Clouds Mean Bright Days For NetApp

By Stephen D. Simpson, CFA | June 01, 2011 AAA

Semiconductors are in the doldrums; the PC market seems to be on life support; and the health of routers and switches seems to depend on whichever company reported last. Storage, though, is clearly an area of strength, as companies struggle to stay on top of their own data management and cloud computing demands ever-increasing hardware support.

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That is good news for NetApp (Nasdaq:NTAP). This storage company seems to get dismissed from time to time as a weak sister to EMC (NYSE:EMC), but the fact remains that it is a growing player in a growing market with its own independent strategy and an architecture approach that some customers seem to prefer.

Is the Fourth Quarter a Return to Beat-and-Raise?
NetApp had a little hiccup with its last quarter, but the company seems to have gotten back on track. Revenue rose 22% this quarter, and the $1.43 billion in reported sales surpassed even the high end of the range. Investors should realize, though, that the company had to change its revenue recognition policies and that boosted revenue such that actual "apples to apples" results were closer to the expected level.

Still, product revenue did increase more than 26%. NetApp reported solid growth in both its mid-range and high-end business, as unit shipments rose 51% and 64% respectively. Although some of this growth was probably catch-up sales for business that could be closed in the prior quarter (due to component shortages), it seems pretty safe to conclude that there is strong underlying demand for NetApp's systems.

Profitability also improved with the higher sales. Gross margin improved more than a full point, and operating income rose 23%. Operating income leverage was limited to some extent by higher sales and marketing expense.

Will the Latest Deal Go Better?
In contrast to EMC, NetApp has a somewhat dicey history with acquisitions. Nevertheless, the company went ahead and spent nearly $500 million for LSI's (NYSE:LSI) external storage business, Engenio. The company does not believe there will be any problems with a fragmented architecture, but then they would be expected to say that (imagine the furor from shareholders if the company announced that the deal would make life worse for customers ...). Then again, the current CEO of NetApp used to run Engenio, so that should improve the integration prospects.

Apart from adding a business that the CEO is already very familiar with, Engenio should expand the company's opportunity in video and high-performance applications, as well as boosting its public sector business. Engenio isn't as high-end as Hewlett-Packard's (NYSE:HPQ) 3PAR or EMC's Isilon, but that shouldn't be a problem as NetApp tends to compete more effectively in the mid-range markets anyway. On top of that, it will be interesting to see if Oracle (Nasdaq:ORCL) will continue to use Engenio now that it is owned by a rival.

Room for More Than One
To some extent, the argument about NetApp's unified architecture and EMC's more fragmented offerings is pointless. Clearly customers have their preferences, and there isn't going to be one approach that pleases everyone. At the same time, it is interesting to see that EMC is migrating a bit towards the NetApp approach (with the VNX line), while NetApp is becoming a little more like EMC with the Enginio deal.

What's more, NetApp has plenty of other rivals from which to grab market share. HP and Dell (Nasdaq:DELL) still have a lot to prove and IBM (NYSE:IBM) and Oracle are not as singularly focused on the storage market.

The Bottom Line
If EMC is serious about gaining back share in the mid-range market, that is a risk that NetApp cannot ignore. Nevertheless, storage is an attractive market right now, and there's room for more than one double-digit grower. EMC looks like a better value today, but not overwhelmingly so, and NetApp offers more growth potential. Both are worth a look and more aggressive investors may find NetApp the more interesting option. (For related reading, also take a look at NetApp Down But Far From Out.)

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