Network Appliance will bounce back
By J.P. Vicente
RedHerring.com, February 07, 2001
For a company considered to be one of the four titans of the fashionable, fast-growing storage sector, Network Appliance (Nasdaq: NTAP) has experienced a disproportional amount of pain over the past few months.
Its share price has plunged a precipitous 70 percent from its all-time high last October; a slew of sell-side analysts downgraded the stock; and theories that rival EMC (NYSE: EMC) will eat the company's lunch in the lucrative Network Attached Storage (NAS) market are quickly gaining supporters in several Wall Street quarters.
So is this the end of the love affair between investors and the storage darling? We don't think so. While we agree it will be hard for Network Appliance to maintain earnings growth rates of about 100 percent in the next few quarters due to a slowdown in corporate spending and heightened competition, we believe that the firm's long-term growth prospects remain solid.
That said, we view the recent sell-off as an opportunity for long-term investors to build positions in the stock. Network Appliance now trades at 77 times 2002 earnings estimates, well below the stratospheric P/E ratio of 256.2 it had back in October.
WARMING TO WARMENHOVEN
In a candid interview with Red Herring at last week's Merrill Lynch storage conference in Santa Barbara, California, Network Appliance's low-key CEO Daniel Warmenhoven acknowledged that the current economic slowdown is the company's biggest short-term challenge. But he said that despite the hurdles, Network Appliance is on track to meet Wall Street earnings expectations of 41 cents a share in its fiscal 2001 year, which ends in April. If Mr. Warmenhoven is right, Network Appliance will post a stunning 95.2 percent year-over-year bottom-line growth.
The company will release its fiscal third-quarter earnings results on February 8, and analysts polled by First Call/Thomson Financial expect the firm to post a 10-cent per-share profit. Network Appliance earned 6 cents a share in the same period last year. Revenues are estimated to come in at $292.7 million, compared to $151.3 million a year earlier. Mr. Warmenhoven, citing a quiet period, refused to comment on the upcoming earnings announcement.
Much of Wall Street's criticism of Network Appliance has centered on the fact that the company's revenue streams are poorly diversified and heavily dependent on money from technology, the Internet, and a few manufacturing clients. "One of the main issues for us right now is our customer base. We sell to companies like Motorola and Texas Instruments, and those guys are not buying much these days," said Mr. Warmenhoven.
Mr. Warmenhoven wants to tackle that vulnerability in the company's business plan by directing its sales force to tap into a more diversified pool of clients. The plan involves building solutions that address problems pertinent to specific vertical markets where Network Appliance's products have little presence today, such as financial services, oil and gas, retailers, airlines, and transportation.
Given Network Appliance's successful history in carving new market niches -- the boom of the NAS market itself is an impressive example -- we believe that the company has a plausible chance to widen substantially its client base over the next 12 months. On top of that, Mr. Warmenhoven said that reduced revenues resulting from slower dot-com spending has been mostly offset by increased demand from application service provider (ASP) and storage service provider (SSP) clients.
BETTER LATE THAN NEVER
Network Appliance's revenue diversification plan could not come at a better time. Despite the fact that the firm has been an early beneficiary of a dramatic shift from the traditional server-attached storage model to networked architectures, stiffened competition from latecomers into the NAS market, including storage giant EMC, represents a formidable threat to Network Appliance. EMC is currently a market leader in the higher-end Storage Area Network (SAN) market.
In a recent report, Credit Suisse First Boston analyst Amit Chopra wrote that EMC will price its products very aggressively to win share in the NAS market. "Our checks with customers suggest that EMC is often undercutting Network Appliance's prices by at least 20 percent," the analyst wrote.
Given its tremendous clout in the storage market, a wide installed base, and an aggressive sales force, EMC can also gain market share by bundling its NAS products with the company's SAN solutions. "We expect to see more of network-attached storage business in the future," says EMC's executive chairman, Mike Ruettgers. "We believe we have a chance to expand our business to have equal market share with Network Appliance [in the NAS market]," he added, but did not specify a time frame.
According to a recent study by research firm IDC, Network Appliance had a 48.6 percent share of the NAS market in 2000, down from 49 percent in 1999. Meanwhile, EMC's share of the NAS market rose to 29.4 percent from 24 percent in 1999.
Network Appliance's Mr. Warmenhoven, however, dismissed claims that competitors' products are cheaper. When comparing total cost of ownership for storage arrays, he says that solutions provided by Sun Microsystems (Nasdaq: SUNW) and EMC are roughly 2.5 times and 3 times higher, respectively, than Network Appliance's. Also, the CEO remains an NAS evangelist, saying that EMC's entry into the market represents an implicit endorsement of Network Appliance's success strategy.
Thomas Kraemer, an analyst with Merrill Lynch, agrees. As an example, Mr. Kraemer reminds us that in 1993, when Cisco Systems (Nasdaq: CSCO) enjoyed its largest year-over-year growth rates, IBM introduced its SAN hubs and routers designed to kill Cisco. "That move had just the opposite effect," he says.
ALLY AND CONQUER
We also like Network Appliance's decision to partner with Brocade Communications (Nasdaq: BRCD) and bundle that company's switches with its solutions. Network Appliance's sharp focus on software development is also a positive.
Those are the right things to do because most of the money to be made in the storage business in the future will not come from the sale of a particular architecture -- as we think NAS vs. SAN is moot point -- but from the sale of integrated, interoperable solutions.
Networking storage networks and providing intelligence to the fabric of the network are the hottest buzz phrases in this market these days, and Network Appliance's recent moves put the company in a prime competitive position. Mr. Warmenhoven, for example, lists local mirroring capabilities and SAN fabric between the systems and disks at the top of his wish list for new storage developments.
"We want to offer a solution that can provide better integration and interoperability between our products and other devices existing in a given client's network," said Mr. Warmenhoven.
With all this in mind, we think the many concerns the market has about Network Appliance are overblown.
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