Pure Storage's Subscription Journey Makes The Stock Worth Watching

If there is one development that has been a revelation to technology investors over the past 10-15 years, it has been the emergence of the subscription model.

It has been a smart evolution. Some of the best businesses of the late 20th and early 21st century were print media firms and pay television. Customers paid every month, ad infinitum, until they decided they no longer needed the service. This provided steady cash flows that could be relied upon month after month, year after year. They flourished... until bad business decisions and new technology decimated their business models in the 2000's.

Software and IT providers, on the other hand, relied on more of a product-based model. Large "major" releases of new software were sold as a product, creating huge windfall fiscal years followed by lean ones. The same was true for IT hardware providers, which relied on upgrade cycles that led to similar (though less pronounced) boom-and-bust periods that had to be adeptly managed.

Eventually, software moved to the subscription model, which frankly makes a lot of sense as most software programs are providing an ongoing service to their consumers. SaaS exploded in the late 2000's and has permeated pretty much every corner of software now, from enterprise customer management systems to mobile gaming apps.

IT hardware, though, is a new one. And transitioning what has traditionally been transactional hardware sales to a subscription model is a very interesting idea. It's the main reason I wanted to review Pure Storage (PSTG), a long-standing Green Screen stock, today.

What Pure Storage Does

Pure Storage offers data storage products and services for clients that need to build out data centers. The company focuses on all-flash (solid-state, no moving parts) storage. Flash has many advantages over traditional rotating hard disk drives. It requires far less power to operate (a major concern nowadays), takes up less space, and is 10x more reliable (leading to lower labor costs to operate it). All of this amounts to a 50% lower cost of ownership over the lifespan of a storage unit - a pretty compelling value proposition.

Pure Storage boasts of 13,000 current customers, including 60% of the Global Fortune 500, and some notables such as Meta (i.e., Facebook), ServiceNow, NASA, and Comcast.

While over half of revenue (55%) comes from traditional product sales, Pure Storage is attempting to transform its storage offerings into an ongoing service model, which they call Evergreen//One. How this works is that a customer, instead of estimating their own future data needs and purchasing hardware from Pure Storage, instead signs a service level agreement (SLA) for storage needs. This is priced either on a bulk rate (e.g., "up to 1TB of storage per month"), or on a rated basis per used amount (e.g., cost per gigabyte of storage used).

Pure Storage then takes care of the rest. They will install the storage arrays, power needs, and rack space. They will maintain the storage structure, fixing/replacing bad hardware, provide around-the-clock support, and constantly monitor for any issues. They will upgrade to newer hardware and perform software updates. For the single monthly fee, you get all your storage needs taken care of, and can easily expand or contract storage as needed.

That's a pretty interesting and - to this point - unique model that applies SaaS advantages to a previously less attractive hardware-only business prone to booms and busts. Pure has increased services as a percentage of sales from just 25% in fiscal 2020 to over 47% in the most recent quarter.

Revenue Growth Potential and Recurrence

Without the "storage-as-a-service" (STaaS) piece, I wouldn't be interested in Pure Storage. IT hardware sales are a notoriously boom-and-bust industry, with no reliable recurring revenues.

Evergreen//One and the other STaaS offerings, though, are more attractive. It creates a reliable revenue stream of recurring service payments, and also creates some switching costs which I'll discuss later. Close to 50% of sales now are from service offerings, and I expect this to grow in the years ahead. This gives Pure Storage a solid and increasing base of recurring revenue that satisfies a key requirement of a "green dot" stock.

Now, what about growth?

Pure Storage has a strong 3-year compound annual growth rate of 19%. While it was down in 2023 (just 3%), sales have started to rebound this year and should come in over 10%. Some of this is due to the transition to service-based sales, which are spread throughout the life of a contract, instead of realized up-front as are product sales. Transitioning to "as-a-service" models have led to multi-year declines in revenue growth for many firms, before coming out the other side as more attractive businesses.

There's a lot of reason to think that storage demands will continue to grow. Artificial intelligence is both a key priority across the business world, and a massive IT resource hog, including for storage. Power demands have become a major concern in the age of AI, and flash storage is a key part of the solution. Hard disk drives still account for 90% of total stored enterprise data, meaning there is still plenty of runway for flash to replace them over the long term.

Overall, Pure Storage has "pretty good" (not outstanding) revenue recurrence and growth potential.

Moat

There is plenty of competition in flash storage array sales. A lot of the big boys, including Dell, Hitachi, NetApp, HP Enterprise, and Lenovo play in the space. Overall, PSTG holds 2nd place in market share at about 20%, behind Dell/EMC (28%) and just ahead of NetApp (19%).

Still, Pure Storage has been able to hold its own - and then some. It has increased market share by 11 percentage points over the past 10 years, while all of its competitors are either flat or down. This has been due to the quality of its offerings. The company has spent those 10 years placing as a "leader" in Gartner's Magic Quadrant rankings for several storage categories. It also sports a supremely impressive 82 net promoter score - by far the highest in the industry and a sign of customer satisfaction with its offerings.

While all this is nice, it's really the emerging STaaS model that's going to build a switching cost moat for Pure Storage. Once committed to this model, it would be quite disruptive for a customer to transition away from it. There's certainly a dependency that comes with it, and abandoning it means ripping out all your storage hardware, and potentially hiring your own IT, estimating your own storage needs, etc. As the subscription model takes hold, Pure's switching costs grow.

Leadership and Financials

Pure Storage has an established and successful management team. Charles Giancarlo has been CEO since 2017, and has over a decade of experience at the company. He's been named "CEO of the Year" by CEO Monthly magazine, fostered several "Best Workplace" awards (from Fortune and Newsweek), and has grown the business' free cash flow by 7 fold over the last 5 years. With a $150 million equity stake in the firm, his financial interests are aligned with ours as shareholders.

Founder John Colgrove is still involved as well, with a seat on the board and title of "Chief Visionary Officer". His personal stake in the firm is substantial, worth over $800 million as of this writing.

Financially, Pure Storage is strong. It has over $1.8 billion in cash on the balance sheet, vs. just $100 million in debt. Free cash flow has gotten quite strong, growing to a 24% margin in the past 12 months, vs. a 5 year average of 17.6%. Cash return on capital is impressive at 58%. Pure Storage's growth has largely been organic, with a few reasonably-sized strategic acquisitions, exactly what we like to see.

No concerns here.

Risks

The ultimate success or failure of the STaaS strategy is absolutely pivotal to the thesis for Pure Storage. If the firm cannot get continued uptake on Evergreen//One, it becomes a less attractive business model. I'd like to ultimately see it grow to 80% or more of sales, and there's no guarantee that's going to happen.

Even it if does, how strong retention turns out to be is also a wild card. We've seen 100% or better net revenue retention for most software-as-a-service models, but will that translate to hardware-based services as well? And how quickly and effectively will competitors like Dell/EMC and NetApp transition to similar offerings? How strong will pricing power be when/if that takes place?

A lot of unknowns here.

Finally, there's the matter of data storage revenue growth not keeping pace with growth in storage needs. While data storage needs have increased five-fold since 2018, industry revenue growth has lagged far behind that. This is due largely to competitive factors like pricing wars, technology advances leading to increased storage efficiency, and overall lower cost-per-GB. How much Pure Storage can actually grow is a question mark.

Conclusion

From a technology standpoint, I'm a firm believer that data storage needs will continue to grow over the long term, and that flash storage is a far superior option to hard disk drives.

I'm also a firm believer that a subscription service-based business model is a FAR better one than a transactional product model.

Pure Storage is a leader in its field in both parts of that equation. From a technology and customer satisfaction standpoint, it is the best in the industry, gaining market share at the expense of its rivals for over a decade. From the business model standpoint, it is leading the way in transitioning a hardware sales model into a service operation, before its competitors.

There are risks in investing in Pure Storage. The "STaaS" model is unproven, and could ultimately prove to have high attrition rates and less switching costs than we think. Profitability, too, is a wild card.

That said, I'm encouraged with what I see in the numbers. I think Pure Storage can grow at 10-12% annual rates for some time, at cash profitability margins exceeding 20%. Along with moderate share dilution (~5% annually) and a higher-than-average 11% discount rate, the stock is worth $45/share. It trades a bit above that at present, so we will park Pure Storage in the Watch List and wait for a better time to buy.