NetApp’s (NASDAQ:NTAP) stock price dropped by around 15% after the firm released earnings last week on Wednesday. The main factor behind investor concerns was the negative impact of reduced government spending on the firm’s top-line and the potential for margin compression in the back half of the year. (See NetApp Headed to $51 Though Macro Conditions Weigh on Growth) NetApp competes with firms like EMC (NYSE:EMC), IBM (NYSE:IBM) and HP (NYSE:HPQ).
We recently revised our Trefis price estimate for NetApp to $51.90 to account for the expected weakness in demand during second half of the year. While our price estimate for NetApp is still about 45% above the market price, we look at some downside scenarios that could justify as lower price estimate for NetApp.
Lower Demand to Negatively Impact Services Business Margins
We currently forecast increasing margins in NetApp’s storage hardware and support as well as its consulting business divisions in 2011 based on the following factors:
1) strong growth in NetApp’s margins year-to-date for 2011 across business segments,
2) improving product costs as well as operating efficiencies at NetApp, and
3) the absence of any indication of possible margin contractions in the firm’s earnings transcript release.
While improving product costs and operating efficiencies reduce the potential for margin contraction in NetApp’s storage hardware and storage software divisions, these might not be enough to prevent NetApp’s services margins from dwindling in the remaining part of the year.
The negative outlook on federal and financial services spend is more likely to weigh on margins for the services business where the services demand may dry up faster than the company can reduce costs.
Potential Downside Scenarios
In a scenario where NetApp’s Support and Consulting gross margin remains decline to 55% in 2011, down 2 percentage points from 2010 instead of increasing to 59% as we currently forecast, there could be just about 10% downside to our $51.84 Trefis price estimate for NetApp.
In addition to above, if gross margin for NetApp’s storage hardware division also remains flat at 56% in 2011 due to macro-economic factors, our NetApp price estimate would be pushed down to as low as $45, which is still around 20% ahead of the current market price.
Note: The margin figures for year 2011 are not modifiable in our Trefis widgets. The downside to our price estimates are calculated by changing the margins for 2011 in our underlying excel models.