Why Buying NetApp Now Makes Sense
Feb 19th 2013 5:00PM
Updated Feb 19th 2013 6:06PM
Over the past three months, shares of NetApp are up almost 40% since reaching a low of $26.26. Ordinarily, this would imply that new investors are late to the party. However, despite this gain, the stock is down 13% over the past 12 months. While NetApp is still a dominant force in the realm of data storage -- aka big data -- there are increasing concerns that the company can't ever overtake rival EMC . But it doesn't have to. The market has proven that it can support more than one leader. And after a solid Q3 report, there are signs that NetApp is poised for more gains.
Netting out a solid third quarter
Considering what has been a broadly soft earnings season for tech, NetApp investors weren't expecting much, especially given IBM's roughly 1% revenue decline. But NetApp delivered the goods. Revenue arrived 4% higher year over year and 6% sequentially. These are not breathtaking numbers, but sales showed good acceleration from Q2's 2% growth. Product revenue was down slightly by 18 basis points, but advanced 6.5% from the prior quarter.
As expected, U.S. public sector revenue was down from the prior quarter, but was up 14% year over year. Likewise, branded revenue advanced 8%. Although this was not stated by management, it looks as if the growth in branded revenue inhibited the progress of product revenue. Regardless, the net effect is still the same; no reason to raise eyebrows. But it will nonetheless be encouraging if NetApp can reverse the trend in the fourth quarter.
There were some mixed results on the operating side. Although non-GAAP gross margin of 60.4% was consistent with management's prior guidance, 53.1% posted in product gross margin was softer sequentially. Management attributed this to a shift in customer mix. Meanwhile, service gross margin advanced 1% sequentially, helped by lower costs. Operating income was impressive, up 8% year over year and 25% sequentially.
Need more "attack" and less "preserve"
It was clear that the company showed a focus on profitability and, in particular, cost management. To that end, operating margins of 17.1% arrived better than management expected, helped by a drop in operating expenses. While NetApp deserves credit for this, I do wonder how long can it keep costs down and still work to grow market share. While IBM is showing some signs of struggle, there will be a point when enterprise spending recovers. And NetApp needs to prepare for attack mode.
The company will need to distinguish itself -- if not from EMC, certainly from IBM. I think management understands the opportunities that lie ahead. However, NetApp guided a bit conservatively. Fourth-quarter revenue is expected to arrive between $1.7 billion to $1.8 billion. This presumes roughly 7% sequential growth and 3% year-over-year growth. Although competition plays a major role in this outlook, investors should expect NetApp to be an outperformer going forward.
Although I've cited IBM as a slight threat in the storage business, there's also Hewlett-Packard and Dell, both of which have been active seekers in the storage market. But both are fading, especially HP, which reported a year-over-year drop of 13% in storage revenue in its fourth quarter. And the company has stated recently that it expects every segment to suffer revenue losses except software. In other words, HP has very little chance to overtake NetApp.
Meanwhile, there's Dell, which recently posted a 16% storage decline in Q3. The company has not been much of a threat ever since it stopped reselling EMC gear in favor of its own "converged" solution. Chances are Dell won't be announcing a sudden uptick in demand. But we'll find out soon enough when it reports Q4 results today after market close. If you consider that IBM posted a 5% decline, this leaves NetApp and EMC as the two most logical options in what has now become a duopoly.
Too good to pass up
Past talks about NetApp's competition should be over. Likewise, valuation concerns should be history. Even though NetApp still trades at a P/E that's 7 points higher than EMC, NetApp does not have to face significant margin pressure -- at least, not anymore, given that three rivals are quickly vanishing. While this makes NetApp an intriguing buy opportunity, the company's now a compelling buyout candidate.
The first name that comes to mind is Oracle. "Database Giant Acquires a 'Big Data' Company": The perfect headline would bring perfect synergy. Plus Oracle can then leverage its recent acquisition of Acme Packet. For now, investors can't pass up 6% long-term revenue growth and 7% free-cash-flow growth. Add the fact that management announced a share buyback that is three times more than Q3, and what's not to like?
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The article Why Buying NetApp Now Makes Sense originally appeared on Fool.com.Fool contributor Richard Saintvilus has no position in any stocks mentioned. The Motley Fool recommends Acme Packet. The Motley Fool owns shares of EMC, International Business Machines, and Oracle. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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