NetApp Earnings Preview: Strong Outlook For Software And Services

NetApp (NASDAQ:NTAP) is scheduled to announce its Q3 fiscal 2015 earnings on Wednesday, February 11. The company reported a 4% sequential rise in net revenues to $1.54 billion in fiscal Q2, which was roughly flat over the prior year quarter. Seasonal demand from the U.S. government (one of NetApp’s major clients) drove NetApp’s net revenues up sequentially during the most recent quarter. However, continuing the trend from the first fiscal quarter, both product revenues and software entitlements and maintenance revenues declined by 3% year-on-year to $929 million and $224 million, respectively. Despite low revenues through Q1 and Q2, NetApp was one the only two large storage systems providers to have maintained its market share in the storage hardware market through 2014 at 13.7%. Most other large companies, such as EMC (NYSE:EMC), IBM (NYSE:IBM) and Hitachi Data Systems, witnessed declines in share in what has been a tough year for storage hardware sales. Furthermore, the decline in NetApp’s hardware and software revenue streams was partially offset by robust sales of hardware maintenance and support contracts, which rose by 7% y-o-y to $389 million in fiscal Q2. The company expects its third quarter revenues to be $1.56-$1.66 billion, which at the midpoint of the guided range implies roughly flat revenues over the year-ago period. ^[1]

We have a $43 price estimate for NetApp’s stock, which is about 10% higher than the current market price.

See Full Analysis For NetApp Here

Storage Hardware Sales Could Pick Up

Global spending on storage systems has witnessed a slowdown in recent years, with total factory revenues growing by 18% in 2010, 10.9% in 2011, 4.8% in 2012 and declining by 0.4% in 2013. The slump continued through the first three quarters of calendar year 2014, with the total factory revenues for external storage systems falling by almost 2% over the prior year period to $17.3 billion. According to IDC, low product sales in the first half of the year were attributable to a 25% y-o-y decline in high-end storage spending. As a result of weakness in the storage hardware market, many large storage systems providers such as EMC, IBM, Hitachi and Dell (NASDAQ:DELL) lost share in market. On the other hand, NetApp’s share in the market stayed constant at 13.7%.

Global demand picked up in the September quarter as storage companies witnessed an increase in shipments of storage arrays costing less than $100,000. Industry-wide external storage factory revenue was up by 1% y-o-y to $5.8 billion in the quarter ended September. ^[2] IDC believes that strong demand persisted through the December quarter, primarily due to seasonality. This was highlighted in EMC’s Q4 results announced at the end of January. EMC reported a 2% annual rise in storage products sales (hardware and software combined) for the quarter. We currently forecast NetApp to end the calendar year at a market share of 13.8% – higher than 2013 levels of 13.1%.

Software And Services Divisions To Sustain Growth

Software entitlements and maintenance (SEM) revenues, which include software upgrades, bug fixes and patch releases, grew at a CAGR of 9% from 2010 to 2013. However, SEM revenues stayed flat in the first half of 2014, mainly due to the sale of new products. Management mentioned that customers typically test or evaluate new products for about six months before upgrading software and listing requirements for patch fixes. In its second fiscal quarter, NetApp introduced a significant number of new products including the all-flash storage array FlashRay, the Data ONTAP 8.3 operating system, Cloud ONTAP software for usage in public clouds and the new range of products from the SteelStore acquisition. Moreover, the rate of NetApp’s Clustered ONTAP system attached with hardware increased across its storage products. The attach rate for high-performance storage platforms was close to 65% during the quarter, while it stood at 50% for mid-range storage products. NetApp’s converged storage architecture solution FlexPod had a solid quarter, with a 50% rise in shipments compared to the prior year quarter. As a result, NetApp’s software revenue stream is likely to reap benefits of a revamped product line and integrated product offerings with cloud provider VMware (NYSE:VMW). ^[3]

Hardware maintenance revenues have witnessed a double digit year-on-year increase in each of the previous eight quarters due to an increased installed base and aggregate contract values under service contracts. The growth continued during the second fiscal quarter, with a 12% y-o-y rise in hardware maintenance support contracts revenue to $311 million. The company expects services revenues to be boosted in the coming quarters due to strong demand for enterprise service agreements from its larger clients.

Cautious Outlook For Margins

NetApp’s non-GAAP gross margin stood at 65% in Q2’15, slightly higher than the guidance given by the company at the end of the previous quarter. The company-wide gross margin improved by 140 basis points over the year-ago period, owing to a favorable product mix and strong growth in the services division. The services gross margin rose by almost 4 percentage points over the prior year quarter, which the company attributed to lower expenditures on support infrastructure complemented by higher support contract revenues. Similarly, the company’s non-GAAP gross margin for the first fiscal quarter was higher than the upper end of its guided range and 3 percentage points higher than the year-ago period at 64.3%. However, management mentioned that unfavorable foreign exchange fluctuations and higher expenses due to the SteelStore acquisition in October could restrict margin improvement in the coming quarters. As a result, the company expects its non-GAAP gross margin to be around 64% for fiscal 2015, despite posting healthy figures for the first two fiscal quarters.

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1. NetApp Q2 FY 2015 Earnings Call Transcript, Seeking Alpha, November 2014 [↩]
2. Worldwide Quarterly Disk Storage Systems Tracker Q3 2014, IDC Press Release, December 2014 [↩]
3. NetApp goes for a ride on VMware’s EVO: RAILs, The Register, December 2014 [↩]