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NetApp (NASDAQ:NTAP), a notable player in the technology sector, has consistently demonstrated resilience and adaptability amidst a challenging landscape. Our in-depth analysis of the company’s Q2 2024 earnings, recent earnings call, and valuation metrics paints a complex yet promising picture. NetApp’s robust financial health and operational efficiency are commendable despite notable macroeconomic pressures and internal challenges, particularly in its cloud subscriptions. The company’s recent performance, including impressive gross margins and potential growth drivers, is contrasted with areas of concern. Though NetApp faces hurdles, its strategic maneuvers and financial performance indicate a potential for growth, tempered by the need for caution given certain weaknesses. We therefore rate NetApp as a ‘Hold’ at this juncture, a decision informed by a detailed examination of the company’s earnings, call analysis, and financial and valuation analysis. This comprehensive review aims to provide readers with a holistic understanding of NetApp’s position, pinpointing both its strengths and areas in need of improvement to facilitate informed investment decisions.
Earnings Analysis
In our opinion, the recently released earnings report for NetApp, paints a more optimistic picture than initially feared by the market. In our analysis, we’ve noted several key factors that signal a positive direction for the company, despite prevailing macroeconomic pressures and some persisting weakness in its cloud subscriptions.
Firstly, we’d like to highlight the fiscal second-quarter results which, in our view, surpassed consensus on both the top and bottom lines. NetApp reported a top line beat by $33 million, equating to a 6.1% year-over-year decrease, and a bottom line beat by $0.19, signifying a 6.8% year-over-year increase. Moreover, the management has raised both revenue and non-GAAP EPS guidance for the third quarter and full fiscal year. We believe this is an encouraging sign of the company’s resilience and potential future growth.
A key takeaway from our analysis is the remarkable improvement in gross margins. Non-GAAP gross margin of 72% was up 580 basis points year-over-year, while non-GAAP operating margin of 26.8% was up 320 basis points year-over-year. This, in our view, indicates an increased operational efficiency and effective cost management. It’s also worth noting that these margins reached an all-time high in the second quarter, a clear testament to NetApp’s potential to deliver sound financial performance.
Looking at the company’s product portfolio, we’ve been impressed by the growth trajectory of the new AFF C-Series. The product’s revenue increased by 14% sequentially in the second quarter, which affirms its competitive edge in the market. Furthermore, NetApp’s success in securing a $16 million deal with an IaaS company is a strong testament to the cost-value proposition of the C-series.
However, it’s worth noting that not all aspects of the business are firing on all cylinders. The cloud subscription services, particularly Cloud Insights and CVO, continue to pose challenges for the company. In our view, the strategic review NetApp has undertaken to address these issues and the subsequent decision to shift customers from cloud storage subscriptions to CSP-based consumption models could help stabilize this part of the business.
Call Analysis
In our analysis, NetApp’s Q2 2024 earnings call, held on November 28, 2023, presented a mixed bag of results, with both encouraging and less optimistic elements.
NetApp’s Q2 performance was commendable, given the company’s operational efficiencies and solid execution. This is encouraging in our view, as it shows that the company is focused on maintaining a high level of operational performance and is not being complacent even in challenging times. In our opinion, NetApp’s confidence in delivering year-over-year (YoY) revenue growth in the second half of 2024 is a testament to their strategic planning and potential growth prospects.
We find it particularly compelling that the AFF C-Series all-flash array continues to exceed expectations and attract new customers. This could be seen as a key driver of future growth and a competitive advantage for NetApp. Their innovation in the all-flash storage portfolio allows them to address a broader total addressable market and maintain a leadership position in public cloud storage services. This, in our opinion, is a strategic move that could potentially increase their market share and solidify their position in the industry.
NetApp’s strong ties with hyperscalers are also noteworthy, as they enhance its ability to displace legacy on-premises competitors. This strategic positioning could help NetApp benefit from the ongoing migration of workloads to the cloud.
However, there are some areas of concern. It’s worth noting that the company reported a decrease in Q2 billings and revenue YoY, due to constrained IT budgets in a challenging macro environment. In our opinion, this is a red flag that requires careful monitoring. The decrease in cloud revenue by 35% YoY is particularly worrying, as it might indicate a declining growth trajectory in a market that should otherwise be growing.
The company’s outlook for fiscal year 2024 is also somewhat less optimistic, with the expectation for revenues to be down approximately 2% YoY. This could potentially indicate a slowdown in their overall business.
On the brighter side, the expected consolidated gross margins of approximately 71% are encouraging. This suggests that despite revenue challenges, the company is maintaining a high level of profitability. The projected revenue of between $1.51 billion and $1.67 billion in Q3, implying an increase of 4% YoY, could be a positive sign of recovery.
From the Q&A session, we note that the company seems to be maintaining a disciplined pricing strategy, even in a soft demand environment. This is a positive indication of their ability to maintain profit margins under challenging circumstances.
Our analysis suggests that while NetApp is facing some challenges due to the macroeconomic environment and a downturn in cloud revenues, there are several positive aspects to their operational efficiencies, innovative product offerings, and strategic positioning with hyperscalers. The company appears to be taking steps to address these issues and is showing signs of resilience in a challenging market. However, it will be crucial for NetApp to continue monitoring these areas and take necessary steps to ensure their growth and profitability in the coming quarters. This is our opinion based on the information given in the Q2 2024 earnings call.
Financial & Valuation Analysis
Note: All historical data in this section comes from the company’s 10-K filings, and all consensus numbers come from FactSet.
Looking at NTAP’s financial trends, the company has demonstrated revenue growth at a compound annual growth rate of 5.5% over the past three fiscal years. However, the consensus estimates a contraction of 3.5% this fiscal year, before recovering to a 4.5% growth in the following fiscal year. The EBIT margin, on the other hand, has shown a steady increase, going from 20.8% to 24.1% over the past three years, and it is predicted to further expand in the coming years.
The company’s EPS growth rate, which has outpaced its revenue growth, is a clear indication of effective share repurchasing strategies, evidenced by a 6.3% decrease in diluted outstanding common shares over the past three years. These share dynamics, complemented by impressive revenue and margin trends, are likely to result in a continued EPS increase in the near future, albeit at a relatively modest rate.
The consensus estimates a free cash flow of $1.234 billion this fiscal year, reflecting a 20.1% FCF margin, a significant improvement from four fiscal years ago when the FCF margin stood at 17.3%. This trend is particularly encouraging, as it suggests a stronger cash generation capability. Moreover, the capital expenditure, averaging 3.2% of revenue, indicates a moderate capital intensity.
NTAP’s strong return on invested capital at 35.0%, combined with a net cash of $229 million, reflects a robust balance sheet. The stock’s current dividend yield stands at 2.6%, a considerable 113 basis point premium over the S&P 500’s dividend yield.
The company’s valuation multiples are worth noting. NTAP is currently trading at an EV/Sales multiple of 2.9, an EV/EBIT multiple of 11.4, a P/E multiple of 14.6, and an FCF multiple of 13.9. Compared to the S&P 500, the stock is trading at a premium on EV/Sales but at a discount on EV/EBIT, P/E, and FCF, which signals potential undervaluation.
When viewed historically, the stock is trading at a forward 12-month P/E of 13.1, just slightly above its 5-year mean of 13.0 and within its 2-standard deviation range of 8.7 to 17.3. This indicates a medium valuation relative to its historical range.
Compared to its peers, NTAP is trading at a higher forward 12-month P/E ratio, with DELL and HPE at 10.9 and 8.0, respectively. This suggests that NTAP’s shares are relatively expensive, but given its strong performance and positive outlook, we believe this premium may be justified.
Conclusion
NetApp’s financial performance and strategic maneuvers have painted a picture of a company that, while not devoid of challenges, is demonstrating adaptability and resilience. The company’s operational efficiency, as seen in the impressive gross margins and robust balance sheet, and the growth trajectory of its AFF C-Series offer a glimpse into NetApp’s potential for future growth.
However, it’s not all smooth sailing. The decrease in cloud revenue and expected contraction in this fiscal year’s revenue are areas of concern. The company’s valuation, while seemingly high against peers, may be justified given its robust performance and positive outlook. Moving forward, it will be critical for the company to maintain its strengths and address its weaknesses to ensure continued growth and profitability. Ultimately, in our view, while the macroeconomic environment and internal issues pose challenges, NetApp’s overall performance and future prospects portray an intriguing investment opportunity.