase is analyzed and a portion of the total purchase price is allocated to the undelivered items, primarily support agreements and training, using vendor-specific objective evidence of fair value of that undelivered item. Under the residual method, the remaining portion of the purchase price is allocated to the delivered items, generally hardware products and licensed software products, regardless of any separate prices stated within the contract for each item. Vendor-specific objective evidence of fair value of the undelivered items is based on the price customers pay when the item is sold separately.

Accounts Receivable and Allowance for Doubtful Accounts

Accounts receivable is reduced by an allowance for doubtful accounts. Our standard payment terms are net 30 days. We monitor all accounts receivable balances of our customers and assess any collection issues as they arise. We believe our credit policies are prudent and reflect normal industry terms and business risk. At September 30, 2004, one customer accounted for more than 10% of our accounts receivable balance. At September 30, 2003, one different customer accounted for more than 10% of our accounts receivable balance. Historically, we have not experienced any significant non-performance by our customers nor do we anticipate non-performance by our customers in the future and, accordingly, typically we do not require collateral from our customers. On rare occasions we will require select international customers to provide a letter of credit. We perform credit checks on all potential new customers prior to acceptance of an order. We maintain allowances for doubtful accounts for possible losses resulting from the failure of our customers to make their required payments and any losses are recorded as general and administrative expenses. As of September 30, 2004, our allowance for doubtful accounts was $35,000. The allowance for doubtful accounts is based upon our judgments and estimates of the uncollectability of specific accounts receivable, historical bad debts, customer credit-worthiness, current economic trends and customer concentrations. Significant judgments and estimates are made when establishing the allowance for doubtful accounts. If these accounting judgments and estimates prove to be inadequate, our financial results could be materially and adversely impacted in future periods.

Valuation of Inventories

Inventories are stated at the lower of actual cost or their net realizable value. Inventories consist primarily of raw materials and finished goods. Inventory carrying values are reduced to our estimate of net realizable value by a reserve for obsolete and excess inventory. As of September 30, 2004, our reserve for obsolete and excess inventory was $689,000. We regularly monitor our inventories for potential obsolete and excess inventory. Our reserve for obsolete and excess inventory is based upon our estimates of forecasts of unit sales, expected timing and impact of new product introductions, historical product demand, current economic trends, expected market acceptance of our products and expected customer buying patterns. We adjust the cost basis of inventory that has been written down to reflect the net realizable value. Significant judgments and estimates are made when establishing the reserve for obsolete and excess inventory. If these accounting judgments and estimates prove to be inadequate, our financial results could be materially and adversely impacted in future periods.

Valuation of Goodwill

NetScout assesses goodwill for impairment at the enterprise-level at least annually or more frequently when events and circumstances occur indicating that the recorded goodwill may be impaired. If the book value of our

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enterprise exceeds its fair value, the implied fair value of goodwill is compared with the carrying amount of goodwill. If the carrying amount of goodwill exceeds the implied fair value, an impairment loss is recorded in an amount equal to that excess.

As of September 30, 2004, goodwill was $28.8 million. We consider the market capitalization of our outstanding common stock versus our stockholders’ equity as an indicator that may potentially trigger an impairment of goodwill analysis. At times, the market capitalization of our common stock may decline temporarily below our stockholders’ equity; however, we do not believe that any temporary decline below our stockholders’ equity would necessarily indicate impairment. If adverse economic or industry trends or decrease in customer demand result in a significant decline in our stock price for a sustained period in the future, we would need to assess an impairment loss. Significant judgments and estimates are made when assessing impairment. If these accounting judgments and estimates prove to be inadequate, an asset may be determined to be impaired and our financial results could be materially and adversely impacted in future periods. Likewise, if a future event or circumstance indicates that an impairment assessment is required and an asset is determined to be impaired, our financial results could be materially and adversely impacted in future periods.

Capitalization of Software Development Costs

Costs incurred in the research and development of NetScout’s products, including the various small point releases and small product enhancements which are released throughout each fiscal year, are expensed as incurred. Costs associated with the development of computer software are expensed prior to establishment of technological feasibility (as defined by SFAS No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed”) and capitalized thereafter, until the related software products are available for first customer shipment. Judgment is required in determining the point at which technological feasibility has been met. Major product enhancements, such as those included in our Performance Manager (“PM”) 2.0 release in fiscal year 2004, would be capitalized under the guidance of SFAS No. 86.

As of September 30, 2004, capitalized software development costs were $1.3 million, and accumulated amortization of capitalized software development costs were $773,000, resulting in net capitalized software costs of $552,000. Capitalized software development costs are subject to an ongoing assessment of recoverability based upon anticipated future revenue for the software products and changes in product technologies. Unamortized capitalized software development costs that are determined to be in excess of the net realizable value of the software product will be expensed in the period in which such a determination is made. Significant judgments and estimates are made when assessing the net realizable value of the unamortized software development costs. If our accounting judgments and estimates prove to be inadequate, we may be required to expense such software development costs immediately and our financial results could be materially and adversely impacted in future periods.

Accounting for Income Taxes

NetScout estimates the quarterly income tax expense (benefit) based on the Company’s projected annual effective tax rate. NetScout’s projected annual effective tax rate differs from the federal statutory and state tax rates primarily due to the impact of federal and state tax credits. During the three month period ended September 30, 2004, the quarterly tax expense (benefit) was also affected by the favorable resolution of a federal income tax audit of fiscal years ended March 31, 2000, 2001, 2002 and 2003. Significant judgments and estimates are made when assessing NetScout’s projected annual effective tax rate. If these judgments and estimates prove to be inadequate, our tax rate could fluctuate significantly and our financial results could be materially and adversely impacted in the future.

NetScout recognizes deferred income tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities. We make an assessment of the likelihood that our deferred income tax assets will be recovered from future taxable income, and, to the extent that recovery

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is not believed to be more likely than not, a valuation allowance is established. All available evidence, both positive and negative, is considered in the determination of recording a valuation allowance. We consider future taxable income and ongoing tax planning strategies when assessing the need for a valuation allowance. While the negative evidence that would suggest the need for a valuation allowance for the Company consists of cumulative pre-tax losses in recent prior years, these losses have continued to be reduced over the last three years and we recorded a pre-tax income in the six month period ended September 30, 2004. Additional positive evidence consists of current healthy cash balances, a current strong balance sheet, solid technology, historically stable gross margins, projected future pre-tax profits, as well as, a consistent earnings history for the Company prior to these operating loss years. The Company believes future taxable income will be sufficient to realize the deferred tax benefit of the net deferred tax assets.

As of September 30, 2004, deferred income tax assets were $10.4 million, consisting primarily of $5.4 million of federal net operating loss carryforwards and $542,000 of federal research and development tax credits, which begin to expire in fiscal year 2012, and $3.8 million of other temporary differences. Significant accounting judgments and estimates are made when determining whether it is more likely than not that our deferred income tax assets will not be realized and, accordingly, require a valuation allowance. If these judgments and estimates prove to be inadequate, a valuation allowance may be required and our financial results could be materially and adversely impacted in the future. If we determine that we will not be able to realize some or all of the deferred income taxes in the future, an adjustment to the deferred income tax assets will be charged to income tax expense in the period such determination is made.

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Results of Operations

The following table sets forth for the periods indicated the percentage of total revenue of certain line items included in our Statements of Operations:

NetScout Systems, Inc.

Statements of Operations

Percentages of Total Revenue

	Three Months Ended September 30,				Six Months Ended September 30,
	2004		2003		2004		2003
Revenue:
Product	59.7	%	56.4	%	58.6	%	55.9	%
Service	38.2		41.1		39.3		41.5
License and royalty	2.1		2.5		2.1		2.6
Total revenue	100.0		100.0		100.0		100.0
Cost of revenue:
Product	19.0		19.2		18.6		18.6
Service	5.3		5.8		5.3		6.2
Total cost of revenue	24.3		25.0		23.9		24.8
Gross margin	75.7		75.0		76.1		75.2
Operating expenses:
Research and development	19.8		21.0		20.6		20.2
Sales and marketing	43.0		45.9		43.3		48.2
General and administrative	8.8		8.8		9.3		9.7
Amortization of other intangible assets	-		-		-		0.8
Total operating expenses	71.6		75.7		73.2		78.9
Income (loss) from operations	4.1		(0.7	)	2.9		(3.7	)
Interest income and other expenses, net	0.6		0.9		0.7		1.1
Income (loss) before income tax expense (benefit)	4.7		0.2		3.6		(2.6	)
Income tax expense (benefit)	(0.5	)	0.2		0.3		(0.9	)
Net income (loss)	5.2	%	-	%	3.3	%	(1.7	)%

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Three Months Ended September 30, 2004 and 2003

Revenue

Product revenue consists of sales of our hardware products and licensing of our software products. Service revenue consists of customer support agreements, consulting and training. License and royalty revenue consists of royalties under license agreements by original equipment manufacturers who incorporate components of our data collection technology into their own products or who reproduce and sell our software products. One customer accounted for more than 10% of our total revenue during the three months ended September 30, 2004 and one different customer accounted for more than 10% of our total revenue during the three months ended September 30, 2003.

	Three Months Ended September 30,				Percentage Change
	2004		2003
Revenue:
Product	$	12,224	$	9,878	24	%
Service		7,826		7,192	9	%
License and royalty		439		445	(1	)%
Total revenue	$	20,489	$	17,515	17	%

Product.    The 24% or $2.3 million increase in product revenue was primarily due to an increase of approximately 17% in unit sales and an increase of approximately 2% in average selling price due to the sale of our high capacity probes. Also contributing to the increase in product revenue was increased sales of our nGenius^® appliance products. We expect to continue to generate increasing sales sequentially from the second quarter to the third quarter of fiscal year 2005, based on continued indications of interest by our customers in our CDM^TM Technology and our nGenius suite of products.

Service.    The 9% or $634,000 increase in service revenue was primarily due to an increase in the number of customer support agreements attributable to new product sales generated during the last 12 months, combined with continued renewals of customer support agreements from our expanding installed base. We expect service revenue in absolute dollars to increase sequentially from the second quarter to the third quarter of fiscal year 2005.

License and royalty.    The 1% or $6,000 decrease in license and royalty revenue was primarily due to a decrease in unit sales. We anticipate license and royalty revenue to be relatively flat sequentially from the second quarter to the third quarter of fiscal year 2005 and subject to the volume of Cisco Systems, Inc.’s (“Cisco”) sales of their products that incorporate our software. As announced in our report on Form 8-K filed on September 21, 2004, following discussions between NetScout and Cisco regarding NetScout’s plan to terminate support for its legacy product, Real Time Monitor 1.4, Cisco announced its intention to discontinue reselling Real Time Monitor as of November 30, 2004. The announcement was contained in a letter dated September 15, 2004, notifying NetScout of the non-renewal of the Private Label Agreement dated October 17, 1995, as amended, and the Project Development and License Agreement dated July 13, 1994, as amended, by and between NetScout and Cisco (the “Agreements”). Pursuant to the foregoing and the terms of the Agreements, the Agreements will expire on June 1, 2005. NetScout will continue to recognize license and royalty revenue based upon reported product shipments by Cisco, with the final product shipments report expected in the fourth quarter of fiscal year 2005. NetScout does not expect a material impact from Cisco’s non-renewal of the Agreements, as it will be offering Cisco Real Time Monitor 1.4 customers a purchase option to upgrade to nGenius Performance Manager 2.0.

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Cost of Revenue and Gross Profit

Cost of product revenue consists primarily of material components, personnel costs, media duplication, manuals, packaging materials, licensed technology fees, overhead and amortization of capitalized software. Cost of service revenue consists primarily of personnel, material and support costs.

	Three Months Ended September 30,						Percentage Change
	2004			2003
Cost of revenue:
Product	$	3,901		$	3,358		16	%
Service		1,077			1,022		5	%
Total cost revenue	$	4,978		$	4,380		14	%
Gross profit:
Product $	$	8,323		$	6,520		28	%
Product %		68	%		66	%
Service $		6,749			6,170		9	%
Service %		86	%		86	%
License and royalty $		439			445		(1	)%
License and royalty %		100	%		100	%
Total gross profit $	$	15,511		$	13,135		18	%
Total gross margin %		76	%		75	%

Product.    The 16% or $543,000 increase in cost of product revenue corresponds with the 24% or $2.3 million increase in product revenue. The cost increase is due to an increase of approximately 17% in unit sales, as well as the increased sales of our nGenius appliance products. The product gross margin percentage increase of 2 points to 68% from 66% was mainly due to an increase of our average selling price of 2% in addition to an approximate 1% decrease of unit costs. We expect to generate increasing sales sequentially from the second quarter to the third quarter of fiscal year 2005, based on continued indications of interest by our customers in our CDM Technology and our nGenius suite of products; therefore, we expect cost of product revenue to increase in absolute dollars.

Service.    The 5% or $55,000 increase in cost of service revenue was primarily due to an increase of $28,000 in repair activity and $17,000 in increased personnel costs to support our increasing customer base. The 9% or $579,000 increase in service gross profit corresponds with the 9% or $634,000 increase in service revenue. We anticipate cost of service revenue to remain relatively constant in absolute dollars sequentially from the second quarter to the third quarter of fiscal year 2005.

Gross profits.    Our gross profit in absolute dollars increased 18% or $2.4 million. This increase in gross profit in absolute dollars was partially due to a $2.3 million increase in product revenue, which resulted from higher unit sales and an increase in average selling prices, offset by an increase of $543,000 in product costs due to the increase in unit sales and the increased sale of our nGenius appliance products. Also adding to the absolute dollar increase in gross profit was the increase in the service margin of $579,000, which resulted from increased service revenue. The net effect of the combined increases in revenue and increases in cost was a 1 point increase in gross margin percentage. We anticipate that our gross margin percentage will remain relatively constant sequentially from the second quarter to the third quarter of fiscal year 2005.

Also, our gross profit is primarily impacted by the mix of product, service, license and royalty revenue and by the proportion of sales through direct versus indirect distribution channels. We realize significantly higher gross profits on license and royalty revenue relative to product and service revenue and higher gross profits on service revenue relative to product revenue.

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Total product and service revenue from direct channels and product, service and license and royalty revenue from indirect channels are below. We typically realize higher gross profits on direct sales relative to sales through indirect distribution channels. While during the three month period ended September 30, 2004 our mix of indirect compared to direct channels was more heavily weighted to indirect channels, our margins improved due to a fluctuation in customer sales where we realize greater margins due to higher selling prices for particular sales opportunities.

	Three Months Ended September 30,								Percentage Change
	2004				2003
Channel mix:
Indirect	$	13,187	64	%	$	8,086	46	%	63	%
Direct		7,302	36			9,429	54		(23	)%
Total Revenue	$	20,489	100	%	$	17,515	100	%	17	%

Sales outside North America are primarily export sales through indirect channel partners, who are generally responsible for selling products and providing technical support and service to customers within their territory. All sales arrangements are transacted in United States dollars. Our reported international revenue does not include any revenue from sales to customers outside North America that are shipped to our North American-based indirect channel partners. These domestic resellers may sell NetScout products to international locations; however, NetScout reports these shipments as North America revenue since NetScout ships the products to a domestic location.

Revenue was distributed geographically as follows:

	Three Months Ended September 30,								Percentage Change
	2004				2003
Geographic mix:
North America	$	16,730	82	%	$	14,994	86	%	12	%
International:
Europe – Middle East – Africa		2,328	11			2,032	12		15	%
Asia-Pacific		1,431	7			489	2		193	%
Subtotal International:		3,759	18			2,521	14		49	%
Total Revenue	$	20,489	100	%	$	17,515	100	%	17	%

Revenue from sales outside North America increased 49% as a result of timing fluctuations in the closing of international sales. NetScout expects revenue from sales outside North America to continue to account for a significant portion of our revenue in the future.

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.

	Three Months Ended September 30,								Percentage Change
	2004				2003
			% of Revenue				% of Revenue
Research and development	$	4,058	20	%	$	3,670	21	%	11	%

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The 11% or $388,000 increase in research and development expenses was primarily due to the application of SFAS No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,” which required the capitalization of software development costs of $258,000 during the three months ended September 30, 2003. Excluding the capitalization of software development costs, research and development expenses increased by $130,000 which was mainly due to increases in engineering consulting costs of 100% or $168,000, which resulted from new hardware product development to expand our nGenius product line. Average headcount in research and development was 102 and 100 for the three months ended September 30, 2004 and 2003, respectively. We anticipate research and development expenses will remain relatively constant in absolute dollars sequentially from the second quarter to the third quarter of fiscal year 2005.

Sales and marketing.    Sales and marketing expenses consist primarily of personnel costs and other costs associated with marketing programs such as trade shows, seminars, advertising and new product launch activities.

	Three Months Ended September 30,								Percentage Change
	2004				2003
			% of Revenue				% of Revenue
Sales and marketing	$	8,802	43	%	$	8,038	46	%	10	%

The 10% or $764,000 increase in total sales and marketing expenses was primarily due to a 60% or $759,000 increase in commission expense that was mainly due to increased revenue attainment and higher attainment of incentive programs. Average headcount in sales and marketing was 145 and 144 for the three months ended September 30, 2004 and 2003, respectively. We anticipate that we will increase sales and marketing expenses in absolute dollars sequentially from the second quarter to the third quarter of fiscal year 2005 due to increased sales compensation expenses resulting from expected headcount additions.

General and administrative.    General and administrative expenses consist primarily of personnel costs for executive, financial and human resource employees and other corporate expenditures.

	Three Months Ended September 30,								Percentage Change
	2004				2003
			% of Revenue				% of Revenue
General and administrative	$	1,806	9	%	$	1,550	9	%	17	%

The 17% or $256,000 increase in general and administrative expense was primarily due to a 22% or $196,000 increase in personnel costs due to increased compensation costs and increased headcount and a 45% or $90,000 increase in professional services, mainly due to efforts associated with compliance with the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”). Average headcount in general and administrative was 53 and 50 for the three months ended September 30, 2004 and 2003, respectively. We anticipate general and administrative expenses will increase in absolute dollars sequentially from the second quarter to the third quarter of fiscal year 2005, mainly due to additional increases in costs associated with Sarbanes-Oxley compliance efforts.

Interest income and other expenses, net.    Interest income includes interest earned on our cash, cash equivalents and marketable securities and restricted investments. Other expenses, net includes gain (loss) on disposal of equipment, gifts to charity, various interest and late statutory filing fees, and other miscellaneous expenses and income.

	Three Months Ended September 30,								Percentage Change
	2004				2003
			% of Revenue				% of Revenue
Interest income and other expenses, net	$	119	1	%	$	160	1	%	(25	)%

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The 25% or $41,000 decrease in interest income and other expenses, net was primarily due to $111,000 of additional interest expense due to the favorable resolution of a federal income tax audit offset by higher market interest rates on cash, cash equivalents and marketable securities.

Income tax expense (benefit).    We estimate our income tax expense (benefit) based on the Company’s estimated annual effective tax rate. The estimated annual effective tax rate as of September 30, 2004 is 24%, compared to an estimated annual effective tax rate of 36% as of September 30, 2003. Generally, the estimated annual effective tax rates differ from the federal statutory and state tax rates primarily due to the impact of federal and state tax credits. In addition, the Company recorded an income tax benefit of $490,000 during the three months ended September 30, 2004 as a result of the favorable resolution of a federal income tax audit. The estimated annual effective tax rates for the three months ended September 30, 2004 and 2003 would have been comparable if not for the favorable resolution of the federal income tax audit during the three months ended September 30, 2004.

	Three Months Ended September 30,
	2004					2003
				% of Revenue				% of Revenue
Income tax expense (benefit)	$	(93	)	(1	)%	$	37	-	%

Net income.    Net income for the three months ended September 30, 2004 and 2003 is as follows:

	Three Months Ended September 30,
	2004				2003
			% of Revenue				% of Revenue
Net income	$	1,057	5	%	$	-	-	%

The $1.1 million increase in net income was mainly attributable to the increases in product and service gross profits of $1.8 million and $579,000, respectively, and decreases in income tax expense of $130,000, partially offset by a decrease in the capitalization of software development costs of $258,000, increases in personnel costs of $237,000, increases in engineering consulting costs of $168,000, and increases in sales commissions of $759,000.

Six Months Ended September 30, 2004 and 2003

Revenue

Product revenue consists of sales of our hardware products and licensing of our software products. Service revenue consists of customer support agreements, consulting and training. License and royalty revenue consists of royalties under license agreements by original equipment manufacturers who incorporate components of our data collection technology into their own products or who reproduce and sell our software products. No customer or indirect channel partner accounted for 10% or more of our total revenue during the six months ended September 30, 2004 and 2003.

	Six Months Ended September 30,				Percentage Change
	2004		2003
Revenue:
Product	$	23,784	$	18,506	29	%
Service		15,931		13,749	16	%
License and royalty		871		863	1	%
Total revenue	$	40,586	$	33,118	23	%

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Product.    The 29% or $5.3 million increase in product revenue was primarily due to an increase of approximately 20% in unit sales, as well as the increased sales of our nGenius appliance products. We expect to continue to generate increasing sales sequentially from the second quarter to the third quarter of fiscal year 2005, based on continued indications of interest by our customers in our CDM Technology and our nGenius suite of products.

Service.    The 16% or $2.2 million increase in service revenue was primarily due to an increase in the number of customer support agreements attributable to new product sales generated during the last 12 months, combined with continued renewals of customer support agreements from our expanding installed base. We expect service revenue in absolute dollars to increase slightly sequentially from the second quarter to the third quarter of fiscal year 2005.

License and royalty.    The 1% or $8,000 increase in license and royalty revenue was primarily due to a slight increase in unit sales. We anticipate license and royalty revenue to be relatively flat sequentially from the second quarter to the third quarter of fiscal year 2005 and subject to the volume of Cisco’s sales of their products that incorporate our software. As announced in our report on Form 8-K filed on September 21, 2004, following discussions between NetScout and Cisco regarding NetScout’s plan to terminate support for its legacy product, Real Time Monitor 1.4, Cisco announced its intention to discontinue reselling Real Time Monitor as of November 30, 2004. The announcement was contained in a letter dated September 15, 2004, notifying NetScout of the non-renewal of the Agreements. Pursuant to the foregoing and the terms of the Agreements, the Agreements will expire on June 1, 2005. NetScout will continue to recognize license and royalty revenue based upon reported product shipments by Cisco, with the final product shipments report expected in the fourth quarter of fiscal year 2005. NetScout does not expect a material impact from Cisco’s non-renewal of the Agreements, as it will be offering Cisco Real Time Monitor 1.4 customers a purchase option to upgrade to nGenius Performance Manager 2.0.

Cost of Revenue and Gross Profit

Cost of product revenue consists primarily of material components, personnel costs, media duplication, manuals, packaging materials, licensed technology fees, overhead and amortization of capitalized software. Cost of service revenue consists primarily of personnel, material and support costs.

	Six Months Ended September 30,						Percentage Change
	2004			2003
Cost of revenue:
Product	$	7,554		$	6,139		23	%
Service		2,142			2,066		4	%
Total cost revenue	$	9,696		$	8,205		18	%
Gross profit:
Product $	$	16,230		$	12,367		31	%
Product %		68	%		67	%
Service $		13,789			11,683		18	%
Service %		87	%		85	%
License and royalty $		871			863		1	%
License and royalty %		100	%		100	%
Total gross profit $	$	30,890		$	24,913		24	%
Total gross margin %		76	%		75	%

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Product.    The 23% or $1.4 million increase in cost of product revenue corresponds with the 29% or $5.3 million increase in product revenue. The cost increase is due to an increase of approximately 20% in unit sales, the increase in the cost for sale of our nGenius appliance products, and an increase of $222,000 in amortization of capitalized software, which commenced in August 2003. Product gross margin percentage increased by 1 point to 68% from 67%. We expect to generate increasing sales sequentially from the second quarter to the third quarter of fiscal year 2005, based on continued indications of interest by our customers in our CDM Technology and our nGenius suite of products; therefore, we expect cost of product revenue to increase in absolute dollars.

Service.    The 4% or $76,000 increase in cost of service revenue was primarily due to an increase of $48,000 in repair activity. The 18% or $2.1 million increase in service gross profit corresponds with the 16% or $2.2 million increase in service revenue. We anticipate cost of service revenue to remain relatively constant in absolute dollars sequentially from the second quarter to the third quarter of fiscal year 2005.

Gross profits.    Our gross profit in absolute dollars increased 24% or $6.0 million. This increase in gross profit in absolute dollars was partially due to a $5.3 million increase in product revenue, which resulted from higher unit sales and an increase in average selling prices, in addition to the increased sale of our nGenius appliance products, offset by an increase of $1.4 million in product costs due to the increase in unit sales and the amortization of capitalized software. Also adding to the absolute dollar increase in gross profit was the increase in the service margin of $2.1 million, which resulted from increased service revenue. The net effect of the combined increases in revenue and increases in cost was a 1 point increase in gross margin percentage. We anticipate that our gross margin percentage will remain relatively constant sequentially from the second quarter to the third quarter of fiscal year 2005.

Also, our gross profit is primarily impacted by the mix of product, service, license and royalty revenue and by the proportion of sales through direct versus indirect distribution channels. We realize significantly higher gross profits on license and royalty revenue relative to product and service revenue and higher gross profits on service revenue relative to product revenue.

Total product and service revenue from direct channels and product, service and license and royalty revenue from indirect channels are below. We typically realize higher gross profits on direct sales relative to sales through indirect distribution channels. While during the six month period ended September 30, 2004 our mix of indirect compared to direct channels was more heavily weighted to indirect channels, our margins improved due to fluctuations in customer sales where we realize greater margins due to higher selling prices for particular sales opportunities.

	Six Months Ended September 30,								Percentage Change
	2004				2003
Channel mix:
Indirect	$	23,209	57	%	$	16,671	50	%	39	%
Direct		17,377	43			16,447	50		6	%
Total Revenue	$	40,586	100	%	$	33,118	100	%	23	%

Sales outside North America are primarily export sales through indirect channel partners, who are generally responsible for selling products and providing technical support and service to customers within their territory. All sales arrangements are transacted in United States dollars. Our reported international revenue does not include any revenue from sales to customers outside North America that are shipped to our North American-based indirect channel partners. These domestic resellers may sell NetScout products to international locations; however, NetScout reports these shipments as North America revenue since NetScout ships the products to a domestic location.

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Revenue was distributed geographically as follows:

	Six Months Ended September 30,								Percentage Change
	2004				2003
Geographic mix:
North America	$	33,999	84	%	$	27,170	82	%	25	%
International:
Europe – Middle East – Africa		4,044	10			4,141	13		(2	)%
Asia-Pacific		2,543	6			1,807	5		41	%
Subtotal International:		6,587	16			5,948	18		11	%
Total Revenue	$	40,586	100	%	$	33,118	100	%	23	%

Revenue from sales in Europe, Middle East, and Africa decreased 2% and sales in Asia-Pacific increased 41% as a result of timing fluctuations in the closing of international sales. NetScout expects revenue from sales outside North America to continue to account for a significant portion of our revenue in the future.

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.

	Six Months Ended September 30,								Percentage Change
	2004				2003
			% of Revenue				% of Revenue
Research and development	$	8,377	21	%	$	6,679	20	%	25	%

The 25% or $1.7 million increase in research and development expenses was primarily due to the application of SFAS No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,” which required the capitalization of software development costs of $1.3 million during the six months ended September 30, 2003. Excluding the capitalization of software development costs, research and development expenses increased by $373,000 which was mainly due to increases in consulting costs of 115% or $72,000 and increases in engineering consulting costs of 100% or $257,000 which resulted from new hardware product development to expand our nGenius product line. Average headcount in research and development was 102 and 100 for the six months ended September 30, 2004 and 2003, respectively. We anticipate research and development expenses will remain relatively constant in absolute dollars sequentially from the second quarter to the third quarter of fiscal year 2005.

Sales and marketing.    Sales and marketing expenses consist primarily of personnel costs and other costs associated with marketing programs such as trade shows, seminars, advertising, and new product launch activities.

	Six Months Ended September 30,								Percentage Change
	2004				2003
			% of Revenue				% of Revenue
Sales and marketing	$	17,585	43	%	$	15,982	48	%	10	%

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The 10% or $1.6 million increase in total sales and marketing expenses was primarily due to a 51% or $1.2 million increase in commission expense that was mainly due to increased revenue attainment and higher attainment of incentive programs and a 3% or $296,000 increase in personnel costs which is related mainly to increased benefit costs and increased compensation. Average headcount in sales and marketing was 145 and 143 for the six months ended September 30, 2004 and 2003, respectively. We anticipate that we will increase sales and marketing expenses in absolute dollars sequentially from the second quarter to the third quarter of fiscal year 2005 due to increased sales compensation expenses resulting from expected headcount additions.

General and administrative.    General and administrative expenses consist primarily of personnel costs for executive, financial and human resource employees and other corporate expenditures.

	Six Months Ended September 30,								Percentage Change
	2004				2003
			% of Revenue				% of Revenue
General and administrative	$	3,760	9	%	$	3,199	10	%	18	%

The 18% or $561,000 increase in general and administrative expense was primarily due to a 21% or $378,000 increase in personnel costs due to increased compensation costs and increased headcount and a 32% or $136,000 increase in professional services, mainly due to efforts associated with compliance with Sarbanes-Oxley. Average headcount in general and administrative was 53 and 50 for the six months ended September 30, 2004 and 2003, respectively. We anticipate general and administrative expenses will increase in absolute dollars sequentially from the second quarter to the third quarter of fiscal year 2005, mainly due to additional increases in costs associated with Sarbanes-Oxley compliance efforts.

Amortization of other intangible assets.    Amortization of other intangible assets relates to the acquisition of NextPoint Networks, Inc. (“NextPoint”) in fiscal year 2001. Other intangible assets were fully amortized as of June 30, 2003 and no amortization occurred after that date.

	Six Months Ended September 30,								Percentage Change
	2004				2003
			% of Revenue				% of Revenue
Amortization of other intangible assets	$	-	-	%	$	272	1	%	(100	)%

Interest income and other expenses, net.    Interest income includes interest earned on our cash, cash equivalents and marketable securities and restricted investments. Other expenses, net includes gain (loss) on disposal of equipment, gifts to charity, various interest and late statutory filing fees, and other miscellaneous expenses and income.

	Six Months Ended September 30,								Percentage Change
	2004				2003
			% of Revenue				% of Revenue
Interest income and other expenses, net	$	298	1	%	$	357	1	%	(17	)%

The 17% or $59,000 decrease in interest income and other expenses, net was primarily due to $111,000 of additional interest expense due to the favorable resolution of a federal income tax audit, offset by higher market interest rates on cash, cash equivalents and marketable securities.

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Income tax expense (benefit).    We estimate our income tax expense (benefit) based on the Company’s estimated annual effective tax rate. The estimated annual effective tax rate as of September 30, 2004 is 24%, compared to an estimated annual effective tax rate of 36% as of September 30, 2003. Generally, the estimated annual effective tax rates differ from the federal statutory and state tax rates primarily due to the impact of federal and state tax credits. In addition, the Company recorded an income tax benefit of $490,000 during the six moths ended September 30, 2004 as a result of the favorable resolution of a federal income tax audit. The estimated annual effective tax rates for the six months ended September 30, 2004 and 2003 would have been comparable if not for the favorable resolution of the federal income tax audit during the three months ended September 30, 2004.

	Six Months Ended September 30,
	2004				2003
			% of Revenue					% of Revenue
Income tax expense (benefit)	$	112	-	%	$	(310	)	(1	)%

Net income (loss).    Net income (loss) for the six months ended September 30, 2004 and 2003 is as follows:

	Six Months Ended September 30,
	2004				2003
			% of Revenue					% of Revenue
Net income (loss)	$	1,354	3	%	$	(552	)	(2	)%

The $1.9 million increase in net income was mainly attributable to the increases in product and service gross profits of $3.9 million and $2.1 million, respectively, partially offset by a decrease in the capitalization of software development costs of $1.3 million, increases in personnel costs of $693,000, increases in engineering consulting costs of $257,000, increases in professional services of $136,000, increases in sales commissions of $1.2 million, and increases in income tax expense of $422,000.

Off-Balance Sheet Arrangements

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

Contractual Obligations

As of September 30, 2004, we had the following current contractual obligations:

	Payment due by period
Contractual Obligations	Total		Less than 1 year		1-3 years		3-5 years		More than 5 years
Operating lease obligations	$	29,358	$	3,271	$	6,302	$	6,652	$	13,133
Royalty		150		150		-		-		-
Total contractual obligations	$	29,508	$	3,421	$	6,302	$	6,652	$	13,133

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Liquidity and Capital Resources

Cash, cash equivalents and marketable securities consist of the following:

	Six Months Ended September 30,
	2004		2003
Cash and cash equivalents	$	37,870	$	30,723
Short-term marketable securities		34,416		34,986
Long-term marketable securities		5,962		6,503
Cash, cash equivalents, and marketable securities	$	78,248	$	72,212

We have a line of credit with a bank, which allows us to borrow up to $10.0 million for working capital purposes and to obtain letters of credit. Amounts available under the line of credit are a function of eligible accounts receivable, bear interest at the bank’s prime rate and are secured by our inventory and accounts receivable. As of September 30, 2004, we had a letter of credit secured under the line aggregating $3.2 million relating to our current principal operating lease for our corporate headquarters. Under the agreement, we are required to comply with certain financial covenants, which require that NetScout maintain minimum amounts of liquidity, the most restrictive of which is a minimum tangible net worth of no less than $70 million. As of September 30, 2004, we were in compliance with such covenants.

Cash, cash equivalents and marketable securities increased by $6.0 million from September 30, 2003 to September 30, 2004. While cash and cash equivalents increased by $7.1 million, short- and long-term marketable securities decreased in total by $1.1 million.

Cash and cash equivalents were impacted by the following:

	Six Months Ended September 30,
	2004		2003
Net cash provided by operating activities	$	3,758	$	3,002
Net cash provided by (used in) investing activities	$	14,333	$	(16,270	)
Net cash provided by financing activities	$	768	$	168

Net cash provided by operating activities

Net cash provided by operating activities amounted to $3.8 million and $3.0 million during the six months ended September 30, 2004 and 2003, respectively. The primary sources of operating cash flow in the six months ended September 30, 2004 included net income of $1.4 million, adjusted to exclude the effects of non-cash items of $2.0 million, improved net working capital management of $1.5 million related to accounts receivable as a result of collection activities, inventory and accounts payable, an increase of $854,000 in accrued compensation and other expenses primarily as a result of the timing of payroll cycles and commissions, and a decrease of $884,000 in deferred revenue, mainly due to the timing of our maintenance contract renewals. The primary sources of operating cash flow in the six months ended September 30, 2003 included net loss of $552,000, adjusted to exclude the effects of non-cash items of $1.9 million improved net working capital management of $2.9 million related mainly to accounts receivable as a result of collection activities, and to a lesser extent inventory and accounts payable, an increase of $106,000 in accrued compensation and other expenses primarily as a result of the timing of payroll cycles, and a decrease of $2.0 million in deferred revenue, mainly due to the timing of our maintenance contract renewals.

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Net cash provided by (used in) investing activities

Cash provided by (used in) investing activities was $14.3 million and ($16.3) million for the six months ended September 30, 2004 and 2003, respectively. For the six months ended September 30, 2004 and 2003, cash provided by (used in) investing activities reflects the purchase of marketable securities of $31.9 million and $60.4 million, respectively, offset by the proceeds from the maturity of marketable securities due to cash management activities of $47.9 million and $46.3 million, respectively, and the purchase of fixed assets to support our infrastructure of $1.7 million and $885,000, respectively. The increase of purchases of fixed assets year over year is mainly due to the investment in our infrastructure as our company continues its operations. Also, for the six months ended September 30, 2003, cash provided by (used in) investing activities was reduced by the investment in capitalized software development costs related to nGenius Performance Manager 2.0 of $1.3 million.

Net cash provided by financing activities

Cash provided by financing activities was $768,000 and $168,000 for the six months ended September 30, 2004 and 2003, respectively. For the six months ended September 30, 2004 and 2003, cash provided by financing activities was mainly due to proceeds from the issuance of common stock in connection with the exercise of stock options and the employee stock purchase plan of $768,000 and $292,000, respectively. For the six months ended September 30, 2003, cash provided by financing activities was also affected by the purchase of $124,000 of common stock as treasury stock related to our open market stock repurchase program.

We believe that our cash balances, marketable securities classified as available-for-sale and any future cash flows generated by operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. If demand for our product were to decrease substantially, our ability to generate cash flow sufficient for our short-term working capital and expenditure needs could be materially impacted.

Additionally, a portion of our cash may be used to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies. From time to time, in the ordinary course of business, we evaluate potential acquisitions of such businesses, products or technologies. If our existing sources of liquidity are insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or convertible debt securities. The sale of additional equity or debt securities could result in additional dilution to our stockholders.

Recently Issued Accounting Pronouncements

In March 2004, the EITF reached a consensus on EITF No. 03-01, “The Meaning of Other-Than Temporary Impairment and its Application to Certain Investments.” EITF No. 03-01 addresses disclosures about unrealized losses on available-for-sale debt and equity securities and the evaluation of other-than temporary impairment related to securities accounted for under FASB Statements No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The provisions of EITF No. 03-01 are effective for other-than temporary impairment evaluations and disclosures in fiscal periods beginning after June 15, 2004. The adoption of EITF No. 03-01 had no impact on NetScout’s financial position or operating results.

Certain Factors Which May Impact Future Results

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. Additional risks that are not yet identified or that we currently think are immaterial may also impact our business operations. Such factors, among others, may have a material adverse impact upon our business, results of operations and financial condition.

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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 impact 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 of our control, including the following:

• current technology spending by actual and potential customers;

• the demand for network management solutions may be uneven;

• the timing and receipt of orders from customers, 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;

• our prices or the prices of our competitors’ products may change; and

• economic slowdowns or the occurrence of unforeseeable events, such as international terrorist attacks, which contribute to such slowdowns.

We operate with minimal backlog because our products typically are shipped shortly after orders are received. As a result, product revenue in any quarter is substantially dependent upon 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.

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 management solutions 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 infrastructure performance management products or enhancements to existing products in a timely and successful manner, it could have a material and adverse impact on our business, operating results and financial condition.

We have and intend to continue to introduce new products related to our previously announced CDM Technology strategy. If the introduction of these products is significantly delayed or if we are not successful in selling these products to our current and potential customers, our business, operating results and financial condition could be materially and adversely impacted.

If our products contain errors, they may be costly to correct, revenue may be delayed, we could be sued and our reputation could be harmed.    Despite testing by our customers and us, 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 fail, 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 and adverse impact on our business, operating results and financial condition.

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We face significant competition from other technology companies.    The market for network management solutions is intensely competitive. We believe customers make network management system purchasing decisions based primarily upon the following factors:

• product performance, functionality and price;

• name and reputation of vendor;

• distribution strength; and/or

• alliances with industry partners.

We compete with providers of network performance management solutions, such as Concord Communications, Inc., and providers of portable network traffic analyzers and probes, such as Network General (formerly Network Associates, Inc.). In addition, leading network equipment providers, including Cisco, 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 could have a material and adverse impact on our business, operating results and financial condition.

The success of our business depends on the continued growth in the market for and the commercial acceptance of network 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. Therefore, we must be able to predict the appropriate features and prices for future products to address the market, the optimal distribution strategy and the future changes to the competitive environment. In order for us to be successful, our potential customers must recognize the value of more sophisticated network management solutions, decide to invest in the management of their networks and, in particular, adopt our management solutions. Any failure of this market to continue to be viable would materially and adversely impact our business, operating results and financial condition. Additionally, businesses may choose to outsource the management of their networks to service providers. Our business may depend on our ability to continue to develop relationships with these service providers and successfully market our products to them.

The current economic and geopolitical environment may impact some specific sectors into which we sell.    Many of our customers are concentrated in a small number of sectors, including financial services, government, health and medical, and telecommunications. Certain sectors may be more acutely affected by economic, geopolitical and other factors than other sectors. To the extent that one or more of the sectors in which our customer base operates are adversely impacted, whether as a result of general conditions affecting all sectors or as a result of conditions affecting only those particular sectors, our business, financial condition and results of operations could be materially and adversely impacted.

Our success depends on our ability to expand and manage our international operations.    Sales outside North America accounted for 18% and 14% of our total revenue for the three months ended September 30, 2004 and 2003, respectively, and 16% and 18% for the six months ended September 30, 2004 and 2003, 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; and

• manage geographically dispersed operations.

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The major countries outside of North America in which we do or intend to do business are the United Kingdom, Germany, Japan and China. Our international operations, including our operations in the United Kingdom, Germany, Japan and China, are generally subject to a number of risks, including:

• failure of local laws to provide the same degree of protection as the laws in the United States provide 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; and

• foreign currency exchange rate fluctuations and political and economic instability.

Our success depends on our ability to manage indirect distribution channels.    Sales to our indirect distribution channels accounted for 64% and 46% of our total revenue for the three months ended September 30, 2004 and 2003, respectively, and 57% and 50% of our total revenue for the six months ended September 30, 2004 and 2003, respectively. To increase our sales going forward we need to continue to enhance our direct sales efforts and to continue to develop new and further expand and manage existing indirect distribution channels, including original equipment manufacturers, distributors, resellers, systems integrators and service providers. Our indirect channel partners have no obligation to purchase any products from us. In addition, they could internally develop products that compete with our solutions or partner with our competitors or bundle or resell competitors’ solutions, possibly at lower prices. The potential inability to develop new relationships and to expand and manage our existing relationships with partners, the potential inability or unwillingness of our partners to effectively market and sell our products or the loss of existing partnerships could have a material and adverse impact on our business, operating results and financial condition.

The non-renewal of our resale agreement with Cisco requires that we sell our product to end user customers.    License and royalty revenue and service revenue from Cisco accounted for 3% and 4% of our total revenue for the three months ended September 30, 2004 and 2003, respectively, and 3% and 4% of our total revenue for the six months ended September 30, 2004 and 2003, respectively. As announced in our report on Form 8-K filed on September 21, 2004, following discussions between NetScout and Cisco regarding NetScout’s plan to terminate support for its legacy product, Real Time Monitor 1.4, Cisco announced its intention to discontinue reselling Real Time Monitor as of November 30, 2004. The announcement was contained in a letter dated September 15, 2004, notifying NetScout of the non-renewal of the Agreements. Pursuant to the foregoing and the terms of the Agreements, the Agreements will expire on June 1, 2005. NetScout will continue to recognize license and royalty revenue based upon reported product shipments by Cisco, with the final product shipments report expected in the fourth quarter of fiscal year 2005. NetScout will be offering Cisco Real Time Monitor 1.4 customers a purchase option to upgrade to nGenius Performance Manager 2.0. If we are unable to sell nGenius Performance Manager to these customers or if Cisco were to decide to internally develop products that compete with our solutions, partner with our competitors or bundle or sell competitors’ solutions, possibly at lower prices, our business, operating results and financial condition could be materially and adversely impacted.

Our future growth depends on our ability to maintain and periodically expand our sales force.    We must maintain and periodically 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 twelve 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 maintain and periodically expand our sales capability, our business, operating results and financial condition could be materially and adversely impacted.

We must hire and retain skilled personnel.    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. If we are unable to attract and retain the highly skilled technical

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personnel that are integral to our sales, marketing, product development and technical 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 and adverse impact on our business, operating results and financial condition.

Loss of key personnel could adversely impact our business.    Our future success depends to a significant degree on the skills, experience and efforts of Anil Singhal, our President, Chief Executive Officer and co-founder, and Narendra Popat, our Chairman of the Board 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 and adverse impact on our business, operating results and financial condition.

Our reliance on sole source suppliers could adversely impact 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. Our reliance on sole or limited suppliers involves several risks, including a potential inability to obtain an adequate supply 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 impact 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 could materially and adversely impact 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 patent, 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.

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, patents, copyrights or trademarks. These claims, whether or not valid, could require us to spend significant sums in litigation, pay damages, delay product shipments, reengineer our products, rename our products and rebuild name recognition 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 could become more frequent as more companies enter the market for network and application infrastructure performance management solutions. Any of these claims or resulting events could have a material and adverse impact on our business, operating results and financial condition.

We may fail to secure necessary additional financing.    We may require significant capital resources to expand our business and remain competitive in the rapidly changing network performance management industry. We may invest in our operations as well as acquire complementary businesses, products or technologies. Our future success may depend in part on our ability to obtain additional financing to support our continued growth and operations. If our existing sources of liquidity are insufficient to satisfy our liquidity requirements, we may seek to raise capital by:

• issuing additional common stock or other equity instruments;

• issuing debt securities;

• obtaining additional lease financings; or

• increasing our lines of credit.

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However, we may not be able to obtain additional capital when we want or need it, and capital may not be available on satisfactory terms. Furthermore, any additional capital may have terms and conditions that adversely affect our business, such as financial or operating covenants, or that may result in additional dilution to our stockholders.

We may not successfully complete acquisitions or integrate acquisitions we do make, which could impair our ability to compete and could harm our operating results.    We may need to acquire complementary businesses, products or technologies to remain competitive or expand our business. We actively investigate and evaluate potential acquisitions of complementary businesses, products and technologies in the ordinary course of business. We may compete for acquisition opportunities with entities having significantly greater resources than us. As a result, we may not succeed in acquiring some or all businesses, products or technologies that we seek to acquire. Our inability to effectively consummate acquisitions on favorable terms could significantly impact our ability to effectively compete in our targeted markets and could negatively affect our results of operations.

Acquisitions that we do complete could adversely impact our business.    Such potential adverse consequences include:

• the potentially dilutive issuance of common stock or other equity instruments;

• the incurrence of debt and amortization expenses related to goodwill and other intangible assets;

• the incurrence of significant costs and expenses; or

• the potentially dilutive impact on our earnings per share.

Acquisition transactions involve numerous business risks.    These risks include:

• difficulties in assimilating the acquired operations, technologies, personnel and products;

• difficulties in managing geographically dispersed and international operations;

• difficulties in assimilating diverse financial reporting and management information systems;

• the diversion of management’s attention from other business concerns;

• the potential disruption of our business; and

• the potential loss of key employees, customers, distributors or suppliers.

Our estimates and judgments related to critical accounting policies could be inaccurate.    We consider accounting policies related to revenue recognition, accounts receivable and allowance for doubtful accounts, valuation of inventories, valuation of goodwill, capitalized software development costs, and accounting for income taxes to be critical in fully understanding and evaluating our financial results. Management makes certain significant accounting judgments and estimates related to these policies. Our business, operating results and financial condition could be materially and adversely impacted in future periods if our accounting judgments and estimates related to these critical accounting policies prove to be inadequate.

Failure to properly manage growth and to implement enhanced automated systems could adversely impact our business.    The growth in size and complexity of our business and our customer base has been and will continue to be a challenge to our management and operations. To manage further growth effectively, we must integrate new personnel and manage expanded operations. We must also implement a new Enterprise Resource Planning (“ERP”) system in order to manage the growth and increasing complexity of our business operations and to enhance our internal controls over financial reporting in accordance with Sarbanes-Oxley. Our ERP selection process is already underway and we anticipate implementation efforts to begin in the later half of our fiscal year ending March 31, 2005, with the new ERP system operational prior to the end of our fiscal year 2006. If we are unable to effectively manage our growth, our costs, the quality of our products, the effectiveness of our sales organization, our retention of key personnel and the implementation of our new ERP system, our business, operating results and financial condition could be materially and adversely impacted.

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The effectiveness of our disclosure and internal controls may be limited.    Our disclosure controls and procedures and internal controls over financial reporting may not prevent all errors and intentional misrepresentations. Any system of internal control can only provide reasonable assurance that all control objectives are met. Some of the potential risks involved could include but are not limited to management judgments, simple errors or mistakes, willful misconduct regarding controls or misinterpretation. There is no guarantee that existing controls will prevent or detect all material issues or that existing controls will be effective in future conditions, which could materially and adversely impact our financial results. Under Sarbanes-Oxley, we are required to evaluate and determine the effectiveness of our internal controls over financial reporting. Compliance with this legislation may divert management’s attention and resources and cause us to incur significant expense. Management’s assessment of our internal controls over financial reporting may identify weaknesses that need to be addressed in our internal controls over financial reporting or other matters that may raise concerns for investors. Should we determine that we have material weaknesses in our internal controls over financial reporting, our results of operations or financial condition may be materially adversely affected or the price of our common stock may decline. Additionally, in order to enhance our internal controls over financial reporting, we will implement a new ERP system in fiscal 2006. If we are unable to successfully implement this system, our internal controls over financial reporting could be adversely impacted and this could have a material and adverse impact on our financial results in the future.

The price of our common stock may decrease due to market volatility.    The market price of our common stock has been highly volatile and has fluctuated significantly since the initial public offering of our common stock on August 12, 1999. The market price of our common stock may continue to fluctuate significantly in response to a number of factors, some of which are beyond our control. Trading activity of our stock tends to be minimal as a result of officers and directors and their affiliates holding a significant percentage of our stock. 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. Also, broad market fluctuations could adversely impact the market price of our common stock, which in turn could cause impairment of goodwill that could materially and adversely impact our financial condition and results of operations.

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 issues that 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 marketable securities purchased with a maturity of three months or less to be cash equivalents and those with maturities greater than three months are considered to be marketable securities. Cash equivalents and short-term marketable securities are stated at cost plus accrued interest, which approximates fair value. Long-term marketable securities are stated at fair value based on quoted market prices. Cash equivalents and marketable securities consist primarily of money market instruments and U.S. Treasury bills. NetScout’s primary market risk exposures are in the areas of interest rate risk and foreign currency exchange rate risk. We currently do not hedge interest rate exposure, but do not believe that a fluctuation in interest rates would have a material impact on the value of our cash equivalents. NetScout’s exposure to interest rates based on outstanding debt has been and is expected to continue to be modest due to the fact that although we currently have a $10.0 million line of credit with $3.2 million of letters of credit secured against it, we have no amounts outstanding under the line and no other outstanding interest-bearing debt.

NetScout’s exposure to currency exchange rate fluctuations has been limited. All revenue transactions are executed in U.S. dollars. NetScout pays for certain foreign operating expenses such as foreign payroll, rent and office expense in foreign currency and, therefore, currency exchange rate fluctuations could have a material and adverse impact on our operating results and financial condition. Currently, NetScout does not engage in foreign currency hedging activities. The impact of currency exchange rate fluctuations is recorded in the period incurred.

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Item 4. Controls and Procedures

As of September 30, 2004, the Company, under the supervision and with the participation of the Company’s management, including the Company’s principal executive officer and principal financial officer, evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-15(b) promulgated under the Exchange Act. Based upon that evaluation, the Company’s principal executive officer and principal financial officer concluded that, as of September 30, 2004, the Company’s disclosure controls and procedures were effective in ensuring that material information relating to the Company, including its consolidated subsidiaries, required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, including ensuring that such material information is accumulated and communicated to the Company’s management, including the Company’s principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.

There were no changes in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II: OTHER INFORMATION

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

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. 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. We received net proceeds of $29.6 million after deducting $2.3 million in underwriting discounts and commissions and $1.1 million in other offering expenses.

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.

Approximately $23.3 million of the proceeds from our initial public offering were used in the acquisition of NextPoint. The balance of proceeds has been invested primarily in U.S. Treasury obligations and other interest-bearing investment-grade securities.

During the second quarter of fiscal year 2005, the Company did not repurchase any shares of its outstanding common stock pursuant to its open market stock repurchase program further described above in Note 8 to the Condensed Consolidated Financial Statements attached hereto.

Item 4. Submission of Matters to a Vote of Security Holders

At NetScout’s annual meeting of stockholders held on September 15, 2004, NetScout’s stockholders took the following actions:

(1) NetScout stockholders elected each of Anil K. Singhal and John R. Egan, both Class II directors, to a three-year term expiring at NetScout’s annual meeting of stockholders in 2007 or until each’s respective successor has been duly elected and qualified or until each’s early resignation or removal. Election of the directors was determined by a plurality of the votes cast at the 2004 annual meeting. With respect to Mr. Singhal, the votes were cast as follows: 29,604,358 shares of common stock voted for the election of Mr. Singhal; and 26,828 shares of common stock were withheld as to the election of Mr. Singhal. With respect to the election of Mr. Egan, the votes were cast as follows: 29,321,060 shares of common stock voted for the election of Mr. Egan; and 310,126 shares of common stock were withheld as to the election of Mr. Egan. No other persons were nominated, nor received votes, for election as a director of NetScout at the 2004 annual meeting. The other directors of NetScout whose terms continued after the 2004 annual meeting were Narendra V. Popat, Victor A. DeMarines, Joseph G. Hadzima, Jr., Vincent J. Mullarkey and Kenneth T. Schiciano.

(2) NetScout’s stockholders ratified the selection of the firm of PricewaterhouseCoopers LLP, independent registered public accounting firm, as auditors for the fiscal year ending March 31, 2005. With respect to such matter, the votes were cast as follows: 29,600,541 shares of common stock voted for the proposal; 17,890 shares of common stock voted against the proposal; and 12,755 shares of common stock abstained.

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Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

10.1 Form of Incentive Stock Option Agreement – Incorporated Terms and Conditions pursuant to 1999 Stock Option and Incentive Plan, as amended.

31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1 Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2 Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b) Reports on Form 8-K

We filed a report on Form 8-K with the Securities and Exchange Commission on July 14, 2004 with respect to Item 12 (Results of Operations and Financial Condition) to furnish a press release announcing the financial information for our first quarter of our fiscal year ending March 31, 2005 and on September 21, 2004 with respect to Item 8.01 (Other Events) to report Cisco’s announcement of its intention to discontinue reselling Real Time Monitor as of November 30, 2004.

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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.
Date: November 4, 2004	/s/ Anil K. Singhal
	Anil K. Singhal
	President, Chief Executive Officer, Treasurer and Director (Principal Executive Officer)

Date: November 4, 2004	/s/ David P. Sommers
	David P. Sommers
	Senior Vice President, General Operations and Chief Financial Officer (Principal Financial Officer)

Date: November 4, 2004	/s/ Lisa A. Fiorentino
	Lisa A. Fiorentino
	Vice President, Finance and Administration and Chief Accounting Officer (Principal Accounting Officer)

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EXHIBIT INDEX

Exhibit No.	Description
10.1	Form of Incentive Stock Option Agreement – Incorporated Terms and Conditions pursuant to 1999 Stock Option and Incentive Plan, as amended.
31.1	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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EX-10.1

Exhibit 10.1

NetScout Systems, Inc.

INCENTIVE STOCK OPTION AGREEMENT—INCORPORATED TERMS AND CONDITIONS

1. Grant Under Plan. This option is granted pursuant to and is governed by the Company’s 1999 Stock Option and Incentive Plan (the “Plan”) and, unless the context otherwise requires, terms used herein shall have the same meaning as in the Plan.

2. Grant as Incentive Stock Option. This option is intended to qualify as an incentive stock option under Section 422 of the Internal Revenue Code of 1986, as amended, and the regulations thereunder (the “Code”).

3. Vesting of Option if Employment Continues. If the employee whose signature appears on the cover page hereof (the “Employee”) has remained continuously employed by the Company through the dates listed on the vesting schedule set forth on the cover page hereof, the Employee may exercise this option for the number of shares of Common Stock indicated on the cover page hereof. If an installment of this option becomes exercisable for a fraction of a share at any time during the dates listed on the vesting schedule on the cover page hereof (including as a result of adjustment provisions contained in the Plan), such installment shall be deemed exercisable only with respect to whole shares, rounded down. The option for any fractional shares aggregated throughout the vesting period (to the extent they result in a whole number of shares) shall become exercisable when the last installment of the option vests. To the extent aggregated fractional shares result in fractional shares, such shares shall be cashed out at fair market value. Notwithstanding the foregoing, the Board may, in its discretion, accelerate the date that any installment of this option becomes exercisable. The foregoing rights are cumulative and (subject to Sections 4 or 5 hereof if the Employee ceases to be employed by the Company) may be exercised only before the date which is ten years from the date of this option grant.

4. Termination of Employment.

(a) Termination Other Than for Cause. If the Employee ceases to be employed by the Company, other than by reason of death or disability as defined in Section 5 or termination for Cause as defined in Section 4(c), no further installments of this option shall become exercisable, and this option shall expire (may no longer be exercised) after the passage of three months from the Employee’s last day of employment, but in no event later than the scheduled expiration date. For purposes hereof, employment shall not be considered as having terminated during any leave of absence if such leave of absence has been approved in writing by the Company and if such written approval contractually obligates the Company to continue the employment of the Employee after the approved period of absence; in the event of such an approved leave of absence, vesting of this option shall be suspended (and the period of the leave of absence shall be added to all vesting dates) unless otherwise provided in the Company’s written approval of the leave of absence. For purposes hereof, employment shall include a consulting arrangement between the Employee and the Company that immediately

follows termination of employment, but only if so stated in a written consulting agreement executed by the Company that specifically refers to this option. This option shall not be affected by any change of employment within or among the Company and its Subsidiaries so long as the Employee continuously remains an employee of the Company or any Subsidiary.

(b) Termination for Cause. If the employment of the Employee is terminated for Cause (as defined in Section 4(c)), this option shall expire (that is, may no longer be exercised) upon the Employee’s receipt of written notice of such termination and shall thereafter not be exercisable to any extent whatsoever.

(c) Definition of Cause. “Cause” shall mean conduct involving one or more of the following: (i) disloyalty, gross negligence, willful misconduct, dishonesty, fraud or breach of fiduciary duty to the Company; (ii) deliberate disregard of the rules or policies of the Company, or breach of an employment or other agreement with the Company, which results in direct or indirect loss, damage or injury to the Company; (iii) the unauthorized disclosure of any trade secret or confidential information of the Company; or (iv) the commission of an act which constitutes unfair competition with the Company or which induces any customer or supplier to breach a contract with the Company.

5. Death; Disability.

(a) Death. If the Employee dies while in the employ of the Company, this option may be exercised, to the extent otherwise exercisable on the date of his or her death, by the Employee’s estate, personal representative or beneficiary to whom this option has been transferred pursuant to Section 10, only at any time within 12 months after the date of death, but not later than the scheduled expiration date.

(b) Disability. If the Employee ceases to be employed by the Company by reason of his or her disability, this option may be exercised, to the extent otherwise exercisable on the date of cessation of employment, only at any time within 12 months after such cessation of employment, but not later than the scheduled expiration date. For purposes hereof, “disability” means “permanent and total disability” as defined in Section 22(e)(3) of the Code.

6. Partial Exercise. This option may be exercised in part at any time and from time to time within the above limits, except that this option may not be exercised for a fraction of a share.

7. Payment of Exercise Price.

(a) Payment Options. The exercise price shall be paid by one or any combination of the following forms of payment:

(i) by check payable to the order of the Company; or

(ii) delivery of an irrevocable and unconditional undertaking, satisfactory in form and substance to the Company, by a creditworthy broker to deliver promptly to the Company sufficient funds to pay the exercise price, or delivery by the Employee to the Company of a copy of irrevocable and unconditional instructions, satisfactory in form and substance to the Company, to a creditworthy broker to deliver promptly to the Company cash or a check sufficient to pay the exercise price; or

(iii) subject to Section 7(b) below, if the Common Stock is then traded on a national securities exchange or on the Nasdaq National Market (or successor trading system), by delivery of shares of Common Stock having a fair market value equal as of the date of exercise to the option price.

In the case of (iii) above, fair market value as of the date of exercise shall be determined as of the last business day for which such prices or quotes are available prior to the date of exercise and shall mean (i) the last reported sale price (on that date) of the Common Stock on the principal national securities exchange on which the Common Stock is traded, if the Common Stock is then traded on a national securities exchange; or (ii) the last reported sale price (on that date) of the Common Stock on the Nasdaq National Market (or successor trading system), if the Common Stock is not then traded on a national securities exchange.

(b) Limitations on Payment by Delivery of Common Stock. If Section 7(a)(iii) is applicable, and if the Employee delivers Common Stock held by the Employee (“Old Stock”) to the Company in full or partial payment of the exercise price and the Old Stock so delivered is subject to restrictions or limitations imposed by agreement between the Employee and the Company, an equivalent number of shares subject to this option (“Option Shares”) shall be subject to all restrictions and limitations applicable to the Old Stock to the extent that the Employee paid for the Option Shares by delivery of Old Stock, in addition to any restrictions or limitations imposed by this Agreement. Notwithstanding the foregoing, the Employee may not pay any part of the exercise price hereof by transferring Common Stock to the Company unless such Common Stock has been owned by the Employee free of any substantial risk of forfeiture for at least six months.

8. Securities Laws Restrictions on Resale. Until registered under the Securities Act of 1933, as amended, or any successor statute (the “Securities Act”), the Option Shares will be of an illiquid nature and will be deemed to be “restricted securities” for purposes of the Securities Act. Accordingly, such shares must be sold in compliance with the registration requirements of the Securities Act or an exemption therefrom. Unless the Option Shares have been registered under the Securities Act, each certificate evidencing any of the Option Shares shall bear a legend substantially as follows:

“The shares represented by this certificate are subject to restrictions on transfer and may not be sold, exchanged, transferred, pledged, hypothecated or otherwise disposed of except in accordance with and subject to all the terms and conditions of a certain Incentive Stock Option Agreement, a copy of which the Company will furnish to the holder of this certificate upon request and without charge.”

9. Method of Exercising Option. Subject to the terms and conditions of this Agreement, this option may be exercised by written notice to the Company at its principal executive office, or to such transfer agent as the Company shall designate. Such notice shall state the election to exercise this option and the number of Option Shares for which it is being exercised and shall be signed by the person or persons so exercising this option. Such notice shall be accompanied by payment of the full purchase price of such shares, and the Company shall deliver a certificate or certificates representing such shares as soon as practicable after the notice shall be received. Such certificate or certificates shall be registered in the name of the person or persons so exercising this option (or, if this option shall be exercised by the Employee and if the Employee shall so request in the notice exercising this option, shall be registered in the name of the Employee and another person jointly, with right of survivorship). In the event this option shall be exercised, pursuant to Section 5 hereof, by any person or persons other than the Employee, such notice shall be accompanied by appropriate proof of the right of such person or persons to exercise this option.

10. Option Not Transferable. This option is not transferable or assignable except by will or by the laws of descent and distribution. During the Employee’s lifetime only the Employee can exercise this option.

11. No Obligation to Exercise Option. The grant and acceptance of this option imposes no obligation on the Employee to exercise it.

12. No Obligation to Continue Employment. Neither the Plan, this Agreement, nor the grant of this option imposes any obligation on the Company to continue the Employee in employment.

13. Adjustments. Except as is expressly provided in the Plan with respect to certain changes in the capitalization of the Company, no adjustment shall be made for dividends or similar rights for which the record date is prior to such date of exercise.

14. Withholding Taxes. If the Company in its discretion determines that it is obligated to withhold any tax in connection with the exercise of this option, or in connection with the transfer of, or the lapse of restrictions on, any Common Stock or other property acquired pursuant to this option, the Employee hereby agrees that the Company may withhold from the Employee’s wages or other remuneration the appropriate amount of tax. At the discretion of the Company, the amount required to be withheld may be withheld in cash from such wages or other remuneration or in kind from the Common Stock or other property otherwise deliverable to the Employee on exercise of this option. The Employee further agrees that, if the Company does not withhold an amount from the Employee’s wages or other remuneration sufficient to satisfy the withholding obligation of the Company, the Employee will make reimbursement on demand, in cash, for the amount underwithheld.

15. Restrictions on Transfer; Company’s Right of First Refusal.

(a) Exercise of Right. Option Shares may not be transferred without the Company’s written consent except by will, by the laws of descent and distribution or in accordance with the further provisions of this Section 15. If the Employee desires to transfer all or any part of the Option Shares to any person other than the Company (an “Offeror”), the Employee shall: (i) obtain in writing an irrevocable and unconditional bona fide offer (the “Offer”) for the purchase thereof from the Offeror; and (ii) give written notice (the “Option Notice”) to the Company setting forth the Employee’s desire to transfer such shares, which Option Notice shall be accompanied by a photocopy of the Offer and shall set forth at least the name and address of the Offeror and the price and terms of the Offer. Upon receipt of the Option Notice, the Company shall have an assignable option to purchase any or all of such Option Shares (the “Company Option Shares”) specified in the Option Notice, such option to be exercisable by giving, within 15 days after receipt of the Option Notice, a written counter-notice to the Employee. If the Company elects to purchase any or all of such Company Option Shares, it shall be obligated to purchase, and the Employee shall be obligated to sell to the Company, such Company Option Shares at the price and terms indicated in the Offer within 30 days from the date of delivery by the Company of such counter-notice.

(b) Sale of Option Shares to Offeror. The Employee may, for 60 days after the expiration of the 30-day option period as set forth in Section 15(a), sell to the Offeror, pursuant to the terms of the Offer, any or all of such Company Option Shares not purchased or agreed to be purchased by the Company or its assignee; provided, however, that the Employee shall not sell such Option Shares to such Offeror if such Offeror is a competitor of the Company and the Company gives written notice to the Employee, within 30 days of its receipt of the Option Notice, stating that the Employee shall not sell his or her Option Shares to such Offeror; and provided, further, that prior to the sale of such Option Shares to an Offeror, such Offeror shall execute an agreement with the Company pursuant to which such Offeror agrees to be subject to the restrictions set forth in this Section 15. If any or all of such Option Shares are not sold pursuant to an Offer within the time permitted above, the unsold Option Shares shall remain subject to the terms of this Section 15.

(c) Failure to Deliver Option Shares. If the Employee fails or refuses to deliver on a timely basis duly endorsed certificates representing Company Option Shares to be sold to the Company or its assignee pursuant to this Section 15, the Company shall have the right to deposit the purchase price for such Company Option Shares in a special account with any bank or trust company, giving notice of such deposit to the Employee, whereupon such Company Option Shares shall be deemed to have been purchased by the Company. All such monies shall be held by the bank or trust company for the benefit of the Employee. All monies deposited with the bank or trust company but remaining

unclaimed for two years after the date of deposit shall be repaid by the bank or trust company to the Company on demand, and the Employee shall thereafter look only to the Company for payment.

(d) Expiration of Company’s Right of First Refusal and Transfer Restrictions. The first refusal rights of the Company and the transfer restrictions set forth in this Section 15 shall expire as to Option Shares on the earliest to occur of (i) the tenth anniversary of the date of this Agreement, (ii) immediately prior to the closing of a public offering of Common Stock by the Company pursuant to an effective registration statement filed under the Securities Act, or (iii) the occurrence of an Acquisition.

16. Early Disposition. The Employee agrees to notify the Company in writing immediately after the Employee transfers any Option Shares, if such transfer occurs on or before the later of (a) the date that is two years after the date of this Agreement or (b) the date that is one year after the date on which the Employee acquired such Option Shares. The Employee also agrees to provide the Company with any information concerning any such transfer required by the Company for tax purposes.

17. Lock-up Agreement. The Employee agrees that in the event that the Company effects an initial underwritten public offering of Common Stock registered under the Securities Act, the Option Shares may not be sold, offered for sale or otherwise disposed of, directly or indirectly, without the prior written consent of the managing underwriter(s) of the offering, for such period of time after the execution of an underwriting agreement in connection with such offering that all of the Company’s then directors and executive officers agree to be similarly bound.

18. Arbitration. Any dispute, controversy, or claim arising out of, in connection with, or relating to the performance of this Agreement or its termination shall be settled by arbitration in Massachusetts, pursuant to the rules then obtaining of the American Arbitration Association. Any award shall be final, binding and conclusive upon the parties and a judgment rendered thereon may be entered in any court having jurisdiction thereof.

19. Provision of Documentation to Employee. By signing this Agreement the Employee acknowledges receipt of a copy of this Agreement and a copy of the Plan.

20. Miscellaneous.

(a) Notices. All notices hereunder shall be in writing and shall be deemed given when sent by certified or registered mail, postage prepaid, return receipt requested, if to the Employee, to the address set forth below or at the address shown on the records of the Company, and if to the Company, to the Company’s principal executive offices, attention of the Corporate Secretary.

(b) Entire Agreement; Modification. This Agreement constitutes the entire agreement between the parties relative to the subject matter hereof, and supersedes all

proposals, written or oral, and all other communications between the parties relating to the subject matter of this Agreement. This Agreement may be modified, amended or rescinded only by a written agreement executed by both parties.

(c) Issuances of Securities; Changes in Capital Structure. Except as expressly provided herein or in the Plan, no issuance by the Company of shares of stock of any class, or securities convertible into shares of stock of any class, shall affect, and no adjustment by reason thereof shall be made with respect to, the number or price of shares subject to this option. No adjustments need be made for dividends paid in cash or in property other than securities of the Company. If there shall be any change in the Common Stock of the Company through merger, consolidation, reorganization, recapitalization, stock dividend, stock split, combination or exchange of shares, spin-off, split-up or other similar change in capitalization or event, the restrictions contained in this Agreement shall apply with equal force to additional and/or substitute securities, if any, received by the Employee in exchange for, or by virtue of his or her ownership of, Option Shares, except as otherwise determined by the Board.

(d) Severability. The invalidity, illegality or unenforceability of any provision of this Agreement shall in no way affect the validity, legality or enforceability of any other provision.

(e) Successors and Assigns. This Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective successors and assigns, subject to the limitations set forth in Section 10 hereof.

(f) Governing Law. This Agreement shall be governed by and interpreted in accordance with the laws of the Delaware, without giving effect to the principles of the conflicts of laws thereof.

EX-31.1

Exhibit 31.1

CERTIFICATIONS

I, Anil K. Singhal, certify that:

1. I have reviewed this quarterly report on Form 10-Q of NetScout Systems, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) [Paragraph omitted in accordance with SEC transition instructions contained in SEC Release No. 34-47986];

(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: November 4, 2004

/s/ Anil K. Singhal

Anil K. Singhal

President, Chief Executive Officer,

Treasurer and Director

(Principal Executive Officer)

EX-31.2

Exhibit 31.2

CERTIFICATIONS

I, David P. Sommers, certify that:

1. I have reviewed this quarterly report on Form 10-Q of NetScout Systems, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) [Paragraph omitted in accordance with SEC transition instructions contained in SEC Release No. 34-47986];

(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: November 4, 2004

/s/ David P. Sommers

David P. Sommers

Senior Vice President, General Operations and

Chief Financial Officer

(Principal Financial Officer)

EX-32.1

Exhibit 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of NetScout Systems, Inc. (the “Company”) on Form 10-Q for the period ending September 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Anil K. Singhal, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ Anil K. Singhal

Anil K. Singhal

Chief Executive Officer

November 4, 2004

EX-32.2

Exhibit 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of NetScout Systems, Inc. (the “Company”) on Form 10-Q for the period ending September 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, David P. Sommers, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ David P. Sommers

David P. Sommers

Chief Financial Officer

November 4, 2004