NetApp: New Name, Better Prospects?

NetApp (NTAP) (20.12, $5.2 billion) officially changed its name last week (from Network Appliance). The bigger question is will the direction of the stock, which began its decline over 16 months ago, soon change as well?

I have been following NTAP since 2000. I can recall attending a Tech Conference in 2001, when the stock was about $8, and listening to what had to be one of the worst presentations at the conference, at least for a tech analyst who wasn’t a technologist. The presenter may has well have been speaking Greek to the practically empty audience as he shared very technical details about what differentiated the company from other network storage solutions companies. I should have just gone with my gut and bought it anyway!

Well, I think that the opportunity to buy a solid company at a fantastic price has presented itself again. Some of you might recall an article I wrote last June highlighting the company as an attractive short (along with two others), which followed a more detailed look after the company reported its first earnings miss in May. The “cockroach” theory proved to be correct, as earnings estimates for the April 2009 FY have been under pressure for quite some time. Boy how things have changed. Analysts are projecting just 15% EPS growth over the next year, and the stock has moved to an all-time low PE.

click to enlarge images

Sales have slowed to about 21% growth over the past year from 29%+ in the prior 4 years and are expected to dip slightly more. The company has relatively high exposure to North America compared to other networking companies at about 55% of sales. Earnings have been hurt by the aggressive expansion of SG&A during a time of deceleration of sales – the company takes a long-term view towards growth and continues to invest (a good thing!). As you can see in the table below (click on it to have a better view), with several storage and networking related companies sorted by GM, NTAP has an extremely low EBITDA margin compared to the group:

In most regards, NTAP, with a GM that rivals software companies (not surprising given that software is the crux of their solution), outranks the group on other attributes, with a lower PE, a stronger balance sheet and a superior Return on Capital.

So, is the problem a macro problem that hit this immature high-growth company, or is there some darker issue, such as a competitive threat? The short answer is that it is unclear to me. What does seem obvious to me is that investors were paying too much for the stock but are now frustrated with the performance and fearful of even slower growth. Clearly, they don’t believe the numbers. I see several potential positive outcomes:

• The company could be acquired
• Growth could reaccelerate
• The company could slow its expenses and improve margins significantly

NTAP was pretty early to fall into decline compared to other tech companies and to its peers. The weakness is even more profound given the complete lack of exposure to the consumer. Of course, there is heavy exposure to Financials. Analysts cut estimates after the Analyst Day earlier this month, but it sure seems to me that it is penalizing the company to put such a low valuation on margins that are depressed primarily due to investing in the business. I expect to see the multiple expand. Technically, the stock has good support now at 19 and resistance at 23. As far as a price target for year-end, I am keeping in mind that the stock almost every year closes strongly. I believe that the earnings are achievable after the reset and the low expectations. Interpolating the FY09 and FY10 estimates yields a calendar 2009 estimate of $1.60. Assuming a multiple of 17.5X, I would expect to see the stock end the year near 29.

Disclosure: Long NTAP

Comments

[davcnslt]

Alan, you timed your note on NetApp perfectly. I had recently added it back to my watch list. Yours is an excellent report and I appreciate the thorough review. I agree with the baseline formation of $19 and suspect we will see opportunities approaching that line over the next few months, as technology in general enters it's C2Q doldrums. Investors should note that global data volume is growing by almost 60 per cent per year(1) and NetApp has a well established solid position in the space. Like you, I admire their willingness to invest in technology during the current climate. I especially like their devlopments in de-duplication technology, a key to complete storage virtualization. See today's article [hyperlink] www.foxbusiness.com/ma...
Another play that your readers may want to consider is a major supplier to NetApp. Xyratex (NASDAQ: XRTX) depends on NetApp for 72% of their $187.8 million networked storage business. So why buy Xyratex when it seems to be a direct proxy for NetApp? A big change for Xyratex during the last quarter was a new relationship with Dell thanks to the latter's acquisition of EqualLogic. During their conference call last week, the company's CEO, Steve Barber said ""We were fortuitous in that Dell acquired a company we previously engaged with. We're in dialog with them on other technology."
Prospective investors should note, however, that any contemplation of Xyratex as a candidate for your portfolio must include some diligence in another area of their business. Xyratex is the leading supplier of "infrastructure&q... to hard drive (HDD) manufacturers. By "infrastructure&q... the company refers to the highly specialized capital equipment that HDD manufacturers require to make and test their products. In this segment, Xyratex has seen revenues fall 60% year over year, as HDD manufacturers tempered their plans in favor of supply/demand balance after a brutal price war in the first half of 2007. While caution due to macro considerations continues to weigh on capital spending, the HDD makers all have expansion plans targeted for the back half of this year. Xyratex's key customers in this space are the two leaders, Western Digital and Seagate Technology. Given the inexorable demand for storage, I believe that Xyratex, NetApp, Western Digital, and Seagate Technology offer potential for patient investors willing to measure their entry point and who are seeking a solid middle ground for a technology recovery in the back half of this year. At the moment, we believe that these companies have seen C1Q exiting with a slowing of ship rates and minor increases in inventory. As this becomes apparent, with possible revisions over the next few weeks, we expect multiple opportunity points to present themselves.
Thank you again for a well researched and thought-out article.

(1) See article on the recent IDC report: money.cnn.com/news/new...

Disclosure: We do not currently own any of the stocks mentioned in this reply

[AlanBrochstein]

Thank you for your kind words and your additional (and more informed!) perspective, Gary.