NetApp: The Anatomy Of A Successful Turnaround
Summary #NetApp reported the results of its fiscal Q2 about 2 weeks ago. The results were a substantial upside in terms of revenues, margins and operating cash flow. Guidance was raised as well. While @NetApp shares performed strongly in the wake of the earnings release and they have been a strong performer for most of this year, valuations remain at very reasonable levels. Guidance appears to be at quite modest levels, leaving substantial room for over-attainment. And many analysts have yet to catch up with the changing environment in the enterprise storage space. NetApp: Where does it go from here? Thanksgiving is a great holiday for many of us. Lots of wonderful food and family. When else is it possible to enjoy scalloped oysters without guilt. Or other old-style comfort foods that I still enjoy such as tomato dumplings and coconut cake. The stock market is open most of the time, but somehow the price action is sort of buffered for many as we concentrate on football and on that proverbial nap after a huge meal and some festive bottles of wine. And this year, for many investors in tech, and I am one of those, this is a year for which there is much to give thanks. NetApp (NTAP) is a holding of mine, and has been so for some time now, and it is a holding for which I’m pleased to give thanks. The company has recorded several quarters of strong operational performance and the shares have responded. Year-to-date, the shares have appreciated by 57% which might leave some investors wondering what’s next for this old-line storage vendor with a new face. The shares have not been this high since the tech bubble of 2000. There are some authors on this site who feel the shares are due for a pull-back. That viewpoint is certainly understandable given the sharp price spike seen both in the wake of the earnings release and the overall rally in tech. But I really look at the fundamentals of the business, the relative valuation and the business momentum. Those elements continue to be under-appreciated at NetApp and hence I continue to think both owning positions and starting new ones is fully justified. Because earnings and cash flow from operations are rising so rapidly, it is not entirely apparent that NetApp shares are more highly valued than they were before they began their run. While earnings estimates have risen to some extent, the level of earnings revision seems to me to be substantially below what might be reasonable, given the trends in the storage space and at this particular company. I feel, as I will explain throughout the foregoing article, that NTAP shares still have much to give. Earnings estimates remain too low. Growth expectations have yet to really adjust to the reality of the company’s pivot. Investors are still mesmerized by the impact the cloud has had on the storage market. The company reported the results of its fiscal Q2 in the middle of this month. The results showed strong progress absolutely and were noticeably high than the prior consensus. In addition, the company offered guidance that was basically higher than the prior consensus expectations. The operational performance was good enough to induce one analyst upgrade, although another well known analyst had upgraded the shares two notches before earnings. That said, NetApp shares simply do not get the attention they might based on the consensus First Call rating which is stuck between buy and hold. And that is logical given the very modest expectations that many analysts still have for this recrudescent growth story. On average, analyst expectations are for just 5% top-line growth this year followed by 4% next year. To be straightforward about the subject, that kind of progression, coupled with the results posted this past quarter, is more or less absurd. The models of many of the analysts that make up the consensus may add up mathematically, but they are a contortion of logical sense. I will discuss some substantiation for that statement later in this article, but part of the case for suggesting that the shares remain a buy is that there are still so many myopic analysts, and presumably portfolio managers as well, who have yet to take time to smell this delicious blend of rising growth, improving profitability and strong cash flow. NetApp’s days as a momentum growth company seem to be in its past. But it certainly has the chance to return to high single-digit top line growth with steady improvements in margins. Advertisement ￼ Just as an example of extreme myopia, the Morgan Stanley analyst who has rated NetApp as a hold during the entire period of its growth pivot continued on that track with a research report best characterized as “know nothing, learn nothing.” It is as though the operational performance of NetApp these past 12 months simply never happened. The issue for the analyst is that, “as competitors regain footing post acquisitions and storage continues to migrate to the cloud, NetApp’s over-performance will come to an end.” But the analyst went on to write that this consummation has now been pushed back by six months or so, more or less leaving her readers with no real actionable advice – although with a $41 price target, a sell rather than a hold recommendation would seem called for. Interestingly, as recently as September, this analyst claimed that Dell was taking market share from NetApp. Maybe not the worst call of the year – but certainly a difficult position to defend after these numbers. Most of the balance of this article will focus on evaluating on how this company stacks up competitively and the article will, at the least, try to project how the market for external storage might evolve in the context of the cloud. That said, it seems to me at this point, that the idea that NetApp’s success is a function of the difficulties and unwieldiness of the Dell/EMC combination, is simply not a sustainable thesis. And while it is true that the days of external storage resuming a pattern of material growth, there is plenty of evidence as well, that the storage market is returning to equilibrium, with demand being driven by the adoption of a hybrid cloud paradigm for a preponderance of workloads. The latest published data suggest that the enterprise storage market grew by 3% last quarter and that the growth trend has been positive. According to the IDC analysis linked here, there are various sub-segments of the market growing far more rapidly, while some segments of the storage market are shrinking. Part of NetApp’s recent success is that its pivot over the past couple of years has left it with higher market share and market share momentum in the growth components of the storage space. The company, which has a share of but 6.4% overall, is not totally at the mercy of the overall market growth rate for the storage market. While it seems likely that the shrinkage of Hewlett Packard (HPE) and Dell within the storage market will abate in whole or in part (Dell actually recorded negative 27% growth in its latest quarter in the storage space according to the IDC statistics), the core of NetApp’s success has been primarily a function of its successful pivot to providing users with a reliable and cost-effective product in the all-flash space. Flash, according to IDC, grew by 38% last quarter, and NetApp reported that its flash storage revenues grew by 58%. I think that NetApp will continue to take share in the flash market as has been the case for at least 18 months based on a set of advantages that have not diminished over that time. Some of the more salient elements of the NetApp quarter As mentioned earlier in this article, NetApp’s revenues grew by 6% in this latest quarter. Perhaps of equal significance, hardware revenues continued to climb at double-digit rates, and were up by 14% in constant currency. That result was, as indicated, mainly a function of the growth of all-flash arrays which grew by 58% on an annualized basis. At this point, with NetApp revenues of all-flash arrays running at $1.7 billion on an annualized basis, it seems clear that the success NetApp is enjoying is far beyond simply replacing the storage of its installed base customers. NetApp has a 13% market share for external storage, a category that’s indeed still shrinking, but it has a 30% share of the all flash market, a category still growing rapidly. All-Flash is now 26% of total external storage revenues for the market as a whole, but it is 61% of NetApp’s storage revenues. One doesn’t have to go much further than those specific numbers to understand the reasons for NetApp’s performance…and there’s absolutely no signs that the trends highlighted above are likely to abate any time soon. Importantly, while software and maintenance revenues still declined by 2% year on year, they showed a 2% sequential increase for the quarter. One of the major growth drivers to expect going forward is that the service revenue headwind will abate and start to reverse in coming quarters, and perhaps sooner than has currently been forecast by the CFO in the latest conference call. The company reported that its non-GAAP EPS for the quarter was $.81, which compared to a prior expectation for the period of $.68. The company had strong operating cash flows during the quarter. The substantial increase in cash flow during the quarter was driven by a 60% growth in GAAP net income, balance sheet items, and an improvement in the deferred revenue metric. That improvement (actually a decline in the net change of deferred revenues) is likely to be a harbinger of strong cash flow growth in future periods. Of equal importance, at least to me, is that the company saw a decline in stock based comp expense of a noticeable amount. Stock based comp fell from 32% of cash flow from operations to just 12%, emphasizing just how strong the trends in CFFO really were this past quarter. The company showed significant improvements in margins in just about every category. The foregoing results are all based on GAAP. Product gross margins increased from 47% to 50.6% year on year. Some of this is probably a function of the apparent turn in the cost of NAND which has been an issue for many hardware vendors for several quarters. Services margins went from 67% to 70%. Operating expense metrics also trended lower and total GAAP operating expenses fell from 51% of revenues to 48% of revenues. Overall, GAAP operating income rose from 10.5% of revenues last year to 15.4% of revenues, a significant attainment that was not really anticipated. The company’s guidance, again considered carefully, is more than may have met the eye and certainly more than is embedded in consensus estimates. The company is specifically forecasting that “despite our over-attainment in Q2, we will still show increasing percentage growth with at least normal seasonality for the balance of this current fiscal year. The consensus revenue forecast doesn’t reflect that “optimism” – it actually seems to go the other way and reflects little of normal Q4 seasonality which historically has been quite strong for this company. With expense constraints still much in evidence, with component costs starting to decline, or at least no longer increasing rapidly and with revenue growth showing at least seasonal patterns, the odds seem very much that this company will be able to surpass both its own earnings guidance and the current consensus for the balance of the year. With rising cash flow, and substantial cash balances, the backdrop for more rapid share repurchase and a further dividend increase seem firmly in place. The why behind the what – or why can NetApp improve on growth rate expectations Since George Kurian became CEO of this company, replacing a leadership team that had been heavily weighted toward men with a field sales background, the emphasis of this company has been on building a differentiated product portfolio. The core technology differentiator for NetApp is what it calls its Data Fabric set of solutions. I’m not going to attempt to analyze why Data Fabric has proven to be a strong factor for NetApp in its competitive positioning. The paradigm for which the solution was designed was that of enabling hybrid cloud deployment. It is said to offer best in class cloud connectivity with performance and efficiency benefits. It is really all about creating an environment that’s optimized for hybrid cloud deployments. Data Fabric, includes ONTAP 9.3, long a mainstay of the NetApp product portfolio, and which currently offers performance guarantees and deduplication efficiency. These days, NetApp offers a guarantee that customers will achieve workload-specific capacity savings or NetApp will make up the difference. ONTAP 9.3 also offers enhanced security and compliance capabilities. In times past, NetApp was late to the party in terms of adopting significant technology trends. At least in so far as is visible to this writer, those days at NetApp are gone. The company is adopting NVMe technology as fast as it is feasible for it to do so The company now is using NVMe in several of its offerings. While Pure (PTSG) will undoubtedly declare victory regarding its deployments of NVMe when it reports its results later today, NetApp certainly appears to be keeping pace with that technology. Investors should want to know some of the details about what’s happening in the storage market. Here is a quote pretty much on that point by the CEO. “This quarter, we saw more than two competitive displacements per day, which is up substantially from the numbers we reported last quarter. The majority of our flash footprint is net new wallet share in customers at the expense of legacy frame SAN arrays from our competitors like HP, IBM, and EMC. We still see substantial room to run…We have several world-record performance benchmarks, a deeply differentiated software portfolio and we continue to see strong momentum going forward.” Of course that was a commercial, but the fact is that commercials can contain elements of fact as well as spin. It seems straightforward to suggest that NetApp continues to displace its rivals in the storage world because it has solutions that are quantitatively superior to those of the major competitors. Yes, sales execution is part of the paradigm in storage, as it is in other areas of IT, but consistent growth at scale well greater than the actual growth of the market can only be explained by providing customers and potential customers a better overall experience in their use of a NetApp solution at an attractive price. The company also has started to offer a true HCI solution. Just how it compares to the solutions being offered by other vendors in this space is a bit early to determine. But the HCI trend is so strong and pervasive that there is room for several vendors. Will NetApp compete effectively with Nutanix (NTNX)? The answer is unknowable except as speculation at this point. Mr. Kurian described business momentum for the HCI platform as exceeding expectation and it seems reasonable to anticipate that one of the upside demand drivers for NetApp will be this platform. As the technology was only introduced last month, it is likely that a clear picture of what is being offered, the parameters of demand for the offering and the competitive capabilities vis-à-vis Dell, VMW (VMW) and Nutanix will only emerge within the next 2-3 quarters. Valuation Has the spike in NetApp shares taken them to an unreasonable valuation? As I have been at pains to point out, NetApp’s earnings and growth expectations have increased noticeably over the course of the current fiscal year. And the details of the guidance suggest, at least to this writer, that upward revisions to both revenue and earnings expectations have further to go. Using 275 million shares outstanding, a number which is likely to decline through the course of the next 12 months due to share buybacks and reduced levels of stock based comp, NetApp has a current market capitalization of about $15.4 billion. The company currently has net cash of about $3 billion, leaving an enterprise value of $12.4 billion. Revenues for the next 12 months are expected to be about $5.8 billion based on the current First Call consensus. So, the EV/S is 2.1X. NetApp is a hardware company, to be sure, and valuations of most IT hardware vendors are quite constrained. That said, an EV/S of 2.1X, given the improving growth outlook for this company, suggests a need for re-rating given the metrics for somewhat comparable vendors. Attempting to compare valuation for this company, to companies not growing or in most cases shrinking, really doesn’t make much sense. Based on the current published consensus, NetApp is forecast to have EPS of about $3.60 for the coming four quarters. Given the specifics of the guidance and management commentary, that is an estimate that seems to reflect expectations that are below trends of the recent past. According to its management, NetApp is supposed to achieve faster percentage growth in the coming quarters than in the past two quarters. Gross margins are supposed to increase and opex levels are expected to be maintained in absolute dollars. All of that is going to push EPS substantially for the balance of the fiscal year and into fiscal 2019. The CFO projected that operating margins this year would reach 20%. With forward 12 month revenues likely to be around $6 billion, that would produce operating income of $1.2 billion. Accruing a 20% tax rate (the current rate the company has been using) and using a weighted average share count of 271 million for the fiscal year as a whole, would produce EPS for the current fiscal year of $3.53 which is about $.20 above the current published consensus forecast. Looking at the forward 12 months in EPS, I think a more reasonable expectation, considering normal seasonality in which Q4 produces the strongest results of the year, is at or above EPS of $4.00. That yields a forward P/E of about 14X, very reasonable in the context of current valuations and of considerably higher earnings quality than peers given the modest use of stock based comp. This past quarter, net stock based comp was 15% of reported non-GAAP net income. That compares to a ratio of 29% the prior year. The company accrued taxes at a 20% rate which is up from a 17% rate accrued the prior year and is consistent with the rate accrued in Q1. As mentioned, cash flow growth at NetApp was quite strong this past quarter. The company has guided to free cash flow to be in the range of 19%-21% of revenues. Clearly, balance sheet factors are significant in estimating cash flow, and they were quite favorable last quarter. There can be, at least in the short term, negative correlations between operating cash flow and faster revenue growth and that could happen over the balance of the fiscal year. But at 21% of revenues, free cash flow this current fiscal year is forecast to be $1.23 billion. Looking at a forward 12-month estimate, free cash flow is likely to continue to grow, particularly as deferred revenue growth resumes due to the strong performance of current product revenues. (Deferred revenues are mainly a product of 12 month billings on installed hardware. As growth in hardware revenue has accelerated, growth in deferred revenue will resume shortly.) I think it is reasonable to anticipate that free cash flow on a forward 12-month basis will be around $1.35 billion which produces an expected free cash flow yield of 10.9%. It is rare to see a free cash flow yield at that level for any IT vendor, let alone an IT vendor showing accelerated growth and improving profitability. As mentioned earlier, free cash flows at these levels will likely lead to accelerated share repurchase – currently running at around $600 million on an annual basis. Higher dividends also are reasonable to anticipate as current dividends of $.80/share represent a payout ratio of just 23%, substantially below the historical payout ratio. Has the spike in share prices carried NetApp valuation to an unreasonable level? That doesn’t appear to be the case. In fact, it might be said that the gains in operational performance are still outpacing the increase in the share price. I have expressed my appreciation for the company’s share price performance earlier in this article. But I expect I will have reason to give thanks yet again over the coming quarters. I expect growth rate expectations to pivot at some point. And while the company may choose to constrain margins to achieve higher growth rates, that is not an invidious trade-off. NetApp shares at this point are essentially at consensus price targets, a sign of the myopia of many of the analysts who cover this name. But price targets, like everything else, are subject to modification and my thesis of faster growth, if confirmed as I expect, will most surely lead to growth in valuation metrics. I think that the shares offer plenty of positive alpha ahead, although perhaps not at the percentage level that has been most recently achieved.