NetApp's Maturity - It doesn't mean well adjusted
I do not know the average age of people who read these articles. I suspect, just based on the published profiles of individual investors these days, that most readers are of a somewhat mature age, and certainly this writer falls into that bucket. Experience is probably a good thing when it comes to investing. It is not such a good thing when it comes to being a storage vendor in the age of the cloud. NetApp (NASDAQ:NTAP) has reached a certain level of maturity having been through some near-death experiences and enjoying years of fantastic growth. The company, having been crippled by both the advent of the cloud and a set of very bad choices in terms of technology and strategy, has been playing catch-up now for a couple of years. It reported the results of its fiscal Q3 last week and the turnaround has reached the 1st plateau.
To a certain extent, investors had expected an upside (the shares appreciated into the numbers), and they got what they were looking for, but not much more. The shares appreciated about 4% - they might have risen by the same amount without an earnings release.
Overall, the company has stopped shrinking, and it continues to make significant progress in restoring its business model. And yet… while the shares have shown strong appreciation over the past year, climbing by about 75%, they have climbed a wall of worry and doubt with many analysts more or less incredulous that the company has executed something of a turnaround. Part of this article will address the concerns that have kept many analysts from expressing enthusiasm about the company's progress and outlook.
The company has seen a few upgrades so far this year. At the present time, of the 34 analysts who rate the name, the consensus is at hold with only 7 buys and 2 strong buys, more or less set off by 7 sell recommendations. Not surprisingly, the average price target for the shares is just a couple of percent greater than current quotations. While the shares have appreciated significantly, they have done so without the approbation of most analysts.
Headlines from a generally successful quarter
Just to review some of the salient headlines from the earnings release, revenues reached $1.4 billion, up slightly from the prior year. Product revenues, perhaps more important in terms of looking at the company's business progress, were up almost 5% year over year. The decline seen in hardware maintenance is likely to reverse in coming quarters on the heels of the growth in product revenues.
Earnings for the period were unchanged on a GAAP basis. The company continued to achieve a strong level of expense control with operating expenses declining by 8% year on year and actually declining sequentially, which is far better than normal seasonality. In a GAAP presentation, this operational improvement was offset by a restructuring charge and significant tax accruals.
In addition, product gross margins declined noticeably year on year. Part of that decline relates to promotions in order to combat competition in the space. To a greater or lesser extent, the decline in product gross margins was just about offset by a sharp improvement in the cost of hardware maintenance and other services. Management mentioned during the call that it might be able to end some of the promotions that have weighed on gross margins in the fiscal year that starts on May 1st. It also suggested that it would be better able to optimize the supply chain as it introduces newer products over the course of the next several quarter.
There are observers who are quite concerned by the current trajectory regarding product gross margins; I think that based on the available evidence that concern is likely overblown, but it has been and will remain a factor in analyst forecasts - until it is remediated as I believe is likely to happen.
Stock-based comp declined by more than 25% in the period and represented 16% of reported non-GAAP profit. Overall, reported non-GAAP EPS reached $.82, up by almost 20% compared to the year earlier quarter and a beat of more than 10% compared to prior expectations.
Cash flow from operations did show a decline primarily due to increases in receivables, declines in deferred revenues and a significant swing in other assets and liabilities, particularly including inventories. But for the 9 months that ended at the end of January, CFFO has been flat and free cash flow contracted marginally. The company has continued to repurchase shares and to pay a modest dividend with a current yield of about 1.9%. The company has a 3-year history of increasing dividends in July. I think it's probable that it will continue that pattern given the overall performance of the company.
The company's guidance has led to a modest uptick in consensus EPS estimates for the current quarter, which ends the fiscal year and a somewhat more significant increase in EPS estimates for fiscal year '18 which ends 4/30/18. The CFO intimated during the course of the conference call that operating margins would see further improvements in the coming fiscal year, and it seems likely that he will raise margin targets during April's scheduled analyst meeting such that estimates will see a further upward revision.
The company also increased its revenue projection for the current quarter to a level that will probably produce product revenue growth in the high-single digits. That guidance is now reflected in the consensus forecast, but the consensus revenue growth being forecast for NetApp is just 2% for fiscal '18, part of the FUD factor that still envelops perceptions regarding the outlook for the company. I expect that the analyst meeting, to be held on April 5th may lead the consensus forecast to a slightly greater growth cadence.
It is a bit more than execution
Yes, sales execution is an important component of the operational performance of any IT vendor. But many other factors have been playing out in the company's comeback. And many of these factors are likely to continue to persist in coming quarters and to become more visible.
There are a few trends that seem to be worth noting. Most of them can be seen in tabular and graphic form in this link. Q4 results, not shown here, showed better growth and further market share gains for NetApp. One key metric is that the percentage revenue declines in the overall storage market has been significantly less in 2016 than in prior years. Not growth, certainly, but less shrinkage. Storage capacity growth is actually continuing at strong levels in the low to mid 30% range. As has been the case for a long time now, pricing remains cutthroat and challenging.
Many investors, aided and abetted by some analysts, believe that storage is a moribund space populated by losers and struggling survivors. That is more than a bit of an exaggeration. What is a more realistic picture of the environment is that "customers are maximizing the value of their data by prioritizing investments to modernize their data centers, increase agility, and integrate cloud resources with on premise environments. Clustered ONTAP allows customers to modernize their infrastructure by replacing stand-alone silos of storage and monolithic frame arrays with a scale-out software-defined storage platform."
I don't think that anyone expects the enterprise storage space to be a consistent growth area in the future. Neither is it moribund with no prospects and no place in a cloud-centric world. There are companies of note that are abandoning their data centers. By far, the most common storage strategy in the enterprise these days is for users to combine their own private storage and connect that to services offered by public cloud providers. By now, it seems clear that hybrid approaches seem to be the most popular form of deployment and the market opportunity for storage vendors is to work in that hybrid space.
Another trend of note is that the Dell/EMC merger has led to significant share losses for that vendor, which have continued at significant rates. The specifics of the transaction, with its use of lots of debt, have in turn led to operational issues that have created opportunities for the other vendors in the space. Simply put, the mountain of debt that was part of the deal structure is making it hard for the new business to fund required investments and is providing opportunities that have lifted lots of boats, including the one in which NetApp is traveling.
IBM (NYSE:IBM) as well, continues to suffer significant market share losses, as its overall hardware businesses continues to contract and resources are shifted to more promising areas. It's a lot smaller opportunity when compared to EMC/Dell, but still a significant opportunity for vendors such as NetApp.
Another trend is the rapid emergence of flash as the mainstream storage technology. Flash grew by 61% in the IDC survey cited here. In the survey, flash was about 20% of overall storage revenues. NetApp now gets almost half of its product revenues from flash and continues to achieve triple-digit growth in that technology.
There can be advantages in being late to a party. It seems likely, that NetApp, having come late to the realization of the winds of change blowing through the storage space due to the emergence of the cloud and to the rapid replacement of spinning disc by flash, has been able to find specific flash deployments that optimize user performance in the hybrid cloud. And it has been able to use its clustered ONTAP architecture, incorporating flash, as part of its messaging and its ability to differentiate itself from its competitors.
The results have been that the company is growing faster than the flash market as a whole and flash is a substantially greater proportion of its business than the industry average. The question for investors, simply put, is will those highly favorable trends persist, and if so, for how much longer and at what cadence. The growth that NetApp is achieving in flash is greater than the growth the largest flash-only storage vendor Pure (NYSE:PSTG) is achieving and overall, NetApp is a larger factor in the flash market than is Pure.
There are more claims in the storage market than used car salesmen have ever thought of articulating - or for that matter, perhaps the comparison is better by speaking of the extraordinary claims made by some of the political classes and the press. NetApp has often talked about storage efficiency advantages… and while it has done a better job of articulating its claims than competitors, it is not clear how storage efficiency really works out in the real world. Just for the record, the company is providing users a workload-specific guarantee that scales to a 5 to 1 data reduction ratio, supposedly the best in class. As an analyst trying to cover the large enterprise storage companies, I am not the individual who can separate out all the rather strident claims regarding one flash technology compared to another. But the results that NetApp has been reporting in flash go quite a bit beyond what might be reasonably ascribed to sales execution.
Where does the company go from here?
There are several moving parts in the NetApp engine. But the one that is most intriguing, and which has the potential to substantially move the growth needle, is the direction articulated by company CEO George Kurian. Mr. Kurian, during the course of his prepared remarks talked about the potential in the hyper-converged space. He said that, "We will do what has not yet been done by the immature first generation of hyper-converged solutions, bringing hyper converged infrastructure to the enterprise by allowing customers the flexibility to run multiple workloads without compromising performance, scale of efficiency."
About a year ago, NetApp acquired SolidFire, in a deal that was not admired at the time. SolidFire's technology will be the foundation of this new offering. SolidFire seems to have been a reasonable success for NetApp thus far, and it has the potential to bring a substantial change to NetApp's center of gravity.
A next-generation, enterprise class hyper-converged solution will be a big deal if NetApp really has that ready early in fiscal 2018. During the call, Mr. Kurian observed that the company would make some exciting announcements in the hyper-converged space early in the coming fiscal year. Excitement, to be sure, is in the eyes of the beholder, but it could just be, given the great success of Nutanix (NASDAQ:NTNX) and the strong share price performance of that company, that a product announcement that laps Nutanix might really be exciting - at least for shareholders, including this writer.
It is worth noting, I think, that the current industry leader in the hyper-converged space is Nutanix. The company is approaching the $1 billion revenue run rate, and it is true that most of its deployments have been in branches and regions of larger enterprises. Bringing hyper-converged to the heart of the enterprise would be a tremendous accomplishment and would likely change the growth calculus for NetApp. VMWare/Dell (NYSE:VMW) also has a significant stake in the hyper-converged space on which I focused in my latest review of that business. Hewlett Packard Enterprise (NYSE:HPE) announced about a month ago that it is buying SimpliVity (Private:SIMP), which is said to be another entrant in the race to sell hyper-converged enterprise solutions. What all this focus on hyper-converged might do to Nutanix is another story not for exploration in this article. Overall, the Hyper-converged market is supposed to reach a value of $12.6 billion by 2022 with a CAGR of 43% between now and that time. It certainly represents a significant opportunity for NetApp that is really not considered by most investors when they think of the possible growth rate for the company.
But of course the core of the company's current business is selling its AFA and hybrid flash set of solutions. The growth the company achieved this past quarter suggests that it is gaining market share on a broad front. Part of that has to do with the on-going disruption at EMC and the feature-poor offerings of HPE. Management believes it is gaining on flash-specialist Pure. The folks at Pure have expressed a different point of view based on some of their technologies - particularly what is called NVMe. That is not a dispute that I could possibly resolve. NetApp already offers storage products that include integrated NVMe. I have no idea if NetApp's NVMe is better, worse or the same as that bragged about by Pure.
In the very short term, there appears to be a shortage of NAND memory that has resulted in somewhat higher component prices. This shortage has been a factor that has lead to a declined gross margins the company reported in its most recent quarter. Expectations are that the shortage of NAND will ease later this year, and this will definitely create a tailwind for NetApp gross margins. As a result of the shortage, and higher prices for AFA, some larger users have elected to use hybrid-flash which NetApp can offer seamlessly due to single operating system.
Like many companies, NetApp has had a history of trying to encapsulate much of its future direction in the course of annual analyst meetings. But I think the gist is that the company will talk about achieving a consistent, but moderate growth rate with an emphasis on profitability and cash generation coupled with a shareholder-friendly capital allocation program. Given current valuations, much more than that, on the order of hitting a home run in the hyper-converged market, would be lagniappe, and quite tasty and nutritious at that. The shares are barely priced to achieve moderate growth and as mentioned above, almost half of the analysts that cover this name do not even believe the company can accomplish that.
When I first wrote about NetApp on this site a year ago, as mentioned earlier, the shares were less than $25, and today they are closing in on $41. The question many readers may have is, are the shares still a value. I think they are, but quite clearly not on the basis of EV/S that obtained a year ago. Back then, NetApp was still blowing quarters regularly; now it has started to beat and rise on a consistent basis.
In my world, EV/S is important, but some level of growth is equally as important. A year ago, NetApp was still shrinking, and the path to growth was far murkier than it is after the company achieved a quarter in which product sales showed a small increase. I also find companies that have low EV/S ratios but are losing market share to have a high potential to be value traps. At this point, the company is now achieving significant market share gains in the most important market in its space. Had anyone suggested that the company would be selling more AFA than PSTG a year ago, they would have been greeted with derision. Things like that should mean something significant, even to value investors.
So, is the company more of a value now, than it was a year ago? I think it is. Many readers will have different opinions.
At the current time, the company has reduced its outstanding shares to 281 million. At today's closing price just shy of $41, that produces a market capitalization of $11.5 billion. The company has a net cash balance of $2.7 billion. That yields an enterprise value of $8.8 billion. The consensus forecast for revenue over the next 12 months is $5.5 billion. That yields an EV/S of 1.6X. Not less than 1X to be sure, but the company is showing a significant improvement in both profitability and growth, which ought to be worth something. Management is proving its chops and that is worth far more than just a statistical metric. The increase in product revenue is the first one NetApp has achieved on a yearly basis for the last several years - since prior to fiscal year 2012. It is not terribly surprising that investors are willing to pay for growth, even if it is marginal growth as opposed to years of decline.
The consensus earnings estimate for the next 12 months is now about $2.95. It is my guess that management will call for a more significant increase in profitability during its upcoming analyst day. But using $2.95 as the denominator yields a P/E of 14X. This will also be the first year for EPS growth since prior to fiscal-year 2012. In that year, EPS was $2.41 and the shares traded as high as $46. Lots of water under many bridges since back then.
As mentioned earlier, cash flow from operations declined in the latest quarter although CFFO has been flat for the full year. It can be difficult to forecast CFFO for any company in a given quarter. Looking at Q4 2016, it seems likely to me that CFFO will increase substantially from the levels the company attained last year. Last year, GAAP net income was negligible for the quarter and this year it is forecast to be about $175 million. In addition, last quarter reflected a significant inventory build in NAND to insure the company had adequate supplies to satisfy demand for AFA over the next two quarters. Considering these factors, I think that for the year CFFO will reach $1 billion, or perhaps a little higher. CapEx has been running at consistent rates throughout the year and should probably fall in the range of $185-$190 million. So, my expectation is that free cash flow will $825 million-$850, providing a free cash flow yield of 9.5%.
I believe that these metrics are indicative of a company still being valued as a name without material growth potential in a market seen as close to toxic. Are NetApp shares still cheap? I think so and suggest that the execution the company has achieved over the past 4 quarters has made them cheaper. And I will be interested to see just how the company's management looks at the company's longer-term business model on its analyst day and equally interested to look at the company's "next generation" announcement of an enterprise class hyper-converged solution. Despite the share price appreciation over the past year, I believe that the company still offers investors a significant amount of positive alpha - and while not putting many eggs in the basket of any particular product launch, if the company pulls off what its CEO has set as a goal, it will have as much growth potential as any storage hardware name out there.
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.