Dinosaurs and how they deal with Q1s
One of the questions before investors these days is whether or not NetApp (NASDAQ:NTAP) remains a dinosaur. There is no doubt that the company is and will remain a legacy storage vendor. But George Kurian, the company's CEO, even in his brief tenure to date has done a great deal to move the company from what it had become to a company that might actually be something less like a dinosaur and a bit more like a modern mammal. He has made some high-profile hires in an attempt to resurrect a culture of innovation and customer service that had been hallmarks of this company in the era before the last CEO. There are signs that the effort is bearing fruit despite continued skepticism on the part of analysts and investors.
If there is one takeaway from Q4 results that the company published last week for readers/investors to ponder, it is that what NetApp calls strategic solutions, which include flash and the other growth areas of the company's business, is now 70% of revenue and grew at 24% last quarter. The balance of the company's business is showing less negative trends - its decline was 7% last quarter. Some transitions are successful, others much less so. The financial data above suggest that this transition is showing significant success beyond levels though possible just a year ago.
Of equal importance, the turnaround is producing comparable trends in terms of margins and operating cash flow (CFFO). Certainly from the financial metrics, NetApp has to be considered as the most successful turnaround of scale in the IT world at this time.
I think it worth noting that in Q3, strategic solutions had been 65% of net product revenues and had grown by 22% year on year while the company's legacy business products fell 18%. It is the differences in those metrics, which showed substantial improvements in just a single quarter that led to the significant upside in revenue and concomitantly in operating margins that this company was able to report this past quarter.
The company had forecast revenues of $1.44 billion for the quarter. The company had forecast non-GAAP EPS of about $.81. The company achieved revenues of $1.48 billion for the quarter with EPS of $.86 despite an increase in its tax rate of 350 basis points that related to a higher proportion of income coming from US sources.
Of equal importance is that product revenues grew by 12% year on year. That is the strongest growth in several years and a significant surprise to what many observers felt was possible. The growth in product revenues will eventually translate into growth in services and software maintenance which are still reflecting earlier declines in product revenues.
Some turnarounds go more quickly than others and some have different destinations. The other day I had the occasion to write an article about Nuance (NASDAQ:NUAN), a company whose turnaround has been underway for five years now and which just produced a quarter with a modicum of organic revenue growth.
NetApp's turnaround has proceeded far more briskly again, and this past quarter saw double-digit product revenue growth, the best performance of that key metric in 14 quarters. And yet… like many turnarounds, it will most likely not be recognized by the preponderance of analysts except in arrears. The skepticism that envelops the shares, while not universal, is pretty substantial with 24 out of 32 analysts who report their recommendations to First Call, rating the shares as either a hold or a sell. To a certain extent, analysts really aren't compensated to find successful turnarounds and it is easier to be skeptical than forward looking. And so, the shares, at least in the opinion of this writer still present investors with a substantial opportunity.
I first wrote about the name on this site some 15 months ago. It was trading at $24.76/share back then, and it has now reached $40/share. That is appreciation of greater than 60% and yet analysts have grudgingly raised sells to holds. Over that same time period, the IGV index has appreciated by 52% although NetApp has provided investors with a cash dividend yield of greater than 2%.
While NetApp's outperformance hasn't been extraordinary, it has been noticeable - and I think there is significantly more positive alpha going forward than the company has generated most recently. The balance of this article will be focused on that subject and will deal specifically with the issue of the company's current quarter guidance.
What NetApp reported and the issue of Q1 Guidance
When NetApp reported its results last week, it initially traded off a bit after hours. The downside wasn't very substantial or sustained. The initial reaction was based on what was described as tepid guidance for the company's Q1 fiscal quarter (ends 7/31), primarily in terms of its earnings estimate. Before discussing the guidance in a bit of detail, I think it makes sense to review the specifics of the company's Q4 earnings results.
I have already written about some of the numbers, but just to review, total revenues rose 5% year on year during the quarter with product revenues rising 12%. The company reported GAAP gross margins of 48% which compare to 44% in the prior year and to 44.5% the prior quarter. This was a considerable surprise to most based on a common perception of excessive price competition in the storage industry coupled with component shortages that have boosted the prices of NAND, a key storage component, by 100%.
One of the major surprises for investors has been the ability the company has had in terms of being able to pass along that kind of component cost increase to its customers. It might suggest that the supply/demand function is not really based on industry overcapacity. It also suggests that when NAND prices decline, as is the forecast, there will be further gross margin upside for this company, not reflected in either guidance or in published expectations.
In Q4, the company's run rate of all flash arrays reached $1.7 billion, up from a run rate of $1.4 billion in Q4. That is sequential growth of more than 20%. While the company is not going to be able to sustain that level of flash growth indefinitely as comparisons get more difficult, it certainly suggests one of the reasons why revenue growth turned out as it did last quarter.
The following expense ratios are all GAAP. Sales and marketing expense fell 6.6% year on year, which is indicative of strong expense management given that this was a Q4 in which product revenues rose 12%. Research and development costs fell 5% year on year, and general and administrative costs fell 17%. Operating expenses rose a bit between Q3 and Q4 with sequential increases in all of the categories typical of Q4 seasonality.
Stock-based comp continued to decline noticeably year on year. In Q4 stock-based comp was $45 million, consistent with Q3, but down more than 25% from the year earlier period. For the full year, stock-based comp fell by 30%. At current levels, stock-based comp represented 3% of revenues and 19% of reported non-GAAP net income.
The company generated cash flow from operations of $365 million during Q4, an increase of 5.8% from the prior year. The growth in cash flow was limited because of balance sheet items including the growth in A/Rs partially due to higher product revenues. Other balance sheet items including accruals and other assets also negatively impacted CFFO.
In addition, the company stockpiled inventories in order to mitigate the impact of chip shortages and to ensure a steady supply of product going forward. Cash flow also saw a lower growth in deferred revenues which reflects the impact of annual maintenance billings and the prior decline in product revenues. The company's free cash flow at $811 million was essentially consistent with the levels of the prior year.
The company continues to maintain substantial liquidity and has the ability to both raise its dividend significantly and to raise the level of share repurchase. Overall, the company has net cash on the balance sheet of $3.7 billion, and it has reduced its outstanding share count to 278 million, down from 284 million.
As mentioned, at the time of the earnings release, there were those who found the company's Q1 guidance disappointing or "tepid." Another view might be that it was prudent and did not really reflect any commentary about the company's business momentum or cost containment philosophy. But as least as concerns the company's Q1 earnings forecast, guidance was less than had heretofore been the First Call consensus.
Until recently and going back for quite some number of years, this company has only guided quarterly. These days it guides for margins and tax rate but does not guide for revenues for the full year. So, the quarter that is said to have been a guide down was not a guide down in terms of what the company had forecast. The company is currently forecasting that it will earn $.57 in the quarter, and 10 days ago, the consensus forecast had been $.67. That shortfall, again, according to the consensus, is going to be made up during the balance of the fiscal year. The new consensus forecast for fiscal 2018 is essentially consistent with the prior forecast.
As I will attempt to suggest below, the logical underpinnings of these expectations aren't very firm, and I expect they will be exceeded by noticeable percentages. Specifically, the company forecast that it would see top-line growth of 2% in Q1 and what it called "moderate" revenue growth for the year as a whole. It also suggested rather explicitly that the percentage growth in Q1 would be the low for the year and would accelerate in subsequent quarters for the balance of the year. That is not really embodied in the analyst consensus and is one reason I anticipate that the company will continue to beat expectations for all of fiscal 2018.
The CFO forecast that it would see a normal seasonal progression of revenues with Q1 being the lowest in that regard and Q4 being the greatest. And it is forecasting that it will achieve low-double-digit EPS growth for the full year. Management during the course of the conference call suggested that the Q1 forecast it has provided was gaited by the fact that Q1 fiscal '17 was a "relatively" stronger quarter than had been Q4 2016. There is some validity to that in that the decline between Q4 and Q1 was less last year when compared to the increase between Q3 and Q4, but those things are difficult to rate at best. What isn't that difficult to rate is that the growth in flash in terms of dollars is at a substantial rate that doesn't show signs of slowing and that the decline in the company's legacy products has abated quite substantially.
I am not too sure what is meant by normal seasonality. Once upon a time - by that I mean perhaps five years ago - normal seasonality had the company having a decline between Q4 and Q1, having a substantial uptick in Q2 due to the end of the fiscal year of our government, having a flat Q3 compared to Q4 and then having a very strong Q4. If it turns out that way, I think NetApp is likely to over attain the current consensus revenue forecast by several hundred basis points.
During the course of the conference call, the company said it would be implementing an across-the-board increase in compensation, something it has been unable to do for some years now despite the very competitive job market in Silicon Valley. In addition, the company still has to contend with massive increase in component prices, particularly for NAND. So the so-called tepid guidance for Q1 comes down to a prudent/conservative evaluation of seasonal revenue trends, some allowance for an across-the-board increase in wages, coupled with absorbing a very significant increase in component costs.
I think it is reasonable for a company like this which has been through a near-death experience to maintain a cautious stance with regards to guidance. But the fact is that looking at the environment, guidance was neither tepid nor disappointing and in fact was better than had really been anticipated which is why in fact 11 analysts have increased their estimates for this year as a whole and why a few skeptical analysts have upgraded NetApp shares by a notch.
My own expectation is that the company will continue to have quarters in which it over attains based on the success of its flash offering and that as it does so will be able to raise operating margins a bit compared to its own projections. The issue of market share is key in my own expectation and I move now to discuss that aspect of valuing these shares.
What is it like in the market for flash storage?
A few years ago, it became apparent that the days of spinning disc were drawing to a close. The two major independent storage companies have had a very difficult time in dealing with that transition and, of course NetApp, with a singularly myopic management, was very late in believing that all-flash arrays would be the standard for storage and would wipe out most other technologies.
In additional to the technology revolution with regards to storage, there has been the revolution with regards to the physical location of storage and much of the market has gone up to the cloud. Both of those trends continue to be sure, but by now it is apparent that there remains a market for on-premise storage that continues to grow despite the shift of many workloads to the cloud.
I have linked to an article here that depicts the growth rate for data storage at a high level. Another article of potential interest to investors is linked here which suggests that there is a looming shortage of data storage! I am not going to try to critique the article - I haven't either the tools or the knowledge to do so, but it suggests that the market for what companies such as NetApp sells is far from extinct. No dinosaurs roaming this space, it says. Lots of the market for storage is going to be in the cloud - this linked report is talking about a market worth $75 billion by 2021. There are other reports that have yet higher estimates.
Almost all of the growth in storage going forward is clearly going to be in the flash area. The latest Gartner MQ report linked here is nine months old, but for what it is worth, it places NetApp in the leader's quadrant. I assume, based on the methodology of this survey, that when the new MQ data is available in August, NetApp will climb further into the leader quadrant.
As mentioned earlier, by now NetApp has driven revenues for its flash products to a $1.7 billion annual run rate, up 140% year over year. While much of its growth has been the replacement of its legacy technologies with flash, it seems straightforward enough that it is likely a market share gainer.
While the 140% number is perhaps not totally relevant in the discussion of market share (it is coming from a small base), the 21% growth in sequential quarterly flash revenue suggests that NetApp is likely to wind up with more than its historical share of the storage market. I think when trying to look at the potential growth for the company, one has to start with the flash market and the seeming success that this company is enjoying.
Just as a comparison, Pure Storage (NYSE:PSTG) grew 31% year on year last quarter. Pure's results were down seasonally, and NetApp will probably not see continued growth in its fiscal Q1 of its flash storage business either, but I think the point is that NTAP is certainly growing as fast as the overall market for flash and that includes the industry leader.
The CEO says that all-flash is still just 10% of the NetApp installed base and that the ramp is long. I think that is a reasonable expectation and is a reason to rerate long-term growth expectations for this company. None of that is in the current valuation of the shares. It is worth the time and exercise of looking at the transcript of the call to see just how incredulous analysts are about the ability of this company to sustain growth.
One factor in NetApp's success is the decline of EMC in terms of its market share in this space. The blood between EMC and NetApp has been bad for as many years as I can remember. Sort of like the enmity between water buffalo and lions. In any event, management says that it displaces EMC once a day. I have no idea if that is net or gross. I do believe, however, that the integration between Dell and EMC has left the storage vendors with a target of opportunity and will continue to do so until the sales force that Dell fields has overcome many issues and until the level of customer support returns to more acceptable levels.
There are many, many claims made in the market for flash storage and for this company in particular, one is bombarded with claims about the efficacy of Clustered ONTAP. Pure talks constantly about NVMe and its leadership in that technology, and NetApp claims that NVMe will be a commodity technology and all will use it. I am not the one who is going to unravel who makes a better flash product. And if I could decipher that, I would still lack the knowledge as to who might market it (all-flash arrays) better. I don't think that this kind of an article is necessarily the place to suggest that NetApp's flash technology stack is equal to, worse than, or better than that offered by PSTG. Again, the conference call suggests that management is comfortable with its evolving competitive position in flash and the numbers bear that out. And that is about as far as I wish to go at this time.
The subject of hyper-converged
It may be remembered that NetApp bought a vendor called SolidFire about 15 months ago. SolidFire was a participant in the hyper-converged infrastructure space. At the time, it wasn't amongst the most popular moves NetApp had made - of course at the time NTAP was thought not to be able to do right. I do not intend to try to put together a buyer's guide for HCI. Every time one looks, the forecasted market size has moved higher. I think the results that were reported last week by industry leader Nutanix (NASDAQ:NTNX) speak for themselves. I have linked to the latest study of the Forrester Wave which is three quarters old. What is interesting is that at the time of this report, SolidFire wasn't even in the running as a competitor. At this point, it is worth noting that SimpliVity has been bought by Hewlett-Packard (NYSE:HPE) and that Cisco (NASDAQ:CSCO) has begun selling its HCU solution that it calls HyperFlex.
So far SolidFire has been on track with the forecast the company provided when it bought it early in 2016. That forecast suggested that SolidFire would add about 2% to NetApp's total revenues or something on the order of $125 million. We don't know how fast it has been growing and it probably hasn't been in the triple-digit growth category or the company would have trumpeted that achievement. But the company will be announcing an entirely new line of HCI technology within the next few weeks. Again, claims and competitive hype aside, SolidFire has always had competitive technology. It had been partnering with Dell for the servers it used in its appliance; it will now use a commodity server. It is forecast that it will increase the number of nodes dramatically - 32 or 64 - and it will of course be all flash.
Yes, there are many vendors selling HCI appliances and hypervisors and so forth in the market. But then it is perhaps one of the more innovative technologies and one of the largest TAMs to be seen in the storage space in some years.
I certainly have no idea what the ramp for the product might be or any other financial implications of the product introduction. It is supposed to be a big thing and I am inclined to believe that it will be so. At the least the management of NetApp these days is very focused on product functionality and competitive characteristics.
Will the product announcement moves the needle on the share price. I am just not sure. Most times a product release doesn't matter much. I think, however, if investors are convinced that the company has a leading entry in the HCI race that could have a meaningful impact on operational performance, it would have an impact on valuation. The company's current valuation simply doesn't reflect any real expectation that its HCI offerings will lead to noticeable growth.
How fast can NetApp grow? The current company projection would appear to be in the 5% range. The potential for SolidFire and its new release might add a few hundred basis points to that expectation. Whatever it might be, it isn't baked into expectations at this point.
Is NetApp still a value story? I think it remains in that category despite the company's share price appreciation. At this point, based on 278 million shares currently outstanding, and Friday's closing share price, the company has a market cap of $11.2 billion. Current net cash amounts to $2.9 billion, leaving an enterprise value of $8.3 billion. The current consensus forecast for revenue is $5.63 billion, 2% growth from this year. Management guidance implies a more realistic number would be perhaps $5.9 billion. At that level, the EV/S is 1.4X. While there are certainly EV/S metrics that are lower than that level, they are usually reserved for sick companies with declining revenues.
The company is forecasting that it will increase its EPS in the low double digits. That comes to an EPS forecast in the range of $3.08 and a P/E of 12.4X non-GAAP. As mentioned earlier, stock-based comp is a significantly smaller proportion of revenues for this company than many comparables and it is falling. There is a better quality of earnings here than is the case with some other comparables.
The company has forecast a free cash flow margin of 17-19%. That would result in free cash flow of $1.06 billion and a free cash flow yield of almost 13%. That is an extraordinary level for most companies that are not in financial straits. It allows the company to fund a healthy capital return program that will support the company's share price valuation.
As part of the earnings release announcement, the company increased its dividend payout to $.20/quarter. It is not the largest dividend increase in the world, and I doubt that anyone buying the shares these days does so because the forward yield is now 2%. But it is likely that the company will be in a position to continue to increase its dividend and to increase share repurchase as well further reducing outstanding shares.
My core investment thesis simply put is that the company's growth potential is still far from appreciated. Consistently faster growth and consistent increases in dividends and share repurchase. I believe the success it has enjoyed in flash is only minimally accepted by investors. The specific numbers of the transition outlined in this article are extraordinarily positive. While speculative, I think that the impending HCI product announcement will be a significant element in the company's forward growth.
Will NetApp be consolidated? It certainly has many of the characteristics that would seem to make it attractive to both private equity and to strategic acquirers. Its total size is attractive and the cash generation makes a private equity transaction easy to finance.
Again, as mentioned in this article, the company's valuation reflects significant skepticism that the company can achieve its goals. Based on the results this past quarter and really this past year, it ought to have as much credibility as most other tech management teams in terms of the accuracy of its forecast. I have been a shareholder of NetApp for some time and expect to continue to enjoy positive alpha.
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.