Pure Storage: Ready to Take Advantage of AI’s Big Storage Opportunity (NYSE:PSTG)

Investment thesis

The enterprise storage systems (ESS) market has become highly competitive, with multiple OEMs vying for market share. To make matters worse, the market size will decline in 2023 due to enterprise slowdown and macro challenges. Moreover, ODMs (Original Design Manufacturers), and High-speed storage has also entered the storage space, making it more difficult for companies to grow. Despite these obstacles, pure storage (New York Stock Exchange: BSTG) succeeded in overcoming these challenges and implemented a successful strategy.

Over the past three years, Pure Storage’s stock price has more than doubled. The company outperformed the S&P 500 and many of its ESS peers by a wide margin (see below). Much of this increase is due to an effective growth strategy and strong execution.

At Miletus Research, our mission is to find successful companies It can beat the market and generate great returns. Our analysis shows that these companies share some strategic traits that set them apart from the rest. We believe that Pure Storage has the potential to be one of these successful companies. In this article, we will share our analysis of the company and its potential for long-term success.

Solid first quarter earnings

Pure Storage posted a strong first-quarter performance recently, with up and down beats. The company reported revenue of $694 million (+18% YoY), beating consensus by $13 million. Non-GAAP EPS was $0.32, a difference of $0.11. The company also maintained its fiscal 2025 guidance of $3.1 billion. See below the results:

Market opportunity – pure storage share

The ESS market is approximately $35 billion with several well-known players including Dell, Pure Storage, NetApp, Huawei, Hitachi, and HPE (note that the ESS market only measures external storage sold by OEMs and excludes internal storage or storage sold directly by Original Design Manufacturers (ODM) to Super Scale). According to IDC, the ESS market will decline by 1.2% in 2023 mainly due to a slowdown in enterprise and macro factors. However, IDC believes the market has reached a turning point and expects 7% growth in 2024 and 5% growth in 2025. Increasing demand is expected to come from Flash Array (AFA) storage which is the ideal high-speed solution. Storage for AI training and inference deployments.

The AFA storage market, of which Pure Storage is a part, represents about half of the ESS market. According to Gartner, Huawei leads the AFA market with a 20% market share, followed by Dell with a 19% share, and Pure Storage with a 16% share. The chart below shows the market share among top suppliers:

Pure Storage is showing a positive trajectory in terms of market share gains in the AFA market. In Q2 2023, the company had a 14% market share, behind NetApp. However, it gained an additional 2% share in the third quarter and surpassed NetApp. Furthermore, Huawei has overtaken Dell and become the world’s largest AFA supplier (see below).

Strategic focus: product leadership and innovation

Successful companies differentiate themselves in the marketplace through strategic focus. Pure Storage’s strategic focus is on product leadership. With its cutting-edge flash offerings delivered through a consumption model (as a service), the company has differentiated itself from the competition. We believe this approach has enabled the company to become a leader in the ESS market, gaining market share in the process.

This strategic focus on cutting-edge products has also helped the company gain leadership positions in industry reports. Gartner’s Magic Quadrant shows Pure Storage as a leader in the primary storage category and cites its high performance and flexible consumption models as key strengths (see below)

We expect Pure Storage to continue its innovation strategy, investing in R&D and strategic mergers and acquisitions to remain competitive.

Bold response to competitive threats

To assess Pure Storage’s competitive threats, we used Porter’s Five Forces model. We also applied the Ansoff matrix to understand how a company responds to these competitive threats (see below)

In the model, we identified two main threats that challenge Pure Storage’s market position:

The emergence of cloud storage offerings from hyperscalers. According to IDC, hyperscalers and service providers have become the main buyers of servers and storage. They currently represent more than 60% of combined revenues, and their share is expected to reach 75% by 2028 (see below)

Super expanders mostly purchase their storage modules from original design manufacturers (ODMs) rather than original equipment manufacturers (OEMs). This creates a threat for Pure Storage, as its customers may prefer cloud-based storage solutions if they move to the cloud. The company’s mitigation strategy here is to put in place its own hybrid cloud storage solution, which spans across on-premises and public cloud environments. The company also offers its Pure storage portfolio to hyperscalers to help them realize cost savings. The company believes its pure products offer multiple advantages of superior scale, such as improved performance and cost savings in energy, space and cooling costs.

ESS OEM Contest: Another risk for the company is competition from original equipment manufacturers. To mitigate this risk, the company positions itself at the top of the market and offers its products through a subscription model. This ensures that its products are always up to date with the latest technology, creating a moat against other vendors.

In short, Pure Storage demonstrates the flexibility needed to mitigate competitive risks. The company continues to implement its growth strategy through product leadership and portfolio diversification.

Pure Storage demonstrates strategic execution

We want to check the company’s strategic priorities and how they align with its financial metrics. See below Pure Storage’s strategic priorities:

• Maintain product leadership with a high-value, high-margin stocking strategy.
• Increase recurring revenue through a subscription-based storage-as-a-service consumption model.
• You can differentiate the hybrid storage approach by combining local and cloud storage.

When we look at the company’s financial metrics, we see a strong alignment between its execution and its strategic priorities. The company’s revenue is accelerating by double digits. In the first quarter, revenue rose from $589 million to $693 million, up 18% year over year (see below)

The increase in operating margins also shows that the company is able to maintain its differentiated offering strategy (see below)

The subscription ARR metric measures recurring revenue stream and is one of the most important growth metrics to monitor (see below). It reached $1.45 billion in the first quarter, up 25% year over year.

The strong growth in revenue, ARR and margins demonstrate Pure Storage’s successful execution of its strategic objectives. It reflects the company’s success in maintaining its product leadership, and expanding the scope of subscription-based consumption models.

Operational discipline – expanding margins

The company continues to demonstrate operational discipline, by keeping operational expenses under control. In the first quarter, gross margin rose to 74%, from 72% a year ago (see below).

Operating margin in the first quarter was 14.5%, up 3% year over year and exceeding guidance. The company aims to achieve an operating margin of 17% in fiscal year 2025. Management aims to increase operating margins by one or two percentage points each year. From the Q4 FY2024 call:

Kevan Chrysler (CFO):

FY25 margin is consistent with our long-term goal of expanding operating margin by a percentage point or 2 each year and represents a 2-point increase from the FY24 guidance we sent out at the beginning of the year.

The company also generated operating cash flow of $222 million, an increase of 22% from last year. As for the balance sheet, it ended the quarter with cash of $1.7 billion and debt of $273 million. Overall, it’s a very strong balance sheet.

Based on our analysis, we expect Pure Storage to maintain its operational discipline and expand its margins further due to the growing mix of recurring revenues.

Rating – Potential for upside

We will use a forward P/E multiple to value the company. The company is on track to achieve revenue of $3.1 billion for fiscal year 2025. Our revenue growth forecast for 2024-2028 is a CAGR of 13% given the significant AI storage potential we see for the company.

We assign a forward sales multiple of 8, and assume that the company will continue to grow at a double-digit rate and expand its margins steadily. With a discount rate of 10%, the target price is $80. This suggests a potential upside of 24% from current price levels (see below).

Risks

We have identified two key risks to the company. The first is Hyperscalers with their cloud storage offerings. Microsoft, Google, and Amazon offer a variety of storage solutions as part of their cloud services, which could create challenges for Pure Storage. Second, increased competition in the OEM market. More players are entering the market, including white label ODM manufacturers. This situation can put pressure on prices and margins if the company is unable to maintain its leading market position.

Conclusion

We believe that Pure Storage is a great company with key strategic characteristics. The company brings innovation to the industry, demonstrates product leadership, and gains market share in a difficult market. Given its advantageous market position, the company is poised to capitalize on the significant storage opportunity provided by AI technology.

Based on our analysis, we believe that Pure Storage can maintain its current price performance. We assign a fair value of $80 to the company.