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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

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 November 3, 2004 was 30,631,123.

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NETSCOUT SYSTEMS, INC.

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2004

TABLE OF CONTENTS

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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 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:

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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:

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:

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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:

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:

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

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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.

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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)

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:

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

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:

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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:

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

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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.

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.