NetApp To Gain Share, Improve Profits Despite Slowdown In Storage Hardware

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Storage giant NetApp (NASDAQ:NTAP) is scheduled to announce its Q1 FY 2015 earnings on August 13. The company witnessed an 8% decline in storage product revenues in the last quarter, while storage software entitlements and maintenance (SEM) revenues remained flat at $227 million on a year-over-year basis. NetApp’s services division grew by almost 8% y-o-y to $379 million. As a result, the company’s net revenues for the quarter declined by 4% to $1.65 billion. Management anticipates the y-o-y decline in revenues to continue through its first fiscal quarter due to a slowdown in storage hardware sales. NetApp’s top line could fall to around $1.47 billion (the mid-point of its revenue guidance) for the quarter, from $1.52 billion last year. [1]

The company did report a higher profit last quarter despite low product revenues due to a favorable product mix, transition towards services and maintenance-based revenues and lower input and operational costs. We have a $41 price estimate for NetApp, which is slightly higher than the current market price.

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External Storage Systems Market On The Decline

According to a recent report on worldwide sales of storage systems by IDC, industry-wide factory revenues generated by external storage systems declined by over 5% y-o-y to $5.6 billion in the March quarter this year. Moreover, the total storage systems market (internal plus external) declined by almost 7% to $7.3 billion. Much of the decline was driven by weakness in high-end storage spend, which fell by 25% on a year-over-year basis. [2]

However, NetApp’s external storage systems revenues declined less than 3% y-o-y to $854 million during the quarter. The company outperformed the market – a trend that continued from the December quarter last year when NetApp and rival EMC (NYSE:EMC) were the only players in the market to witness growth in storage hardware in a period when the industry faced a decline. As a result, NetApp gained share in the external storage systems market. We forecast NetApp to continue to gain share in the market on the back of a solid customer base, a high number of client maintenance contracts and a revamped product line, including the clustered ONTAP storage system and the EF flash-array series.

Additionally, NetApp’s weakness in products sold via the original equipment manufacturer (OEM) channel, which included products sold by partner companies such as IBM (NYSE:IBM) and Fujitsu, is likely to continue as IBM terminated its deal with NetApp to sell the latter’s storage products. The contribution of revenues from the OEM channel has decreased significantly in the last few years from about 18% of its product sales to just over 11% in 2013. Comparatively, NetApp’s branded sales have grown consistently in each of the previous seven quarters. [3] Although termination of the IBM deal may hinder NetApp’s top line growth in the near term, it is likely to push margins up since OEM sales typically have lower margins for the manufacturer.

Growth In Services And Maintenance To Improve Profitability

NetApp’s Software Entitlements and Maintenance (SEM) revenue stream, which includes software upgrades, bug fixes, and patch releases, grew at a CAGR of 9% from 2010 to 2013. Although SEM revenues were flat at $227 in the previous quarter, the company expects integrated cloud services and open source solutions in the software-defined data management framework to drive SEM revenues in the coming quarters. Additionally, the company also intends to independently sell unbundled software from full systems to large customers, which could drive SEM revenues. However, management believes that this may not be an incremental revenue stream and might just cut into hardware/product revenues.

NetApp’s hardware maintenance revenues have witnessed a 15-20% year-on-year increase in each of the previous seven quarters on the back of an increased installed base and aggregate contract values under service contracts. Given the continued growth in maintenance contracts, NetApp’s hardware maintenance revenues are likely to continue that growth in the coming quarters.

NetApp’s gross margin improved by over 3 percentage points in Q4’14 over the prior year quarter. There were two main reasons for the healthier margins:

  • Change in revenue mix

The contribution of Storage products (hardware and software) to overall revenues declined from 65% of net revenues in 2012 to 63% in 2013. Consequently, NetApp’s non-GAAP gross margins improved from 59.3% to 61.5% in that duration. The trend continued in the previous quarter with a reduced contribution of product revenues over the year-ago period. The revenue mix is expected to continue to shift towards services and SEM revenues through 2014 owing to a slowdown in storage systems sales, which is likely to enhance NetApp’s overall profitability.

  • High-margin products

The second factor to contribute to margin improvement was relatively high-margin product sales such as flash-arrays and converged storage systems. Non-GAAP gross margin for storage products rose from 51.8% in 2012 to 54.8% in 2013. This figure further improved to 58% in the previous quarter due to an increasing mix of high-margin products. The company expects to continue to sell products with high margins in the coming quarters.

Management expects Q1’15 margins to be 2-3 percentage points higher than that prior year period owing to an expected shift towards a favorable product mix, lower hardware warranty costs and an increasing revenue contribution of software and services. Additionally, the company is likely to continue to lower its expenses by reducing headcount and other realignment measures leading to enhanced overall profitability.

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Notes:
  1. NetApp Q4 FY 2014 Earnings Call Transcript, Seeking Alpha, May 2014 []
  2. Worldwide Quarterly Disk Storage Systems Tracker Q1 2014, IDC Press Release, June 2014 []
  3. NetApp Supplemental Quarterly Data, NetApp Investor Relations, June 2014 []