Description

NetApp, Inc. (Ticker: NTAP) is a mid/large-cap, hybrid cloud data services company that provides software, services, and products for managing applications and data in public and private clouds. NTAP is a solid cloud franchise positioned to ride the tailwinds of strong growth of the cloud.

With reduced business visibility arising from covid-19, this writeup is not so much a detailed vision for the near-term, but more a macro industry view based on favorable market dynamics that benefit a cheap, high-quality business, with a historical track record of success.

Some will be unhappy with this approach, arguing historical earnings and cash flows are irrelevant during a pandemic, since future earnings and cash flows will do unpredictable things. As the argument goes, “the virus changes things, and you can’t rely on what happened in the past.”

But we think this is always the argument against value stocks. That is, you can’t rely on past fundamentals, because something is broken with this firm. There is more bad news on the way, expectations are low, and there are good reasons why it’s cheap. But while it’s true that the pandemic clouds future forecasts, we argue that historical earnings and cash flow continue to provide a good basis for thinking about valuation. Historical earnings reflect earnings power. And we are looking at earnings power in a relative sense, i.e., how cheap is it compared to other firms? Many firms have been affected by the pandemic. Is there a reason to think that the pandemic will affect future prospects more for this firm than those of the average firm? With a low P/E & TEV/EBIT, NTAP is certainly cheap on a relative basis, as it is cheaper than 95% of our investable universe of stocks > ~$1bn market cap+ and meeting certain criteria for distress, liquidity and other factors. Based on its strong historical performance, cash flow, and margins, and low relative valuation, we believe NTAP is interesting.

Cloud Deployment

There are several broad categories that describe the deployment of cloud computing solutions. They can be simplified into 4 areas: 1) public, 2) private, 3) hybrid, and 4) multi-cloud.

The public cloud refers to computers hosted at a data center managed by a third party. Amazon Web Services (AWS) is an example of a large public cloud service provider. AWS is great for businesses who are just getting started, because it’s an affordable solution for the little guy.

Pay-as-you-go cloud computing can shift IT spend from capex and the balance sheet over to opex and the income statement. But the public cloud is not always cheaper, since applications with predictable demand might be more economical to run in-house. If usage is heavy and steady, businesses may opt for the private cloud, in which dedicated servers are owned and maintained by the organization. In the private cloud, servers are accessible by only one organization, so that can enhance control, security and performance. But in general, the private cloud is more expensive, at least until you achieve a degree of scale. As with the public cloud, private clouds can be managed by a third party. Hewlett Packard Enterprise (HPE) is an example of a private cloud vendor, offering customized private cloud solutions.

The hybrid cloud is a combination of public and private clouds, with some integration between them. A typical hybrid cloud arrangement might consist of servers built and managed by a firm in the private cloud, which then integrate with public cloud resources to serve enhanced workloads, or to address non-sensitive long-term storage needs. The hybrid cloud could also be appropriate for disaster recovery, for instance, or to avoid certain hardware costs. Finally, multi-cloud involves the use of multiple cloud service providers, in order to reduce reliance on a single vendor.

Public and Private Cloud Market Growth

The market for cloud computing is growing at high rates. The public cloud is larger and growing more slowly, while the private cloud is smaller and growing more quickly.

Gartner estimates the global public cloud market in 2020 at $265 billion, growing to $354 bn by 2022, a CAGR of ~16%. Grand View Research estimates that it will reach ~$450 bn by 2025, for a 15% CAGR. The largest component of new cloud growth is associated with Software as a service, growing at ~14%-15%, and Infrastructure as a service is growing the fastest, at rates of >20%.

Grandview estimate the global private cloud market in 2020 at $60 bn, and that the market will grow to ~$100 billion in 2022, and $205 billion by 2025, representing a CAGR of approximately 28%. The majority of the growth will come from third party hosted providers, with data security, disaster recovery and mobile workforce driving most of the growth.

These estimates should be taken with a grain of salt, as they were made before the impact of the pandemic could be assessed, but the world’s move into the cloud is a trend that will clearly continue. This is growth you want to be a part of.

NTAP, the Cloud, and the Pandemic

NTAP is a leading hybrid cloud data services company, and has strong offering in the market for private and public cloud services. It’s important to differentiate between how the cloud is affected by the pandemic versus other industries. NTAP doesn’t operate directly in portions of the economy that have been hardest hit by the pandemic, such as, say, air travel, energy, entertainment, hospitality, tourism or retail, which involve public spaces or crowds; these firms are looking at 20%-30% drops in their revenues. That’s not true for NTAP. We believe that in contrast to these businesses, NTAP’s cloud markets should be comparatively insulated from pandemic effects. Yes, some of these businesses are customers or prospects, who will postpone infrastructure and software upgrades, but we argue that the secular shift to digital and the cloud is clear, and that Covid-19 is actually accelerating many trends towards cloud-based services, such as remote work, virtual desktop infrastructure environments, and video conferencing. Given that NTAP has a reasonable footing in growing cloud markets insulated from direct pandemic effects, let’s look at some key historical fundamentals.

Free Cash Flow

NTAP is a free cash flow machine, having generated ~$1 billion of FCF over the past year (including ~$380mm in the most recent quarter, representing 26% of revenues), and $8.3 bn of FCF over the past 8 years. We believe a firm’s long-term free cash flow on assets indicates its ability to generate cash on its investments over a business cycle. With assets of $7.5 bn, NTAP has earned substantially more FCF than its assets over that period, which is a strong signal that it has been successful in generating FCF in excess of its capital expenditures. In the last 12-months, FCF was 12.4% of Assets. This is an unusually high relationship of FCF to Assets and this is superior to some well-known tech names, including NVIDIA Corporation, VMware, Microchip Technology, Citrix Systems, and others.

Margins

NTAP has strong, growing, predictable and stable gross margins. NTAP’s LTM gross margins were 67%, and the company has grown gross margins in each of the past four years, and in seven of the past eight years. Notably, the software maintenance segment, which constitutes 19% of revenues, has ultra-high gross margins (>95%) and grew at 9% LTM. Over the past eight years, the company has grown gross margins by an average of 4.3%. This demonstrates that NTAP may have pricing power in its markets.

Return on Assets and Capital
Assets generate future cash flows, and firms create value when those cash flows are sustained and exceed the cost of capital. We look at long-term (8 yr) returns on assets to try to smooth peaks and valleys over a typical business cycle. NTAP had long term (8 yr) Return on Assets of 6.2%, not earth-shattering, but solid.

Capital is required to operate a business, and high returns on that capital reflect pricing power and competitive advantages. A company that can earn sustained high returns on capital should be able to distribute capital earned in excess of the financing costs of that capital. We believe a strong long-term measure of ROC can help predict future ROC. NTAP’s long-term (8 yr) Return on Capital was 15.7%, additionally, NTAP’s ROC increased over the past year versus the prior year.

Solid Fundamentals

Over the past year, NTAP had ROA of 10.9% and FCF/Assets of 12.4%, both of which were higher than the previous year. Over the past year, the company’s net income exceeded its cash flow from operations, suggesting it is not using accruals, which we consider an accounting red flag. Last year, gross margins increased by 2.8%. NTAP’s turnover ratio (sales/assets) increased last year, indicating greater productivity of its asset base. We think these metrics indicate operational momentum which, ceteris paribus, is desirable.

NTAP has shareholder friendly managers. Last year, NTAP paid out almost 50% of its FCF to shareholders in the form of dividends. Over the past 12 months, the company has been a net repurchase of stock, and over the past couple of years, NTAP has repurchased $3.5 bn of stock, although they are pausing their buyback program.

Summary

In a pandemic, it's hard to be confident about forecasting accuracy in the near term. But we believe the broad-based cloud and remote access software trends in place before the pandemic will remain in place going forward. And there is room to run. The themes of digital transformation, data analytics, automation, security, reliability, flexibility, interoperability, remote workforce, and more continue to drive increased cloud usage. There is a lot of opportunity for cloud companies and NTAP seems relatively cheap.

Catalyst

- Continued cloud growth

- Continued strong FCF, margin growth

- High returns on capital and assets