NetApp Is Cheap But A Long-Term Value Trap
Summary
- NetApp is trading at ~10 times historical earnings and a yield of ~4.5% with a good chance of returning to around $55 per share.
- Capital distributions of dividends and buybacks have exceeded operating cash flow for most years recently and this looks set to continue.
- Hybrid cloud remains an opportunity but competition is strong and revenue growth is negative despite solid profitability.
- Although there is a short-term trade opportunity from ~$45 to $55, for long-term investors NTAP is a value trap.
NetApp is cheap for a reason
Overpaying for growth is the main risk for technology investors; however, cheap technology stocks also have risks. A "value trap" investment looks solid and profitable whilst being priced soundly on the market. But once you examine the business fundamentals without rose colored glasses, it is clear that the company has already started the long gentle slide into this good night. In our recent travels looking for market sell-off bargains, we thought our review of NetApp's (NASDAQ:NTAP) situation was worth sharing.
So, this week we review NetApp as part of our Global Technology Growth Star investment strategy. In this strategy, we focus on strongly growing technology companies with a market capitalization in the range of 1-100 billion USD, not just in the United States, but from around the world. We look at our standard tests to consider if NTAP is worth investing for our technology strategy as either a growth or a value stock.
What does NetApp do? Data storage, particularly flash private cloud.
Founded in 1992, when George Bush Senior was planning his reelection bid, NetApp is a grand old dame of data storage. The classification as a hardware company may seem harsh with software management of data storage vital, particularly in these days of hybrid cloud. However, hardware sales are still a key component of NetApp's pitch as a hybrid cloud provider, linking and balancing LAN and WAN storage to the public cloud.
The key to NTAP is whether it can restart growth. A technology company with declining sales is a dead man walking, even if that decline is profitable and gentle. The demand for data storage is far from declining with an explosion of need from Internet of Things, healthcare research, data mining, artificial intelligence and more.
Test 1: Growth - Can a mature firm restart growth?
Spoiler alert, NetApp doesn't meet the growth metric. Let's look at the long-term figures. Now 28 years old, NetApp is struggling to recreate the stellar growth from 2001-2010 in the face of increasing cloud based competition.
Source: CGP Asset Management
It is useful to know that NetApp's fiscal year starts around the 1st of May each year. This means the company has already reported fiscal Q3 2020 figures for the period ending 24 January 2020. So we don't have a time machine sadly.
Anyway, let's look at more recent quarterly numbers to see what we can elucidate about more recent trends.
Source: CGP Asset Management
Growth was gentle but present until early calendar 2019 when fiscal Q4 2019 disappointed and afterward a noticeable easing has commenced. Management blamed the decline on less ELAs, which are enterprise software license agreements with large companies. These were the strength of fiscal 2019 but that is no longer true.
While NTAP might not be growing much at the moment, it still has a solid profit making ability, so let's have a look at that more deeply.
Test 2: Profitable or heading that way
Being a consistent cash machine is what most investors want and NTAP has a steady history of profits. The first two figures show NTAP is profitable, but here is net income 2009-2019 to focus on the issue.
Source: CGP Asset Management
The last few years have shown considerable volatility in earnings that is worth understanding. Here are some quick notes:
- 2018 was artificially lower because it included a tax allowance of $1.09 billion, an increase of $934 million over 2017 due to changes in legislation.
- 2019 was indeed a strong year with strong sales growth until Q4.
- 2020 sales, which aren't in the figure above, have declined over the previous year and on current tracking likely to be around the $600-800 million figure depending on the impact of COVID-19.
Test 3 and 4: Sustainable Competitive Advantage and Total Addressable Market
It makes sense in this case to combine these tests as the answers are related.
Does NTAP have a sustainable niche or is market share being lost to other players? The market is quite competitive with a range of different players. Here is market share for 2019 where you can see NTAP was steady in the 7-10% depending on results for specific quarters.
Source: IDC
The public cloud has taken all the growth from private cloud vendors.
Although NetApp has a strong market share in its segment, things aren't that simple. Despite rising shipments of capacity, spending was essentially flat in 2019 over 2018. The reason is the public cloud continues to grow with shipments of storage growing 38% in 2019 Q4 over 2018.
This is particularly true for the largest scale cloud players like Amazon (AMZN) Web Services (AWS), Microsoft (MSFT) Azure, Google (GOOG) (GOOGL) cloud, as well as other public cloud players and data center operators. NTAP isn't benefiting from this growth. The good news is Nutanix (NTNX) and Pure Storage (PSTG) aren't benefiting either, but this isn't much comfort.
Software defined storage is possibly the biggest threat. A completely commoditized hardware storage sales could destroy margins.
Software defined storage is possibly an even bigger threat than the public cloud in that it risks commoditizing storage hardware and destroying margins. Competitors in this space can be any innovative software company and include competitors such as VMware (VMW) and Red Hat (IBM), which are often the first names you find that are pushing a hybrid cloud solution.
These software players can innovate freely without the risk of cannibalizing a legacy hardware business. Red Hat, see figure below for example, pitches lower costs and no vendor lock-in for storage hardware. What is NetApp's advantage against such vendors?
Source: Red Hat
So you could argue that:
- NTAP has a consistent position short term. NTAP has a steady position in external storage systems despite competing against several much larger companies with wider product offerings.
- TAM isn't growing. The market segment NTAP targets isn't growing because growth in sales for storage is being directed to the public cloud.
- Risks abound long term. Storage growth is being directed to public cloud and software defined storage vendors are threatening to commoditize hardware for the private cloud destroying margins.
Test 5: Management
The gentle decline of NTAP's balance sheet is accelerating.
Paying out more in dividends and buybacks is not the route to a strong balance sheet. Any REIT investor will tell you that a sustained payout ratio of excess of 100% is a big red flag, but that is what we see with NTAP. Steady dividends look sustainable, but the growth in share buybacks has been a remarkable drain on cash, frequently exceeding cash flow from operations by a considerable margin in recent quarters.
Source: CGP Asset Management
Put another way, here is the payout ratio, which is heading up and is now averaging above 150% of operating cash flow. For quarter 2 of fiscal 2020, which had negative cash flow from operations, we have entered 100% because -1,130% is quite meaningless, so ratios could have been even worse.
Source: CGP Asset Management
Dividends, buybacks and operating cash flow are far from the only elements of a cash flow, so it is quite possible there is more to the story. So let's look at a more bottom-line number that shows the combined impact of gently increasing debt and steadily declining assets - shareholders' equity. That's a firm trend.
Source: CGP Asset Management
Most damning is that high distribution levels usually show management lacks growth ideas. That seems true here too.
Of course, shareholders' equity can be buffed artificially, but here we think it is a fair reflection of reality. Fortunately for NTAP management and shareholders, their starting point before all this started was a strong financial position with plenty of capital.
If you're not growing, you're dying.
Still, NTAP isn't yet in a hole with around $3 billion in cash and short-term investments on the balance sheet at end of fiscal Q3 2020. It has, however, steadily depleted its big asset pile by payouts to shareholders. If this continues, it will reduce options, say to buy strategic assets, for the company in future. It is revealing that management's hottest new growth idea is employing 200 new salespeople in 2020.
Debt is not a mountain, but no longer a molehill.
NTAP doesn't have high debt levels with only $1.14 billion and servicing costs well under control. But given the steady cash production and lack of investment opportunities, borrowing to fund share buybacks feels a lazy way for management to improve earnings per share without actually doing anything to improve business fundamentals.
Source: NTAP Q3 2020 10-Q
Test 6: Valuation
Valuation is the strong ground for NetApp.
- Historical PE of 10-11. Around 10 is usually a good guide of value.
- Dividend yield of 4.5%.
Interestingly, NTAP's stock price isn't much above its level of 10 years ago despite spending $8.8 billion in shareholders funds on buybacks since 2012.
Data by YCharts
There is a good argument to say that NetApp should recover to a stock price in the mid-$50s which is 20%, at least in the short term.
The figure below shows clearly that in the short term, NetApp is likely to regain ground based on valuation and yield to to mid-$50s, and $60 per share isn't impossible; a good firm dividend yield, buybacks, fair valuation and possibly a short-term boost from COVID-19 spending should see to that.
Data by YCharts
Bottom line
Many investors can't ignore a 4.5% dividend yield and the potential capital gain of 20% for a steady looking company. However, we prefer to allocate capital to companies with stronger growth and futures.
- Short-Term Traders: NetApp might rebound 20% in the short term due to valuation and solid yield of 4.5%.
- Long-Term Investors: Look elsewhere, this is a value trap due to declining shareholder value, stagnant sales and little growth prospects.
This article was written by
Analyst’s 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
Recommended For You
Comments (7)
