Wednesday, September 26, 2012

NetApp Looks Good Value

Shares in NetApp $NTAP suddenly became very interesting after a set of results that could be described as stabilizing. I realize my description is not going to excite anyone but what you have to understand is that NetApp’s evaluation is so cheap right now that all it has to do is demonstrate some stability and market share retention and the stock is likely to go higher. Furthermore, it is a small player, with a decent market share in a competitive market. I think it is a strong takeover target.

What’s Special about the Evaluation?

Unusually, I am going to start with the evaluation.

With a current price of $33 the stock trades with a market cap of $12.1bn but has around 40% of it in net cash and cash-like instruments on the balance sheet. This means its enterprise value is only $7.52bn and moreover the business is highly cash generative. For example, in the year to April 2012 the company generated $1.06bn in free cash flow and its target is to average 19-21% of its revenues in free cash flow for 2013-15. A quick look at analyst estimates for revenues gives free cash flow for 2013 & 2014 to average $1.33bn.

Let me put this into the context of a potential bidder.

If a competitor like say IBM $IBM where to come along and bid for NetApp and pay an assumed 30% premium it would pay $15.73bn. Strip out the 4.6bn in net cash and this comes to $11.15bn. Now assume NetApp generates $1.3bn in a year, this means that a year from now IBM would have effectively paid $9.85bn. If NetApp generates another 1.3bn in free cash the next year, the company would stand on an effective free cash flow yield of 13.1%. And none of this assumes any synergy effect of adding their market shares together (both are in the mid to low teens) in order to get to something close to EMC $EMC market share.

Attention will obviously focus on IBM because the other two leading storage players, Hewlett Packard $HPQ and Hitachi, are not exactly in a position to go out making acquisitions right now. However, another potential suitor is Oracle $ORCL  perhaps NetApp’s partner Cisco Systems $CSCO? Oracle $ORCL is interesting because it has the cash, an acquisitive nature and complementary products to storage solutions. Oracle is a long time partner and Larry Ellison is on record as thinking buying NetApp is a possibility.

If all of this sounds too good to be true, then it probably is. There are a lot of questions to be answered about NetApp’s competitive positioning and no one (investor or business acquirer) wants to buy a business in decline.

How Where the Latest Results?

As Einstein pointed out, it’s all relative isn’t it? In the previous results NetApp had given guidance which was horribly below market estimates and the stock got hit hard. It guided towards a midpoint with a 15% sequential decline, when the traditional decline to fiscal Q1 is around 10%. Moreover it declined to give full year guidance either then or at the analyst day in June. Europe, global public spending and a weak financial vertical were all blamed and visibility was seen as low. Now that is how to downgrade expectations! Estimates were slashed.

Of course, when you have downgraded expectations it is that bit easier to beat them. NetApp duly came in with the 15% sequential decline in Q1 but beat market estimates on EPS. Furthermore, I note that IDC Storage Tracker had NetApp taking market share over IBM in the last quarterly report given in June. Indeed, the guidance that NetApp gave for Q2 was for a much more normalized sequential revenue movement. These are all good signs and analysts are generally positive about the launch of ONTAP 8.1 and ramping of growth in other areas.

On a more negative note, product revenues were down 7% and as this is the key to future growth, cautious investors might want to see some stabilization in these numbers before piling in. In stark contrast to NetApp, EMC reported product sales up 4.4% on the year and up 3.6% sequentially. It’s hard not to conclude that EMC aren’t taking market share and it will be interesting to see what HP reports in its storage segment.

Where Next For NetApp?

This is definitely a stock for value investors with a stomach for risk. The reduction in guidance in the last quarter took everyone by surprise but to be fair, NetApp hit the revised guidance so it’s reasonable to expect it to do the same in the next quarter. The evaluation is cheap and if NetApp can demonstrate a bottoming out of product sales then I suspect it will be higher in future. Definitely one to watch.