The Best Value Tech Stock in the Market?

Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

NetApp (NASDAQ: NTAP) is one of those stocks that splits investors. On the one hand it offers fantastic value prospects while also being a genuine takeover target. On the other hand, growth is weak, it is exposed to some difficult end markets (Government is a key vertical) in a highly competitive industry and there are long term questions over its business. It is an intriguing situation.

NetApp Looks Good Value

The value case for NTAP is simple. It has nearly a net $4 billion in cash and liquid assets on its balance sheet and a market cap of around $12.6 billion as I write. Furthermore, the business has annually generated around $1 billion in free cash flow for the last two years.  Indeed it aims to translate up to 20% of revenues into free cash flow. So if you are an existing storage player like IBM (NYSE: IBM) or even a tech company with a key partnership with NetApp like Cisco Systems (NASDAQ: CSCO) the attractions are obvious.

IBM could buy NTAP for say $15 billion and get hold of $4 billion in assets and then another $1 billion in a year’s time in cash flow. The deal would effectively only be at $10 billion; it would make a quantum leap up in market share and make it a significant threat to EMC’s (NYSE: EMC) market leading position. Given that the struggling Dell and Hewlett-Packard are also major players in storage, an observer would be entitled to think that this industry is headed for consolidation. Moreover, IBM is an OEM customer and actually has some products that overlap and compete with NTAP's own branded products.  A deal would remove that issue and give IBM some synergy from buying a vertical, although it’s not clear what IBM could do with NetApp’s other OEM customers.

As for Cisco, the company has the cash. It has the need for growth and it has recently expanded its partnership with NTAP in cloud service provider infrastructure. A quick look at Cisco’s recent results will confirm that bundling together solutions in this area is one of Cisco’s strongest growth drivers right now.

Tough End Markets, Trading Down?

I’ve no doubt all of the above sounds appealing--at least I hope so because it is tempting me--but investors need to brace themselves for some near term risk and some longer term existentialist questions.

Its government and European exposure is relatively high in the industry, and whenever a company reports strong results in the public sector these days the next question is usually, how much of your sales are you now going to lose? NetApp has made efforts to diversify from Federal spending, but there is only so much you can do, and while sequestration (and endless discussion of it) hangs over the market then doubts will persist with NetApp. It is a similar thing with its European exposure, and investors are very aware of what happens to tech companies when they miss earnings due to end market weakness.

On a brighter note, its branded business actually grew 8% in the quarter and made up nearly 88% of revenues in the quarter. The problem was with the OEM business, which declined 17%. There is not a lot NTAP can do if its customers are seeing declining market share, and we only need to look at what IBM, Hewlett-Packard and Dell are reporting to see that it is a tough industry to be in right now. EMC has been doing well but, rather like NTAP, storage is its core legacy business.

The other issue that management stressed was that sales cycles are lengthening and it is seeing more strength at the low end. These are usually early warning signs of a slowdown, and this is an industry with little visibility.

In summary, anyone buying the stock needs to be aware of short term risk. Indeed management is taking a downbeat tone over prospects even as its branded products are doing okay.

Where Next for NetApp?

Looking longer term, there are some questions. No one disputes that data is going to increase, and since data needs storage and storage management software then there is clearly long term demand in the industry. It’s branded products seem to be gaining market share and it is surely more committed to investing in the industry than say Dell or HP.

On the other hand, how will data be stored in the future, and are cloud offerings like Amazon likely to be competitors? Or what about NTAP’s argument that they could actually be helping it by building out an architecture that will create long term demand for on-premise storage and/or flash based storage?  This is a difficult question to answer right now, but you will need to take a view.

In conclusion, the stock looks very cheap but has some near term risks. In my view, it should not be bought for the long term unless you are comfortable with its industry prognosis. On balance I will stay out, but am looking out for any warning that could create a tactical opportunity.


SaintGermain has a position in IBM. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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