Pure Storage: Buy The Pullback
Summary @PureStorage recently reported Q3 earnings which showed growth and earnings above consensus expectations. The company broke even (on an adjusted earnings basis) for the first time in Q3, even as the top line showed accelerating growth of 41% y/y. Guidance also showed meaningful upside ahead of consensus. A recent drop in #NAND prices, a key raw input to all-flash arrays, should also help Pure Storage’s margins. Despite the good news, PSTG has pulled back since reporting earnings, creating a tactical buying opportunity. Pure Storage (NYSE:PSTG), a leader in all-flash storage arrays and SSD technologies, has seen a surprise pullback after reporting a favorable earnings quarter in Q3. To be fair, it’s not the only technology company that’s seen a selloff after beating on earnings – investors seem to be rotating out of growth technology stocks this quarter regardless of performance – but Pure Storage’s combination of improving margins, break-even pro forma earnings, and rapid growth in the usually sleepy storage industry makes for a compelling long thesis. Make no mistake, Pure Storage has already seen its fair share of outperformance this year: year to date, its gains of ~50% are still far outpacing 27% and 18% YTD gains for the NASDAQ and S&P 500 indices, respectively. The sharp pullback in early December post-Q3, however, presents a well-timed opportunity for investors to buy shares as they consolidate and prepare for a run in 2018. ￼PSTG data by YCharts At its current market cap of $3.7 billion and enterprise value of $3.1 billion (netting out Pure Storage’s cash balance), the company trades at a reasonable 2.4x EV/CY18 revenues, assuming a ~30% revenue growth rate in 2018 for an estimated revenue of $1.3 billion. Given the company’s superior growth profile relative to storage competitor NetApp (NASDAQ:NTAP), which is trading at ~2.1x EV/FTM revenues but growing in the low teens, I believe Pure Storage to be worth at least $24, implying a valuation of 3.5x EV/CY18 revenues. Note that this is still below Nutanix (NASDAQ:NTNX), a related competitor for hyperconverged infrastructure appliances and software that is trading at ~4.2x revenues, with a higher growth profile but lower margins. In addition to the good news coming out of Q3, Pure Storage also stands to benefit from a recent surprise drop in NAND and DRAM pricing, as reported by SA News. NAND and DRAM flash are raw inputs into solid-state arrays, and due to tight supply in the flash chip markets, producers of end-appliances like Pure Storage are often price-takers in NAND and don’t have much control over margins as flash prices spike. Pure Storage noted in its 10-K filing that “our gross margins […] are subject to variation from period to period and are difficult to predict,” citing NAND and DRAM flash prices as a top risk factor for margin variability. NAND prices fell 1.5% and DRAM prices fell 1.1%, reversing an uptrend that has seen NAND and DRAM prices rise 5-10% in the last quarter of 2018 alone, as noted on Hewlett Packard Enterprise’s (NYSE:HPE) earnings call – a company that has also been victim to rising component prices. Pure Storage’s margins improved in Q3, contributing to the upside in earnings, and will continue to see further increases as the prices of its key inputs drop. Advertisement ￼ Overall, Pure Storage looks structurally well positioned for outperformance in 2018. Many bears criticize Pure Storage for its failure to live up to Nutanix in the hyperconverged infrastructure (HCI) offerings, but I view the two companies as having entirely different specialties, and am bullish on both. Pure Storage is the Gartner-designated leader in solid-state arrays, and while it faces plenty of competition, its 40%-plus growth rate speaks to its ability to gain share in a crowded market. Q3 recap: Accelerating revenues, gross margin boost Pure Storage posted revenues of $277.7 million in Q3, up 41% y/y and beating consensus of $272.4 million (+38% y/y). The below chart, taken from Pure Storage’s earnings release, recaps the highlights from Q3: Figure 1. Pure Storage Q3 earnings summary ￼ Source: Pure Storage earnings materials There are a couple key items to note on the top line. Pure Storage’s revenue actually sequentially accelerated to 41% y/y growth this quarter from just 38% y/y growth in Q2. For a company at this scale, acceleration of any amount – let alone three points – is an accomplishment to be celebrated. This is also the first quarter that Pure Storage surpassed a $1 billion revenue run rate, making it a large contender in the storage market. The company added 300 new customers in the quarter, increasing the total customer count to 4,000+. Pure Storage also lifted its revenue outlook for the full year to $1.012-1.020 billion, representing a midpoint that’s up from the $0.985-1.025 view given in Q2 and a full-year growth rate of 40% over 2016 revenues. Analyst consensus placed full-year revenues at $1.01 billion, marking a beat in guidance as well. Gross margin also saw 70bps of improvement in the quarter, driven primarily by an increase in support gross margins as well as a small lift in product gross margins. As previously mentioned, a decline in NAND and DRAM prices should contribute to a meaningful gross margin increase in Q4 and beyond. Pure Storage also achieved a major operating margin boost to just a -15.1% margin, up from -39.7% in 3Q16 (though $30 million of operating expenses in 3Q16 owed to a one-time legal settlement – excluding this charge, operating margin in 3Q16 would have been -24.5%). This indicates that the company is closing in on profitability despite the rapid growth it’s still seeing on the top line. Adjusting for stock comp, Pure Storage’s pro forma EPS of -$0.01 (essentially breakeven) was a 2c beat over consensus of -$0.03. Given that Q4 is typically the strongest quarter for any IT stock, Pure Storage will likely continue to be profitable on a pro forma basis, with GAAP net income to follow shortly (GAAP net margin of -15% is also closing in on breakeven, if Pure Storage’s operating margin improvements continue at the same pace). Pure Storage also generated impressive cash flow in the quarter. OCF in Q3 was $28.2 million, a huge boost over 3Q16’s OCF of -$47.3 million. Netting out capital expenditures of $14.3 million, Pure Storage also generated free cash flow of $14.0 million. Figure 2. Pure Storage Q3 cash flow ￼ Year to date, the company has generated $13.7 million in operating cash flow. Though it’s too early for Pure Storage to have a basis for valuation support in cash flows, its huge jump from steep losses to positive cash flows (a 10% OCF margin in Q3) indicates that PSTG is a maturing company that is balancing its growth well with margin and cash flow improvements. Final thoughts The storage industry has made a comeback in the back half of 2017, after trading sideways for much of 2016. Given Pure Storage’s sudden pullback despite good earnings results, it’s a prime candidate to bet on going into 2018, as growth remains strong and component prices ease. Incidentally, Tintri (NASDAQ:TNTR), another small-cap all-flash array competitor, will report earnings on December 13. Tintri has a history of earnings volatility since its IPO earlier this year, and disappointing results in that company (though likely isolated to Tintri itself) may take Pure Storage down with it, creating a further pullback opportunity. Tintri has a growth profile that’s far inferior to Pure Storage (its growth sits below 30%, despite being an eighth of Pure Storage’s size) and a terrifying margin profile, and liquidity issues are a serious concern for Tintri and its precarious balance sheet. IT buyers tend to notice and back away from vendors with teetering financials for fear that product support will evaporate as the vendor goes under, so it’s likely that a lot of Tintri’s business can shift over to Pure Storage in the near term. Also important to note is that Pure Storage’s position in the Gartner Magic Quadrant for Solid-State Arrays is leagues ahead of Tintri (Tintri isn’t even in the Leaders quadrant, as of the July 2017 version), highlighting Pure Storage’s superiority from a technical product perspective. Trading at just 2.4x EV/FTM revenues, Pure Storage carries a highly favorable risk/reward profile. If the company happens to drop to 2.1x EV/FTM revenues ($15.50), in line with its slow-growth peer NetApp, a long position in Pure Storage is a simple no-brainer.