NetApp Earnings Preview: Low Product Sales, Falling Prices To Continue To Impact Top-Line Growth

NetApp ( NTAP ) is scheduled to report its fiscal Q3 earnings on Wednesday, February 15. Over the first three quarters of the calendar year, NetApp has witnessed a decline in net revenues driven by low product sales. Moreover, low demand for storage hardware coupled with falling prices led the company-wide gross margin to compress by 10 basis points to just under 61% for the three quarters combined. Comparatively, NetApp's services and software maintenance revenues have improved to offset the decline from product sales.

We have a $31 price estimate for NetApp , which is around 20% lower than the current market price.

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Guidance For Q3 FY'17

To offset the decline in revenues, NetApp's management indicated earlier this year that it would cut 1,200 jobs to enhance profitability. This led to an improvement in the operating margin in the first half of the year. The company further initiated cost reduction measures starting in November to reduce around 6% of its global workforce, which would result in a one-time charge of $50-60 million in the third fiscal quarter. This should help NetApp save around $130 million a year on operating expenses going forward. For the third fiscal quarter, NetApp's operating profit margin (non-GAAP) could be around 13.5%, which is almost a percentage point higher than the previous year quarter. Consequently, its net income per share could improve by around 6% y-o-y to 75 cents per share.


Product Sales Fail To Impress

Global spending on conventional external storage arrays has continued to decline - a trend consistent over the last few years. Keeping up the trend, most large vendors such as Dell-EMC, NetApp, IBM ( IBM ) and Hewlett-Packard Enterprise ( HPE ) have had a tough year in terms of storage hardware product sales, with revenues falling compared to the previous year period. According to IDC's latest report, Dell-EMC, NetApp, IBM and HPE reported revenue declines in the high single digits to the mid-teens from January through September, as shown in the table below.


Comparatively, industry-wide revenues from sales of external storage systems were down by just over 3% through the year to $16.5 billion. Given that NetApp's product sales through the first three quarters of 2016 fell by 10%, its market share in the external storage systems market has fallen this year. NetApp's market share fell by almost a percentage point to just over 11% from almost 12% in the comparable prior year period.


Other Segments

Combined revenues of non-product divisions through the first three quarters of the year were roughly flat over the year-ago period at $1.9 billion. Among non-product divisions, hardware maintenance and services revenues were around 2% down to just under $1.2 billion. Low product sales have also impacted hardware maintenance revenues, with revenues falling by 2% to $388 million for the quarter. Management mentioned that the company observed an increase in the installed base and attach rate but revenues still fell on a year-on-year basis, presumably due to falling prices. We forecast hardware maintenance as a percentage of hardware product sales to increase to over 60% in the long run.

On the other hand, software maintenance revenues this year have increased by around 1% to around $720 million. This was the only segment which did not face a revenue decline this year. We forecast software maintenance revenues as a percentage of product sales to increase from around 30% in 2015 to over 35% by the end of our forecast period.

In terms of profits, both software maintenance and hardware maintenance segments improved their profitability through the year, as shown below. The gross margin (GAAP) of the hardware maintenance and services segment was up by over 5 percentage points to 66.9% through the first three quarters of the year. Moreover, the software maintenance gross margin was up to 96.7% from 96% in the comparable prior year period. Low product sales complemented by a fall in hardware prices led the product division gross margin to fall by 460 basis points to 45.5%.


Going forward, a few key challenges still remain for NetApp. Firstly, the company will now compete with significantly larger competitors, given that Dell completed the EMC acquisition earlier this year. Among the top five large storage vendors, NetApp is now the only company that is primarily a storage systems manufacturer. It now competes with IT behemoths such as HPE, IBM and Dell, which have deeper pockets, widely spread sales channels, massive customer bases and the ability to integrate storage products across various verticals such as servers and other IT hardware. In this scenario, it is imperative to compete directly with smaller vendors and flash-storage startups to stay relevant in this changing industry.

Last year, NetApp announced the release of its sub $25k AFF8000 all-flash array in an attempt to compete with smaller flash array players such as Pure Storage, Violin Memory and Nimbus Data. NetApp witnessed 240% growth in its all-flash array revenues in early 2016, which was almost 3 times higher than the industry-wide growth. While this led NetApp to compete with smaller players, its margins in the product division have suffered. This could prove challenging for the company, given that providing customizable storage solutions to clients to compete with smaller vendors would likely impact NetApp's margins negatively.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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