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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended December 31, 2003

OR

For the transition period from              to             

Commission file number 0000-26251

NETSCOUT SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

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 February 5, 2004 was 30,348,140.

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NETSCOUT SYSTEMS, INC.

FORM 10-Q

FOR THE QUARTER ENDED DECEMBER 31, 2003

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PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

NetScout Systems, Inc.

Condensed Consolidated Balance Sheets

(In thousands, except share and per share data)

(Unaudited)

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

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NetScout Systems, Inc.

Condensed Consolidated Statements of Operations

(In thousands, except per share data)

(Unaudited)

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)

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 December 31, 2003 and for the three and nine months ended December 31, 2003 and 2002, 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 nine month periods ended December 31, 2003 are not necessarily indicative of the results of operations anticipated for the year ending March 31, 2004. The balance sheet at March 31, 2003 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 year ended March 31, 2003, as filed with the Securities and Exchange Commission on June 13, 2003.

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. 123, “Accounting for Stock-Based Compensation”, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure - an Amendment of FASB Statement No. 123.” All stock-based awards to non-employees are accounted for using the fair value method in accordance with SFAS No. 123.

Had compensation cost for NetScout’s stock-based compensation 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:

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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

NetScout considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents and those with original 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 December 31, 2003, with maturity dates of January 2004 through January 2005, were as follows:

Marketable securities held by NetScout at March 31, 2003, with maturity dates of April 2003 through June 2003, were as follows:

Restricted Investment

NetScout has a restricted investment account related to a deferred compensation plan of $672 and $463 at December 31, 2003 and March 31, 2003, respectively, which is currently included in prepaids and other current assets. At December 31, 2003 and March 31, 2003, there were unrealized gains (losses) of ($2) and $7, respectively, recorded as other comprehensive income.

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NetScout Systems, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(In thousands, except share and per share data)

(Unaudited)

4.    Inventories

Inventories, net consist of the following:

5.    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 software products are available for first customer shipment. During the nine month period ended December 31, 2003, NetScout capitalized $1.3 million of software development costs. Beginning in August 2003 we commenced amortization on capitalized software development costs on a straight-line basis over a two-year period.

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 amortization required at this time.

6.    Long-Lived Assets

Goodwill and Other Intangible Assets

In July 2000, NetScout recorded goodwill and other intangible assets using the purchase method in connection with the acquisition of NextPoint Networks, Inc. (“NextPoint”). Other intangible assets consist of customer base and completed technology. Until March 31, 2002, all goodwill and other intangible assets were amortized on a straight-line basis over a period of two to five years. NetScout adopted the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” on April 1, 2002. Accordingly, NetScout ceased amortization of goodwill of $28,839 on that date. NetScout concluded that it had one reporting unit and assigned the entire balance of goodwill to this reporting unit for purposes of performing a transitional impairment test as of April 1, 2002. NetScout performs an annual test of impairment of goodwill or when changes in events or circumstances indicate that an impairment test is required.

Other intangible assets consist of the following:

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NetScout Systems, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(In thousands, except share and per share data)

(Unaudited)

6.    Long-Lived Assets (Continued)

Note Receivable

For the three and nine months ended December 31, 2002, NetScout recorded charges of $0 and $1,019, respectively, related to the write-off of a long-term note receivable, based on management’s assessment of the uncollectability of this note.

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 indemnifies its officers and directors from certain occurrences while they are or were serving in an official capacity for the Company, and this indemnification remains effective for the benefit of that individual’s estate, heirs, executors and administrators. The maximum potential amount of any future payments that NetScout may be required to make is unknown; however, NetScout does carry directors’ and officers’ insurance policies that limit our exposure. We believe that the total impact of NetScout’s indemnification obligations, while limited as a result of our current insurance policy coverage, could potentially have a material and adverse impact on our financial condition and results of operations.

NetScout warrants to its customers that its software and hardware products that they purchase 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 90 days thereafter. With regard to hardware, the standard warranty commences upon shipment and expires 12 months thereafter. In addition, 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.

Contracts that we enter into in the ordinary course of business may contain standard indemnification provisions. Pursuant to these agreements, we could be required to defend any third party claims brought against a partner or direct customer claiming infringement of such third party’s (i) U.S. patents, (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.

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NetScout Systems, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(In thousands, except share and per share data)

(Unaudited)

7.    Commitments and Contingencies (Continued)

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.

Our indemnification obligations pursuant to these agreements are generally not limited to a certain term. 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. Accordingly, we believe the fair value of our guarantor agreements to be immaterial as of December 31, 2003. However, if we are required to defend a related lawsuit and settle claims or indemnify any third parties, such payments could potentially have a material and adverse impact on our financial condition and results of operations.

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 nine months ended December 31, 2003, NetScout repurchased 34,000 shares of common stock. As of December 31, 2003, 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 for the three and nine month periods indicated:

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

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NetScout Systems, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(In thousands, except share and per share data)

(Unaudited)

10.    Other Comprehensive Income (Loss)

Other comprehensive income (loss) consists of unrealized gains and losses on marketable securities and foreign currency translation adjustments. Other comprehensive income (loss) related to unrealized gains and losses on marketable securities and restricted investment for the periods ended December 31, 2003 and 2002 was ($11) and $0, respectively.

11.    Geographic Information

Revenue was distributed geographically as follows:

The North America revenue includes shipments to domestic resellers who may sell NetScout products to international locations. NetScout reports these shipments as North America revenue since NetScout ships the products to domestic locations. Revenue attributable to locations outside of North America are primarily the result of export sales to indirect channel partners. Substantially all of NetScout’s identifiable assets are located in the United States.

12.    Offer to Exchange

On November 8, 2002, NetScout commenced an option exchange program (the “Exchange Offer”) whereby employees who held stock options granted under the 1999 Stock Option and Incentive Plan and/or the NextPoint Networks, Inc. 2000 Stock Incentive Plan assumed by NetScout in connection with the acquisition of NextPoint with an exercise price of $10.00 or greater per share were given the opportunity to tender such options for new stock options to be granted by NetScout. Participants who elected to participate in the Exchange Offer were also required to exchange any other options granted to him or her in the six months immediately prior to the commencement date of the Exchange Offer. Other than the Chief Executive Officer and the Chairman of the Board of Directors of NetScout, all employees of NetScout and its subsidiaries holding eligible option grants were eligible to participate in the Exchange Offer. On December 9, 2002, the Exchange Offer expired. Outstanding options to purchase 2,142,723 shares of common stock were accepted for exchange and cancelled. The exercise price of all new options granted under the offer was equal to the per share market price of NetScout’s common stock as reported by the Nasdaq National Market at the close of trading on the date of grant. On June 13, 2003, NetScout granted options to purchase 2,048,599 shares of common stock at an exercise price of $4.22 per share in accordance with the Exchange Offer.

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NetScout Systems, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(In thousands, except share and per share data)

(Unaudited)

13.    Recently Issued Accounting Pronouncements

In December 2002, the Emerging Issues Task Force (“EITF”) issued EITF No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” EITF No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. EITF No. 00-21 established three principles: revenue arrangements with multiple deliverables should be divided into separate units of accounting, arrangement consideration should be allocated among the separate units of accounting based on their relative fair values and applicable revenue recognition criteria should be considered separately for separate units of accounting. EITF No. 00-21 is effective for all revenue arrangements entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted. The adoption of EITF No. 00-21 on July 1, 2003 had no impact on NetScout’s financial position or operating results.

In December 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46R, “Consolidation of Variable Interest Entities” (“FIN 46R”), which clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support and replaces FASB Interpretation No. 46. FIN No. 46 provides guidance on the identification of entities for which control is achieved through means other than through voting rights called “variable interest entities” or “VIEs” and how to determine when and which business enterprise should consolidate the VIE (the “primary beneficiary”). This new model for consolidation applies to an entity in which either (i) the equity investors (if any) do not have a controlling financial interest or (ii) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. In addition, FIN No. 46 requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE make additional disclosures. This interpretation is effective in financial statements of public entities that have interests in variable interest entities or potential variable interest entities commonly referred to as special-purpose entities for periods ending after December 15, 2003. Application of this pronouncement by public entities for all other types of entities, subject to FIN 46R, is required in financial statements for periods ending after March 15, 2004. NetScout has no investments in variable interest entities requiring disclosure under FIN 46R.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 149 is effective for existing contracts and new contracts entered into after June 30, 2003. The adoption of SFAS No. 149 had no impact on NetScout’s financial position or operating results.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”, which establishes standards for how an issuer of financial instruments classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003. In November 2003, the FASB deferred the classification and measurement provisions for certain mandatorily redeemable noncontrolling interests for an indefinite period of time. The adoption of SFAS No. 150 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 cost management 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.

Critical Accounting Policies

NetScout considers accounting policies related to revenue recognition, accounts receivable and allowance for doubtful accounts, valuation of inventories, valuation of long-lived assets, 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.

For multi-element arrangements, each element of the arrangement is analyzed and a portion of the total fee under the arrangement is allocated to the undelivered elements, primarily support agreements and training, using vendor-specific objective evidence of fair value of the element. Under the residual method, the remaining portion of the fee is allocated to the delivered elements, generally hardware products and licensed software products, regardless of any separate prices stated within the contract for each element, under the residual method. Vendor-specific objective evidence of fair value is based on the price customers pay when the element is sold separately.

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

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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.

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 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.

Accounts Receivable and Allowance for Doubtful Accounts

Accounts receivable is reduced by an allowance for doubtful accounts. Our normal payment terms are net 30 days. We monitor all payments from 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 December 31, 2003, no customer accounted for more than 10% of our accounts receivable balance. At December 31, 2002, one 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, we do not require collateral from our customers. 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. 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 or adversely impacted in future periods.

Valuation of Inventories

Inventories are stated at actual cost. Inventories consist primarily of raw materials and finished goods. Inventories are reduced by a reserve for obsolete and excess inventory. 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 or adversely impacted in future periods.

Valuation of Long-Lived Assets

NetScout assesses goodwill for impairment on a reporting unit basis 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 reporting unit 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 December 31, 2003, goodwill was $28.8 million. We operate as one reporting unit. 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

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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 our accounting judgments and estimates relating to long-lived assets 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 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 software products are available for first customer shipment.

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 taken together with our marginal year-to-date loss. Significant judgments and estimates are made when assessing NetScout’s projected effective annual tax rate. Because the income tax expense (benefit) to be recorded for the remainder of fiscal year 2004 will be largely dependent on our performance, if our judgments and estimates prove to be inadequate, the tax rate could fluctuate significantly with slight changes in pre-tax income (loss) and/or federal and state tax credits.

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 is not believed to be more likely than not, a valuation allowance is established. When assessing the need for a valuation allowance, we consider such factors as our historical cumulative taxable income or loss, projected taxable income in early future periods, trends of our operating results and the strength of our business from both a financial and technological perspective.

As of December 31, 2003, deferred income tax assets were $9.3 million, consisting primarily of federal net operating loss carryforwards and federal research and development tax credits, which begin to expire in fiscal year 2012, and 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 our judgments and estimates relating to our deferred income tax assets prove to be inadequate, a valuation allowance may be required and our financial results could be materially

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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 in the period such determination is made.

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

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Three Months Ended December 31, 2003 and 2002

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 consist 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.

Total revenue includes revenue generated from Cisco Systems, Inc., which represented 3% and 9% of our total revenue for the three months ended December 31, 2003 and 2002, respectively. No customer or indirect channel partner accounted for 10% or more of our total revenue during the three months ended December 31, 2003 and 2002.

Product.    The product revenue increase was primarily due to an 8% increase in unit sales, which was mainly attributable to the effects of the improving economic climate, along with growing market acceptance of our CDM^TM technology, which consolidates performance management functions and traffic flow data into a single, integrated solution. We expect to generate increased sales order flow in the coming quarters, based on an expectation of continued improvements in the economic climate and continued indications of interest by our customers in our CDM^TM technology and our nGenius^® suite of products.

Service.    The service revenue increase was primarily due to an increase in the number of customer support agreements attributable to new product sales generated during the last twelve months, combined with continued renewals of customer support agreements from our expanding installed base. We expect service revenue to continue to grow sequentially in a manner similar to this quarter.

License and royalty.    The license and royalty revenue decrease was primarily due to a decrease in unit sales and a decrease in royalty price. We anticipate license and royalty revenue sequentially to be comparable with those of the quarter ended December 31, 2003 and will be based on the volume of Cisco’s sales of their products that incorporate our software under our current agreement.

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Cost of Revenue and Gross Margin

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.

Our gross margins increased primarily due to a 14% decrease in average cost per unit and an increase in service margin, which resulted from increased service revenue and decreased service cost and a decrease in our royalty expense. The benefit gained from the increase in service margin percentage was partially offset by decreased license and royalty revenue margin contribution.

Product.    The increase in cost of product revenue was primarily due to the amortization of capitalized software development costs associated with our CDM^TM technology. While revenue increased primarily due to the 8% increase in unit sales, average cost per unit decreased by 14% due to the mix of probe sales, which included more sales of our lower-cost probes as well as a decrease in our royalty expense, which is a function of changes in unit sales subject to royalty. The increase in product gross margin percentage corresponds with the 5% increase in product revenue versus the smaller 3% increase in cost of product.

Service.    The decrease in cost of service revenue was primarily due to decreases in repair costs due to lower repair activity and decreases in travel expenses. The increase in service gross margin corresponds with the 14% increase in service revenue compared with the 13% decrease in cost of service revenue.

Gross margins.    Gross margin 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 margins on license and royalty revenue relative to product and service revenue. We typically realize higher gross margins on direct sales relative to sales through indirect distribution channels.

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Revenue from indirect and direct channels is as follows: