Is there anything positive to be gleaned from NetApp's operating results?
About three months ago, I wrote for the first time on this site regarding NetApp (NASDAQ:NTAP). I will specify here and now that it was not one of my more felicitous calls, I think I want a mulligan for it - but I have a hard enough time getting one in golf and here the issue is real dollars. You can't get them back. Overall, since I published that article, NetApp shares have increased about 1.5% while the IGV tech index has increased by more than 16%. That is a lot of lost alpha.
NetApp's Q4 FY 2016 earnings report was ugly. That was hardly a surprise. Analysts had been busy reducing ratings and estimates all quarter long. Management described the results as being within guidance ranges and so far as that goes it was. But it was a miss based on consensus expectations and that is what matters in investing. I will summarize some of the salient figures for the convenience of the reader. On balance, there was very little positive in the numbers although perhaps there are a couple of positive takeaways. For the record, in the quarter total revenues were down by 10% year on year, product revenues were down 17% and even maintenance revenues dropped by 1.4% sequentially. Non-GAAP product gross margins dropped by 700 bps year on year. Management said that much of the decrease was due to promotional pricing and required sales concessions. DSO increased from 38 days to 54 days, not the best of signs. On the other hand, inventories dropped to $98 million, one of the lowest levels I have ever seen. Management on the call said that the quarter was back-end loaded and that its business improved significantly throughout the quarter. That sounds good and I'm sure that the facts were as described but I should point out that one might expect to see that pattern as April is the last month of the fiscal year and generally there is a flurry of business at that point. That probably was less this year as so few sales people would reach accelerators or even reach quotas.
On the more positive side was the fact that the company's growth products are now 61% of revenue and grew by 21% year on year. The legacy product lines declined 40% and that led to the 17% decline in product revenues but overall the company is coming closer to the time when its growth products will start to overcome the drag from its legacy solutions.
Stock-based comp was basically flat at 8% of revenues in the quarter. Net cash from operations in the quarter declined by 12.8% or by $51 million year on year. The company actually raised its quarterly dividend to $.19/share which affords investors a yield of 3%.
The company generated $974 million of cash flow last year and spent $160 million on CapEx. Of the remaining balance of $814 million, the major acquisition of SolidFire cost $842 million, share repurchase cost $960 million and dividend payments were about $204 million. At the new dividend rate, cash required to support the dividend will be around $250 million or about 31% of last year's free cash flow. The new dividend is self evidently more than covered even at this abysmal level of performance. The company's net cash position is $2.96 billion, down significantly primarily due to the acquisition of SolidFire and share repurchases. Only 10% of the cash balances are in the U.S. This company does much of its R&D in Israel primarily to enjoy tax benefits and secondarily because of lower personnel costs. The promotional Israeli tax rate has driven the company's effective tax rate to less than 17% but it means that much of the profit is booked in Israel and the cash that is generated by the profits cannot be repatriated to the US without substantial additional tax payments. The cash balance is $10.42/share or 42% of the current share price.
By far, the largest single positive item in the sea of distress was the increase in deferred revenues. Deferred revenues during the quarter increased by $238 million compared to $88 million in the year earlier quarter. Most of that increase reflects stronger product bookings than might be apparent from the level of reported product revenues. And it might also be consistent with the very low level of inventories at the end of the quarter. Product revenues dropped by $157 million during the quarter. Product bookings... we really don't know as the company doesn't report that metric.
In the wake of such abysmal numbers, what can the investment case possibly be?
There is an honorable saying from the past that is still true to the effect that a rule for investing successfully is to take your losses and let your profits run. Many readers and investors might consider throwing up their hands at the kind of performance that NetApp just announced and let someone else bear the risk. It was a conclusion I was very tempted to reach myself, and one that can be readily justified. Why didn't I dispose of my position and go somewhere else? Mainly because the shares are too cheap and because most of the negative commentary is already built into the share price. Also, from what I can tell, the company's status as a market share donor has or is coming to an end. And the new CEO is bringing in his own team including the new CFO Ron Pasek and Henri Richard to head up worldwide sales. I don't really look at yield in my own investment decisions, but the increased dividend is certainly serving to put some kind of floor on valuations, particularly in the wake of yesterday's earnings release.
Market share statistics in tech are slippery things. NetApp at the moment, and given its product mix, is no longer the massive market share donor it probably has been in the recent past. That may not be totally apparent, but what I mean is that in the categories in which it competes, it has apparently stopped losing market share. The company sold 345% more FAS flash units this year compared to the year-earlier period. Clustered Data ONTAP node shipments grew by 85% this year amid significant displacements of installed competitive units, Overall, this past quarter, the company's flash products enjoyed 35% quarter to quarter growth to an annual revenue run rate of $700 million. That is 25% of last year's product revenues. The all-flash market is just not growing at over 100% a year and the clustered ONTAP market - to the extent it can be described that way - is not growing at 80%-90%/year. Flash and clustered ONTAP market share looks to be rising and not shrinking.
The strategic portion of the business - the products that make up 61% of the current mix - will need to see continued 20% growth just to keep product revenues from falling further. I will comment on guidance below in that framework. I think there is reason to believe that such a result is reasonable to expect.
I particularly like the fact that Tom Georgens and many of his direct reports are now gone. Georgens, it may be remembered, was CEO who was dubious about the necessity for all flash arrays and who laid out lots of money to buy Engenio. Changes in NetApp's executive suite have been overdue for some years now and it is promising to see many new faces.
The issue that I and other investors must wrestle with is well laid out in an article by Seeking Alpha author Eric Jhonsa who synthesized and extrapolated from an IDC report forecasting a gradual decline in traditional data center hardware sales because of a shift in infrastructure spending to cloud deployments. It is hard to deny the evidence in front of us that cloud deployments are reducing investments in traditional data center hardware. I wrote 3 articles in succession on how that trend to move workloads to the cloud was helping the profits of Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT) but had yet to become a significant growth driver at Google/Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL).
What is not quite apparent is the extent to which the shift from on-premise, data center centric networks to cloud is going to impact the specific products offered by NetApp. NetApp bought SolidFire just so it could have solutions to sell to cloud service providers. On the call, last evening, the CEO actually spoke about selling very high-end storage solutions that include hyper scale cloud (not from NetApp) with NetApp private storage and what NetApp calls its data fabric. Will the TAM for NetApp decrease or increase because of the change in user spending patterns that are moving from data centers to clouds of various types? The conventional wisdom says that the TAM will diminish - I think the jury is still out, but because of the lowered expectations that are encompassed in the company's outlook, I do not think it matters all that much.
My guess is that most private cloud deployments will be managed by their owners although some outsourcing is inevitable. It is not an either/or proposition. There are going to be lots of private cloud deployments - probably more than is forecast because the preponderance of users appear to be committed to hybrid cloud deployments. Given the abysmal level from which NetApp starts, it is quite conceivable that the combination of SolidFire and all-flash arrays can actually help the company to resume a moderate level of revenue growth. At the moment, the current analyst consensus is that NetApp will continue to shrink both this current fiscal year and on into fiscal 2018. Analysts, however, have a forecast for modest earnings recovery over the period.
There are still 37 analysts who publish earnings estimates for this company. Of that group, 23 rank it as a hold and 11 rank it as a sell and one analyst hates it even more. Two either very brave or very dumb analysts still rank the shares a buy. I would say that on the conference call most of the analysts exhibited more than a little distrust of management expectations which is surely a good thing for potential investors at this point. There is no irrational optimism here.
There may be more downgrades to come in the wake of the recent earnings report. And yet with so many analysts already at hold or sell, perhaps not. So, one of the first conditions for continuing to recommend to investors that they hold on to or establish positions in NetApp shares is that many of the investors who want to sell have done so already in the wake of the very negative sentiment among analysts. One can simply look at the reaction of NetApp shares to the quarterly miss. The shares are down 2% while shares of storage competitor Pure (NYSE:PSTG) which had a bookings problem lost 15% of their value today.
Another positive sign, at least to me, is that almost none of the stock is in the hands of retail investors. 97% of the outstanding shares are held by institutions. Over the years, the acuity of active institutional investors has been severely challenged to be sure. On the other hand, institutions appear to be a bit less keen to pull triggers than is the case with retail investors and many of them have had no real expectations that NetApp would be turned around in a single quarter.
Claims, Claims and More Claims
Look, you have put together an investment case for NetApp that seems reasonable. But knowing that everyone hates both the company and the shares isn't going to get me to buy the stock. What is the real outlook for this company?
It was apparently Mark Twain, attributing the quote to Benjamin Disraeli about lies, damned lies and statistics who popularized the phrase. When it comes to trying to do a deep dive into what is really happening in the storage market the way forward is cluttered by heavy sandstorms that reduce visibility to a few feet. I like to use Gartner to guide me on these kinds of expeditions - they have lots of credibility and they cover just about everything in tech. But there is no way you will ever find a Gartner report that explicitly says that NetApp is beating EMC (NYSE:EMC) or Dell or HPE (NYSE:HPE) or vice versa. They really do not do that.
I think the most reasonable thing I can do in regards to answering the question here is to provide some pertinent quotes from the NetApp CEO. Before anyone accuses me of naiveté, I'm well aware of just how many CEOs are economical with the truth. I do not think that is the case here but I do think it conceivable that the CEO has the "happy ears" syndrome.
In response to a question from an analyst on the call, the CEO said, "I think we see, first of all, the flash market transitioning from where it was a performance use case to one where it replaces performance drives. …It can be one of three ways."
"The first is greenfield... the second could be a retrofit of an existing architecture where in the case of clustered ONTAP we are able to give people a completely transparent way to upgrade... And the third as we have noted is all-flash systems (that are) the new SAN configuration. And we have replaced in customer after customer traditional fiber channel frame arrays from our incumbent competitors with (our own) flash systems."
The next quote is going to have to be significantly edited in order to insure clarity. A questioner wanted to know what percentage of that (NetApp) installed base is at risk of leaving NetApp. The CEO responded as follows, "First of all the total installed base …is growing. So our installed base is not declining... so the percentage of systems under clustered ONTAP actually represents, under represents sometimes the total value of the systems we have transitioned…85 % of the shipments of the factory (are clustered ONTAP) and ONTAP represents (40% of the capacity) under management."
A third question that was asked by an analyst related to NetApp's competitive position relative to leaders like Nutanix and VNX rail. Mr. Kurian said, "With SolidFire we get the extreme ease of deployment, the simple scalability and the ability to offer through the use of solutions like OpenStack, the benefits of hyper-converged technology meaning rapid time to value and ease of deployment and administration, without the compromises that (other) hyper-converged solutions offer. "
So, NetApp is gaining market share in flash and flash is replacing basically everything. NetApp is replacing everything that its users currently have installed. Its installed base is growing and it is replacing many users with competitive fiber channel stacks. I think it would be fair to say that these types of positive forecasts are not embedded in the current share price of NetApp. It would, to be sure, be more than tiresome to evaluate all of these claims. But they present a totally different view of the outlook for this company than is embedded in headlines or for that matter in most of the analyst reports that have appeared earlier today.
Are they true? I'm sure the statements are actually true to the best of Mr. Kurian's understanding. He simply doesn't strike me as someone given to using damn lies or statistics to prove his point. But I'm sure that other reasonable people looking at the same data might reach different conclusions.
Guidance Good, Bad or Indifferent?
The new CFO must have forgotten that the old NetApp did not provide annual guidance. The new policy is welcome and represents significantly more transparency than has been seen in prior years. In any event for the full year of fiscal 2017, the forecast is that "we will ultimately drive moderate revenue growth as we emerge from FY'17." That is clearly better than current consensus expectations that call for revenue declines both in this current fiscal year (2017) and for fiscal 2018 as well. The company, at the midpoint of its guidance (all numbers are non-GAAP) is forecasting an increase in gross margins to 62% compared to the overall 61% gross margin of fiscal 2016. The company expects total operating margins of 15%-17% up from 13.5% this year and including 200 bps of headwind from the combination with SolidFire. The company is forecasting a tax rate of 16.5%, up from 15.4% recognized this year. The CFO said the company would generate significant free cash flow. I certainly hope so, although what that means in dollars is undefined. If you put everything together, I think you would probably derive a forecast of more or less flat revenues with a small decline in product revenues offset by an increase in service revenues. Taking the mid-point of the range, operating income is supposed to expand by 18.5% and after-tax income would be up by 17% overall. EPS would be expected to increase a bit more than that due to the continuation of share buybacks. That yields EPS of about $2.50-plus compared to the current published consensus forecast of $2.31.
The Q1 forecast is for a significantly reduced revenue decline of 4.5%. NetApp has financial years of 52 weeks rather than 12 months. Q1 this year will be 13 weeks compared to 14 weeks last year. I'm not too sure as to the exact adjustments that ought to be made to account for that. Probably not 7% and probably something noticeable. In any event, the Q1 revenue forecast is above the current consensus of $1.25 billion and possibly significantly above depending on the adjustment for one less week in the quarter.
The EPS forecast is below the consensus at about $.37 at its mid-point compared to the prior consensus of $.45. Again, how much of that is a function of the shorter quarter is hard to quantify. It is certainly true that the highly profitable software and hardware maintenance lines will be impacted materially by the shorter quarter which would account for the significant discrepancy. Gross margins in Q1 are expected to improve to 62%-plus but operating margins are expected to be only 10% compared to 16% for the full year. The low operating margins in Q1 are a function of the absence of some software and hardware maintenance revenues.
Taking a more careful look than headline writers, Q1 guidance reflects a change in the length of the fiscal period. Overall, the company is forecasting better fundamental revenue generation and a modest improvement in margins. The full-year fiscal 2017 is actually a guide up of some magnitude compared to prior consensus estimates. At the mid-point, EPS guidance would be 8.5% greater than the current consensus forecast.
As I mentioned earlier, one of the major reasons to own NTAP shares are because they are very cheap if the company's turnaround is even partially real. The company has a market capitalization of $7.07 billion and net cash of $2.964 billion. That is an enterprise value of $4.1 billion. I think that sales for the current year should be around or over $5.5 billion. So that is an EV/S of .8X. Usually companies with EV/S of less than 1 are facing severe financial problems or they will be probably be bought. Even P/E firms can pay more than .8X EV/S to buy a profitable company.
The P/E is around 10X. Stock-based comp is less than 5% of revenues. The company generated free cash flow last year of $814 million. That's actually a free cash flow yield of 19.8%. For me, anyway, these valuation metrics are just too compelling to ignore, although I imagine there will be articles about the extent to which the shares of NetApp are a value trap.
I don't imagine that there is anyone familiar with information tech who would make an investment in storage a first priority. But then again, one almost never sees these kind of valuation metrics either. I think there is enough good to overcome the very ugly quarter that NetApp printed.
NetApp reported a very ugly quarter to end its fiscal year. All of the headline metrics, particularly on the revenue side, were ugly looking even though they just about matched the low side of company guidance. Management presented a far better picture both quantitatively and qualitatively on the conference call than the headline numbers implied. The company's growth businesses now are up to 61% of revenues and grew by 21% year on year last quarter. The company had very strong performance in its flash arrays and its ONTAP clusters. It seems based on the statistics that were released as though the company is taking market share in the higher growth areas of storage.
There continues to be a vigorous debate regarding the overall prospects for storage as cloud computing becomes more entrenched. Company management talked about the success it had enjoyed in its private cloud offerings combined with hyper scale solutions. I'm not going to resolve that debate in this article. I think the most that can be said is that I think the overall issue is still open to multiple conclusions.
Company guidance was said to be below consensus. It is true that company EPS guidance was lower than the consensus for Q1-2017 but that has to do more with a shorter quarter than in the year-earlier period. Revenue guidance was actually a raise. Full-year fiscal 2017 guidance is certainly a raise with regard to EPS and is probably above the current consensus that calls for a 3.5% decline in revenues.
NetApp is hardly a company without its flaws and many areas of challenge - if it weren't it wouldn't be valued as it is. This wasn't the prettiest of quarters - but the shares already reflected that. I think the shares are worth considering even in the wake of this quarter.
Disclosure: I am/we are long NTAP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.