NetApp’s Recent Stock Rally Appears Overdone

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NetApp

NetApp (NASDAQ:NTAP) has had a solid year thus far, with strong results through the first three quarters of the year. NetApp’s all-flash storage product line has witnessed robust demand, leading to significant revenue growth through the year. In the most recent quarter, NetApp’s net revenue, gross margin, operating margin and EPS beat guidance. Furthermore, the company gave solid guidance for the current quarter.

We have a revised $44 price estimate for NetApp, which is around 20% lower than the current market price. NetApp’s stock price jumped from $46 to $54 after the company announced strong Q2 FY’18 results earlier this month. Below we take a look at key areas of growth for the company and our forecasts for them.

See our complete analysis for NetApp

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What Drove Growth For NetApp

This strong performance was driven largely by strength in product sales combined with a higher mix of flash products (which have typically higher margins) in recent quarters. NetApp’s strategic storage makes up roughly 70% of product sales. Storage product sales were up by 12% year-over-year to $2.4 billion this year. Within the product division, strategic product sales (including sales for products such as the all-flash array) rose 23% on a y-o-y to over $1.6 million, while mature product sales were down 7% to $730 million. As shown in the table below, revenue growth has come from product sales rather than the software maintenance or services business this year.

As a result of increased product sales, NetApp’s share in the storage systems market has risen this year. According to data compiled by IDC, NetApp’s market share has improved from 11.2% in the first half of 2016 to 13.5% through the first two quarters of 2017. We forecast NetApp’s market share to eventually increase to over 15% through the end of our forecast period.

With product revenues rising significantly, both hardware and software maintenance revenues suffered – a trend likely to accompany the increase in product sales in future quarters as well. Hardware maintenance revenues were down 4% to $917 million. Software maintenance and professional services revenues were roughly flat over the comparable prior year period, as shown above.

An increasing mix of strategic products, which include certain high-margin flash storage products, has driven product gross margins higher. NetApp’s non-GAAP product gross margin has improved by almost 3 percentage points this year. This is the first time since 2014 that product gross margins have improved. We forecast margins to improve through 2018 and stabilize going forward.

In addition to the product division, both maintenance divisions reported an improvement in gross margins, as shown below.

Furthermore, improved operational efficiency this year led NetApp’s operating income to increase 44% on a y-o-y basis to almost $790 million. This was attributable to cost reduction measures primarily by reducing headcount. As a result, NetApp’s operating margin improving by 5 percentage points through the year. Resulting diluted earnings per share stood have also risen by over 40% this year, beating analyst estimates.

According to consensus estimates, NetApp’s EPS for the current quarter is expected to be around 12% higher on a y-o-y basis at 91 cents a share, in line with the company’s guidance. NetApp’s revenues growth and margin improvement is expected to continue in the near term, but we remain conservative in our estimates since we expect the impact of product refresh to normalize by the end of next year. You can modify the interactive charts in this note to gauge how a change in individual drivers can have on our price estimate for NetApp.

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