NetApp Is Probably Cheap, But The Headwinds Aren't Going Away

By Stephen D. Simpson, CFA | May 22, 2013 AAA

Tech is in the dumps. That's not really new or controversial, as even Cisco's (Nasdaq:CSCO) report was not all that strong in absolute terms. To that end, it's not entirely surprising that NetApp (Nasdaq:NTAP) reported results that were a bit weak and guidance that wasn't terribly impressive either. I don't believe that NetApp is closing the gap with EMC (NYSE:EMC), nor will in the foreseeable future, but I believe there's plenty of money to be made as the #2 storage company, and I believe these shares continue to look meaningfully undervalued.

Margins Save The Day For The Final Fiscal Quarter
Not unlike EMC, IBM (NYSE:IBM), or Dell (Nasdaq:DELL), NetApp really didn't impress anybody with its top-line growth in this quarter. Revenue rose 1% from the prior year and 5% from the prior quarter, with product revenue growth even stronger (up 2% and 7%), but that was still a bit below expectations. While the E Series and 3000 were both strong with double-digit sequential growth, the 2000 and 6000 were less impressive and overall storage capacity shipped grew just 4% over last year.

Where NetApp did impress was on the margin lines. Gross margin (non-GAAP) improved almost two points from last year and nearly a point from the prior quarter, beating the sell-side average estimate. While the company gave up some of that momentum as operating income declined 5% from last year and rose just 5% sequentially, the resulting operating margin was still a little better than estimated.

SEE: Analyzing Operating Margins

Continuing To Break From The Back, But Industry Demand Is An Issue
Flash, cloud, and storage software are all shaking up the storage market, to say nothing of a broad slowdown in enterprise IT spending, but at least one theme remains intact. EMC and NetApp continue to separate themselves from the competition (IBM, Dell, Hewlett-Packard (NYSE:HPQ), et al) in the storage hardware market.

The big question for NetApp, though, is whether the company can maintain its new-found share in the industry as it transitions from disruptor to incumbent. For instance, while NetApp's unified architecture has a lot going for it, it can lead to long and complex implementation. At the same time, EMC and Nimble (a private company) are making progress into NetApp's core mid-market – Nimble's focus on appealing price/performance trade-offs seems almost custom-built to target NetApp and Dell. If that wasn't enough, Oracle (Nasdaq:ORCL) and IBM have both been transitioning away from NetApp and towards internally-developed systems.

That's not to say that NetApp doesn't have aspects working in its favor. NetApp has been integrating flash into its platforms and management is confident that it can take share from EMC's high-end VMAX with all-flash arrays. Based on Cisco's report it also seems that the Cisco-NetApp partnership is starting off well and holds a lot of promise in the datacenter market.

SEE: Is Cloud Computing An Investable Trend?

Capital Returns Are Nice, But Growth And Margins Matter More
There have been rumblings for a while that NetApp management needed to “do something” with respect to its capital to excite shareholders. To that end, the market liked what it heard this quarter – NetApp will be nearly doubling its share buyback authorization (to $3 billion), with much of that coming in the next year, and initiating a dividend. Management is also looking to restructure its costs, with the firing of 900 workers featuring prominently.

This is all well and good, but it doesn't excite me much. NetApp has plenty of cash, but it takes cash to stay competitive in tech – very few companies can achieve all of their needs with internal R&D, and strategic acquisitions have been a feature of EMC's rise to the top of the storage industry. While I don't think these capital return moves necessarily hamstring NetApp's ability to do deals, the fact is that the company's ability to navigate the changing trends of the storage market (flash, cloud, a hardware-to-software transition) and improve its cost structure are far more significant in determining where the stock will be in the future.

SEE: A Primer On Investing In The Tech Industry

The Bottom Line
Maybe it sounds strange to like both EMC and NetApp, but that's where I'm at today. I actually own EMC shares in my own account, and I've been tempted to add NetApp as well. If NetApp can grow revenue by 5% and free cash flow (FCF) by about 6% (a point more than I expect from EMC), fair value would seem to be in the low to mid $50s. It's also worth noting that those assumptions presume that NetApp will never really match EMC in terms of margins.

With the weak recent growth trends and resulting stock performance, there are a lot of tech stocks with interesting-looking valuations. EMC, Cisco, and Oracle all fit that bill, as does NetApp. Buying into this weak tech environment takes some courage, and NetApp's soft Q1 and heavily back end-loaded fiscal 2014 guidance doesn't help. Still, on a long-term cash flow basis, these shares look appealing today unless you believe storage demand growth is about to evaporate on a long-term basis.

At the time of writing, Stephen D. Simpson owned shares of EMC.

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