If a stock seems too cheap, there's really only two things to do (and they're not mutually exclusive) - run the numbers backwards and forwards, and buy it. While the IT hardware market in general, and the network storage market in particular, has slowed in recent quarters, NetApp (Nasdaq:NTAP) looks too cheap, unless analysts are completely wrong in their basic assumptions. Although I don't think NetApp is going to seriously threaten EMC (NYSE:EMC) for the storage throne, fading efforts at Dell (Nasdaq:DELL), Hewlett-Packard (NYSE:HPQ) and maybe IBM (NYSE:IBM), leave plenty of share to grab above and beyond the underlying market growth.

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

Pretty Good Numbers for Fiscal Third Quarter
While the results from EMC and IBM probably should have had NetApp investors a little nervous going into this report, NetApp came through. While the macro environment is definitely tough (and maybe getting worse), operationally NetApp is doing pretty well.

Revenue rose 4% this quarter (and 6% from the prior quarter) on relatively flat growth in product revenue (up 7% sequentially). Product revenue growth was stunted by NetApp's OEM business, as core branded product revenue rose about 6% from the year-ago period.

NetApp also did meaningfully better on the operating side. Gross margin (non-GAAP) improved a point from last year, while a mix shift took a little out of the sequential comparison. Operating income rose nearly 8% from last year (and about 25% sequentially), and the company seemed to underspend relative to estimates down the line.

Earnings quality also looked pretty solid, as there was nothing untoward in accounts receivable or inventories.

SEE: Earnings: Quality Means Everything

Share Movements Favor the Top Two
Based on what we've seen so far through the earnings cycle, there's nothing to suggest that EMC and NetApp aren't continuing to gain share in the storage market. Excluding the OEM business, NetApp actually gained on EMC (6% year on year growth, versus 5% at EMC), but both put more distance between themselves and IBM (down 5%). Neither HP nor Dell has reported yet (Dell is scheduled to report in four days), but reseller surveys suggest more share erosion at both of these troubled storage players.

One thing to be a little concerned with at NetApp is the mix. It looks like EMC did meaningfully better on the high end (6% growth at EMC versus flat performance at NetApp), while NetApp saw greater strength with lower-end products. That also doesn't necessarily speak well to the health of the market if customers are trading down.

Plenty Going On In 2013
While NetApp joined most hardware companies in projecting pretty modest performance in the near term, there is plenty going on right now at the company. Project Mars will come out in 2013 and the general assumption is that this is an all-flash array product. While the company's CTO said a while back that the company didn't have plans for an all-flash array, it would be a logical response to EMC.

Elsewhere, the company may able to drive some addition share gains with the new ONTAP 8.2. Longer term, expanding partnerships with Cisco Systems Inc. (Nasdaq:CSCO), Citrix Systems Inc. (Nasdaq:CTXS), SAP (NYSE:SAP) and Amazon (Nasdaq:AMZN) not only expand NetApp's potential addressable markets, but may also serve to create more headaches for rivals like EMC, VMware Inc. (NYSE:VMW) and IBM.

SEE: A Primer On Investing In The Tech Industry

The Bottom Line
I own EMC shares myself, and I'm happy with that position, but I have to admit that NetApp shares look interesting right now. Between an IDC estimate of storage market growth of about 5% over the next five years and potential ongoing share gains, I'm comfortable with a 6% long-term revenue growth for NetApp. At the same time, I think the company has more room for margin and free cash flow conversion improvement, such that free cash flow growth could come in around 7%.

At that level of growth and even with an elevated discount rate, fair value on NetApp shares would seem to be in the mid-$50s. Obviously, that is much, much higher than today's price for the shares. Working backwards, it looks like the market is projecting no growth at all for NetApp (and that the company will squander that cash on the balance sheet). Now I'm willing to acknowledge the risk that storage companies could oversaturate their market like the networking companies did years ago, but I happen to believe the storage growth is legitimate. Consequently, NetApp looks priced to move and seems to be a deeply undervalued stock right now.

At the time of writing, Stephen D. Simpson owned shares of EMC since 2012.

Related Articles
  1. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  2. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  3. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  4. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  5. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  6. Investing News

    How AT&T Evolved into a Mobile Phone Giant

    A third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
  7. Stock Analysis

    Home Depot: Can its Shares Continue Climbing?

    Home Depot has outperformed the market by a wide margin in the last 12 months. Is this sustainable?
  8. Stock Analysis

    Yelp: Can it Regain its Losses in 2016? (YELP)

    Yelp investors have had reason to be happy recently. Will the good spirits last?
  9. Stock Analysis

    Is Walmart's Rally Sustainable? (WMT)

    Walmart is enjoying a short-term rally. Is it sustainable? Is Amazon still a better bet?
  10. Stock Analysis

    GoPro's Stock: Can it Fall Much Further? (GPRO)

    As a company that primarily sells discretionary products, GoPro and its potential falls right in line with consumer trends. Is that good or bad?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center