Vladimir_Timofeev
Assessing the outlook for Pure Storage in a recessionary environment
Why look at Pure Storage (NYSE:PSTG) shares now? There are an abundance of investment opportunities within the high growth IT environment. Some readers and commentators, I suppose will say that this is a function the relative valuation of a bubble valuation, and the valuation implosion is simply a return to normal. No question that in terms of EV/S ratios, high growth IT shares reached a high point over the course of the first months of 2021. But so too did the percentage growth of the space, and the growth in free cash flow margins. Much of that growth is still continuing, although probably at a somewhat lower trajectory than was the case during a boom period. The comments of ServiceNow (NOW) CEO, Jim McDermott about macro headwinds affecting demand are about as dispositive as any. Because of the pivot to recurring revenue models, free cash flow growth has continued at strong levels that are not well recognized in much that is written about valuations in this space.
One company whose shares never reached a bubble valuation is Pure Storage. It is a hardware company after all, and hardware companies are less profitable and don’t have recurring revenue models and are very cyclical. Except none of the above is true when it comes to Pure. The last several quarters have seen Pure’s growth and its market share gains accelerate, along with its profitability. That hasn’t done much for its share price which is down by 19% so far this year, and down by 29% from its high which was reached last as recently as the end of March.
I have been a long term holder of Pure shares. I acquired my initial position in the shares during May of 2019 at a price of $16.14. And I have added to my position a couple of times since that point. Owning Pure shares hasn’t been without its perturbations and frustrations.
I last wrote about Pure a couple of years ago; it is time to refresh those comments and present my current investment thesis and try to touch on the concerns that are weighing on the shares. When I last wrote about the shares they were $13 and I found them attractive. I still do, because while the shares have doubled, the company’s revenues have grown by about 60%, the company now has a base of substantial base of recurring revenues, and its free cash flow has grown by 7X. Of course April 2020, was at the start of the pandemic, and many valuations had compressed at that point, but the fact is the shares are arguably cheaper now than they were back then, and Pure’s business, at least, is less risky given that about 35% of the company’s revenues are recurring these days.
I have a long term bias, as is obvious, and I tend to retain positions in company’s whose market share gains are consistent and significant, especially where business models are improving. And at the end of the day, the Pure story is one of market share gains, technology innovation and a business model transformation, available at very reasonable valuation metrics.
At this point, at least from an investment perspective, the question is really how Pure will be able to maintain its growth in an environment that might be marked by a recession. Of course the jobs report of Friday, July 8, has probably suggested to some that a recession isn’t immediately impending but I believe that the shares of Pure have seen constrained valuations because of fears that a recession will tip the storage space into an era of declining growth and price competition that will impact the results of this company.
The basic answer in terms of assessing Pure’s performance during a recession is likely to rest on two interrelated themes. One is that of continued market share gains, and the other is innovative new products. To a significant extent, the current published 1st Call consensus already reflects growth concerns, and concerns regarding margins as well. Forecasting the trajectory of the percentage growth storage market is a fraught undertaking; forecasting that Pure will gain market share is far less tendentious. Market researcher IDC is projecting that the ESS market (Enterprise Storage) is growing at about 2% this year. Within that market, the component in which Pure competes. I.e. enterprise flash storage is forecast to grow at around 14% CAGR over the next several years as can be seen in the above link. Pure has been a share gainer for several years, and for several reasons, and it would be extremely unlikely, in my opinion, for Pure not to exceed market growth, and perhaps by a significant amount.
Recent Business Trends at Pure and its competitors
Pure reported the results of its first fiscal quarter at the start of June. Growth was a stunning 50% organically. Those revenues were 19% greater than projected and margins were 4X greater than the forecast. The free cash flow margin was 30%. The company raised its forecast for annual revenue growth from 20% to 23%. It raised its margin guidance by 50 bps as well. This was actually the second quarter in a row in which results were far above forecasts and expectations.
Last quarter, 35% of Pure’s revenues came from subscriptions, compared to 39% in the prior year. Basically, Pure had an extraordinary quarter in terms of product revenue growth (60%) and a fairly typical quarter with regards to subscription revenue growth (34%). It is highly unlikely that product revenue growth will reach 60% ever again. The company indicated that product revenues were bolstered by an acceleration of $60 million, or about 30% of the number reported by pull-ins These pull-ins were mainly driven by the ability of Pure to deliver against orders, despite supply chain challenges, something that competitors were not able to match. Excluding these pull-ins, product revenue growth would have been 36%, still an elevated number, but not quite as much of an outlier as was the 60% reported product revenue growth.
Pure, despite nominally being a hardware company has a rather sizeable RPO balance and a significant level of ARR. It’s RPO balance rose 26% year on year in the last reporter quarrel, while its ARR balance rose by 29%. As this was a Q1, the sequential comparison in terms of growth is not germane to an analysis.
It is well worth comparing these results to Pure’s competitors. For example, NetApp (NTAP), grew its product revenues by 6% and grew its all-flash ARR by 12% in its most recent reported quarter that ended at the same time as Pure’s quarter. Dell’s (DELL) most recent quarter showed its storage revenues up 9%.
Pure’s revenues, which are now projected by the company to reach $2.66 billion this current fiscal year, are still far below revenues of both NetApp and Dell, but the company continues to gain share, and is doing so at an accelerated tempo. While many investors/analysts believe that there are not substantial differences between flash storage arrays offered by the many vendors in the space, users have found that the Pure portfolio offers better value and have been willing to pay premium prices for the company’s products. That can best be seen by looking at gross margins.
Last quarter, Pure’s non-GAAP gross margin on its product revenue was 70%, which compared to 69% in the year earlier quarter. That compares to a gross margin of 51% for NetApp on its product revenues. Dell doesn’t report gross margins for its storage revenues or its ISG group as a whole. Overall, Dell’s non-GAAP gross margins were reported at 23%. It seems highly likely that the company’s non-GAAP gross margins on storage are far less than 50%.
Obviously, both NetApp and Dell sell all-flash arrays, hybrid arrays and even spinning discs. So, it isn’t straightforward to suggest that the difference in gross margins is entirely a function of the premium prices that Pure is able to charge. But the difference in margins is, at the least, suggestive, of the perceived advantages and total cost of ownership criteria that a Pure solution is thought to offer Cost of ownership advantages for Pure include its form factor/ physical size, the evergreen architecture and most notably these days, power consumption and heat dissipation compared to the all flash arrays that are offered by the company’s competitors and particularly by NetApp and Dell.
Overall, non-GAAP operating margins for the quarter reached 14%, which compares to break-even non-GAAP operating margins the prior year. Stock based compensation was 12% of revenues in Q1 compared to 15% of revenues the prior year. The 3 major operating expense cost ratios all improved; the improvement was greatest in terms of general and administrative expense, while both research and development and sales and marketing spending grew by about 19% year on year. Pure spends a rather elevated 19% of revenues on a GAAP basis on research and development. It seem straightforward to assert that the company has been able to leverage that level of development spend into market shares gains and elevated gross margins.
The company’s guidance while typically prudent, also reflected continued market share gains. Excluding the $60 million of revenue pull-ins, the company is anticipating a 13% sequential growth in revenue; in the prior year, sequential revenues grew by 20%. The company’s full year forecast obviously is intended to indicate growth deceleration-the company’s forecast actually indicates some expectation that Q4 growth will be just 5% or a bit more-this seems a more conservative than seems realistic, short of an really substantial implosion of the economy.
The company margin forecast is also a bit skewed. While expected non-GAAP operating margins for Q2 at 11%+ seem reasonable, the projection of full year non-GAAP margins of just 12%, implies a rather significant margin compression for the balance of the year, especially as Q4 non-GAAP operating margins are typically the strongest of the year because of seasonality. Last year, Q4 non-GAAP operating margins were 17%. So, the company, or so it seems, has already made a forecast that accounts for possibly weak macro or deteriorating storage market conditions.
Why is Pure’s market share rising? Is it sustainable?
In the short term, the answer is simple-it has to do with product availability. Pure designs its own hardware-always has-and doesn’t, therefore use commodity chips-the ones that are in such short supply. So, it has been able to fulfill orders when its competitors have been constrained. The Pure supply chain is simply much simpler to manage than the supply chains of other flash storage vendors. Very specifically, Pure these days use lots of NAND, and NAND is not in short supply, indeed NAND pricing has been stable.
The company is far more focused on developing and selling advanced technologies than its competitors. It chosen to build a business model that is based on very high development spending, that has translated into higher than average selling prices, gross margins and growth. Last quarter, for example, the company’s research and development spend was $161 million or 20% of revenue. That compares to NetApp which spent 14% of revenues, or $235 million on development despite have a significantly more complex product line that includes hybrid as well as pure flash arrays. The Dell comparison is not really meaningful, because that company has to fund development of so many products including PC’s and other products within what it calls its Client Solutions group. That said, its development spend at just 2.6% of revenues is indicative of a dramatically different business strategy than that of Pure.
I am not going to try to describe all of the technologies that Pure has been bringing to the market; a few are good examples. One area of focus lately has been that of QLC (quad-level cells). That is capacity optimized technology that has substantially improved price/performance metrics in the storage world. QLC has some inherent disadvantages as well as advantages, and using it is a bit of a challenge, but one that Pure has been willing to tackle.
Pure Fusion, which the company introduced about a year ago, and which offers essentially limitless scale, has seen rapid acceptance as it is particularly suitable to manage storage in the cloud. Last month, the company introduced FlashBlade//S. The company had maintained that this new offering was its most significant new offering in several years. Whether that claim can be substantiated, FlashBlade//S is a major advance in providing unstructured data storage at vastly improved price/performance levels and far greater scale than has been possible before. This is a product built using all-QLC architecture. I have linked to a 3rd party review of the offering including the differentiating factors. Potentially, a significant percentage of users will choose to acquire FlashBlade//S through an Evergreen subscription. The company has revamped its Evergreen subscriptions in conjunction with the introduction of FlashBlade//S. The new component of Evergreen is based on a consumption, pay-as-you-use model which is likely to be quite lucrative for Pure, over time, given the historical trends of storage capacity utilization.
And as mentioned above, Pure has long enjoyed advantages in terms of form factor, power consumption and heat dissipation, all of which resonate strongly with users. The company has focused quite a bit of its messaging on these kinds of sustainability advantages. As some readers will recollect, Meta (META) has become a Pure customer. Its choice of Pure has been said to have been animated by sustainability factors; that said, I am sure that sustainability was translated into total cost of ownership metrics in the decision making process.
The storage space has been marked for many years by intense competition bordering on personal rivalries. For years, EMC and NetApp fought what seemed to outsiders to be a grudge match. Given the size of the many competitors in the space, the only way for a smaller company like Pure to succeed is by having a business model that is differentiated. I don’t think that the developers at Pure are smarter than their counterparts at Dell and NetApp. I do think they are far more focused on a single area of the storage universe and are thus likely to be more productive. The Glass Door reviews linked here suggest that Pure’s culture has fostered a higher level of job satisfaction than its competitors. I believe that Pure will continue to be a share gainer for the foreseeable future.
Can Pure weather the squalls of an impending recession?
Many analysts are making many calls based on their views of a potential recession. On this most recent Monday, it was the turn of the MS IT analyst team who downgraded a number of information technology companies due to their belief that the growth of IT demand is waning and that companies with usage based pricing models will be vulnerable to slower growth. The message appears to be resonating with investors, at least on this Monday,/Tuesday with many IT names down 3%-5%. It seems a bit ironic that growth concerns are rising on Monday, in particular, after a jobs report last Friday that suggested a healthier economy than had been forecast.
Some, but not all of the analysts who cover Pure, have cut their ratings and their outlook based on concerns with regards to the macro environment. The analyst at B of A actually cut his ratings and estimates on Pure just before the company announced its latest blow-out quarter. The shares are actually about 10% higher than when the call was made.
Most recently there have been no published revisions in either ratings or estimates for Pure. Most analysts seem content to maintain buy ratings even while forecasting moderating growth. Of course management was asked about the current state of the business and how a recession might impact demand during the most recent conference call.
Charlie Giancarlo
Very good. Thank you, Simon. I hope you’re well. So Simon, our — what we’re seeing is strong momentum in the market overall. All of our products, customers buying more, the fact that we have a stronger and broader portfolio now being brought into a much greater set of opportunities in large existing customers and a stronger brand that’s allowing us to penetrate net new logos and to penetrate with larger opportunities in larger companies as a net new logo. So we’re actually seeing strength.
And just to address your question, I would say that our — the way we’re looking at the macro is a little bit different. I would say we have not yet seen affects — the macro affecting us or the customers that we speak to, but we are not blind to the fact that the macro and the possibility of economic slowdown can affect us going forward.
So I would say what we’re currently seeing — what I’m currently seeing in the market through last quarter, continues to be strong demand by IT customers and then a greater acceptance for Pure overall, just the strengthening, if you will, of our brand and our value proposition — and the breadth of our value proposition to our customers. And I’m going to let Rob answer the question on Snowflake.
Admittedly, this comment is 43 days old at this point, and there are those who will say the economy has taken a step back or maybe several steps back since the start of June. But at this point, my guess is that Pure’s market share gains are going to continue unabated. While Pure’s market share gains based just on availability are not sustainable in the long-term, its share gains based on what is called sustainability are certainly a key part of the story.
Omdia: Sustainability ranks top on data center operators’ agendas despite cost and reliability barriers
LONDON, 11 July, 2022 – Global research and advisory firm, Omdia, today unveils its Data Center Thermal Management and Sustainability Intelligence Service. The new annual service offers technology manufacturers, vendors and service providers comprehensive insight and analysis of sustainable data center practices and strategies, with a focus on new technologies such as liquid cooling and energy storage.
Increasing compute requirements continue to drive data center development requiring new approaches to thermal management. At the same time, data center operators and end-users are looking for data centers with sustainability credentials and are making purchasing decisions based on the presence of practices that reduce greenhouse gas emissions.
Sustainability, as defined in the above summary of a third party survey, has been one of Pure’s priorities since the company’s foundation. Pure’s unique architecture is what enables the company to provide users physical hardware that is in a smaller form factor, and which has major efficiency advantages in terms of storage capacity/watt, and other similar measures. And its architecture as well is what enables the company to be able to offer its Evergreen service, which has many benefits for users in that the arrays that they buy or subscribe for can be used for many years without the need for forklift replacement. And beyond sustainability, Pure’s advantages such as its Evergreen offering, and FlashBlade//S and Pure Fusion are also helping to sustain the market share story.
Of course a recession of some kind is going to factor into storage demand for Pure and its competitors. For example, Meta, as mentioned is a Pure customer, and its announced cutbacks probably mean it will not be buying the Pure storage products to enhance the capabilities/capacity for its AI initiative, at least in the next two quarters. But sales to Meta have never been in Pure’s forecast; the timing of those orders is not something over which the company has much if any influence. Pure also has other hyper-scaler customers and their demands may be attenuated in a recessionary environment.
But this is not 2008. Storage demand collapsed at that point during the financial crisis because so much enterprise storage demand was tied to the real estate bubble. Amongst other use cases, banks and other loan originators are required to store mortgage underwriting data electronically. That resulted in a massive demand for storage during the housing boom 15 years ago; those particular use cases may have been 15%-20% of total storage demand. That just went away, almost entirely in 2008-9. The banking customers themselves were on the cusp of failure and they were certainly not in a position to make capex.
So, looking at the last recession, and considering the cyclicality from that era may provide a poor analog for considering storage demand in the expected recession in the next few quarters. Then too, all-flash arrays continue to replace spinning discs, and hybrid arrays, and that is going to continue in a recession. Finally, Pure’s relationships, such as its partnerships with AWS and other cloud hyperscalers, as well as its newest announced partnership with Snowflake, are just now starting to achieve some revenue momentum.
I don’t doubt that in a recession, Pure’s growth will be less than it has been most recently, but it will still likely be positive growth. The strong tailwind of flash growth, Pure’s market share gains, and the company’s newest offerings are all likely to buoy growth that will overcome the slowdown likely in demand for enterprise storage as a whole.
Pure’s Valuation/Recommendation
Pure’s valuation has compressed to levels that belie its status as a growth company. The compression is both a function of the share price as well as the rapid improvement in the company’s business model. In the prior fiscal year, the company achieved a free cash flow margin of 14%, Last quarter, with the significant level of revenue pull-ins, the free cash flow margin was 30%, compared to a small free cash burn in the same quarter in the year earlier period. A significant component of the rise in the company’s free cash flow margin was the reduction in the company’s A/R balance which constituted more or less 100% of the free cash flow. The reduction in receivables related to the very strong growth in bookings the prior quarter when the RPO balance rose by about $200 million, or 16% sequentially. In Q1, the RPO balance was flat sequentially, which is fairly typical seasonality, especially given that much of the company’s upside was a function of accelerated deliveries that were recognized as revenue immediately without reaching the RPO balance. The company’s deferred revenue balance actually did increase sequentially; as well as did non-GAAP profitability. Overall, I anticipate that going forward, free cash flow margins will run slightly higher than non-GAAP operating margins because of depreciation expenses and the growth of deferred revenues and deferred commissions more than offsetting the capex at least through the end of the fiscal year. I have estimated that the company’s full year free cash margin will reach 17%. With a 12 month forward revenue forecast of $3.1 billion which is more or less consistent with consensus estimates, my free cash flow estimate is $590 million, or a free cash flow yield of more than 7%.
Pure is a profitable company. The current non-GAAP EPS consensus estimate for the year ending 1/31/23 is $.94. I typically look at a 4 quarter forward estimate to make comparison more equivalent. My earnings estimate for the next 4 quarters is $1.15. So, the P/E for the shares is about 23X. Pure’s EV/S is actually all of 2.3X. And using my assumptions, the company’s shares have a DPV of more than $60.
Demand for enterprise storage has been marked my substantial cyclicality. And Pure’s results have also seen growth spikes as well as growth compressions. In 2020, Pure’s revenue growth was just 2.5%, although of course that was the year in which the pandemic had a huge impact on the economy and ultimately on demand for storage capacity additions, Some of Pure’s growth spikes and compressions have related to its transition to a model with substantial recurring levels. At this point, recurring revenue is now about 35% of the total. In the last couple of quarters, the company saw a substantial spike in what are described as capex sales, as buyers, seeking immediate fulfillment of storage requirements not available from other vendors in the industry bought substantial amounts of Pure’s storage arrays.
Of course the growth from that source particularly isn’t likely sustainable at the most recent elevated levels, and thus percentage revenue growth is going to compress in the next few quarters. In Q3, fiscal 2022, Pure’s revenues rose by 37%. Some of the upside in that period was a function of a major purchase by Meta. Given Meta’s business issues, and its stated intention to constrain expenses, it is very unlikely that it will buy anything significant from Pure in this current quarter and of course, Pure, in this latest conference call explicitly called out that it didn’t expect to sell anything either to Meta or to any other hyper-scaler. Pure has been trying to sell to other hyper-scalers, but finalizing a transaction with that class of buyer is not something which can be forecast, and thus the company’s sequential growth forecast for the quarter is at prudent levels. The same might be said as well for the company’s full year forecast, implying substantial growth deceleration.
The early week stock market decline in the IT sector has basically come in the wake of an interview given by the CEO of ServiceNow, Bill McDermott. I am not going to try to interpret whether those comments are meant to apply to any specific business outlook for NOW, or to the enterprise software space as a whole, or to all IT businesses. What I do believe to be the case is that the current published expectations for Pure already have been framed with some significant macro headwinds in mind, and valuations for Pure are at levels that suggest investors think there is downside below the constrained forecasts.
The current consensus growth for what is essentially 2023 (fiscal ’24) calls for 14% growth. Given the many demand tailwinds that Pure enjoys, this would suggest that overall growth in the storage space would be negative. The outlook for the company’s market share gains isn’t really affected because of recessionary demand influences; because of Pure’s architecture, it enjoys significant cost advantages and product availability that are differentiated from its competitors.
Given Pure’s free cash flow generation, and its market share gains, the company is likely on the watch list for acquisition by many P/E firms. In that regards, it might be noted that the company CEO spent years as a consultant and a director of Silver Lake Partners, one of the leading P/E firms. I never find it useful to forecast an acquisition, but I would be anything but surprised if Pure sees interest from P/E firms; while the company’s technology would appeal to many competitors, I think anti-trust concerns probably rule out such an acquisition at this point.
It hasn’t been fun to own almost any high growth name in the IT space in recent months and Pure, despite very strong results, has been no exception. In the wake of the events of the last 8 months, I am not going to make any assertions about bottoms or anything like that. Valuations, for Pure, for other IT vendors, and for the market as a whole don’t have to be rational and concerns that I might think are already “baked into” valuations, are seen by others as on-going risks. But I think the investment case for this company is about as strong as it gets; I have a significant weighting in Pure, and I may increase it further.
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