NetApp Earnings Preview: Weakness In Product Sales Likely To Hinder Top Line Growth

Storage giant NetApp (NASDAQ:NTAP) is scheduled to announce its Q2 fiscal 2016 earnings on Wednesday, November 18. ^[1] The company has seen weakness in its core storage business over the last few quarters, with revenues falling by 25% y-o-y to $664 million in the most recent quarter. As a result, net revenues were down by 10% year-over-year to $1.3 billion. ^[2] Weakness in the storage hardware business is expected to continue over the next few quarters, due to which NetApp’s management expects Q2’16 revenues to be around $1.4-$1.5 billion, which at the midpoint of guidance implies a 6% year-over-year decline. ((NetApp Q1 FY 2016 Earnings Call Transcript, Seeking Alpha, August 2015)) The company has enhanced its focus on hybrid cloud and all-flash storage solutions in an attempt to migrate data storage from disk-based storage solutions to flash and cloud-based storage.

We have a $36 price estimate for NetApp’s stock, which is about 10% higher than the current market price. The stock price has fallen by over 20% since the beginning of 2015.

See Full Analysis For NetApp Here

Product Sales Likely To Remain Low

NetApp’s product revenues fell by over 25% y-o-y to $664 million in the previous quarter. Similarly, product revenues for the fiscal year ended April were over 7% lower than the previous year at $3.6 billion. NetApp introduced new products in the second fiscal quarter, which could help boost revenue figures in the long run. With the company expanding its product offerings to include cheaper storage arrays, it could lead to a wider customer base to cater to. The company remained optimistic about top line growth for Q2’16, expecting a nearly 10% sequential improvement in revenues for the second fiscal quarter. However, a 10% sequential improvement in revenues to about $730 million implies a more than 20% year-over-year decline.

Moreover, the gross margin (GAAP) for the products division in Q1’15 was about 7 percentage points lower than the comparable prior year period at 48%. Management attributed approximately half of the decline to FX fluctuation through the quarter. The company expects FX headwinds to continue through the December quarter as well. However, the negative impact of currency fluctuation is expected to fade through the latter half of NetApp’s fiscal 2016.

A similar trend was observed by competing storage provider EMC (NYSE:EMC) in the September quarter, as it reported a 6% annual decline in product sales (hardware and software combined) to under $2.4 billion. The decline in storage hardware sales has been consistent for all major storage systems providers including EMC, NetApp, IBM (NYSE:IBM) and HP (NYSE:HPQ), which lost share to original design manufacturer (ODM) direct sellers in recent quarters. Comparatively, the combined revenues generated by companies outside the top five vendors saw a 9% increase in revenues through the first half of 2015. Moreover, customer preference is shifting to low-cost ODM storage boxes, cutting into the addressable market for large vendors. ^[3]

Growth Expected From Software And Services Divisions

Software entitlements and maintenance (SEM) revenues, which include software upgrades, bug fixes and patch releases, witnessed limited growth through fiscal 2015, 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. This led to a brief delay in customers opting to refresh software maintenance contracts. As a result, SEM revenues through FY 2015 were about 2% lower than the previous year at just under $900 million. Since the company had major product launches in Q2 last year, SEM revenues were likely to pick up starting Q1’16. Subsequently, SEM revenues surged by 12% year-over-year in the previous quarter to $248 million for the quarter. This trend is likely to continue over the next couple of quarters.

NetApp’s hardware maintenance revenues (excluding professional and other services) have grown at double digit percentages (y-o-y) in each of the last twelve quarters. Services revenues have risen due to an increased installed base and aggregate contract values under service contracts. The company witnessed a 14% y-o-y rise in hardware maintenance support contracts revenue to $346 million in the most recent quarter. Additionally, the company enhanced its services portfolio with the introduction of AltaVault solutions in May. ^[4] Moreover, the company has extended software support to all-flash storage array AFF8000 customers for seven years – significantly more than the typical 3-5 year support offered by the company – which could help drive services revenues further. Management mentioned that the company’s intention to enhance its focus on large enterprise customers and cloud providers in the coming quarters could result in improved margins for the services division.

Outlook For Fiscal 2016

The company-wide gross margin is expected to be around 63.2% for the quarter, which is about 50 basis points lower than the previous year quarter. Margins could pick up in the latter half of NetApp’s fiscal year due efforts by the company to cut costs, improve supply chain efficiency and improve pricing of products. Moreover, the company also intends to cut operating costs by reducing its global workforce by around 4% through fiscal 2016. ^[5] Revenues for the fiscal year 2016 are expected to be 5% lower than the FY 2015 at about $5.8 billion, with top line growth recovering in early 2016. However, even as revenues (and gross margins) recover in the latter half of the fiscal year, the consolidated gross margin for fiscal 2016 is expected to be a percentage point lower than FY 2015 levels.

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1. NetApp Hosts Second Quarter Fiscal Year 2016 Financial Results Webcast, NetApp Press Release, August 2015 [↩]
2. NetApp Reports First Quarter Fiscal Year 2016 Results, NetApp Press Release, August 2015 [↩]
3. The Rise Of White-Box Storage, Network Computing, August 2014 [↩]
4. NetApp Challenges The Status Quo with New AltaVault Cloud-Integrated Backup and Restore Solutions, NetApp Press Release, May 2015 [↩]
5. NetApp to cut 500 jobs, Reuters, May 2015 [↩]