Why NetApp’s Profits Are Likely To Shrink In 2020 Despite Steadily Declining Expenses

NetApp (NASDAQ: NTAP) is a technology company that makes money selling data management hardware, software and solutions. The company has achieved steady growth over FY 2016-2019 (ending April), with the company’s net income witnessing a 5.1x increase over this period thanks to a combination of surging revenues as well as falling expenses. Although expenses in dollar terms are expected to decline in the near term, total expenses as a percentage of revenue are expected to jump in 2020 mainly as a result of a 8% decline in NetApp’s Revenues for the year. This should result in NetApp’s earnings margin (i.e. revenues less all expenses, expressed as a percentage of revenues) shrinking slightly from 19% in 2019 to an expected 18.6% in 2020. Trefis breaks down the company’s major expense components in its interactive dashboard How Does NetApp Spend Its Money?, parts of which are summarized below.

Notably, selling costs (which represents the selling and marketing expenses) are expected to be $1.45 billion in 2020 – making up 32% of NetApp’s $4.6 billion in 2020 expected total costs. NetApp’s selling expenses are about 75% of the company’s largest expense driver – the cost of sales.

• NetApp’s total expenses have declined 6.4% since 2016 – decreasing from $5.3 billion in 2016 to $5 billion in 2019 driven by a 10% decline in operating expenses, partially offset a slight increase in the cost of sales.
• Total expenses are expected to decline in 2020 driven by a combination of decreasing cost of sales as well as lower operating expenses.
• However, the company’s total expenses as % of revenue are projected to increase by 40 basis points, from 81% in 2019 to 81.4% in 2020.

Breaking Down NetApp’s Total Expenses

Cost Of Sales

• The cost of sales primarily consists of three elements:
  • (1) cost of product revenues, which includes the costs of manufacturing and shipping our storage products
  • (2) cost of software maintenance, which includes the costs of providing software maintenance and third-party royalty costs
  • (3) cost of hardware maintenance and other services revenues.
• Cost of sales is the single largest expense driver, accounting for nearly 44% of the company’s total expenses in 2019.
• Total cost of sales as % of revenues has declined from 39.2% in 2016 to nearly 36% in 2019 driven despite higher average selling prices due to higher margins on product revenues and hardware maintenance and other services revenues.
• However, the cost of sales in absolute terms has nudged ahead from $2.17 billion to $2.2 billion over the same time period.
• Lower cost of sales (as % of revenues) coupled with steady revenue growth has helped NetApp’s gross margin expand from 60.8% in 2016 to 64.2% in 2019.
• Going forward, we expect the cost of sales to steeply decline to $1.9 billion in 2019 driven by lower product revenues, representing 33.3% of total revenues of $5.65 billion.

Operating Expenses

• NetApp’s Operating Expenses include sales & marketing, R&D, G&A, and other expenses. Operating expenses have declined 10% since 2016, falling from $3 billion to $2.7 billion in 2019, led by a $135 million decrease in selling expenses as well as a $100 million decrease in other expenses.
• Sales & marketing expenses have decreased 8% over 2016-19, going down from $1.8 billion in 2016 to around $1.65 billion in 2019 driven primarily by lower compensation and incentive-related costs as well as lower facilities and IT support costs.
• Other expenses (income) which include restructuring charges and gain on sale of properties have consistently decreased since 2016, falling from $65 million to around -$40 million in 2019 primarily due to one-time gains resulting from the sale/derecognition of assets.
• G&A expenses are also on a declining with the expenses declining by 9.4% over 2016-19, driven by lower compensation costs.
• Overall, total operating expenses are projected to fall by 7.7% to $2.5 billion in 2019, representing 44.5% of total revenues.

Non-Operating Expenses (Income)

• NetApp’s non-operating expenses have decreased from $3 million in 2016 to -$47 million in 2019 driven by a combination of higher interest and other income.

Additional details about how NetApp’s Non-Operating Expenses (Income) have trended over the years are available in our interactive dashboard.

Income Tax Expense

• NetApp’s income tax expense has hovered around $120 million over 2016-2019, apart from 2018 when this metric spiked to $1.1 billion due to one-time charges linked to the U.S. tax reform.
• We expect the company’s effective tax rate to be around 20% in 2020.

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