NTAP: Initiating Coverage With An Accumulate (2H)
Salomon Smith Barney
Tuesday, November 30, 1999
--SUMMARY:--Network Appliance--Computer Storage
*We are initiating Network Appliance with a 2H (Outperform, High Risk)
and a $145 12-month price target.
*NTAP is the marquee Network Attached Storage (NAS) company with an
estimated 46% market share and a clear product lead over competition.
*We Project NTAP's revenues will grow to $523.0 million, representing
80.7% y/y growth, this year (F2000); and $835 million, representing
59.7% y/y growth in F2001.
*Our EPS projections for F3Q00 and F4Q00 are $0.20 and $0.23,
respectively. Our fully diluted EPS projections for F1Q01, F2Q01,
F3Q01 and F4Q01 are $0.23, $0.26, $0.28 and $0.32, respectively. Our
FY2001 EPS estimate is $1.10, representing a 39.9% y/y increase.
*We are very excited about NTAP's long term growth prospects.
--EARNINGS PER SHARE--------------------------------------------------------
FYE 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year
Actual 04/99 EPS $0.10A $0.11A $0.12A $0.13A $0.46A
Previous 04/00 EPS $N/A $N/A $N/A $N/A $0.79E
Current 04/00 EPS $0.16A $0.19A $0.20E $0.23E $0.79E
Previous 04/01 EPS $N/A $N/A $N/A $N/A $1.10E
Current 04/01 EPS $0.23E $0.26E $0.28E $0.32E $1.10E
Previous 04/02 EPS $N/A $N/A $N/A $N/A $N/A
Current 04/02 EPS $N/A $N/A $N/A $N/A $N/A
Footnotes: NTAP end its fiscal year on an April quarter.
--FUNDAMENTALS--------------------------------------------------------------
Current Rank........:2H Prior: Price (11/29/99)....:$133.18
P/E Ratio 04/00.....:168.6x Target Price..:$145.00 Prior:No Change
P/E Ratio 04/01.....:121.1x Proj.5yr EPS Grth...:0.0%
Return on Eqty 99...:N/A% Book Value/Shr......:N/A
LT Debt-to-Capital(a)0.3% Dividend............:$N/A
Revenue (00)........:523.00mil Yield...............:N/A%
Shares Outstanding..:84.0mil Convertible.........:No
Mkt. Capitalization.:11187.1mil Hedge Clause(s).....:
Comments............:(a) Data as of the most recently reported quarter.
Comments............:
--OPINION:------------------------------------------------------------------
COMPANY OVERVIEW
----------------
In 1992, Network Appliance helped originate Network Attached Storage
(NAS) which has evolved into today's fast growing market expected to
reach $562.5 million in 1999 (as measured by hard disk drive NAS
revenues). Although Network Appliance may not have been the sole
inventor of the NAS concept, it has certainly been the marquee NAS
company with an estimated 46% market share today and a clear product lead
over competition.
Network Appliance's strategy to remove the I/O burden of file accessing
from application servers with a separate dedicated file storage appliance
that connects directly onto the Local Area Network (LAN) has developed a
storage market that has caught the eyes of investors and competing
storage vendors alike. Network Appliance's Filers have quietly been
increasing their features/functions and migrated into the data centers of
many corporations and ISPs, including 3Com, Adobe Systems, Tripod, John
Deere, NationsBanc, and GTE.
Network Appliance's NAS approach reduces the cost and complexity of
managing mission-critical data. We believe Network Appliance has
strategically positioned itself to be one of the leading beneficiaries of
today's information boom by providing simplified data storage and
management.
WHAT IS NAS?
------------
Network Attached Storage (NAS) is a storage networking architecture that
allows storage subsystems to connect directly onto the existing computing
network, the Local Area Network (LAN). Traditional storage subsystems
attach to the back end of servers (called server-attached) and have used
costly application server capacity to transfer files from storage devices
to clients (desk top computers). This "application server tax" is
avoided in the NAS architecture by attaching a smaller, less expensive
server (called a thin server) to a disk subsystem and directly attaching
the combined subsystem (referred to as a NAS appliance) onto the LAN;
thus forgoing the traditional dependence of file access on application
servers.
Through the NAS architecture, storage subsystems gain access to multiple
hosts (both servers and desktops). The key customer needs that NAS is
specifically designed to address are: 1)lower storage management costs by
simplifying the storage process and 2)achieve heterogeneous connectivity,
thereby, enabling file sharing across multiple platforms and lowering the
overall cost of storage management.
COMPETITIVE POSITIONING
-----------------------
Network Appliance has effectively positioned itself as the number one NAS
company by consistently offering reliable products that are easy to use.
In 1992, Network Appliance gained its foothold in the computer storage
subsystem market by offering simplified storage subsystems targeted at
the departmental and working group levels of technology companies.
Network Appliance has rapidly evolved to an estimated $523 million in
revenues in fiscal 2000 (ending April) while many competitors have
struggled. Network Appliance has also been able to leverage its NAS
solutions into larger accounts. Recently Network Appliance has had some
large account wins including: 3Com, Adobe Systems, Tripod, John Deere,
NationsBanc, and GTE.
International Success:
Network Appliance has been experiencing exceptional international growth,
which currently accounts for 30% of revenues. This rapid growth has been
fueled by the natural fit between Network Appliance's products and
international customer demands.
Recent downturns in international economic conditions have refocused
international customer needs to: simplicity, price and performance. One
of the first things to go when companies begin to cut budgets is IT
spending. Couple a shrinking IT budget with explosive data growth and
the demand for less expensive solutions that do not require increased
manpower increases significantly. These conditions make Network
Appliance a natural fit.
We feel this is one of the large reasons why NAS, in particular Network
Appliance, has really taken off in the last year.
Customer Centric Business Model
Network Appliance segments its target market into 1)understanding the
customer and 2)delivering a product that satisfies customer needs. In
our view, Network Appliance's customer centric business model, followed
by its solid and consistent product delivery, has embedded it as one of
today's fastest growing companies. We believe Network Appliance will be
able to successfully leverage its NAS focus into larger account wins and
continued revenue growth as a result of its already diverse and loyal
customer base.
EXPANSION STRATEGY
------------------
Increased Capacities
Network Appliance's decision to go from a SCSI based NAS appliance to a
Fibre Channel based NAS appliance has enabled it to triple its available
capacities from approximately 0.5 terabytes a year ago to approximately
1.5 terabytes today. In the future Network Appliance will be using 36
gigabyte Fibre Channel drives (today it uses 18 gigabyte Fibre Channel
drives) which will enable it to offer up to 3 terabyte capacities by
C1Q00 and up to 6 terabyte capacities by the end of 2000.
We believe Network Appliance's ability to increase its storage
capacities will be an essential contributor to its strategy to move
further into data centers; thereby, expanding its potential addressable
market.
Pricing Strategy
Network Appliance's competitive pricing strategy has increased its
market footprint by reducing up-front storage costs. Network Appliance
expects to maintain current pricing levels of its highest capacity
product, while reducing lower capacities by as much as 50% for each
generation. This would mean that tomorrow's high-end product would cost
the same as today's high-end product, but with increased
features/functions. Also, today's high-end product would be reduced in
price by 50% when the new generation was released. (Network Appliance
anticipates having 15-18 month product cycles.)
The bottom line is that Network Appliance wants to maintain its
price/performance lead over competing NAS products as well as competing
non-NAS storage subsystems.
RECENT QUARTERLY RESULTS
------------------------
Network Appliance reported F2Q00 revenues of $124.7 million for the
period ending October 29, 1999, representing an increase of 90.0%
year-over-year and 20.8% sequentially. Net income for the quarter
increased 90.1% year-over-year to $16.0 million or $0.19 per share,
consensus estimates expected $0.17 per share. Gross margins for the
quarter were an impressive 58.7%.
The company sighted the Internet as one of the largest contributor's to
revenue growth in the quarter. Other key areas of growth were software,
accounting for 14% of revenues, and international expansion (specifically
Europe and Asia), accounting for 28% of revenues. Fibre Channel products
accounted for over 90% of systems revenues for the quarter, representing
shipment of over 1,100 units in the quarter.
Network Appliance's Average Selling Price per unit (ASP) increased from
approximately $70,000 a year ago to approximately $80,000 with a trend
toward shipping multiple units per sale.
We believe these trends are all positive and give further support to our
enthusiasm for Network Appliance's future.
RISKS
-----
Network Appliance is still a relative small company in a developing
market. There are many risks associated with current market demographics:
Reliance On Higher Capacity Products:
In order to achieve projected revenue growth rates, Network Appliance
must increase its current capacity limitations of approximately 1.5
terabytes. Without the expansion of Network Appliance's product line,
its market potential could be significantly reduced from current
projections.
In order to scale its current Filers to larger capacities, Network
Appliance will have to rewrite its current software filing system to
handle the increase. We believe this is a major undertaking and one that
should be noted as a potential risk which may delaying larger capacity
product introductions. Management has assured us that production of the
new software is on schedule and we have no reason at this time to doubt
current product launch schedules.
We feel the company has a clear product roadmap and will be able to
deliver higher capacities, almost tripling current levels, within the
next year.
Reliance On Ethernet
Since Network Appliance attaches directly to the LAN, or Ethernet, it may
overburden the LAN when performing large tape back-ups. Ethernet is
designed to transmit small packets of data.
Network Appliance has historically overcome this obstacle by attaching a
Fibre Channel SAN, offering tape back-up, to the back-end of its Filers.
Fierce Competition
With success comes competition. Network Appliance's success has
attracted many new, larger competitors to enter the NAS market, such as
EMC. Also, companies such as CrosStor have entered the NAS market from
the software side looking to level the playing field for Network
Appliance's competitors by offering a robust NAS file system.
We believe EMC will be able to capture a fair amount of the NAS market
share within the next two years. However, we believe Network Appliance
will continue to lead the NAS market for at least another year.
Scaling A NAS To A SAN Could Lead To Complication
As Network Appliance moves its NAS architecture into a SAN architecture
as it scales, Network Appliance's products lose their simplistic
appeal. We believe this obstacle would be a good problem for Network
Appliance to have. It would mean that the company successfully entered
the higher-end storage market. In fact, we believe the ability to scale
a NAS to a SAN improves the value of the NAS architecture. In our view,
this is one of the ways SANs will evolve.
TARGET MARKET
-------------
Network Appliance has three product categories: Filers, representing 80%
of F2Q00 revenues; Caching products, representing 6% of F2Q00 revenues;
and software add-ons, representing 14% of F2Q00 revenues (the latter of
which we could not find industry analysis).
Projections
Dataquest estimates the overall NAS market will grow from $562.5 million
in 1999 to $6.7 billion in 2003, representing a 75.2% CAGR. Network
Appliance is focussed on the departmental enterprise (D/E) segment, or
high-end segment, of the NAS market which is expected to grow from $511.8
million in 1999 to $4.8 billion in 2003, representing a 66.0% CAGR.
CACHING PRODUCTS
Network Appliance's caching products have been increasing in importance
as the Internet gains mass. Caching products are currently a small
portion of Network Appliance's business accounting for between 4.5% and
7.5% of overall revenues over the past 18 months.
Dataquest estimates the D/E caching market will grow from $59.4 million
in 1999 to $1.2 billion in 2003, representing a 113.0% CAGR.
OUR PROJECTIONS
---------------
We Project Network Appliance's revenues will grow to $523.0 million, or
growth of 80.7% year-over-year, this year (F2000); and $835 million, or
growth of 59.7% year-over-year, in F2001.
Our revenue growth rates are in line with consensus numbers and company
guidance, but below the overall NAS market growth rate. Our revenue
growth rates may seems conservative in light of Dataquest's projections;
however, we believe our estimates are warranted as a result of the
uncertainty currently surrounding the NAS market, such as: 1)customer
adoption rates of NAS are very difficult to predict, 2)it has not been
proven that the NAS architectures can scale to support large data
centers, and 3)competition in the upcoming years will be significant.
Our fully diluted EPS projections for F3Q00 and F4Q00 are $0.20 and
$0.23, respectively. Our fully diluted EPS projections for F1Q01, F2Q01,
F3Q01 and F4Q01 are $0.23, $0.26, $0.28 and $0.32, respectively. Our
full year F2001 EPS estimate is $1.10, representing a 39.9%
year-over-year increase.
We assume minor gross margin erosion over the next two years moving from
58.6% gross margins this year (F2000) to 57.0% gross margins in F2002.
We believe Network Appliance has been able to attain recent gross margin
levels due to the lack of competition in the NAS market. As competition
increases, we expect margins will come in a little. However, we do not
expect price to be a major competing factor (EMC historically has not
used price to gain market share and we do not expect it to undercut
prices in the NAS market).
VALUATION
---------
We are initiating Network Appliance with a 2H (Outperform, High Risk) and
a $145 12-month price target. We have based our conclusions on our
belief that:
ú Network Appliance is a clear market leader in an exploding market; the
company has an estimated 46% market share,
ú Network Appliance has at least a one year lead over competition,
ú Network Appliance has a top notch management team,
ú Network Appliance has a clear future product road map to stay in the
number one position in its market,
ú we believe there is upside to our estimates,
ú Network Appliance merits a premium valuation similar to that accorded
other technology market leaders.
Price PE/Growth
CSCO $92.75 3.14
DELL $43.75 2.05
EMC $88.50 1.86
MSFT $91.90 4.20
SUNW $136.81 3.39
ORCL $72.56 3.16
NTAP $133.19 2.71
Source: Salomon Smith Barney and First Call.
Network Appliance is trading at a discount to the average technology
leaders multiple to growth: forward 12 month PE multiple/(trailing 12
month EPS to forward 12 month EPS growth). We believe Network Appliance
is a clear market leader and deserves the corresponding multiple to
growth rate. We have assigned a 2.96 multiple to growth rate to Network
Appliance in order to bring it inline with other technology market
leaders. This brings us to our $145 price target which translates into
an 110x multiple on forward 12 months EPS, 12 months from now. |
