NetApp Earnings: Growth In Maintenance, Services Not Enough To Offset Decline In Product Sales

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NetApp (NASDAQ:NTAP) announced its Q3 fiscal 2016 earnings on February 17, reporting a massive 11% year-over-year decline in net revenues to $1.39 billion. [1] Net revenues were slightly lower than the guidance given by management at the end of the previous quarter. Product revenues fell by over 19% on a y-o-y basis to $750 million – a trend consistent across 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 2% over the previous year quarter to $636 million.

Over the last few quarters, the company has witnessed a decline in usage of the traditional ONTAP 7-Mode operating system and a surge in Clustered Data ONTAP. ((NetApp Q3 FY 2016 Earnings Call Transcript, Seeking Alpha, February 2016)) 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 through the end of the current fiscal year.

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Stifled Product Sales

NetApp’s product revenues fell by nearly 20% y-o-y to $750 million through the quarter, which had a negative impact from FX fluctuations. Much of the decline was attributable to revenues generated by some of NetApp’s “mature” business lines such as ONTAP 7-Mode and products sold to OEMs were down by over 40% on a y-o-y basis. [2] Moreover, the product division was largely responsible for low company-wide margins. The reported gross margin (GAAP) for the product division was almost 6 percentage points lower than the comparable prior year period at 49.2%. Management attributed the decline of about 2 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. This trend was consistent with product revenue decline and unhealthy margins reported in the previous two quarters.

On the other hand, fiscal 2016 has been a breakthrough period for NetApp in terms of customers transitioning towards a combination of on-premise solution deployments and cloud-based storage solutions from existing storage platforms. Within storage products, the flash business – including EF and AFF product lines – contributed about $150 million through the quarter, which was nearly 25% annual growth. 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 fiscal 2017. With the company expanding its product offerings to include cheaper storage arrays, it could lead to a wider customer base to cater to.

Moderate Growth In Software Maintenance, Services

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 fiscal 2016. Subsequently, software maintenance revenues surged by 12% year-over-year in the previous quarter to $248 million in Q1’16 and by 4% y-o-y to $233 million through Q2’16. The trend continued through Q3’16, with 4% annual growth in revenues to $234 million. Despite FX headwinds, software maintenance gross margin (GAAP) stayed flat over the previous year quarter at 96.1%

NetApp’s services revenues consist of hardware maintenance revenues and professional services revenues. Hardware maintenance revenues have risen due to an increased installed base and aggregate contract values under service contracts. Moreover, with a slowdown in global expenditures on hardware, maintenance revenues have driven top line growth for the company, with NetApp reporting a double digit growth in eleven consecutive quarters until Q1 FY’16. However, this slowed down to a modest 3% growth in hardware maintenance revenues to $326 million in the December quarter. Moreover, professional and other services revenues declined by 5% y-o-y to $75 million for the quarter. The weakness in the enterprise storage segment could continue to have an impact in the coming quarters despite a large aggregate contract base.

Impact on Margins

NetApp’s company-wide non-GAAP gross margin for Q3’16 stood at 63.1%, which was about 150 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 the storage hardware product division. The product division suffered the most, with the non-GAAP gross margin falling by almost 6 percentage points to 51.1%. On the other hand, hardware maintenance gross margin was about 2 percentage points healthier compared to the year-ago period at 66.2%. Similarly, software maintenance gross margin was up by about 30 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. [3] NetApp’s combined cash operating expenses were down by over 12% y-o-y to $630 million. As a a result, its operating margin (non-GAAP) stood at 17.6% for the quarter, slightly higher than the company’s guidance at the end of the previous quarter. However, the operating margin was about a percentage point lower than the comparable prior year period due to suppressed revenues.

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Notes:
  1. NetApp Reports Third Quarter Fiscal Year 2016 Results, NetApp Press Release, February 2016 []
  2. NetApp Q3 FY 2016 Earnings Call Transcript, Seeking Alpha, February 2016 []
  3. NetApp to cut 500 jobs, Reuters, May 2015 []