Why NetApp’s Stock Is Worth $28

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NetApp

NetApp (NASDAQ:NTAP) has seen weak demand for storage hardware over the last few years, corresponding to weak IT spend across the globe. NetApp’s storage product revenues have consistently fallen over the last four years, a trend observed by many large IT hardware, telecom hardware and storage hardware vendors. Competing storage systems manufacturers EMC (NYSE:EMC), Hewlett-Packard Enterprise (NYSE:HPE), Hitachi Data Systems and IBM (NYSE:IBM) have also witnessed low demand for storage hardware. As a result, storage systems manufacturers are shifting their focus to fast-growing market domains such as flash-based storage arrays or converged systems (which include servers, storage and networking equipment in one box) or software-defined storage to stay relevant. Moreover, it has become imperative for hardware vendors to enhance their focus on software solutions and post-sales hardware maintenance & services given that they are higher-margin businesses and have had high customer demand over the years.

Below we take a look at key growth drivers for the company that justify our $28 price estimate for NetApp, which is around 15-20% lower than the current market price. NetApp’s stock price is up by over 30% since the beginning of the year.

See Full Analysis For NetApp Here

Stagnation In Product Sales

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Storage vendors are increasingly facing competition from so-called White Box storage vendors. Over the last few years, customers are shifting preference to low-cost original design manufacturer (ODM) storage boxes, which is cutting into the addressable market for large vendors. As a result, NetApp’s share in the external storage systems market has fallen from over 13% in 2013 to 11.1% in 2015. This trend could continue in the coming years with smaller vendors gaining share from large manufacturers.

Low product sales have led to discounted selling prices, which ultimately drove down product margins significantly. The adjusted gross margin for the product division has fallen from under 55.6% in 2011 to around 50.3% in 2015. This could further fall to around 47.3% in 2016.

ntap_serv1

Hardware Maintenance & Other Services

NetApp’s top line growth since 2011 has been driven by two of its non-product divisions, namely Hardware Maintenance & Services and Software Maintenance. Hardware maintenance and support includes installation of new storage solutions, post-sales services for storage hardware and software products to ensure that they are compatible with clients’ IT systems and architecture and helping clients achieve technology transitions and migrations. Additionally, professional services and client education includes training services for clients and monitoring of clients’ storage architecture. This division reported 9% annual growth in revenues to $1.6 billion in 2015. As a result, hardware maintenance as a percentage of storage hardware revenues has increased from 28% in 2011 to over 48% in 2015. We forecast this figure to increase to over 65% by the end of our forecast period as services become more relevant in the storage business and hardware sales stagnate.

In addition to driving the top line, the hardware maintenance and services division has also contributed positively to improving the company’s profitability. The product division’s gross margins fell by over 5 percentage points from 2011 through 2015 due to pricing pressure from smaller vendors. On the other hand, the services division’s gross margin improved by over 5 percentage points. [1] In the long run, the services division could continue to become more profitable for the company as a large aggregate client base could lead to a higher refresh rate for maintenance contract renewals. We forecast the hardware maintenance gross margin to improve to nearly 70% by the end of the decade as shown in the table below.

ntap_serv2

In terms of operating efficiency, the company has made efforts to reduce its cash operating expenses over the last few quarters. This has resulted in lower sales & marketing and research & development costs through fiscal 2016. Additionally, NetApp’s management indicated that it will cut 1,200 jobs by July, which is roughly 12% of the company’s total workforce. [2] This should help reduce operating expenses in future quarters. The company further expects an operating margin of around 13.5% in the coming quarter, an improvement from around 11-12% in previous quarters. [3] As a result of a positive set of Q1’17 results and robust guidance for future quarters, NetApp’s stock jumped 15% the day after its earnings release to around $33. [4] However, the sustained weakness in NetApp’s core product division and over-dependence on one revenue stream could be a risk going forward. As a result, we maintain our $28 price estimate for NetApp’s stock. You can modify the interactive charts in the article above to see how much the change in individual drivers such as gross margins or market share impacts the price estimate for NetApp’s stock.

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Notes:
  1. NetApp Reports First Quarter 2017 Results, NetApp Press Release, August 2016 []
  2. NetApp To Slash 12 Percent Of Workforce, Fortune, February 2016 []
  3. NetApp Q1’17 Earnings Call Transcript, Seeking Alpha, August 2016 []
  4. NetApp shares surge after easily topping earnings expectations, CNBC, August 2016 []