The Dow Jones Industrial Average (DJINDICES: ^DJI ) traded slightly higher in early afternoon trading, in what has been an up and down week.
What the what?
Last night after the closing bell, NetApp reported results for its fiscal fourth quarter. The company beat estimates for earnings, posting non-generally accepted accounting principles results of $0.84 per share, but missed on revenue expectations.
The company forecast fiscal 2015 revenue to decline 3% year over year, but it expects to grow earnings by 4%. NetApp's stock has had a tough run over the past three months, and investors responded to the higher than expected earnings by bouncing the stock up nearly 4% higher in Thursday trading.
Why are investors largely ignoring the miss on the top line? Partly due to much improved earnings, but it may also be because NetApp has someone to blame for the miss: IBM.
Branded versus OEM revenue
To understand how IBM fits into the picture, we have to drill down a bit into NetApp's revenue model.
The company builds and sells database management solutions -- their servers house and manage the extremely complex big data needs for largest enterprises around the world (for example, the U.S. military).
NetApp sells these solutions under its own brand name, but also allows third parties to buy NetApp goods in bulk, slap on their own logo, and then sell the product as the "original equipment manufacturer."
In the company's fourth quarter, the branded business -- in which NetApp sells its own products directly to the end user -- did quite well. Branded revenue was up 6% quarter over quarter driven by strong sales of the company's ONTAP next-generation cloud storage solution. According to CFO Nick Noviello in an interview with Barron's, the company will raise its internal expectations for growth in this sales channel.
Meanwhile, revenue on the OEM side of the company declined 30% quarter over quarter, and 34% year over year. This decline is made even more significant by the fact that indirect revenue makes up nearly 85% of the company's total revenue.
NetApp's largest OEM partner? IBM, of course.
Noviello said, "You have to look at the overall landscape of IT, and what some partners are dealing with. Our largest OEM partner who people know of is IBM. Take a look at their earnings and you can draw your own conclusions."
IBM's revenue issues have been well documented. The company is moving away from low-margin hardware businesses and toward higher-margin service and software opportunities.
The trend is representative of a shift across the entire enterprise information technology space. Dell went through a very public proxy battle last year to take the company off the public markets. Why? So that management could attempt the same transformation from hardware to software and services.
CEO Tom Georgens stated on the NetApp earnings call that the company has been expecting this decline in OEM, and that's why the emphasis has been on growing the branded business. On the surface this may seem to allay investor concerns. But given that it makes up the great majority of total revenue, the transition from OEM to branded could get ugly in the interim.
To blame IBM ignores the long-term trend
Analysts this morning pointed to NetApp's cost management and increased dividend and share buyback program as reasons to be bullish on the stock. The company's margins are impressive, and it will almost certainly continue to generate strong cash flow to fund more dividends and more buybacks.
Piper Jaffray assigned an overweight rating after the earnings call, with a target price of $39. Brean Capital recommended the stock as a buy, also with a $39 price target.
That's all well and good from a financial standpoint, but what about the business fundamentals? On the earnings call last night, CFO Noviello projected middle single-digit branded revenue growth in fiscal 2015, which could be more than offset by declines in OEM revenue of potentially 40%.
Citigroup also assigned a $39 price target, but this represents a reduction of $4 from its previous expectation. The analyst noted the revenue problems and remained neutral on the stock. I tend to agree more with Citi than with Piper or Brean.
Cost savings and financial engineering can only go so far to buoy a stock. I'm much more interested in companies with the strongest business fundamentals and even better valuations. NetApp is trading at about 20 times earnings; for a company playing the blame game to account for its negative growth, that price strikes me as being a bit expensive.
If you're looking for value, NetApp at best remains a wait and see.
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