Network Appliance ( NTAP) shares took a beating Wednesday, losing 7% of their value after a sell-side note panned the stock on a day when most tech issues did poorly. But the storage vendor's selloff may be the right medicine for an equity that even its fans were calling expensive. "At $38, this stock was priced to perfection," said T. Rowe Price analyst Chirag Vasavada. "But as it pulls back, it looks more interesting," he said in an interview. Vasavada's company did not hold shares as of the latest filing period. Indeed, since hitting a 52-week intraday high of $38.50 on April 20, the stock has depreciated by nearly 26% to $28.60 as of Wednesday's close. This week's slide was apparently triggered by Kaufman Brothers analyst Shebly Seyrafi, who published a note replete with worries, including a rising finished-goods inventory, weak channel checks in Europe, concerns about sales to the federal government and a still historically high price-to-earnings ratio. Seyrafi noted that the company's latest 10-K filing disclosed that NetApp's finished-goods inventory increased from $34 million, or 53% of inventory, in the third fiscal quarter, to $46 million, or 72%, in the fourth quarter -- the highest level since at least 2000. A more typical level is 50% to 55%, he said. Kaufman Brothers does not have an investment-banking relationship with NetApp. The company's 10-K filing on Monday also revealed that NetApp received a comment letter from the Securities and Exchange Commission relating to a "routine review" of company filings. The disclosure may also have contributed to Wednesday's selloff, said Baird analyst Daniel Renouard. However, he said the letter appears to be a standard inquiry regarding accounting practices typically received every few years by all companies and "unrelated to option-granting practices. Thus we view it as a non-issue," he said in a note to clients.
Renouard, whose company does not have an investment-banking relationship with NetApp, said the finished-goods inventory build appears related to new-product launches and not to softening demand. He said the current weakness in the stock is "related to mostly spurious issues" and added that the downturn "presents a more attractive entry point." Analysts have been concerned about the company's lofty valuation, particularly when the expense of employee stock options is factored in. On that basis, NetApp is trading at about 43 times 2007 earnings (before Wednesday's slide), compared with 15 times for rival EMC ( EMC), according to Seyrafi. Offsetting that concern for some has been the company's surging top-line growth. In the last two reported quarters, revenue grew by better than 30%, and the company's guidance for the current quarter calls for revenue to increase by 36% to 39% from a year earlier. This growth rate is all the more impressive when compared with the industry's rather anemic compound growth rate of 5.4% for the next five years, says IDC storage analyst Brad Nisbet. The market for external storage systems, the heart of the storage business, is expected to grow to $22.7 billion in 2010 from $17.4 billion in 2005, according to IDC. Although NetApp's forecast may sound aggressive, Loomis Sayles analyst Tony Ursillo said "they set a conservative level of guidance for sales and margins. In the past, though, management let expectations get ahead of reality, and that was a stumbling block." His company is one of NetApp's largest shareholders. Reining in its guidance is just one of the changes that has made NetApp an attractive buy. Once a provider of relatively low-end hardware for network-attached storage, the Sunnyvale, Calif., company has made a number of well-regarded acquisitions and a strategic alliance with IBM ( IBM), moves that have given it the chops to compete for business in the lucrative storage area network market.
The relationship with IBM, which is also a competitor, has given NetApp access to corporate data centers, where the largest deals can be found. Meanwhile, the company has moved into storage software, which enables it to sell even more products into its installed base, says Nisbet. The company has also broadened its hardware line, offering both high-capacity and high-performance drives in the same storage device, he says. And in May, NetApp launched a new line of high-end storage devices aimed at competing with EMC's ( EMC) flagship Symmetrix line and Hitachi Data Systems' ( HIT) TagmaStore platform. There's some disagreement about whether the new products are really in the same class as its rivals -- Enterprise Strategy Group storage analyst Tony Asaro says they are not -- but it is clear that NetApp is moving up the food chain in a manner that bears watching. IDC's Nisbet says it is too early to know if NetApp is winning high-end share from EMC with its new products, but the company's ability to offer a varied product line built on a single operating system is a big plus.