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Categories: Pure Storage

@PureStorage is a technology leader in solid-state drives.
The company’s disruptive business model has resulted in happy customers.
Though the company has been very innovative, fears of commoditization allow the stock to be bought for a reasonable valuation.
Investment Thesis
Pure Storage (NYSE:PSTG), maker of flash-array storage devices, is a solid investment because of its disruptive business model, high customer satisfaction, and reasonable valuation.

Disruptive Business Model
Pure Storage sells solid-state drives (SSDs), sometimes known as flash-arrays. SSDs have no moving parts compared to its counterpart, the spinning hard-disk drive (HDD). This enables faster recall of your data, resulting in faster processing speeds and more storage space. In short, SSDs are the superior technology.

According to this article, the difference is night and day. An HDD is like walking across the room and opening a book to find information, whereas an SSD is more similar to the internet in that information pretty much just appears.

Unsurprisingly, most data centers have switched to SSDs and a lot of new laptops will contain this storage technology. One may guess that, as SSDs become more universal, they will become commoditized as a piece of hardware. But Pure Storage has gone great lengths to fend off this potential problem.

The company’s software, called Purity, allows IT professionals to manage storage operations from a cloud-based environment. Similar to how Arista (NYSE:ANET) focuses on software-defined networking switches, Pure Storage puts a big emphasis on its software as a differentiator.

But that is just the beginning. The company also provides an Evergreen model where customers subscribe and get automatic storage updates since the software is cloud-based. This model is pretty disruptive in the SSD space and it has earned Pure Storage a top spot by Gartner (NYSE:IT).

Source: Analyst Day Presentation

But the company hasn’t stopped there. A recent announcement about container storage-as-a-service shows the company is not slowing down anytime soon. This isn’t to mention the company’s somewhat new product, FlashBlade, and its emphasis on AI infrastructure while teaming up with Nvidia (NASDAQ:NVDA).

High Customer Satisfaction
All of these innovations have resulted in happy customers. The company boasts an 83.7 NPS (net promoter score), a proxy for customer satisfaction. To put this number in perspective, the industry average is around 23. Peer review sites also give the company 4.8 stars.

What’s more is that Pure Storage’s top 25 customers spent about 11x their initial purchase amount within 18 months. Once customers see what Pure’s software-defined SSDs can do for them, they continue buying more.

This has surely shown up in the financials as well. The company grew revenues 40% to $256 million. To break that down, product sales, which make up about 80% of total revenues grew 37% whereas support services grew at a faster 52%. Interestingly enough, gross margins came in at 65%. Clearly, the company’s product has not been commoditized. To give some context, Apple’s (NASDAQ:AAPL) gross margin is usually around the mid-to-high 30%s. So just from the numbers, you can see Pure’s pricing power.

Source: Q1 Presentation

In the last three years, Pure’s revenues more than doubled to over $1 billion. At the same time, operating losses have narrowed immensely. Last quarter, non-GAAP operating losses shrunk from 14% of sales to 6% and free cash flow was almost at breakeven compared to -15% of sales in Q1 of last year. The company non-GAAP profitability this year and I believe they will continue to show operating and cash flow leverage.

Source: Q1 Presentation

Reasonable Valuation
Pure Storage, for fears of it just being a hardware provider, trades at a reasonable valuation, when taking into account revenue growth and operating leverage. The market cap is $5.5 billion, but backing out the $1.1 billion in cash on its balance sheet, the enterprise value comes out to $4.4 billion. Full-year sales estimates come in at $1.35 billion, but that will likely prove conservative. This results in a 3.2 forward EV/sales ratio, a bargain by many measures. Since the company is not profitable on an earnings basis, a forward EV/sales is a good valuation metric. The enterprise value backs out cash which is more appropriate and the market is generally forward looking, so this is why I like using this metric.

Source: Q1 Presentation

If the company can continue to become more profitable and bring down its sales and marketing costs, which most recently were 48% of sales, the valuation will look even better.

Though Pure Storage has been successful in garnering customer’s thus far, the company faces tough competition. NetApp (NASDAQ:NTAP) is a relative giant in the storage space with a market cap of over $21 billion. It focuses on all sorts of cloud-based environments and its flash-arrays portion of sales has been growing very quickly as of late. The company is placed below Pure by Gartner in the Magic Quadrant which is telling considering NetApp’s quantity of resources.

The company also does face the supposed risk of commoditization and proprietary hardware. Most customers do not like being locked into specific hardware deals, so that will be something to watch for in Pure’s future product announcements. If management focuses more on proprietary hardware than the differentiation within its software environment, that might be an indicator of possible greed. The NPS score should reflect customer dissatisfaction but a decrease in this score will likely be hidden by the company rather than put in plain view.

That is all to say, if Pure doesn’t focus on the customers, it likely will become commoditized. However, I believe the company is in good hands, especially with its relatively new CEO Charlie Giancarlo, former Cisco (NASDAQ:CSCO) exec