Good morning, ladies and gentlemen. Thank you for standing by. Welcome to NetScout's second quarter fiscal year 2018 results conference call. At this time, all parties are in a listen-only mode until the question and answer portion of the call. As a reminder, this call is being recorded. Andrew Kramer, Vice President of Investor Relations, and his colleagues at NetScout are on the line with us today. If you require operator assistance at any time, please press star zero. I would now like to turn the call over to Andrew Kramer to begin the company's prepared remarks.
Thank you, Keith. Good morning, everyone. Welcome to NetScout's second quarter fiscal year 2018 conference call for the period ended September 30, 2017. Joining me today are Anil Singhal, NetScout's Co-founder, President, and CEO; Michael Szabados, NetScout's Chief Operating Officer; and Jean Bua, NetScout's Executive Vice President and Chief Financial Officer. There's a slide presentation that accompanies our remarks, and that can be accessed on the investor relations section of our website at www.netscout.com. The slides can be advanced in the webcast viewer to follow our commentary. We will call out the slide numbers we are referencing in our remarks. Today's agenda will be consistent with prior calls. Anil Singhal, our President and CEO, will review our performance and major highlights. Our COO, Michael Szabados, will briefly discuss key wins and go-to-market developments. Our CFO, Jean Bua, will review second quarter results and our fiscal year 2018 guidance.
Moving on to slide number three, I would like to remind everybody listening that forward-looking statements as part of this communication are made pursuant to the Safe Harbor provisions of Section 21E of the Securities Exchange Act of 1934, as amended, and other federal securities laws. Investors are cautioned that the statements in this call, which are not strictly historical statements, including, but not limited to, the statements related to the financial guidance and expectations for NetScout, share repurchase activity, market conditions, and customer demand, anticipated revenue from specific customers and specific products, along with all of the other various product development, sales and marketing, and expense management, and other initiatives planned for fiscal year 2018 and beyond, constitute forward-looking statements which involve risks and uncertainties. Actual results could differ materially from the forward-looking statements due to known and unknown risks, uncertainties, assumptions, and other factors.
This slide details these factors, and I strongly encourage you to review each of them. For a more detailed description of the company's risk factors, please refer to the company's annual report on Form 10-K for the fiscal year ended March 31, 2017, and the subsequent quarterly report on Form 10-Q, which are on file with the Securities and Exchange Commission. NetScout assumes no obligation to update any forward-looking information contained in this communication or with respect to the announcements described herein. Let's turn to slide number four, which involves non-GAAP metrics. While this slide presentation includes both GAAP and non-GAAP results, unless otherwise stated, financial information discussed on today's call will be on a non-GAAP basis only.
This slide, which we also encourage you to read, provides information about the use of GAAP and non-GAAP measures, because non-GAAP measures are not intended to be superior to or a substitute for the equivalent GAAP metric. Non-GAAP items are described and reconciled to GAAP results in today's press release, and those and other reconciliations supplemental detail are included at the end of this slide presentation, which is available on the website. As we detailed in our press release today, our second quarter results came in ahead of our expectations entering the quarter. We've continued to innovate and make further progress on our product roadmaps. We move into the second half of the year focused on addressing the challenges that lie ahead and capitalizing on the opportunities we see. With that as the high-level background, I'll now turn the call over to Anil. Anil?
Thank you, Andy. Good morning, everyone, and thank you for joining us. Let's begin on slide six with a recap of our non-GAAP results. NetScout's second quarter performance exceeded our plans entering the quarter, with revenue coming in at $259.9 million, a gross margin of 75.5%, an operating margin of 16.3%, and diluted EPS of $0.29 per share. Jean will review our performance in more detail, but I'll share a few observations. Our quarterly revenue exceeded our plans for the quarter, due largely to certain service provider orders that were previously expected for the third quarter and accelerated into the second quarter. While revenue was higher than we anticipated, it declined by 8% from the same quarter in the prior year, in part due to the ongoing moderation in spending by one of our large Tier 1 customers.
Our gross margin improved by a full percentage point, primarily as a result of favorable shifts in product mix as we continue to make progress with our software-driven product strategy. In terms of our profitability, we have continued to prudently manage our costs, even while funding a range of development activities that we believe will play a critical role in our long-term growth and success. On the new product front, we continue to make important progress with our efforts to innovate and expand our product portfolios and capabilities. Let's move to slide number seven to cover that in more detail. As we discuss our approach to collecting and analyzing network traffic or wire data is differentiated by our patented Adaptive Service Intelligence, or ASI, technology, which instantly converts high-volume network traffic at the collection point into highly structured, multidimensional metadata, or what we call Smart Data.
We are using this Smart Data to power an expanding range of analytics that address a growing number of use cases. At the foundation of our Smart Data strategy is our real-time information platform, the InfiniStreamNG, which offers deployment options that range from traditional appliance to software-only. We introduced this platform last fall, and we are making excellent progress in driving adoption of this platform in the software form factor with our service provider customers. Later on in the call, Michael will highlight how one of our cable MSO customers is deploying our InfiniStreamNG software to monitor their expansive Wi-Fi infrastructure. While the majority of the InfiniStreamNG deals we are striking are for one-time perpetual software licenses, a number of our international carriers of varying sizes are now advancing discussions for multi-year enterprise license agreements.
The software-only version of our InfiniStreamNG was approximately 10% of our second quarter product revenue, up from the low single digits in the first quarter. This progress reinforces our confidence is that this platform will represent 8%-10% of the total product revenue in fiscal year 2018 and help drive notable improvement in our gross margins this year. We have executed well on our product roadmaps to augment our new InfiniStreamNG platform. Last quarter, we unveiled new complementary instrumentation options and new analytics that extend visibility and enabling deeper, more flexible and comprehensive analysis of both wired and non-wired data to support our customers' network performance, application performance, infrastructure performance, cybersecurity, and big data requirements.
These new offerings are intended to expand our total addressable market and elevate our value proposition as we help our customers monitor virtualized network functions, ensure application performance across both conventional IT data centers and private and public cloud environments, identify the root cause of infrastructure issues that impact the end-user experience, and detect advanced security threats. We have been pleased with the growing interest in these offerings from both existing customers and prospects. During this past quarter, we continued to innovate. In July, we announced the integration between our InfiniStreamNG and the Arbor Spectrum analytics for network threat analysis, which enables network and security operations team to each benefit from access to network traffic as a data source.
Earlier this summer, as part of our plan to further differentiate the Arbor Spectrum, we acquired Efflux Systems, which brings us a small but extremely talented engineering team with deep security and machine learning expertise. Over the coming quarters, we plan to integrate their technology and capabilities into our advanced threat offerings in ways that can support faster, more accurate, and insightful detection of threat actor behavior. In September, we formally introduced our nGenius Business Analytics, which makes wire data consumable for big data applications in a scalable, cost-effective manner. The product is already being used by more than a dozen service providers to help them automate operations, enhance customer care, and deliver personalized services. Similar to how we have coupled our InfiniStreamNG software from the appliance itself, we are doing the same for our network packet broker product line.
Earlier this month, we announced the availability of the nGenius Packet Flow Extender or PFX software for service assurance and cybersecurity monitoring. This disaggregation of software-driven packet broker functionality from the underlying hardware is unique in the industry and disrupts how traditional packet broker using proprietary hardware has been priced and licensed. We believe that this will enhance our ability to compete in increasingly price-sensitive markets, particularly for small and mid-size enterprise accounts. As a result of our progress in bringing our newest offering and capabilities to the marketplace, we are nearing the end of our latest product cycle. We move into the second half of the year, having made good progress across multiple fronts during the first six months of fiscal year 2018. This brings us to our outlook, which is covered on slide number eight.
Entering into fiscal year 2018, we set our top-line target at around $1.2 billion, recognizing that keeping revenue relative unchanged against the prior year would be an ambitious goal, since our largest tier 1 service provider customer will continue to significantly moderate their 4G-related spending. We continue to expect that this customer year-over-year decline in spending with us could be up to $100 million. Our plan at the beginning of this year was to offset this decline through a combination of growth in other tier 1 service provider accounts and by expanding our enterprise business. While our results to date are slightly ahead of our original expectations, we do some challenges ahead in the second half.
In particular, the service provider spending environment remains under pressure. This is likely to continue influencing the timing and magnitude of larger service assurance and security purchases at many of our larger service provider customers. We are also concerned that carrier spending activity in North America could be further compromised by potential M&A activity. In the enterprise customer second quarter orders from the government vertical were not as strong as we originally anticipated, and it's unclear which projects, if any, that went unfunded last quarter will move forward during the second half of this fiscal year. For these reasons, we are taking a more conservative view into the third quarter. Although these dynamics make it more challenging to fill the revenue gap created by the anticipated decline in spending at our largest tier 1 customer, we have left our non-GAAP revenue and EPS guidance for the year unchanged.
We continue to focus on mitigating the potential risks that we see through a variety of sales programs that are aimed at realizing potential upside opportunities from across our customer base over the next five months. As we have demonstrated consistently over the years, delivering on our EPS target continues to be our top priority. If necessary, we are prepared to take certain actions to adjust our cost structure and preserve our EPS performance to the greatest extent possible. In closing, we remain confident that our strategic direction and our ability to deliver tangible value to all our customers, employees, and shareholders over the long term. We are seeing a steady adoption of our new real-time information platform across our expansive service provider customer base. Our newest enterprise products are amplifying our value proposition to make us even more strategic, valuable, and trusted partner to our customers.
Our DDoS solutions remain best in class. We expanded our security offerings to help customers address advanced security threats. Consistent with this perspective, the board authorized a new 25 million share repurchase program that provides us with the scope to further optimize our capital strength as we move forward. We'll give due consideration to the timing, magnitude, and approach to our buyback activity, particularly as we achieve greater visibility on the issues that could impact our near-term results. That concludes my prepared remarks. I'll now turn the call over to Michael at this point.
Thank you, Anil, and good morning, everyone. Slide number 10 outlines the areas that I will cover. As we discussed on our prior calls, our top priority in fiscal year 2018 is to fortify our incumbency with service providers by driving adoption of our software-only platform. We are continuing to make good progress on this front. This morning, I'd like to cover a new ISNG software win at a major North American cable MSO. Over the years, this customer has used our traditional solutions to monitor voice applications, programming guide activity across set-top boxes and mobile apps, and Wi-Fi connectivity. Wi-Fi is a strategic area for this customer, particularly as it seeks to continue promoting this offering to its expansive subscriber base, as well as market new high-quality mobile calling services for which it can cost-effectively offload mobile traffic to the existing Wi-Fi infrastructure.
However, tight budgets have limited the customer's Wi-Fi monitoring to only its largest markets. Given these dynamics, our ISNG software played perfectly into the customer's plans, and it has freed up well over $5 million to fund the rollout of our software across the remaining markets over the next couple of quarters. In addition, this customer is also one of the dozen-plus accounts that has started to deploy our nGenius Business Analytics product. This cable provider plans to use these capabilities in conjunction with our ISNG to enhance visibility into its network infrastructure, thereby further enriching the key data sets that should ultimately help it make better business decisions and improve the customer experience. In the enterprise, we are starting to generate additional traction with our new vSCOUT and vSTREAM offerings that we introduced last quarter.
These offerings provide enterprises with deeper application visibility, regardless of whether those apps run in a traditional data center or in the various forms of the cloud. We believe that these new products will ultimately bring us into new areas of IT organization and enable us to tap into new budgets that were previously quite difficult for us to access. During the second quarter, a large civil service agency selected and began deploying vSCOUT in conjunction with NetScout's traditional solutions to ensure that key applications operate with peak performance for both internal users and public customers. More specifically, vSCOUT will provide visibility into its critical applications running in virtual environments on Linux and Windows servers where the agency was previously blind to issues.
This deal, which was valued in the high six figures, further illustrates the flexibility of our technology to help our customers enhance their ability to deliver high-quality applications and quickly identify and triage issues that arise. In security, Arbor enjoyed another strong quarter of enterprise growth. This quarter, Arbor secured a $4 million DDoS order from a blue-chip U.S. financial services company to refresh and expand its existing deployment of Arbor TMS on inline DDoS attack mitigation solution. Arbor TMS is the most broadly deployed mitigation solution in the market due to its strength in filtering traffic in real time, thereby allowing business services to remain available even while a DDoS attack is being mitigated.
Over the past year, Arbor has made significant investments in the TMS platform, increasing its mitigation capacity from 40 gigabits per second to 100 gigabits per second, while at the same time significantly improving the overall total cost of ownership. The new Arbor TMS solution has allowed this customer to substantially extend its deployment to cover more data centers and on the globe. To further strengthen its reach with smaller and medium-sized enterprises, Arbor recently announced a suite of new affordable, flexible, advanced DDoS protection options for unified protection across hybrid cloud environments. Now, a few words about go-to-market. As we move forward, we are very excited about the potential for our newest products as they move through the initial stages of their respective sales cycles.
In addition to vSCOUT and vSTREAM, we are also very pleased to see growing interest in our new nGeniusPULSE offering as a highly complementary active testing and infrastructure performance monitoring capability to diagnose infrastructure performance issues impacting servers, routers, load balancers, and other infrastructure equipment. We are investing in lead generation activities that will enable us to drive demand and raise greater awareness for these new offerings with both existing customers and prospects. For example, as the hybrid cloud continues to gain momentum across our customer base, we believe that our participation in events like last quarter's VMworld and the upcoming AWS re:Invent conference will yield good results. At the same time, the market continues to recognize our product as best-in-class. For example, during the past four weeks alone, our Arbor Cloud service received three significant awards for excellence in DDoS protection.
I hope to share news of similar accolades for our newest products on future calls. This concludes my prepared remarks, and at this point, I will turn the call over to Jean.
Thank you, Michael, and good morning, everyone. This morning, I will review key metrics for the second quarter and key revenue trends through the first six months of fiscal year 2018. After that, I'll review our fiscal year 2018 guidance. As a reminder, this review will focus on our non-GAAP results, and all reconciliations with our GAAP results are in the appendix of the slide presentation. Slide number 12 shows our results for the second quarter and first six months of fiscal year 2018. Focusing on our second quarter results, total revenue decreased by $23.3 million, or 8%, to $259.9 million. Our overall gross margin of 75.5% increased by approximately 100 basis points this quarter. This reflected good progress in improving product gross margins, especially in light of a $25 million decline in product revenue.
This improvement primarily reflects favorable shifts in product mix due to ongoing progress with our product strategy that is aimed at replacing legacy hardware-dependent offerings with our ASI software technology. Our operating expenses were essentially flat, our operating profit margin was 16.3%. This translated into diluted earnings per share of $0.29. Turning to slide 13, I'd like to review key revenue trends. As we've discussed on prior calls, we are managing through a significant moderation in purchasing by one of our large Tier 1 service provider customers following several years of elevated purchasing. We continue to expect fiscal year 2018 spending from this customer will decline by up to approximately $100 million from the prior year. In the second quarter, this customer's spending declined by approximately $25 million. Within our service provider segment, overall revenue declined by 10%.
The decline from that large Tier 1 customer was compounded by a mid-teen decrease in Arbor's service provider business as it lapped a tough comparable that was boosted by a product transition for one of its offerings this time last year. These declines were partially offset by 25% growth in all other service assurance service provider accounts. Our enterprise vertical declined by roughly 6% in the second quarter. We saw strong revenue growth with Arbor's enterprise DDoS offerings. Revenue from the core NetScout enterprise offerings declined modestly due to the government vertical not being as robust as we had expected. We continue to see revenue declines in certain other ancillary product lines. The composition of the first half's revenue reflected the decline in our service provider vertical, and the mix was 52% of total revenue coming from service provider and 48% from enterprise.
In terms of revenue by geography, which is calculated on a GAAP basis, our first half revenue in the United States declined due to the decrease in revenue from that large Tier 1 carrier. International revenue was relatively flat. International represented 39% of total first half revenue versus 35% in last year's comparable period. We did not have a 10% revenue customer for either the second quarter or the first six months of the fiscal year. Slide 14 details our balance sheet highlights and free cash flow. We ended the quarter with cash equivalents, short-term marketable securities, and long-term marketable securities of $313.4 million. During the second quarter, we used $100 million to repurchase our stock. At the end of the second quarter, our revolver had $500 million of available credit under the existing facility, which left us with total liquidity of nearly $815 million.
Our free cash flow for the second quarter of fiscal year 2018 was $13.9 million. It was $63.2 million for the first half of the year. We anticipate that our free cash flow for fiscal year 2018 will equate to approximately 100% of our non-GAAP net income. In terms of our share repurchase activity, we repurchased 3,022,355 shares of common stock at an average price of $33.09 per share, totaling approximately $100 million in the aggregate. This represented a negligible effect on the second quarter's earnings per share. Our buyback activity for the first six months represents an incremental $0.07 increase to our earnings per share outlook for the year. We ended the quarter with approximately 971,000 shares remaining under our existing 20 million share repurchase authorization.
As detailed in today's press release, the board has authorized a new 25 million share repurchase program that will go into effect once we complete the existing program. We expect to be active in the market during this quarter. To briefly recap other balance sheet highlights, accounts receivable net were $215.2 million, down from the end of last fiscal year. DSOs were at 72 days, an improvement from 80 days at the end of the fiscal year 2017, and 80 days at the same time last year. Moving to slide 15 for guidance, I will focus on the non-GAAP guidance and remind you that the reconciliation of our GAAP guidance to our non-GAAP guidance is in the appendix. This slide details our revenue and earnings per share targets for the year.
Earlier on the call, Anil detailed certain risks that we see in the second half of our fiscal year that may limit our ability to absorb the anticipated full-year decline in spending by one of our largest tier 1 service provider customers and meet our annual revenue target. However, we are focused on advancing plans and tactics that will help mitigate those risks by accelerating and maximizing a range of opportunities across our customer base over the next five months. Accordingly, we have left our fiscal year 2018 guidance unchanged at this time. As Anil noted, we are taking a cautious view into the third quarter and anticipate revenue in the range of $300 million-$320 million. Other full year modeling assumptions based on our outlook are outlined on this slide.
Based on the quarterly impact of these assumptions, most notably relatively flat operating costs and roughly 88.5 million diluted shares outstanding for the next two quarters, this would translate into third quarter diluted earnings per share in the range of $0.60-$0.66. That concludes my formal review of our financial results. Before we transition to Q&A, I will note that slide number 16 highlights the various investor conferences we plan to participate in over the next couple of months. That concludes our prepared remarks this morning. Thank you again for joining us, and we're now ready to answer questions. Keith, you may now begin the Q&A session.
At this time, if you'd like to ask a question, please press star 1 on your touch-tone phone. If you wish to remove yourself from the queue, press the pound key. We do ask, in the interest of time, that you limit yourself to one question and one follow-up. We'll take our first question from Eric Martinuzzi with Lake Street Capital. Please go ahead. Your line is open.
I had a question. You talked a little bit about the carrier weakness continuing here. This is just kind of a continuation of a theme, but you did peel it back and talk a little bit about both on the assurance and on the security side. I was wondering, are those both under pressure in equal amounts, or is the security more of a surprise for you?
I think security is more of a surprise, not a surprise, but as a lot of customers are also finding out that, slowly discovering that Arbor is really part of NetScout. There is some deal consolidation, discount pressures, renewal pressures. That's somewhat different than what we thought earlier. Rest most of where the pressure is on the service assurance side.
I think just to add to that, Eric, I think the other thing that Arbor would tell you is it's also an absorption of a lot of the equipment, the DDoS protection that the service providers had bought in the last part of our fiscal year after there was that large attack. They probably see it as a little bit of a digestion pause.
Understand. You also talked about potential impact of carrier consolidation. This isn't the first time that NetScout has been impacted by the potential for carrier consolidation. Are you seeing a pattern repeat here? I'm specifically thinking back to the AT&T play for T-Mobile as far as how it's impacting pipelines.
Yeah, I think there is some uncertainty. I think this may be a bigger impact, because that was I think there was a big difference between the sizes of two companies and right now what's going on. It's isolated to one or two cases, so I think it's slightly more complex than the AT&T-Mobile situation previously.
Yeah, just to further add on to that, both of those carriers that are being contemplated in the news today are both customers of NetScout. On the positive side, their business strategy is to try to gain subscribers in a fight with a subscriber population with the other large tier 1s. In that effort, as you know, they're cutting prices on their programs, but they're expanding their network, and they're focusing on the quality of their network. Both of those customers are NetScout customers, and we've seen good growth with them over the last couple of years as they continue to invest. The one thing that we would have to watch is, as a combination, would that distract people from focusing on the network and would the inventory that both of these customers have cause any kind of pause in spending?
There's upside and downside to that combination.
Understand. Thank you.
We'll take our next question from Matthew Hedberg with RBC Capital Markets.
Hey, guys. Good morning. Thanks for taking my questions.
Sure.
Anil, or maybe Jean, I guess for both of you guys. You mentioned on the prepared remarks that there are some challenges you're seeing, and I think, Anil, you said you're taking a little bit more conservative view to Q3. I'm curious, to offset that, you're talking about some increased sales initiatives to help, I assume, harvest additional revenue from your base. Can you talk about what some of those sales initiatives are, those sales programs?
I think one of the things, one of the traditional one is discounts. I think giving them a bigger solution, some assurance on that solution is going to be, again, span and across the virtual and the physical infrastructure. It's a traditional sales program. There are some incentives for the sales team, and in the second half, over and beyond, for meeting the quota. Those are nothing special, fairly traditional, but somewhat more aggressive than what we had at the beginning of the year.
Yeah. The only thing I would add to that, Matt, is, as you know, we have an excellent DDoS product in Arbor, and they have good traction in the enterprise. Then, as you also are familiar with, we have an excellent customer base in the NetScout core enterprise sales force. We're also focusing efforts on the cross-selling and the combination of those two strengths to try to accelerate any kind of DDoS or enterprise selling.
Got it. That's helpful. Then maybe another one for Anil. Again, kind of referencing your prepared remarks, you talked about the software-only version of InfiniStreamNG. I think what you said was 10% of product revenue. That's great to hear. Can you talk about the ACV, the annual contract value, of a software-only deal for InfiniStreamNG versus maybe what a hardware-software deal several years ago might look like for a similar type commitment?
I think what we are seeing is, the biggest trend going on in the service provider side is one of the most important places to monitor for quality and business analytics is the link where there is a lot of OTT traffic. Those traffic rates, because of all you can eat plan and other thing, is doubling every year. There's no way they could monitor that with effective cost and everything at the prices level before. Overall, I would say the size of the deals is roughly the same, but they're buying a lot more for that. Normally you would have expected growth that if traffic has doubled, then maybe our revenue for that deal would be doubled or at least one and a half. Because of the budget pressure and other thing is not linear to the traffic growth.
Whether we do it with hardware or software combination or a software combination, software only right now, a deal size right now will be same. This is just a budget and they say, "You do it however you want to do it." The advantage of the software model for us is that we are able to manage this without impacting the margin, in fact, improving the margin. That's what is the dynamic playing in. It's not really software-hardware combination customers are demanding. They are demanding a lower price. For a company of our size, the only way we can mitigate that is through a better margin model, which is software versus small competitors who can just throw a discount at the deal.
Got it. Very helpful. Thanks, guys.
Yeah.
We'll take the next question from Zach Cummins with B. Riley & Company.
Hi. Good morning. Thanks for taking my question. Just starting off, you talked a little bit about your release of nGenius Business Analytics, which is already in use with about a dozen plus of your service provider customers. Can you talk about the potential impact this new solution can have on deal sizes down the road?
I think, in terms of for the next, I would say several quarter, that the biggest impact is it makes us more sticky in account. It doesn't necessarily increase the deal size, but it makes us sticky in account, and it makes us much more competitive. In the past, they will buy a separate InfiniStream-like product from a different vendor for business analytics, and they'll buy one from us for service assurance. Now, that functionality being in the same solution set makes it possible to do the big deals and multi-year agreements we have been doing across the world, especially outside of the U.S. That's what the big role of business analytics. Second part of that is a lot of people, customers have big data lakes, and they want our rich data sets feed into the data lake.
One of the roles of the business analytic is to convert some of those people into our partners, and we might be announcing one of those partnership over the next three to six months.
All right, great. That was helpful. On the buyback, you've bought back $200 million in stock over the first two quarters, the board recently approved a new 25 million share program. Should we assume this $100 million pace continues going forward, what are some of the factors that could change the pace of the buyback?
We have bought, for the first half of the year, roughly $200 million, $100 million per quarter of our outstanding stock. I think as we've talked about in the past, what we generally look at is the actual market itself and what we think of the effects on our share price and whether as an investment in that share price at that time, if we think it's a good return for our dollars. We continue to do that going forward. We have substantial liquidity, so we do have the availability to do something that would be more of a magnitude if we so chose. This quarter, we expect that we will continue with our share repurchase program and will be active in the market.
Okay, great. Thanks for taking my questions.
Thank you.
We'll go next to Chad Bennett with Craig-Hallum. Please go ahead.
Great. Thanks for taking my questions this morning.
Sure.
I guess just a question on the guide and the maintaining the guide, considering, Anil, your commentary and the caution that you've talked about before, and then the Q3 color that you gave on the call. The fact that Arbor was a little bit weaker. Enterprise was on a pretty good trend of growth year-over-year. Looks like that reversed. I guess, maybe it's a simple question. Why stick with the revenue guide considering how back-end loaded it now is and the risks that you guys talked about in the call?
I'll mention maybe a couple of factors. Just to mention at the beginning of the year, despite ups and down, tough service provider market, Arbor, I think except for this one Tier 1 making up for the shortfall in the Tier 1 provider, things are going quite well. They're not going well enough to make up for that big number. That probably has changed as time is passing by. The second half, even though it's much more polarized on the bigger portion versus the past, these are our best quarters because for, especially in service provider, because there is a budget flush in Q3, and then there is new budgets in Q4. How much of that helps us close this gap is not clear to us.
We have traditionally update guidance in January because we have a better view and better visibility into, because if we want to change guidance, then we want to also have to change it to something. Right now, it's not very clear how we see a lot of upside. We see a lot of challenges, and we need to see how this Q3 phases out and how the forecast and funnel looks for Q4 before making that decision.
Got it. Second question for me, the Tier 1 customer that you highlight, that you believe will be down, I think, $100 million this year. Have they adopted your software-only service assurance solution yet?
Not yet, basically one of the things they were waiting for is they love the functionality which were delivered. One of the reason it was the biggest customer was they were a customer of both Tektronix and NetScout. Both the solutions in the past were hardware-software combinations. After the acquisition, they're expecting to, before they deploy our software-only solution, to not only have both the features available in software because they like it, but in a single product. That just happened six months ago. That's why we think the future sales to even this customer will be in the software form, but that has not happened yet.
Got it. Thank you for taking my questions.
Thank you.
We'll take the next question from Alex Kurtz with KeyBank Capital Markets.
Hey, guys. I just had some modeling questions here, and then a bigger question for Anil. Jean, just running through the Q3 numbers, what you've outlined here and looking into the implied Q4 guide. Your high single digit number for high single digit to low double digit for EPS growth. What has to happen in OpEx and margins to get you to that outcome when you look from Q3 to Q4?
What has to happen in the operating expenses to get to
Yeah. Do you expect a big decline in OpEx to get there? What do you think about product and services margins? Because services margin looked like it dipped this quarter. How do you see margins ramping, and how do you see OpEx ramping from Q3 to Q4?
I guess I would say at this point, based on where we come in at the implied fourth quarter guide, we are remaining with our $1.2-ish revenue guidance that the margins are basically improving because you have higher volume. The operating cost will stay relatively flat. We still anticipate that, and as Anil had said earlier, it's five months, six months that we have left in this quarter and this year to achieve our goals. We anticipate that the margins will improve through gross margin and that the operating cost would stay relatively flat. Given if there is some kind of a change in the revenue, there's probably about 5% of costs that we could easily identify to moderate any kind of a change in revenue.
Okay. Well, we can get into that a little more offline. Just back to your previous question about why not de-risk the March quarter a bit, relative to your guide. Anil, you've outlined some challenges with Arbor, which is kind of a new item in my view, and obviously some challenges with domestic carriers. Why put yourself in a corner here with the big sequential growth into the March quarter?
Well, like I said, I think we do the best job of managing the risk versus expectations as we go. We still have half year to go. A lot of good things happen. If you remember, last year also, there was a similar question around this time about concern about the second half. We managed to pull it off. Right now, I think the gap is bigger. We just feel that we want to not just change something, we need to give the reasons and change it to some X to Y. We are not in a position to have the level of visibility to do that. Don't want to make a second change again. All these are leading up to saying, "Let's do our analysis." We already gave you guidance for Q3 based on discussion.
Yes, that puts pressure on Q4. I think we don't feel that this is the right time to make the change.
Do you feel like there's enough service provider backlog or pipeline that's pretty well along the process that gives you that confidence to stick with the number for the second half? Is there enough activity in the pipeline to get there? At least, it sounds like it's progressed enough that you feel that you can have some confidence in hitting the back half numbers.
Yeah. Well, I think confidence may be a strong word. At the same time, not having visibility is another side of strong word. I think basically, if the probability was zero, we would be making the change right now.
Right.
I think that the probability is higher than that. It's lower than when we started with the year, it's still good enough for us to not make the change right now.
Okay. Just last question. Product growth most likely will be down year-over-year in fiscal 2018. Do you think product can grow next year, Anil?
Yeah. I think I mentioned that there are I think this is a tough transition year for us, surprise service provider environment change. A lot of pressure on tier 1 in the U.S., tier 1 provider in the U.S. We had integration challenges. We had some issues with this. I think all the side effects or negative effects of that Danaher acquisition are starting reaching their tail end. All the positives of the integrated product roadmap, all the investment we have made, whether in security or service assurance or service provider, it's just beginning to start. I think I'm feeling despite what happened this year, regardless of that, it'll be a good next year because we think that we are onto something, grow growth starting next year.
Got you. Thank you.
Yeah.
Thanks, Alex.
As a reminder, it is star and one for questions. We'll go next to Mark Kelleher with D.A. Davidson. Please go ahead.
Great. Thanks for taking the questions.
Sure.
Just wanted to go back to that tier 1 issue. You talked about the decline there. Is there any risk that that situation develops at another one of your tier 1 carriers? Do you sense any competitive dynamic change at the tier 1 carriers?
Good question. First thing is that there is no other customer anywhere close to that size, and that's number one. Second is, there was another customer like that, and that tapered off last year, and it's actually on the rise. It's possible that once we hit the bottom here, it might go on the rise. One of the big reasons being integrated solution and software product. Our competitive environment is actually getting better for us, partly because the only reason competition could win against us was price. Software model has given us a leg up on that front also. Anytime anyone was winning, most of the time, the big factor was the price. We have the reach, we are worldwide, we have the combination of Tektronix and NetScout. We have the best technology. We're in business for 25 years versus many people for five, 10 years.
Price was a big reason, and our ability to discount our solution was compromised by margin and other issues, which was not a problem for smaller private companies. Going to a software model has increased our ability for both driving bigger deals in terms of stickiness and otherwise, plus being very competitive. I think our competitive situation is constantly improving.
Thanks.
Sure.
It appears we have no further questions at this time. I'll turn the floor to management for any closing remarks.
Thank you very much, Keith. Like to thank everybody for listening in this morning. If you do have any follow-up questions, certainly feel free to reach out to investor relations. Look forward to seeing those of you out at various conferences and look forward to our next communication with you.
This will conclude today's program. Thanks for your participation. You may now disconnect. Have a great day.