DECEMBER 22, 2003
STREET WISE
By Amey Stone
Network Appliance: A Bit Too Good?
The data-storage company is going so great, some portfolio managers think it has peaked. They could be wrong
On Dec. 3, data-storage company Network Appliance (NTAP ), one of the hottest stocks of 2003, briefed analysts on its forecast for its next fiscal year. Fiscal 2005 sales would grow around 25% (most analysts were projecting 20% growth), to $1.4 billion, and earnings would come in at around 51 cents a share -- nearly 35% higher than fiscal 2004's expected results.
Nonetheless, the analyst briefing failed to reverse a slump in the stock that started after Network Appliance reported a near-doubling of profits for its second quarter of fiscal 2004 on Nov. 18. It traded as high as $26 before announcing pro forma net income of $33.6 million, or 9 cents a share (reported income was even higher due to a tax benefit), up from $17.5 million, or 5 cents a share for the same quarter a year earlier.
By Dec. 19, the stock was trading at $20, down more than 20% since the company started reporting so much good news. So what's the problem at Network Appliance?
PAST ITS PRIME? Call it too much of a good thing. When the stock was at $26, investors had scored a 160% gain since the beginning of 2003, and the share price was looking a bit overdone. It was trading at 10 times sales, when most tech stocks with the same growth projections trade at more like five or six times sales, says Omar Al-Midani, an analyst with Soundview Technology Group. It was trading at a price-earnings ratio of 64 times 2004 earnings. "Even for its growth rate," notes Al-Midani "it was really highly valued over its peers."
Network Appliance's business may also have been getting a little too good for the tastes of some investors, who worried that peak growth was priced into the stock. Not only has it held onto its leadership as a maker of midrange networked-storage appliances this year, according to market research firm IDC, but it is successfully expanding into new markets for high-end storage area networks (SANs) and low-cost disk-based backup and recovery systems.
For investors who missed out on Network Appliance's run, the December skittishness of portfolio managers may prove a buying opportunity in a few months if the company can continue to execute on its business strategy as well as it has in the past.
RED FLAG. Chances are good that it can. Lack of diversification was the key risk for Network Appliance a few years ago. "Now the company can play in almost all areas of the market," wrote IDC analyst Brad Nisbet in an e-mail interview. "The phrase 'firing on all cylinders' comes to mind."
Network Appliance has also diversified its customer base. Instead of 75% of its revenues coming from Internet and tech companies, as was the case two years ago, now just 25% comes from that group. An important growth strategy is to win a higher percentage of the amount spent on storage equipment from those new customers, says Network Appliance Chief Financial Officer Steve Gomo.
The red flag for that strategy is intense competition, say analysts. Network Appliance's 2005 forecasts assume that it won't face any pricing pressure. But Al-Midani finds it hard to believe it won't have to give just a little bit on price as it tries to sell more equipment to big companies. "The problem with Network Appliance is that if it grows just five percentage points less than expected and margins come down five points, those two things hit your earnings-per-share number by 50%," he says.
PULLING THROUGH. Gomo admits that Network Appliance's gross profit margins may slip from its current very rich 60% level to 58% or 59% in 2005. But that's not because of competitive pressures, which it has proved it can deal with handily for the past couple of years, he says. Instead, it because Network Appliance will derive a higher percentage of its revenues from services and from sales through its partners and resellers, both of which have lower gross margins, he says.
Gomo says the superiority of the software that goes into its equipment will allow Network Appliance to maintain its industry-leading margins. He's neither surprised nor worried that some investors, especially professional portfolio managers, have used December to lock in gains. He's confident they'll be back next year.
They may well be. Al-Midani admits that Network Appliance has a remarkable record of executing well on its strategy even in tough times. Look at storage king EMC (EMC ), which from the storage industry's peak sales in the fourth quarter of 2000 to its trough in the third quarter of 2001 lost more than half its revenues and halved its gross margins. In contrast, Network Appliance's revenues fell 32%, but its gross-margin decline was only 2%, says Al-Midani. Even if 2005 is a tough year for business, it's not likely to be as bad as 2001.
Current buyers should keep in mind that Network Appliance is still darn expensive. And as recent events show, a sharp sell-off could be triggered by the slightest suggestion that steep profit growth could be a little bit harder to come by in the future –- even if no evidence show that's starting to happen yet.
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Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column
Edited by Beth Belton |
