Pure Storage (PSTG), one of the industry’s leading manufacturers of all flash storage arrays (AFAs), is in our view a purchase as it continues to grow faster than the market and is taking market share from large incumbents such as NetApp (NTAP), Hewlett Packard Enterprise Company (HPE), Dell (DELL) and IBM (IBM). Yet it is disliked and underestimated by investors. Customers, however, love Pure Storage products (a high Net Promoter score of 86 confirms this affection) and Gartner and other independent analysts also consider the products to be among the best in the industry. Despite Pure Storage’s strong results and positive comments made by Pure Storage at its last earnings release on May 29, the stock has weakened. Given our confidence in its continued ability to take shareholdings, outperform its biggest rivals by quickly and effectively launching products based on newer NAND flash geometries, compelling valuation and catch-up potential, we would be a buyer for the stock.

Pure Storage has one of the best portfolios in the industry

Pure Storage, although it has one of the most modern and successful product portfolios in the industry, continues to underperform the broad technology market. Many investors we’ve talked to believe that the majority of new storage capacity will be deployed in the cloud and that growth in on-premise storage is likely to continue to decline. While we agree that the majority of growth is likely to be in the cloud, a significant portion of workloads (over 50%) will continue to be stored on-premise. Much of the on-premise storage infrastructure is still based on old hard drive technology that runs slow and inefficient.

Companies are upgrading their existing storage infrastructure with newer and more modern NAND flash-based data arrays. The new storage arrays are smaller, consume less energy, are quieter and do not generate excessive heat in the data center, and therefore do not need to be cooled. Flash storage arrays are typically cheaper to operate and are extremely fast, which speeds up applications. Pure Storage, by all accounts, makes the best storage arrays in the industry and continues to grow faster than leading storage vendors such as NetApp, Dell, HPE and IBM.

According to Gartner, Pure Storage’s market share was 12.7% in the first quarter of 2020, up from 10.1% a year earlier. HPE, NetApp and IBM lost market share. According to blocksandfiles.com, the size and evolution of the market shares of AFA providers are paraphrased below:

  • “Dell EMC – 34.8% ($766 million) versus 33.7% a year ago
  • NetApp – 19.3% to $425 million versus 26.7% a year ago
  • Pure Storage – 12.7% for a calculated $279.7 million versus 10.1% a year ago
  • HPE – 8.4% – $185 million compared to 10% a year ago.”

Pure has gained shares almost every year since it began selling storage bays in 2011. According to Gartner, Pure Storage is consistently ranked #1 for completeness of vision, as illustrated in the following table.

Source: Gartner

Investors worry about the secular decline in storage

Investors we spoke with are concerned about the secular decline in storage due to the shift of workloads to public cloud providers such as Amazon Web Services (AWS), Microsoft Azure Services (MAS) and Google Cloud Platform (GCP). Investors seem to think that storage companies such as Pure Storage are likely to see their business decimated by the shift of applications to the public cloud. While the cloud is certainly slowing the growth of on-prem storage, the impact is felt mostly by large incumbent vendors such as Dell, HPE, NetApp and IBM. Each of these companies have seen their storage revenues decline over the past three or four years, as many customers believe their products are somewhat inferior to Pure. However, Pure Storage is unique in that it has increased its revenues in each of the last 9 years.

What are Pure Storage’s revenue drivers?

Pure has products to cope with the growth of cloud storage as well as products to stimulate the growth of remote storage. For on-prem data centers, Pure sells Flash Array to handle block storage workloads (for databases and other critical workloads) and FlashBlade for unstructured data or file workloads. Revenues from on-prem storage are primarily due to the replacement cycle of existing storage arrays.

In addition, the company also sells subscription products such as Pure-as-a-service and Cloud Block Store. Enterprises purchase storage from vendors such as NetApp or Pure in the cloud to avoid vendor lock-in by cloud providers.

Despite double-digit revenue growth, Pure Storage underperformed the market

Although results for the fourth quarter and the first quarter of ’21 were strong, Pure Storage was up only about 2%, while the Nasdaq was up 17% and the SOX index was up nearly 11%.

Source: Yahoo Finance

Pure Storage is currently trading at 1.9x EV/C2021 sales versus 1.6x for NetApp. While Pure Storage is expected to grow by about 16%, NetApp is only expected to grow by about 2%. The following graph illustrates the hardware peer group’s assessment.

Source: Author based on data from Thomson Reuters

Source: Author based on Thomson Reuters data

Guidance and estimates

Pure Storage is used to beating the odds and guiding people. Over the past 20 quarters, the company has beaten revenues for 17 quarters by an average of $4.9 million, or about 3%. Of the three times the company missed revenue, one was due to supply constraints at one of its distributors and the other two were due to average selling prices (ASPs) falling faster than the company had anticipated. A larger than expected decline in ASP (due to oversupply from NAND) is one of the risks of the stockholding business. The following chart illustrates Pure Storage’s performance in meeting its outlook.

Source: Author based on data from Thomson Reuters

After the company reported its results for F1Q21 (April quarter), it did not provide formal guidance for F2Q21 (July quarter), citing the lack of visibility of its pipeline and the potential for agreements. Pure Storage also withdrew its forecast for the full year, citing increasing macroeconomic uncertainty and the loss of visibility on the conclusion of contracts. However, the company indicated that ‘sales will be virtually stable year-on-year and operating profit will be close to break-even’ and warned investors that these comments should not be considered as formal guidance. Based on the above comments, The Street forecasts sales of approximately $396 million, essentially stable year-on-year, and EPS of one penny. We believe this forecast is conservative and more than achievable.

A number of companies such as Micron have recently reported better than expected results and have also provided guidance that was ahead of estimates. Given this and our belief that storage is less discretionary than many people on the street think, we believe Pure Storage is likely to exceed estimates when it releases its results on 19 August. We also expect the company to forego providing formal guidance given the uncertainty surrounding the opening of the economy following VIDOC-19. Because we believe that storage is less discretionary than many people believe, we are increasingly optimistic about the prospects for Pure Storage. As a result, our revenue and EPS estimates are ahead of consensus. Here is a graph of our estimates compared to the consensus.

Source: Author of Thomson Reuters Data

Share Ownership Risks

Pure Storage competes with some of the pillars of the technology industry such as NetApp, Dell-EMC, Hewlett Packard Enterprise, IBM, Hitachi and others. These companies control vast distribution networks, are responsible for most of the largest storage consumers in the industry, and have strong balance sheets. All of these companies also generate strong cash flow from operations and have abundant cash on hand. On numerous occasions, these large companies have used price reductions and even selling at a loss to lock in strategic customers. Many of these large companies also use “bundling” (i.e., the bundling of servers and storage) to prevent smaller competitors from entering their markets. A prolonged and indiscriminate price war within the storage industry could have a negative impact on Pure Storage’s revenues and profits. Any decline in revenues and profits due to a price war or other bundling techniques could result in inventory liquidation.

Pure Storage buys raw NAND flash from OEMs such as Micron, Hynix and Samsung. The cost of NAND is dictated by the dynamics of supply and demand within the industry. In 2019, the rapid decline in NAND prices has impacted the company’s revenues and margins. The price declines were sharp and violent and Pure Storage’s ASPs declined faster than the company anticipated at that time. Historically, prices for storage products have declined year over year in the low single digits (approximately 8-9%). However, in early 2019, the decline in ASPs reached mid-year and impacted revenues and margins.

In times of supply constraints, NAND Flash OEMs choose to first sell available NAND products to their large customers such as Dell/HPE/Apple, etc. before Pure Storage can source. Before Pure Storage can source. In these cases, Pure Storage would have to buy NAND on the open market at a higher price. While the company can pass on some of the higher cost of NAND to customers, it may not always be possible for it to recoup lost profits. As a result, Pure Storage is at the mercy of its major storage component suppliers.

Macro and management execution is always a major risk for most companies that have a fairly large revenue stream based on perpetual/capital. Pure Storage derives the majority of its revenue from the sale of storage boxes, which is an investment item for most companies. VMware’s quarters are typically loaded at the end of the quarter, meaning that a significant portion of the business closes in the last two weeks of the quarter. Any slippage in the business, for whatever reason, in the last weeks of the quarter can impact revenues and profits, resulting in inventory liquidation.

How to invest in equities

Since the company released its results on May 29, the stock has declined 3% and has underperformed the market. The company is expected to release its second quarter 21 results on August 19. We expect Pure Storage to publish results that are largely in line with Street’s estimates and will publish a likely positive commentary. We believe that any positive commentary on the underwriting activity and pure service offering will be welcomed by professional investors. It is very likely that Pure Storage will not issue formal guidance for the October quarter, but will issue qualitative comments as it did for the July quarter. As we are fairly confident in the long-term prospects of the company and the strength of its product line, we would buy before the company’s results. For some unforeseen reason, if the stock sells, we believe it offers an even better buying opportunity. We would back off and buy more shares.

Net-net, given that the company is considered one of the best new age data storage companies in the industry, and based on a reasonable valuation, we would purchase shares of the company at any time. In the event that the company does not meet the estimates or if the stock is sold due to other macroeconomic factors, we would invite investors to double their bets and buy more.

 

Disclosure: I/we have no position on the actions mentioned, and I/we do not plan to take any in the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving any compensation for this (other than from Seeking Alpha). I have no business relationship with any company whose shares are mentioned in this article.

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2020-07-13