Is It Demand Or Competition Troubling NetApp?

By Stephen D. Simpson, CFA | May 23, 2012 AAA

Those tech companies that reported their earnings as part of the regular cycle all seemed to be more or less in good shape - numbers came in broadly in-line and guidance was relatively positive. Since then, though, numbers and sentiment have gotten a little wobbly, and maybe none more so than NetApp (Nasdaq:NTAP). Although these shares still seem to have meaningful value, investors have to ask whether the company's weak guidance is truly a byproduct of a weaker market, or whether competition has ramped up and management is unwilling (or unable) to acknowledge it.

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A Decent Close to the Fiscal Year
While NetApp's guidance was lousy, the fourth quarter numbers themselves were actually pretty good. Revenue rose 19% from last year on a reported basis, with organic revenue growth in the high single digits. Growth was exceptionally strong in the high-end systems (albeit from a lower base), while mid-range growth seemed to slow down.

Profitability was pretty solid as well. GAAP gross margin did fall about seven points from last year, but picked up slightly on a sequential basis. Operating income growth on a GAAP basis was a little odd (up 4% from last year, 41% from the third quarter), but more consistent on a non-GAAP basis (up 12% and 18%, respectively). In either case, NetApp significantly increased its R&D spending from prior levels.

SEE: Understanding The Income Statement

Guidance Spoils the Story
Management definitely surprised and alarmed the Street with its guidance for the next quarter. Management dropped its mid-point for revenue about 8% below the prior average estimate, while the EPS number drops by nearly 40%.

SEE: How To Evaluate The Quality Of EPS


So, what's going on here?

On one hand, NetApp has been criticized in the past for overly optimistic guidance and the transition from fiscal fourth quarter to the next fiscal first quarter has been a little dicey in the past. So there could be an element of conservatism here.

Management seemed to make it pretty clear that they were seeing a more difficult macro environment and that they didn't believe they were losing meaningful share. I'm not sure about this. EMC (NYSE:EMC) has been taking aim at NetApp's core mid-market business. What's more, EMC has spoken to investors and analysts relatively recently and didn't seem to have any major worries about the market. What's more, even Dell (Nasdaq:DELL) didn't seem to want to blame macro factors for its storage business performance, even though it posted disappointing numbers.

SEE: Earning Forecasts: A Primer

Is NetApp Losing Some Ground?
It's worth asking the question if NetApp is starting to lose some of its hard-won momentum. Converged stack is becoming more important, and the recent product announcements from IBM (NYSE:IBM) and EMC would seem to highlight NetApp's relative weakness here. What's more, the delays in getting a general availability release of ONTAP 8.1 to market may have created some problems.

The Bottom Line
Unfortunately for investors who have to make buy/sell decisions today, it's going to take a little time to see how NetApp's guidance and commentary plays out. If EMC continues to roll along, it will raise some questions about market share shifts and management credibility. On the other hand, if there is an industry-wide slowdown over the next quarter or two, it doesn't really damage the long-term potential all that much.

If the latter case proves true, that this is largely just a speed bump, these shares are still pretty cheap relative to the growth and cash flow potential. That said, EMC is the technology and market leader and it seems like the better play today.

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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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