NetApp Posts Strong Quarter Despite Low OEM Sales

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NetApp (NASDAQ:NTAP) announced its Q2 FY 2014 earnings on November 13, posting a strong quarter driven by non-GAAP gross margins of 63.6% which were more than 2% higher than the company’s guidance. [1] The company attributes this to a favorable product mix in the hardware division, with products revenues clocking their highest gross margins in the last nine quarters. Branded revenues, which accounted for about 90% of net revenues, increased 5% year-on-year (y-o-y) offsetting a 28% decline in OEM revenues. [2]

Looking ahead, the company expects net revenues for next quarter to be in the range of $1.575 to $1.675 billion, which is a 5% sequential increase, but around the same as Q3 of last year. NetApp’s current market price is just below our $45 price estimate for NetApp.

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Growing Software And Services Revenues

The storage software segment of the company makes the highest profit among all divisions with gross margins in the range of 96-97% over the last few quarters, compared to overall gross margins of around 60%. The higher profit margin and an increased demand for cloud storage, software defined storage and software defined data centers (SDDCs) has led NetApp to shift its focus to these businesses in recent quarters. NetApp enabled the use of hybrid cloud architecture on its Data ONTAP platform, which is the leading software storage operating system. It also integrated ONTAP with Verizon’s Cloud Compute and Cloud Storage to provide the operating system as a virtual storage appliance for Verizon’s cloud clients. NetApp also collaborated with network virtualization giant VMware to provide an integrated Data ONTAP on the vCloud Suite for virtualized environments. With the industry shifting towards virtualization (see VMware Posts Strong Growth), NetApp seems to be in a strong position to capitalize on the SDDC market.

There was cautious spending in terms of new products and hardware purchases among clients, causing a 10% decline in overall products revenues, but NetApp saw a 15% y-o-y increase in hardware maintenance support revenues. Maintenance support contracts revenues, which contributed to approximately a quarter of net revenues, also saw 15% y-o-y growth in each of the four quarters in the last fiscal year. Due to these positive trends, we expect the company to see positive growth in the services segment in the upcoming quarter.

Branded Products Lead To Margin Expansion

Branded revenues were up 5% y-o-y to $1.4 billion, as the company maintained its market leadership. The OEM business, which includes orders taken by IBM, Fujitsu and other companies that use NetApp’s sourced kit and market it under their own name, suffered a 28% decline in revenues which was more than what NetApp had anticipated at the beginning of the quarter. The current quarter (Q3 of the company’s FY 2014) is the end of the calendar year and typically receives more OEM orders compared to any other quarter. The company expects a 4% sequential increase in revenues next quarter.

Due to an increase in sales of higher-margin rich-configured systems and a decrease in lower-margin OEM sales, the company’s product sales had a 57% non-GAAP gross margin, the highest in the last nine quarters. Going forward, the company expects OEM sales to be higher in the current quarter relative to the first two quarters of the fiscal year as OEMs typically see an uptick in orders near the calendar year-end. As a result, NetApp’s products gross margin guidance is around 55%, and management expects overall margins to be around 61%.

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Notes:
  1. NetApp Reports Fiscal Year 2014 Second Quarter Results, NetApp, November 14 2013 []
  2. NetApp Management Discusses Q2 2014 Results – Earnings Call Transcript, Seeking Alpha, November 14 2013 []
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