Shares of data storage networking company NetApp (NTAP 63.51, -3.84, -5.70%) were
hit hard this morning after the company issued disappointing 3Q19 results after
the close last night and issued mixed guidance for 4Q19. Although the company
is doing a very good job of managing costs, which is driving margins,
profitability, and cash flow higher in turn, the primary concern for investors
in the company comes on the demand side of the equation.
For the first time in nine quarters, NTAP missed expectations on the top line, while revenue growth of 1.6% was also its weakest since 3Q17. Additionally, for the second time in the last three earnings report, the company issued downside revenue guidance for the quarter ahead. Before going into detail about what is ailing the company, it helps to first understand the transition NTAP has been making over the past few years.
As flash storage and cloud computing have become increasingly prevalent, NTAP has realigned its product line to better position itself for those trends. If one were to compare and contrast the product offerings described in its Annual Reports from 2018 and 2013, that individual would notice a substantial increase in the number of cloud, hybrid-cloud, and flash based storage products available today. As tech behemoths like Amazon (AMZN), Microsoft (MSFT), and Google (GOOG) built out cloud-based infrastructure to handle their massive amounts of data, NTAP launched new backup, synchronization, and storage products and partnered with these data center giants to support their cloud-based development.
Global Economy or Competition?
So, the good news is that NTAP had the foresight to adjust to those rapidly changing dynamics in the data storage market. However, as growth in these emerging technologies accelerated, new entrants into the field emerged -- including a pair of recent IPOs, Nutanix (NTNX) and Pure Storage (PSTG). These two direct competitors have been growing much faster than the more established NTAP and have had little trouble exceeding the Street's expectations. With that said, it seems fair to question whether NTAP has been losing some share to these companies, especially when taking into account that its commentary regarding market conditions was quite different from that of its largest customer, technology distributor Arrow Electronics (ARW).
Specifically, during the earnings call last night, NTAP management stated that purchasing from its largest enterprise customers weakened due to deteriorating outlooks for the global economy, as well as uncertainty regarding trade policy. NTAP also noted the government shutdown as a key headwind during the quarter. For its part, the company said that that it didn't see any real change in the competitive environment and that its win rates remain healthy.
What's interesting is that during its February 7 earnings call, hardware and software distributor ARW -- which accounts for about 80% of NTAP's sales -- commented that enterprise computing in the America's region remained strong, with sales up 9%. Meanwhile, NTAP's North America revenue as a percentage of sales dropped to 52% from 57% last quarter. Additionally, ARW commented that it has seen virtually no impact from the government shutdown. However, NTAP's revenue from the public sector fell to 11% from 14% in Q2 as NTAP cited the shutdown as the cause.
These differing viewpoints could suggest that NTAP did indeed succumb to competitive pressures. We will have a much better read on this when both NTNX and PSTG report their earnings on February 28.
Q4 Review & Outlook
NTAP reported EPS of $1.20, exceeding its guidance of $1.12-$1.18, and the Street's forecast of $1.15. On a growth basis, EPS was up nicely at +21% as gross margin expanded to 63.7% from 63.0% in the year ago period, with NTAP crediting "sales force discipline" as the catalyst for the improvement.
The company also executed well from a cost containment standpoint. Non-GAAP operating expenses declined to $629 mln from $640 mln in the year ago period. As a result of the improved margins, NTAP generated healthy cash flow from operations of $451 mln, up 7% year/year.
The less encouraging news is that revenue was nearly stagnant, up a scant 1.6% to $1.56 bln, missing the $1.60 bln estimate. In the section above, we highlighted the primary culprits for stagnation (soft enterprise demand, government shutdown) as denoted by the company. Achieving a standout performance was the company’s all-flash array business, which rose up 19%, hitting an annualized net revenue run rate of $2.4 bln. However, investors may be viewing even this performance as a disappointment since growth decelerated from 29% in the prior two quarters. On the positive side, NTAP has a lot of runway for growth in this higher-margin business as only 15% of its installed base is running all-flash arrays.
On the topic of its growth outlook, NTAP issued mixed guidance for Q4, projecting EPS of $1.22-$1.28 vs. the $1.25 consensus, with revenue of $1.59-$1.69 bln vs. the $1.70 bln expectation. On a year/year basis, revenue would be essentially flat, continuing on its downward trend.
From a longer-term perspective, the company remains bullish about its prospects given that it is well-positioned to capitalize on a few key secular trends such as flash, private cloud, and cloud data services. But as its growth rate and top-line performance continue to disappoint, NTAP has become a "prove it" story now.
Key Takeaways: In a challenging environment, NTAP is managing costs well and is protecting its margins, leading to strong earnings and cash flow growth. Unfortunately, this execution is "clouded" by a lack of growth on the top line, which continues to frustrate investors. Without question, there are some macroeconomic headwinds facing the company that are out of its control. However, NTAP's largest customer, technology equipment and software distributor ARW, has offered a more bullish take on business conditions and downplayed the impact of the government shutdown. Furthermore, one of NTAP's main competitors, PSTG, has seen little drop off from its 30-40% growth rates over the past several quarters, while NTAP's growth rates have fallen. So, in our view, it would seem that the more challenging conditions are having a negative impact on its business, but the company may also be losing out on some deals to the competition in its efforts to protect prices and margins.