When a company's financial and operational performance decline, its stock price follows. Because the story has worsened, it is natural for the stock to perform worse as well. But on occasion, a company's stock decline is disproportionately large relative to the decline in its performance. When such a decoupling occurs, chances of a takeover increase. We believe that such a decoupling has occurred with regard to NetApp (NTAP), and believe that the company's stock is oversold.
For the record, we own shares of EMC, NetApp's primary competitor. EMC has proven itself to be the superior of the two over the past year, both in its financial results, its product portfolio, and its stock performance.
(click to enlarge)While both companies have underperformed the S&P 500 (SPY) over the past year, NetApp has lost nearly half its value. The company's business, however, has not deteriorated by half. While we still view EMC as the superior company, there comes a point when a competitors stock is too cheap to ignore. And in our opinion, NetApp has reached that point, and we outline our thesis below.
Quarterly Results & Guidance Overview
After the markets closed on May 23, NetApp announced its fiscal 2012 fourth quarter and full year results. For the quarter, NetApp posted non-GAAP EPS of 66 cents per share on revenues of $1.7 billion. NetApp's results beat estimates on both EPS and revenue, which were 63 cents and $1.68 billion respectively.
While NetApp beat estimates for the fourth quarter, its guidance fell a good deal short of expectations. For the first quarter of fiscal 2013, the company forecast non-GAAP EPS of just 34-39 cents per share on revenues of $1.4-$1.5 billion, compared to estimates of 59 cents in EPS and $1.61 billion in revenue. That represents a sequential decline of 12-18% in revenue and a year-over-year change of between -4% and +3% NetApp attributed this to normal seasonality of the first quarter as well as an "increasingly uncertain macroeconomic environment." It is important to note that concerns over the economy have affected NetApp before. In past quarters, when NetApp missed expectations or lowered guidance, investors initially assumed that it was in fact due to macroeconomic issues. But then EMC reported its earnings and they were always bullish and upbeat about the general state of business. As a result of this, analysts questioned whether NetApp is simply hiding behind macroeconomic "uncertainty" as a smokescreen for losing share to the competition (meaning EMC) on the conference call. Morgan Stanley was the most blunt, asking point blank if it is "fair to say that the conservative guidance is almost entirely macro related, and nothing that you're seeing on the competitive environment is driving the conservatism?" CEO Thomas Georgens defended NetApp's competitive positioning, arguing that while the competition NetApp faces may be intense, he has not seen anything to suggest that NetApp's positioning in the marketplace has deteriorated. In addition, Georgens said that the end of the government's fiscal year in Q2 and the calendar year in Q3 could help the company meet its internal forecasts. But, Georgens conceded that NetApp's conservative guidance was in fact due to macroeconomic headwinds the company is seeing (arguments can be made about which is worse for a company; cutting guidance due to a weak competitive position, or a weakening economy).
It would seem that there are no silver linings for NetApp here. And yet, if one looks below the surface, it may be possible to find them. NetApp may have guided for revenue to be down 12-18% sequentially, but it guided for gross margins to rise to 60-61%, up from 58.44% in this most recent quarter. As FBN Securities noted, it is quite rare for companies to cut revenue guidance while increasing gross margin guidance at the same time. The implication of this is that NetApp may be being conservative with guidance and that the company may beat its revised estimates for the quarter. Analysts mostly lowered their ratings on NetApp after earnings were released.
The vast majority of analyst revisions following NetApp's earnings were negative, with many analysts not buying into NetApp's assertions that there are no competitive issues. We profile analyst reactions to the company's earnings below.
- Credit Suisse: The firm cut its price target on NetApp to $30 from $45 and kept a neutral rating. EPS estimates were slashed to $2.14 for fiscal 2013 and $2.26 for fiscal 2014. Credit Suisse noted that although it sees NetApp as being in a growth industry, the company is facing increasing competition. Credit Suisse is not convinced that NetApp's weak guidance is due exclusively to macroeconomic issues. The firm notes that while shares may be cheap, it is tough to be constructive on the NetApp given a lack of growth.
- Argus: The firm cut its rating to hold and withdrew its price target. Argus is concerned that other firms in the sector, including HP (HPQ), Dell (DELL), and EMC have not reported macroeconomic headwinds in their storage businesses. Argus is worried that competition may be impacting NetApp more than anticipated, with EMC in particular seen as intensifying its assault on NetApp's markets. 2013 EPS estimates were lowered to $1.75, and 2014 estimates were lowered to $1.91.
- Merrill Lynch: The firm kept its neutral rating and cut its price target to $34. Merrill Lynch sees the company's operating leverage at risk if revenue growth fails to materialize sometime soon. It expects NetApp's management to evaluate the need for restructuring in the next few quarters to preserve operating leverage. That being said, Merrill Lynch sees valuations as compelling at these levels. Fiscal 2013 EPS estimates were cut to $2.06 and fiscal 2014 estimates cut to $2.04
- S&P: The firm maintained its sell rating and cut its price target from $39 to $29, believing that competition from EMC is growing, especially in the mid-level market. S&P is concerned that NetApp is set to maintain expenses at current levels, particularly in R&D, which could weigh on margins for some quarters to come. Fiscal 2013 EPS estimates were cut to $1.67, from $2.47.
- Barclays: The firm maintained its outperform rating, but cut its price target from $49 to $35. Barclays sees the competitive pressures posed by EMC, but believes that sales at NetApp will pick up by the company's July quarter. The firm notes that from a fundamentals standpoint, EMC is the superior stock. Fiscal 2013 EPS estimates were cut to $2.06 from $2.67.
- Pacific Crest: The firm reiterated its outperform rating, but slashed its price target from $50 to $37. Pacific Crest is worried about the company's bookings trends, and the fact that operating margins are set to fall sharply, to 11.5% from 17.9%, which implies that the Engenio product line is not as accretive to the bottom line as expected. Pacific Crest sees the need for possible operating expense reductions.
- Needham: The firm maintained its buy rating, but cut its price target from $49 to $38. Needham notes the mixed nature of NetApp's end markets, with Asia-Pacific and American Commercial markets doing well, but EMEA, financial services, and government markets posting weak results. Needham sees the fact that NetApp is guiding for increased gross margins as evidence that competition is not the issue, and the firm remains confident in NetApp's position in the storage market. Fiscal 2013 EPS estimates were cut to $2.01 from $2.62.
- BMO: The firm maintained an outperform rating on NetApp, but cut its price target from $42 to $30. Fiscal year 2013 estimates were cut from $2.71 to $2.35 and the BMO stated that it "strongly prefers" EMC at this point in time. However, the firm also noted that at stock's currently depressed price, NetApp may begin to attract buyers. According to BMO estimates, NetApp will generate $3.10 per share in free cash flow in 2013, and it currently trades at just 5x free cash flow, and has $11 per share in cash. Such valuations may be too tempting for a large technology company to ignore.
- FBN: The firm was the only one we have seen to actually upgrade NetApp on the back of its earnings release, from sector perform to outperform. FBN sees NetApp's cash and valuations as becoming too tempting for buyers to ignore, and the firm named Cisco (CSCO) and IBM as potential buyers. FBN sees NetApp's 2000-series products as growing rapidly (up 23% year-over-year), and thinks NetApp may be being conservative with guidance, as evidenced by its expectations for higher gross margins. In addition, FBN sees slowing headcount growth as a possible precursor to layoffs, which could be a catalyst for the stock. NetApp may also begin to aggressively buy back stock at these levels, FBN notes.
It is the last 2 analyst commentaries that we would like to focus on, for they make an interesting case as to why NetApp could be a takeover target.
Cash & Valuations: Too Tempting to Ignore?
Based on the company's trailing EPS of $1.58, NetApp trades at a P/E ratio of just 18.11x, which is unassuming by the standards of the technology market. By contrast, EMC trades at a P/E ratio of nearly 21.
Backing out NetApp's cash makes the company's valuations even more attractive. At the end of this quarter, based on our calculations, NetApp had net cash of $4.1336 billion, which works out to $10.82 per share. Based on the company's stock price of $28.61 as of this writing, 37.82% of NetApp's market capitalization is in cash. By contrast, EMC ended its most recent quarter with net cash of $4.16 per share, meaning "just" 17.17% of its market capitalization is in cash. As FBN notes, NetApp trades at just 8-9x earnings when cash is excluded.
Let us assume then, for a moment, that NetApp will be acquired for $40 per share, representing a premium of 28.48% from current levels (NetApp currently has 381.7 million diluted shares outstanding, and the majority of its convertible debt is hedged against dilution).
Even with a generous premium of over 28%, NetApp could still be bought for just over $11 billion, which is an affordable sum for many Tier 1 technology companies. $11 billion would be a small price to pay to gain a foothold in the growing storage market, as well as challenge EMC. For companies looking to expand their storage presence, a buyout of NetApp is the only real way to do so. Dell, HP, and IBM all see their storage businesses as key parts of their growth strategy going forward, and we do not think they will be sellers. And with a market capitalization of over $50 billion, the only companies that can afford to buy EMC are the ones that have no interest in it [Apple (AAPL), Google (GOOG), and Microsoft (MSFT)]. That effectively leaves just NetApp as a takeover target.
So who may be a buyer of the company? We highlight possible acquirers below. Before we do so, we must note that EMC will not be buying NetApp. As investors in EMC, we would like to see the company be rid of its primary competitor, which has proven to be a nimble one. EMC was forced to pay $2.1 billion for Data Domain back in 2009 to prevent the company from falling into NetApp's hands, which bid $1.5 billion for the company in May 2009. But, we do not believe that an EMC-NetApp deal would be approved because of anti-trust considerations. Based on most recent market share statistics, a combined EMC and NetApp would have 40.7% of the storage market, a level that would likely cause concern for regulators. Therefore, we must consider other possible acquirers.
- HP: We do not think a deal with HP is likely (HP held just over 10% of the market at the end of 2011). Meg Whitman has her hands full with HP's turnaround, and the company is still in the process of integrating Autonomy. We do not think that HP would wish to burden itself with another large deal. And in any case, with net debt of almost $22 billion, we do not think HP could afford a deal of NetApp's size without damaging its credit ratings.
- Dell: A Dell-NetApp deal could make sense. As we stated in our article covering Dell's most recent earnings, we believe that the company is in need of either a large, meaningful deal or large share buybacks. NetApp would greatly expand Dell's presence in the storage market. Dell has $8.217 billion in net cash, and we do not think that financing a deal for NetApp would be an issue for the company.
- IBM: With just over 15% of the storage market, IBM is the second largest company in the sector, behind EMC. Though IBM has net debt of almost $15 billion, the markets have much more confidence in its finances than that of HP. While we believe that IBM could finance a purchase of NetApp, the bigger question is does it want to? A deal for NetApp would stand out for a number of reasons. First, it stands out based on sheer size. At our theoretical $11 billion price tag, NetApp would be IBM's largest acquisition by far. IBM's largest takeover to date has been the $4.9 billion purchase of Cognos in November 2007. Second, IBM's the vast majority of IBM's deals are for software companies, something that NetApp is not. It would take a large shift in the sector to convince IBM to invest billions into the market.
- Oracle (ORCL): Oracle is a possible buyer of NetApp, if for no other reason than that such a deal would inconvenience Oracle's competitors, something that CEO Larry Ellison loves to do. Oracle and NetApp have little overlap in their product portfolios, and the price tag is doable for Larry Ellison. He has stated that around 60% of NetApp's storage business comes from storing Oracle databases. He then added that "we'd love to have that 60%." In addition, a deal for NetApp would prove to be a headache for IBM. NetApp bought Engenio, LSI's (LSI) storage division in 2011, and IBM buys a good deal of Engenio products for use in its own systems, such as the DS5000 array. And in 2011, as Mark Hurd made his move to Oracle from HP, rumors swirled that he was working on a deal to take over NetApp. If that was indeed the case, we believe that the drop in NetApp's stock price has made such a deal even more likely.
- Cisco: Cisco is another logical buyer of NetApp, given the company's close partnership. Cisco and NetApp are collaborators on the FlexPod architecture, which allow customers to easily scale their storage needs based on their demand. FlexPod also allows customers to transition to Microsoft's private cloud solutions. NetApp and Cisco have expanded their relationship in the past several years, and as NetApp's stock price has fallen, it is certainly possible that Cisco has begun to examine if it is worthwhile to acquire NetApp outright. Rumors of a Cisco-NetApp deal have been brought up several times in the past, including in late 2010. Cisco has no meaningful presence in the data storage market, and a NetApp deal would enable the company to expand into a fast-growing market, and growth is something that Cisco is in need of. Cisco has made no secret of its desire to become a vertically integrated IT company. Cisco has 2 of the 3 pieces needed: networking and servers. What it lacks is storage, and NetApp would solve that issue. And with over $32 billion in net cash, Cisco has all the cash it needs to be able to solve that problem.
Of the 5 companies we discussed, we believe that Oracle and Cisco are the 2 companies most likely to make bids for NetApp. But that assumes NetApp would even want to sell. After all, the company's stock traded at $60 as recently as February 2011. But that was before NetApp's business began to deteriorate. We agree with most analysts that NetApp's issues are due more to competition from EMC than macroeconomic issues. Shareholders may be willing to ride out macroeconomic issues, but when a company's competitive position begins to weaken, shareholders have only so much patience. After a certain point, they will begin to call for change. We believe that NetApp's stock price is approaching those levels.
Let us be clear: for investors looking to invest in the data storage market, we believe that EMC is the company to invest in, based on fundamentals alone. It is the clear market leader, and has shown little of the macroeconomic headwinds that seem to be confined to NetApp. That being said, NetApp has its own catalysts. The company is still solidly profitable, has a large and growing cash pile, and is trading at valuations that could be too tempting for larger technology companies to ignore. NetApp's stock may have fallen by almost half over the past year, but we do not believe it business has weakened to such a degree. That kind of disconnect has created an opportunity, in our opinion. NetApp may be suffering, but the stock is suffering far more than the business, and at these levels, we think there is more upside than downside in the stock. It is possible that a larger technology company shares the view that NetApp's stock has suffered far more than it should have, and would use that disconnect to buy the entire company. The possibility of a takeover, and NetApp's solid financial profile, make us bullish on the stock.
Additional disclosure: We are long shares of CSCO, IBM, MSFT, and HPQ via the SPDR Dow Jones Industrial Average ETF. We are long shares of GOOG via a mutual fund that assigns the stock a weighting of 2.23%.