Network Appliance (NTAP) is a data storage company that takes standard hardware (disk drives), adds proprietary software and creates a high value technology. They devised and commercialized a type of storage called Network Attached Storage that dramatically lowered the cost of data storage systems for businesses. Their main competitor is EMC (EMC) who dominates the market for a higher end storage product called SAN. Over time (15 years), NetApp has rounded out their product line and has transitioned from a role as the scrappy underdog to an industry incumbent.
They are the growth leader in an industry with natural growth. Their customers include companies like Yahoo! (YHOO) and the Federal government.
The leadership team has been more or less intact since their IPO over ten years ago. They have executed, executed and then executed again.
Some people owned the stock on and off again for almost as long for a variety of reasons, not all of which include rigorous investment analysis. Bought in 1998, sold some on meteoric rise to dot-com bubble top, sold the rest on the way down, bought some after the crash, sold some last year. They were always uncomfortable as NetApp was a true growth stock - little revenue but the promise of riches "some day". Most of the investors think of themselves as a passive investor first, value investor second and growth investor almost never. Fortunately, the company is now at a place where they can evaluate it using their “value” hat.
Wall Street has been and is obsessed with this company's margins and precise revenue growth rates. The company has repeatedly told Wall Street to go to h*** and has done whatever they thought was in the best interest of the company over the longer term. If that meant hiring a lot of sales people who wouldn't produce sales for a quarter or two, so be it. Time and time again, the wisdom of the company's decisions has been proven.
When a valuation hangs on a 20% growth rate, a couple % up or down can make a huge difference in the current price.
The reality is that company sales and profits will almost surely continue to grow. The natural growth in storage helps. A big pickup in demand overseas should more than make up for what will be a tough period selling into the financials, their second largest vertical. They have developed new sales channels that continue to widen the sales effort. They have products at many different levels so in countries that are growing they can capture move up buyers and in hurting industries they can get the move down buyer.
At this point in time, however, talk about whether growth will be 25% or 15% (great or merely really good) is missing the forest for the trees. The stock is so cheap that the company could have no growth over the next 5 years and it wouldn't matter.
Cheap is never a word they thought they would utter in the same breath as NetApp. But it's true.
Wall Street has been so busy being prissy about a point of margin here or there and the generous stock options offered to employees that it has failed to notice that the company has become a cash cow.
Over time, because of the intersection of accounting policies and a change of sales mix behind its revenue, NetApp is recognizing less and less of its income upfront and in combination with its explosive growth, the story of its profitability is not in its net income numbers but in its free cashflow results.
GAAP income numbers include all sorts of accounting adjustments like depreciation and amortization. Sometimes these allow companies to dramatically overstate true profitability (e.g. Enron) and sometimes these underestimate earnings.
For most companies, the number that shareholders should care about is a metric called "free cashflow". This tells you how much money, after making necessary capital expenditure, is available to either payout to shareholders or make new investments. Cash IS king.
And when it comes to cash, NetApp is a member of the royal court.
Looking at P/E, NetApp is still a growth stock and the growth metrics matter. Using free cashflow as the valuation metric tells another story. Using the numbers the company gave today, $233 million, and currently depressed share prices, Network Appliance is trading at just over 8x free cashflow. This is a valuation for a distressed company, not an industry leader growing like hotcakes.
How can this be?
The story is mostly in the shift of the company towards more revenue from software and service contracts. This is great business, but accounting rules require most of the revenue to be reserved and recognized over a couple of years.
This has meant that the published revenue numbers are not meaningful by themselves, particularly if you are interested in the growth rate of the business, which is all that Wall Street has cared about since the beginning of time for this company.
You have to do some manipulation to figure out what are revenues from newly booked business. You start with published revenues, subtract out revenues released from reserves and add back new deferrals. The situation gets particularly confusing since the new lines of business are more subject to deferral than the older lines. According to the calculations I have done, GAAP revenues broken down by product line dramatically underestimate the role of the more profitable service and software sales within the business.
And if you are concerned about margin numbers, forget about it. With deferred revenue, most of the costs are booked upfront so this wreaks havoc with profitability ratios.
In this graph, shown the traditional profitability ratio of net income as a percentage of revenues versus an adjusted number where they use free cashflow instead of net income and they adjust up revenue for increases in deferred revenue. Using the adjusted metric, net margins are over 20%, instead of 10%. In addition, instead of falling off, margins have improved.
NetApp’s management has clearly tried to refocus attention on cashflow metrics and be clear that projections for growth in GAAP revenue numbers offer little insight into the true state of the business, without that much success.
Okay, NetApp is cheap. Why should that change?
Insider stock sales have noticeably come to a halt and the company has been buying back huge amounts of its own shares (8% of shares over the last 9 months!). More of the deferred revenue will start to show up in revenue numbers and the size of deferred revenue should start to stabilize.
Market sentiment could change fairly soon about the company, or it could not. In the meantime, though, the most likely scenario is that the company keeps making money, keeps growing and keeps buying back stock. From that perspective, having the analyst community take some time to come around might be a positive.
There are risks. There are the typical risks with any individual company – strategic snafus, top management departures, loss of market share. There are the risks of economic downturn. In a stock market meltdown, anything could happen.
There are risks specific to NetApp. Most obviously, they are in the middle of a very public food fight with Sun over patents and technology [NetApp’s side of the story / Sun's version].
US financial companies are a big piece of NetApp’s revenues and this sector will be weak for sometime. The company was very upfront that it expects orders to be quite weak from this portion of the market, as they were last quarter. Still, according to company estimates, financials are only 12-13% of NetApp’s business. Last quarter, which included credit crunch time, revenues from NetApp’s top enterprise customers fell 4%. You could have orders from the banks fall by 50% and overall growth rates of adjusted revenues would still be in the 20%+ range because growth overseas and a broadening of their sales base in North America through sales partnerships should more than compensate for any amount of weakness in Wall Street’s budgets.
And remember, NetApp is a value company, not a growth company, so who cares if revenue growth is “only” 20%?
On balance, the potential rewards of buying a company of NetApp’s quality at the current valuation would seem to outweigh the risks.
Data from company SEC filings and Morningstar.com. Data and calculations are believed but not guaranteed to be accurate. TTM as of November 2007.
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