NetApp Earnings: Weakness In Product Sales Continues To Impact Top Line, Margins

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NetApp (NASDAQ:NTAP) announced its Q2 fiscal 2016 earnings on November 18, reporting a 6% year-over-year decline in net revenues to $1.45 billion. [1] Net revenues were in line with the guidance given by management at the end of the previous quarter. In line with expectations, product revenues fell by over 12% on a y-o-y basis to $815 million – a trend common for most large storage vendors in recent quarters. On the other hand, maintenance (both software and hardware) and other revenues combined were up by a modest 3% over the previous year quarter to $630 million.

Fiscal 2016 has been a breakthrough period for the company in terms of customers transitioning towards a combination of on-premise solution deployments and cloud-based storage solutions from the existing storage platforms. Newly appointed CEO George Kurian highlighted this trend, with the latest figures on the decline in usage of the traditional ONTAP 7-Mode operating system and the surge in Clustered Data ONTAP in the last couple of quarters. ((NetApp Q2 FY 2016 Earnings Call Transcript, Seeking Alpha, November 2015)) In the course of the current fiscal year, NetApp aims to continue to expand its all-flash storage solutions towards seamless data movement from disk based storage to flash and cloud-based storage.

We have a revised $33 price estimate for NetApp’s stock, which is slightly higher than the current market price. The stock price has fallen by about 25% since the beginning of 2015.

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See Full Analysis For NetApp Here

Product Sales Remain Low

NetApp’s product revenues fell by 12% y-o-y to $815 million through the quarter, which had a sizable impact from FX fluctuations. Moreover, the product division was largely responsible for low company-wide margins. The reported gross margin (GAAP) for the product division was almost 7 percentage points lower than the comparable prior year period at 49.9%. Management attributed the decline of about 3 percentage points to FX fluctuation through the quarter. Additionally, an unfavorable product mix was also responsible for the revenue decline (and consequent margin decline) in the product division.

NetApp has new products in the pipeline, which could help boost revenue figures in the coming quarters. As a result, the company is optimistic about top line growth for starting early next year. 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 witnessed a significant transition period for existing product lines through the quarter. The attach rate for the Clustered Data ONTAP operating system on NetApp’s FAS systems was up to 70% for the quarter, up from only 65% in the previous quarter and 25-30% last year. During the quarter, the company announced a Cisco (NASDAQ:CSCO) validated design for its all-flash FAS FlexPod converged system with Cisco’s application centric infrastructure. This is more likely to boost sales in the long run than have an immediate impact on storage hardware sales.

Growth In Software, Services Lower Than Previous Quarters

Software maintenance revenues, which include software upgrades, bug fixes and patch releases, witnessed limited growth through fiscal 2015, mainly due to the sale of new products. As a result, software maintenance 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, revenues were likely to pick up starting Q1’16. Subsequently, software maintenance revenues surged by 12% year-over-year in the previous quarter to $248 million for the quarter. However, software maintenance revenues were up by only about 4% y-o-y to $233 million through Q2’16. Despite FX headwinds, software maintenance gross margin (GAAP) stayed flat over the previous year quarter at 96.1%

NetApp’s hardware maintenance revenues have grown at double digit percentages (y-o-y) in each of the last eleven quarters. Services revenues have risen due to an increased installed base and aggregate contract values under service contracts. However, this slowed down to a modest 5% growth in hardware maintenance revenues to $326 million through the quarter. Moreover, professional and other services revenues declined by 9% y-o-y to $71 million for the quarter. These revenues have been lower on a y-o-y basis in the last few quarters owing to weakness in the enterprise storage segment.

Margins And Outlook For Fiscal 2016

NetApp’s company-wide non-GAAP gross margin for Q2’16 stood at 62.5%, which was about 250 basis points lower than the comparable prior year period. Although both software maintenance and hardware gross margins improved through the quarter, it wasn’t enough to offset the decline in storage hardware product division. The product division suffered the most, with the non-GAAP gross margin falling by over 650 basis points to 51.8%. On the other hand, hardware maintenance gross margin was about 2 percentage points healthier compared to the year-ago period at 64.7%. Similarly, software maintenance gross margin was up by about 10 basis points to 96.2%.

Moreover, the company was successful in reducing its operating expenses with lower SG&A and R&D expenses through the quarter. [2] NetApp’s combined cash operating expenses were down by over 6% y-o-y to $739 million. As a a result, its operating margin (non-GAAP) stood at 15.2% for the quarter, slightly higher than the company’s guidance at the end of the previous quarter. However, the operating margin was about 250 basis points lower than the comparable prior year period due to suppressed revenues.

Management expects Q3’16 revenues to be around $1.4-$1.5 billion, which at the midpoint of guidance implies a 7% year-over-year decline. Most of the decline is expected due to a continued period of FX headwinds and weakness in its core storage hardware business. Gross margin is expected to be around 61.5% for the quarter, which is over 3 percentage points lower than the previous year quarter. Margins could pick up in the latter half of NetApp’s fiscal 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. Revenues for the fiscal year 2016 could be 5% lower than 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, consolidated gross margin for fiscal 2016 is expected to be a percentage point lower than FY 2015 levels.

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Notes:
  1. NetApp Reports Second Quarter Fiscal Year 2016 Results, NetApp Press Release, November 2015 []
  2. NetApp to cut 500 jobs, Reuters, May 2015 []