Why You Shouldn’t Buy Pure Storage Inc stock Following Q2 Earnings

• Pure Storage Inc nearly doubled its revenue, growing at an accelerated pace in Q2 FY17.
• Gross margins expanded while operating and net losses were cut in half.
• Expect a short term rally, but Pure Storage is still a speculative bet. Here’s why.

Shares of Mountain View, California-based enterprise flash storage company Pure Storage are going through the roof (in after-hours trade) since the company delivered significantly improved Q2 results to beat analyst estimates. While the results are impressive, there are some key risks investors should be aware of. While Pure Storage doubled its revenue and halved losses, it’s losses are still huge. More importantly, the company nearly doubled its stock-based compensation and saw a near 2.6X jump in the number of outstanding shares, both of which will dilute equity and hurt investors.

First, the good part

Pure Storage smashed past estimates, reporting a non-GAAP loss of $0.16 per share compared to analyst estimates of $0.24 per share (loss). The company also beat revenue estimates of $155 million by delivering $163.2 million in revenue for Q2 FY17.

Giving credit where it’s due, Pure Storage stormed past estimates in style. The company’s revenue grew by a jaw-dropping 92.8% Year-on-Year (YoY), albeit off a small revenue base. In fact, revenue grew at an even faster clip this quarter than it did in Q1, when the company delivered a growth of 89%.

Both, the company’s ‘product’ and ‘support’ segments grew at a fast clip, growing by 84% YoY and 140% YoY respectively. The ‘support’ segment now accounts for ~20% of revenue, up from ~16% a year ago.

While the ‘product’ segment with its 60%+ gross margins has traditionally been a significantly higher margin business, over five quarters, the ‘support’ business has seen its gross margins expand from 34% to 57%. So, all in all, that’s great news for Pure Storage.

The company’s overall gross margins have expanded by nearly 7 percentage points YoY to touch 65.2%. That’s good news for investors because it indicates that the business is inherently capable of being profitable, if the company manages to curb operating expenses.

Now, for the not so good part

The Losses Are Still Heavy And The Competition Is Mounting

Again, giving credit where it’s due, Pure Storage cut its losses in half, with both operating and net losses falling from ~75% to ~36%. But that’s a transition from really terrible to less terrible, not from terrible to beautiful. Agreed that it’s a big step in the right direction, but to assume that Pure Storage will become profitable would be jumping the gun.

That’s because Pure Storage faces competition from a lot of biggies, including the likes of EMC, HP, IBM, Dell, NetApp and Lenovo. And of course, there are a host of smaller firms and start-ups looking to disrupt this space. What inevitably follows increased competition is pricing pressure.

Pure Storage claims to be working with ~20% of Fortune 500 companies. It has 2,300 customers, implying that a significantly large chunk of these customers are likely to be small or medium sized businesses. But in a highly competitive space where even small businesses tend to be price sensitive, Pure Storage might not have the liberty to use pricing as a lever to move the needle.

Equity Dilution Is A Serious Risk For Investors

While most investors tend to focus on revenue growth and earnings growth, they tend to miss the equity dilution risks attached to their investments. Pure Storage doubled its revenue and cut its losses in half, but it also seriously bumped up the number of outstanding shares.

Since October 2015, when Pure Storage went public, the number of outstanding shares has shot up 2.6 times. The company, which had about 75 million outstanding shares, now has over 190 million outstanding shares. What’s more, there aren’t any signs that Pure storage will stem the flow, with stock-based compensation expenses jumping 1.8X during the same period.

We’re actually talking about a 9 month period here. And both of these numbers, which are growing way faster on a YoY basis than revenue and earnings, will hurt investors.

Summing It Up

Pure Storage shares have shot up by over 11.5% in after-hours trade since the company reported its Q2 earnings last evening. While the company did deliver a significantly improved performance, the underlying risks haven’t dissipated. Pure Storage doubled its revenue and cut its losses in half during Q2. However, losses are still heavy even as competitive pressures continue to mount, and equity dilution is a serious risk.

Investors should note that the stock is still trading way below its listing price of $17 a share. Also, more recently, the stock received a near ~13% thrashing earlier this month after analysts voiced their skepticism around earnings. So, a short-term rally won’t be surprising, but Pure Storage is still a speculative bet at this point in time.