Merrill Pulls Back as Network Appliance Story Loses Luster

You can forgive Network Appliance (NTAP Quote) 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 Quote) did it to General Motors (GM Quote). The personal computer did it to the mainframe. And NetApp, said Christensen, was doing it to EMC (EMC Quote).

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."