NetApp Earnings Preview: Product Hardware Sales To Remain Subdued As Ancillary Segments Drive Growth

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NetApp (NASDAQ:NTAP) is scheduled to report its fiscal Q4 earnings on Wednesday, May 24. [1] Through the course of last year, NetApp has witnessed a decline in net revenues driven by low product sales. Moreover, low demand for storage hardware coupled with falling prices led the company-wide gross margin to compress by 10 basis points to just under 61% for the three quarters combined. Comparatively, NetApp’s services and software maintenance revenues have improved to offset the decline from product sales.

We have a $37 price estimate for NetApp, which is slightly lower than the current market price.

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Guidance For Q4 FY’17

NetApp’s management expects a steady 4-5% growth in net revenues to around $1.45 billion in the fourth fiscal quarter. Despite revenue growth, gross margin could continue to be low due to pricing pressure on product sales. As a result, NetApp’s non-GAAP gross margin for the fourth quarter could be around 10 basis points lower on a y-o-y basis at 61%. [2] Comparatively, the company anticipated long-term margins of around 62-64% through the end of the decade. [3]

ntap_q3_e3

On the other hand, NetApp’s operating margin could improve by almost 6 percentage points to 19% – a trend consistent over the last few quarters. NetApp’s management indicated early last year year that it would cut 1,200 jobs to in an attempt to offset the decline in revenues and to enhance profitability. [4] This led to an improvement in the operating margin through the first three quarters of the fiscal year. The company further initiated cost reduction measures starting in November to reduce around 6% of its global workforce, which would result in a one-time charge of $50-60 million in the third fiscal quarter. This should help NetApp save around $130 million a year on operating expenses going forward. Consequently, its net income per share could improve significantly to around 82 cents a share as shown above.

Product Sales Remain Subdued

Global spending on conventional external storage arrays has continued to decline – a trend consistent over the last few years. Keeping up the trend, most large vendors such as Dell-EMC, NetApp, IBM (NYSE:IBM) and Hewlett-Packard Enterprise (NYSE:HPE) have had a tough period in terms of storage hardware product sales. According to IDC’s latest report, Dell-EMC, NetApp, IBM and HPE reported revenue declines last year, as shown in the table below. [5] [6]

ntap_q4_ep1 While industry-wide revenues from sales of external storage systems were down by 5% through the year to $23 billion, NetApp’s product sales fell by 8% to under $2.5 billion. As a result, its market share in the external storage systems market fell by 40 basis points to around 10.7% for the year.

ntap_q4_ep2

Maintenance Revenues, Profits Show Growth

Combined revenues of non-product divisions last year were roughly flat over the year-ago period at $2.5 billion. Among non-product divisions, hardware maintenance and services revenues were around 5% down to just under $1.6 billion. Low product sales impacted hardware maintenance revenues, with revenues falling by 4% to $1.3 billion for the year. Management mentioned that the company observed an increase in the installed base and attach rate but revenues still fell on a year-on-year basis, presumably due to falling prices. [7] Despite low revenues, hardware maintenance as a percentage of product sales has increased over the years. We forecast hardware maintenance as a percentage of hardware product sales to increase to over 60% in the long run.

On the other hand, software maintenance revenues this year have increased by around 2% to around $960 million. This was the only segment which did not face a revenue decline this year. We forecast software maintenance revenues as a percentage of product sales to increase from around 33% in 2016 to over 37% by the end of our forecast period.

In terms of profits, both software maintenance and hardware maintenance segments improved their profitability through the year, as shown below. The gross margin (GAAP) of the hardware maintenance and services segment was up by almost 5 percentage points to 68.1% through the year. Moreover, the software maintenance gross margin was up 70 basis points to 96.8%. Low product sales complemented by a fall in hardware prices led the product division gross margin to fall by almost 5 percentage points to 45.7%.

ntap_q4_ep3

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Notes:
  1. NetApp Hosts Fourth Quarter Fiscal Year 2017 Financial Results Webcast, NetApp Press Release, May 2017 []
  2. NetApp Q3 FY 2017 Earnings Call Transcript, Seeking Alpha, February 2016 []
  3. NetApp Financial Update, NetApp Financial Analyst Day Press Release, April 2017 []
  4. NetApp To Slash 12 Percent Of Workforce, Fortune, February 2016 []
  5. Worldwide Quarterly Disk Storage Systems Tracker Q3 2016, IDC Press Release, December 2016 []
  6. Worldwide Quarterly Disk Storage Systems Tracker Q4 2016, IDC Press Release, March 2017 []
  7. NetApp Q2 FY 2017 Earnings Call Transcript, Seeking Alpha, November 2016 []