Is NetApp Now a Good Investment Opportunity?

NetApp has fallen significantly this year due to losses in its OEM business, but in looking at the company as a whole, those fears might be overblown.

May 28, 2014 at 10:30AM

NetApp (NASDAQ:NTAP) is a data-storage giant, right up alongside industry leader EMC (NYSE:EMC), selling both software and hardware to a variety of customers. In 2014, NetApp has lost 12% of its valuation, and investors have become increasingly worried about IBM's (NYSE:IBM) decision to quit selling NetApp's storage hardware. However, with the company still growing -- and being extremely shareholder-friendly -- such losses might present an opportunity.

IBM making a move
NetApp is an original equipment manufacturer, or OEM, meaning it develops specific hardware to serve a purpose to meet its clients' needs. The N Series is one example, and in the past was used by IBM in its storage systems segment, a business for IBM that has fallen rapidly, including a 23% year-over-year revenue loss during the first quarter this year.

As a result of IBM's losses and its attempt to become more efficient, the company announced that it will no longer sell the N Series, and it will put more focus on selling its own hardware. IBM clearly thinks this strategy will at least stop the bleeding in its storage segment, although the company has given investors no reason to believe that it can remain competitive in this space following continuous declines.

Nonetheless, NetApp's OEM business is greatly affected due to this news -- the segment saw a 34% revenue loss during the company's last quarter, to under $110 million.

How relevant is this news?
As an investor, you never want to see a 34% cut to a segment's revenue, but if this were going to happen, it's best in OEM, a segment that accounts for only 7% of NetApp's total revenue. The majority of revenue comes from its branded business, which sells hardware and software as both products and services.

While branded revenue did fall 1% in the company's fiscal fourth quarter, it has consistently grown at a high-single-digit rate, and is expected to grow in the mid-single digits this year. NetApp and EMC were the only two major overall storage providers to see increased sales during 2013 in hardware. And with IBM's market share of the space relatively close to NetApp's -- albeit falling -- it shouldn't serve as a big surprise that Big Blue is breaking away from NetApp.

Thankfully, it appears that NetApp will do just fine without IBM. Not only is NetApp's hardware business growing, but its services segment rose 8% in its last quarter, to $378.7 million. Therefore, it's pretty well-diversified, making IBM-related fears exaggerated.

Buybacks point to the investment of choice
EMC and NetApp are the two essential investment plays in hardware storage, but both are also seeing relatively strong performance in software. These are two companies that have managed to grow market share despite the rise of cloud infrastructure. Further, this rise also gives both NetApp and EMC space to grow when they decide to enter.

With that said, which is the better investment? NetApp and EMC trade at 11 and 12 times forward earnings, respectively, with very similar dividend yields. In fact, choosing one over the other is a toss-up, but one reason investors might like NetApp is because of its buyback policy.

NetApp spent $374 million in buybacks during its last quarter and $1.88 billion in the entire year. In comparison, EMC spent a very comparable $390 million last quarter and is spending about $2 billion this year. Therefore, the programs are similar, yet EMC has 4.5 times the market cap, meaning NetApp's program is far more valuable. Moreover, as NetApp purchases more shares, its EPS rises, share count and volatility decreases, and its stock should rise.

IBM is a good example of how buybacks drive value: The company hasn't grown in five years, but because of an aggressive buyback program -- $14 billion last year -- its stock has nearly doubled during the last five years.

Final thoughts
RBC Capital recently said that the fundamental effect of IBM's decision is already priced into NetApp's guidance, meaning there shouldn't be too many earning surprises looking ahead. This fact, combined with management's generosity and the growth of its branded revenue, equals a seemingly solid investment opportunity.

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Brian Nichols has no position in any stocks mentioned. The Motley Fool owns shares of EMC and International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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