A Stumble For NetApp Isn't A Disaster

By Stephen D. Simpson, CFA | November 21, 2011 AAA

Even a good market, like enterprise storage, isn't completely bulletproof. Investors always try to read between the lines of the releases from IBM (NYSE:IBM), Dell (Nasdaq:DELL), EMC (NYSE:EMC) and Hewlett-Packard (NYSE:HPQ), and try to figure out the "real" story on the enterprise market. And, then, there are the occasional outlier events, like the recent flooding in Thailand that stir up the market. All of that said, slightly disappointing guidance from NetApp (Nasdaq:NTAP) shouldn't completely sour investors on this name; it is not as strong of a prospect as EMC, but the price on these shares is nevertheless interesting. (For more on the tech industry, read A Primer On Investing In The Tech Industry.)
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A Mediocre Second Quarter
For its fiscal second quarter, NetApp reported about 20% revenue growth, missing the average analyst' guess but only slightly. Organic revenue growth was much more modest, though, and something in the low single-digit range (3 or 4%). Product revenue rose 23%, as reported (and up 5% sequentially) on strong year-on-year shipment growth in midrange products. Although NetApp had some issues with specific large customers, demand from the likes of Dell and Teradata (NYSE:TDC) was encouraging.

Profitability was not so impressive. Gross margin skidded both sequentially and on a year-on-year basis, with the sequential drop amounting to nearly a full point. Operating performance was better - operating income fell just below 10% from last year, but did improve about 9% sequentially.

Flooding Shouldn't Wipe Out Profits
It will be interesting to see how much impact the floods, in Thailand, have through the storage food chain. At a minimum, it seems likely that hard drive (HDD) prices will be higher for some time, and availability could be an issue in some cases. I don't think this is going to choke off the business (or its profitability) to any great degree, but it's a risk.

Moreover, it's also an opportunity for EMC to gain further ground. EMC has a strong relationship with Seagate (Nasdaq:STX), and that could be a leverageable advantage, if or when actual availability becomes a real problem. (For more on Natural disaster and its effects, check out The Financial Effects Of A Natural Disaster.)

Shares Still Sorting Out
Momentum seems to be with the pure-players EMC and NetApp, with much of the incremental share coming from IBM, Toshiba and Hewlett-Packard. Like as not, this will continue, and the battle will really come down to EMC and NetApp - Dell and Hewlett-Packard may not like this viewpoint, but they just don't seem to have the products or market positioning to build any real momentum.

For now, EMC seems to have solid momentum in both the low and high end of the market, while NetApp seems to still be strong in that mid-range market. Keep in mind, though, that EMC is really working on developing more cloud-oriented products (and owns most of VMware (NYSE: VMW)) and is supposedly on the hunt for more tuck-in acquisitions. The market can definitely support two pure-plays, but NetApp has to stay on its toes.

The Bottom Line
I think EMC is one of the best tech stocks out there today, both for price and performance. That said, NetApp is not a terrible alternative, and it is cheaper than EMC right now. Although EMC has the VMware kicker, and more of a blue-chip gloss to it, NetApp may well have a better chance of producing the higher growth rates that tech investors so often drool over. It's a toss-up then; my preference is EMC, but NetApp is arguably a more interesting play for investors who can take a little more risk in the pursuit of reward. (If you are interested in tech stocks, see Technology Sector Funds.)

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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