NetApp Puts Some Fears To Rest

By Stephen D. Simpson, CFA | February 22, 2012 AAA

The outlook for enterprise IT in 2012 is still uncertain, but one thing that does seem more certain is that the demand for enterprise data storage capacity is only going to increase. While data gets more crowded, NetApp (Nasdaq:NTAP) has established itself as a strong and solid No. 2 player in this growth market and investors can still count this as a name worthy of consideration.

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Third Quarter Broadly In Line
NetApp's financial results for its fiscal third quarter were broadly in line with analyst expectations. Revenue rose 21% as reported, with sequential growth of 4% and year-over-year organic growth of 5%. While the United States public sector revenue was down 7%, U.S. enterprise was up 30%.

Analysts were expecting worse margins and NetApp delivered exactly that. Gross margin fell more than two points sequentially and more than seven points annually, while operating income fell 29%. NetApp is seeing some impact from hard drive disruptions tied to the Thai flooding, but also lower margins in the pursuit of high-end customers. (To know more about income statements, read Understanding The Income Statement.)

New Products Doing Well
Although I wish the company would provide a bit more segment-level data, the information on management's conference call is enough to suggest that the company's attempts to penetrate the high-end market are going pretty well. As background, the high-end market is new territory for NetApp, as it has long been dominated by EMC (NSYE:EMC) with competition from IBM (NYSE:IBM) and Hewlett-Packard (NYSE:HPQ).

Unit sales of the company's 6000 product (the high-end product) were up 250% from last year, while sales of the mid-range 3000 were up about 22%. NetApp also launched some refreshed 2000 products in the past quarter, the first such update in some time.

Looking to Create a Two-Horse Race?
NetApp is hardly surrendering anything to EMC, and NetApp is quite competitive when it comes to price and product line-up. That said, it's probably more constructive to think of the storage market as less about EMC-versus-NetApp and more about EMC/NetApp versus everybody else.

In particular, IBM, HP, Dell (Nasdaq:DELL), and Hitachi (NYSE:HIT) have much to prove with respect to staying in the game with more advanced products. HP's 3Par acquisition should give it a longer lease on relevance, but it would seem that IBM and Dell need to get moving or risk getting left behind.

Certainly, NetApp has made several sound strategic decisions. Entering the high-end margin is likely going to cost some margin in the short term, but there's a lot of long-term promise there. Likewise, partnering arrangements with Accenture (NYSE:ACN) and Cisco (Nasdaq:CSCO) seem like logical moves. All that really remains is for NetApp to strengthen its software offerings.

The Bottom Line
I have always been a fan of EMC, but there's a lot to like about NetApp as well. While there is some risk to this company from the growth of flash storage alternatives (from the likes of Fusion-IO (NYSE:FIO), that is presently more of a niche or specialty market.

NetApp admittedly doesn't look so impressive from a P/E or enterprise multiple perspective, but a cash flow analysis offers up a picture of potentially significant undervaluation. If NetApp can maintain solid single-digit compound free cash flow growth, these shares are worth owning from a value perspective. That said, investors considering this stock should be wary of the company's No. 2 status - in the momentum-driven world of tech investing, value alone seldom leads to a winning investment. (For additional reading, check out 5 Must-Have Metrics For Value Investors.)

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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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