Pure Storage: Subscription Wins Will Drive Further Gains (NYSE:PSTG)

Amid a stock market that is rallying to YTD highs, it’s still never too late to move more of our portfolios into “growth at a reasonable price” stocks. In my view, these names have both downside protection in case bearish attitudes return, while also having upside potential because their valuation multiples have room to re-inflate higher.

Pure Storage (NYSE:PSTG), in my view, is an excellent stock in this regard. This data storage company, known for its flash products, has seen its share price soar more than 30% year to date. A recent Q3 earnings print was initially poorly received by the markets, but that trend quickly reversed as interest-rate enthusiasm sent the whole market up.

Subscription success drives the bull case for Pure Storage

In any case, Pure retracted post-earnings for nonsensical reasons, at least in my view. The company cut its FY24 guidance outlook (for which there is only one quarter remaining) in large part due to stronger-than-expected sales of its subscription products, which, needless to say, cannibalizes near-term one-time product sales in favor of a longer recurring revenue stream. Net/net, this is great for Pure Storage as it moves away from lumpier deals and into more value-added software and storage packages that deliver more consistent revenue over time.

I last wrote a bullish article on Pure Storage in September, when the stock was trading closer to $39 per share. Now, with a slightly more muted share price and what I consider to be a positive Q3 update (and tailwinds heading into FY25), I remain quite bullish on this name.

The chart below shows that though the company had cut 450bps of its y/y growth expectations since its original outlook, 150bps of growth was due to a large one-time deal where shipment will occur next year, and the remaining 300bps of growth was due to additional deferrals from better-than-expected subscription software sales. Note as well (not included on this chart) that from a y/y perspective, Pure Storage had a large one-time deal shipment in Q1 of FY23 that caused a tough compare for Q1 of this year.

This all jives well for FY25, where consensus is expecting much stronger growth rates for the company – the Street is calling for $3.17 billion in revenue, up 12% y/y (which is also closer in line with the company’s Q3 revenue growth rate of 13% y/y, which beat expectations). And we note that against expectations for acceleration in revenue and earnings growth next year, Pure Storage remains incredibly cheap.

At current share prices near $36, Pure Storage trades at a market cap of $11.41 billion. After we net off the $1.35 billion of cash and $901.6 million of debt on Pure Storage’s most recent balance sheet, the company’s resulting enterprise value is $10.96 billion.

This puts Pure Storage’s valuation at 3.4x EV/FY24 revenue. Note as well that Pure Storage is beginning to gain substantial margin leverage (and we should see more improvement as the company’s subscription transition moves closer to maturity), and it’s also trading at a ~24x P/E ratio against consensus’ $1.53 pro forma EPS expectations for next year – in other words, the company will soon be able to be reasonably valued from a bottom-line perspective as well.

As a refresher for investors who are newer to Pure Storage, here is my full long-term bull case for this stock:

• Shifting into a subscription/services play, which will help drive multiple appreciations for Pure Storage. Despite macro headwinds, Pure Storage still grew subscription services at a mid-20s y/y pace. This kind of revenue stream is just what Wall Street prizes: a recurring, high-margin stream of revenue from repeat customers. Yet in spite of this, the market’s valuation of Pure Storage still treats it like a commodity hardware play, even if its pro forma gross margin now resembles most SaaS stocks in the high 60s/low 70s.
• Industry recognition. Pure Storage has been named a leader in storage for eight consecutive years by Gartner, the most influential software industry ranking system. Customers choose Pure Storage for the combination of its broad platform, its modern cloud-first approach, and simplicity for installation, and an unintimidating pay-as-you-go pricing model.
• Huge TAM. Pure Storage estimates its TAM at $60+ billion, which means its current ~$2.5 billion revenue run rate is only ~4% penetrated into this overall market.
• Pay-for-consumption is a win-win for both Pure Storage and its customers. Pure-as-a-Service is priced based on usage, generally priced on a GiB/month basis. Outside of relatively low minimum commitments, this is a benefit for new customers because they can start out with Pure Storage for select workloads only, reducing the barriers to entry. For Pure Storage, it’s an advantage because, over time, these customers can expand to become major clients.
• Enterprise focus is growing. More to the point above, more than 50% of Pure Storage’s revenue is now coming from enterprise clients, and the top 10 customers spend more than $100 million annually.
• Cash flow. Pure Storage is delivering huge cash flow, but with FCF margins in the mid-single-digits versus a low-teens pro forma operating margin, there’s still plenty of room for expansion.

Stay long here: there’s plenty of upside to go in 2024.

Q3 download

Let’s now go through Pure Storage’s latest quarterly results in greater detail. The Q3 earnings summary is shown below:

Pure’s revenue grew 13% y/y to $762.8 million, ahead of Wall Street’s expectations of $761.5 million by a smidge. Underlying subscription revenue growth, meanwhile, was much stronger at 26% y/y.

The company also added 353 net-new customers in Q3 – which was more than the 325 customers added in Q2. Management notes as well that it has seen accelerating trends in the AI space, signing a double-digit number of AI deals in the quarter to end Q3 with a total of over 100 customers in the AI vertical.

ARR also grew at a 26% y/y pace to a total of $1.30 billion (comprising 41% of next year’s $3.17 billion revenue consensus; note that today, subscription revenue is also 40% of the total revenue mix). This roughly also matched the pace of the prior few quarters:

Here’s additional commentary from CEO Charlie Giancarlo’s remarks on the Q3 earnings call, detailing the performance of the company’s subscription product, EverGreen//One:

The Pure Storage platform also promises a cloud operating model for our customers, enabling them to manage their data storage like the cloud providers to reduce their storage costs in the cloud to provide tailored storage services to their developers like the cloud and to consume storage like the cloud as a service.

This model is gaining traction with leading customers. Evergreen//One, our Storage as a Service consumption offering saw continued extraordinary growth, more than doubling year-over-year. Evergreen//One and Evergreen/Flex are our preferred services for providing customers data storage on a consumption basis.

Although we continue to offer customers the choice of consuming storage as CapEx, we believe the continued high demand for Evergreen//One is being driven by our sales activities, new customer buying behavior, and the current macro environment. Customers are attracted to the ability to manage and consume Evergreen storage as a cloud service as they need it. But with the low cost advanced capabilities and data security of on-prem storage.

The outperformance of Evergreen//One this year has been significantly above our prior expectations and we now expect this strong level of demand to continue through Q4. While this success is a long anticipated and welcome expansion of our business model, its overperformance will have an effect on near-term revenue.”

The company also noted strong sales of its core FlashBlade products, with its latest FlashBlade//E solutions (released this year in April) having become a “meaningful portion” of overall FlashBlade sales. And as previously mentioned, the company closed a large $41 million product sale (worth more than 1 point in full-year y/y growth rates) that will be held in deferred revenue until it ships in FY25.

From a margin perspective, Pure Storage’s increased mix toward software revenue helped slide overall gross margins up to 74.0%, up 310bps y/y. Underlying subscription and product margins also improved by similar amounts:

Pro forma operating income also jumped 58% y/y to $169 million, representing a strong 22.2% margin – 630bps higher than the year-ago quarter. Pro forma EPS of $0.50, meanwhile, jumped 61% y/y and beat Wall Street’s expectations $0.40 with 25% upside.

Key takeaways

With catalysts for accelerating growth in FY25, including strong subscription sales and a large one-time deal deferral pushing to next year, there’s a lot to like about Pure Storage – especially as the company continues to ramp up its margin profile and delivers solid earnings and cash flow. Stay long here.