Merrill Pulls Back as Network Appliance
Story Loses Luster
By Thomas Lepri
Senior Writer
6/25/01 7:07 AM ET
You can forgive Network Appliance (NTAP:Nasdaq - news - commentary)
CEO Dan Warmenhoven if he looks a bit distracted these days. In two weeks
the company has lost more than $3 billion of market value. In the meantime,
and perhaps more significantly, NetApp has lost its biggest supporter on Wall
Street.
That supporter would be Merrill Lynch, whose computer hardware analyst
Tom Kraemer downgraded NetApp to neutral from accumulate on
Wednesday. The news was a kick in the teeth for NetApp, which had already
fallen 34% over eight trading sessions as money raced out of the once
white-hot Internet infrastructure sector.
With sell ratings rare, a "neutral" remains the
kiss of death on Wall Street, even amid the
newfound skepticism among brokerages. But
the blow was even harsher coming from
Kraemer, whose firm had built a reputation as
NetApp's most enthusiastic booster. Merrill
had co-managed a 1999 offering of 2.5
million shares, and it wasn't too long afterward that Steve Milunovich, then
Merrill's enterprise hardware analyst and already a storage bull, started
promoting NetApp to clients as a company possessing a "disruptive
technology" capable of shaking its industry at the very foundations.
Brokerages have made an awful lot of money in the past few years telling
sexy tech stories like that one. Now, with considerably less to gain, they're
starting to focus on the details. In his note Wednesday, Kraemer based his
downgrade of NetApp on his belief that price competition is heating up,
estimating that gross profit margins will fall to 53.7% in 2005 from 60.1% in
2001. And where does that put NetApp, whose price target Merrill had once
pegged at $85 a share? Kraemer came up with a fair value of $12.62 --
ironically, just 12 cents above the split-adjusted level at which Merrill priced
NetApp's 1999 stock offering. The stock closed Friday at $11.33.
It's important to note that Kraemer's calculations don't involve NetApp's
business falling apart. On the contrary, he noted that his $12.62 estimate
assumed annual sales growth of 44% through 2005 -- still a smoking pace for
a company that already has annual sales above $1 billion. What Kraemer
didn't assume was what so many people, including analysts, tacitly did in the
recent past: that NetApp could continue growing its quarterly sales above
70% -- as it did for 21 straight quarters before faltering this year -- indefinitely.
Kraemer didn't return calls seeking comment.
Everybody's Doing It
The term "disruptive technology" was coined by Harvard business professor
Clayton Christensen in his 1997 book The Innovator's Dilemma. It refers to a
technology that, though sometimes crude, is cheap enough and simple
enough to gain critical market share. Disruptive technologies, the theory goes,
attack dominant products from below. Toyota (TM:NYSE ADR - news -
commentary) did it to General Motors (GM:NYSE - news - commentary).
The personal computer did it to the mainframe. And NetApp, said
Christensen, was doing it to EMC (EMC:NYSE - news - commentary).
Back to 1997?
The rise and fall of Network Appliance stock
Here's how: NetApp makes server appliances -- mainly filers and caching
devices -- for network-attached storage, or NAS, systems. These appliances
are built to store and route data; that's all they do, and they do it well. And the
storage networks they create are relatively cheap and easy to set up and
maintain. Unlike the traditional server-attached storage, or SAS, model, NAS
detaches data storage devices from the servers that run applications for a
network's workstations. Putting storage devices directly on a network helps
alleviate bottlenecks and allows technology managers to add storage capacity
easily by attaching additional appliances to the existing network.
Christensen joined Merrill Lynch's TechBrains Advisory Board in January
2000, and Merrill's Milunovich was soon peppering investors and reporters with
research notes describing NAS as a disruptive technology. The company
itself was only too happy to appropriate this language. The "disruptive" aspect
of NAS became the justification for claims to NetApp's limitless growth
potential. It also became the standard explanation for why a much larger
company like EMC couldn't compete head-to-head with NetApp: EMC
salesmen, NetApp managers maintain, can't sell their NAS products
aggressively without threatening their core server-attached storage market.
La Grande Illusion
Milunovich ascended to the lofty role of global tech strategist in September
2000, bequeathing his ebullient coverage of NetApp to Kraemer. At that time,
NetApp was buzzing around its all-time high of $150. Now, with the huge
demand created by the dot-com explosion having vanished, Kraemer has
been left with the dirty business of ratcheting down expectations.
"The thing should have never been more than a $20 stock, even at its peak,"
says Mike Davey, an analyst at New York brokerage Investec Ernst, who has
no position in NetApp. "But people just got so insane. It had a multiple of 400,
and it wasn't even one of those dot-coms you couldn't analyze. It was a real
hardware company with real gross margins and real operating margins. You
could never in a million years justify the valuation. But it captured everybody's
imagination. It always beat the numbers. They were the poster child."
Part of the reason that NetApp, like other Internet infrastructure stocks, has
been under such intense pressure lately has to do with fears about its
short-term performance -- in particular, its fiscal first quarter, ending next
month. One sell-side analyst who has spoken with sources in the company's
sales force says that the current quarter got off to an extremely poor start,
and that management has been demanding that its salespeople become more
aggressive. The company declined to comment.
At some point, NetApp will probably come out of the current downturn. But it's
naive to think that its stock, or anyone else's, will ever return to its 1999 form.
The loss of Merrill's support this week is as clear a signal as you'll get that
those days are likely gone for good.
"It's like they're going back to 1997," says Davey. "Forget about this whole
period. It was just like an illusion." |
