NetApp, Inc (NTAP) is a leading provider of storage systems and data management solutions for IT infrastructures. The company's products helps its clients manage and store the increasing amount of data that is generated in today's digital world. We are now entering an era of big data, in which the amount of data processed and stored by enterprises is pressuring traditional storage architectures. NTAP provides products and solutions optimized to handle growing analytics, bandwidth, and content workloads. Economic pressures are depressing IT budgets around the world, which has stalled NTAP's previously robust growth trajectory, particularly because Europe and the public sector are key markets for NTAP. Despite these pressures and significant competition from EMC and others, we believe that NTAP is well-suited to compete in the midrange and lower-end storage systems space.
NTAP's unified fabric-attached storage (FAS) platform offers the optimal storage platform for business applications, shared infrastructures, and cloud environments. The market has experienced a shift from traditional dedicated storage to shared storage in virtualized IT infrastructures. Virtualization allows the organizations to separate applications and data from dedicated hardware so that the server, storage, and networking infrastructure can be shared and used more effectively. The Cloud has also become a primary battleground for NTAP, as the company provides a foundation designed to lower costs and provide operational efficiencies that allow IT to respond more rapidly.
The company's objective is to help organizations benefit from the efficiency and flexibility that NTAP's products can provide, depending on the company's desire for an on-site cloud solution, or an external cloud service provider. For companies that decide to outsource their cloud solutions, NTAP works with a number of 3rd party providers to ease the process. The E-Series systems, which were acquired in the LSI acquisition, provide high-performance and cost effective storage building blocks for value-added customization and big data workloads.
NTAP's products and services are designed to meet the growing requirements and service levels of large and mid-size enterprises, and their key business applications. The company designs products to satisfy the demands of high-performance computing and technical data center applications. The company develops integrated solutions that optimize the performance of its customers' applications and their infrastructure in partnership with key industry leaders such as Cisco (CSCO), IBM, Microsoft (MSFT), Oracle (ORCL), SAP (SAP), and VMware (VMW). NTAP's innovation and technological partnerships are keys to its success in an extremely competitive market.
By partnering with industry leaders, the company offers what it calls an "innovation stack" that includes best in class applications and technologies from a variety of vendors. NTAP does not have the depth of products that EMC has, nor does it compete really well on the highest-end of the market. These technologies change quickly, and while there is some protection from high switching costs, NTAP must stay in front of the technological innovation curve. To accomplish this R&D expenses have been 13%, 13%, and 14% of net revenues in fiscal 2012, 2011, and 2010, respectively. During fiscal 2012, 78% of net revenues were generated through indirect sales channels. Electronics distributors Arrow Electronics (ARW) and Avnet (AVT) accounted for approximately 17% and 12%, respectively, of net revenues over the year. Any serious disruption in NTAP's key partnerships or sales channels could put pressure on the company's earnings.
On November 14th, NTAP reported 2nd quarter earnings that exceeded estimates. Revenue in the quarter was up 2% YoY to $1.54 billion, gross margins were 60.6%, and operating margins were 14.4%. Non-GAAP EPS was $.51 and the company generated $269MM of free cash flow, which was 17% of revenue. Branded revenue was up 8% sequentially and 4% YoY in spite of a difficult environment. OEM revenue was down 9% from last year, while product revenue was down 2%. Asia-Pacific was the only geography that showed nice growth, up 14% YoY. Deferred revenue grew 14% to $2.77 billion, and the company ended with $5.57 billion in cash and equivalents.
The company bought back 6MM shares in the quarter and announced an additional $1.5 billion share buyback. Unfortunately the company issues a ton of stock and has $1.229 4 billion of convertible debt that could also be dilutive, so the share count only declined by 3MM in the quarter. The convertible notes become fully convertible in March and are due in June. The company is considering either just paying off the notes with cash or issuing new debt. With interest rates so low it would probably be prudent to access the capital markets, and with the stock price so low I certainly would not like to see a convertible feature.
For the 3rd quarter, the company guided for revenue to be between $1.575 billion, non-GAAP gross margins of 60-61, and non-GAAP operating margins of approximately 15%. The company's non-GAAP EPS estimate is between $.53-$.58 per share. GAAP guidance is between $.29-$.34 per share. The company estimates that it will have 365MM shares in Q3 based on the average stock price of $27.66. If the stock were to go above $31.85, the company would likely have more shares. Based on 365MM shares outstanding, the company has $11.90 a share in net cash. Much of this cash is held outside of the United States, but the company's financial strength is clearly sound.
NTAP uses ridiculous accounting in its communications with investors, putting undue emphasis on non-GAAP numbers, which exclude stock compensation that is one of the largest expenses that the company has. This type of nonsense boosts free cash flow, but I'd encourage investors to focus more on the actual GAAP numbers. Over the last 12 months NTAP has generated about $1.30 in GAAP earnings. At $27.12 the company has a market capitalization of about $9.9 billion based on 365MM shares outstanding. By backing out the $11.90 of net cash, NTAP's enterprise value is about $5.55 billion.
While this looks amazingly cheap based on the company's greater than $1 billion of annual free cash flow generation, it is still cheap at just over 10 times what I consider to be trough GAAP earnings. This calculation isn't perfect as it doesn't include the impact of interest income, but when you consider NTAP's markets and history of growth, the stock looks quite cheap.
If you are hesitant to invest due to fears of macroeconomic pressures, it might not be a bad idea to sell some puts on the stock. At the time of this writing the $25 puts for January 2014 were going for around $400 per contract. Therefore, if NTAP closes above $25 at expiration you'd make 19% on the maximum risk of $2,100 using this strategy. The worst case scenario would be having to buy the stock at a cost of $21 per share. NTAP could be a target for larger IT companies as well, especially when you consider that the enterprise value is quite cheap. Management might be reluctant to sell due to the depressed price, and it could be complicated because part of NTAP's value is its relationship with a myriad of 3rd party vendors.
After reporting strong earnings, it looks like the stock might head up on Thursday morning so using put options might be the more disciplined way to get in at a cheaper entry price.