DELL - NetApp: Macro Headwinds Make Me Cautious

2023-10-20 10:54:15 ET

Summary

• NetApp is facing challenges in the enterprise IT spending environment, including reduced budgets and competition.
• The company's performance in the Hybrid Cloud sector is strong, but Public Cloud growth is facing challenges.
• The storage sales market is tightening, but there is potential for a rebound in 2024 with AI and multi-cloud solutions.

Thesis

NetApp, Inc. (NTAP) is grappling with a subdued enterprise IT spending environment. While I like the company's unique cloud offerings and its dominance in AFA for on-site solutions, it faces challenges, including reduced enterprise IT spending, optimization of storage budgets, and limited market share gains due to competitors' resurgence. Currently, NetApp's stock trades at a 13x forward PE multiple, consistent with its historical average, and I don't see significant triggers for a stock reevaluation in the near-term, which is why I currently assign a hold rating to the stock.

Company Description

NetApp is a leading provider of networked storage solutions addressing both the SAN and NAS markets, providing unified storage systems that support both FC/iSCSI SAN attachment as well as the company's core competency in Network Attached Storage (NAS, IP-attached). The company was a pioneer of the network attached storage, or NAS, market. NAS is a file-level networked storage topology that allows servers to share a pool of storage resources over the Ethernet network. NAS transfers data at a file level (based on the CIFS and NFS protocols), while the SAN market transfers data at a block level and utilizes the dedicated FC or iSCSI-based network, and now the emerging Fibre-Channel over Ethernet (FCoE) protocol. In 2016 the company acquired SolidFire, a provider of all-flash storage.

F1Q24 Review & Outlook

NetApp reported strong F1Q results, with revenues and earnings surpassing expectations and a positive F2Q forecast. However, while the company's performance in the first half of the fiscal year was commendable, it did not revise its projections for the full year. This indicates that despite a robust performance in Hybrid Cloud, Public Cloud is facing challenges. This is evident from the Public Cloud ARR's modest growth and a decline in subscription services. Consequently, NetApp has revised its Public Cloud growth estimates for FY24 and is now reassessing its Cloud Portfolio to enhance its primary services and subscription performance. Details of this review will be shared in F2Q. On a brighter note, the strong performance of Hybrid Cloud is anticipated to persist throughout the year, balancing the revenue challenges from Public Cloud. Despite NetApp shares trading below their historical average, I remain cautious for now given the uncertain IT spending environment, especially in storage, and the ongoing review of the Cloud Portfolio.

NetApp Storage Sales Tighten but AI Could Catalyze 2024

In 2023, enterprise storage sales are expected to decline due to shrinking corporate IT budgets driven by recession fears. NetApp is expected to be impacted due to this. The decline might have been steeper if not for the conversion of backlog orders into sales; however, this advantage is expected to lessen in the second half of the year. While there's a growing preference for all-flash-arrays ((AFA)) among customers, this segment is not exempt from the overall reduced IT spending. AFA sales are projected to remain stagnant in 2023, impacting the sales trajectory of NetApp.

To sum it up, NetApp is bracing for subdued demand in the enterprise storage sector due to economic uncertainties leading to tightened IT budgets. That said, the market might witness a revival in 2024, with AI and multi-cloud solutions potentially driving increased sales.

Multi-cloud deployments are an emerging secular driver for a storage-investment rebound in 2024. Although 2023 could be a down year for storage systems, companies will need to spend to at least add capacity to support data growth, in my view. I believe that due to cost considerations, businesses may reconsider their cloud strategies, potentially shifting some applications and data back to their private and shared data centers. This could lead to increased investments in on-site storage capacity, favoring industry frontrunners. Although the shift will be gradual, hyperscale cloud providers will remain integral to multi-cloud strategies. Companies like NetApp, Pure Storage, Inc. ( PSTG ), and Dell Technologies Inc. ( DELL ), which offer systems or management tools that seamlessly integrate cloud and on-site platforms, stand to gain from this shift.

AI Remains a Catalyst for NetApp

Top all-flash-array ((AFA)) such as NetApp is poised to benefit significantly from the surge in artificial intelligence workloads in both public and private clouds. As AI, especially large language models (LLMs), demands more storage to maintain accuracy, storage will become a dominant component of AI infrastructure. Owing to the need for quick access and consistent availability in AI and machine learning, flash storage emerges as the sole viable storage solution. There are opportunities in the public cloud for AFA providers, exemplified by Pure Storage's integration in Meta's AI Research SuperCluster. This model could set a precedent for other AI storage applications. In the long run, due to considerations like cost and security, I anticipate a shift of some AI tasks to on-premises setups, providing an additional sales boost for AFA suppliers.

Financial Outlook & Valuation

NetApp is navigating a tough enterprise IT expenditure landscape, potentially making sales growth in fiscal 2024 a challenging endeavor. The company could experience delays in upgrades due to uncertainties in cloud investments, and its cloud software sales might be impacted by corporate cloud optimization strategies. Nonetheless, the mounting requirements for data could push the need for increased capacity, hinting at a potential recovery in the second half. NetApp's growing portfolio of all-flash-array products and cloud data services is poised to boost its gross margin. Coupled with recent organizational restructuring, this could help maintain its operating margin and result in a slight EPS growth.

NetApp's stock is currently trading at a 13-14x multiple, consistent with its historical average. I don't foresee significant factors that might lead to a reevaluation of its stock, while concerns about potential downside remain due to the current macro-environment. Hence, I remain cautious for now and assign a buy rating to the stock.

Investment Risks

There's potential for enterprise spending to decline more than anticipated. While I currently expect flat to minor growth in enterprise expenditure for 2023, any downward deviation from this could negatively impact the stock price. Additionally, heightened competition, especially with Dell's aggressive positioning of its midrange storage products and HPE's consolidation around its rapidly growing Alletra series, could pose challenges for NetApp.

Conclusion

NetApp is navigating a challenging landscape due to decreased enterprise IT spending. Cloud investment uncertainties could lead to upgrade delays, and the company's cloud software sales may be affected by corporate strategies to optimize cloud usage. Currently, NetApp shares are trading at a 13x forward PE, in-line past performance, I don't anticipate any catalysts in the near-term that would prompt a re-rating of the stock. Hence, I currently assign a hold rating to the stock.

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