Business context and reporting period
NetApp, Inc. supplies enterprise storage and data-management hardware, software and services. This unaudited Form 10-Q covers the 13-week second quarter of fiscal 2013, ended October 26, 2012, and the six months then ended. Comparisons are with the corresponding periods ended October 28, 2011, except balance-sheet comparisons, which are with April 27, 2012. NetApp reports one operating segment.
Financial performance and position
| Metric | Q2 FY2013 | Q2 FY2012 | Six months FY2013 | Six months FY2012 |
|---|---|---|---|---|
| Net revenue | $1,541.2 million | $1,507.0 million | $2,985.8 million | $2,965.2 million |
| Gross profit / margin | $913.9 million / 59.3% | $913.0 million / 60.6% | $1,764.0 million / 59.1% | $1,809.9 million / 61.0% |
| Operating income / margin | $135.3 million / 8.8% | $192.4 million / 12.8% | $215.5 million / 7.2% | $368.6 million / 12.4% |
| Net income | $109.6 million | $165.6 million | $173.4 million | $305.1 million |
| Diluted EPS | $0.30 | $0.44 | $0.47 | $0.78 |
| Operating cash flow | Not stated for the quarter | $565.6 million | $610.8 million |
Revenue grew 2% in the quarter and 1% year to date. Product revenue fell 2% and 4%, respectively, while software entitlements and maintenance revenue and service revenue each rose 11% in both periods. Operating expenses increased 8% in each period year over year, to $778.6 million for the quarter and $1,548.5 million for the six months. The six-month effective tax rate was 14.1%, versus 13.1%.
At October 26, 2012, cash and cash equivalents were $1,816.8 million and short-term investments were $3,754.2 million, totaling $5,571.0 million. Working capital was $3.3 billion. Total liabilities were $5,151.7 million. The $1.265 billion principal amount of 1.75% convertible notes is due June 1, 2013; its $1,229.4 million net carrying amount was classified as current. Six-month capital expenditures were $129.0 million. The company repurchased $348.3 million of stock in the six months. Accounts-receivable days sales outstanding improved to 36 days from 44 at fiscal year-end.
Material changes versus the prior comparable period
- Profitability weakened despite modest revenue growth: quarterly net income declined about 34% and six-month net income about 43% year over year. Gross margin fell 1.3 percentage points in the quarter and 1.9 points year to date; operating margin fell 4.0 and 5.2 points, respectively.
- Management attributed lower gross margin primarily to product and service mix, higher hardware warranty expense and unfavorable exchange rates. Product costs included an $11.4 million quarterly and $23.4 million six-month increase in hardware-related warranty expense versus the prior year.
- Configured-system unit volume increased 15% in the quarter and 12% year to date, but lower average selling prices and weaker non-configured and OEM product revenue weighed on product sales. Asia Pacific and Japan revenue grew 14% in the quarter and 11% year to date; EMEA was affected by macroeconomic conditions and currency movements.
- Operating cash flow declined by $45.2 million year over year in the first six months. Cash and short-term investments increased $172.5 million from April 27, 2012, after operating cash generation and employee stock issuance, offset principally by share repurchases and capital expenditures.
- Distributor concentration remained significant: Arrow represented 20% of quarterly revenue and Avnet 15%; for the six months, they represented 18% and 14%, respectively. Indirect channels generated 80% of six-month revenue.
Outlook, commentary, risks and unusual items
- The filing provides no specific revenue or earnings guidance. Management said current liquidity and expected operating cash flows should meet requirements for at least the next 12 months, while cautioning that weaker liquidity could require spending cuts or restructuring. Results are not necessarily indicative of full-year performance.
- Management expected $150 million to $200 million of capital expenditures for the rest of fiscal 2013, including an anticipated $69.6 million buyout of properties under synthetic leases. The company stated its current intention was to buy out these leases as their terms expired in December 2012 through January 2013.
- On November 14, 2012, the board authorized a $1.5 billion increase to the stock repurchase program. The same day, NetApp completed its approximately $90 million cash acquisition of CacheIQ; purchase-price allocation was still in progress.
- The notes mature June 1, 2013 and become unconditionally convertible at holders’ option on March 1, 2013. NetApp said it was evaluating repayment options, including available cash or new debt. Conversion could require cash up to principal and shares for any excess conversion value; note hedges are expected to offset about 80% of potential dilution, with warrants potentially dilutive above their strike price.
- Cash, cash equivalents and short-term investments included $3.1 billion held internationally. Management intended to keep foreign funds permanently reinvested; repatriation could trigger U.S. federal and state taxes. The company also disclosed $165.3 million of unrecognized tax benefits and ongoing U.S. and foreign tax examinations and appeals.
- Other exposures include $46.5 million fair value of illiquid auction-rate securities, non-cancelable contract-manufacturer purchase commitments of $266.7 million, and financing guarantees with $170.8 million maximum potential payments, partly offset by $154.5 million of deferred revenue. NetApp reported compliance with synthetic-lease financial covenants.
- The filing reported no material legal-contingency accrual and listed no legal proceedings in Part II. Separately, risk disclosures describe ongoing discussions with the DOJ and GSA concerning government contract compliance and a company review and cooperation with U.S. authorities regarding allegations that products reached Syria through a third party. Outcomes and potential financial effects are not clear from the filing text.
- Principal operating risks include uncertain IT spending and competition, product acceptance and execution, pricing and margin pressure, supply-chain and inventory commitments, reliance on distributors and OEM partners, currency and investment-market risks, tax outcomes, and potential note dilution. Management attributed higher operating costs partly to headcount and compensation growth, including stock-based compensation effects.
Important facts for investors to verify
- Whether product revenue and pricing stabilize, and whether service and maintenance growth can offset hardware weakness without further margin deterioration.
- Whether the elevated warranty costs persist and how they affect product gross margin and warranty reserves.
- How NetApp will fund or refinance the $1.265 billion notes due in 2013, and the resulting effect on cash, interest expense and potential dilution.
- How much of the $5.6 billion liquidity balance is practically available for U.S. needs, given the $3.1 billion held internationally and potential repatriation taxes.
- Developments in tax audits, the DOJ/GSA contract-compliance discussions and the Syria-related review, including any resulting liabilities or restrictions.
- Execution of the synthetic-lease property buyout, the expanded repurchase authorization, and integration of the CacheIQ acquisition.
- Whether distributor concentration, purchase commitments and inventory growth create added exposure if demand or customer forecasts weaken.