NetApp: The Transition Story Continues

| About: NetApp, Inc. (NTAP)

Summary

NetApp reported results of its fiscal Q3 last week and once again the company shrank and missed estimates.

Amidst the hand-wringing and the angst, there were a few green shoots - flash storage grew by 60% from fiscal Q2 to fiscal Q3.

The growth parts of NetApp's business have now passed 50% of the company's total product revenues.

NetApp is well hated by the analyst community for a history of consistently missing projections and providing overly optimistic expectations.

As a result, the shares now sell for less than 1X revenue and for about 2x recurring maintenance revenues - valuations that will almost certainly spark acquisition interest.

Background

One of the hardest things to do in the tech business is to engineer a turnaround, especially if the overall environment has been lousy. The CEO - and it is most often a new CEO - is looking to put his fingers into multiple dikes, to man the pumps but also to plow the fields and to fertilize promising new crops. And usually there are a bunch of enemies firing large bore munitions at dikes that haven't been kept in good repair. There are those readers who will doubtless tell me I mix metaphors and for that I am sorry. But I wanted to suggest that NetApp (NASDAQ:NTAP) is not a simple story and the outcome is by no means a given, but the rewards if the transition can be made are uncommonly generous.

For those of you who may not have been following the unfolding drama, the NetApp saga of recent years has had at least as many sub-plots as Downton Abbey. Last week the company announced the results of its fiscal Q3. All in, the results were nothing short of dismal - except EPS was on target and cash flow, to some extent enhanced by shrinkage, performed at levels that enhance an already rock solid balance sheet. At a high level, the company reported that product revenue shrank by 19% in Q3 compared to the prior year, while total revenue fell by almost 11%. Product revenue is usually thought to be a leading indicator for software and maintenance which make up the non-product revenue cohort.

NetApp's Non GAAP EPS beat expectations at $.70 compared to the prior consensus of $.68 but that was still down from $.75 EPS in the prior year's quarter. Forward guidance was pretty dismal as well. The consensus EPS forecast for the current quarter (ends April 29, 1016) is now for $.58 compared to $.73 before the latest earnings release - although to be fair, some of that is a function of the dilution expected from the just completed SolidFire merger. Almost all of my discussion will be based on non-GAAP metrics which the company has long emphasized although to be fair the percentage of reported earnings coming from stock-based compensation is not insubstantial. Last quarter $.21 of the reported $.70 in non-GAAP EPS was a function of stock-based compensation.

Looking forward, product sales are now forecast to be down another 9% in this quarter compared to the results of the 2015 quarter which will bring the two-year decline to about 25% in that category. Overall revenues at the midpoint of guidance are forecast to contract by about 13% over the same span.

All in all, anything but a pretty picture. So why should investors stop and take a look at a company like this whose operating track record over the past two years looks as though it is on the road to extinction? Two reasons, really. One is the relatively extraordinary valuation of this company where the combination of lots of cash and a dramatic decline in the share price have left more than half of the company's market capitalization in cash. And the other is the possibility that this management team can actually turn it around.

I think it fair to comment, and I shall, that NetApp over the years has made more than its share of mistakes. But the company has turned out some of its more senior figures responsible for some of the mistakes. But the CEO of the company, George Kurian, has only been in his current position since June of 2015 and the CTO Mark Bregman joined NetAPP just this past September. In addition, Jeff Bergmann has been in his role for barely a month as interim chief financial officer.

There are still holdovers on this team. Tom Mendoza as Vice Chairman, Rob Salmon as head of Worldwide Sales and Dave Hitz who is responsible for future strategies have been around for many years at this company. But the point is that NetApp has a new group of men at the top of its executive staff who have been in their posts for just a few months. Yes, the results and the guidance just published were lousy. But given the valuation of the company's shares and the fact that the new team has only been in place a few months, I think it is reasonable and prudent to give the new leadership a bit of leeway before declaring defeat as has been done by some analysts. The upside potential is simply too great to ignore.

NetApp shares have enjoyed a bit of a dead cat bounce since the company announced its results last week. The shares are up almost 16% at this writing since, setting a low on February 11th. On the other hand, the shares are still down by more than 27% since before the company announced the results of its prior quarter, and are down by 35% over the past year. The valuation of NetApp shares has been compressed significantly and the valuation metrics seem attractive - now if the company can only achieve a real turnaround. I will try to address those prospects below.

Background

NetApp was founded in 1992 and became a public company in 1995. It was one of the poster children of the internet boom in the late 1990s and revenues grew rapidly to $1 billion. Like many such companies, NetApp had a near-death experience in the subsequent internet bust when revenues declined by more than 20%. But the fact is that at that point, the company had a commanding position in the filer space compared an to older technology called block storage which is sold by EMC (NYSE:EMC) and Hitachi Data Systems. Most often, at that point and into the present, NetApp has been known as the leader in Network Attached Storage (NAS) while EMC is known as the leader in Storage Attached Networks. At this point, with the overall market for spinning discs being superseded, I think those differences are far less important than had heretofore been the case. NetApp's first real CEO, who helped insure the company's leadership position in NAS, was Dan Warmenhoven. Warmenhoven was brash, driven and more than a bit arrogant as well as being firmly behind the company's sales culture. He formally retired after 20 years at NetApp in 2014 as Chairman and was replaced by Tom Georgens. Probably Warmenhoven's single biggest failure was his inability to complete the Data Domain merger shortly before he stepped down as CEO. That failure really was an exceptionally costly mistake that kept NetApp out of the data back-up/reduplication market for many years and probably cost the company significant add-on/drag-on sales as well. Perhaps not as well publicized, but certainly costly as well, was the eight-year saga of trying to integrate the Spinnaker acquisition into NetApp's OnTap software. It was costly, embarrassing and probably deterred the company from making other acquisitions that might have changed its competitive positioning.

Tom Georgens is an amiable, down to earth executive with a solid background in managing a tech sales force who would have been perfect for NetApp in a less tumultuous era in the storage space. Georgens had become CEO in 2009, after a stint as a Regional Vice President for NetApp, and his tenure was marked by some incredible miscues. For whatever reason, Mr. Georgens simply had a blind spot when it came to flash and he was very slow in moving the company into some of the more rapidly growing segments of the storage business such as what are called hyper-convergence and virtual machine storage. Perhaps one of the all-time mis-statements ever made by an executive of an enterprise storage vendor was when then CTO at the time Jay Kidd said as late as November 2012 at an analyst meeting I attended, that NetApp saw no need for an all-flash storage array. I certainly do not claim any prescience when it comes to technology trends. Some I get, some I don't. But I can tell you that lots of analysts that day hurried from the meeting and passed up the free lunch in order to write something about what they perceived all the way back then as a serious error in corporate strategy.

Hindsight is of course 20/20 but regardless of that, I believe that Mr. Kidd's statement, and the concomitant decisions that flowed from that sentiment, led NetApp to make one of the worst decisions yet seen by an enterprise storage vendor. I will try to pick an analogy for those readers not familiar with the storage business - perhaps a good analogy might be for the CTO of Ford in 1914 after the electric self-starter was initially invented that the company didn't see the real advantage of that technology.

Current Position

I suppose that there are some observers who might feel as though I have focused too much on the negatives in trying to position this company for readers. But it's hard to really describe just how colossal a mistake it was when NetApp, really known for a decade and more, as the company selling leading technologies in the storage industry failed to get on the flash horse early in the race. But history is prologue as the saying goes and let's take a look at exactly where NetApp stands in the storage space and exactly how the storage space is doing and is likely to do in the intermediate term.

I recently wrote an article about CommVault (NASDAQ:CVLT) where I tried to answer the question as to the health of the storage market and how it was impacting the growth of that company. Subsequent to writing the article, CVLT reported the numbers for its January quarter that suggested that its growth, anyway, was back on track. But for the storage vendors themselves, the fact is that growth in the space has slowed and doesn't appear to be getting any better. There are great studies on storage growth that are published by market research vendors. Sadly however, the studies are published in arrears so they don't do investors much good. That being said, the storage market in terms of dollars is simply not growing at this time although the amount of data being stored is still rising by 30%/year. The disconnect is a function of many factors. One of these is the increasing use of storage efficiency strategies. The most common of those is deduplication but in recent years' new technologies have come to the fore. Another major factor is the cloud and most particularly Amazon (NASDAQ:AMZN) Web Services (AWS). Most industry analysts seem to believe that for every dollar of spend within AWS, overall infrastructure spend - which includes storage-declines by $3 to $4. In addition to AWS, Microsoft (NASDAQ:MSFT) Azure is having similar impacts on independent storage vendors such as NetApp. One chapter in a marketing piece authored by Microsoft is entitled "Slaying the Storage Capacity Monster." The chapter might have been just as well entitled, "Slaying the growth prospects for the enterprise storage vendors" since the ultimate effect of slaying the so-called "capacity monster" really is going to depress a significant amount of demand for storage.

There are other technologies as well that are making their impact in the market for traditional external storage arrays. Just to remind readers of some of these threats, technologies such as storage virtualization, software defined storage and of course flash are sounding the death knell for spinning discs. Mark Peters, a senior analyst at Enterprise Strategy Group, has written that "2016 is the year when everyone - vendors, users and commentators alike - will be publicly talking about the degree of genuine and dramatic change that is nascent in the storage ecosystem." What he goes on to say is the end of the external storage array industry is in sight. It is his belief that software defined storage is the technology that is going to impact the traditional vendors. Another commentator, David Floyer of Wikibon, says that 2016 will be the first time that more than 50% of enterprise storage spending will be on low latency storage (he means flash). He says that "disk storage will continue to dominate capacity storage until the early 2020's after which disk will decline rapidly."

I would not say that engineering a turnaround in such an environment is the simplest of projects that a new CEO has ever faced. And one has to consider macro headwinds as well. Storage is hardly immune from capex cycles and its performance during the Great Recession was close to disastrous. But I do believe that NetApp has a plan, and some green shoots that go with that plan, that could possibly turn the company around and the rewards of doing something like that for shareholders, especially considering today's valuation are highly significant.

The most important thing is that NetApp has finally got flash technology that is competitive and selling well. Last quarter NetApp reached a run rate of $600 million/year in flash, which was up from $370 million the prior quarter. For those not wanting to do the math, that is 60% sequential quarter growth and I think it is hugely significant. I would not suggest to anyone that NetApp has or can buy back the time it lost until it decided to emphasize flash, but the results of the past quarter, dismal though they were overall, really had a nice green shoot in flash revenue that one can touch and feel.

I also would comment that while the company faces a variety of "hot" competitors including Pure Storage (NYSE:PSTG), Nutanix, Violin (NYSE:VMEM) etc., it is fortunate that it is also dealing with EMC whose internal structure remains challenged by the forthcoming merger with Dell. Other competitors that NetApp faces such as Hitachi, IBM (NYSE:IBM) and Hewlett Packard (NYSE:HPE) are large but not particularly well positioned. They have underinvested in R&D, in my opinion, Gartner rates them as challenged and they do not appear to have developed growth strategies for their portfolio of storage offerings and mainly compete on price.

Another major issue for NetApp has been its absence of a hyper-converged solution. I am sure that the word "hyper-converged" is not likely to be tripping off the lips of most investors. For the record, it can be defined as "a type of infrastructure system with a software-centric architecture that tightly integrates compute, storage, networking and virtualization resources using commodity hardware supported by a single vendor." If terms like those make your eyes water take comfort in knowing that I have a similar reaction. But also understand that it is a really hot topic these days in the world of storage procurement. It is also worth noting that NetApp hasn't been in that market at all. Now, however, partially as a consequence of the company's recent SolidFire acquisition, NetApp plans to be building a competitive product in the space that certainly has the potential to make a significant difference in the company's growth potential.

The other major business opportunity for NetApp is what is called clustered Data ONTAP. Again, I don't imagine many readers know or care about the specifics of NetApp's technology. Readers might be surprised as to just how complex the technology behind storing data really can be but it is a very large business and it has huge opportunities and there are lots of clever engineers trying to make storage quicker, cheaper and more reliable. One way to accomplish those goals is through a technology called storage virtualization. At a very high level, virtualization works by moving data between different tiers of storage non disruptively. It is one way users have of improving the efficiency of their storage systems without buying loads of excess capacity. The fact is that excess capacity is the bane of users who sometimes develop infrastructure with only 10% efficiency just so they can insure their networks have the capacity to handle occasional peak loads. NetApp actually pioneered the technology many years ago but it has had enormous issues selling its current version. It would take up more space than it is worth. But the fact is that prior management sadly misjudged the effort involved in migrating users to so-called data clusters. Basically, the company needs success in this area, if it has a hope of achieving success. Last quarter, in what may be a breakthrough, clustered ONTAP showed revenue growth of 60% year on year.

So compared to about nine months ago when Tom Georgens was replaced, the company has two strategic revenue components that are sustaining significant growth and one significant potential. All in, the company's strategic solutions made up 55% of total revenue and grew by 26% last quarter. The problem is and will likely continue to be that the revenue from the legacy storage businesses, particularly OEM and ONTAP-7, fell by more than 40%.

As I wrote at the start of this article pulling off a transition for a company like this is probably the equivalent of a good athlete who has never climbed a mountain trying to ascend K-2. It can be done, but it is isn't going to be easy or quick or without some twists and turns along the way.

I do believe, however, that compared to prior quarters, the math suggests that the guidance NetApp management has given is pretty realistic. If 50%-plus of revenue can continue to grow at 26%/year and the balance shrinks by 40%-plus/year, then forecasting overall product revenues to shrink about 9% or so on an annual basis seems to make some kind of sense. And if those trends persist for another year, then simple math suggests that NetApp product revenues are going to start to increase again.

I really have a basic lack of second sight when it comes to trying to forecast things that haven't happened yet. I think anyone who even attempts to suggest that they "know" that the transition is going to work or isn't going to work is wildly self delusional. The changes atop NetApp were a function of lots of bad decisions and sloppy execution in almost every part of the corporate fabric. How quickly the new management can pick up the pieces and return this company to growth is more or less unknowable. But at least the CEO recognizes the issues and seems to have an appropriate sense of urgency. It seems to this writer that NetApp actually has the pieces of technology that are needed to pull off a turnaround of decent magnitude. I think it is a reasonable bet that the new management can put the company back on a growth pattern going forward.

Valuation/Investment Case.

I have written about some of the valuation metrics early in the article so I'm just going to touch on a few highlights. The company has a market capitalization of $7.3 billion but its enterprise value is just $3.7 billion due to a current cash net balance of about $3.5 billion. EV/S is thus an extraordinary .68X. Just for the record, the company is generating about $2 billion-plus/year in software maintenance. Thus, it is selling for less than 2X its recurring revenue base. And somewhat surprisingly, through all the turmoil, that revenue stream is still growing by a couple of percent year on year. Valuations of that level frequently elicit bids from either P/E or strategic buyers. The company generated $355 million in operating cash flow this past quarter and more than $600 million in operating cash flow to date. Stock based compensation was 30% of the year to date figure and 15% of last quarter's cash flow. Capex is running at about $150 million/year.

The acquisition of SolidFire was completed after the close of the quarter for a total consideration of $870 million which will obviously impact some of the above valuation numbers. SolidFire has a run rate of only about $100 million in revenues according to estimates so it will push up the EV/S ratio and of course the consideration will reduce the company's net cash balance when it next presents its balance sheet.

The company is selling for a forward P/E of just a bit over 10X based on company guidance and current consensus expectations that includes significant dilution from the SolidFire acquisition.

This company has had a long record of achieving cash flow from operations that significantly exceeds net income and there is certainly no reason to think that this relationship is likely to change anytime soon. Forecasting operating cash flow that includes totally unknowable components such as changes in assets and liabilities is a daunting task. But even with current constrained EPS estimates, I believe that operating cash flow is likely to run between $900 million and $1 billion in fiscal year 2017 leaving the company a significant margin to pay the current dividend and to continue to buy back stock. While I'm not particularly fond of owning tech shares for their dividend yields given the extremely volatile nature of business in the tech world, at the current share price, NetApp shares yield 2.9%, less than some other hardware vendors, no doubt but certainly a support of some degree to current valuations.

While it is hard to handicap the potential success of the company's turnaround plan with anything like quantitative precision, the fact is that at current valuations, it isn't of central importance. No doubt analysts have been and continue to be disgusted by the performance of the company. This used to be one of the great growth stories of the prior decade and analysts who stuck with the name found themselves defending the indefensible. Thus, it is hardly surprising to me that the average rating on the shares on the part of 25 analysts who publish their ratings is a low 3.2 and the average price target is just $25. I think the bet has been set up such that even a semi-successful transition will yield a home run in terms of share price appreciation and a transition that goes nowhere is going to get this company sold for a decent premium. Either outcome would be a solid win for shareholders at these prices.

Conclusion

NetApp shares are well hated in light of the company's dismal operating performance over the course of the past 2-plus years. The company has seen its product sales shrink by 25% over that time and total revenues also are down double digits. The company has been a laggard in embracing trends within the storage industry including the adoption of flash technology, the development of virtualized solutions and the introduction of hyper-converged products. In my view, dismal though the past quarter was at an overall level, there were some green shoots of note. In particular, sales of SSDs grew by 60% sequentially, there was significant acceptance of OnTap 8 and the company's acquisition of SolidFire will provide it with the needed technology to offer hyper-converged systems - if management can fulfill its plan. While the outlook for fiscal 2017 is not particularly bright as the legacy components of this company's revenue stream continue their rapid decline, the growth areas of the business have now exceeded 50% of revenues. The company has a solid balance sheet and its valuation is such that it will almost surely attract some kind of significant interest from potential acquirers.

I don't have second sight and forecasting with any degree of conviction that this company and its new management team is going to achieve a strategic turnaround is something that would be irresponsible for anyone to predict and not grounded on any very solid basis after the disasters of recent quarters. But one doesn't need to be convinced that a turnaround will be successful in order to make a reasonable case to own the shares. An acquisition would work fine for shareholders and so the bet here is that if the turnaround works there is a home run and if it doesn't, shareholders have to settle for a single or a double. Neither of those is a bad outcome.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.