NetApp (NASDAQ:NTAP) posted its Q4 FY2013 earnings on May 21, reporting a 1% y-o-y jump in revenues. Total revenues were at the high end of the guidance issued at $1.72 billion, up 1% y-0-y.  Growth in the software and services businesses more than offset the decline in storage hardware. As expected, gross margins improved due to a favorable mix of revenues from its businesses.
Operating margins (after adjusting for one-time items) declined mainly due to an increase in R&D and SG&A expenditures.  The company generated free cash flow of $392 million.  Under severe pressure to return more of its growing cash to shareholders (cash after net of debt constitutes over 30% of our current price estimate), the company increased its common stock repurchase amount by $1.6 billion. The company will now purchase $3 billion of its common stock in the next three years.  NetApp has also decided to initiate a dividend payment. Further, as part of its strategy to boost profit amid increasing expenditures, it will eliminate over 900 jobs. 
For the next quarter, NetApp estimates revenues in the range of $1.47-$1.57 billion and non-GAAP EPS between $0.45 and $0.50. Below we take a detailed look at the trends observed and key business developments.
Services And Software Drive Growth, Hardware Declines
On a yearly basis, hardware/product revenue fell by 2% due to cautious IT spending, a weak macroeconomic environment and federal budgetary pressures in the U.S. The company saw its revenues from the U.S. public sector decline by double digits. Revenues from OEM, which comprises revenue from the sale of NetApp’s products by other companies like IBM and Fujitsu under their own brands, continued to decline at a high-teen rate. OEMs have reduced their purchase of NetApp-sourced kit. Growth from branded products, however, negated it partially. The mid-end array FSA 3000 continues to see strong traction as more midsized businesses are consolidating operations onto a shared storage platform. Shipments of high-end array FAS6000 also rose slightly on a sequential basis after the company refreshed its products. However, the sales of entry-level array FAS 2000 were down. 
Branded E-Series products, which have failed to match initial expectations since the Engenio acquisition, seem to have picked up growth with a 17% increase compared with Q3.  The EF540, an all-flash array built on E-Series, is also doing well. NetApp has one of the broadest flash portfolios and as of Q4 2013 has shipped over 44 petabytes of flash. In Q4, bookings for systems with Flash pools, a hybrid disk and SSD solution, grew 32% sequentially. 
The growth in the software business was due to growth in installed base of Data ONTAP, rated the #1 storage operating system by IDC. ONTAP 8 continues to see strong customer adoption as over 50% of the global installed base has moved to the platform, with many of them already shifting to version 8.1.  Services business, through which NetApp provides support solutions, and customer education and training, also grew at high single digit growth due to a growing installed base.
Gross Margins Improve, But Operating Margins Take A Hit
Overall, gross margins increased as the revenue share of high margin software increased during the quarter. Gross margins also benefited from a favorable mix in the hardware segment with the sale of high margin branded products growing compared with a decline in low margin OEM business. Gross margins within the hardware segment improved over 3% on a yearly basis. However, the service segment margins declined 3% due to investment in support infrastructure.
Operating margins declined due to a rapid increase in R&D and SG&A costs. The company is investing heavily on marketing and branding to gain back the growth momentum through new contracts and strategic partnerships. It has also intensified its efforts to develop new products to fend off increasing competition from EMC and its own partners. This is expected to pay off in the long term through an increase in revenue growth.
Near Term Challenges Remain, But Long Term Outlook Looks Good
In the near term, NetApp may continue to face challenges as spending from the U.S. public sector is expected to remain dull following budgetary pressures. The U.S. public sector contributes over 13% in revenues. Further, it has high exposure to Europe with the region contributing nearly 30% to its revenues. Macroeconomic conditions and IT spending continue to remain weak in Europe.
NetApp has been focusing on the development of its ONTAP platform while increasing the installed base. This will help in the long term as it provides a perpetual revenue base through services and software entitlements. Further, NetApp is strengthening its existing partnerships with Cisco while investing in new partnerships with system integrators and cloud service providers including SAP and VMware. As cloud storage demand is expected to maintain rapid growth, this should help NetApp going forward.
To expand its FlexPod’s addressable market, NetApp is also working on providing FlexPod solutions with the capability to manage up to 10,000 servers. This level of scalability will expand NetApp’s reach to customers in larger data centers, public sector and cloud service providers. Further, as noted above, NetApp’s comprehensive flash portfolio continues to witness strong growth. Flash provides high speed data performance, and despite the costs associated with it companies are willing to pay for the enhanced performance. We can see the hybrid solutions becoming a major driver going forward.
We are updating our $38 Trefis price estimate for NetApp to reflect the latest earnings and recent trends. NetApp’s stock has increased close to 15% this year.Notes: