NetApp, Inc. — Q2 Fiscal 2019 Form 10-Q
Reporting period: Three and six months ended October 26, 2018; comparative periods ended October 27, 2017. Unaudited interim results. NetApp provides enterprise data-management software, systems and services supporting on-premises and cloud environments.
Financial results
| Metric | Q2 FY2019 | Q2 FY2018 | Six months FY2019 | Six months FY2018 |
|---|---|---|---|---|
| Revenue | $1.517B | $1.415B | $2.991B | $2.736B |
| Gross profit / margin | $974M / 64% | $900M / 64% | $1.937B / 65% | $1.724B / 63% |
| Operating income / margin | $286M / 19% | $216M / 15% | $540M / 18% | $356M / 13% |
| Net income | $241M | $174M | $524M | $305M |
| Diluted EPS | $0.91 | $0.63 | $1.96 | $1.10 |
| Operating cash flow | $165M | $314M | $491M | $564M |
Q2 revenue rose 7%; six-month revenue rose 9%. Product revenue increased 11% in Q2 and 16% for the half, led by strategic products, which grew 15% and 19%, respectively. Software maintenance revenue rose 5% and 4%; hardware maintenance and other services declined 1% in both periods. Strategic products represented 71% of product revenue, versus 69% a year earlier.
Management attributed improved gross margins primarily to higher-margin software license components of several enterprise license agreements (ELAs), and to a lesser extent higher average selling prices. Under ASC 606, ELA license fees are recognized upfront; NetApp reported approximately $20M of incremental ELA product revenue in Q2 and $110M for the first half compared with the prior accounting treatment. Prior-year comparatives were retrospectively restated for ASC 606.
Cash, debt and capital allocation
- At October 26, 2018, cash and cash equivalents were $2.359B and short-term investments were $1.940B, totaling $4.299B, down $1.092B from April 27. Approximately $3.894B was held internationally and $405M in the U.S.
- Six-month operating cash flow was $491M, compared with $564M; investing activities provided $381M, while financing activities used $1.429B. Financing outflows included $1.061B of share repurchases, $207M of dividends and $135M of net commercial-paper repayments.
- Principal debt totaled $1.800B: $1.550B of senior notes and $250M of commercial paper. The balance sheet reported $1.543B of senior notes before current/non-current classification, plus $249M of commercial paper. A $400M senior-note principal amount due September 2019 was classified as current. The $1.0B revolving credit facility was undrawn; the company reported covenant compliance.
- Working capital was $2.2B, down $1.3B from April 27, primarily due to lower cash and investments and reclassification of the $400M note to current liabilities. The cash conversion cycle was negative 19 days, versus negative 10 days a year earlier.
- NetApp repurchased 14M shares during the first half at an average $77.94 per share; $2.939B remained authorized. Dividends declared were $0.80 per share for the half. A subsequent $0.40-per-share dividend was declared November 14, payable January 23, 2019.
Outlook, commentary and risks
- Management said existing liquidity, operating cash generation, capital-market access and committed credit lines should meet requirements for at least the next 12 months. It cautioned that cash generation may fluctuate with results, shipment timing, collections, inventory and supplier payments, taxes, and compensation payments.
- Capital expenditures for the remainder of fiscal 2019 were expected to be $100M–$150M. The filing provides no specific revenue or earnings guidance.
- The May 2018 restructuring reduced the global workforce by less than 2%; substantially all related activities were completed. First-half restructuring charges were $19M.
- The six-month effective tax rate was 7.3%, versus 16.9%, including a $34M discrete tax benefit related to intercompany transactions following ASC 606 adoption, as well as tax reform and stock-compensation effects. NetApp had not completed its accounting for the U.S. Tax Cuts and Jobs Act and continued evaluating GILTI tax treatment.
- Unrecognized tax benefits were $356M gross; $324M, including related amounts, was recorded in other long-term liabilities. U.S. and foreign tax audits were ongoing. The Danish withholding-tax dispute remained unresolved; the company said the timing and range of possible changes in unrecognized tax benefits could not be estimated.
- NetApp disclosed active patent litigation and other ordinary-course claims. It believed the ultimate outcome was not expected to materially harm the company, but noted adverse outcomes could involve damages, injunctions, redesigns or licensing; no material accrual was recorded.
- Key business risks include intense competition and shifts to public cloud and consumption models; product-transition, execution and forecasting risks; dependence on channel partners and suppliers; cybersecurity, product-quality and intellectual-property claims; international, foreign-exchange and tax exposure; and market, economic and geopolitical uncertainty. Arrow Electronics and Tech Data together represented 45% of Q2 revenue, and Tech Data held 24% of receivables at period end.
Important facts for investors to verify
- How much reported growth and margin improvement depended on upfront ELA revenue recognition, and how that compares with recurring or ratable revenue.
- Whether strategic-product growth and service revenue trends continued after the quarter, given the product transition and evolving cloud/consumption models.
- Distributor concentration, especially the share of revenue and receivables attributable to Arrow Electronics and Tech Data, and collection performance.
- Cash generation after substantial buybacks and dividends, including the location and practical availability of overseas liquidity and the September 2019 $400M note maturity.
- Resolution and potential cash or earnings effects of tax audits, the Danish dispute, and patent litigation; also final accounting consequences of tax reform.