February 13, 2015 NetApp, Inc. Current Recommendation Earnings Update: NetApp Reports Q3 Results SUMMARY DATA NEUTRAL Prior Recommendation Outperform Date of Last Change 08/19/2013 Current Price (02/12/15) $36.90 Target Price $39.00 52-Week High $43.69 52-Week Low $33.59 One-Year Return (%) -8.44 Beta 1.44 Average Daily Volume (sh) 2,841,937 Shares Outstanding (mil) 312 Market Capitalization ($mil) $11,500 Short Interest Ratio (days) 4.34 Institutional Ownership (%) 86 Insider Ownership (%) 2 Annual Cash Dividend $0.66 Dividend Yield (%) 1.79 5-Yr. Historical Growth Rates Sales (%) 11.5 Earnings Per Share (%) 13.4 Dividend (%) N/A using TTM EPS 16.2 using 2015 Estimate 16.2 using 2016 Estimate 15.1 Zacks Rank *: Short Term 1 3 months outlook 3 - Hold * Definition / Disclosure on last page SUMMARY Risk Level * (NTAP-NASDAQ) NetApp reported the third-quarter fiscal 2015 results wherein the bottom line matched the Zacks Consensus Estimate but the top line missed the same. Moreover, the company provided weakerthan-expected revenue guidance for the next quarter. We believe that uncertain IT spending outlook and competition from other players remain the headwinds. Continuous decline in OEM revenues also remains a cause of concern. Nevertheless, we maintain our long-term Neutral recommendation as the company is gaining momentum in flash-based solutions with the newly introduced all-flash array, which will help it to gain traction in the storage market. The recent product launches and product refreshes will drive revenues and stringent cost controls will ensure margin expansion. Below Avg., Type of Stock Large-Blend Industry Comp-Storage Dv Zacks Industry Rank * 107 out of 267 ZACKS CONSENSUS ESTIMATES Revenue Estimates (In millions of $) Q1 Q2 Q3 Q4 Year (Jul) (Oct) (Jan) (Apr) (Apr) 2013 1,445 A 1,541 A 1,630 A 1,717 A 6,333 A 2014 1,516 A 1,550 A 1,610 A 1,649 A 6,325 A 2015 1,489 A 1,543 A 1,551 A 1,611 E 6,211 E 2016 1,527 E 1,532 E 1,645 E 6,271 E Earnings Per Share Estimates (EPS is operating earnings before non-recurring items, but including employee stock options expenses) Q1 Q2 Q3 Q4 Year (Jul) (Oct) (Jan) (Apr) (Apr) 2013 $0.25 A $0.38 A $0.51 A $0.55 A $1.69 A 2014 $0.37 A $0.52 A $0.58 A $0.71 A $2.18 A 2015 $0.45 A $0.52 A $0.60 A $0.56 E $2.28 E 2016 $0.48 E $0.58 E $0.66 E $0.72 E $2.44 E Projected EPS Growth - Next 5 Years % 2 2015 Zacks Investment Research, All Rights reserved. www.zacks.com 10 S. Riverside Plaza, Chicago IL 60606
RECENT NEWS NetApp (NTAP) Q3 Earnings In Line, Revenues Lag; Soft View Feb 11, 2015 NetApp posted third-quarter fiscal 2015 results wherein its bottom line matched the Zacks Consensus Estimate but the top line missed the same. The company s adjusted earnings (including stock-based compensation but excluding amortization and other one-time items) of $0.60 per share came in line with the Zacks Consensus Estimate, improving year over year. Quarter Details NetApp s revenues decreased 3.6% year over year to $1.55 billion and missed the Zacks Consensus Estimate of $1.61 billion. The year-over-year decline was primarily due to a 21% drop in original equipment manufacturer (OEM) revenues. Moreover, Branded revenues decreased 2% from the yearago quarter to $1.43 billion. On an operating segment basis, Product revenues (60% of total revenue) decreased 8.4% from the yearago quarter to $929.5 million. Software Entitlement & Maintenance revenues (15%) were almost flat year over year at $226.6 million. Nonetheless, Service revenues (25%) increased 7.4% year over year to $395.2 million. Within Service revenues, hardware maintenance support contracts revenues increased 10.4% from the year-ago figure, which more than offset the decline in revenues from Professional & Other Services (down 3% year over year). The company witnessed strong demand for its storage operating system Data ONTAP and flash solutions. Arrow Electronics and Avnet contributed approximately 22% and 16%, respectively, to net revenue. Adjusted gross margin (including stock-based compensation but excluding amortization and other onetime items) expanded 110 basis points (bps) from the year-ago quarter to 64.2%. The improvement came primarily on the back of higher service gross margins. Adjusted operating expenses (including stock-based compensation but excluding amortization and other one-time items), as a percentage of revenues, increased 180 bps to 49.9%. Operating margins (including stock-based compensation but excluding amortization and other one-time items) contracted 70 bps to 14.3% from the year-ago quarter, as the benefit of increased gross margin was more than offset by higher operating expenses, as a percentage of revenues. Net income (including stock-based compensation but excluding one-time items and related tax effect) came in at $190.7 million compared with the year-ago figure of $203.7 million. Balance Sheet & Cash Flow NetApp exited the quarter with cash, cash equivalents and investments of $5.25 billion, compared with $5.27 billion in the previous quarter. Receivables were $666.3 million versus $632.7 million in the last quarter. The company has a long-term debt balance of $1.49 billion. NetApp generated cash from operations of $274.6 million compared with $381.4 million in the earlier quarter. During the quarter, the company repurchased stocks worth $200 million and paid $51.4 million as dividend. Guidance Equity Research NTAP Page 2
For the fourth quarter of fiscal 2015, NetApp expects revenues in the range of $1.55 to $1.65 billion (midpoint $1.60 billion). Management expects non-gaap earnings per share to come between $0.70 and $0.75. VALUATION NetApp s shares are currently trading at 16.2X TTM earnings, a discount to the industry average of 22.4X and to the S&P 500 average of 19.0X. However, it is trading below the mid point of the historical range of 15.9X to 36.3X TTM earnings, which indicates possibility of upward movement from the current level. Moreover, the shares are trading at a discount based on our fiscal 2015 forward estimates. The current 3% discount to the industry average for fiscal 2015 is lower than the average discount for the historical period of 30.7%, which indicates possibility of downward movement. Given the mixed signals, we expect the shares to remain range-bound in the near term. Thus, we initiate our coverage on NetApp with a Neutral recommendation and set a price target of $39.00. Key Indicators F1 F2 Est. 5-Yr EPS Gr% P/CF 5-Yr High 5-Yr Low NetApp, Inc. (NTAP) 16.2 15.1 10.4 12.0 16.2 36.3 15.9 Industry Average 16.7 43.9 14.5 14.4 22.4 111.5 15.0 S&P 500 16.5 15.4 10.7 15.1 19.0 19.4 12.0 Seagate Technology Public Limited Company (STX) 12.3 11.2 8.0 7.5 11.9 16.5 3.0 Western Digital Corporation (WDC) 12.7 11.7 9.5 7.8 13.0 13.6 3.8 Teradata Corporation (TDC) 18.9 16.8 7.5 11.4 16.5 30.9 15.2 Super Micro Computer, Inc. (SMCI) 19.7 17.8 15.0 29.1 22.8 37.5 12.9 TTM is trailing 12 months; F1 is 2015 and F2 is 2016, CF is operating cash flow P/B Last Qtr. P/B P/B ROE D/E Div Yield 5-Yr High 5-Yr Low Last Qtr. Last Qtr. NetApp, Inc. (NTAP) 3.5 6.2 2.2 20.2 0.4 1.8 7.7 EV/EBITDA Industry Average 3.9 3.9 3.9-22.1 0.3 0.4 2.6 S&P 500 5.3 9.8 3.2 25.5 N/A 2.1 N/A Equity Research NTAP Page 3
Earnings Surprise and Estimate Revision History NOTE THIS IS A NEWS-ONLY UPDATE; THE REST OF THIS REPORT HAS NOT BEEN UPDATED YET Equity Research NTAP Page 4
OVERVIEW California-based NetApp, Inc. (NTAP) provides enterprise storage and data management software and hardware products and services. The company s product line comprise two storage platforms FAS storage platform and E-Series platform. FAS Storage Platform is based on the NetApp Data ONTAP operating system, which combines storage efficiency, data management and data protection. The FAS product line includes FAS6200, FAS3200 and FAS2000 series. The E-series platform helps in the deployment of Hadoop Big Data infrastructure. The E-series product line comprises EF540 Flash Array and the recently introduced EF550. Leveraging these solutions the company addresses both the Storage Area Network (SAN) and Networked Attached Storage (NAS) markets. A networked storage necessarily provides external data repository that can be shared through LAN, thus freeing local storage space. Also, network storage also supports automated backup programs that prevent data loss. The company also offers support, consulting and training services. The company markets and distributes products worldwide through a direct sales force, value-added resellers, system integrators, original equipment manufacturers and distributors. NetApp derived 62.3% of fiscal 2014 revenues from Products (down 4% year over year), 14.5% from Software entitlements and maintenance (up 2% year over year), and 23.2% from Service (up 9% year over year). During fiscal 2014, NetApp had two 10% plus customer, Arrow Electronics and Avnet Inc, who accounted for 22% and 16% of total revenue respectively. On geographical basis, NetApp derives 56% of revenues in fiscal 2014 from Americas (United States, Canada and Latin America), 31% from Europe, Middle East and Africa (EMEA) and the rest 13% from Asia Pacific (APAC). NetApp faces stiff competition from Dell, EMC, Hitachi Data Systems, Hewlett-Packard, International Business Machines Corp and Oracle Corp. REASONS TO BUY NetApp is expected to gain from the shift from traditional dedicated storage to shared storage in virtualized IT infrastructures. The company is gaining traction in the network-attached storage (NAS) market. Enterprises are shifting to NAS primarily due to its easy deployment capabilities and support for several networking environments. Other advantages includes regulatory compliance needs, tremendous growth in digital data due to shift of legacy and media content to digital formats and general IT trends such as server virtualization, need for improved efficiency of storage devices and data center consolidation. NetApp s Data ONTAP software supports storage area network (SAN) and NAS environments and is compatible with various operating systems such as UNIX, Linux, Windows and web environments. This omni-compatible nature remains the key point for its rapid adoption. NetApp has initiated a restructuring plan, in March 2014, which entails downsizing the workforce by 4% which is expected to be complete by the second quarter of fiscal 2015. The company will realign its business and invest in strategic initiatives that will help it to mitigate the pricing pressure and soft sales encountered due to constricted IT spending and lower demand from U.S. Federal agencies. This initiative is expected to reduce operating costs and boost profitability in the weak demand environment. Equity Research NTAP Page 5
NetApp is seeing higher demand for its flash-based solutions. In the last reported quarter (first quarter of fiscal 2015) shipments of all-flash arrays, EF and all-flash FAS products increased 48% year over year. Moreover, with IT organizations increasingly preferring the flash based storage systems, due to its cost effectiveness, faster speeds in read and write tasks, NetApp with broad portfolio of arraybased flash solutions should be able to capitalize on this opportunity. NetApp s strong operating cash flow of $215.5 billion, reported in the first three months of fiscal 2014, has helped it to return cash to investors. As of Jul 25, 2014, NetApp paid $53.4 million through dividends and bought back shares worth $118.9 billion. These shareholder-friendly initiatives not only instill investors confidence but also boost earnings. REASONS TO SELL NetApp s original equipment manufacturers (OEM) revenues have been on a decline. In the last reported quarter (first-quarter fiscal 2015), OEM revenues declined 22.7% on a year-over-year basis as OEM customers such as IBM, Teradata, Fujitsu, etc., are developing their own product lines or are reacting to the weak demand environment. Revenues from OEMs account for approximately 10% of the total revenue. NetApp is heavily dependent on sales through indirect channels, value-added resellers, systems integrators, distributors, OEMs and strategic business partners, which account for approximately 79% of revenues. Among them, sale through distributors Arrow Electronics, Inc. and Avnet, Inc. account for roughly 22% and 16% of revenues (first three months ended fiscal 2014), respectively. Thus, loss of any key customers, resellers or distributors could affect the company s overall results. NetApp faces intense competition from bellwethers such as Hewlett-Packard, Dell, International Business Machines and Oracle. These companies have greater financial strength and capacity to develop a technology potentially disrupting NetApp s present line of business. Equity Research NTAP Page 6
DISCLOSURES & DEFINITIONS The analysts contributing to this report do not hold any shares of NTAP. The EPS and revenue forecasts are the Zacks Consensus estimates. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Outperform- Zacks expects that the subject company will outperform the broader U.S. equity market over the next six to twelve months. Neutral- Zacks expects that the company will perform in line with the broader U.S. equity market over the next six to twelve months. Underperform- Zacks expects the company will underperform the broader U.S. Equity market over the next six to twelve months. The current distribution of Zacks Ratings is as follows on the 1121 companies covered: Outperform - 15.3%, Neutral - 76.9%, Underperform 7.2%. Data is as of midnight on the business day immediately prior to this publication. Our recommendation for each stock is closely linked to the Zacks Rank, which results from a proprietary quantitative model using trends in earnings estimate revisions. This model is proven most effective for judging the timeliness of a stock over the next 1 to 3 months. The model assigns each stock a rank from 1 through 5. Zacks Rank 1 = Strong Buy. Zacks Rank 2 = Buy. Zacks Rank 3 = Hold. Zacks Rank 4 = Sell. Zacks Rank 5 = Strong Sell. We also provide a Zacks Industry Rank for each company which provides an idea of the near-term attractiveness of a company s industry group. We have 264 industry groups in total. Thus, the Zacks Industry Rank is a number between 1 and 264. In terms of investment attractiveness, the higher the rank the better. Historically, the top half of the industries has outperformed the general market. In determining Risk Level, we rely on a proprietary quantitative model that divides the entire universe of stocks into five groups, based on each stock s historical price volatility. The first group has stocks with the lowest values and are deemed Low Risk, while the 5 th group has the highest values and are designated High Risk. Designations of Below-Average Risk, Average Risk, and Above-Average Risk correspond to the second, third, and fourth groups of stocks, respectively. Equity Research NTAP Page 7