Pure Storage: Hold On For The Long Term
Summary
- Shares of Pure Storage have rallied only modestly despite recently releasing strong results to a coronavirus-impacted Q1.
- As a company that sells primarily products and not subscriptions, Pure Storage's revenue deceleration of five points in Q1 came in harder than for most other tech companies.
- However, Pure Storage also delivered nearly ten points of operating margin gains, and bookings growth clocked in at 24% y/y.
- Pure Storage also believes that the pandemic has increased customers' interest in Pure-as-a-Service, allowing Pure Storage to build up its recurring revenue base.
- Pure Storage also has a substantial ~$1.3 billion cash balance ($0.8 billion in net cash).
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Pure Storage (NYSE:PSTG), the flash storage company that is attempting to re-invent itself as a SaaS subscription offering, remains one of my favorite value stocks to invest in during the pandemic. The company tests well against two important criteria: one, despite the near-term revenue hits, the coronavirus pandemic is actually a long-term boost to Pure Storage's technology and demand; and second, the stock still remains below comp valuations.
In light of the impact of the coronavirus, Pure Storage recently released strong Q1 results that smashed Wall Street's estimates on both the top and bottom lines. Revenue growth decelerated, as expected, but Pure Storage more than made up for that with a huge corresponding boost in operating margins and cash flow. Still, shares have barely moved since:
Data by YCharts
Stay long here - there's a plethora to like about Pure Storage at current levels.
Subscription shift
The key thing investors should know is that Pure Storage believes the current pandemic to be an accelerant in the company's long-term goal of becoming a subscription-oriented company. Flash storage has long been a product-oriented business: companies buy the storage units they need, and the only recurring revenue that they generate is perhaps a support contract to service that previous purchase. The coronavirus, however, has increased the need for businesses to be agile and to rapidly scale up and down their infrastructure.
As such, on the Q1 earnings call, CEO Charles Giancarlo noted that Pure-as-a-Service had a record quarter:
Pure's subscription services had an outstanding quarter. Subscription services include our non-disruptive Evergreen services, Pure as-a-Service, and Cloud Block Store for multi-cloud environments. Evergreen reduces the risk and economics for customers by ensuring that Pure's on-premise systems never grow old. After seven years, competitors are still playing catch up to Pure's Evergreen program of continuous non-disruptive upgrades, providing customers a subscription to innovation rather than a contract for obsolescence.
But Pure has leapfrogged yet again with our Pure as-a-Service offering, also reducing the risk and economics of storage in the multi-cloud age. Customers leveraging Pure as-a-Service have the flexibility to determine their cash and capital commitments in the short as well as the long term, the flexibility to own or to subscribe and the flexibility to change where they place their data at any time. They have the freedom of a multi-cloud contract for storage and to only pay for what they use, when they use it, regardless of where they place their data."
The company began offering a "first three months free" promo in Q1 for customers signing up for a contract of longer than 12 months, which is certain to drive additional demand.
The reason this subscription transition is important is because, as Pure Storage continues to build up its recurring revenue base (currently only about one-third of the company's overall revenues), in addition to its high software-like gross margins, investors will begin to see Pure Storage more as a software company and less like a commodity hardware provider. Right now, Pure Storage is sitting between the two, and being seen as a software company will provide the multiples expansion that will give shareholders double-digit returns.
Valuation update
The other point that investors should be aware of is that Pure Storage currently has a valuation below that of most similarly-growing software companies. At present share prices near $17, Pure Storage has a market cap of $4.49 billion. After we net off the $1.27 billion of cash on Pure Storage's balance sheet against $484 million of convertible debt, we arrive at an enterprise value of $3.70 billion.
Pure Storage has withdrawn its guidance for the current year amid demand volatility, but Wall Street consensus has a target of $1.78 billion for the year. We note that this consensus estimate is a tad conservative, representing ~8% y/y growth versus Pure Storage's 12% y/y growth in Q1 (and the very real possibility that demand will re-accelerate in the back half of FY21). Still, even if we apply this low consensus estimate, Pure Storage's valuation is only 2.1x EV/FY21 revenues.
That's substantially below (one or two turns) where other "cheap" software stocks that are expected to grow in the mid-teens are trading:
Data by YCharts
Note that, with Pure Storage's Q1 pro forma gross margin clocking in at 73%, there's virtually no difference between Pure Storage and other software companies, so continuing to value Pure Storage as a pure hardware company makes no sense. The only differentiator now is Pure Storage's ability to become a majority-recurring revenue company, which the current pandemic is a catalyst for.
Let's also conservatively assume Pure Storage can generate three points of OCF margin growth this year to 14.5% (versus prior-year margins of 11.5%; 1Q21 cash flow margins are already up 750bps). This gives us a $258.1 million operating cash flow estimate for FY21, applying the same consensus revenue estimate. This indicates Pure Storage is also trading at 14.2x EV/FY21 OCF, showcasing that it looks like a value stock from a profitability perspective as well.
In my view, as the subscription/recurring story continues to build throughout the year, Pure Storage should be able to "catch up" to comps like Box and hit 3.5x EV/FY21 revenues, implying a price target of $26 and ~51% upside to current levels.
Q1 download
Let's also dive through Pure Storage's most recent quarterly results in greater detail. See the earnings summary below:
Figure 1. Pure Storage 1Q21 results
Source: Pure Storage 1Q21 earnings release
As previously mentioned, revenues did decelerate this quarter, down to 12% y/y growth (five points weaker than last quarter's 17% y/y growth). On the bright side, however, this was significantly better than the $349.3 million (+7% y/y) that Wall Street had penciled in (and perhaps after fully digesting this quarter's beat, FY21 consensus will also shift upward from 8% y/y growth). In addition, Pure Storage's subscription revenues showed much stronger 37% y/y growth to $120.2 million, showing barely any deceleration from Q4's 41% y/y pace of growth. The overall mix of subscription revenues, which investors are also tracking closely, rose six points to 33% in Q1 versus 27% in the prior year quarter.
Management's commentary on the exact impact of the coronavirus on Pure Storage's sales was actually rather mixed. From a total bookings perspective (that is, the full dollar amount of deals that were signed in the quarter but not necessarily recognized as current-quarter revenue), Pure Storage actually benefited from customers potentially pulling in demand to satisfy needs linked to a remote work shift, with bookings up +24% y/y and much stronger than revenue growth. This bodes well for revenue growth for the remainder of the year. Note that when Pure Storage began the year, prior to any known impact of the coronavirus, the company had only projected bookings growth of ~20% y/y. At the same time, management has also called out uncertain demand and some customers delaying their purchasing timelines. CFO Kevan Krysler's prepared remarks help to shed some qualitative light on this impact:
Total bookings or sales during Q1 grew 24% year-over-year and is broadly diversified across industry verticals and customers. Sales during Q1 to our enterprise and government customers in the United States were solid and growing, while we saw overall weakness in our commercial business. We are pleased with our partnership and continued momentum from our channel partners worldwide [...]
Our business during Q1 benefited from increased demand of mission critical IT needs arising in response to the unprecedented pandemic. We fulfill these orders without significant delays and supply shortages based on the remarkable efforts and resilience of our global supply chain and manufacturing operations. Partially offsetting this tailwind, we saw an increase in opportunities in our pipeline that were expected to close during the quarter but did not close."
In any case, Pure Storage's revenue deceleration was also offset by strong margin gains. Thanks largely to lower sales and marketing costs stemming from a stoppage of travel, Pure Storage managed to boost pro forma operating margins by 8.1% to -1.5%, or virtually breakeven - despite the fact that Q1 is typically Pure Storage's worst quarter for profitability.
Figure 2. Pure Storage operating margin trends
Source: Pure Storage Q1 earnings deck
Ditto for cash flow - Q1 is typically Pure Storage's lowest cash flow quarter because the company is moving past the bookings-heavy year-end, but this time around, the company managed ~5x growth in operating cash flows to $35.1 million. Operating cash flow margins jumped from 2.0% in 1Q20 to 9.5% this quarter, while free ash flow also swung from -$17.7 million to +$11.3 million this quarter.
Figure 3. Pure Storage cash flow trends
Source: Pure Storage Q1 earnings deck
Pure Storage's strong profitability trends are yet another differentiator for the company against other tech stocks that makes its below-market ~2x forward revenue multiple untenable.
Key takeaways
Investors currently still have an opportunity to buy Pure Storage while it's in limbo between being treated as a hardware company and software company by the markets. Strong 37% y/y subscription growth and an ever-growing mix of subscription revenues heavily favors Pure Storage's eventual shift to being a majority recurring-revenue company and earning the richer valuation multiple associated with SaaS. And so far, despite revenue deceleration in Q1, Pure Storage's bookings growth suggests that the hit from the coronavirus this year won't be too bad. Stay long here.
This article was written by
Analyst’s Disclosure: I am/we are long PSTG. 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.
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