It's starting to look as though those tech companies reporting late in the cycle have better news to give to the Street, as Cisco's (Nasdaq:CSCO) earnings report was decent and now so too was NetApp's (Nasdaq:NTAP). Although it's an open question as to whether much share is shifting between EMC (NYSE:EMC) and NetApp, both companies seem to be putting lesser competitors further and further behind. While there's definitely a risk that the near-term IT spending environment could worsen, NetApp still looks attractively-priced as a growth play on enterprise storage.
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A Solid Fiscal Second Quarter in a Twitchy Market
In a more bullish market, NetApp's quarter probably wouldn't get nearly so much positive attention. As it stands today, however, an in-line quarter is a pretty strong result in a market where analysts and investors seem to be perpetually wincing in anticipation of the next bit of bad news.
Revenue rose about 2% as reported (and about 7% on a sequential basis), just barely beating the average sell-side estimate. Product revenue fell 2% (but rose 11% sequentially), and management's indicated that there was good unit growth on both the low end (the 2000) and the high end (the 6000), suggesting some pressure on the 3000 series. Overall, NetApp's product revenue performance wasn't markedly different than that of EMC for this quarter.
NetApp also did pretty well on margins and profits. Gross margin did worsen from last year (by more than a point), but improved about a half-point sequentially, and hard drive costs seem under control. On the operating line, NetApp saw a sizable year-on-year decline (27%), but good sequential growth (up 54%), and operating margin worsened significantly on an annual basis but likewise improved sequentially. While the reported numbers for the adjusted/non-GAAP calculations were of course different, the changes were directionally very similar (particularly at the margin lines).
Separating from the Pack
Based on the past few quarters, it increasingly sounds like the biggest shifts in the storage market are not between EMC and NetApp, but rather between EMC/NetApp and other large hardware providers. IBM (NYSE:IBM) saw a double-digit decline in storage for its third quarter, and I won't be surprised if Dell (Nasdaq:DELL) and Hewlett-Packard (NYSE:HPQ) likewise continue to lose ground and cede share.
That isn't to say that NetApp is not looking to challenge and apply pressure to EMC. Partnerships with Fusion-io (NYSE:FIO) and Cisco could prove to be significant as time rolls on, particularly given that the dissolution of the once-strong relationship between EMC and Cisco has likely created some bad feelings.
We're Not in the Clear Yet
NetApp posted a respectable quarter and relieved some investor worries, but that's not say that it's smooth sailing from here. For starters, it looks like the company got a nice boost from the end-of-year budget flush from government customers. What's more, Europe is still weak and there hasn't been a lot of optimism lately from Fortune 500 companies on their spending plans for 2013.
The Bottom Line
I will be a little surprised if NetApp is still independent in five years. Given the growth and significance of storage within the IT spending food chain, NetApp could make sense to multiple companies (including IBM and HP, as well as more long-shot ideas such as Cisco, Oracle (Nasdaq:ORCL) and current EMC partner Lenovo (OTC:LNVGY)).
Here and now, NetApp looks too cheap. If NetApp can grow its free cash flow at a long-term rate of 6-8%, the shares should be trading considerably higher than they are today. In fact, strip away all of the cash and project less than 4% growth and the stock still looks undervalued by perhaps 10% today. While I chose EMC for my own portfolio, that was as much about portfolio construction and risk/volatility balance as the relative quality of the two companies. While NetApp is likely to be a riskier and more volatile pick than EMC, I think NetApp is a very interesting stock to consider today.
At the time of writing, Stephen D. Simpson owned shares of EMC since September 2012.