NetApp Looks Forward To Positive Year After Storage Slump In 2014

Storage giant NetApp (NASDAQ:NTAP) has had a positive fiscal 2015 thus far, with its stock price rising by over 25% since the end of its fiscal 2014 in April. The company is poised to grow strongly in the coming quarters on the back of a revamped product lineup, strength in the storage software market and its presence in the fast-growing converged infrastructure and flash array market. Below we take a look at how NetApp’s various product categories performed in 2014 and what to expect in the coming quarters.

We have a $43 price estimate for NetApp’s stock, which is roughly in line with the current market price. The stock price has risen by about 5% since the company reported its Q2’15 earnings in mid-November.

See Full Analysis For NetApp Here

Storage Systems Market And NetApp’s Presence

In recent years, the storage hardware business has slowed, as evidenced by an industry wide decline in external storage systems revenues as reported by IDC. The year started slow for storage system sales throughout the industry. Total worldwide external disk storage systems factory revenue for Q1 this year was over 5% lower than the comparable prior year period at $5.6 billion. Low product sales were attributable to a 25% y-o-y decline in high-end storage spending, according to IDC. ^[1] Similarly, total disk storage factory revenue, which includes internal and external storage systems, declined by over 6% y-o-y to $7.3 billion. Weakness continued through the second quarter, as industry-wide external storage systems revenue declined by 1.4% y-o-y to just under $5.9 billion. ^[2] The trend reversed in Q3, as demand picked up for storage arrays costing less than $100,000. Industry-wide external storage factory revenue was up by 1% y-o-y to $5.8 billion. ^[3]

NetApp has been one of the few large storage system vendors this year to have maintained its market share through the first three quarters this year at 13.7%. EMC’s (NYSE:EMC) share in the storage systems market is significantly higher at 30.2% in 2014 thus far. However, its share has dropped from 30.7% in the comparable year-ago period. Similarly, IBM’s (NYSE:IBM) share fell from 11.6% last year to 10.4% this year, and Hitachi Data Systems’ share declined from 8.1% to 7.5% in the first three quarters of 2014. There was higher demand in the mid-range market, with niche players gaining share at the expense of larger companies. We currently forecast NetApp’s external storage systems market share to gradually rise to over 15% through the end the decade.

In the first two quarters of NetApp’s fiscal 2015, branded product and services revenues grew by almost 2% over the year-ago period to $2.78 billion. In the same period, products sold via the original equipment manufacturer (OEM) channel declined by 23% y-o-y to $248 million. Weakness in NetApp’s OEM channel, complemented by the termination of the IBM-NetApp deal in May, has led the company to expect a 30-40% y-o-y decline in OEM revenues through fiscal 2015. Although these revenues have declined by only 23% y-o-y in the first half of the current fiscal year, management mentioned that OEM revenues for the full fiscal year could fall by up to 40% despite a lower decline in the first half. Branded revenues are expected to rise through the end of the calendar year, owing to the revamped range of products on offer and strength from product sales and corresponding services revenues. The company expects its Q3’15 revenues to be $1.56-$1.66 billion, which at the midpoint implies roughly flat revenues over the year-ago period. ((NetApp Q2 FY 2015 Earnings Call Transcript, Seeking Alpha, November 2014)

Hardware maintenance revenues have witnessed a double digit year-on-year increase in each of the previous eight quarters due to an increased installed base and aggregate contract values under service contracts. The growth continued during the second fiscal quarter, with a 12% y-o-y rise in hardware maintenance support contracts revenue to $311 million. Professional and other services revenues declined by 10% y-o-y to $78 million for the quarter, partially offsetting the growth in revenues on maintenance contracts. The company expects services revenues to be boosted in the coming quarters due to strong demand for enterprise service agreements from its larger clients.

Solid Outlook For Software Due To Revamped Product Line

In its annual conference at the end of October, NetApp announced the launch of five new products to further its data fabric vision. Four of the five new introductions were software-based products,  while the fifth was the design and deployment of professional services to help customers with hybrid cloud adoption. The software-based product launches included cloud data management suite Clustered Data ONTAP 8.3, data management for public cloud access Cloud ONTAP, NetApp’s Private Cloud Storage manager, and private and public cloud provisioning software suite OnCommand Cloud Manager. This highlights NetApp’s intention to enter the software virtualization and cloud computing domains. ^[4]

In its second fiscal quarter, NetApp introduced a significant number of new products including all-flash storage array FlashRay, the Data ONTAP 8.3 operating system, Cloud ONTAP software for usage in public clouds and the new range of products from the SteelStore acquisition. Moreover, the rate of NetApp’s Clustered ONTAP system attached with hardware increased across its storage products. The attach rate for high-performance storage platforms was close to 65% during the quarter, while it stood at 50% for mid-range storage products. NetApp’s converged storage architecture solution FlexPod had a solid quarter, with a 50% rise in shipments compared to the prior year quarter.

Furthermore, NetApp signed an agreement with virtualization and cloud computing provider VMware (NYSE:VMW) to combine its storage arrays with VMware’s EVO: RAIL software stack. ^[5] VMware’s  EVO:RAIL combines compute, networking, and storage resources into a single converged appliance that makes it an easy-to-deploy solution. NetApp’s hyper-converged system will have three offerings including the NetApp FAS storage array, NetApp’s Cluster Data ONTAP operating system and VMware’s EVO: RAIL. Since NetApp’s management ruled out a large-scale acquisition of a virtualization or cloud computing firm, it will likely continue to collaborate with a third party such as VMware, and have integrated product offerings.

Software entitlements and maintenance (SEM) revenues, which include software upgrades, bug fixes and patch releases, have been flat since the beginning of the year, mainly due to the sale of new products. Management mentioned that customers typically test or evaluate new products for about six months before upgrading software and listing requirements for patch fixes. Consequently, the company should generate higher SEM revenues in the coming quarters. Additionally, the company also intends to independently sell unbundled software from full systems to large customers and sell pure-software solutions to clients using third-party storage arrays, which could further drive SEM revenues.

Margins Improve, Conservative Forecast

NetApp’s non-GAAP gross margin has been over 64% in its current fiscal year thus far, nearly 4 percentage points higher than the year ago period. Margins are higher than the guidance given by the company owing to a favorable product mix and strong growth in the services division. The company attributed the improvement in margins to lower expenditures on support infrastructure complemented by higher support contract revenues. Margins also improved by over a percentage point due to improved supply chain efficiency, a favorable product mix and lower warranty costs – a trend similar to Q4’14. Management mentioned that unfavorable foreign exchange fluctuations and higher expenses due to the SteelStore acquisition could restrict margin improvement in the coming quarters. As a result, the company expects its non-GAAP gross margin to be around 64% for fiscal 2015.

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1. Worldwide Quarterly Disk Storage Systems Tracker Q1 2014, IDC Press Release, June 2014 [↩]
2. Worldwide Quarterly Disk Storage Systems Tracker Q2 2014, IDC Press Release, September 2014 [↩]
3. Worldwide Quarterly Disk Storage Systems Tracker Q3 2014, IDC Press Release, December 2014 [↩]
4. NetApp Helps Enterprises and Service Providers Build a Hybrid Cloud Foundation, NetApp Press Release, October 2014 [↩]
5. NetApp goes for a ride on VMware’s EVO: RAILs, The Register, December 2014 [↩]