NetApp Revised Higher On Solid Growth And Profit Margins But Challenges Remain

by Trefis Team
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NetApp (NASDAQ:NTAP) posted its Q1 FY2014 earnings on August 14, with total revenues of $1.52 billion, a 5% jump on a yearly basis. [1] As noted in our pre-earnings note (NetApp Earnings Preview: Hardware Weakness Offset By Software And Services), weakness in the OEM business continued to weigh on revenues in the storage hardware business, but branded hardware products more than offset the pressure with high single digit growth. The software business got a boost from the launch of an updated version of its Data ONTAP storage operating system, which gained strong traction. The services business benefited from a higher installed base of NetApp’s products, which generate maintenance fees.

Gross margins benefited from a favorable product mix in the storage system business as well as a higher revenue contribution of the high margin software and services businesses. The improvement in gross margins, coupled with cost-cutting measures, boosted adjusted operating margins. Free cash flow jumped to $220 million due to the company’s focus on improving its working capital cycle. Geographically, the Americas were the main growth driver with nearly 7% growth while Asia Pacific lagged with just 3% growth. [2]

Below we take a detailed look at the earnings and key business developments.

See our full analysis on NetApp

Branded Business Drives Growth, Operating Margins Improve

Overall hardware/product revenue grew by 4% with branded products seeing strong growth. Branded revenues grew by ~9% during the quarter, the highest in the last seven quarters. This suggests the company may have gained some market share from its competitors like EMC and IBM, which registered slightly lower growth. Its FSA family of arrays registered growth across price ranges, especially the high-end array. Shipments of the high-end array FAS 6000 grew 16% on a yearly basis after the company refreshed the product family a while back. The shipment growth was much higher at 28% on a sequential basis. The mid-end FSA 3000 also saw strong growth as more mid-sized businesses continued to consolidate operations onto a shared storage platform. Growth in the E-Series products is also accelerating due to the growing use of extremely large data sets.

NetApp’s flash portfolio continues to grow at a rapid rate due to increasing requirement for high-speed arrays. During the quarter, over 60% of FAS systems were shipped with flash cache and/or flash pool. Systems with flash pools, a hybrid disk and SSD solution, grew 50% sequentially. The EF540, an all-flash array built on E-Series, is also doing well. Sales of the FlexPod system, a converged infrastructure solution, increased 30% on a yearly basis. Revenues from OEMs, which comprises revenues from the sale of NetApp’s products by other companies like IBM and Fujitsu under their own brands declined by 20%. However, this was anticipated due to NetApp’s focus on high margin branded products as OEMs continue to reduce their purchase of NetApp sourced kits.

Growth in the software business largely came from growth in the installed base of Data ONTAP, which continues to see strong customer adoption. The launch of Data ONTAP 8.2 has seen the strongest customer adoption of any major release of the software. Further, the majority of clustered ONTAP systems are going to either new customers or new applications for existing customers. The services business, through which NetApp provides support solutions, and customer education and training, also grew at a high single digit growth rate due to the larger installed base.

While a favorable product mix was one of the major reasons for the company’s improvement in operating margins, a rapid decline in SG&A costs also worked in the company’s favor. With growth concerns looming, the company has taken several cost-cutting measures. Last quarter, the company cut more than 900 jobs (1/8th of its workforce), which resulted in lower SG&A costs. R&D as a percentage of revenues also declined. Operating margins improved to around 15% from 12.5% in the same period last year.

Near Term Challenges Remain

For the next quarter, NetApp estimates revenues in the range of $1.56-$1.66 billion, ~5% yearly growth and a non-GAAP EPS between $0.60 and $0.65. This is a bit low considering that the quarter has been one the strongest quarters for the company with the fiscal year of the U.S. federal government ending on September. Further, the growth forecast is slightly below what its competitor EMC expects. This could largely be due to federal budgetary pressure as NetApp generates close to 12% of its revenues from the U.S. public sector.

Despite near-term challenges, we have revised our price estimate for NetApp to $45 from $38. One of the reasons for this change was a lower number of outstanding shares and a decline in SG&A costs. Under pressure to return more of its growing cash to shareholders, NetApp increased its share repurchase amount to $3 billion last quarter. NetApp has since then been purchasing its shares aggressively and is planning to complete $1 billion of repurchases by the end of Q2 (full $3 billion by the next year end). Further, SG&A costs have declined at a rapid rate after NetApp took several cost cutting measures. In the last quarter the company announced to cut 900 jobs and will continue to take similar measures to boost margins. Earlier we were anticipating these improvements to be offset by continued investment in its marketing efforts to boost sales. However, the company’s earnings have confirmed that cost-cutting measures are outweighing increases in other costs. Accordingly, we have reduced our forecast for SG&A expenditures, from around 34% of revenues to below 32% in 2013.  We expect it to further decline in 2014, before increasing to 33% by the end of our forecast period.

Further, we have extended the forecast period by one year in our model to 2020. The increase in price estimate was partially offset by a change in our forecast for working capital requirements. Instead of our earlier expectations of a continued decline in working capital changes, we now forecast it to approach zero by the end of our forecast period.

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Notes:
  1. NetApp Reports Fiscal Year 2014 First Quarter Results, NetApp, August 14 2013 []
  2. NetApp Management Discusses Q1 2014 Results – Earnings Call Transcript, Seeking Alpha, August 14, 2013 []
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